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Accountant says that many companies that used backdating as a form of compensation are now struggling to deal with the regulatory problems it created
THE HOME DEPOT INC.'S ADMISSION that for 20 years it routinely awarded backdated stock options to employees indicates the company may have violated accounting and tax rules, including overstating its net income by failing to properly account for the options grants, according to experts in corporate accounting.
They said it also suggested a serious failure of corporate controls.
Atlanta-based Home Depot disclosed Dec. 6 that from 1981 through November 2000, in awarding annual and some quarterly option grants, management "generally followed a practice of reviewing closing prices for a prior period and selecting a date with a low stock price to increase the value of the options to employees." These awards were later approved by the company's board.
Home Depot said it would adjust its balance sheet for the year ending Jan. 28, 2007, and it would not have a material impact.
The strongest words against the practice come from U.S. Securities and Exchange Commission Chairman Christopher Cox, although he has not commented specifically about Home Depot. He did remark on the practice at a September meeting of the Senate Committee on Banking, Housing and Public Affairs. "There are many variations on the backdating theme," Cox explained. "Here is a typical example of what some companies did: They granted an 'in-the-money' option-that is, an option with an exercise price lower than that day's market price. They did this by misrepresenting the date of the option grant, to make it appear that the grant was made on an earlier date when the market value was lower."
He added, "Rather obviously, this fact pattern results in a violation of the SEC's disclosure rules, a violation of accounting rules, and also a violation of the tax laws."
Cox explained that the way options are granted can also impact a company's financial statement. If the exercise price-the price of the option on the day it was given to the employee-was equal to the market price on the grant date, the company would not have to record its value as an expense on its income statement.
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Securities and Exchange Commission Web site:
SEC Chairman Christopher Cox's testimony concerning options backdating (Sept. 6, 2006)
"Indeed, no expense would ever need to be recorded in the financial statements for fixed options that weren't granted in-the-money," Cox said.
In Home Depot's case, the total value of the difference between the lower exercise price at which the stock was awarded and its actual market value on the official date of grant amounted to $200 million over the period, excluding tax consequences, the company said.
For backdating to continue so long at Home Depot astonished Charles W. Mulford, professor of accounting at Georgia Tech's College of Management and director of Tech's Financial Reporting and Analysis Lab. He is the author of four books on accounting, as well as numerous journal articles.
Mulford said backdating is normally associated with the bull market of the 1990s and the high-tech bubble. "To see this go on consistently for 20 years is the biggest point I take away. A key question is why they did it," Mulford said.
Home Depot didn't record any expense on its income statement for the options granted, Mulford noted. "They could show a higher profit as a result," Mulford said. "The question is, was this an accounting error, or was there an intent to mislead by not telling shareholders and not showing it as an expense?"
Mulford said the decision will be made by regulators at the SEC, which Home Depot said is conducting
an informal inquiry into the company's stock option practices. The agency could impose a civil penalty-or refer the matter to the U.S. Department of Justice as a criminal case.
Carolyn Reed Turnbull, director of tax research at Habif, Arogeti & Wynne in Atlanta, said while the practice creates tax and accounting problems, it is not illegal according to the Joint Committee on Taxation. She and others noted that many companies used backdating as a form of compensation and are now struggling to deal with the regulatory problems it created.
Victor E. Fleischer, a law professor at the University of Colorado who has studied the tax issues related to options, said Home Depot's problems will depend on the type of options granted.
If the company offered non-qualified stock options to top executives, "the company may have improperly taken a deduction for the equity" paid to them, Fleischer said. He said the tax code clearly limits the deductibility of their compensation unless the compensation is performance-based.
Both Home Depot founders Marcus and Arthur Blank have said they neither requested nor received stock options while at the company.
Home Depot may also have some liability for failing to withhold the appropriate amount when it awarded incentive stock options to rank-and-file employees.
"Home Depot employees may find that they paid income taxes at lower capital gains rates rather than ordinary income rates," Fleischer said.
Both Fleischer and Mulford said the length of time the practice continued at Home Depot suggested a lack of accountability within the company.
"This is a clear breakdown of internal controls by overriding the compensation committee. I suspect that by the time this got to the committee, it probably was not aware that this was going on," Mulford commented.
Fleischer said the backdating "reflects a weakness in the financial controls of the company that was common in the 1990s. The long history of the practice at Home Depot suggests that it's rooted in a sloppy way of doing business that was just accepted as a harmless practice at the time."
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