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 the 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.