Generally Accepted Accounting Standards (GAAP)

I understand and appreciate the need for rigorous accounting standards and I appreciate that our financial system and our capital markets in the US enforce the use of generally accepted accounting standards (GAAP) for the reporting of company financial information. Without standards rigorously applied, investors would not be able to understand what is going on in the companies. That would be awful.

But when I read Gretchen Morgenson’s recent article in the New York Times accusing companies of “spinning losses into profits” my eyes rolled.

The truth is the the accountants who run the accounting standards have forced companies into reporting their financials in a certain way that neither the companies nor the sophisticated investors who own many of these companies’ shares believe accurately represents the financial condition of the reporting companies.  Gretchen quotes this stat in her piece:

According to a recent study in The Analyst’s Accounting Observer, 90 percent of companies in the Standard & Poor’s 500-stock index reported non-GAAP results last year, up from 72 percent in 2009.

That sure feels like the market speaking. When 90% of your customers order the scrambled eggs differently than you normally serve them that tells you something.

My pet issue is stock based compensation. When a company issues options to an employee, accounting standards require that the option be valued (usually by a formula called Black Scholes) and expensed over the vesting period. That sounds reasonable. But the truth is that that option may end up being worth nothing. Or it may end up being worth 10x the value that it was expensed at. By taking out the stock based comp expenses and reporting an “adjusted EBITDA” number that does not include it, companies are giving investors an idea of what the earnings power of the company is without this theoretical expense. And that stock based compensation expense is a non-cash expense meaning that even though it theoretically costs the company something, it is not paid in cash but in dilution of the total number of shares outstanding.

This is not a cut and dried issue. Different investors will approach it differently depending on whether they care about cash flow, long term dilution, or something else. But the accountants who control the accounting standards board require a certain way of presenting these numbers and that is that.

So investors and the reporting companies offer other ways of looking at these accounting issues. That is not bad. That is not spinning. That is transparency and it is good.


Comments (Archived):

  1. JimHirshfield

    I hear ya man. It’s accrual world.

    1. Mario Cantin

      Ah, that’s what that Pink Floyd The Wall song was really saying: “Goodbuy accrual world, I’m leaving you today, goodbye, goodbye, goodbye….”

    2. Russell

      woh woh woh

    3. kidmercury

      lol you’ve been on fire the past few weeks……when are you taking this act on the road? sign me up for VIP passes! 🙂

      1. JimHirshfield

        No road show, sorry. Might do a VR/AR show in 2048.

        1. Mario Cantin

          Sorry, I might miss it due to having died before. Won’t happen again though.

          1. JimHirshfield

            It’s all virtual. No need to be alive.

          2. Mario Cantin

            It’d make it a little tricky to emote, don’t you think? If I bother to virtually attend, I want to be able to laugh man 🙂

        2. jason wright

          who are you with?

          1. Mario Cantin

            They aren’t born yet.

          2. JimHirshfield

            No one. Direct to consumer model.

        3. Twain Twain

          By then, you may already have become the “Red or blue pill?” we take that goes straight to neurons. No need for AR/VR!Lol.

    4. Anne Libby

      Are you here all week?

      1. JimHirshfield

        Whether you like it or not.

  2. Tom Labus

    But what many companies are now saying is: We made money except for our losses. Even Andy Fastow, of Enron fame, has been calling this out. What I find amazing is that all parties seem to think this is fine.

    1. fredwilson

      Or we made money depending on how you value the stock we issue to our employees

      1. Matt Kruza

        Yeah, how you value it is the key, (obviously) and I think this is relevant for tech and younger companies. So say etsy has SBC, since there is still much variability and upside (or downside) potential in future returns it makes more sense to discount or ignore SBC. Now with Facebook and Google and certainly non-tech established companies (walmart, JP Morgan etc), it makes more sense to include the SBC because the options are closer to cash for businesses which are evaluated more on actual cash performance vs expected growth. Even though future growth is definitely embedded, its much more likely to be low compared to a high volatility / beta young tech company

        1. JLM

          .It is also important to recognize that the high volatility young tech company is plugging that same volatility assumption into Black Scholes which is why I hate it so.JLMwww.themusingsofthebigredca…

          1. Matt Kruza

            Yeah. I agree makes back scholes then overstate price of said option right? That is how you are arguing it? I guess my question is how else would you value the option? Are there other option pricing mechanisms that you prefer? I am decently familiar with black scholes and implied volatility etc but not aware of others that are used

  3. William Mougayar

    Maybe a tripple entry accounting can better identify these creative practices so they don’t look so much as spinning.

    1. pointsnfigures

      They keep three sets of books already! Tax, internal cost, and public GAAP.

      1. William Mougayar

        well, you know triple entry doesn’t mean 3 books 🙂

        1. pointsnfigures

          Yes, I should have put a smiley on my comment. was a bad joke. I should let @JimHirshfield:disqus do the jokes around here.

          1. JimHirshfield

            Hahahaha…no. All are welcome.

    2. creative group

      William Mougayar:if a company has to make it look like something it isn’t there lays the problem.

      1. William Mougayar

        I meant that it would bring some clarity.

  4. pointsnfigures

    Agree. I also like that more companies who used to hide behind “notes to financial statements” are being more transparent about the true cost. Providing notes was GAAP. For example, if you ran an airline, you might not actually own the planes-you lease them. You are liable for the lease costs and would show the true cost in the note. To know the real effect on earnings, a person would have to take the note, run it through a net present value calculation, and bring it onto the balance sheet as a liability. Now a lot of companies will do the math for you in the note or by showing non-GAAP earnings.One of the nice things about seed investing is the accounting is much easier than later stage or private equity investing!

  5. Candyman

    I’ve watched in dismay as an equity analyst over the past few decades as we have drifted more and more into more “relevant metrics” like Adjusted EBITDA. I agree that SBC muddies the waters and should be accounted for in a more thoughtful way. It does have an impact on equity investors, especially if things go well. Of course it’s generally a very small one so can be ignored to get to the magnitude and direction of the upside.I still do everything based on revenue and operating cash flow. Thankfully it still works (at least over the longer term). I don’t read much financial press anymore but some of the articles that have come to my attention do show a lack of financial and intellectual depth that surprises me.Ah well, back to work!

    1. creative group

      Candyman:did you mean the NYT which was the story that was used to start this post.Why exclude any information used as reference (positive or negative) by those who influence?We have always been registered Independent’s but wouldn’t exclude MSNBC or FOX News programing understanding both programming biases.

      1. Candyman

        You’re right! I associated that reporter with the WSJ. My bad! Apologies to the WSJ!

