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I was chatting with a friend over the weekend and realized that the major media is doing a terrible job of covering why the stock option scandal is important and what exactly is going on. So, I hope to rectify that.

Basically, there are two different “scandals” going on with different implications. The first one has to do with granting options just before news that will make the stock price jump. This has raised insider trading questions with the SEC and may lead to criminal charges. The second has to do with backdating options to a low point in the stock. This is not illegal in and of itself, but the way it has been gone about is the legal problem.

To describe why it is a problem, we have to have a primer on accounting rules. Basically, companies could elect to follow an old accounting standard (APB 25 if you want to look smart to your friends) that allowed them to not recognize any expense when they issued stock options. The accounting rulemaking body (FASB) tried to force companies to recognize the expense of issuing options, but their paid Congressman lobbyists convinced their friends in Congress to threaten FASB’s existence if expensing was required. FASB, in a move to continue it’s existence, allowed companies to continue using the old standard.

The way that companies could avoid recognizing expense on the stock options granted was to price the options at the closing price on the date the options were granted. For example, Milton Ceo gets a grant of 5 million options on May 1, 2006, when the stock price is $25. Ceo’s company can avoid recognizing compensation expense in the financial statements if the options are priced at $25. Ceo’s company can price the option at any amount they want, but they will have to recognize an expense if they don’t have a strike price of $25.

Well, Milton Ceo looks back and sees that on March 1, 2006, the stock price was only $20. He gets the Board (that he handpicked to rubberstamp his decisions) to pretend that they issued the options on March 1. Therefore, Milton Ceo has a built in gain of $5/share and the company won’t have to recognize an expense.

The problem is that you can’t really do that. The compensation expense is clearly calculated on the date that the options were granted. The SEC requires companies to follow FASB, so the company is now in violation of SEC requirements.

Most of the stock option grants that are in question are prior to the issuance of Sarbanes-Oxley. Sarb-Ox (as it is known) changed the requirements for disclosure of options issued to insiders. The old rules required that option grants be disclosed within six months, effectively giving CEO’s a six month lookback period. Sarb-Ox required that option grants be disclosed within three days of filing, making it a lot harder to fake the date on stock options.

Unfortunately, for Milton Ceo, a muckraking University of Iowa professor began looking at option dates and stock performance.  He noted that some executives were exceeding lucky and consistently had option grants right before the stock ran up. That led to an SEC investigation and now the IRS is involved.

Why is the IRS involved? Well, backdated options are generally not deductible for a company (well, $1 million of total compensation is deductible, but you get the picture) while regularly priced options are. Uncle Milty’s $25 million windfall above is largely non-deductible, but the companies would have deducted the amounts because we’re all pretending that the options were issued on March 1.

So, now the companies have the SEC and the IRS on their tails for backdating options in an attempt to further game the system.