Share-based payment expense – we’d keep it if we understood it!

Here’s the kind of disclosure we’ve probably all seen numerous times:

  • Adjusted EBITDA is a non-GAAP term and has been reconciled to profit / (loss) for the financial periods, being the most directly comparable measure calculated in accordance with IFRS. Management relies on adjusted EBITDA to better translate historical variability in our principal business activities into future forecasts. By isolating incremental items from net income, including income / expense items related to how the Company choses to manage financing elements of the business, management can better predict future financial results from our principal business activities. The items included in this calculation have been specifically identified as they are either non-cash in nature, subject to significant volatility between periods, and / or not relevant to our principle business activities. Items adjusted in the non-GAAP calculation of adjusted EBITDA, are as follows:
  • non-cash expenditures, including depreciation, amortization, and impairment expenses; and equity-settled stock-based compensation…

This particular randomly-selected example, from Trican Well Services Ltd., goes on to add five additional bullet points of adjusted items, but I wanted to focus on the “non-cash expenditures, including…equity-settled stock-based compensation.” For purposes of a close reading, the company’s use of “either…and/or…” doesn’t really help – is the adjustment solely prompted by equity-settled stock-based compensation being non-cash, or is it that it’s non-cash and subject to significant volatility and not relevant to principle (sic) business activities. For purposes of this article, we’ll assume it’s all three.

The Footnotes Analyst website recently took on the appropriateness of such justifications, commenting as follows on the first two:

  • Non-cash “…non-cash does not mean non-expense. Economically, granting equity options for free is the same as paying cash to employees and requiring those same employees to use that cash to purchase equity investments – why would this result in an expense, but not if combined into a single transaction?”
  • Volatility- “… many items in the income statement that are not excluded from APMs are also subject to catch up adjustments and a volatile expense is no less an expense than any other. Volatility, the influence of catch up adjustments and changes in the value of equity is a good reason for disaggregation and separate presentation, but it is not a reason to ignore the expense entirely.”

Not much argument there from me. As for the other item, well, being not relevant to principal business activities could of course mean anything. Just on a basic level, what and how you’re paying your employees seems pretty fundamental to whatever your business is. The Footnotes Analyst points out one reason why stock-based compensation may seem less immediately relevant:

  • Certain expenses may have an ‘investment’ element built in whereby the company not only obtains benefit from the expense in the current period but also in the future – so-called ‘expensed investment’. Restructuring costs and some spending that creates intangible value are good examples.

But…

  • In our view this is only partly true for stock-based compensation because the incentivization effect is already reflected in the accounting. The requirement to allocate the grant date value over the vesting period, rather than recognise in full at grant date, goes a long way to reporting the expense in the appropriate period.

It seems to me the biggest problem though is that people have trouble understanding what stock-based compensation expense actually represents. As I put it once before, the standard is based on the assumption that since no one gets something for nothing, an entity issuing share-based payments must have received some form of economic resources in return for them. That’s why, more than old Canadian GAAP did, IFRS emphasizes measuring the share-based instruments at the fair value of the goods or services received, unless that fair value can’t be measured reliably. It follows, in broad terms, that certain kinds of conditions (so-called vesting conditions) will (at least in theory) affect the economic resources to be received, for example by incentivizing the recipients to work harder or better. Other kinds of conditions though (non-vesting conditions) won’t affect the resources received: the conditions are beyond the control of the recipients, so they’ll put in the same amount and quality of work either way. In the first case, then, the outcome of the condition may result in revising the expense in the light of experience (by applying forfeiture-style accounting), but in the second case it doesn’t. A broad-based market condition, such as a target return on a share index, always falls into the second category, because it reflects the performance not only of an entity itself but that of other entities outside the group as well, and so is inherently beyond the control of any employee.

Of course, all of this assumes an extremely programmatic view of human behaviour, more so than I think non-specialist users can readily grasp and accept. The difficulty is compounded as, of course, the value of the share-based payment expense may not bear any relationship to what the individuals ultimately ended up realizing on exercise. Regulatory regimes (such as the Canadian Form F1-102F6) may compensate to some extent by requiring at least some disclosure of the payout value of vested awards and suchlike, but such a perspective is absent from the financial statements. Certainly it’s a justifiable absence in the context of the objective and scope of IFRS 2, but you can’t blame non-specialist users if they may think it’s an odd one, even to the extent of rendering the whole accounting mechanism basically pointless…

The opinions expressed are solely those of the author

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