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Bucking tradition: is stock-based comp expense a worthy performance measure for Facebook?

U.S. accounting standards require companies to recognize expense based on the fair value of the stock-based compensation awards issued to employees; most commonly these are stock options and restricted stock units. Some know this accounting standard as Financial Accounting Standard (FAS) 123R, now referred to as Accounting Standards Codification (ASC) 718.

Most companies adopted this standard in 2006 and concurrently decided to exclude stock-based compensation expense from their financial statements when reporting their results to investors in earnings releases. Why? The most common reasons were that the charges were noncash in nature and that they believed excluding these amounts made their financial statements more comparable period-over-period and more comparable with other companies’ financial statements.

Now Facebook’s situation is calling this tradition into question.

In an article released Sept. 22, Barron’s questions the value of Facebook stock and criticizes the company for excluding stock-based compensation expense from its adjusted earnings. “This dubious approach to calculating profits is based on the idea that only cash expenses matter,” writes Andrew Bary. “That’s a fiction, pure and simple.” (Read “Still Too Pricey” online.)

Facebook, however, believes that by excluding these costs they are providing meaningful supplemental information to investors. In Facebook’s earnings release for the second quarter of 2012, it’s explained that “varying available valuation methodologies, subjective assumptions and the variety of award types that companies can use” can cause incomparability between Facebook and the competition. The earnings release also references the $1 billion expense, which was technically granted and earned over several years, that Facebook recognized in their first quarter as a public company.

Ironically, the top two reasons the Financial Accounting Standards Board (FASB) issued its fair-value accounting guidance were 1) to address concerns from financial statements users, including institutional and individual investors, regarding the faithful representation of compensation expense; and 2) to improve the comparability of reported financial information.

Here’s the big question: is stock-based compensation expense really a meaningful measure of a company’s operating performance? Both Google and Apple would join Facebook in saying it isn’t. I can see arguments for both sides, but it’s not about what I believe: it’s up to investors to draw their own conclusions. While companies like Facebook (technology companies especially) generally exclude stock-based compensation expense from their reported non-GAAP earnings, they are also required to provide disclosures, including the amounts excluded and the basis for excluding the charges. So, if you believe that Facebook shouldn’t have excluded $1.1 billion of stock-based compensation expense from its reported $1.9 billion of total operating expenses for the second quarter of 2012, or the $2.2 billion of unrecognized stock-based compensation expense as of June 30, 2012 that it expects to recognize over the next two years, then add it back in. It’s a calculation, not a conspiracy.

For another look at stock compensation, see RoseRyan guru Stephen Ambler’s “Stock compensation rules mask true operating performance.”

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Equity compensation: the devil is in the details

Equity compensation can be a significant factor in attracting and retaining talent. Lately a lot of attention is being given to effective compensation strategy, investor expectations and shareholder dilution. Philosophies have evolved and rules and regulations have changed, but one thing that remains constant is there are often surprises in the accounting for stock awards. We see start-up companies struggling to get the accounting right, and we see struggles in public companies with well-designed internal control systems, too.

What not to do

Many of these challenges can be avoided simply by paying attention to the details. Getting the paperwork right sounds easy, but you’d be surprised at what can happen. Here are a few of the most common errors to be on the lookout for:

  • The number of shares to be granted is a mystery, because the number of shares in the grant paperwork doesn’t agree with the number of shares approved in the board minutes.
  • There is confusion over when the employee started work. It’s not uncommon for employment start dates to be revised between the time the offer letter is sent out and the day the employee actually shows up. Granting stock to someone before they are an employee can cause problems; the accounting for option grants to employees is different than the accounting for option grants to nonemployees. And some stock plans prohibit granting options to nonemployees.
  • Stock is granted without proper approval. Understand (and communicate) who is authorized to grant stock or options. Having a clear stock grant policy is critical—as is making sure people understand it and follow it.

We also see data entry errors, which include:

  • Grant date or option strike price are entered incorrectly.
  • Vesting schedules are entered incorrectly (for example, a grant is entered as vesting ratably over four years instead of having a one-year cliff).
  • The grant is not input or is input twice.
  • Paperwork is not processed on a timely basis. This applies to inputting new grants as well as cancelling grants for terminated employees.

Keep accounting in the loop

Reconciliations are your friend. Make sure to reconcile your stock records to the transfer agent records as part of your monthly close process. Compare new hire listings to stock grant records, and termination listings to stock cancellation records. Double-check data input to source documents.