  6. sigmaalgebra

    Fred, you blew it!Your first mistake: I read Gretchen Morgenson’s recent article in the New York Times That’s something no sensible person should ever do!Fred, believe me, I didn’t do that. No way would I do that. my eyes rolled. Of course they did. Why? Because of your mistake — you read the NYT. Again, should never do that!Moreover you made a second mistake: You took what you read in the NYT seriously. Again, should never do that.Fred, believe me, I don’t do that. No way would I do that.So, sure, as you explained, the companies want to report more information rather than less, and, thus, the NYT sees an opportunity: Danger, deception, scandal, sin, corruption, conspiracy, collusion!Collusion? Sure, it’s right there, the fraction of companies engaging in this deceptive practice — no doubt based on contemptible, capitalistic greed — has skyrocketed from 72% to 90%.Why? The usual: First, the NYT is in [drum roll, please] the ad business.Second, for their ads, they want eyeballs.Their view, going way back through W. Hurst, B. Franklin, etc. is to grab people by the heart, the gut, and below the belt knowing that, then, the eyeballs will be sure to follow.One of their main ways to grab people by the gut is to make claims of danger, deception, scandal, sin, corruption, conspiracy, collusion — in simple terms, heavy, bad stuff is goin’ down.They can also grab people by the heart and below the belt.That’s what the media has done for well over 100 years, and it’s what they still do.The NYT is writing lots of stuff; e.g., can see lots of links to their stuff on Hacker News and Drudge Report. So, they are trying for something, maybe to stay in business. But one thing they are showing is how many different ways it’s possible to create total BS.And, yes, the NYT content is made-up, deceptive, silly, fantasy nonsense and, if taken at all seriously, dangerous — really, as Trump has been saying, “disgusting” — good word choice.But, with the Internet, there is hope for better content.Of course, there can be some reasons to read the NYT: First, we can discover the total BS other people are reading and maybe taking seriously. Second, the NYT is a huge source of many, daily examples of thinking that definitely should avoid.In traditional academic terms, the NYT fills a much needed gap in the literature and would be illuminating if ignited.Over the years, in their many efforts to get me to subscribe, I had to respond that “I no longer have dead fish heads to wrap, and my kitty cat prefers regular kitty litter”.

    1. creative group

      sigmaalgebra:intelligent, educated, the well informed and difference makers don’t exclude information when they influence.We recognize you are in your tighty whities jumping up and down attempting to be acknowledged and hoping anyone will engage in your diatribes of Nutwing grandeur and no sense of reality views.We engaged in your childish look I am over here because discipline from time to time with low hanging fruit becomes a necessary evil. Consider yourself fortune to even be addressed.You will attempt to go back and forth to no avail without further engagement. Your persona you are attempting to create only highlights your same views as another contributor. Now go away and sit down and allow adults to have dialogue.

      1. sigmaalgebra

        You will feel better once you sober up.

    2. LE

      Of course they did. Why? Because of your mistake — you read the NYT. Again, should never do that!If I take you literally, not according to the way that I think. It’s important to read what the enemy is telling people. You can’t defeat and counter an opponent without intel. Not that I am fighting any particular battle. I also read a few trashy tabloids (NY Post, NY Daily News) because I like to know what they are telling the people that read those papers.The NYT is writing lots of stuff; e.g., can see lots of links to their stuff on Hacker NewsThis is because of intellectual Harvard Grad Paul Graham loving the NY Times “long time” as well as the millennial liberal leanings of many Hacker News (gag me) commenters. To be sure I don’t have any basis at all for my Graham statement but I would bet I am correct about this. [1]Many people like the NY Times for the same reason that they don’t like Trump and they do like Elizabeth Warren (and Bernie for that matter). It’s just that “oh we are so fair, calm and balanced” way of speaking or writing. NY Times gets by with it’s “to be clear” or “to be sure” type statements [2] whereby they have their angle but resolve any bias by pointing out (like a waiter telling you what dish to avoid to build honesty) the other side. It’s very effective it seems.[1] [2] Watch and learn.

  7. creative group

    FRED:We can only look at any company from an investors eye and all the basic tools and metrics traditionally used are becoming less and less a true measure of a business financial health. Day traders call this hocus-pocus reporting.Now unsophisticated investors (All Day Traders think they are sophisticated but can’t get a CEO on the phone) use P/E, dividend yield, price-to-book and, sometimes, price-to-sales and still are not provided the true financial health of a company. It is like playing Vegas the house always wins.

  8. Guy Gamzu

    Unfortunately, innovation has a negative connotation when it comes to accounting. That’s wrong. Accounting is designed to reflect the reality and consideration as viewed by the people who run the business. In too many cases, GAAP compliance is merely an overhead to all: management needs to ‘translate’ its financial perspective and investors have to figure out what’s really going on.

  9. creative group

    CONTRIBUTORS:One last send off. RIPP

  10. dailyonline

    To me, the problem boils down to the question of whether the compensation of managers & employees is (partly) an investment or not. From an accounting perspective, operating costs run through the P&L, whereas “investments” run through your cash flow. The salary / cash part is common operating costs, no doubt about that. Equity, however, is the part where things get tricky. IFRS forces you to show / accrue costs for equity components in the P&L, whereas many companies argue that the “operational” profit should be regarded excl. these components and show restated results.But: Would you be able to hire the CEO without the equity package? Would you be able to retain employees only based on the salary? Would you be able to align incentives and company ambitions without the use of these instruments? The only reason you don’t show investments in your P&L is that your economic use of the investments is being distributed over a certain period of time, represented by the depreciation in the P&L. What is an “investment” in managers & employees? The “economic use” of an employee is quite limited once he has left the company, so it is fair to assume the costs are best reflected in the P&L, each year again (whereas you could argue whether such costs need to be above or below EBITDA).Long story short: If companies are paying their employees via a number of instruments, I don’t see much reason not to include the costs of these instruments when assessing the operational strength of these companies.

