[vc_row][vc_column][vc_column_text]Today we bring you a translation of an enlightening article from the Harvard Business Review , for those who want to understand the relationship between Financial Statements and Digital Companies. Enjoy reading.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column][vc_column_text]
Why don't financial statements work for digital companies?
On February 13, 2018, the New York Times reported that Uber is planning an IPO (initial public offering). Uber's value is estimated between $48 and $70 billion, despite having reported losses in the last two years. Twitter reported a loss of $79 million before its IPO, but was valued at $24 billion on its IPO date in 2013. In the following four years, it continued to report losses. Similarly, Microsoft paid $ $26 billion for LinkedIn's losses in 2016, and Facebook paid $19 billion for WhatsApp in 2014, when it had no revenue or profit. In contrast, the share price of industrial giant GE fell 44% compared to last year, when news broke of its first losses in 50 years.
NetSuite named Leader among Cloud-Based Financial Management Suites
But why do investors react negatively to losses in the financial statements of a manufacturing company, but disregard these losses for a digital company?
In his 2016 book , *The End of Accounting* (not yet published in Brazil), New York University professor Baruch Lev stated that, over the past 100 years, financial reports have become less useful in capital market decisions. Recent research allows for an even bolder assertion: accounting gains are practically irrelevant for digital companies. The current financial accounting model cannot capture the main value creator for digital companies, which is increasing the return to scale on intangible investments.
This becomes clear when comparing the two most important financial statements of a company: the balance sheet and the income statement. For an industrial company dealing with physical assets and goods, the balance sheet presents a reasonable picture of productive assets, and the income statement provides a reasonable approximation of the expenses necessary to create shareholder value. But these statements have little significance for a digital company.
The assets reported on a balance sheet must be physical in nature, owned by the company, and within the company's boundaries . However, digital companies often have assets that are intangible in nature, and many possess ecosystems that extend beyond the company's boundaries. Consider Amazon Buttons and Echo , Alexa, Uber cars, and Airbnb residential properties, for example. Many digital companies have no physical products and no inventory to report. Therefore, the balance sheets of physical and digital companies present entirely different data. Compare Walmart's $160 billion in tangible assets at its $300 billion valuation against Facebook's $9 billion in tangible assets at its $500 billion valuation.
The foundations of a digital company are research and development, brands, organizational strategy, peer and supplier networks, customer and social relationships, computerized data and software, and human capital. The economic objective of these intangible investments is no different from that of the factories and buildings of an industrial company. However, for the digital company, investments in its building blocks are not capitalized as assets; they are treated as expenses in the calculation of profits. Thus, the more a digital company invests in building its future, the greater the reported losses. Investors, therefore, have no choice but to disregard gains in their investment decisions.
The research conducted by the authors of the article found that intangible investments have surpassed fixed assets as the primary means of capital creation for American companies – further suggesting that balance sheets have become a regulatory compliance artifact with little or no utility for investors. The balance sheet has also become less useful for banks' lending decisions because banks rely on asset coverage to calculate their security. Interestingly, companies are allowed to report acquired brands and intangibles as assets on the balance sheet, creating distortions between earnings and assets for digital companies that rely on organic growth versus acquisitions.
As digital companies become more prominent in the economy and brick-and-mortar businesses become more digital in their operations, income statements also become less significant in investor decisions . Another study showed that profit explains only 2,4% of the variation in a company's stock returns in the 21st century – meaning that almost 98% of the variation in annual stock returns is not explained by annual earnings. Profits also seem to matter less for CEO compensation: companies are reducing cash bonuses based on profits and shifting to stock-based CEO compensation, in part to prevent opportunistic managers from cutting valuable investments as a way to report higher profits.
The current financial accounting model fails in another aspect. In a previous HBR article , the authors argued that, in contrast to physical assets that depreciate with use, intangible assets could improve with use. Consider Facebook: its value increases as more people use its product because the benefits accrue to an existing user with the arrival of each new user. Its value growth is driven by the network, not by increments in operating costs. Therefore, the most important goal for digital companies is to achieve market leadership, create network effects , and command a “winner-takes-all” profit structure . Facebook’s 76% gross margin on its $46,5 billion in 2017 revenue illustrates this reward-gathering – each additional dollar of revenue creates almost equivalent value for shareholders. (You can contrast this with Twitter's and Yelp's 2017 revenues of $2,4 billion and $0,8 billion, respectively, as both companies have yet to reach the break-even point).
However, there is no place in financial accounting for the concept of network effects, or the increase in the value of a resource with its use. This actually implies a negative depreciation expense in accounting jargon. Therefore, the fundamental idea behind the success of digital companies (the increasing returns to scale) goes against a basic principle of financial accounting (assets depreciate with use).
This leads to another question: if profits are so insignificant, why do investors react positively to rumors about a digital company becoming profitable? For example, when Twitter reported its first profits , its stock price rose 20%. The same thing happened with Yelp . A plausible reason could be that this news has an important signaling effect – that the company may have crossed its initial investment phase, that it may now break even, or that it may embark on a trajectory where it can reap winning rewards. This conjecture challenges the general argument that profits are uninformative; another challenge could be that the initial losses of digital firms present risks involved in buying their shares.
As balance sheets fail to reflect the value of a company's resources and income statements increasingly fail to capture the value created by the company, CEOs are now wondering what to do. They frequently ask: what does the preparation and auditing of financial statements based on the fiscal year amount to? Wouldn't digital companies be better off simply reporting a summary of their cash transactions? What can digital companies do to improve financial statement communication?
The answers are not yet clear. It is unlikely that accounting standards will change in the near future to allow digital companies to capitalize on their intangible investments (and even if digital companies did capitalize on their intangibles, the recalculated profits or assets would not come close to justifying their current market values). But there are things companies can do to convey their true value to investors. The work of the authors of the article found that investors look for certain clues about the success of a company's business model, such as: acquisition of large clients, introduction of new products and services, technology alliances, marketing and distribution, new subscriber accounts, revenue per subscriber, customer churn, and geographic distribution of customers. Companies can disclose these items in the "Management Review and Discussion" section of their annual report (This example can be better understood by consulting item 7 of Facebook's annual report ).
Any significant and relevant development for value should be disclosed immediately, rather than waiting for the annual report. Other research has shown that disclosures about network advantages, such as web traffic and strategic alliances, are considered highly relevant by investors. When combined with these non-financial indicators, financial performance measures become more relevant . Furthermore, companies can provide detailed information about intangible investments made by the company – even if this information is not examined by auditors – by reporting these investments in three categories: customer relationships and marketing, information technology and databases, and talent acquisition and training.
To summarize all of this, as companies become more digital and spend more on intangible investments, and as digital companies represent the new face of corporate America, they will also have to drastically alter the way and methods in which they convey their value to investors.
