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In essence, the revision enabled companies to increase executive compensation without informing their shareholders if the compensation was in the form of stock options contracts that would only become valuable if the underlying stock price were to increase at a later time.In 1994, a new tax code (162 M) provision declared all executive income levels over one million dollars to be “unreasonable” in order to increase taxes on all applicable salaries by removing them from their previous tax-deductible status.To avoid having to pay higher taxes, many companies adopted a policy of issuing “at the money” stock options in lieu of additional income, with the idea that the executive or employee would benefit through the option by working to increase the value of the company without exceeding the one million dollar deductibility cap for executive income.
It allegedly failed to inform investors, or account for the options expense(s) properly.
If a company grants options on June 1 (when the stock price is 0), but backdates the options to May 15 (when the price was ) in order to make the option grants more favorable to the grantees, the fact remains that the grants were actually made on June 1, and if the exercise price of the granted options is , not 0, it is below fair market value.
Thus, backdating can be misleading to shareholders in the sense that it results in option grants that are more favorable than the shareholders approved in adopting the stock option plan.
Corporations, however, have defended the practice of stock option backdating with their legal right to issue options that are already in the money as they see fit, as well as the frequent occurrence in which a lengthy approval process is required.
In 1972, a new revision (APB 25) in accounting rules resulted in the ability of any company to avoid having to report executive incomes as an expense to their shareholders if the income resulted from an issuance of “at the money” stock options.
While this conclusion is logical in cases of options backdating in which executives knowingly participated in the criminal actions, options backdating can be a result of normal accounting or corporate policies that are not criminal in nature, and is a legal practice as long as the backdated contract is appropriately reported for tax purposes.