Stock compensation expense, cash flows, and inflated valuations
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Stock compensation expense, cash flows, and inflated valuations Sanjeev Bhojraj 1 # Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract This paper reviews the statement of cash flow implications of stock compensation expense and the effect it can have on valuations. The paper suggests that treating stock compensation as a noncash item in the statement of cash flows can be misleading from internal decision-making and external valuation perspectives. This is important, given the increasing role of non-GAAP cash flow disclosures in financial reporting as well as their use internally by managers. The paper quantifies the potential size of the problem and suggests potential solutions, including treating stock compensation expense as an operating cash outflow and a financing cash inflow, adding further descriptive disclosures to the financial statements, or both. Finally, the paper also highlights a similar issue that occurs with the cash flow implications of finance leases. Keywords Stock compensation . Stock options . Valuation . FAS 123R . Cash flows
Zander Lurie, chief executive of SurveyMonkey’s parent, said investors were likely willing to overlook the company’s net losses because it has strong cash flow. Profitability for the 19-year-old company is still likely several years away, he said in an interview (Driebusch and Farrell 2019).
1 Introduction Accounting for stock compensation expense has been a controversial issue for over 25 years. The issue became prominent in the mid-1990s with the increasing use of I would like to thank Mary Barth, A.J. Chen, Patricia Dechow, Nick Guest, John Hand, Matthew Malgari, Partha Mohanram, Mark Nelson, Shiva Rajgopal, L. Shivakumar, Robert Swieringa, Mani Sethuraman, Richard Sloan, and Jim Wahlen for their helpful comments.
* Sanjeev Bhojraj [email protected]
1
Johnson Graduate School of Management, Cornell University, Ithaca, NY, USA
S. Bhojraj
stock options to pay employees. At the heart of the debate was the issue of whether compensation using stock options is an expense. Arguments against the expensing of stock options (primarily from managers of tech firms) included that they are not a real cost but a noncash charge, difficult to value, and have no value until exercised. Other arguments against expensing were that doing so would hurt young businesses that rely on options and reduce their use, thereby reducing alignment between employees and shareholders, as well as that by using diluted shares outstanding market prices implicitly correct for the effect on equity values. Supporters of expensing argue that options are a real cost to companies and are issued in lieu of cash compensation to employees and therefore are an expense. They also rebutted all of the arguments presented against expensing.1 After much controversy and despite pushback from firms, FASB issued SFAS 123R (now ASC 718) in 2004, which required the expensing of stock options (IFRS 2 preceded the introduction of SFAS 123R). While stock compensation in the 1990s and early 2000s w
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