Stock Options, Meet Pro Forma

''It's getting to the point where we're almost talking about earnings before costs," according to one observer.
Craig SchneiderOctober 31, 2005

An emerging trend in pro forma reporting is making some securities analysts cringe.

Under Statement 123R, the Financial Accounting Standards Board’s revised rule on stock-option expensing, the costs of issuing stock options must be included on the income statement rather than hidden in footnotes. Companies with year-ends after June 15, 2005, have begun to comply with 123R, but several companies are backing out all charges for stock-based compensation — even for restricted stock — from their pro forma, or non-GAAP, earnings.

“Nobody used to back out restricted stock,” says Jack Ciesielski, the principal of R.G. Associates Inc., a Baltimore-based investment research and portfolio management firm. “Now it’s the whole kitchen sink.”

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Is backing out restricted stock simply a sensible way to treat comparable items comparably — or it might provide an artificial, and deceptive, boost to earnings?

Analysts have long considered pro forma a useful supplement, given the fact that companies must disclose GAAP earnings as well, and reconcile the two sets of figures. Historically, pro forma has often been used to eliminate nonrecurring items from a company’s financials, and if the market is already using non-GAAP numbers to analyze the company’s results, a company that issues pro forma numbers allows analysts and investors to make apples-to-apples comparisons. Indeed, Google made such an argument earlier this month when it issued pro forma figures for its third-quarter earnings estimate.

Since stock options are a noncash expense, many observers expected companies to exclude them from their pro forma results, but the exclusion of restricted stock by some companies seems to have been a surprise. “Shame on them,” said Chuck Mulford, an accounting professor at the Georgia Institute of Technology, upon hearing the details. “They’ll try to feed you anything if you’ll eat it.” Mulford believes that few analysts will be fooled by this “funny business,” and that most will favor companies that are more forthright with their earnings reports.

“It would be incredibly naïve of investors to forgive companies for incurring compensation expense just because it’s denominated in shares of stock, especially as it becomes a more material part of the corporate fabric,” added Ciesielski last week in his blog, Analyst’s Accounting Observer.

Microelectronics supplier Entegris, wrote Ciesielski, disclosed that its pro forma earnings excluded stock-based compensation charges, primarily for restricted stock. Linear Technology issued a similar disclosure, previously reported in The Wall Street Journal, that its pro forma results excluded all charges for stock-based compensation, including restricted stock.

Ciesielski noted that Linear did not come right out and say that it was excluding restricted stock from GAAP to derive its pro forma numbers. Instead, he added the company stated that 123R covers all forms of stock-based compensation, including restricted stock, then proceeded to exclude the total from the pro forma result.

“Beware the generic ‘Statement 123R stock-based compensation’ add-back because companies aren’t being extremely descriptive about what’s in it,” wrote Ciesielski. “It’s easy to dismiss such charges as a simple noncash charge, but it’s getting to the point where we’re almost talking about earnings before costs.”

David Zion, a research analyst at Credit Suisse First Boston, issued a similar warning: “We recommend caution, as some companies may release pro forma results that exclude not only option compensation cost but also the cost of all stock-based compensation. That could give the company an artificial earnings boost, as it is now trying to get you to ignore a cost that it previously included in earnings.”

Robert Willens, an accounting and tax analyst for Lehman Brothers, isn’t surprised to hear that restricted stock is being lumped in with the compensation-expense exclusion from pro forma earnings. “I think if you’re going down that road, it probably makes sense,” he says. “It would be even more confusing to adjust only for certain compensation charges and not for others.” Indeed, he notes, both restricted stock and stock options “are compensatory and entail noncash charges.”

Even so, Willens fears that as more and more companies are required to comply with 123R, a pro forma “free-for-all” will confuse investors: different companies will define pro forma earnings differently, leading to a loss of comparability. “We’re going to wind up in a more confused state than we ever were,” he says.

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