C&B Notes

The Pro Forma Games

Conservative accounting is important both for valuing a business and for evaluating management teams.

At many companies, the difference between pro forma and reported earnings has been considerable of late.  Over the past four quarters, Facebook ’s reported net income was equal to 56% of its pro forma measure.  At Twitter, pro forma earnings over that period were 22 cents a share versus a reported loss of 98 cents.  LinkedIn was similar: Its reported loss of 36 cents shifted to earnings of $2.21 on a pro forma basis.  In each case, stock-based compensation accounts for most of the difference.

Now, though, many tech companies are pushing the pro forma envelope even further.  Facebook, for example, doesn’t just exclude its stock-options expense from its pro forma earnings; it also keeps out payroll-tax expenses related to such compensation.  But these payroll taxes are only a loosely related cost and are incurred over a different time period than share-based compensation expense.  The latter is a noncash expense arising from the granting of stock-based awards to employees during the financial reporting period.  Payroll taxes are a cash expense based on the taxable income of the employee, typically withheld at the time options are exercised.  The expense is relatively small, amounting to 2.7% of Facebook’s operating income in the first quarter.  But it points to the lengths tech companies are going to gild the pro forma lily.

Some in the tech world try to justify all this with timeworn arguments that doling out stock options is an equity event, not an operating expense, and so should be excluded from earnings.  Yet that flies in the face of Silicon Valley reality: Awarding shares as compensation is a regular cost of doing business and attracting talent.  “Earnings are supposed to be a performance measure,” says Wendy Heltzer, an associate professor of accounting at DePaul University.  “You start with revenues and subtract all the resources you used up to generate that revenue.  Human capital is one of those resources.”  In other words, backing out stock-compensation expense is tantamount to saying employees are working for free.

Granted, there may be instances where pro forma earnings have a purpose, as in the case of an acquisition.  Such adjustments can sometimes help investors better understand and predict a company’s underlying performance and potential.