Apple Incorporated (Apple) is one of the most admired companies in the world. Pioneered by Steve Jobs, it is, to date, a hugely successful and popular company. However, it can be argued that profitability and the ability to churn out products that consumers rave about represent only one aspect of a company’s greatness – that honesty and integrity reflected on the organization as a whole also plays a vital role in meeting success. Public perception is such that the company’s is constantly under scrutiny from consumers, investors/shareholders and regulators.
According to Apple, it was during the middle of 2006 when internal review of employee stock options revealed some glaring irregularities and inconsistencies (“10-K Report” 2). Apple was quick to take the news to the market and announced as early as June 29, 2006 that such inconsistencies were uncovered and appeared to be based on mishandled stock options. A special committee was convened by Apple’s management in order to look into the matter.
By August, presumably on limited but sufficient grounds, the company announced that the irregularities were likely to constitute a restatement of earnings. The adverse news prompted the market to expect lower earnings and the company’s stock fell 2.4% shortly after the announcement (Associated Press).
The irregularities and inconsistencies found in the stock option grants were based on a practice called “back-dating.” Stock options are non-cash compensation given to employees. In Apple, stock options are granted to both executives and regular employees. In practice, stock options can substitute for cash insofar as rewarding employees with partial ownership which can be resold in equity markets for cash. Stock options also provide incentive since grantees are given the opportunity to work harder so that the value of the stock in the market increases, hence increasing the potential cash value of the equity stake.
For example, a manager granted with stock options can be persuaded to increase worker productivity to essentially increase firm profits which, in turn, drive up the value of the stock. Also, granting the company’s research and development team stock options could provide impetus to design new consumer products that are as vastly successful as the iPod.
As aforementioned, a stock option granted to an employee is a form of compensation not based on cash. This, however, does not mean that the stock option does not count toward the company’s expenses. On the contrary, SFAS 123 recognizes stock options as accountable transaction wherein equity instruments are conferred to certain individuals as remuneration for goods and services provided by that individual (“Summary of Statement 123”).
SFAS 123 specifically covers the accounting of equity instruments exchanged for services rendered by individuals internal to the organization – the standard falls short of covering transactions rendered by 3rd parties. According to FASB, the standard also falls short of accounting for employee stock ownership plans and appear to center mainly granted equity instruments as a form of special compensation.
Stock options, according to Statement 123, should be measured and accounted as a cost over the service period of the employee, or the period for which the equity-remunerated services are provided, which is termed as the vesting period. The value of the stock options should be based on the fair value of the equity instruments at the date-granted. In the case of Apple, some stock options were “back-dated” or were valued to a time when the price of the stock was at a low (Guynn C-1). The practice means arbitrarily selecting a date before the date the stock option was granted when the stock price is low.
This would, in effect, create “sure profit” for the recipient of the grant. By picking a low point in the equity instrument’s historical value, grantees can profit from the spread between the price at “supposed” date of grant and the time the option rights are exercised. The practice is also a way to control or limit the inherent volatility of equity markets. Since stock options have vesting periods, the employee can only exercise full rights on the equity instruments after the said period.
For the interim period, the value of the stock can move up or down, but the practice of backdating and arbitrarily selecting a point in time when prices are low reduces the chance that the stock option is exercised at a time when the market value is lower than the exercise price.
Below, a table is provided as an illustration. In a hypothetical situation, an employee was, in truth, granted the stock option some time in February 2006. At the time the option was actually granted, the stock was trading in the secondary market for $54.00. However, with “backdating”, the stock option is instead valued at some point in January 2006, presumably when the price hit a low – the example provides $48.00.
Supposing that the employee can only exercise the right 1 year after the equity-based compensation is granted, the option which was backdated actually made a profit, while the option valued at the correct date can only exercise the right with a $4 loss for each share. In this regard the illustration shows that backdating builds in profit (up to a certain degree) and essentially lowers the risk that the stock option becomes worthless after the vesting period.
Forensic accounting is a form of accounting that utilizes scientific methods to determine the accuracy and veracity of financial statement data in order to produce such quality and assurance as to be suitable for use in legal proceedings and administrative review (Crumbley). When Apple’s special investigative committee uncovered some of the details of the irregularity, the independent counsel was brought into the picture along with an investigative team of forensic accountants (“10-K Report” 85). The independent team siphoned thru millions of physical and electronic documents and spent, according to the report, over 26,500 man-hours in performing their capacity.
The findings of the forensic accountants were that some 15% of 42,077 or 6,428 options granted between 1997 and 2002 were found to be anomalous (Markoff & Dash). The options were not found to benefit any single person and were, in fact, beneficial to both executives and regular employees alike (“10-K Report” 4-5). In a few of the cases, the options were backdated so much so that the beneficiary of the stock option had not even started working (SFAS 123 requires, as mentioned, that the cost of the equity instrument compensation be measured over the period in which the requisite service is provided). Moreover, the findings of the team acquitted Stever Jobs and executives, including the CFO, presiding over the intervening period of any wrong-doing.