  11. JLM

    .There is nothing wrong with GAAP. It is a tool and only a poor craftsman blames his tools.Having said that, Fred is absolutely correct, it is difficult to understand the financial health of a company and how non-cash costs (stock options, depreciation, goodwill impairment) are accounted for without discretely considering them.I personally believe that the Black-Scholes formula is pure nonsense for a little company. It is fine for Exxon but nonsense for newly public companies. That is my opinion having used it for decades. It is impossible to define the requisite level of “volatility” for little companies whose stock has not been trading for several years. This is a mathematical complaint only.EBITDA is not a GAAP defined term and if you use it in the reporting of a public company (as I did for more than a dozen years), you will get a pissy letter from the SEC telling you to “cease and desist” from using non-GAAP terms in your financial statements.[Even the smallest public company gets an every 3 year review of its financials — primarily for the fairness in which results are presented — by the SEC and some contact from the PCAOB (public company accounting oversight board). They are, actually, quite good in their commentary. You respond in writing, promise to buck up, and go on about your business for the next three years after a convo w/ your auditors.]The secret is to arithmetically “derive” EBITDA (earnings before interest taxes depreciation and amortization, to which you can add non-cash compensation (options) and, perhaps, goodwill impairment) starting from GAAP defined terms. Duh.If you do that, the SEC will shut up and not bother you. I learned that lesson quickly.A company subject to GAAP, essentially, keeps three sets of books.The first is GAAP.The second uses the GAAP books and marks them to some form closer to the cash flow of the company by making modifications pertinent to options, depreciation, goodwill impairment and other non-cash costs. <<< This is the set that Fred refers to and which the NYT laments, appropriately so.The third set is Federal/State income tax based which is entirely different than the other two.With an enterprise level accounting system, this is very easy to do. With a good CFO, this is like reading a novel with three different climaxes and denouements. It is not rocket science.Taken with a well footnoted income statement and balance sheet and statement of cash flows (GAAP), this information provides a pretty good look at how a company is doing.Throw in a conference call, a timely annual meeting, few questions, and you can judge where any company is at an instant in time.A word as to footnotes to financial statements — read them.I am constantly amazed at the kinds of things that are revealed — revenue recognition policy, allowances for doubtful accounts, pending legal matters, non-cash compensation (options), CEO Employment Agreement — which can have a huge impact on the financial health of a company.You have to actually read them and know what the stuff means. Anyone who has been around a public company could teach you what this means in a couple of hours over barbecue.GAAP is only the beginning. The CEO has to tell the “story” starting with GAAP and the footnotes.Make no mistake, the ability of a CEO to tell his company’s story starting with GAAP and deriving EBITDA-X is a skill and not one that is being taught in business schools. It is an earthy skill that has to be mastered.The adjustments to GAAP are not “spin”, they are the meat upon the bones of GAAP. GAAP is the structure and the adjustments are the adornments.Count me with Fred as it relates to wanting those adjustments. I just have the earthy experience of having gotten my wrists slapped and having learned how to do it. The adjustments don’t overcome lousy results but they can explain them better.Yes, there are a lot of companies who are trying to get you to believe they are, in fact, making money but if you can read the GAAP statements, evaluate the adjustments skeptically, study the footnotes — unless they are engaged in fraud a la Enron — the story can be learned.One last thing — always remember that the core and overarching purpose of GAAP is to “fairly represent” the financial condition of the company. I won many an argument with auditors, SEC, CFOs by throwing that little chestnut in their face in the early days of my getting comfortable with EBITDA-X.JLMwww.themusingsofthebigredca…

    1. sigmaalgebra

      Wow! Gotta keep that one.

      1. LE

        Apparently though (by the top rated comment as of now) AVC visitors would rather hear a good joke than learn something.

        1. sigmaalgebra

          Everyone can laugh. Not everyone can become rich!It may seem unfair to Bernie, but in the top 1% can have, let’s see here, with my spreadsheet, that’s it, 1%. Amazing. Did I really need a spreadsheet for that?But, Garrison, it is possible to have nearly everyone above average! Indeed, now that we have had Obama, that is the case for the collection of POTUS so far!

          1. JLM

            .One’s sense of humor improves with one’s net worth.I think Attila or Sun Tzu said that. Maybe it was my dead Shih Tzu, Rufus.JLMwww.themusingsofthebigredca…

    2. Josh Maher

      Love this part:”evaluate the adjustments skeptically”There’s a lot that can be learned about management and the business from understanding why a company is reporting GAAP and non-GAAP.

      1. JLM

        .Healthy skepticism is a rare commodity which is missing from most things these days. It is not the same thing as being a cynic. I am skeptical on a lot of things.JLMwww.themusingsofthebigredca…

        1. PhilipSugar

          I’d just call it common sense JLM. Have you ever noticed that some of the smartest people around have no common sense.I really believe it has to do with not interacting with regular people on a regular basis.That veteran sergeant would bang a bunch of common sense into a new lieutenant yes?

          1. JLM

            .At VMI the day you get your commission, you exit Jackson Memorial Chapel (Stonewall taught at VMI) and you run into a Cmd Sgt Mjr who you salute. He is lurking waiting for all the new butter bars.Since it is your first salute in his Army, you flip him a silver dollar. Legend has it that if the exchange is made well, you will turn out fine.If the exchange is made poorly, the silver dollar is dropped, you will die in combat.Here is an actual photo — modern times — of the exchange.I can recall asking my platoon sergeant, at least a million times, “Sergeant Carter what are your thoughts on …….”To which SFC Carter would respond, “Well, Lieutenant, I’ve seen it done like this.”He would then ‘splain it to me and I’d say, “Make it so, Sgt Carter, and report back to me.”When I was a company commander (best job in the world second only to being a feudal Chinese warlord), I would say to my First Sgt, “Top, what’re your thoughts on this?”To which he’d say, “Smart officers do thus and such.”When I was a salty and seasoned company commander and knew just about everything that was needed to know, I still used to say, “The First Sgt will sort it out. Whatever he suggests comes from me.”JLMwww.themusingsofthebigredca…

          2. LE

            If the exchange is made poorly, the silver dollar is dropped, you will die in combat.Hmm. Remind me of the wine dripping from the glass in the wedding wedding scene in “Deer Hunter”.

          3. LE

            I really believe it has to do with not interacting with regular people on a regular basis.Yeh many reasons including what I will call “not specifically taught”. An example is an ex girlfriend, a radiologist and valedictorian. She tried to heat up cold pizza in the paper box in the oven. Didn’t know that the paper would burn. I call these “single function machines”.That veteran sergeant would bang a bunch of common sense into a new lieutenant yes?With my stepkid I am that guy. The other day he set up the hockey net in front of the metal garage door and started to hit soccer balls into it. And the soccer balls were banging against the garage door (after hitting the net). So I went ballistic. I said “did it ever occur to you that the ball might damage the door!!”. (My wife of course didn’t even think of this you know “not specifically taught”). I was harsh on purpose and a bit unfair. Reason? I want him to think first and realize what he does has consequences. He does really good in school (tops in math in the school I think).

          4. PhilipSugar

            “not specifically taught” is a good line because you are right it applies.There are people that do very well when they are told exactly what they must “learn” and what the rules are.

