Question

Chapter 11 After Enron, World Com, and other major corporate scandals that rocked America in the recent past, it seemed that nothing would surprise investors or regulators. However, almost everyone was shocked by revelations that as many as 20 percent of all public corporations may have allowed their officers and directors to "backdate" their stock option awards and account for the awards improperly. For a time, hardly a day went by without another public company's fraudulent stock option practices being revealed. A stock option is an award granted under which key employees and directors may buy shares of the company's stock at the market price of the stock at the date of the award. As an example, assume that Company A's stock price is $15 per share on January 1, 2007. Further assume that the company's CEO is awarded 200,000 stock options on that date. This means that after a certain holding (vesting) period, the CEO can buy 200,000 shares of the company's stock at $15 per share, regardless of what the stock price is on the day he or she buys the stock. If the stock price has risen to, say $35 per share, then the CEO can simultaneously buy the 200,000 shares at a total price of $3 million (200,000 times $15 per share) and sell them for $7 million ($35 per share times 200,000 shares), pocketing $4 million. Stock options are a way to provide incentives to executives to work as hard as they can to make their companies profitable and, therefore, have their stock price increase. Until 2006, if the option granting price ($15 in this case) were the same as the market price on the date the option was granted, the company reported no compensation expense on its income statement. (Under accounting rule FAS 123R, effective in 2006, the required accounting changed. However, if the options were granted at a price lower than the market share price (referred to as "in-the-money' options) on the day the options were granted, say $10 in this example, then the $5 difference between the option granting price and the market price had to be reported as compensation expense by the company and represented taxable income to the recipient.

Answer 1

1) Yes, a good internal control system could play a excellent role in preventing the fraudulent backdating practices through:

a) Keeping the documents of issue the stock options to the officials and directors.

b) Reconciling the options issued and allotted along-with the date of activities.

c) The internal control is not under the control of a individual officer or director, so it would be difficult to overpower the controls of the department.

d) Internal control department can detect the reason of fraud happening at the first opportunity or catching of fraud. Therefore, there is chance for the employees to commit the frauds again and again.

e) The Internal control department not only detect the frauds, but also bring out with preventing steps.

2) The executives and directors of many companies have allowed the dishonest “backdating” practice in their companies because in each and every case, one or the other operation controller is involved in the fraud to provide space for such a fraud to happen through his/her authority. Secondly, the allowing executives and directors are of the view that company is providing the options at lower prices and the market prices are not in their hand. So, the profit or loss on selling the shares at higher prices in market by employees is the employees’ individual game and company has nothing to do with that.

3) Yes, a whistle-blower system would help to detect and prevent these dishonest practices of “backdating” by executives and directors of the board because the frauds can be early and easily be detected at the work place so an employee who is working in the system can find out the fraud happening. The whistle-blower system is the active human work-force which raise voice against the fraudulent activities happening in the organization. This system awake all the forces to fight against the fraudulent activities. All this is because every employees life style is attached with the life-line of the company. If company exists, the employee exists and the frauds kills both company and the employee. So, the whistle-blower system should be encouraged in the organizations.

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