Option backdating is the practice of altering the official date on which a stock option is granted. The intent of this change is to set the option date on that date when the market price of a company's stock was as low as possible. By doing so, the recipient is given a very low exercise price, and so will realize the largest possible gain when he or she eventually sells the shares. Since the company issuing the shares experiences no out-of-pocket cash outflow by altering the exercise date in this manner, there is no built-in internal control over keeping backdating from occurring.
For example, a company grants a senior employee 10,000 stock options. On the date when the board of directors approves the grant, the company's shares are selling for $10.00 on the open market. However, two days earlier, the shares were selling for $9.50, so the options are backdated to the earlier date in order to set the exercise price of the shares at $9.50. Because of the backdating, the employee will earn an extra $0.50 per option when he eventually sells the shares, which is an increase of $5,000 over what would have been the case if the backdating had not occurred.
Backdating is found by comparing the board of directors meeting date (when the options were approved) to the date stated on the stock options. If there is a difference, then option backdating is occurring.