Deep in the footnotes of Facebook’s financial statements, where few casual investors dare to tread, Anup Srivastava, an assistant professor of accounting information and management at the Kellogg School, has found some perfectly legal—yet to his mind troublingly inscrutable—accounting maneuvers.

Some Background
When companies give stock or stock options as a form of employee compensation, it is not uncommon for that compensation to come with strings attached. Usually, strings are in the form of service agreements—devote three or four years to us, the company says, and then the stock or stock options you’ve been promised will “vest,” which means you can actually own or sell them.

For many years, companies didn’t have to recognize expenses related to stock compensation when they calculated their reported profits. But in 2006, this changed: even though the company wasn’t actually paying out cash, it had to recognize the value of the stock options so that the expenses it used to calculate profits were representative of its true operating margins. Stated differently, the company was required to recognize an expense equivalent to whatever cash it would have otherwise paid to its employees.

As you might imagine, companies didn’t much like this. So, as stock options were no longer attractive for reporting lower expenses and higher profits, many companies reverted back to restricted stock based compensation.

Facebook’s Unusual “Liquidity Condition” Maneuver
Facebook, too, began to offer its employees these restricted stock units (RSUs). But the company devised an additional mechanism to bypass reporting expenses before its now rather infamous IPO. Specifically, in addition to attaching the usual service condition, the company also attached a much rarer liquidity condition: not until after a liquidity event such as an IPO would the stock be vested.

Anup Srivastava

It’s not hard to take a stab at why Facebook may have added the liquidity condition; it was, in fact, preparing for its 2012 IPO—a process that required Facebook to provide financial statements so that potential investors could gauge its financial health. Notably, these RSUs were allotted to its rank-and-file workers, who would otherwise have been paid via salary, bonus, or stock options—all of which would have qualified as compensation expenses. By keeping its earnings calculations free of all expenses related to the RSUs, Facebook showed higher profits (perhaps bumping up that IPO price, though of course we’ll never know for certain).

As mentioned earlier, Facebook was required by law to report this maneuver—which it did,  “buried in the footnotes,” says Srivastava.  Specifically, Facebook disclosed to keen-eyed investors that a share-based expense valued at $965 million dollars (and related to pre-IPO service) would be recognized after the IPO. Indeed, it recognized the expense in 2012, the first post-IPO reporting year. Consequently, despite reporting revenues of $5.09 billion (higher than the $3.71 billion it reported in 2011), Facebook reported profits of just $53 million in 2012—much lower than the $1 billion it reported in 2011 (the exactly $1 billion of profits it reported in pre-IPO 2011—probably not a coincidence, says Srivastava.)

Now, some may dislike Facebook’s decision not to subtract the RSU expenses from its reported profits until after its IPO; Srivastava counts himself among these numbers. But what happens next—again, perfectly legally— is even odder. It illustrates how, despite following accounting regulations, firms can provide an incomplete and potentially misleading picture.

Post-IPO Value of RSUs
Had Facebook not attached the liquidity condition, employees would have received their restricted stock before the IPO. Six months after the IPO, they would have been able to sell their stock and pay taxes at capital gains tax rates—typically lower than personal tax rates. In contrast, since Facebook’s RSUs were not vested until after the IPO, employees who cashed out had to pay taxes on the proceeds as if they were regular income (at rates around 45% for most employees in California.) Consequently, Facebook agreed to pay those taxes for their employees and withheld stock to sell for just that purpose.

Based on the value of shares withheld, Srivastava was able to calculate how much the RSUs valued at 965 million dollars during pre-IPO days were worth after the IPO. The numbers are rather shocking: around 8.9 billion dollars, based on Facebook’s own pre-IPO calculation (though this quickly fell to 6.2 billion dollars as share prices declined post IPO).

Yet when Facebook eventually recognized the expense on its books after the IPO, it used not the post-IPO valuation between $6.2 and $8.9 billion, but the original, pre-IPO valuation of $965 million. To put these numbers in perspective, the difference between $965 million and $6.2 billion is significantly larger than Facebook’s average annual revenues from 2011 to 2012. Yet this enormous figure was never recognized as an operating expense—and it never will be; Facebook will never report the true value of the compensation paid to its employees as an operating expense.

Clever Structuring—with Consequences
“It was clever structuring,” says Srivastava. He is quick to reiterate that he does not doubt the legality of the maneuver, nor does he question whether its reporting met extant accounting standards (though he’d like to see more details about how the initial value of 965 million was calculated).

But Srivastava nonetheless argues that the final reporting of compensation expenses does not reflect the underlying economics of Facebook’s operations. “Because, in their own admission”—based on the amount of taxes Facebook paid on its employees’ behalf—“they gave something worth between 6.2 and 8.9 billion dollars to their employees.”  If this is not an operating expense required to generate revenues, then what else is it? He tells me, “You can’t have your cake and eat it too.”

So what are the consequences of such clever structuring for the average investor? Inscrutability. Just how much does it cost Facebook to produce a dollar of revenues? It’s not clear, says Srivastava, whether the firm’s operations are in the black or in the red.

What is clear, however, is that existing accounting rules allow companies to avoid recognizing true compensation expenses when calculating profits. Facebook is a case in point: for new economy firms, which so often make use of stock-based compensation, unrecognized expenses can run into billions of dollars, even exceeding annual revenues.

See Anup's earlier comments about Facebook for the Insight Blog here and here.

Artwork by Felipe Briceño, a department administrator at the Kellogg School.