Unfortunately, these conditions are rarely met, making backdating of grants illegal in most cases.Further, at-the-money options are considered performance-based compensation, and can therefore be deducted for tax purposes even if executives are paid in excess of million (see Section 162(m) of the Internal Revenue Code).However, if the options were effectively in-the-money on the decision date, they might not qualify for such tax deductions.In comparison, had the options been granted at the year-end price when the decision to grant to options actually might have been made, the year-end intrinsic value would have been zero.Backdating does not violate shareholder-approved option plans.The Wall Street Journal (see discussion of article below) pointed out a CEO option grant dated October 1998.
However, under the new FAS 123R, the expense is based on the fair market value on the grant date, such that even at-the-money options have to be expensed.) Because backdating is typically not reflected properly in earnings, some companies that have recently admitted to backdating of options have restated earnings for past years. The exercise price affects the basis that is used for estimating both the company's compensation expense for tax purposes and any capital gain for the option recipient.Thus, an artificially low exercise price might alter the tax payments for both the company and the option recipient.Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options.An example illustrates the potential benefit of backdating to the recipient.
Most shareholder approved option plans prohibit in-the-money option grants (and thus, backdating to create in-the-money grants) by requiring that option exercise prices must be no less than the fair market value of the stock on the date when the grant decision is made. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant.(Under APB 25, the accounting rule that was in effect until 2005, firms did not have to expense options at all unless they were in-the-money.