Modifications can have major accounting implications, including significant current P&L expense. Oftentimes companies make decisions about stock option modifications without considering the accounting implications. A good practice is to have your accounting department analyze modifications and compute the potential P&L impact before a decision is made. The stock options may still be modified because that makes business sense, but everyone will understand the amount of the additional expense before the modifications are approved.

And remember: a stock option grant modification is any change to the terms after the stock is granted; these include changing the number of granted shares, altering vesting terms and repricing options. (It’s not unusual for a CEO to agree to modifications with a terminating executive without discussing it with accounting—and that can result in huge P&L impacts that could have been prevented.)

Because stock is part of employee compensation, errors are a double whammy. They can have a significant impact on employee morale and motivation, for example, if employees don’t get what they thought they were getting, or if a grant has significant tax implications for them. Errors can also impact the company financially because incorrect data can affect the computation of stock-based compensation expense.

The good news is these problems can be avoided with education, discipline and communication. A good place to start is our upcoming seminar at the end of October.

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Living to work? Remember, you only live once

A few years ago, well before I joined RoseRyan, I met a recruiter who was trying to fill a CFO opening in a fast-moving start-up. The role sounded interesting, until the recruiter said the CEO was looking for a young candidate as they were less likely to want a “work-life balance.”

Immediately, I knew the discussion had just hit a fatal roadblock, because I am a strong believer in work-life balance. Someone once said you should work to live, not live to work. That is so true.

When I first started working, I did not have that balance. I would work long hours, and I definitely put work above most other activities. After a few years, I began to realize I was going down the wrong track. My social life was suffering, and I was beginning to see that some perceived benefits were not there. For example, I met people who had dedicated themselves to their companies for years, only to lose their jobs in times of recession or streamlining operations without an ounce of thanks from their former employers. Because their jobs had been their life, they were left with nothing. I felt really bad for them, and began to realize the same thing could happen to me if I wasn’t careful.

So I started to change my ways. I banished my cell phone from social events and Little League baseball matches, and made efforts to get home to be with my family at mealtimes and in the evening. I took steps to avoid my laptop on one full day out of the weekend, and instead to go do something interesting. I can honestly say my work did not suffer from these changes. If anything it got better, as I was now much sharper, healthier and less stressed.

The final vindication of my actions came to me on September 11, 2001. I was one of the people at the World Trade Center that morning, and I was fortunate to get out of there with my life. I had plenty of time that week to reflect on that Tuesday’s events. They cemented in me the need for a proper work-life balance, as you never know what’s coming next.

You only live once. Make the most of it and work to live—don’t live to work.

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What separates great audit committees from the merely good?

As a former audit partner of a Global Six accounting firm, I’ve done my fair share of presenting at audit committee meetings. I’ve noticed that when it’s time for the auditors to present, there will always be the occasional board member who turns to his or her laptop for a bit of day trading or to check email (no, this didn’t hurt my feelings at all).

More important, I’ve been able to observe what characterizes an effective audit committee. This has been on the minds of Public Company Accounting Oversight Board members lately, too. Last month, the PCAOB unanimously adopted AS 16, Communications with Audit Committees. Though the intent is to enhance the relevance and timeliness of communications between the auditor and the audit committee, the standard has little to do with influencing the audit committee’s dynamic with management.

So, here is a compendium of my direct observations on what separates a truly effective audit committee from the rest.

Risk-focused meetings. Meeting agendas should evolve with the growth stages of the company and respond to changes in the economic and competitive environment.

Challenge historical policies and practices. The key operating and financial reporting risks will never be uncovered unless the committee challenges the past.

Transparent and honest communications. It’s crucial that audit committee members talk candidly about what’s going well and what isn’t.

A dynamic chair. It’s paramount that the committee is led by a strong communicator who facilitates discussion, keeps it on track with the agenda and acts as an objective voice during heated exchanges.

Global representation. Committee members who represent the company’s foreign operations add insight into cultural, legal and tax-structure differences.

“Pre-meeting” with the finance team. The most effective audit committee I observed flew in the day before the meeting to have dinner with key finance team members. This informal setting facilitated communication and gave the committee a chance to formulate more questions. It also gave the finance team a heads-up about late developments that weren’t on the agenda.

Quarterly lunch with the independent auditor. Yes, I understand that the audit partner “takes you out” and then bills the company, but he or she can provide valuable insights, such as feedback on the performance of the management team and an honest take on accounting and internal control risk areas. The committee chair isn’t likely to get this kind of information from the formal slide presentation.

For more suggestions, check out Ernst & Young’s excellent article, “Audit Committees: Going Beyond the Ordinary.” It’s a great piece from the June 2012 issue of E&Y’s BoardMatters Quarterly newsletter.

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