          5. LE

            Medicine, and to a lesser extent law are like that. I would travel to medical seminars with my ex girlfriend. She would say “I love sitting in the room being spoon fed information”. Quite a contrast to being an entrepreneur where there is no roadmap and you have to figure it out as you go along.My stepdaughter is great at gaming the system. I told her “no more spending time on minecraft try to learn something like making videos”. So she goes and starts to make videos of minecraft and uploading them to youtube. I thought that was great. Growing up I was rewarded and reinforced for doing shit like that with my dad, not punished. The other day she didn’t listen to me so I told her “you are losing computer for a few days”. Later that night she won $3 in a “find the matzah” contest. So I told her “if you give me $3 you can use your computer”. She went along to easy. She gave me the $3. I told her she should have negotiated me down from my initial request.

          6. Matt Zagaja

            I will remember to try that when I renew my lease with my landlord.

        2. Girish Mehta

          “What is wanted is not the will to believe, but the will to find out, which is the exact opposite”. – Bertrand Russell, The Sceptical Essays.

    3. LE

      Excellent post.Yes, there are a lot of companies who are trying to get you to believe they are, in fact, making money but if you can read the GAAP statementsCurious about one thing. If everybody is doing it (“only as honest as the competition”) then isn’t it a bit like the butcher’s scale in the small town with only one butcher that is off? Everybody is cheated equally. The price per lb. doesn’t matter it’s the total cost that you are paying. Not disputing that you should read the footnotes obviously.It is a tool and only a poor craftsman blames his tools.Sometimes the tools are bad. So this then implies a) game the system b) don’t play the game c) do what the competition does

      1. JLM

        .Stock based comp is an element in a well designed compensation plan which is based on salary, benefits, short term incentive comp, long term incentive comp (stock options) and special considerations.Many companies, particularly young ones, do not have a balanced or well designed program at the start and overuse SBC as an element of compensation.Sometimes, they grow out of it realizing that they have to compete with more mature companies.[OTOH, young companies always have “unlimited vacation” policies which dilute performance. Why would one try to build a great company while sending their best employees to the beach more often?]SBC is often a passing phase which is spread like peanut butter in the early stages of the company (remember most stock option programs are 10 year programs) and are not as essential below the senior management and C suite level once the company is out of their short pants.Last point — this is one more reason why phantom equity and restricted stock grants are coming back into vogue.This is the most popular blog post in the history of The Musings of the Big Red Car: http://themusingsofthebigre…And, it deals with the design of such programs. By designing a good comp plan, less emphasis is put on SBC.JLMwww.themusingsofthebigredca…

        1. LE

          OTOH, young companies always have “unlimited vacation” policies which dilute performance. Why would one try to build a great company while sending their best employees to the beach more often?Oh that’s all bullshit anyway. I have what you might consider unlimited vacation (and have since literally graduating from college). But I am rarely away. I think after college I did not get away for like 5 years or so working so many hours and days. Nobody would make it anywhere in a company [1] if they are constantly not around to do work and are perceived as loafing. Of course with the new way of thinking maybe I am wrong. I grew up in an environment where I would call my parents when leaving the office late (really late) as if to say “see mom and dad I am still working”. And they liked that type of thing. But now perhaps it’s the opposite.A much better point would be to highlight why companies are giving off so much time for maternal or paternal leave. I know they have to do it because the competition is doing it but it’s retarded. (Yep little bus). Who hires people whereby you can afford to have them not at work for long stretches of time? If that is the case why do you need them? Why not just make jobs 1/2 time to begin with then? At least you can plan around that, right?

          1. JLM

            .It is hard to believe that the US engaged in parenting and business in the past.JLMwww.themusingsofthebigredca…

        2. Twain Twain

          This morning I’m at Fenwick West’s talk on ‘SEC’s Silicon Valley Initiative: SEC’s scrutiny of private companies and secondary markets’, covering unicorns and how transparent the stock-based equity compensation is for employees.

    4. Twain Twain

      Thanks for this great breakdown. Wasn’t Black-Scholes some of the contributing factor to the issues at Long-Term Credit Management and global financial crisis?*…*…Again, AI was at play then.Notably, there’s subjectivity in every representation — even as the data is presented as objective because it’s “quant” and supposedly qualifies things. Despite it being clear that quantity and quality are different entities, some people insist that they’re the same and equivalent (this annoys me no end because 1 million counts that something is a chair still won’t tell us it’s wooden / metal / square / curvy / sturdy / shaky; ergo, quantity tells us nothing about quality).Bigco CEOs, CFOs & Legal Counsels earn their worth by the artistry with which they represent the accounts within the jurisdictional laws.Mark to market is easier if there are broad peers to benchmark with — but even there it can still be like comparing Fuji apples with Red Delicious.

      1. JLM

        .Never, ever let a lawyer near the accounts. They are fine as it relates to the legal implications of footnotes and the content of conference calls but never let them use a calculator.I am an apple lover and love your analogy.JLMwww.themusingsofthebigredca…

        1. Matt Zagaja

          After watching my classmates struggle during tax law class, I will co-sign this recommendation. There are some lawyers who are good at math but they are rare.

      2. Girish Mehta

        LTCM had Scholes and Merton on their team. They were doing ‘convergence arbitrage’ – Scholes said they were like a giant vacuum sucking up up the nickels people had overlooked.To make serious returns from vacuuming nickels – they had to employ huge leverage. That leverage eventually brought them down. Nothing new – happened before, will happen again (The proximate event was the Emerging markets turmoil of Aug ’98; Russia devalued and defaulted).In 1997 they returned capital back to some investors, while keeping assets same. Thereby magnifying leverage for those investors that remained…leverage ratio went up to 25-30. When the assets declined in 1998, their leverage ratio shot up over 50.Their assumed ‘Value at Risk’ (VAR) in August 1998 was $45 million a day. In that same month, their portfolio declined by $1.7 Billion. Obviously that “Value at Risk” was wrong.

        1. PhilipSugar

          They were picking up nickels in front of a steam roller.

          1. Girish Mehta

            Yes, Lowenstein uses that phrase in his book (picking off Scholes’ comment to Merton about “vacuuming nickels”) – its a clever contrast to the famous Efficient Markets ‘story’ of the two Chicago Professors picking up a $10 bill lying on the ground.

          2. JLM

            .Haha, bouncing a basketball through a minefield.JLMwww.themusingsofthebigredca…

          3. Girish Mehta

            Hadn’t heard that one.

