Subscribe to FeedAshworth University Financial Statements Instructor Explains Why Stock Options Can Be “Tricky Business.”
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I’d like to discuss the challenges of accounting for stock options used as compensation. Stock options are very popular with start-ups and firms expecting high growth. The reasoning is simple. Both types of firms have huge cash flow needs today. If they had to rely on salaries to attract employees, they most likely would not be able to afford the talent they really need to grow the business. By awarding their employees stock options, the right to buy stock in the future, they delay part of their compensation expense. Stock options give their holders the right to buy stock in the future at a specified exercise price. Typically, the exercise price is higher than the current market price of the stock. This gives employees incentives to take actions that will raise stock prices, including actions that favorably distort earnings.
The problem with stock options is that the company records no compensation expense for them. When an employee exercises an option, the firm must have a share to sell to the employee at the exercise price. Usually employees do not exercise their options until they are “in the money,” meaning the market price is higher than the exercise price. At this point, the company has to buy back stock at the higher market price to sell to employees at the lower exercise price or issue new shares or issue shares from treasury stock. In any event, this is a real cost to the firm. Currently, this expense does not appear on the income statement. It has only recently become a requirement to disclose the expense in the footnotes to the financial statements. For a company like Microsoft that makes extensive use of stock options, this severely overstates reported earnings.
I discuss a couple of increasingly popular tricks used by struggling companies to boost reported earnings in your lesson reading assignments. The first is stock buybacks for the purpose of reducing the number of shares outstanding. By reducing the shares, the EPS rises. This causes the stock price to rise. The important point is that no value is created in this transaction. The same earnings are now concentrated in fewer hands, so price per share will go up even though total market value is constant.
Another troubling development is the creation of earnings definitions other than net income. In order to distract attention from earnings reported according to GAAP, companies will often present alternative definitions of earnings such as pro forma earnings, core earnings, or EBIDTA. Their argument is that GAAP earnings are not representative and the firm is trying to present a more accurate figure for its true earnings potential. The problem with this is twofold. There are no accepted definitions for any of these alternative earnings measures. Second, in practice, the items excluded from these earnings calculations tend to be ones that lower the firm’s earnings in that accounting period. Beware of the firm that presents “pro forma” earnings. The correct use of that term means forecasted earnings in the future. Firms today are increasingly using the term to mean, “This is what our earnings would have been if all these bad, non recurring things had not happened to us.” Often these things include depreciation and interest—I certainly don’t think these are non-recurring expenses!
Lee Woodward, CPA
Financial Statements Instructor
Ashworth University School of Business
