Also, to be clear, I am just discussing this stuff because it is late on a Friday night, my kids are all away in distant lands doing fun things, and it is honestly quite lonely here. But I never thought I would reach the point of discussing accounting issues on a Friday night because it beat all of the available alternatives. Wow!
And Rich, glad to make your Friday night more interesting!
Saul
It may also be worth noting that it would be somewhat unusual for a company to simply issue new shares which were then bought by the CEO with his salary at market rate. If he or she is purchasing at market rate, he or she is probably buying them off the market and there is no impact on the company’s issued shares (as someone else pointed out). If the CEO is given something, it is most likely options which may or may not be immediately exercisable and who price may be significantly different from the current market or not. Clearly, accounting for the grant and the exercise are quite different than the simple scenario of buying newly issued shares … not clearer, necessarily, but different.
So why let form dictate the results over substance? The substance in all of these cases is compensation and a capital infusion; I fear that it is misleading to allow the company to act as if it is earning its profits without paying its CEO just because it pays him with stock instead of cash. This would allow the company to hide its CEO’s compensation by, in essence, treating a capital infusion as a profit, basically. But that is JMO, and I am a nobody, so honestly, who cares what I think?!
Rich,
That was the best explanation I have received. Thank you for taking the time to answer my question. Everything I know about the financials I have picked up from these boards and by reading books so its very important towards my education to be enlightened with posts like yours and everyone else’s on this board. Thanks for your contribution and thanks to everyone else also.
Andy
Tamhas,
That is a great point about options and it is the hardest for me to follow when companies are distributing a large amount. What I end up doing is just tracking the compensation on the cash flow statement and not bothering with following the options when they are granted. Also I have been going with Gaap earnings instead of non-gaap because I thought that more accurately showed the companies performance. But now with this thread I have alot to think over because Saul, Fletch, and Rich have all brought up some really good information that needs to be mulled around. I think I want to hear TomE’s view point on this also :).
Andy
Hi Saul,
No worries, my friend. I’m not upset. It’s just an issue that I’m pretty passionate about, having been in the trenches when FAS 123 was issued, and I should probably tone that down in my board posts. No harm, no foul, as they say.
Fletch
What I would find really interesting is to know how often you disagree on the conclusion regarding the future prospects of an investment. What I mean is if you to disagree about GAAP v non-GAAP but in the end pretty frequently reach similar conclusions, then it’s rather a moot argument.
and
Good point BrittleRock! Fletch and I actually usually agree on the stocks (as far as I know), so I guess it IS a moot point.
Haha, it’s a great point. I think Saul and I agree on companies much more often than we disagree. So perhaps this really is much ado about nothing.
Fletch
Haha, it’s a great point. I think Saul and I agree on companies much more often than we disagree. So perhaps this really is much ado about nothing.
Wow! I am so relieved that you both agree on this observation, irrespective of how much you disagree on accounting methodology.
As I’ve said before (maybe 4 times), I am lousy at financial analysis. It’s not the math, I live part time in China and do centigrade to Fahrenheit conversions in my head almost instantaneously (as an aside, the Fahrenheit system is utterly ludicrous, how or why it was adopted rather than scorned I can’t imagine).
Anyway, it’s separating the important from the unimportant, understanding what’s substantive versus what’s just noise that baffles me. And there’s the Qs, a variety of Ks, conference calls, and an insane number of “analysts”, especially if you include MF posters, SA authors (for want of a better term), CNBC and FBN commentators, The Nightly Business Report, Marketwatch, The Street, et cetra, ad infinitum. Not to mention those unsolicited incredible (I choose that word carefully) investment opportunities that regularly show up in my mailbox (is it my zip code? The credit cards I carry? What?). Maybe some of you get them too - some breakthrough technology, some new oil/gas or other mineral find, but I best act fast because there’s only a limited window to get in on the ground floor while the stock is still available on the cheap. And I read this morning: “In June, AP announced that it would begin using automation technology to write breaking news stories and earnings reports.” Oh boy! robot financial news - somehow, I think, this fits in with high-speed trading.
So, I look to guys like Saul and Fletch as filters who may disagree on how they arrive at their conclusions, but thankfully, pretty much agree on the conclusions.
Thanks guys . . .
Anyway, it’s separating the important from the unimportant, understanding what’s substantive versus what’s just noise that baffles me.
