It’s an old and repetitive story. Managers of hi-tech firms are so aware that they need to produce profits that they seemingly will do anything to produce numbers that look good whether or not the numbers in fact reflect something good in practice. If managers would put as much effort into developing new strategies, the hi-tech industry would have greater chances of success.

 In the case of eBay, the managers have decided to continue to pretend that stock options given to employees do not act as compensation expense. Of course, these guys are the same ones who would like to say that depreciation and amortization are also not expenses. Given their logic I suppose that these managers, if they had their way, would equate net income with revenues.

But let’s recall the fundamentals. In Concepts Statement No. 6 the FASB clearly explains that "Expenses are outflows or other using up of assets or incurrences of liabilities … from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations." Because stock options have value to managers as part of their compensation package, clearly the employment of stock options is an ongoing central operation. Stock options consume assets or incur liabilities in either of two ways. Most companies use funds to purchase treasury stock and then transfer the certificates to the managers. This activity clearly and directly uses up assets. If the firm does not make treasury purchases, its only option is to issue more shares of stock. This alternative deprives the company of cash it otherwise would receive when the firm issues stock. Either way, the firm consumes assets, and so stock-based compensation constitutes an expense.
  

Albert Meyer, the chief analyst at 2nd Opinion Research, has recently written a report that casts doubt on the true profitability of eBay. The contrast between the net income of eBay versus its income with the stock options properly subtracted out is interesting (in thousands of dollars):

 

	2000	2001	2002	2000-2002
Reported Net Income	48,294	90,448	249,891	388,633
Pro forma	(114,221)	(117,987)	62,942	(169,266)
Free cash flow	(1,088)	117,547	285,773	402,232

The pro forma earnings show that eBay has lost money over the last three years. Meyer also points out, "During the past three years, employees exercised 21 million shares and realized $827 million, or more than $550 million after-tax, in stock option gains." Notice that this last number corresponds approximately with the difference between the reported net income and the pro forma earnings numbers ($558 million). This observation validates the utility of the pro forma numbers over the reported numbers and clearly demonstrates that eBay actually has very little sizzle!

The free cash flow numbers are interesting because these free cash flows, estimated by Meyer, must be used by management to pay providers of capital. After one applies the three-year free cash flow to cover these stock options, the residual cash flow becomes a negative $147 million. This number obviously reflects a negative residual, and any rational investor in eBay wouldn’t be happy with his or her declining value.

"But wait," some hi-tech guru will yell, "eBay hasn’t made any treasury purchases. That nullifies your argument." No, it just changes the analysis. The total reported net income for the 2000-2002 period is $388 million with earnings per share of $1.35. This computation includes 63 million shares that eBay has issued to its employees. Without this compensation, the earnings per share would have been $1.73 over the three-year period. In addition, eBay has 37 million stock options just waiting to be exercised. If they all are exercised, eBay’s earnings per share will drop to $1.20. The message to the stock market is simple -- each eBay investor has lost $1.73 -- $1.20 or $0.53 per share because of the transfer of wealth from the investors to the employees. Given that this loss persists forever, that’s a very high tax to pay!

The bottom line message is simple: the FASB is on the right track as it unanimously agreed to require stock-based compensation to be placed on the income statement. Pressures from members of Congress and from hi-tech managers will challenge the board as well as the SEC to change this decision. My hope is for the FASB members to maintain the fortitude to resist this confrontation.

 

The analysis by Meyer is compelling. To show the true impact of stock options, companies must deduct them as stock compensation.

 

See also: Ebay's Unannounced Restatement of Earnings
 

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of the forthcoming Hidden Financial Risk, which explores the causes of recent accounting scandals.