Ok, this is a rhetorical question. I know why it’s done – I just can’t figure out why it’s so widely accepted? Sure it’s easy to gloss over these numbers and claim it’s a non-cash expense. But these are committed funds that don’t filter directly to the rightful owners – the shareholders. A bit of history might be helpful. Stock based compensation is the practice of issuing stock options to employees in lieu of cash. These expenses which are non-cash in nature had previously been kept off the income statement. Many in the investing community (including myself) believed that these entries were indeed expenses and should be treated that way. As we know, many companies were able to inflate GAAP earnings figures by simply issuing options to management. The technology industry was perhaps the greatest abuser of this practice.
After much debate, the Financial Accounting Standards Board (FASB) issued FAS 123 which required companies to expense stock options issued in late 2004. These expenses which are non-cash in nature had previously been kept off the income statement. One would think that this would put an end to GAAP and non-GAAP reporting when it came to compensation – well think again. Non-GAAP numbers are routinely reported and primarily used by sell-side analysts. It is true that at least we investors can see these numbers clearly broken out in order to draw are own conclusions. But often we don’t take the time to dig just beneath the surface.
Here is the official language from Financial Accounting Standards Board (FASB):
Scope of This Statement
This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This Statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” This Statement does not address the accounting for employee share ownership plans, which are subject to AICPA Statement of Position 93-6, Employers’ Accounting for Employee Stock Ownership Plans.
Serial Abusers:
The majority of companies out there report this way. However, some take advantage of this policy more than others. I hate to use CSCO as an example (I picked on them in a previous article) – but here it goes. In their most recent report, there was a significant difference between GAAP and non-GAAP numbers. Here is a typical headline -
This was a successful quarter by most standards. However, there was no reference to actual GAAP numbers in this piece. Reading through Cisco’s press release and it’s as if GAAP didn’t exist. One can find the reconciliation to GAAP at the very end of the press release. The non-GAAP number reported was $.40 per share while the GAAP number was $.32 per share – a big difference. The difference isn’t due entirely to stock based compensation of course. The actual number was about $370 million or about $.06 per share – still a pretty big difference. Stock based comp was almost 20% of net income. As a standard rule, stock option expense should be no greater than 5% of operating cash flow.
Disclosure: none
