The Public Company Accounting Oversight Board recently issued its inaugural audit practice alert, warning auditors to be on the watch for problems with the timing of, and the accounting for, stock-option grants."Auditors planning or performing an audit should be alert to the risk that the issuer may not have properly accounted for stock-option grants and ... may have materially misstated its financial statements," the alert said, alluding to recent investigations by the Securities and Exchange Commission and the Internal Revenue Service into whether companies routinely backdate, spring-load or otherwise manipulate stock-options grants to top executives.
The board's alert noted that while the implementation of Sarbanes-Oxley and a new rule from the SEC requiring companies to report the issuance of a stock-option grant within two days appear to have curtailed the abuse of option grants, there are still no guarantees.
The PCAOB specifically addressed options backdating, defining the practice as the "selection of exercise prices based on market prices on dates earlier than the grant date" and "modification of option documentation for purposes of indicating a lower exercise price than the market price at the actual grant date."
The oversight board also described spring-loading options "purposefully granted ... immediately before the release of information that the issuer believed would be favorable to its share price."
While spring-loading does not necessarily result in accounting errors, the practice "may create legal or reputational risks and raise concerns about the issuer's control environment." Auditors were also reminded that even small misstatements could be seen as significant when related to unlawful acts.
Prosecutors and the SEC filed civil and criminal fraud charges against the former chief executive of Brocade Communications Systems Inc. a little over one month ago, the first such brought in an ongoing investigation of option grants.
The alert, titled "Matters Relating to Timing and Accounting for Options Grants," is available at www.pcaobus.org/news_and_events/news/2006/07-28_release.pdf.
The extent of the problem
Meanwhile, a new collegiate paper revealed that more than 2,000 companies appear to have used backdated stock options.
Professors Erik Lie of Iowa's Henry B. Tippie College of Business, and Randall A. Heron of Indiana's Kelley School of Business at Indiana University, estimate in their study that 29 percent of firms had manipulated stock-option grants to top executives at some point between 1996 and 2005.
Since August 2002, when the SEC tightened reporting requirements to require that company executives report stock- option grants within two business days, the paper said that the backdating figure appears to have declined significantly.
Lie and Heron examined nearly 40,000 stock-option grants to top executives at 7,774 companies dated from Jan. 1, 1996, to Dec. 1, 2005, using information from the Thomson Financial Insider Filing database. The study also found that more than 13 percent of the options granted to top executives during the years were backdated or otherwise manipulated.
Dozens of companies have publicly disclosed that they're targets of federal investigations regarding options backdating.
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