      3. sigmaalgebra

        > Long-Term Credit ManagementYou got the LTCM right, but it stood for Long Term Capital Management, and, IIRC Myron was part of it.They believed in Brownian motion and really, really took the central limit theorem (CLT) very, very seriously.Myron, the usual proofs of both Brownian motion and the CLT use the assumption of independent and identically distributed,, a.k.a. i.i.d. How sure were you about that assumption.Study the proofs and work a good sampling of the better exercises in Rudin, Royden, Neveu, Breiman, Cinlar, Chung, Karatzas, etc., and will come to understand the importance of the assumptions.Look, Myron the CLT only holds in the limit, and typically get accuracy in the tails last of all. If you are talking 5 sigma out, then convergence with accuracy can take a long time. And, you are essentially assuming a lot of stationarity which, for some fast and loose Asian financial playing around, doesn’t hold. So, Myron, too darned much leverage for the real world.Look at the Lindeberg-Feller version of the CLT — it assumes next to nothing about the distribution of the data. Darned tricky assumption. So, that distribution can be just awash in black swans, but get CLT convergence to a Gaussian anyway. Of course, that convergence might be next century sometime.On the way via the CLT to good accuracy several sigma out in the tails of the Gaussian, can encounter a lot of black swans — you should have known that.

        1. Twain Twain

          Well, you do know the same Brownian motion model and Central Limit Theorem that didn’t work at LTCM is now being replicated in the 2Vec models in Natural Language Processing, right?I do indeed see how that model would miss all the black swans that actually contribute to and cause the meaning and understanding in the words and sentences.That’s why it’s simultaneously maths, business model, investment model and technology problem.

          1. sigmaalgebra

            The intuitive descriptions there look nice. The descriptions do mention that have to estimate volatility. Hmm …Well, another assumption is that the price of the underlying stock follows Brownian motion (or the log of Brownian motion — here assume just Brownian motion). Well, the increments (difference in price between two times) in Brownian motion are all independent (of the past and the future of that stock price) and zero mean Gaussian. So, if have the standard deviation (i.e., volatility) of the Gaussian over some interval of time, say, a day, then know the full Gaussian distribution of any increment over any interval of time and can calculate to 50 digits of accuracy the probability of a black swan 10 standard deviations out, say, a once in a 1000 years event that might cost the highly leveraged company $1 trillion.Ah, not to worry, right? I mean, we will all have sold out and retired by then!Okay, now how are we to estimate the standard deviation? Sure, collect some data and use the standard (unbiased) formula for estimating standard deviation. Yup. Do that. And, the data to use? How about for a few days? Okay, be generous, each day for a month? Since we are all Harvard/Nobel types, two months? Maybe.Okay, now the arithmetic says that with our big leverage we are really safe and can put down the big bucks.We’re really sure about that volatility, right? I mean, over the two months, we used 60 independent and identically distributed (i.i.d.) samples, right? I do my little confidence interval calculation, and I have the volatility, standard deviation, within a gnat’s ass nearly all the time, right? I mean, we do trust the strong law of large numbers, right? To remove all doubt, there is a gorgeous proof directly from the martingale convergence theorem. Gorgeous (nearly a “barbed wire enema” otherwise). And we’re talking the strong law, not the weak one a lot easier to prove.And the central limit theorem (CLT) says that even if the stock price increments over short intervals of time are not Gaussian, in the limit, the distribution of the larger increments will still be Gaussian. And that holds, from the powerful Lindeberg-Feller version of the CLT for which we assume next to nothing about the distribution of the smaller increments. Then we just need the independence assumption, but we can get that from the no arbitrage assumption, right? I mean, if the future increments are not independent of the past, then they are dependent on the past and we can clean up on the arbitrage, right? I mean we do trust the efficient market hypothesis so that there is no arbitrage, right? You are with me, here, right? We’re on solid ground, right?WRONG! Send it all back to Stockholm, guys.First, and the small part, you are not really sure about the independence part. Broadly we have to suspect that, when the really powerful theorems do a really good job exploiting independence, then in using the results of those theorems we have to be really sure about having independence. We have to suspect that. Independence is nice stuff, and has a nice intuitive side, but, really, looked at carefully, it has some just astoundingly powerful consequences. So, in a sense, and maybe important in practice, independence is asking a lot. Might want to be careful here.Second, and the biggie, the distribution of the increments in the stock price, even one that passes Lindeberg-Feller, can be wacko, bizarre, with black swans that could sink the world and with no hint in your 60 days of data. Look, the CLT, strong law of large numbers, long term Gaussian increments, etc. all hold in the limit, but until your sample of the increments is large enough to include some of the really rare but really huge black swans, your estimate of standard deviation can be way, Way, WAY too darned low. WAY too darned low. Then somewhere in Asian finance some black swan poops a really ugly brown one; it’s not a chocolate candy bar; and LTCM and $1 trillion head for the sewage treatment plant.Net, you didn’t know enough about the distribution of the increments and some of its rare but huge events; your sample size for estimating standard deviation was way too small, too small to notice some of the rare but huge events; your estimate of standard deviation was way too small; your Gaussian estimate of the risk of your bets was way too small; and soon you went broke.It’s a little like you are a high school round ball player, took a look at the opposing team, and concluded that you and your team would win easily. Alas, you didn’t notice young Lebron, already 7’0″ and 250 pounds or some such and could dunk with his feet still on the ground and otherwise could easily deposit a penny on the top of the backboard. Your sample size was not big enough.

    5. PhilipSugar

      I’m glad you brought up Goodwill that is the first thing I brought up.Having studied Black-Scholes for an entire semester in Fin6 at Wharton, I can say the other thing I don’t like about it is it doesn’t take into account the value of the security. It assumes like all models that the current price accurately reflects the value. I understand well the efficient market theory but I don’t believe in it.Like all financial and economic models it has some big holes especially for Black Swan type of events.

    6. Mark Essel

      This comment’s a keeper. JLM digital hall of knowledge, in the accounting section.

    7. Chimpwithcans

      One of your best ever posts – in a geeky, accounting kind of way 🙂

      1. JLM

        .Haha, particularly funny considering I have been an advocate for an open season on accountants with a seasonal bag limit of say, four per year.JLMwww.themusingsofthebigredca…

        1. Chimpwithcans

          Well, knowing the habits of your prey so well will surely increase your success rate!

  12. iggyfanlo

    When public companies adjust earnings for SBC (numerator) do they also fully account for all options being exercised (denominator). If so then they can display 2 ratios that investors can evaluate.

