What We Should Know About Stock-Based Compensation

When it comes to accounting for stock based compensation, there are usually two contradicting points of view.

First is that stock based compensation should not be reflected as an expense because the company does not pay for it in cash.

On the flip side, there is an argument that this form of compensation is an expense because it dilutes shareholders’ equity due to a greater number of outstanding shares.

So which should we believe?

Investors who are familiar with the technology sector know that this has become an increasingly pertinent issue as more technology companies issue stock based compensation as a way to attract and reward company employees.

Before 2005, it was not necessary for companies to report this form of compensation as an expense. But since then, it has become a routine accounting practice in GAAP (Generally Accepted Accounting Principles) standards in America.

Despite this, many companies continue to report non-GAAP accounting profits and earnings by removing stock based compensation and touting these figures as a more accurate reflection of the company’s standing and profitability. The difference between these two accounting methods can sometimes mean reporting a healthy profit or a heavy loss.

Unsurprisingly, management teams of some companies usually encourage investors to use these non-GAAP figures as it usually paints a rosier picture of the company.

However, if we dig a little deeper into understanding what stock based compensation really means for the company, we realise neglecting it as some accounting mumbo-jumbo is actually unjustified.

Firstly, it does not make sense that companies can neglect all expenses by paying everything in stock. For example, if a company paid its supplier using its own stocks, does that mean the cost of goods bought should not be counted as an expense?

Secondly, stock based compensation increases shares outstanding and leads to dilution of shareholders equity. This will eventually lead to share price depreciation. Companies that use stock based compensation may end up having to offer more stock options or stocks as an incentive to retain talent when stock prices tank.

The Foolish bottom line

As investors, we should take note that stock based compensation is, in fact, a very real expense. Warren Buffett noted in his 2016 Annual letter to shareholders, “ The very name says it all: ‘compensation.’ If compensation isn’t an expense, what is it?”

Shrewd investors should not ignore stock based compensation as it does have a great deal of effect on current shareholder equity. We can do this by either acknowledging it as an expense on the income statement or taking note of how it affects shareholder equity by looking at diluted earnings and assets per share.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.