Is Backdating Executive Stock Options Always Harmful to Shareholders?

2 Pages Posted: 11 May 2011

See all articles by Philippe Gregoire

Philippe Gregoire

Lakehead University - Faculty of Business Administration

R. Glenn Hubbard

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Michael F. Koehn

Analysis Group, Inc.

Jimmy Royer

Analysis Group, Inc.; Université de Sherbrooke - Department of Economics

Marc Van Audenrode

Université Laval - Département d'Économique; Analysis Group, Inc.

Date Written: May 1, 2011

Abstract

Current accounting rules relating to the issuance of employee stock options (ESOs) treat ESOs as a corporate expense. Prior to 2005, accounting rules required corporations that issued ESOs to treat at-the-money options differently from in-the-money options for financial reporting purposes. A corporation that granted in-the-money options was required to expense the intrinsic value of the options, while no expense had to be recognized when at-the-money options were granted. Since 2005, corporations have been required to expense all ESOs at their grant-date fair value. This paper considers the ex ante cost to shareholders when the firm awards backdated stock options to its executives, selecting a date when the stock price is below the award date price, thus granting in-the-money rather than at-the-money options. Using a binomial model, we show that the non-transferability of ESOs and the risk aversion of the manager receiving them make it possible for the firm to grant in-the-money ESOs at a lower cost than at-the-money ESOs without reducing the manager's utility level. This result is always true when the underlying stock's expected return is equal to the risk-free rate. Only if the underlying stock's expected return exceeds a certain spread over the risk-free rate-and the manager is made no worse off having been awarded in-the-money rather than at-the-money ESOs – are shareholders made worse off. For a given level of the risk-free rate, the threshold expected return at which granting in-the-money rather than at-the-money ESOs cannot simultaneously benefit shareholders and managers is positively related to the manager's level of risk aversion and is negatively related to the manager's non-option wealth. In the majority of cases, issuing in-the-money ESOs is welfare-enhancing for both managers and shareholders.

Suggested Citation

Grégoire, Philippe and Hubbard, Robert Glenn and Koehn, Michael F. and Royer, Jimmy and Van Audenrode, Marc, Is Backdating Executive Stock Options Always Harmful to Shareholders? (May 1, 2011). International Conference of the French Finance Association (AFFI), May 11-13, 2011. Available at SSRN: https://ssrn.com/abstract=1836782 or http://dx.doi.org/10.2139/ssrn.1836782

Philippe Grégoire (Contact Author)

Lakehead University - Faculty of Business Administration ( email )

955 Oliver Road
955 Oliver Road
Thunder Bay, Ontario P7B 5E1
Canada

Robert Glenn Hubbard

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

HOME PAGE: http://www.gsb.columbia.edu/faculty/ghubbard

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Michael F. Koehn

Analysis Group, Inc. ( email )

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10th floor
Boston, MA 02199
United States

Jimmy Royer

Analysis Group, Inc. ( email )

1000 De La Gauchetiere
Suite 1200
Montreal, Quebec H3B4W5
Canada

Université de Sherbrooke - Department of Economics

Marc Van Audenrode

Université Laval - Département d'Économique ( email )

2325 Rue de l'Université
Ste-Foy, Quebec G1K 7P4 G1K 7P4
Canada
418-656-3125 (Phone)

Analysis Group, Inc. ( email )

1080 Beaver Hall Hill
Suite 1810
Montreal, Quebec H2Z 1S8
Canada

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