Introduction & Stock Based Compensation
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04:07:06 of on-demand video • Updated September 2014
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English [Auto] In this video we address gap versus non-GAAP presentation of financial statements by companies. Companies must present financial statements like the balance sheet the income statement the capital statement and the statement of shareholders equity in accordance with Gap gap reflects an attempt to present information in a useful way to the investing public. But there are many gray areas where there are disagreements about the optimal way to present something. Some of those common grey areas where gaps accounting treatment is different from the prevailing analyst's treatment includes the treatment or presentation of stock based compensation expense amortization expense and most interestingly non-recurring items. We're going to start with stock based compensation expense. Most companies that issue stock options to employees issue them at the money and with vesting periods. Meaning that employees are unable to immediately derive value from options. However stock options that are issued at the money and have a vesting period are still better than not having anything. Most employees would certainly prefer to have at the money options with a vesting period over not having them. And that means that they clearly have some value. The value just derived in what's going to happen in the future. And so because of that under gap companies are required to estimate this value today that the accrual principle and recognize it as compensation expense. Just like regular wages. Now companies can use a variety of option pricing models to estimate this value. But unlike salary the company doesn't have to issue cash immediately or even stock immediately the expense recognized on the income statement is therefore a non-cash expense like depreciation it represents simply a accounting valuation of the potential future value of stock options. Despite the gap requirement though most analysts and investors covering industries where there is a lot of stock based compensation generally ignore the expense and just reported earnings to exclude the expense. Analysts do that under the argument that it is a non-cash expense. It's based on a whole bunch of assumptions about what's going to happen in the future and it's therefore the argument is made better to just ignore it altogether. And presumably in industries where there's a similar amount of stock based compensation awards is a part of the total package. If you ignore all of it you remove some noise from the income statement that is noncash and it makes analyzing companies across the same industry a little bit easier. That's the argument for ignoring this gap requirement basically. Now since stock based compensation expense reduces gap tax expense. This is another nuance of what happens when you ignore stock based compensation expense as most analysts do. What ends up happening is because stock based compensation expense reduces gap taxes when analysts ignore stock based compensation expense. They should also ignore the reduction to Gap tax expense due to the stock based compensation. If you're going to pretend like you don't have like the company that you're analyzing doesn't have stock based compensation expense. You should also pretend like the company doesn't get a tax benefit from having this expense. Like depreciation amortization stock based compensation is not explicitly identified on the income statement but because it is a non-cash item it's added back to net income to get to cash from operations on the Cashell statement and you see that here. Here is Apple's cash flow statement. It starts with net income which is the last line on the income statement and the second ad back after depreciation and amortization is stock based compensation which is presumably buried within the operating line items on the income statement and is a non-cash item that needs to be added back for Apple. Like many companies that issue significant amounts of stock as part of employee compensation this line and can be a significant non-cash component of expenses. Next we turn to amortisation and the treatment by analysts of amortization expense and how it's different from GAP. So even ization as we know is a non-cash expense but it is sometimes ignored by analysts when analyzing earnings meaning the reported gap based results for a company's income statement are adjusted by analysts to exclude the impact of this amortization and when amortization is ignored the earnings per share without the amortization expense is often called cash earnings per share. The logic of removing amortization is similar to the logic of removing stock based compensation in the sense that both are non-cash expenses and they're sort of subject to assumptions useful life assumptions that the management puts puts on the intangible assets that generate the amortization and therefore there's a way to sort of wash away those subjective accounting adjustments that have no cash impact. This is obviously a violation of some basic tenets of her cruel accounting. One of the counter arguments is if for companies that are acquisitive they make a lot of acquisitions and are buying up a lot of intangible assets that generate a lot of amortization the large amortization expenses can really skew the picture of true operating performance. This being an accounting driven and assumption driven expense. Imagine a company that has bought a whole boatload of intangible assets and comparing it to another company that hasn't just bought a whole boatload of intangible assets. The company that just made those acquisitions is going to have massive amortization expenses that's going to make it difficult to actually ferret out what's happening from a core operational standpoint that doesn't have to do with these large acquisitions. That's the justification of the argument for ignoring amortization expense.