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Technology Stocks : Cisco Systems, Inc. (CSCO) -- Ignore unavailable to you. Want to Upgrade?

To: Boca_PETE who wrote (64582)	9/15/2003 11:10:44 AM
From: Stock Farmer	Read Replies (1) \| Respond to of 77400

Pete, When a company writes down depreciation, there is no cash flow. And no asset actually leaves the company. And nothing changes hands at all. We merely transfer numbers around on the books so that everything adds up properly. Increasing and decreasing of phantom assets to make books balance is hardly a novel concept in accounting. But there is an expense. Same with a provision for restructuring costs. We just create a fictitious asset or liability in the present, chock up income or expense against the change, and then reconcile future cash flows against it. And cash flow is not the determinant, as you well know. Consider the case of a customer who is also a supplier, in conjunction with an offset agreement where amounts owing by one party can be net off against amounts owed to that same party. Clearly the actual cash flow from the supplier to the company is only the difference between what the company books as revenue and what the company books as cost. But woe betide the company that books cost as zero and books the cash flow as high-margin revenue. Or who books artificially inflated revenue offset by artificially inflated costs to give the illusion of revenue "growth". It is a long standing principle of accounting to separate out cash flows from accounts provided that reconciliation occurs appropriately - which might be in the same time period as in the case of revenues offset by costs, or over different reporting periods as in the case of a provision for restructuring offset by the subsequent severance cash flows. For example. And finally it is a long-standing principle of accounting that when there is a reasonable certainty that the company will recognize cash flows in the future as a consequence of decisions made in a reporting period that an estimate of these future cash flows is reflected on the current accounts. Again, provisions for restructuring are a good example. Apparently in your essay you have neglected these principles which stand against your point but chose others that support it. Fair enough, for that is the measure of good debate. However, if we are entertaining a principled dialogue, then we should introduce arguments that encompass existing principles whether they support or stand against the conclusions we would like to believe. In the case of options, we all recognize that the company gave something of value to the employee and that the employee produced effort in the course of operations in exchange. You don't have to be an accountant to recognize a wage being paid here. Somehow, however, we have reached the point where contemporary accounting ascribes a value of zero to this wage. Which flies in the face of any objective reasoning. So we dig deeper. Something is wrong if a non-zero wage expense is being recorded as zero. In fact, when we look closely, all we see is a residual financing activity. Which gives us our first clue. Let us develop the scenario from first principles. Let's say I am a company, and you are my accountant. I have decided to pay my employees a "bonus" based on the performance of my stock. I come to you at year end with the following accounting nightmare. I just gave my employees all a bonus. I wrote them a promissory note, payable on any date they choose on any day between 3 and 10 years from now, provided only that they are still employed when they surrender the note for cancellation. The amount I will pay at that time is the amount by which my shares have risen between now and the date that they present the note, multiplied by some number of shares. Now, as my accountant, I'm asking you to help me figure out how to present this on the books. This is a bonus, and it will cost me something. I have a binding agreement for a future activity that will more likely occur than not occur, consequently I must to book a provision for future estimated wage expenses. You would agree. You and I would have a devilish time trying to figure out what this amount would be. In the end, we would use some science and come up with some estimate. And we would end up with a provision on the books and a non-cash charge against earnings. And when the time came for employees to present their notes then I would draw down against this provision. Pretty straight forward accounting. Nothing new here. Now, you might ask me how I plan to pay for this bonus. I believe it will be possible to raise capital to cover this expense by issuing common shares when the employees cash, and so this is what I intend to do. Since my shares will have gone up (or my employees will not surrender my note), and the amount of the note is indexed to both a number of shares and a change in share price, then I can cover the cost by selling the number of shares and be guaranteed to have in infusion of excess capital. And I can also determine in advance the maximum number of shares I must set aside and register these in advance with the appropriate authorities, and provide full disclosure to my shareholders of expected future increase in shares outstanding. So I have a sound financing plan to cover the expense as registered in the provision. And again, we know how to account for this too. Whatever accounting we come up with for the wage expense (which we both should agree is non-zero, but also not present) should be independent of who I sell my shares to in the future. Just like revenue being booked should be independent of who my customer is. So if I end up getting my employees to agree as part of their bonus that they will buy the shares from me, then I can eliminate risk and cost of having to find some independent third party. However, just as it is important to properly record revenue from suppliers, it is equally important to properly record financing from wage earners. That is, we should record the wage activity separate from the financing activity. So that we can keep the books straight. And having done this, we can reduce the amount of money going back and forth through an offset agreement where I agree to offset the amount of financing owed to company for the amount of wages owed to the employee. When the dust settles, employees pay me the difference between what they are worth and the amount of their bonus. Which turns out to be today's share price. So basicly the way they get their bonus is to pay me today's price for a share when they claim their bonus, and I give them a share. Accountants know how to treat offset agreements: there is a wage component and a financing component. Net cash flow ends up being the difference between the two. This way we don't make the mistake of under-stating the wage expense or under-stating the financing expense. And by application of these fundamental principles of accounting I would show a non-cash provision for wage expense on the date of awarding the bonus and a financing flow against this provision on the date at which the employee claims the bonus. And the amount of the financing cash flow is the full amount of the share price on the date that the bonus is claimed. The amount of the wage expense is the appreciation in the stock times the amount of stock. The difference between the two turns out to be the actual cash flow, which is net positive to the company. In other words, the financing flows into the company are greater than the wage flow out of the company. And since the third scenario is indistinguishable from the grant and exercise of a stock option, it would not be unreasonable to say that such acounting treatment for stock options is based on application of fundamental principles. But what do we do today? Well, what we do today is first of all ignore the wage component altogether when the option is granted. And second of all, when the option is exercised we offset the wage component from the financing component and record only the residual amount. This is like pretending that we have really high margin revenues when we sell our products to our suppliers. The net result is to understate the actual costs of operations, to overstate the profitability of the firm, and understate the degree to which the company is subsidizing operations through equity financing. Tsk tsk tsk. I would be interested in your observations on this.