Are Stock Options Compensation? Yes, But So What?

Nov 16, 2008

Well, are they? Should stock options be valued, and treated as an operating expense to be run through the company’s income statement? The accounting issue was “settled” a few years ago by GAAP statement FAS 123R, which requires companies to “expense” stock options. But it’s still up in the air: most securities analysts will tell you that more investors would rather see the pro forma income statements, with stock option expense backed out, than the GAAP financial statements.

First of all: Are stock options compensation? Well, company stock is a scarce and valuable resource – just like cash, or cars, or health insurance – that companies offer to prospective or current employees to get them to accept a job offer. Or reward them for a job well done. Or keep them from going to work somewhere else. Hello? Of course stock options are a compensation expense!

So why do so many people want income statements without the stock option expense? Is this a paradox? No, not if you ask this question first: What is the income statement for?

Back up one more step: How much is a company’s stock worth? As every MBA will tell you, it’s the discounted net present value of the company’s future cash flow. Obviously, that’s very hard to estimate, but if you can do that accurately, it’s the only thing you need to do to determine if a stock is worth more or less than its current price. And a company’s historical income statements are one of the few objective tools for assessing its cash-generating potential.

So now the question becomes: Does expensing stock options make it easier to use income statements as a tool for forecasting future cash flow? Or harder? If you believe what the analysts are saying, investors are voting against expensing stock options.

Does this mean we should “repeal” FAS 123R? No. Stock options are a compensation expense, and there are plenty of investors who want to see them expensed in the income statement. But it appears that even more investors prefer income statements that don’t expense options. Rather than “fixing” the accounting standards, accounting firms and their regulators need to focus on making sure that investors get the information they need. So get over it – pro forma statements aren’t always so bad.

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

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