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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.
ESOs are usually granted at-the-money, i.e., the exercise price of the options is set to equal the market price of the underlying stock on the grant date.
The company would then grant the option but date it at or near its lowest point.
This is the granted option that would be reported to the SEC.
The number of shares subject to option was 250,000 and the exercise price was (the trough in the stock price graph below.) Given a year-end price of , the intrinsic value of the options at the end of the year was (-) x 250,000 = ,750,000.
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.Using the executive stock option (ESO) backdating scandal as a backdrop, this paper examines whether compensation committees can effectively set executive compensation contracts in the presence of a founding CEO.