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Wednesday, Nov 25, 2020

Accounting GAAP: Why digital companies struggle with reporting standards

Accounting GAAP: Why digital companies struggle with reporting standards

The legacy accounting system often misses the mark for many businesses. 

CFOs of digital companies face a dilemma every time they release their companies’ quarterly and annual reports — the metrics most informative of their companies’ health are in their pro forma reports and not in their income statement and other reports that follow traditional GAAP accounting standards.

But if they go into too much detail in their non-GAAP reports, they risk tipping off competitors to sensitive proprietary information.

“You don’t want too much non-GAAP data given to the public because it exposes the business’ inner workings,” Patrick Gildea, CFO of digital media company GumGum, told CFO Dive. GumGum is a private company, but Gildea previously led the finance operation of publicly traded Blackhawk Network. “It’s dangerous having competitors get access to that kind of data.”

And yet if CFOs were to rely solely on traditional GAAP reports, the true measure of how their companies are doing would be obscured.

“Financial reporting standards have fallen into disrepute as means of understanding current operating performance,” Michael Kwatinetz, managing partner with Azure Capital partners, said in a widely referenced blog post he wrote for CIO Network several years ago. Investors, he said, “rely on pro forma results instead of GAAP accounting, because they find pro forma statements provide more insight into the overall performance and health of a company.”


Widening gap


The gap between GAAP - Generally Accepted Accounting Principles - and non-GAAP metrics has been widening for decades, as dominance in the economy has shifted from the industrial companies GAAP was designed for and today’s digital companies.

At the core of the divide is how intangible assets - research and development, brand identity, social networks and staff expertise - that are so important to digital companies are treated by GAAP: as regular expenses rather than as investments that can be depreciated the way manufacturing companies can depreciate their plant and equipment.

As a result, the income statement, which is the traditional front line of a firm’s public reporting, poses valuation problems for a lot of companies. “The net income statement doesn’t include a lot of a company’s true value,” said Mary Barth, professor of accounting emerita at the Stanford Graduate School of Business. “So net income itself has become less relevant to shareholders,” Barth told CFO Dive.

A key example is GAAP's treatment of research and development as an expense. “It’s not recognized as an investment,” Barth said, “yet it's an investment that may have (significant) future value.”

Accounting for sales and marketing costs also poses a problem. According to John Bonney, CFO of digital software company Harness, those costs might be high when a young enterprise is growing its customer base, but then level off in later years after the base is established. That can lead to very high losses in early years and very high revenue in later years. Both exaggerate and distort the real financial status of the firm.

All too often, Barth said, digital companies will show rapid sales growth, have vast resources invested in R&D, and build a pipeline of future customers through an exponentially growing social network, yet show losses year after year. “It looks like they’re losing money when in fact they’re really just investing,” said Barth.

Accounting for this and other differences between the two types of measures has led to an awkward system in which companies are forced to come up with a slew of non-GAAP items that typically get tucked away in footnotes or discussion sections of a financial report.

These non-GAAP items include bookings and growth rates. It also includes dollar-based net expansion rates, which Bonney said is a great predictor of growth and profitability. “Almost every software company is disclosing it now,” Bonney said to CFO Dive.


System needs tweaking

The consequence of this tiered treatment is a lack of transparency that can harm retail investors, public investors, analysts, private investors, job seekers, the media, and other users of financial information, including the general public.

Even the company can be harmed if its GAAP numbers make it more difficult to attract top quality talent or tarnish a company’s reputation among customers and suppliers.

The problems are especially acute when the company is a recent IPO or simply young. “The younger the company, the less they look at GAAP measures and the more they look at other metrics,” said Bonney. In these cases, the income statement is increasingly disregarded or, at least, relegated to a lower status by investors.

And yet no one is suggesting the system should be thrown out completely. “GAAP is very useful as a baseline standard,” said Bonney. “It’s not perfect, but it’s evolved over time to address the new industries.” He cited ASC- 606, issued in 2014 by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), as helpful guidance for digital companies on revenue recognition issues.

“As bad as the GAAP system is, it’s still a very good foundation on which to build,” Barth said. “No one wants to throw it out and start with something new.”

There appears to be no immediate change on the horizon. Instead, the problem is being addressed in incremental steps, as standards-setting boards issue guidance, memo by memo, over time. The reason for the incremental pace isn’t clear, but, according to Barth, companies, analysts and other groups are simply slow to accept change.

“It takes standards setters a long time to win hearts and minds, because people are used to doing things one way and not so keen to change things,” she said.

But as more companies become digitized or otherwise migrate from the legacy business model, the GAAP accounting dilemma will likely worsen. More industries are starting to look like technology firms. Even manufacturing and financial services companies are increasingly technology-intensive.

“The new economy companies are definitely growing in number,” Barth said. “Technology is pervading a lot of industries now. So the problem needs to be addressed.”

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