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Donít fall in the GAAP in Pro Forma Performance.

By Joseph Vaughn-Perling

Generally Accepted Accounting Principles

Wall Street wantsí your money.  Let us take a look at one of the ways the fool and his money are parted using the example of Facebook Inc. (FB).  Facebookís first earnings report as a public company may serve as a good example. How?  It boils down to accounting and how this is reported to us as public consumers of the currency they create, namely the stock in their company.  For full disclosure, the author has profited from shorting options on this equity.

When calculating a company's quarterly profit estimates, Wall Street analysts who cover technology companies often leave out a certain type of accounting charge; namely, the expenses a company incurs when it allows insiders and employees to buy its shares for less than their market price. This is a common practice and one of the reasons silicon valley companies like to go public, so they can use their company stock to pay employees.

Most public companies do the same thing, Facebook is just the most striking recent example because in the case of Facebook's latest quarterly results, that expense was more than $1 billion. This is larger than ought be expected in forward quarters because that number was inflated by the company's initial public offering in May. Chief Executive Mark Zuckerberg and other insiders cashed in big-time on the largest-ever Internet IPO.

But keep in mind that stock-compensation charges aren't typically a one-time charge for public companies that give large amounts of equity compensation to executives, venture-capital investors and rank-and-file workers. Technology companies tend to incur such expenses as a large and recurring charge. And for Facebook's second quarter, the amount was more than enough to offset revenue and cause the company to report a net loss putting them in the red.

All of this is well and good, except if you are taking your queues from Wall Street analysts, especially from one of those employed by one of the many investment firms that received an allocation in return for managing the public offering.  If you had been reading the stock reports any of these three dozen or so analysts who covered Facebook, you have not likely seen any mention of this important fact, or how it impacts Pro Forma earnings.

What are 'Pro Forma' Earnings?

More than a decade ago, the organization that sets accounting rules for U.S. companies moved to bring the standards for financial reporting here in line with international rules. The goal was to provide global investors a valid way to measure the results of rival companies based in different countries against each other, a good thing generally.

The problem from the point of view of the companies is that computing exactly what a stock option is worth is difficult and that the proposed changes would thus result in the reporting of results that wouldn't reflect accurately the health of a company's underlying business. Put aside the idea that FB has weekly options and dollar incremental strike prices and so is one of the most easily valued of all options available on the market today.

Historically this argument seemed sound due to the complicated nature of option accounting, and the rules were held up for years as accountants hashed out which arcane formula should be used to value them. In the meantime, FASB officials defended their plan at often-hostile Congressional hearings.

But in arguing against the rules, the tech lobby was, in effect, ignoring a fundamental characteristic of a public company: when you issue stock at a discount to one class of shareholders, you dilute the stake of all others. What's left after that dilution is the number that public investors should have access to when determining whether to buy a company's stock.

In the end, the dot-com stock implosion destroyed enough wealth and aroused enough anger to get the FASB reforms approved and implemented. So while the reasons for the decision are no longer as valid as they were, the decision has not changed.

As a result, all of those tech companies that routinely had reported what they called "pro forma" results--which excluded stock expenses and other charges--were forced to lead their quarterly press releases and file their SEC documents using numbers that adhered to the new rules under GAAP, or generally accepted accounting principles.

'Non-GAAP' Earnings

There is a loop-hole in this process, through which a long convoy of trucks are passing filled with investor monies. Because the rules applied to public companies' financial reports, but not to the stock reports published by Wall Street, equity research analysts who cover tech companies simply continued to leave out stock-based charges.

Even worse for retail investors, the firms that compile analyst reports, such as Thomson Reuters, Zacks and FactSet, had no choice but to use the estimates they were given when compiling their quarterly consensus estimates.

Those estimates, of course, are the ones that set the expectations for an earnings report--even if they reflect so-called 'non-GAAP' earnings which don't adhere to accepted accounting standards.

That is why retail investors thought that, as of last week, Wall Street expected Facebook to report "earnings" of 12 cents a share. Yet we now know that the company posted a net loss of $157 million, or 8 cents a share. Unless a company is able to guide analyst opinion heavily toward the right numbers, this problem continues to surprise to the down side because, every time a Facebook employee or insider cashes in, the company's share count will go up and the diluted piece of Facebook will get smaller.

That's why investors should always pay attention to a company's earnings "attributable to common stockholders," which can be found at the bottom of its quarterly statement of operations.

If you want to see what can happen to the stock of a company that hands out gobs of equity, take a look at a decade-long chart of Microsoft (MSFT) or Cisco Systems Inc. (CSCO). There's a reason these stocks have gone nowhere for 10 years. Essentially, a very large chunk of the per-share profit that they generated during the past decade already had been given away, in advance, to its insiders, executives and employees during the 1990s. Similarly, with Facebook, much of the company's future profits already have been extracted from it.

In the case of Facebook, the company's quarterly stock-compensation charges may be at least $100 million for the foreseeable future, as more insiders cash in. There is no way to know for sure, though, because Facebook didn't provide a financial forecast.

So now you know one of the reasons why Facebook's shares have kept plunging. Investors had been surprised that the company posted a net loss in its first publicly reported results, but the surprise was one that the attentive investor has, or should have, expected.

Joseph Vaughn-Perling is a Fellow of The Business Forum Institute and is currently the Security and Authentication Capability Manager for British Telecom Global Services.  He holds a B.S. degree in Psychology & Cognitive Science from the University of California Los Angeles and studied Law at the University of San Diego Law School. Prior to joining British Telecom he was LAN/WAN Technologist for William OíNeil & Co. publisher of Investors Daily; and was Senior Consulting Engineer, (Global Security, Security Development & Legal Dept) at Infonet Services Corporation. Joseph is a Certified Information Systems Security Professional (CISSP) and a Certified Checkpoint Systems Engineer (CCSE) He is a recognized Network Design Architect for fault tolerant globe spanning networks and applications and Member of the Board of Directors for International Networking companies.

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