Stock compensation expense, cash flows, and inflated valuations

Abstract

This paper reviews the statement of cash flow implications of stock compensation expense and the effect it can have on valuations. The paper suggests that treating stock compensation as a noncash item in the statement of cash flows can be misleading from internal decision-making and external valuation perspectives. This is important, given the increasing role of non-GAAP cash flow disclosures in financial reporting as well as their use internally by managers. The paper quantifies the potential size of the problem and suggests potential solutions, including treating stock compensation expense as an operating cash outflow and a financing cash inflow, adding further descriptive disclosures to the financial statements, or both. Finally, the paper also highlights a similar issue that occurs with the cash flow implications of finance leases.