Is backdating executive stock options always harmful to shareholders?

Prior to 2005, accounting rules required corporations awarding employee stock options (ESOs) to expense their grant-date intrinsic value. Accordingly, only ESOs granted in the money would have a negative impact on accounting income. Backdating ESO grants in order to award in-the-money ESOs while reporting them as at-the-money would then eliminate an expense. However, whether an ESO has been granted inor at-the-money, its dilutive impact on earnings per share only depends on its strike price, and diluted earnings per share are always communicated to shareholders. U.S. fiscal rules, on the other hand, treat incentive stock options (ISOs), which cannot be granted in the money, differently from non-qualifying stock options (NQOs). The profits an executive realizes with an ISO are taxed at a more favorable rate than an NQO but are not tax deductible for the firm. As a result, backdating an ESO grant in order to award ISOs instead of NQOs in the same quantity and with the same strike price would have a negative impact on a firm’s cash flow while enriching executives. If, however, such substitution is done in a manner that leaves an executive’s utility level unchanged, then fewer backdated options are needed to replace non-backdated ones. If, on top of that, we consider the non-transferability of ESOs and assume that the executive is risk averse, then backdating ESOs can reduce the cost to shareholders. It this paper, we show that this is the case when the underlying stock’s expected return is equal to the risk-free rate and reasonable conditions are imposed on tax rates. A backdating arrangement that leaves an executive’s utility level unchanged becomes costly to shareholders when the spread between the expected stock return and the risk-free rate exceeds a certain threshold, this threshold being positively related to the executive’s level of risk aversion and negatively related to his or her non-option wealth.