Does the Cash Flow Statement Lie?[Fool on the Hill] June 8, 2000

An Investment Opinion

Does the Cash Flow Statement Lie?

By Warren Gump (TMF Gump)
June 8, 2000

Many people think that while the income statement can be distorted by anomalies within Generally Accepted Accounting Principles (GAAP), the cash flow statement (CFS) is gospel. This information source allows investors to track cash, the lifeblood of any business. While a lot of information can be gleaned from the CFS, you have to be careful with how it is used -- particularly regarding employee stock options (ESOs). After reading this article, tell us what you think in our poll.

What Exactly Is an ESO?
A company achieves several objectives by issuing to employees the right to buy company shares at the present-day stock price for the next several years. These securities reward employees for helping increase a company's per-share value -- aligning employees interests with those of shareholders. Better yet, this objective is achieved without any explicit cash outlay from the company.

Making options even more attractive for a company is the fact that they vest, or become exercisable by employees, over a period of years. This turns into an incredible retention tool for companies where employees believe success is probable. Employees are going to be reluctant to leave an organization if they are giving up a potential option "gold mine." This could be the most valuable aspect of options, particularly in an economy where good employees are one of the scarcest resources.

ESOs can be viewed as an employee bonus plan tied to stock price performance. From an economic standpoint, employees shouldn't care whether this bonus is in the form of cash or company stock (ignoring tax implications).

A company could achieve the same motivational objectives by offering a bonus program that gives employees a cash payment equal to stock price appreciation on 100 shares over a 10-year period or granting a 10-year, 100-share ESO. All the company would need to do is implement a bonus vesting schedule equal to the option vesting schedule and stipulate that employees could request payout on the vested portion of the bonus at any time. While the economic characteristics of these two programs are equivalent for employees, they are treated very differently on the company's income and cash flow statement.

Income Statement Impact
I'm not going to fixate on the how differently these two bonus structures are accounted for on the income statement (this article's about cash flow!). However, being aware of the difference helps make it clear why option plans are so popular with employers. A company records any cash payouts from the above-mentioned bonus plan as compensation expense, which in turn lowers reported net income. On the other hand, accounting rules stipulate that no compensation expense be recorded if a company uses a standard stock option plan.

So the company's choice is either 1) implement a bonus plan, record compensation expense equal to the paid bonuses, and lower net income, or 2) use a stock option plan that provides employees with the same economic benefit, yet incurs no compensation expense or profit hit. Which do you think is more popular? The correct answer is number two.

Cash Flow Statement Ramifications
A company utilizing the cash bonus plan has to hand greenbacks out to its employees, which is reflected in the operating section of the CFS. End of issue, no accounting problem.

A company using a stock option plan doesn't utilize this same accounting treatment. When an ESO is exercised, the CFS details this transaction by showing no change in the operating cash flow and a boost to financing cash flow (equal to the cash received from employees). While these entries correctly track money flows, one important aspect is completely missed. In the process of selling stock to employees at discounted prices, the company foregoes obtaining the true market value for the stock that was issued.

Let's look at an example where employees own 40,000 vested options in The Option Co. at a $5 strike price that are about to expire. With a current market price of $100, the employees exercise these options immediately before expiration. They hand over $200,000 (40,000 x $5) and The Option Co. issues 40,000 shares. This transaction would not affect The Option Co.'s operating section of the cash flow statement, but would result in a $200,000 inflow in the financing section.

While this seems to accurately reflect the transaction, the reality is that The Option Co. could have received a lot more than $200,000 for the 40,000 shares issued to employees. If the company had sold those same shares on the open market, the company would have increased cash by $4,000,000 instead of $200,000. The $3,800,000 difference represents money the company could have raised, but instead passed along to employees for work done in prior periods. Even though everybody knows this foregone cash represents a compensation expense, the $3,800,000 is never seen on the company's income statement... or its cash flow statement. That's wrong.

Current accounting rules permit a significant amount of compensation expense to be completely hidden from reported financial statements. This accounting loophole is one of the reasons that options programs have proliferated and become so generous. It also partially explains why reported earnings quality has deteriorated over the years.

Magnitude of the Problem
I'll let you decide whether the magnitude of foregone cash is significant. Below are the ranges of foregone cash (market value minus weighted average exercise price) from options at several major companies during their last fiscal year. The ranges reflect the minimum and maximum amount of foregone cash, based on the lowest and highest market price for each stock during their fiscal year. The actual foregone cash amount lies somewhere within the range. The shares column reflects the number of shares exercised during the year.

                        Shares    (Billions)
Company                  (Mil.)  Min.     Max.
Amgen (Nasdaq: AMGN)      26.9   $0.4    $1.5
Cisco (Nasdaq: CSCO)     186.0   $1.3    $5.8
GE (NYSE: GE)             61.7   $1.5    $2.8
Microsoft (Nasdaq: MSFT) 175.0   $6.6   $15.6
Pepsi (NYSE: PEP)         19.6   $0.3    $0.5
(These figures reflect options granted over several years, but they don't represent all options vested during the year or the change in value of previously vested, unexercised options.)

Stock Buybacks
Not convinced that foregone cash is real? Look down at the financing section of the statement of cash flows of a company repurchasing shares. Many investors believe that stock buybacks are benefiting them by reducing the number of shares outstanding. In reality, these programs are often implemented to offset the dilution caused by stock option grants. But investors usually ignore this fact since the cash flow is listed under financing rather than operating activities.

Amgen spent more than $600 million repurchasing shares last year (that's $1 billion in gross purchases offset by about $400 million in proceeds from options grants and tax benefits). Despite expending this cash, which equaled 56% of net income, the company's diluted share count increased 2% during the year. That means a 100-share stake in Amgen at the beginning of the year represented 2% less of the company at the end of the year, even though the company shelled out more than half of net income to repurchase shares.

Seeing a company like Amgen expend 56% of net income on stock repurchases to only partially offset option grants demonstrates the cash expense of option grants. If the company were to have completely offset the dilution from employee programs, Amgen would have needed to increase gross repurchases more than 80%! Most people don't consider the $600 million real cash outflow related directly to options expense as employee compensation. Almost no one takes into account the additional cash that would need to be expended to ensure that diluted share count were not affected by all employee stock incentives.

I don't mean to pick on Amgen here (it happens to be a company I own). It's just a great example because it didn't do any acquisitions last year and its entire share count change is related to options. You could look at most other companies with significant share repurchases and employee option programs to see the same thing. Looking at the facts surrounding this issue forces you to view stock options as a real expense that directly affects the cash kept in a company till.

ESOs align employee incentives with shareholder objectives and provide an alternative financing route for most companies. Their place in the corporate finance world is indisputable and investors should be glad that they are in a chief financial officer's toolbox. But investors should demand that financial statements clearly reflect the true costs of these programs. Until that happens, published financials for companies with significant stock option programs will not reflect the economic reality of their results. You'll have to read them all -- even the cash flow statement -- with a skeptical perspective. Investors may not be paying too much attention to this issue now, but they will someday.

What do you think? Should investors be concerned about foregone cash related to stock options? Give us your opinion in our poll.

Related Links:
  • Some Thoughts on Stock Options
  • Why Microsoft's Stock Options Scare Me
  • Stock Option Rebuttal
  • Optionmania! (Part 1, Part 2, Part 3)