SMITH BRAIN TRUST — Twitter has a brain-drain problem, which it's fighting it by issuing stock and stock options to employees it wants to retain. Such payments come on top of the stock those employees already own, which has underperformed expectations.
The expense represented by that compensation may or not be worth it, but we can all agree it's an expense, right? Actually, no. Twitter, like most tech companies, does not consider stock compensation to be an expense for accounting purposes. That stance has long drawn criticism — Warren Buffett has beat the drums for years on the issue— but some financial analysts think the problem is getting worse. They say such accounting tricks are masking weaknesses in a number of well-known companies, and perhaps in the economy as a whole.
Many companies issue "pro forma" financial statements, the face they want to present to the public, in addition to the versions that follow Generally Accepted Accounting Principles (GAAP). Managers encourage analysts and the media to focus on the pro forma numbers, although the difference between the two can be considerable. Chesapeake Energy Corporation, of Oklahoma City — whose founder and ex-CEO died this month in a possible suicide — reported a loss of $14 billion last year under GAAP, but only $329 million on its pro forma statement. It based some of its calculations on oil prices in 2013, which reduced the impact of the dive in prices that has occurred since. The SEC has raised an eyebrow at such moves, even in the pro forma context.
There is some evidence the gap between pro forma and GAAP earnings is growing. According to Institutional Investor, GAAP earnings were 74 percent of pro forma profits for S&P 500 companies in 2015, the lowest ratio in seven years.
The more a company leans on stock for compensation, the more it matters how accountants treat it. Twitter's stock-based compensation equaled nearly 250 percent of its pro forma earnings last year. In other words, count the stock and the earnings disappear. The figure for Facebook was 46 percent and for Alphabet (aka Google) 26 percent.
Companies are allowed considerable leeway on their pro forma accounts, so long as they also issue statements that follow GAAP, a set of rules agreed upon by the Financial Accounting Standards Board (FASB), an independent body whose rules the SEC has agreed to embrace.
Some of the things that companies exclude on their pro forma statements are "innocent enough," says Stephen Brown, associate chair of the accounting and information assurance department at the Robert H. Smith School of Business, at the University of Maryland. This include gray-area items such as the amortization of "purchased intangibles," including copyrights and customer lists, and expenses that were formerly categorized as "extraordinary items," such as damage to a factory caused by (say) an erupting volcano. "That's something that is clearly not representative of the performance of the company's underlying business," Brown says. "Extraordinary items" is no longer a category recognized by the FASB, so companies use the pro forma statements as a way to flag those and similar items.
Stock compensation, however, is obviously an expense, Brown says. That means financial statements that deny this are dubious — but he thinks it's unclear whether the practice causes real-world problems. "For me, it seems hard to believe that something as blindingly obvious as this would fool anyone," Brown says. Research has been mixed about whether ordinary invested are misled by pro forma statements. One study, however, found that companies with larger chasms between their pro forma and GAAP statements perform worse that companies where the two are closely aligned.
The battle over the accounting of stock compensation — which is popular at start-ups, especially in the tech industry — is an old one. In the early 1990s, the FASB announced it was putting its foot down and requiring that stock compensation be reported as an expense. The tech industry and its allies in Congress rebelled, and FASB backed down. It ended up making reporting stock as an expense optional, but such compensation had to at least be revealed in a footnote. After the Enron implosion led fresh scrutiny of accounting practices, the current regime was established: Recording stock compensation as an expense was required for the official books, but companies could also produce the pro forma reports.
Warren Buffett is among those who are not satisfied with the current compromise. Excluding stock-based compensation is "the most egregious example" of "managers telling their owners to ignore certain expense items that are all too real," he wrote in his latest shareholder letter. "If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”
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