Of course stock based compensation is an expense of doing business but it is sill wrong to account for it as an expense on the income statement. It’s bad accounting. The expense is not made by the company but by the shareholders who give the employees some shares. How is this reflected in traditional accounting?
The company issues some shares and gets some cash for them (I’m omitting the intermediary steps)
**Concept Debit Credit**
Cash 100,000
Capital 100,000
Since the number of shares has increased the earnings per share takes a hit. The shareholders HAVE BEEN INFORMED!
If you also add the “compensation” to the P&L statement, you have accounted for the thing TWICE.
Management likes to hide stock based compensation by buying back shares. The accounting is the reverse of the above
**Concept Debit Credit**
Cash 100,000
Capital 100,000
This last entry implies a free lunch which it is not, now the company is downsizing by liquidating some shares. The sellers take their money and run but the remaining shareholders have shares with higher earnings per share.
The situation is back to the original position, the optioned shares have been canceled, earnings per share are back to the previous number. What has changed is that some anonymous shareholders have been replaced by employees who typically sell their shares back to some anonymous shareholders. In other words, the compensation was not paid by the company but by Mr. Market!
Why then does Warren Buffett hate stock based compensation so much that he is willing to destroy proper accounting? Because, during the first stage it goes against his investing thesis which is to accumulate shares. If he were to buy back those shares the dilution would disappear. But this goes against his investing thesis as well which is to hoard cash, other people’s cash.
Denny Schlesinger
Note: The accounting is not exactly a wash depending on the cash paid by the optionees and the price paid for the shares bought back but in the grand scheme of things it’s a fairly unimportant number.