Kellogg Insight

Posted
May 2011

Sifting through Stock-Based Compensation

Managers and analysts use the expense for different purposes

Based on the research of Mary E. Barth, Ian Gow And Daniel J. Taylor

The issue of whether to recognize stock-based compensation expense is one of the most enduring controversies in accounting. Although accounting standards require that reported measures of income reflect this expense, many managers and analysts exclude it when reporting income or predicting future performance to shareholders and potential investors.

According to research by Ian Gow, an assistant professor of accounting information and management at the Kellogg School of Management, managers and analysts report alternative, noncompliant numbers for different reasons. “In a nutshell, managers seem to be more motivated by hitting benchmarks, making their numbers look better,” Gow says. “The analysts are more motivated by trying to come up with a better number for valuation purposes.”

Circumventing a Controversial Standard
Gow explains that “stock-based compensation expense” is a general term. “Basically what we are talking about is stock options granted to employees.” Prior to 2006, the vast majority of the stock options that firms issued would not have been recognized in firms’ income in any way, he says. However, since then, revisions to generally accepted accounting procedures in the United States, or GAAP, have required firms to recognize stock-based compensation expense. “The reason these regulations came down is the perception of the Securities Exchange Commission [SEC] that a lot of firms were attempting to fool investors by reporting these non-GAAP numbers,” Gow says. “They were including items that should have been excluded and excluding items that should have been included. So there was a significant concern that the only reason that managers were producing these numbers was to fool investors.”

The GAAP revisions are just one of many reforms that came about after accounting scandals came to light in the early twenty-first century, such as the Enron scandal involving the accounting firm Arthur Andersen and the Adelphia Communications scandal involving the accounting firm Deloitte & Touche. Still, the regulation about recognizing stock-based compensation expense is controversial. “Normally, you don’t get high-level people in government opining about accounting issues, but this is one issue where senators, representatives, and other officials were taking strong stands on whether stock-based compensation gives rise to an expense or doesn’t give rise to an expense,” Gow recalls.

Although the regulation became effective in 2006, many people still do not agree that including stock-based compensation expense is necessary. In fact, some managers and analysts continue to exclude stock-based compensation expense when they present measures of net income in earnings announcements (non-GAAP earnings) and consensus earnings forecasts (Street earnings).

However, due to the requirements of the SEC’s Regulation G, when managers present non-GAAP earnings, they have to reconcile any such numbers with numbers prepared in compliance with the GAAP standards. In other words, even though managers are required to include stock-based compensation expense in calculating their income for financial reporting purposes, such as filing with the SEC, a significant number of them exclude stock-based compensation expense when reporting alternative numbers. Gow gives the example of a hypothetical firm that reports core earnings of 40 cents per share in its SEC reporting, but also reports an alternative core earnings of 50 cents per share to its investors. The firm is required to reconcile these numbers, and it might do so by reporting that the difference is 10 cents of stock-based compensation expense.

Managers and Analysts Have Different Motivations
Gow and his colleagues wondered whether managers and analysts have different reasons for excluding stock-based compensation expense from non-GAAP and Street earnings. They examined two possible motivations: “opportunism” and “predictive ability.” Opportunism is a desire to manage investors’ perceptions of firm performance. Predictive ability refers to the belief that the excluded expense will not help predict future firm performance, and excluding it will result in an earnings measure that is more useful for equity valuation.

The researchers hand-collected earnings announcements for fiscal 2006 for each of 1,845 firms, using the SEC Web site. Using several statistical analyses, they tested for the possibility of motivation by opportunism and by predictive ability for both managers and analysts. The results showed that many managers opportunistically excluded the expense in order to produce reports that showed higher earnings and met earnings benchmarks. There was no evidence, however, that managers included or excluded stock-based compensation expense with the goal of producing reports that better predicted future firm performance. The researchers detected just the opposite behavior by analysts, who excluded the expense from earnings forecasts when the exclusion increased earnings’ predictive ability for future performance. There was no evidence that analysts excluded the expense to make a firm’s numbers appear more positive.

One unexpected finding was that analysts’ decisions to include or exclude stock-based compensation expense were not dominated by managements’ decisions. As Gow puts it, “my expectation had been that analysts would pick up on the cues of management, excluding stock-based compensation expense when it was good for managers. At some point in the deep, dark past, the idea was that analysts were sort of the tools of managers. But we did not find evidence of that.” Analysts will “include stock option expense when it helps them accomplish that goal and exclude it when that helps them,” he adds.

In addition to shedding light on how managers and analysts have reacted to the mandate to include stock-based compensation expense in official reports, Gow and his colleagues have gained insight into the nature of the surrounding controversy. “What we find is that for some firms, stock-based compensation expense is relevant, so it makes sense to include it,” Gow says. “But for a lot of other firms it doesn’t seem to behave like an expense, so it makes sense to exclude it.” He adds that because this information has different roles for different firms, it stands to reason that not everyone sees things the same way. “If there were a single right answer for all firms, there would be less to argue about.”


Related reading on Kellogg Insight

Suspiciously Short: CEOs with stock options may purposely miss earnings targets

Rating the Raters of Corporate Governance: Independent examination reveals inconsistencies

About the Kellogg Researchers

Ian Gow was a member of the Department of Accounting Information and Management faculty between 2009 and 2011.

 

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Ian Gow


About the Research

Barth, Mary E., Ian Gow, and Daniel J. Taylor. 2012. Why Do Pro Forma and Street Earnings Not Reflect Changes in GAAP? Evidence from SFAS 123R. Journal of Accounting Research, 17(3): 526-562.


About the Writers

Beverly A. Caley, JD is an independent writer based in Corvallis, Ore. who concentrates on business, legal, and science topics.