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Many companies' stock option plans provide that stock options must be granted at an exercise price no lower than fair market value on the date of the option grant.
If a company grants options on June 1 (when the stock price is $100), but backdates the options to May 15 (when the price was $80) 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 $80, not $100, it is below fair market value.
It allegedly failed to inform investors, or account for the options expense(s) properly.
Since the advent of stock option backdating, corporate policies have moved first toward a posture of encouraging backdating as a standard business practice, but then toward a posture of avoidance as public scandals emerged and investigations into fraudulent or dishonest business practices increased despite a commonly held belief that backdating was an acceptable and legal practice.
One of the larger backdating scandals occurred at Brocade Communications, a data storage company.
It was forced to restate earnings by recognizing a stock-based expense increase of 3 million between 19, after allegedly manipulating its stock options grants for the benefit of its senior executives.
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.
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.
Additionally, companies can use backdating to produce greater executive incomes without having to report higher expenses to their shareholders, which can lower company earnings and/or cause the company to fall short of earnings predictions and public expectations.