Is Backdating Executive Stock Options Always Harmful to Shareholders

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.