The controversy over options backdating just won't go away, and with good reason.According to the latest count, more than 120 companies are under investigation for doing it. In September, the heretofore-worshipped Steve Jobs was in the news with an apology for past backdating misdeeds at Apple. Even though he denied receiving any backdated options, he apparently approved some, but claims he was unaware of any accounting impropriety.
While it seems hardly possible to say anything new, we think it's essential to make the unequivocal point that backdating (including its variants) is nothing but bad ethics. Furthermore, no one will come out of this smelling good: not management, not auditors, not policy-makers and not even accounting professors.
Indeed, they all come out smelling rotten. As unlikely as it seems, the only way to clear this foul odor is a new accounting standard that puts unvarnished truth about options in financial statements for everyone to see. No dating games, no deferrals or smoothing - just reporting what happens when it happens.
Management
No matter how much we have criticized the management corps for failing to understand capital markets and repeating the same ludicrously transparent arguments, we confess that we are taken extra-aback at the sorts of conversations that occurred in at least 120 companies, and probably many more. They must have run something like this:
"I've got an idea but I'm not too sure about it, so hear me out before you laugh."
"OK, we're all ears."
"Well, you know the kind of quarter we've had, with the stock price run up by 10 points from that all-time low in early April, and you know that it's time for annual option grants."
"Yeah, go on."
"So, why don't we propose to the compensation committee that they let us retroactively pick the day on which the options grant takes place?"
"I get it: We get in a time machine and take the grant with us back to April, and write it with that price instead of today's. That idea is so good that it has to be against some rules."
"I've looked and haven't found anything in writing, and I also came up with another sweet part of the deal. We can value the options as of April, and that smaller amount of compensation will show up in the pro-forma disclosures in the footnote, instead of the higher value when they're actually granted ... ."
These ideas are ethically repugnant, especially in light of the mantra for using options in the first place: namely, that they are effective for getting managers' future efforts aligned with shareholders' interests. That rationalization goes right out the window if the options have already appreciated when they're granted.
So, what kind of compensation committee would go along with backdating? Perhaps the same folks who routinely roll over at managers' requests for ever-more-generous perks. Backdating and the staggering amounts of executive compensation are living proof that the oversight is illegitimate.
Only the most naive would ever think that the accounting angle wasn't central to this scheme, too. For managers who believe that there is no such thing as options expense, and who weren't reporting one, the temptation to play with grant timing must have been huge. If the options are free, after all, what's wrong with moving the grant date to an advantageous date?
If you don't assign any cost to the options in the financial statements, how can you expect managers, directors and even auditors to look at them as valuable resources? We have argued for years that bad option accounting would produce despicable behavior. Alas, we were right - but we never thought we would be this right.
Auditors
We're also stunned about the auditors' role in this mess, despite our seemingly continuous harping on the twin defects of their lack of independence and their inability to make judgments about fairness other than affirming compliance with minimum generally accepted accounting principles requirements.
We cannot imagine what was said when managers discussed backdating with their auditors. We have substantial concern that the idea may have been conceived by somebody's auditor and then passed on to other clients. Now wouldn't that be another black eye for the accounting profession?
The widespread occurrence of backdating suggests that there may have been a common source, and who has more contacts with a wide range of companies than their auditors? Only time and honest disclosures will tell the role of the auditors in this tawdry affair.
Regardless of what discussions took place, the fact remains that the newly uncovered backdating and spring-loading incidents were not objected to by the auditors, at least not sufficiently to change the managers' minds or to produce an adverse opinion or resignation.
Bottom line, it was bad ethics if the auditors signed off while being aware of the highway robbery and bad accounting. Even when we give them the benefit of the doubt, we still condemn them for being so detached from their responsibility to serve statement users that they did not see that backdating is simply wrong.
Either way, the auditors should be indicted as co-conspirators with the managers, and subjected to investigations and sanctions. Enough is enough, and this is more than enough.
Policy-makers
In probably at least a dozen previous columns, we have criticized the members of the Financial Accounting Standards Board for not developing a sound standard for reporting clear and complete information about options. Admittedly, they faced tremendous political pressure, and we can understand their need to acquiesce.
Nevertheless, one root cause for backdating has to be the board's inferior "grant-date" accounting practices. This approach means that only the initial measure of the options' value is crucial to what gets reported in the pro-forma footnote or income statement. FASB should have anticipated that many would play with the numbers, although backdating is so far out of ethical bounds that we extend the board some grace for not anticipating it.
With that said, however, since its first deliberations on expensing options, the board has been repeatedly reminded of the poor-quality information produced by using the grant-date value, instead of continuously revaluing the stock options up to the exercise or expiration date.
Our criticism extends to the Securities and Exchange Commission, as well. After all, it is charged with oversight of the board, and has ultimate responsibility for any poor standards that get issued. In this case, a succession of chief accountants stood by and did nothing to keep this powderpuff rule from getting issued not once, but twice.
A new standard?
We hope that the stench created by this scandal will reach into the halls of power, such that a new standard will be issued. We know beyond any question that the most complete and useful information is provided when options are recorded at their estimated value when issued, and then marked to market as long as they are outstanding.
If this practice had been followed, the full value transferred to the backdated option grantees would have been reported right on the income statement in the year it happened. This method would also reveal the consequences of other shenanigans that often occur, including repricing and accelerated vesting. (It also gets more useful measures of income tax expense, stockholders' equity, and operating and financial cash flows, but that's another story.)
There is also a need for additional useful information in the mandatory disclosures about options. Right now, what's in the footnotes is essentially indecipherable. About all that can be grasped is that management has taken down a boatload of options, but no one knows for sure just how big the compensation really is. It's the stockholders' money, for goodness' sake, and they deserve to know how much of it has been taken from them.
Blame to spare
Of course, academic accountants share the blame for this situation, too. After all, at least one accounting course must be on every manager's transcript, and a whole lot more than that for auditors and policy-makers. Someone down the line dropped the ball by not creating a strong ethical platform that would have helped all these co-conspirators figure out that something was really, really wrong with options.
What a fine mess we have all gotten ourselves into, and there is no time machine that can take us back and stop it from happening.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs, and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.