Ninety percent of what passes for news and analysis is garbage and I’m being generous. Zacks already has robots writing news, a factoid I discovered last year. Many years ago Forbes said that to make money in the market, don’t invest, write about it. Lots of folks are following his advice.
One has to figure out the basics and there are only two of them:
1.- Business exists to give customers products and services they are happy to pay for. Top line matters.
2.- Management’s job is to make sure the top line coverts into a profitable bottom line for the owners.
Everything else is just filler. I believe most of us would agree that Warren Buffett is a shrewd businessman and investor. One of his methods that is seldom discussed is how he manages the companies he buys outright. It can be summed up as follows: He buys the entire company and retains the old owners as managers. The managers are free to run the company as they see fit. They can talk to Buffett if they want to but they don’t have to. The only thing that Buffett controls directly is the cash which he use for investing. It is a very hands-off kind of management style. As long as the business is profitable and produces cash Buffett does not care how the sausages are made.
I wrote an essay some time ago about my “Mini Conglomerate,” the stocks I own. Why can’t it be managed like Buffett manages his? We pay our managers to run our companies. If you don’t trust management you shouldn’t own the stock – that kept me out of AAPL and GOOG 
. As long as top and bottom lines are clicking the stock price will follow. That still leaves the question of what is a good entry price. Using FA you would look at P/E and P/S as compared to competitors and growth rates. You would look at the financial statements looking for negatives like debt, or anything else that might make the business fragile. Using TA you would look for a good entry point. Charts don’t lie, they convey the market’s moods and opinions. I’m a believer in the systemic nature of markets which are best summarized and reflected by charts.
Denny Schlesinger
I believe Buffett also controls the salary of management. In general you don’t get a better CEO by paying $100 million than by paying $10 million. You certainly don’t get one that is 10 times better.
Often the very best, most gifted CEO, like Jobs or Musk take small salaries , depending instead on a rising stock price. And Buffett also said a good business beats good management.
"One has to figure out the basics and there are only two of them:
1.- Business exists to give customers products and services they are happy to pay for. Top line matters.
2.- Management’s job is to make sure the top line coverts into a profitable bottom line for the owners."
I agree 100%. For young companies I look to sales mostly, but if every increase in sales is met by even bigger loses, I avoid them.
The best time to buy is often with the first positive earnings . Or on some temporary bad news, or a bear market, because that is the only time these companies are cheap.
With small companies the computers are often hard to figure out and analyze, especially if they are only part of a larger company.
I read this board with great interest and digressed to Investopedia to read up on Employee Stock Option and learned a lot.
But I have to say that your reply to Rich is not really addressing the issues he pointed out in the scenarios. The ESO is indeed combining the two effects of paying a CEO and issuing new shares into one, so it is reflected in such in way in financial statements. That Rich has stripped it down to its essence by using the same amount does not make it any more confusing. I side with Rich and Fletch on this matter, though I know next to nothing about accounting.
This should be my first post on Saul’s board. I must not leave without saying a big thank you, to you and Fletch and all that post here who are really serious investors and generous teachers. I have come to this board like returning to my old MBA class 10 years ago, and I know where I have learned more.
Oce
P.S. I came to know of Saul and his board through John Sergeant, who recommended it to us via his post on SA:Options. He’s my one of my favourite Fools.
Hi guys,
Here are a couple of other random thoughts about whether compensation paid to a CEO in the form of company stock should be accounted for as a hit to earning. Basically, these thoughts go to the notion of accounting consistency – you want to have accounting rules that are consistent.
In figuring out how to account for things, you cannot just say, “Well, that is unlikely, so we do not need a rule for it.” You have to be able to account for everything that might happen. So it is not really relevant to this exercise to point out that the scenarios I describe are unlikely, which is certainly true. But let me also point out that in my long career I have actually seen companies do each of the things described below except buying sodas for the vending machine with company stock (and the companies using inventory to pay salaries were not AAPL).
These thoughts occurred to me on the shower, which is troubling on so many levels . . . . They are, of course, IMO and probably wrong.
1. Using Property to Pay CEO Salary and Bonus. If a company pays a CEO in cash, we all agree the salary or bonus should be a hit to earnings. How about if it pays the CEO using euros from a foreign account?
How about if it uses gold from its stash of gold in a bank safety deposit box?
