In recent years, many well-known companies, including Apple

In recent years, many well-known companies, including Apple and Home Depot, have been accused of backdating options. A February 2009 National Post article titled “OSC, RIM in tentative settlement” explained that the Ontario Securities Commission was charging Research In Motion Limited (RIM) with the backdating of options. The following are some excerpts from the article:

“According to a statement of allegations filed by the OSC late yesterday, the total ‘in the money’ benefit resulting from the incorrect dating practices for all employees was about $66-million, including $33-million that has not been reimbursed or repaid to RIM or otherwise forfeited. The regulator said 1,400 of 3,200 option grants made between 1998 and 2006 were made using incorrect dating practices…

“An internal investigation at RIM revealed that options had been ‘backdated’—or set at earlier lower prices that would give the recipient an immediate gain on paper—leading to improper accounting treatment in the company’s books. As a result of the internal probe and earnings restatement, Mr. Balsillie left his chairman’s post and Mr. Kavelman was assigned to a different job within the company. Some directors were also replaced…

“According to the OSC’s statement of allegations, the directors and officers involved ‘did not take reasonable steps to provide proper oversight in relation to RIM’s options granting practices or to ensure that RIM’s public disclosure reflected those practices.’

“The regulator alleged that the grant dates selected resulted in more favorable pricing for the options or ‘in the money’ grants.

“In many instances, the lowest share price in a period was chosen using hindsight in order to set the grant date and, therefore, the exercise price,’ the OSC said.

“Between July, 1998, and August, 2006, ‘RIM repeatedly made statements in many of its filings, including prospectuses, financial statements, annual reports, and management information circulars, that contained the misleading or untrue statement that options were priced at the fair market value of RIM’s common shares at the date of the grant and were granted in accordance with the terms of the plan,’ the OSC said in its final statement of allegations released yesterday.”*

In settlement of this case, four senior executives (Kavelman, Loberto, Balsillie and Lazaridis) were required to pay $77 million in fines to the OSC and restitution to RIM.  In addition, the executives were required to pay  $1.76 million to the SEC for penalties plus give back more than $800,000 in profits made on the sale of the backdated options.

Instructions

Access the financial statements of Research In Motion Limited for the fiscal year ended March 3, 2007, from SEDAR (www.sedar.com) or from the company’s website.

(a) Explain the nature of the errors that the company has made. Describe the process that the company undertook to determine the extent and nature of these errors. What is meant by backdating of the options?

(b) What was the impact of these errors on the net income and cumulatively on retained earnings for each of the years 1999 to 2006? In what years does this restatement appear to have the largest impact?

(c) For the years ended March 4, 2006, and February 26, 2005, explain the impact on cost of sales; research and development; and selling, marketing, and administration expenses. What percentage of net income did total restatements represent for each of these years? What is the impact on the EPS for each year?

(d) What is the impact on the balance sheet for March 4, 2006? What is the impact on the current ratio and debt-to-equity ratio before and after these restatements?

(e) What is the impact on the operating cash flows for the years ended March 4, 2006, and February 26, 2005?

(a) As indicated in Note 4, the restatement is a result of errors made in the reporting of certain stock options granted by the company since December 4, 1996, when the stock option plan was adopted. 

The review was completed by the Special Committee and involved the revising of all the facts related to 3,231 grants of options to acquire common shares that were made to 2,034 employees between December, 1996 and August 2006.  The Committee reviewed electronic and paper documents and interviewed senior managers and the directors.  The error was in using the wrong measurement date on which to determine the value of the options.  The Stock Option Plan outlined that all options were to be approved by the Board of Directors or the Compensation Committee.  Furthermore, the exercise price of the options granted was to be no less than the closing price of the common shares on the last trading day preceding the date on which the grant was approved.  The review by the Special Committee found that the majority of grants made used an incorrect measurement date for accounting purposes, causing the exercise price to be less than the fair market value of the common shares on date on which the options were approved.  In some cases, hindsight had been used to determine the most favorable exercise price for the option.  This resulted in some options being in the money, but not being correctly recorded as an in-the-money option for reporting purposes.  Three different types of errors were found that related to misapplying the accounting standards related to share awards.

Under the company’s policy, the exercise price for options was to be set as the share price on the last trading day preceding the date of the approval for the granting of the options.  Back dating of the options means to set an exercise price that was before the actual date of the grant.  In this case, the company looked to find the lowest price in the past to set as the exercise price, even though this was well before the actual date that the options were approved for granting.

(b) The net impact of these errors each year are as follows: (as provided in note 4)

In millions of US$	Expense (Benefit)	Cumulative effect on Retained earnings
1999	27.7	27.7
2000	551.7	579.4
2001	(316.9)	262.5
2002	(46.5)	216.0
2003	11.5	227.5
2004	5.5	233.0
2005	7.8	240.8
2006	7.4	248.2

It appears that the largest impacts were in the early years of 2000 and 2001.

(c) The impact on the expenses for each of the years is as follows:

(Additional expenses)

In thousands of US$	March  4, 2006	February 26, 2005
Cost of sales	383	396
Research and development	1,258	1,485
Selling, marketing and administration	2,897	3,108
Tax impact	2,884	2,786
Net reduction to net income	7,422	7,775
Net income before error corrections	382,078	213,387
Error correction as % of net income	1.9%	3.6%
Impact on EPS - basic	$(0.04)	$(0.04)
Impact on EPS – diluted	$(0.05)	$(0.05)

(d) The impact on the balance sheet of March 4, 2006 is to increase the Deferred income tax asset by $1,775 million, increase Accrued liabilities by $5,127 million, increase Capital stock by $216,315 million, decrease Retained earnings by 248,202 million and increase Paid- in capital by 28,535 million.  The impact on ratios is calculated below:

In thousands of US$	Before restatement	After restatement
Current assets	1,256,997	1,258,772
Current liabilities	279,098	284,225
Current ratio	4.50	4.43
Total liabilities	313,807	318,934
Total equity	1,998,767	1,995,415
Debt /equity	0.16	0.16

There is a slight deterioration in the current ratio, but since it is already very high, at over 4, this slight reduction would not have impacted an investor’s decision.  Similarly, the debt to equity does not change, since the equity is so high, and it remains consistent at 0.16 before and after the restatement.

(e) There is no net impact on the operational cash flows for either year.  The restatements in the net income are offset by restatements in the deferred tax adjustments, the share based payments adjustments and net working capital adjustments.