May 1, 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

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.

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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 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.”

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.

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 & Touché. 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

Featured Faculty

Ian Gow

Member of the Department of Accounting Information and Management faculty between 2009 and 2011

About the Writer

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

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.

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