Fielding Questions on Corporate Governance

Question: I'm a former Pricewaterhouse CPA, and I wanted to ask you about how companies report the tax benefit from the exercise of stock options on their cash-flow statement. Most companies used to report this line item in the financing section of the cash-flow statement. Now, most are reporting this line item in the operating section. But this item is clearly not cash generated from operations.

Last quarter, Yahoo! (YHOO - commentary - Cramer's Take), for example, reported cash flow from operations of $99 million. But $21 million of that (almost one-fifth of total cash generated from operations) came from the tax benefit realized on the exercise of stock options. This is truly misleading. If the proceeds from the exercise of stock options are in the financing section of the cash-flow statement, why doesn't the related tax benefit also go to the financing section?

-- J.G.

Answer: You're right, of course. The tax benefit from options has nothing to do with operations. The fact that some companies refuse to expense options on the income statement, but then recognize cash flow from the tax benefit, is silly. To include that in operating cash flow, instead of cash flows from financing activities, is disingenuous, at a minimum. Options are just another way to sell company stock (it's a sale of stock to employees), so it's clearly a financing activity, not part of ongoing operations.

Question: I would appreciate it if you would give me a better understanding of this "expensing options" issue. First, it seems to me like this isn't an expense at the time of granting. The options might never be exercised. Second, the cost to shareholders is dilution when the stock is issued to optionees.

Answer: Wrong on both counts. First, options are an expense at the time of issuance. Not recognizing them would be like an insurance company not recognizing a liability on policies that they issue -- on the thought that they may not have to pay on the insurance policy. All financial statements are a series of estimates and conventions. And one convention is present value. We recognize present value of contracts by using estimates. This gives the reader of financial statements better information because current income is matched against current expense.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, Alsin and/or ACM was long Boeing, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.