Debating Non-GAAP Metrics
Kudos to Thomas Selling and Gregory Sommers for “Why Accountants Should Care about Non-GAAP Financial Metrics” (June 2016). I am a fan of non-GAAP metrics. Their article brings to mind what, to me, is perhaps FASB’s most egregious display of “truthiness” in accounting and why GAAP is not always useful—SFAS 123 (AU 718), Accounting for Stock-Based Compensation.
That pronouncement resulted in part from a tortuous rationalization in support of FASB’s conclusion that awards of equity to employees were actually expenses of the entity that granted them. FASB itself (Statement of Financial Accounting Concepts 6, para. 80) defined expenses to be the “outflows or other using up of assets or incurrences of liabilities.” As we all know, no such actual outflows result from the granting of share-based compensation, only inflows, when an employee may pay cash to acquire shares upon vesting. I have always believed that this argument was the central and pivotal weakness of SFAS 123.
FASB’s stated “explanation” was, in part, that in performing service to the entity, an employee created an asset that was instantaneously consumed (SFAS 123R, B19–21). Thus did FASB conjure up the accounting equivalent of subatomic physics’ “virtual particle,” which has no mass and a life so short that it can be observed only by the wake it leaves in some host medium. This example of sophistry left many of us shaking our heads.
In a peculiarly worded paragraph (SFAS 123, para. 91), FASB appears to have cherry-picked rationales, as between concepts and practicality. FASB stated both that it saw no conceptual basis justifying “different accounting” for stock-based compensation, but also that its decision not to base compensation expense on fair value was “not based on conceptual considerations.” Overall, practicality lost out.
The resulting illusory depression of GAAP income has prompted issuers and users to add back the GAAP-based expense attributable to such awards when arriving at their non-GAAP metrics. That is, issuers and users prefer to ignore SFAS 123 because, as Selling and Sommers state, expensing stock-based awards “does not adequately capture the underlying economics of a business.”
FASB stated both that it saw no conceptual basis justifying “different accounting” for stock-based compensation, but also that its decision not to base compensation expense on fair value was “not based on conceptual considerations.”
Reasonable people may differ. This exchange of views exemplifies what we all know—that accounting is an art, not a science. Non-GAAP metrics often serve to satisfy those of us who are in substantive disagreement with standards-setters’ decisions.
Neal B. Hitzig, PhD, CPA, New York, N.Y.
The Authors Respond
Professor Hitzig’s letter is tangential to the general thrust of our commentary. Notwithstanding that, we disagree with his position on the accounting for stock-based compensation.
We believe that FASB’s definition of an expense is eminently reasonable and an appropriate perspective for determining whether employee stock-based compensation should be recognized. The conclusion that all services of employees are costs that will eventually be recognized as an expense, regardless of the form of payment, follows logically from this definition.
But even setting aside the semantics, we question whether the logical extension of Hitzig’s position to similar transactions would lead to consistently high-quality financial reporting. One such extension must be that stock-based compensation for services from nonemployees should also go unrecognized. For example, paying rent for office space by issuing stock or stock options would result in no cost of occupancy. That alone is sufficient for us to reject his position.