What if it pays the CEO with a piece of real estate the company owns?
How about if it uses inventory (e.g., AAPL pays its execs with iPhones)?
IOW, where do we draw the line on whether property used to compensate a CEO should be a hit to earnings?
I am asking the question, so fortunately I do not have to try to answer it.
2. Using Stock to Pay Other Expenses. Let’s go in the other direction. Suppose the company is so happy that it does not have to take a hit to earnings when it uses stock to pay its CEO that it decides to go large on this strategy; it decides to pay every expense using newly issued company stock.
So, the landlord gets company stock instead of cash.
No more COGS, because the company pays for all material and labor using company stock.
The sodas in the vending machine? Purchased with company stock.
At year-end, the company has revenue but zero expenses (assuming stock payments do not hit earnings) – do we feel that the company is incredibly profitable?
The point is not that this is likely, of course – it is ridiculously unlikely. But it is in theory possible, and raises (in a funny way) the question of accounting consistency – when are stock-based payments a hit to earnings, and when are they not?
I.e., are stock payments to a CEO for his compensation somehow special, or should the rule be that all stock payments of company costs and expenses, of whatever sort, are not treated as expenses or capital expenditures?
Certainly, if a company gives stock to acquire another company, that is not a hit to earnings nor is it a capital expense. But if, for example, a company is paying every employee’s salary with stock, or if it is paying the rent with stock – what should the rule be?
Rich
CED
And Rich, glad to make your Friday night more interesting!
Saul,
I hope you realize what you have done by raising this type of difficult conundrum – I am no longer the life of the party; instead I am the guy mumbling to himself who wanders through the crowd while people desperately scatter in an effort to avoid a conversation about accounting issues . . . .
: )
Rich
Suppose the company is so happy that it does not have to take a hit to earnings when it uses stock to pay its CEO that it decides to go large on this strategy; it decides to pay every expense using newly issued company stock.
Hi Rich, Sometimes start-ups do this. They have no revenue and no cash so they pay everyone in future hopes. What results is vast dilution (They have no profits anyway).
If a company pays a CEO in cash, we all agree the salary or bonus should be a hit to earnings. How about if it pays the CEO using euros from a foreign account? How about if it uses gold from its stash of gold in a bank safety deposit box? What if it pays the CEO with a piece of real estate the company owns?
Interesting question, Rich, but easy to answer, I think. These are all cash equivalent expenses. After paying him the company NO LONGER HAS the euros, the gold, the real estate, etc. HOWEVER, when it pays him in stock or stock options, the company just makes them up out of thin air. It dilutes the stock, but there is NO COST to the company. Those examples really clarify the whole question!
Thanks again Rich for those examples. The more I think about them, the more they clarify the question!
Saul
For FAQ’s and Knowledgebase
please go to Post #5584
1. Using Property to Pay CEO Salary and Bonus.
Every asset has a value. One dollar happens to have a value of $1.00
2. Using Stock to Pay Other Expenses.
They are all secondary offerings that increase the share count. Instead of taking a hit to earnings, the shareholders get a hit to their portfolios.
Denny Schlesinger
HOWEVER, when it pays him in stock or stock options, the company just makes them up out of thin air. It dilutes the stock, but there is NO COST to the company.
Hi Saul,
Suppose you didn’t have to make a living by posting to these boards, and instead you owned two profitable companies – Expensing Inc and Dilution Inc. You are thinking of selling both these companies and retiring to Kauai. You’ve invited prospective buyers to look at the books, and you show them these income statements:
Expensing Inc Dilution Inc
------------- ------------
Sales 10,000,000 10,000,000
Expenses 6,000,000 6,000,000
Manager Salaries 500,000 0
Operating Profit 3,500,000 4,000,000
The buyers remark that Dilution appears much more profitable than Expensing. You smile and say, yes, the managers of Dilution convinced you to give them part ownership in the company instead of a salary – they said, after all, there’s no cost to the company, and to boot the company is now much more profitable. They even wanted a bonus for better performance! You end up selling both companies. Unfortunately you had to share some of the moolah from Dilution with those pesky managers.
There is no ‘right’ answer to this. The question is do you want to think more like an owner or think more like a manager? If you’re a Warren Buffett fan, you want to think more like an owner.
Thanks,
Ears