As published in MicoCap Review Magazine
NON-CASH COSTS CAN SINK THE SHIP
By: Corey Fischer
Managing Partner, Weinberg & Company P.A.
Most CEOs and CFOs are very conscious about producing operating results that will meet investors’, analysts’ and Wall-Street expectations. In their daily oversight, such results are dependent upon revenue generation, profitable margins and cost control. These are key metrics that drive company analysis, assessment of management performance and overall stock performance.
While focusing on these performance metrics, many CEOs, CFOs and investors have learned the harsh reality that operations are not the only factors that come into play when determining earnings or liquidity of a public company. Complicated, and often times highly misunderstood, non-cash charges resulting from accounting rules are frequently arising that distort the company’s true operating performance. These non-cash charges are particularly severe to microcap companies, whose limited scale of operations often times becomes insignificant to the large values assigned to these non-cash charges. Almost all of these non-cash charges relate to issuance of company equity or debt securities.
Probably the harshest pill for the preparers and readers of the microcap financial statements to swallow is the creation of large derivative liabilities that occur when companies issue equity and debt agreements (principally convertible notes) that contain reset provisions to the exercise or conversion price of these instruments based on future sales of equity. The creation of this liability directly reduces stockholders equity on the balance sheet, and causes a sizable hit to earnings when recorded. And it just doesn’t end there. According to the accounting rules, these liabilities must then be measured to fair value each reporting period, and the changes to the fair value are recorded on the statement of earnings. The amounts recorded for these liabilities, and the corresponding adjustments to market, are hard to predict. Furthermore, as the creation of these liabilities directly reflects net equity, this could unexpectedly create violations of debt covenants, or worse, result in problems with the trading exchanges that have minimum equity requirements. What is even harder to swallow for management, is that these non-cash derivative liabilities will almost never be settled for cash, and distorts the company’s true liquidity.
Other culprits that can cause significant unwanted non-cash charges to earnings would be the issuance of convertible debt instruments whose conversion terms into common stock are below market price of the common stock on date of issuance. This “beneficial conversion feature” will result in an additional charge to future earnings. Also, issuance of warrants as a kicker in conjunction with debt financing will result in additional future non-cash interest charges based upon the value assigned to the warrants. These non-cash amounts created by the warrants and /or “beneficial conversion feature” often times can equal the face value of the financing instruments issued (ouch!).
Most preparers and readers of financial statements of public companies now understand that a grant of option awards also will create a non-cash charge to earnings. However, what many do not realize is that modifications to any stock award, including a change in the life of the award, vesting dates, and exercise price or termination provisions can generate an unwanted additional charge to earnings. Furthermore, options or warrants issued to non-employees contain other pitfalls, making earnings hard to manage or predict. That is because, as opposed to awards granted to employees whose award value is fixed at the time of the grant, these types of awards given to non-employees have to be remeasured at fair value at the end of each reporting period. This can cause wild or unpredictable swings in a company’s earnings depending on the volatility of the company’s stock price.
What’s a company to do? First thing would be for company CEOs and CFOs to do everything they can to avoid these types of agreements. Though easy to say, circumstances may dictate otherwise. If such transactions do arise, companies should seek out solid accounting advice from their financial advisors who are experienced with these transactions – before it gets to the auditors. If you find yourself stuck with these non-cash issues, you still have one last way to communicate to your investor base. Public companies are increasingly including a reconciliation of earnings per the financial statements to an adjusted earnings amount that eliminates these non-cash charges within the Management Discussion and Analysis, and in press releases. The Securities and Exchange Commission allows this type of reconciliation. Management of many companies have found this the best way to bridge the gap between the earnings as reported per financial statements, and a more meaningful earnings number for investors and financial statement users to monitor operating performance.
You would think the goal of the accounting rules would be to create a “useful” “understandable” earnings number in the first place.
Corey Fischer, CPA, is Firm Managing Partner of Weinberg & Company, a multi-office, PCAOB-Registered firm specializing in the audit, assurance and tax needs of micro and small cap companies. He has more than 25 years of experience, having worked with the Big 4 accounting firms and as an SEC reporting officer for a number of NASDAQ-listed companies. He is based in Los Angeles, and is an expert in financial reporting, SEC compliance, raising debt and equity, mergers and acquisitions, and structuring accounting operations. Email: firstname.lastname@example.org or 310-601-2200.