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Consequences of backdating stock options

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This paper contrasts the post-tax returns of backdated at-the-money options to currently-dated in-the-money options (with the same strike price as the backdated options) and demonstrates that a Canadian executive can earn a significantly larger after-tax return from backdated options compared to a US executive.

Other similar practices are being reviewed by government officials as well.Based on our experience, here are some of the worst effects of such undervaluation. We see these most frequently at two stages in a company’s life: during the first financial audit; and during the IPO preparation process.A cheap stock charge is an additional expense that an audit firm (or the SEC) forces a company to include on its income statement.The audit firm (or the SEC) decides that the common stock was undervalued at some point in the past and, as a result, stock options were issued with a strike price that was too low.To correct this, the company is required to restate its financial results by taking a non-cash charge against earnings to account for the “extra compensation” that was, in effect, “paid” to employees. Because the IRS has stated that a cheap stock charge is one of three “red flag” issues for which it looks when examining a company’s stock option pricing.We often are asked, “It’s a non-cash charge, how bad can that be? So, you may acquiesce to your auditor (or the SEC) and accept a cheap stock charge to put the issue behind you.