Stock options give their holder the right to purchase the common stock of a corporation at a specific price. This right is available over a date range, such as for the next five years. Once a stock option is used to buy shares, these shares are typically sold right away, in order to pay any related income taxes. Consequently, a person who has been awarded stock options will only use them if the current market price is higher than the exercise price built into the options. The exercise price is usually the market price of the shares on the date when the options were awarded. For example, a person is awarded 1,000 stock options that allow him to buy the shares of the employer for $10.00 per share. After three years have passed, the price of the shares has increased to $12.00. The investor exercises the options to buy 1,000 shares from his employer for $10,000. He immediately sells the shares on the open market for $12,000, pocketing a profit of $2,000.
An issue with stock options that management can illegally take advantage of is to backdate the options. The date at which the option price is set is shifted backward to that date on which the market price of the stock was the lowest. By doing so, those awarded stock options can now buy the shares at a lower exercise price, so that they reap larger profits when they sell the shares. To use a variation on the preceding example, management backdates the stock options by three weeks, to a day on which the company’s stock price was $9.00 per share. The person awarded the options later buys the shares at $9.00 and sells them for $12,000, resulting in a profit of $3,000. Because of the backdating, the individual earned a 50% larger profit than would otherwise have been the case.
Stock option backdating is difficult to spot, since it is not immediately apparent in a company’s financial statements. Instead, one must examine the date of the board of directors minutes to see when the options were authorized, and then trace this date back to when the options documentation was completed. A disparity between the dates indicates that backdating has occurred.