“The Sting” was fictional but backdating isn’t

Implications: When all the dust settles, there will be no doubt that backdating was wrong, even if it wasn’t illegal.  Furthermore, it will be shown that there were two reasons for its existence:  poor ethical reasoning and bad accounting standards.  The judge has seen through the smoke and mirrors and rightly characterized backdating to be like betting on a horse race that’s already been run; the only difference is that “The Sting” was a fictional story and backdating is as real as can be.  Alas, GAAP created another fiction that should never have been published instead of the authentic truth that options are liabilities.

Analysis: It appears the current management at UnitedHealth continues to hold on to two primary personal values that were displayed by Dr. William McGuire:  “When you’re in charge, don’t let anybody tell you what you can or can’t do” and “When you’re in charge, you’re entitled to everything you can get your hands on.”

Instead, they should have applied, and still should be applying, the wisest ethics rule of thumb yet known to mankind:  “Would you want the results of this decision to appear on the front page of tomorrow’s newspaper?”  On the face of it, backdating is clearly inappropriate for stewards of other people’s money.  It is nothing short of deception.  The irony is that these managers were so well entrenched that they could write themselves essentially any kind of compensation plan they wanted.  They could have paid themselves plenty, and there was nothing magic about getting that loot through backdated options or just straightforward salary, bonuses, or special pension benefits.  

So, why did they use backdated options?  After all, wouldn’t they know there would be an outcry when they were discovered?  And, shouldn’t they have expected that they would be exposed, sooner or later?  

(I just have to wonder how this scheme ever got started; it seems to me that whoever brought it up would have been laughed out of the room.  Nonetheless, the idea not only lived, it survived the “scrutiny” of lawyers and auditors, not to mention compensation committees.  I also have to wonder how the idea spread from one place to another:  was it directors of one company taking it to another, was it a law or audit firm bringing the idea to its clients, or was it CEOs talking in one venue or another?)

I am convinced the allure was created mostly by the original version of FASB’s Statement 123 that did not require management to report its compensation if the option strike price equaled or exceeded the stock’s market value.  In the case of backdating, all that mattered was the fictitious grant date.  Once that was pulled off, the accounting followed:  NO COMPENSATION EXPENSE.  Thus, the managers were able to pull down all that money and never report it on the income statement; of course, the footnote was so vague and incomplete that it didn’t tell the story either.

Would a different standard have produced a different result?  Yes, but, alas, there would have been only a little difference if the newly revised SFAS 123 had been in effect when backdating occurred, simply because the option valuation model would have been applied on the fictitious grant date and would not have revealed how much was really plundered from the shareholders.

Instead, what is needed is a new standard that would treat options for what they are:  derivative liabilities with volatile market values.  And, if these liabilities were to be marked to market, the initial backdated discount would have flowed right into compensation expense in the grant year.

For example, suppose the board of directors approved (on December 31, 1999) a grant of 100,000 options as of January 1, 1999, at a strike price of $20, which equaled the stock’s market value on the bogus grant date.  Under the intrinsic value method allowed under the old SFAS 123, the company’s income statement would report no compensation expense, even though the stock’s market value at December 31, 1999, was $60.

Under SFAS 123 (revised), the options would be valued as of January 1, 1999, based on the facts as they existed at that date, such that they might come out with a value of, say, $3 each, for a total cost of $300,000.  This amount would then be spread over the vesting period of, say, 3 years, for a hit to earnings of about $100,000 for 1999 and next two reporting years.

Under realistic and complete accounting, the options would be valued as of the balance sheet date, and then reported as a liability.  The offsetting debit would be to compensation expense.  If the stock was worth $60 at the end of 1999, the options would have been worth at least their intrinsic value of $40 each, plus maybe another $5 for the option feature.  The liability accounting method would report a liability of $4,500,000 and compensation expense of the same amount, a far cry from the piddling $100,000 under SFAS 123 (revised).  Then, as the liability changed in value over its life, compensation expense for each reporting would be increased if it appreciated and decreased if it depreciated.  

This method doesn’t make any smoothing amortizations based on assumptions about when the compensation is earned, and it doesn’t put outdated numbers on future income statements.  Instead, all it does is observe and report economic facts when they happen:  what the options are presently worth and how much that value changed during the reporting period.

Note that there are no new reliability issues with this method either.  It would apply the same valuation model that is presently applied at the grant date.  The difference is that it would apply that model to ALL options at EVERY reporting date until the options are exercised or lapse.

The only objection to reporting options as liabilities is that the truth would be known and fully disclosed for everyone to see.

So, if this method had been required in the past, perhaps no backdating would have ever occurred.  

There are two more points to observe.  

First, if and when it’s determined that the options were indeed backdated and improperly so, they would have an intrinsic value on the real grant date (the market value of the stock exceeded the strike price), which means the income statements will have to be restated to reflect the compensation expense that should have been reported.  However, so much time has passed that those statements will never be republished.  To the shock of those who took those backdated options, though, the IRS is licking its chops to get at them because that positive intrinsic value would have created taxable income to the grantees as of the grant date, with the unpleasant result (for them) that they owe a slew of back taxes plus interest and possibly penalties if it’s determined they filed fraudulent returns.  That will hurt, and they won’t get much sympathy outside their closest circle.

Second, did you notice the pathetic gesture on the part of McGuire in his offer to keep his options with a new higher price?  He just doesn’t get it – he was caught pilfering large amounts from the shareholders and now he’s asking them to let him pilfer a bit less just because he confessed.  Remember his two true values:  “don’t let anybody tell you what you can and can’t do,” and “get yours while you can.”  Just because he isn’t in jail now doesn’t mean he won’t be when everything is fully known.