Effective tax rates and stock-based compensation

Stock-based compensation can have a significant impact on the effective tax rate. For US companies the effect is driven to a large extent by changes in the stock price. In 2021 this reduced the effective tax rate for many companies; however, in 2022 you could well see the reverse.

We use Netflix to explain the effect of stock-based compensation on cash taxes and deferred tax adjustments. The accounting is complex and made even more challenging for investors by differences between IFRS and US GAAP. Unfortunately, neither US GAAP nor IFRS financial statements may fully reflect the underlying economics.

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Non-GAAP is more than earnings before bad stuff

Non-GAAP measures can be useful for investors, but they are also controversial. Some argue that certain non-GAAP adjustments are unacceptable and should not be permitted. This recently happened to US company MicroStrategy, where the SEC required it to amend the presentation of cryptocurrency gains and losses.

We do not agree with the SEC approach and believe MicroStrategy gives valid reasons for its cryptocurrency non-GAAP adjustment. We have less sympathy with other aspects of the company’s non-GAAP earnings calculation. However, we believe that the disaggregation that results from all non-GAAP disclosures generally benefits investors.

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Disaggregation is key to understanding performance

Limited disaggregation of income and expense items with different characteristics impairs investors’ ability to assess and forecast performance. Recent proposals by the IASB for a new disaggregation principle and related disclosures of ‘unusual’ items will help. However, in our view, they do not go far enough.

The IASB also proposes to include management alternative performance measures (non-GAAP or non-IFRS) within audited financial statements. We welcome this. Additional subtotals can be helpful if they are clearly described and what is omitted is clearly identified. What would also help is to ban the use of labels such as ‘underlying’, ‘core’ and ‘recurring’.

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Forecasting ‘sticky’ stock-based compensation

Stock-based compensation grants to employees in 2020 are likely to be affected by the changes to share prices and reduction in profitability currently being experienced by many companies. However, the impact on the related expense and on reported profit may not be what you might expect.

For most companies, stock-based compensation is a ‘sticky’ expense that is only indirectly or partially affected by current period changes. Limited disclosure in financial statements makes forecasting this expense a challenge. You should focus on the value of new grants, the vesting period and the effect of potential changes to assumptions. Our interactive model will help.

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In search of free cash flow – Amazon

Amazon provides investors with three alternative calculations of a free cash flow metric. For 2018 these range from $8.4bn to $19.4bn. In contrast our preferred approach gives a negative free cash flow of $3.4bn. What explains these material differences?

The disclosures by Amazon about its free cash flow measures are good and the calculations go further than many other companies. However, in our view important components are missing. We explain our additional adjustments in respect of leased assets and stock-based compensation.

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