    1. JLM

      .Options are evaluated as being “in the money” or “out of the money” for reporting purposes. They also have a life that burns off with the passage of time or their exercise. They are fairly dynamic.If they are in the money, they impact the calculation of fully diluted earnings per share.An appropriate footnote can explain whatever the CEO/CFO/auditors want to explain. It is a blank canvas and while it has to be true, there is tremendous latitude as to where the discussion can go.The use of options as part of a well balanced comp program is not particularly adventurous (salary, benefits, short term comp, long term comp (options), special considerations) and should be discussed in some detail particularly as it relates to the most highly compensated employees.JLMwww.themusingsofthebigredca…

  13. Josh Maher

    The options problem swings both ways….Look at Salesforce – their options clearly have value, the executives they issue the options to exercise them regularly to prove the value exists. Yet this compensation is often yanked from their non-GAAP figures… spinning losses into profits.

  14. kidmercury

    i’m countering fred’s eye roll of the nyt article with an eye roll of this blog post. investors and companies obviously have their own interests, and the GAAP people should not view these investors/companies as their customers. it is closer to the opposite as a bit of antagonism in their relationship may be for stock-based compensation, i think damodaran is on the money here. here is the killer passage that delivers the TKO in this beef:3. Is it a non-cash expense?Many equity research analysts seem to think so, but then again, their judgment on a number of fundamental valuation issues remains questionable. Let’s be clear on what it is not. It is not an expense like depreciation, which is truly non-cash and should be added back to get to cash flow. It is closer in spirit to an in-kind compensation than a non-cash compensation. To explain my reasoning, let me use an analogy. Let’s assume that you own and run a business that has an overall value of $100 million and generates $10 million in annual income. Let’s assume that you hire me as your manager and that my compensation is $1 million and that rather than pay me with cash, you give me 1% of the business as compensation (1% of $100 million is $ 1 million). While you may maintain the fiction that this is a non-cash expense and that your income is still $10 million, you are now entitled to only 99% of that income in perpetuity. In effect, your share of the business is worth less and it will get even smaller over time, if you continue to compensate me with equity.I would argue that as common stockholders in any company that grants options or restricted stock to its employees, we are in exactly the same position. The stock-based compensation may not represent cash but it is so only because the company has used a barter system to evade the cash flow effect. Put differently, if the company had issued the options and restricted stock (that it was planning to give employees) to the market and then used the cash proceeds to pay employees, we would have treated it as a cash expense.

    1. PhilipSugar

      The only flaw in that argument is let’s say you hire me and because I am such a kick-ass manager I increase your business to $1B with $200mm in annual income in five years. I wasn’t willing to come work for you unless I could participate in the upside and you wouldn’t have gotten there without hiring me. That 1% option ends up being worth $10mm, but it is the best money you’ve ever spent.On the other hand if I’m a shitbird and it’s an option not a grant (which is what we are talking about) it is worthless.

      1. kidmercury

        understood and agreed that stock options have greater risk and greater reward, and this can help align incentives between shareholders and management. however, to say options are not a form of cash-like compensation — that options have real value like cash, but should not be treated as such in accounting — seems to me like a form of mathematical fiction.

        1. PhilipSugar

          They certainly have value. The fact that you can buy them proves that beyond a doubt. They have to be reported. But the question is how do you value them?? I would say that is much more complex than just saying $X dollars of expense. As people go round and round you can see that it is a balance sheet issue, an expense issue, and an incentive issue. It also depends the company’s goals: Cash flow, growth at all costs, etc.

    2. JLM

      .One could argue that you are conflating an income statement item with a balance sheet item. Nothing wrong with that but we should know where we are standing when we are speaking.Say the company’s stock is trading at $1/share and the option is granted at a strike price of $1/share. No short term benefit to the grantee.The company’s stock, due to the great performance of the option grantee, then increases to $10/share.The shareholders — the owners of the company — have realized a $9/share increase in value and have lost exactly what?I could easily argue — NOTHING. In fact, they have been treated rather grandly, no?This is even more convincing if the option was granted from a body of Treasury stock which was held in the Treasury for exactly this purpose. it was arguably not even dilutive when granted.It is not as easy as anyone wants it to be. I favor behavior that incentivizes management to perform which lets ownership get rich on the back of management’s sweat.JLMwww.themusingsofthebigredca…

      1. kidmercury

        yes, shares may expand the pie for shareholders while diluting them — and thus could increase the overall wealth of shareholders. cash can do the same thing. for instance, if you pay someone $100, and they do enough work to increase the value of your business by $200, then both you and the employee have earned money. however, no one would argue from an accounting perspective that because the employee created $200 of value that you should not consider paying them as an expense. no, we still do the basic arithmetic of adding their value and subtracting their cost. yet somehow when it comes to options there are many who claim arithmetic no longer applies.

        1. JLM

          .On the income statement, you incur a cost of $100.On the balance sheet, you receive $1/share for something that was worth $1/share when you granted the option to acquire the stock.There is no profit and there is no expense.The investors (including the grantee) reap a profit that doesn’t touch either the income statement or the balance sheet.It is arguably constrained to the shareholding records and nowhere else.The grantee receives a zero value option — FMV $1/sh for $1/sh — that appreciates.I agree with you intellectually but not from an accounting perspective. This highlights why it took so long to come up with the rules. The rules were made by accountants for accountants.JLMwww.themusingsofthebigredca…

          1. PhilipSugar

            The challenging part is they do have value:If you told me it was my choice take options or not of course I’d take them.If you told me I was buying a company that had a 50% overhang of options or 0% it would affect my valuation.But yes on the balance sheet I am really just selling stock for what its worth today.Accountants want to value future obligations, rightfully so because they do affect what happens in the future. I.e. if I prepay my lease for 10 years you can’t recognize that all today.But this is a much harder one and I think the best thing is to just have heavy disclosure.The accountants don’t like “grey” areas. But the fact is that there a ton of them. The biggest is I can just decide to scrimp on quality and lower my expenses. Not measurable but I guarantee if I decide to do no maintenance and landscaping on a building for ten years and have the cheapest/worst janitorial staff I can find, it will affect my value much more than giving out some options.

          2. JLM

            .Of course, options also have other features — the vesting, conditional vesting, their treatment when a grantee leaves the company.They are not simple. But they are understandable.JLMwww.themusingsofthebigredca…

          3. PhilipSugar

            They are and so is the maintenance and quality of your company. But they aren’t just a number.You can tell I love this subject. I really believe in strict accounting. I really believe that when you let people play with the numbers they focus on that not the customer.But the interesting ying to that yang is that there is so much that you can try and measure, the most important thing is corporate values which comes from the top. I can report on the other things. I can decide to make sure everybody does the right thing but that is not measurable.You can just “feel” it. I know people won’t like this example but I don’t care:…I have been in line when I have seen somebody short on money with kids and have a manager do an “adjustment” to their bill. I don’t agree with all of the values, but they have a set.

