In the little more than four months since the news surfaced that investigators were probing KB Home executives for backdating option grants, the company went from red flag to code red. Suspicious coincidences morphed into material evidence that stock option?grant dates had been manipulated, monetarily benefiting grant beneficiaries. Chief among them was CEO Bruce Karatz, whom investigators alleged was at the root of the activity, along with KB's director of human resources and chief legal officer. With that, KB became another offender–albeit the first in the home building industry–in the latest scandal sweeping corporate America.

And in a single stroke, Bruce Karatz, the lifeblood of the operation for more than 20 years, was out. COO Jeffrey Mezger was in.

The change in command may evoke relief among stakeholders unsettled by the financial chicanery, but Mezger's watch begins amid a host of both internal and external problems, ranging from minor headaches to major crises. The many pains associated with the scandal–delayed corporate filings, multimillion dollar balance-sheet charges, years of balance sheet restatements, tax implications, legal and accounting fees, to name a few–are taking shape against the backdrop of a national housing decline that has swung KB's most recent earnings expectations downward by 32 percent year over year.

Mezger's challenge is to put a triage plan in place, first working quickly to neutralize the collateral damage from the scandal before securing a strategy that will allow the business to survive the ailing market. Without decisive resolutions, the aftershock of the scandal threatens to keep the business off-kilter amid an unsteady market.

First Things First

At press time, priority No. 1 at KB is to file its 3Q2006 10-Q with the Securities and Exchange Commission. Since filing for an extension on Oct. 10, 2006, the company has only submitted an 8-K related to anticipated land inventory impairment charges of between $235 million and $285 million for the fourth quarter, leaving the regulatory and investor communities panting for more.

In the wake of the revelation of seven years of options backdating activity, a burning question is how much of a hit KB's balance sheet will take to atone for the discrepancy between the actual strike price and the backdated price of the stock option grants in question. KB currently estimates a total incremental non-cash compensation expense of roughly $41 million. Moreover, with respect to associated tax effects, the company expects to have to extract approximately $60 million in equity to account for an increase in liabilities, as well as provide for an income tax provision increase of about $15 million. Tack on significant accounting, legal, and consulting costs related to the investigation, audit, and even restatement of earnings documents, and although these charges may not be overly concerning for a company as well capitalized as KB, they still chip away at equity.

But without that filing, no one can know the exact impact the misdeeds will have on the business. What is known is what can happen if that filing is further delayed. Not only does a tardy third-quarter filing hinder a timely filing of its annual report, but any further delay could ignite a domino effect of unwanted events, including an eventual delisting on the stock exchange, the most extreme among the consequences.