Google: Accounting Changes to Whack Cash Flow

Two accounting changes will significantly affect the optics of Google's operating cash flow and earnings beginning in Q1 2006.  Neither will change the actual cash generated by the company.  As Microsoft's recent implementation of a similar accounting change demonstrated, however, sometimes optics matter.

The first of these changes will require that "tax benefits from stock-option exercise"* be reclassified on the cash flow statement as Cash from Financing Activities instead of Cash from Operations.  There is spirited debate about whether this change is warranted--cash is cash, and issuing options to employees for compensation is clearly an operating activity--but the SEC has mandated the change.  So unless analysts choose to change the way they calculate Free Cash Flow, Google's FCF will drop significantly.

To give a sense of the magnitude, if Google had accounted for the tax benefits as cash-from-financing instead of cash-from-operations for the first nine months of 2005, Free Cash Flow would have dropped more than 20%, from $1.2 billion to $937 million.  Because free cash flow (in my opinion) is the most valid valuation metric for Google, this change will make Google look 15% more expensive than it does today: About 95X 2005E FCF versus 80X currently (a.k.a., frighteningly expensive, whichever accounting you use).

The second accounting change requires Google to stop breaking out "stock-based compensation" as a separate line-item on the income statement (thus making it easy for analysts to strip it out and report "pro forma" numbers), and, instead, include it within the relevant expense line items (Sales and Marketing, Research and Development, etc.).  Analysts will still be able to strip out (read: ignore) the stock comp, but they'll have to dig a little to be able to do it.  And while digging, perhaps, they will have time to wonder whether treating significant stock grants to employees (compensation) as a non-expense is really the most valid way of assessing the company's performance.

(The first of these changes, of course, will hit Yahoo!, too.)

*Tax benefits from stock option are generated when employees exercise options.  The difference between the strike price and exercise price--the amount the employee takes home--is tax deductible, even though this cost never appears on the income statement.  This charming (and absurd) little option feature is probably the result of fierce lobbying by accounting firms some decades ago.  The accounting firms, presumably, made two different arguments: one to FASB and one to the IRS.  The FASB argument must have gone like this: "No, stock options are not an expense--there's no way to value them properly--so they should not be expensed on the income statement."  The contemporaneous IRS argument, meanwhile, must have gone like this:  "Yes, stock options are clearly an expense--if they're not an expense, what are they?--so the cost to shareholders should clearly be tax deductible."  Let's hear it for the rigor and transparency of modern accounting.

Comments

[googleguy]

Henry, you are the only person I've ever seen who actually bothered to discuss the impact of FASB like that.

The most I've ever heard from my colleagues is that "Oh, the analysts will find a way to bury the new info and so will companies, so retail will still have no clue what's going on."

You make it seem like they wont be able to hide the employee stock compensation largesse anymore.

If you REALLY want to get angry- you should be aware that Google is now compensating their employees with "Google Units" which are restricted shares that vest like options. But since they are technically NOT options and NOT restricted shares (they are actually just a contractual agreement, google claims) then Google does NOT HAVE TO REPORT the compensation until the time that the contract allows employees to sell.

In other words. Google can issue an employee 10 billion dollars worth of Google units that "vest" in 4 years, but Google will not have to report anything to the SEC until 4 years elapse.

This was done specifically to thumb their nose at FASB and completely sidestep the problem of massive compensation diluting earnings- at least for the next 3 or 4 years.

This will have the desired result that all the previous Google employees (read bigwigs and high level execs with millions of dollars worth of shares to sell) will be able to unload for the next 4 years before wall street ever learns how much of the store they gave away. This will keep the stock price high in the near term, but collapse in the long term. By then those execs will have long since dumped their shares and could care less.

[bronxite]

So the argument goes that the accounting industry didn't want to learn anything about how stock options should be priced, but are more than comfortable with the way impairments to goodwill and in-process R&D from acquisitions are calculated.

Why did the SEC decide to move the tax relief on options from operations to financing? In spirit, it's still a compensation item.

[mike simonsen]

Love seeing you call any Internet company, 'frighteningly expensive'.

[Jiashu]

Hi,

Would love to see your take on the disparity between Google and Yahoo! on the definition of free cash flow. Google excluded tax benefits from stock option exercise from the calculation of FCF, while Yahoo! still included that. Do investors noticed the difference? While there is no GAAP definition of Free Cash Flow, is Yahoo! being dishonest when they insist on including the tax benefit while SEC mandates that is part of the cash flow from financing activities?

[Samueltt]

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