Page 77 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 2. Performance Measurements and Standards 63

plans using company stock. They are also called treasury shares. In Table 2-8, the cost
of the 795,200 shares purchased is reported to be $6,362,200.
• Treasury stock method This is the method used to calculate diluted EPS. It
assumes that outstanding options have been exercised at the beginning of the year and
all restricted stock awards have been released at the same time. The proceeds received
are used to hypothetically buy back at the average market price (for the period) as
many shares as possible. Proceeds include not only cash from stock option exercises
but also the cash effect of tax deductions.
• Working capital See Liquidity.
• Yield This is the rate of return on an investment. For bonds, it is interest received
divided by bond cost. For stock, it is annual dividends per share divided by the stock
price. If dividends for the year were $.46 ($6,953,600 from Table 2-2 divided by
15,250,000 from Table 2-1) and the stock price was $10, the yield would be 4.6 per-
cent. Yield increases with rising dividends and falling stock prices and decreases with
reduced dividends and increasing stock prices. This enables an easy comparison with
alternative investments after adjusting for future growth and investment risk.
Unscrupulous CEOs and CFOs Pay programs based on the financial measurements just
described will encourage unscrupulous CEOs and CFOs to undertake “creative accounting”
to affect the income statement or balance sheet. For example, the income statement might be
altered by inappropriate actions.
Sales might be
• Overstated because of reporting nonsales items as sales or reporting sales before
transactions are completed
• Understated by deferring recognition of sales
Expenses might be
• Overstated by including future expenses
• Understated by shifting expenses to the future
The balance sheet-might also be altered by inappropriate actions.
Assets might be
• Overstated of realizable value
• Understated of realizable value
Liabilities might be
• Overstated of future obligations
• Understated of future obligations
Therefore, it is not surprising that many believe the best financial statement to use is the
cash flow statement. Whereas the income statement measures performance on an accrual
basis, the cash flow statement ignores future financial obligations. As shown earlier, accrual
accounting requires judgments, some of which can lead to creative accounting. Many agree
that the most important section of the cash flow statement is net cash provided by operating
activities, namely, running the business, not investment or financing activities. But the oper-
ating activities section could also be the focus of creative accounting by capitalizing expens-
es, counting not-cashed checks as accounts receivable, including security sale proceeds, and
selling accounts receivable.