Monday, June 19, 2006

Stupid Accounting Tricks: Option expensing

Welcome to my new highly irregular series: Stupid Accounting Tricks. It isn't the accounting that's stupid, it's just that these tricks can easily make an analyst look stupid if he doesn't keep track of them. I will occasionally highlight one of these tricks so you can be one of the people in the know and spot sillyness in the financial press.

Recent market rule changes force expensing of stock options. Companies had previously kept these options “off the books”. While I heartily endorse moving the options onto the books some of the rule changes can have strange effects on corporate balance sheets and cash flow analysis.

First the background: during the go-go boom days many companies were awarding huge numbers of stock options as compensation. This didn’t show up directly in the financial statements. Meanwhile the nominal cash the employees eventually paid for the shares, combined with a curious tax write-off the companies received made the practice show up as an actual profit source. The truth is that the dilution of shares removed money from shareholders pockets and in many cases companies were (and are now) spending their profits on share buybacks that do little more than buy back the shares they gave out as payment. When a company spends its profits buying shares that it just issued to an employee as payment, shouldn’t that be an expense? The SEC and the Financial Accounting Standards Board (FASB) thought so as well.

The new rule has several parts. The main change, and the one most people are aware of, requires companies that issue options to charge those against earnings as an expense. The second, stealthier, part of the new rule has to do with the tax benefits of this tactic. When the employee cashes in stock options it is considered a deductible compensation cost, even though the money doesn’t generally come directly out of the company’s pocket. This gives the company a nice compensation cost deduction and partially explains why stock option compensation was so popular with management – the company actually winds up with more money than it started with before giving out the compensation. (The money comes from the investors, whose ownership gets diluted.) The new rule moves this tax benefit from the operating cash flow (where tax items generally reside) to financing cash flow (which is typically populated by loans and share offers).

The company is still getting cash, but now it doesn’t look in reports like that cash is coming from the business operations, which is probably a good change. The cash does need to be considered when looking at a companies creditworthiness (Z-score computationists take note), but cash flow from issuing stock to employees is not really a sustainable business model.

The trick here is that the change means comparisons to past years can be difficult. I like to analyze net present value by using cash flow when I consider buying stock in a company, but now one has to be aware that a declining cash flow number could be due to this accounting change. In its most recent quarter Cisco reported cash from operations of $2.3 billion – excluding $260 million in tax benefits that this rule change moved from operations to financing. If you were doing a cash flow analysis on Cisco you might think they had fallen 11% short, when in fact the money had just been moved elsewhere on the balance sheet. Google had a similar hit of 9% as $77.3 million was moved by this new rule.

Most people also calculate free cash flow without the financing category, so that number would also be reduced.

Now that you know the trick, look out for articles about drops in cash flow from companies that you suspect might have lots of options floating around – it could just be the accounting change kicking in. And I will make sure to take this into account when I do stock analysis as well.

Invest Well,

The Finance Wonk
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Blogger Dustin T said...

It is nice post.

7:20 PM  

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