The practice of issuing an employee stock option on a date preceding the actual date of grant. This usually occurs when a firm attempts to increase the value on a stock option by issuing it “at the money” rather than “in the money”. That means, setting the exercise price of the option lower than the firm’s stock price at the date of grant. As a result, the granted option will be of higher value to the holders (typically, executives and senior management members).

Companies usually backdate options in order to reap tax benefits and produce greater executive compensations. However, that comes unfairly at the expense of shareholders who would probably receive lower earnings and bear the brunt of a potential deterioration in earning predictions. Technically speaking, backdating can be costly for shareholders because it reduces the corporate tax deduction at the time of exercise (the deduction amount is equal to the corporate tax rate times the difference between the exercise price and the stock price).

Nevertheless, and because of the strong link between executive pay and reported earnings, CEOs also tend to secretly backdate non-executive option grants (those given to low-level employees), so that earnings can be inflated by issuing in-the-money options without expending them. The artificially increased earnings, in turn, enable executives to covertly enlarge their bonuses and boost their profits from selling the stock.

Historically, practicing backdating was possible because reporting the issuance of employee stock options to concerned authorities (such as the SEC) was allowed to take place within a relatively long period of time (two months) after the actual grant date. Companies used to grant the option, wait until the stock price reaches its lowest level within that time, and then date it at that price. Nowadays, backdating is no more practically possible, as companies are required to report option grants to authorities within a very short period of time (typically two business days).