Backdating, however, is not illegal (Williams). The legal implication of the backdating scandal, which according to Williams 129 other companies share with Apple, only holds for as long as prosecutors actually find evidence that an executive or board director intentionally defrauded the company’s investors (Guynn C-1). According to Williams, backdating is perfectly acceptable for as long as the company’s financial statements properly reflect such and the IRS, for tax purposes, is informed of such a grant. Illustrative of the tax effects on the share-based compensation is found the company’s 10-K Annual Report.
The incremental effect on the pre-tax expense of the company totaled to $105 million between 1998 and 2006 and the restatements made by Apple reveal that shareholder equity eroded by $47 million (which is quite insignificant compared to total equity).
The investigative team pretty much absolves Apple and its management of any wrongdoing. Nevertheless, federal action and several complaints alleges that Apple’s backdating practice benefited certain individuals at the expense of investors. In the case “In re Apple Computer, Inc. Derivative Litigation” (actually a compilation of several actions that had similar assertions, i.e. backdating), the company serves itself as defendant against claims unjust enrichment, breach of fiduciary duty and several similar charges (“10-K Report” 40).
Even though there are no laws that cover the actual practice of backdating, save the official endorsement of the SEC of SFAS 123R, it could be potentially construed as a self-serving practice that breaches the faith of investors.
The practice of backdating stock options means that certain individuals are favored. Backdating means that the grantee gets more than what is deserved and that excess fails to make it to the books. In the illustration provided above, pricing the option at the lower value or fair value results in an understatement of expenses and this paints a mucked picture of company performance – bolstering the idea that the company is performing better than it really is. On the other hand, tax implications also have some bearing on backdating.
Under section 162(m) of the Internal Revenue Code, certain performance based compensation are actually qualified for tax deductions (“Options Backdating Update”). Understandably, some investors (as mentioned, the cases are bundled together) would be wont to cry foul because the self-serving act defrauds investors from potential saving granted by tax deductions.
The third legal aspect of backdating is that, if done intentionally and without informing all concerned parties, backdating means a breach in Section 18 of the Securities and Exchange Act of 1934 by submitting misleading and false financial statements. Breach of Section 18 of the Securities and Exchange Act opens the company to civil actions that could prove to be quite costly particularly when the misleading information is damaging to investment decisions.
The ethical aspect of backdating is rooted in the legality of the practice (or the intention of the practice since there is no actual law against it). The management of a corporation has a fiduciary duty to its investors. People put money into the company so that it may serve them in some form or capacity. Backdating to enrich one’s self at the expense of investors is a breach of that duty. People put money into the company and placed their trust and confidence into the hands of management.
The executives of a company should place the interests of their investors before their own and satisfy their fiduciary duty. In the case of Apple, some feel that the practice was, indeed, a breach of trust, and the lawsuits are mounting. The lawsuits are again additional costs that the company has to face at the expense of investors.
The case of Apple opens certain questions: Are the legal aspects enumerated above enough to preclude companies from indulging in practices such as backdating? Perhaps the case of Apple and the 129 similar recent cases should prompt regulators to legislate more stringent measures to prevent backdating. While the effects of backdating appear innocuous enough, a deeper understanding of the consequences of the practice shows that this seemingly harmless accounting faux pas can prove to be quite costly for investors.
Fortunately, the Sarbanes-Oxley Act provides some measure of comfort for investors as the law requires stock option grants to be reported within 2 business days following the date of grant (“Options Backdating Update”). Prior to the Sarbanes-Oxley Act, companies had greater opportunity to backdate as reportorial requirements were more lax. Even though the SOX law does not totally eliminate the practice, the reportorial requirements make it considerably more difficult to indulge in such activities. Perhaps the future of legislation holds more stringent penalties to uphold accounting standards and to more proactively ensure honesty and integrity in the corporate world.
“10-K Annual Report” Apple, Inc. Jan 2007. 24 Apr. 2007
Crumbley, D. Larry. “What is Forensic Accounting?” Journal of Forensic Accounting.24 Apr. 2007
Guynn, Jessica. “More Stock Option Fallout.” San Francisco Chronicle. 4 Jan 2007. 24 Apr. 2007
Markoff, John & Dash, Eric. “Apple on Options Backs Chief.” The New York Times. 30 Dec. 2006. 24 Apr. 2007
“Options Backdating Update.” V&E Securities Litigation E-Lert. 26 July 2006. 24 Apr. 2007
“Summary of Statement 123.” Financial Accounting Standards Board. 24 Apr. 2007
Williams, Chris. “Apple to Un-Backdate (Some) Options.” The Register. 16 Mar 2007. 24 Apr. 2007