Tech Profits Mirage: Big Public Companies Attempt to Exclude Stock Compensation

When big, successful, even iconic companies start playing accounting games with their earnings statements, it is usually because they know they can no longer keep up with smaller, nimbler and less expensive enterprises. We saw this during the dotcom era. But what is worrisome - as the following article explains - is we are starting to see it again.

Facebook, LinkedIn and Twitter, among others, are attempting to exclude stock-based compensation - in Silicon Valley a necessary and significant expense - from earnings. No surprise that the primary culprits are all in social media, whose P2P - path to profitability - has long been suspect. Could just be greed. Or it could be a signal of less edifying results to come. JL

Miriam Gottfried reports in the Wall Street Journal:

Earnings are a performance measure. You start with revenues and subtract all the resources you used up to generate that revenue. Human capital is one of those resources. Backing out stock-compensation expense is tantamount to saying employees are working for free.
Do an Internet search for the words “tech bubble,” and most results will reflect current worry over whether we are in one.
The top one, however, still harks back to the dot-com bubble of the late 1990s when the market became overly confident about the future profitability of Internet companies, many of which faltered or failed. Much of today’s hand-wringing stems from fears the tech sector, with its high valuations and focus on user growth, is returning to that frothy period.
One sign that may lend credence to that concern: the often-widening divide between two sets of earnings tech companies present to investors.
All public U.S. companies must report earnings based on generally accepted accounting principles. Many tech companies also present a second set that exclude certain charges, most significantly stock-based compensation. Such pro forma earnings were the targets of regulatory reform in the early 2000s after companies focused too heavily on them, obscuring actual results.

Tech companies today appear to be following revamped rules. But many are again trying to get investors to see the world through rose-colored glasses—and in some cases adding new pro forma wrinkles. Analysts, meanwhile, are dutifully playing along, typically basing estimates on these figures.

At many companies, the difference between pro forma and reported earnings has been considerable of late. Over the past four quarters, Facebook FB -0.10 % ’s reported net income was equal to 56% of its pro forma measure. At Twitter, pro forma earnings over that period were 22 cents a share versus a reported loss of 98 cents. LinkedIn LNKD -0.22 % was similar: Its reported loss of 36 cents shifted to earnings of $2.21 on a pro forma basis. In each case, stock-based compensation accounts for most of the difference.
Now, though, many tech companies are pushing the pro forma envelope even further. Facebook, for example, doesn’t just exclude its stock-options expense from its pro forma earnings; it also keeps out payroll-tax expenses related to such compensation.
But these payroll taxes are only a loosely related cost and are incurred over a different time period than share-based compensation expense. The latter is a noncash expense arising from the granting of stock-based awards to employees during the financial reporting period. Payroll taxes are a cash expense based on the taxable income of the employee, typically withheld at the time options are exercised.
The expense is relatively small, amounting to 2.7% of Facebook’s operating income in the first quarter. But it points to the lengths tech companies are going to gild the pro forma lily.
Some in the tech world try to justify all this with timeworn arguments that doling out stock options is an equity event, not an operating expense, and so should be excluded from earnings. Yet that flies in the face of Silicon Valley reality: Awarding shares as compensation is a regular cost of doing business and attracting talent.
“Earnings are supposed to be a performance measure,” says Wendy Heltzer, an associate professor of accounting at DePaul University. “You start with revenues and subtract all the resources you used up to generate that revenue. Human capital is one of those resources.”
In other words, backing out stock-compensation expense is tantamount to saying employees are working for free.
Granted, there may be instances where pro forma earnings have a purpose, as in the case of an acquisition. Such adjustments can sometimes help investors better understand and predict a company’s underlying performance and potential.
In a 2012 paper, accounting professors Mary Barth, Ian Gow and Daniel Taylor found evidence analysts’ independent decision to exclude stock-options expense from pro forma earnings increased the predictive ability of those earnings for the company’s future performance.
But when management excluded stock-based compensation, the professors found evidence they did so opportunistically—to increase and smooth earnings and to meet earnings benchmarks. They found no evidence the exclusion resulted in an earnings measure that better predicts future performance.
Investors have seen this movie before. Before climbing back on the pro forma earnings