It wasn't long ago that stock compensation wasn't considered an expense according to GAAP, which bloated the reported net income figures of many otherwise barely satisfactory companies. But common sense eventually prevailed, and so income statements now contain an estimate for stock compensation expenses. However, this expense item is not trivial in its application, and can lead to shareholder confusion and misinterpretation.
Consider the cash flow statement of Meade (MEAD), a company discussed a couple of weeks ago on this site as a potential value investment. Meade shows fiscal 2011 operating cash flows of just $88K, helped by a cash flow line item of $323K titled "stock-based compensation".
This sort of thing should set off red flags to shareholders, as it suggests that the company is only cash flow positive because it is paying its managers in options instead of cash. (This situation has been discussed on this site before with another company here.) If the $323K in compensation had been paid in cash instead of options, the company would not have the "benefit" of being able to add back this expense item in the cash flow statement.
But this line of thinking would be erroneous, because of a subtlety of how option expenses are accounted for. Options are not all expensed immediately, but are rather amortized over the life of the options' vesting period. In Meade's case, the company has stopped giving out large option awards; but the company still has to expense options from previous years that have not yet amortized.
This info is all available from the company's notes to its financial statements. Meade states that "As of February 28, 2011 and 2010, there was approximately $0.1 million and $0.4 million, respectively, of unrecognized compensation cost related to unvested stock options." The bulk of the difference between the $0.4 million and the $0.1 million is the $323K (referred to above) that was expensed this year.
Shareholders can also see how many options were granted this year in that same note (Note 10 to the 2011 financial statements) in a table listing details of the options that are outstanding. Meade started and ended the year with 78K outstanding options, having only granted 1K options all year (with 1K options also forfeited).
The implications of such an analysis are intriguing. While an initial glance at the cash flow statement suggested the company was diluting its shareholders in a bid to stay cash flow positive, this is actually not the case. Meade is only expensing options it gave out years ago, and because it is no longer giving out options, its net income today underestimates what the company earned this year (all else equal). Investors are encouraged to dig into the company's financials to confirm they understand this distinction.
Disclosure: Author has a long position in shares of MEAD