          4. PhilipSugar

            And believe me, I doubt that discount was correctly accounted for but there were about 30 people in line along with the double drive in windows packed with all of the employees and that discount probably made them come back an extra time. The ROI must have been huge.

  15. MJB

    But if GAAP actually made sense, and companies reported adjusted EBITDA accurately, what would all the investment banking analysts do with their time? No more nights or weekends spent adjusting earnings for SBC? Does this mean layoffs?

    1. JLM

      .No, there are a lot of widows and orphans who still require rolling. Throw in the drunks and no IBer has to worry about steady employment.My son is one and he has begun to pick up the tab — thirty years in the making — when we eat out.So, there is that.JLMwww.themusingsofthebigredca…

  16. the public markets

    Fred: I’m a long-time reader and supporter of your many insights, so thanks for writing everyday. But I’d venture that you haven’t seen this obfuscation up close in mature public securities.Sellside analysts value companies on an Adjusted P/E, which almost always adds back stock-based compensation. Shares trade in accordance with the sellside’s opinion — this is a major problem that must change. But it’s the truth.Less prudent CEOs than yours use quarterly accounting to shift cash-compensation into stock-based compensation, effectively removing the largest cost in their P&L. The sellside will disregard the SBC compensation in their quarterly analysis, and so management can perpetuate the facade of higher incremental margins. Algorithms will boost the share price after these positive earnings revisions.Now, eventually this dynamic may unwind after several years, but usually only if something else disappoints first.You either believe the public markets are perfectly efficient or you believe that SBC isn’t a real expense — you can’t have it both ways. And if you believe in inefficient markets, I’d argue that the ability to “show it both ways” is offset by the inefficiency it causes, at least for public equities reliant on continued share grants to retain employees (as most software companies are). As for they “may be worth nothing,” that’s not really true for public equities with no leverage, especially when you account for restricted stock grants.

    1. fredwilson

      I believe it’s an expense. I just don’t think we are measuring it very well

      1. the public markets

        JLM: for companies manipulating their financial statements with non-gaap accounting, It’s more like a steady 2-year climb to cruising altitude until all four engines suddenly explode at once and you careen down 75-100% lower — Valeant, SunEdison, many MLPs.As for our ability to measure SBC, the inputs are circular, so I’m not hopeful on an improved remedy from the current state (unless you can improve on Black-Scholes?). Is SBC an expense? yes. Then are markets efficient? no. So can we precisely value share grants? no.So I’d maintain the negative externalities offset the benefits of widely used non-gaap disclosures, a fact that I’m sure is less true for private markets.I appreciate all your work here JLM. And Fred, keep it up,- the silent majority

        1. TSC

          Interesting you bring up Valeant. I’ll bet $5 that their accounting gets exposed as not just manipulation but outright fraud. Common shares are likely worthless as are non secured creditors.

        2. JLM

          .A few of the examples that you cite are garden variety disasters. Frauds, maybe. Nothing to do with SBC at all. They are fails at their core business.I am waiting with baited breath to find out what is going on with Theranos. It involves a blonde and a black turtleneck. Always a dangerous combo.JLMwww.themusingsofthebigredca…

      2. TSC

        How would you measure it?

      3. PhilipSugar

        I think you are spot on in saying that people evaluate it in different ways and for different companies.If you think it’s a mature cash flow business maybe it’s undervaluing the cost of those options because it gives management incentives to move the stock versus just grow the profit.If it’s a high risk business and the employees are what makes and breaks the business and you want a ten bagger or go home, then yup they are overvalued.One of the big inputs in Black-Scholes is volatility and as you can see from my examples it ends up being the wrong input for employee based compensation.

      4. SubstrateUndertow

        Compete ignorance speaking here !I’m just trying to extract a 10,000 foot superficial characterization from what I’m hearing here, dangerous I know, but to me this delivers some fun/learning value. Over time I’ve learned lots here form AVCers while angling to comprehend discussion that are very often over my head :-)Question:If SBC is and expense isn’t it ultimately a % share-dilution-tax expense on shareholder end value per reporting period?If it was reported as such would it not fillet out a more actionable expense perspective for shareholders in a format that effectively isolates it from the company’s regular operating expenses ?

      5. Carlia Joseph

        phew, no matter how hard you tried to get GAAP in to circumvent the earnings/stock price mismatch, twitter stock still sucks big time. down 12% already.I bet this opens at $10 tomorrow..

    2. JLM

      .Efficient markets are not IMMEDIATELY efficient. They are like turning an oil tanker. They often turn in small increments.When you fly an airplane and are being vectored into the airport, you turn halfway to the new direction, let the plane find equilibrium, turn another half, let the plane find equilibrium and then slowly come to the appointed direction.Experienced pilots make it so seamless, you cannot see exactly what they are doing.It is a gradual process particularly when the direction change is great.Markets are similar, no?JLMwww.themusingsofthebigredca…

  17. Steven Kane

    hi fred. have to respectfully disagree here. (though i completely agree on the particular re stock options expensing.) when 90% of companies report non-GAAP results that is indeed the market speaking — and what its saying is, there is no “moral hazard.” given the toothless and feckless enforcement by the SEC and other regulatory agencies, no public company fears playing fast and loose — or whatever way they feel like — with their reporting.after all, those 90% of companies aren’t all doing their non-GAAP reporting in exactly the same way. they are doing whatever non-GAAP reporting they wish. to use your metaphor, they’re not all ordering their scrambled eggs with cheese, telling the diner to offer that option on the menu, they’re ordering anything they please and calling it “scrambled eggs.” which means the diner may as well have no menu at all.the entire idea of GAAP reporting is essential and also by definition doomed to failure. a single set of “Generally Accepted Accounting Principles” can’t possibly please everyone. alas, the next best thing is to please no one. a better metaphor than diner food is probably speed limits. if we as a society agree we want speed limits and law enforcement of same, someone has to — somewhat arbitrarily – set those speed limits. despite that we all know that, no matter how high the limit is set, people will drive faster. or slower. if 90% of drivers are exceeding the speed limit, it may be a good idea to raise it. unless its in a school zone, in which case greater safety concerns override popular desire for speed, and law enforcement should vigorously enforce. you and i may not agree with her vis a vis stock option expensing, but anyone who follows gretchen morgenson’s work knows she is broadly deeply concerned that public accounting is a school zone with no law enforcement…

  18. Peng Jin

    Fred, I can’t agree with you more on this issue. You should use your public influence to bring more awareness to this non-sense we are all facing.When companies use shares to compensate employees, the result is enlarged share base, which in turn should lead to decreased per-share price and less per-share gain for option holders. In a way, it is the existing shareholders sacrificing their personal values for the benefits of the company. I honestly don’t see why that should be a company expense. While I fully agree that the intention of the GAAP is to bring standardization and order to the financial market, the real world is an ever evolving place and people should never assume that the GAAP is even close to being all reasonable. I just feel that the GAAP is not nearly updated or challenged as often as it should be. The fact is GAAP has created way too many complicated interpretations and effectively made financial statements impossible to understand. It is great that companies are fighting back by reporting non-GAAP figures. I just think similar efforts should be exerted at higher up levels. Regulators should really take a “Lean Start-up” perspective sometimes. They need to iterate faster and be more open to opinions. There is no single truth in how to best handle these complications. It is all about being adaptive.

