The most common stock options are known as “at the money” options, which let you buy the company’s stock at the price that it had on the day of the grant. They’re valuable only if the stock price rises after you get them. The companies involved in the recent scandal were backdating options to a time when the stock price was lower, making them immediately lucrative. As it happens, companies are perfectly free to issue options priced below the current market: those are called “in the money” options, and they’re worth something right when they’re issued. (If you’re given an option with a strike price of ten dollars when today’s stock price is fifteen dollars, each option can yield an immediate profit of five dollars.) But there’s a rule that companies have to follow when they issue “in the money” options: they have to disclose it in their financial statements. The backdating companies broke this rule: they reported how many options they were issuing, but conveniently omitted the fact that they had been backdated … The bigger reason for choosing to backdate is to get around some bothersome accounting regulations. Until recently, the regulations distinguished, for no good reason, between in-the-money and at-the-money options. In-the-money options—but not at-the-money options – had to be recorded as an expense, which drove down reported earnings. Backdating allowed companies to reward employees with in-the-money options while getting the favorable accounting treatment of at-the-money options.
The “rule” was APB 25, which has been replaced by SFAS 123:
In 1993, FASB issued an exposure draft that would have required companies to report the value of stock option grants issued to employees as compensation expense in the year the grant was made. It was met with resounding opposition. Detractors claimed that the dramatic hit to earnings would have detrimental effects on competitiveness and innovation. The final regulation, SFAS 123, merely encouraged companies to adopt this reporting approach, while continuing to allow reporting under APB 25 rules so long as footnotes contained a pro forma presentation of earnings as if SFAS 123 had been adopted. The APB 25 rules required compensation expense to be reported only if the exercise price was less than the extant stock price at date of grant. In most cases, options are granted with an exercise price at or above the current stock price. The result was that most companies did not report stock option expense on the income statement.
APB 25 allowed companies to report the “intrinsic value” of options and omit the value derived from the “head I win, tail you lose” aspects of options, which could sizeable for volatile stocks. Backdating was a gimmick to hide even the intrinsic value of granting options. Yet another reason why APB 25 should have been discarded years ago. Which reminds me of yet another reason Joe Lieberman should not be in the Senate.