Question

Discussion #4 Ethical Behavior Applied

A number of the lower level executives at Enron believed that because they were directed by upper management to participate in financial fraud, that they had no culpability in the Enron downfall. They reasoned that business was competitive, the bosses were smart (smartest guys in the room), and everyone seemed to be making money.

That outlook has been described as a sub-culture that can pervade startup companies where the executive officers are young, inexperienced and aggressive and don't believe that rules and regulations apply entirely them. This is one of the reasons that backdating options has become such an issue. For example, a company wants a critical employee to stay with them and not leave for a competitor. The stock, when the employee is contemplating leaving is worth $10 per share. However, just 12 months ago the stock was worth $1 per share. The company considers giving the employee and option to purchase 250,000 shares of the stock at $1 per share, saying it was promised to him a year ago. As we know, with stock options, there is generally no payroll tax to deal with upon the grant so the company is able to creatively compensate a talented employee and keep her on board and avoid paying payroll taxes. Moreover, the CEO says, this employee will stay with the company, help make the company more profitable and thus pay more taxes in the long run. Additionally, because the employee is working on an important technology that will be patented, will allow the company to hire more employees in the near future.

Is this kind of backdating of options legal? Why or why not? How would you deal with this if you were the audit senior manager or partner in charge? How would you deal with this if you are the CFO? Identify who benefits and who could get harmed if this scenario plays out as planned by the CEO.

This question is for an Accounting Ethics course.

Answer 1

Such kind of option backdating is not legal since it amounts to fraud with investors sentiments as well as revenue leakage of government in the form of lost tax hat they might have obtained through payroll taxes as well as less expenses booked by the income in it's income statement as showing option at lower prices than actual will allow company to book fictitious expenses in the name of employee stock options. Also a company has to disclose the details of stock options granted and if company do not disclose since it is backdating then it has to pay penalties also for violation of disclosures regulations.

It is a serious violation and it should be reported to those charged with governance as well if necessary to the regulatory authorities . Also since it is the violation of law, provision for any foreseeing legal liability should also be made. Also it should be seen that is this amounts to material misstatement in financial statements and call for adverse audit opinion or adverse audit report.

As a CFO, the primary responsibility of a CFO is to protect the interest of stockholder and take decision which are favourable for the stockholders. CFO should advise CEO to correctly disclose the option price and also tell him the consequences that the company may have to pay if this perpetration is unveiled.

Benefit from the backdating of stock option will be thst the company has to pay less taxes since it has shown pricing of option to be very less whereas shares of the company are trading at a very high prices which will lead to fictitious expense to be booked by the company.

The biggest harm from this play would be to the stockholders of the company it is because if this fraud got caught and the information comes in the public then there should be no doubt that it will lead to a very steep decline in the prices of shares of the company as a result the wealth of the innocent investors will get destroyed. Also it is causing harm to the tax revenue if government in the form of less tax collected by the company. Further company may have to face huge penalties for such fraud . So currently the cost may not be qualified but it will have serious implications variety of users.