    1. TSC

      “I honestly don’t see why that should be a company expense.” If it’s not an expense then give shares in your company to me, I don’t need much, let’s say 15%. In fact, when you do, I’ll even pledge my voting rights to you so that you can be assured I will not harm your voting interest. Since these shares aren’t costing the company anything then giving them to me should not affect you or the other shareholders one bit using your logic. But we all know that isn’t true. In the future, your shares will have decreased earnings attributed to them because 15% of that is now going to me. So the net present value of your stock is lower because future earnings are also lower. That’s a real expense and needs to be accounted for.

  19. PhilipSugar

    The other rule I’ve never liked is accounting for Goodwill. If I use my highly valued stock that is trading at 50 times book value to buy a company for 5 times book value. I now have to add 4 times the book value as Goodwill and start to depreciate it. It makes sense for me to do this all day long. But when you look at my GAAP reported income it is adjusted down. Again why people report EBITDA numbers

  20. Mark Essel

    Hah Black Scholes came back around, just visited that today in a wikipedia trip while reviewing Sigma Algebra’s comment on the AI post a few days ago. Ended up grabbing an Introduction to Stochastic Integration based on Sigma’s recommendation to get a deeper look at it.

  21. cavepainting

    I once knew a company (with low capex) which had a positive EBITDA but negative cash flow. It was the period lag, they said, and it will eventually catch up.But it never did. They now said it was just a collections issue and does not reflect the health of the business which was profitable based on accruals. But it never was. The company eventually went bust.The point is that both revenue accounting and expense accruals are open to interpretation and have an element of spin. May be sanctioned spin but spin nevertheless.But free cash flow – especially over a period of time – does not lie and is a much better reflection of the truth underlying the business. Cash is cash and you cannot make it become what you wish than what it is.

    1. JLM

      .High regard — telling the story without saying “Cash is king.”JLMwww.themusingsofthebigredca…

  22. creative group

    Apple misses estimates!Tell us something we didn’t expect. And with the IWatch debacle can expect future decline.

  23. Villi

    Fred, I hear you, but I don’t agree with you. The whole point of non-GAAP reporting is to give the company an opportunity to explain the uniqueness of their results. There is wide variability around what adjustments companies make for non-GAAP. Should deferred revenue writedowns be added back to non-GAAP revenue? Who is to say? Is it material?The fact that 90% of companies report non-GAAP does not surprise me, nor does it trouble me. Businesses, just like humans, are unique. We all think we are different and we all want to demonstrate that uniqueness. This is not GAAP’s job.And specifically to SBC, what are you proposing? I hear your frustration, but what is the solution? Here is one: given the uncertainty around the economic value of options, they should not be included on the Income Statement. Rather, let’s beef up the disclosures around options and allow investors to capture their economic impact (through dilution). Some who love the capital markets would scoff at this bc we have well established literature around how to value derivatives, so why are we not using it.

  24. Adam Quinton

    When it comes to including option comp in the income statement per GAAP I side with Warren Buffet who said (roughly):If options aren’t compensation – what are they!?If compensation is not an expense – what is it!?If an expense doesn’t belong in the income statement – then where do you put it!?There are many things in a set of financial statements that are a function of management judgement and estimates. Just because some estimates are harder to make than others doesn’the mean you simply ignore them.As to the large number of public companies reporting non GAAP numbers, they are for the most part trying to get investors to focus on metrics favorable to management. Stripping out a substantial expense (option comp say) to flatter the performance of the company is just one example of that.

  25. Kevin Murdock

    The reason why the accounting standards as so confused is because the accountants have the wrong framework for valuation. They want to value options once, and only once, at issuance. That is fundamentally wrong. The value of the option and its impact on the company is only really known when the option is exercised. At that moment its value is unambiguous. If I have an option to buy a stock for $20 and the stock price is $30, then the cost to the company is $10 (the difference between what I pay and what the company could have gotten on the open market).Black Scholes is simply the best estimate (at the time of issuance) of what that future cash cost will be. But if the stock price falls, then the option will expire with no cost to the company. Conversely, if the stock price rises, the cost could be far higher.The right way to account for stock options is to book a charge for the actual cash cost at the time of exercise and to hold a reserve (that may be updated along the way) to prepare for that future expense. The better analogy is how a bank holds reserves against future losses in its loan portfolio. The reserves get “trued up” when the loan is repaid or if it is sold at a loss.The accountants get all tied up about options are an “equity instrument” that only gets valued once. But that is really accountants counting angels on the head of a pin. The reality is that options are a contingent liability, where that liability can be known with certainty (at exercise).There still would be interim reporting issues when a stock takes off or falls suddenly (but the contingent liability in reality would greatly increase or decrease so those effects would be driven by the underlying condition of the contingent liability).This “contingent liability” treatment of stock options would greatly bring back a greater honesty into the structure of our financial statements.

  26. Jan Schultink

    There are 3 audiences for financial statements: investors, people who collect tax, people who pay tax. Pleasing all 3 in one spreadsheet is hard.

  27. Irene Leblanc

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  28. t10media

    Couldn’t disagree more.1. The entire income statement is acruals based. Some items such as depreciation is entirely non cash and based on an estimate of useful life.2. In practice, the cost is usually fully realized as companies will typically buy back the newly created stock to avoid dilution.3. In the event that there is no buy-back there needs to be a recognition of the cost in the period when it was incurred to be consistent with actual accounting.The fatal flaw in stock option accounting is that the options are not revalued at each reporting period and so end up at the final cost

  29. Todd Stilo

    A much forgotten (or little-used) financial statement is the statement of cash flows. This statement presents how a company is generating cash flow (or not), by breaking down the sources and uses of cash under 3 categories (a company’s operating, investing and financing activities). Further the effects of non-cash items such as stock-based comp and goodwill impairment are extracted out of earnings. A keen eye and good understanding of that statement may reveal much about a company’s financial well-being.

  30. Robert Holtz

    GAAP = Generally Accepted Accounting Principles (not Standards).