Updated: May 29, 2020
I sought to anatomize the Harvard Business Review's article entitled “Why Financial Statements Don’t Work for Digital Companies” for this analysis.
The implicit declaration in the article’s title is that the two primary financial statements traditionally utilized in financial accounting are virtually irrelevant for digital companies. This sweeping statement is actually somewhat mitigated within the article’s full text and discussion. The authors contend that the balance sheet and income statement do not, in isolation, convey sufficient useful information to those assessing the value of today’s tech companies. Despite their opinion that current accounting practices are geared more toward traditional industrial or manufacturing firms, they ultimately conclude that traditional financial accounting statements still have a salient role to play for tech stakeholders. The article’s take is that additional public disclosures (contemporaneous with actual, germane market events), as well as copious notes to periodic financial statements, represent the new flesh to be overlaid upon the generally accepted financial practices’ backbone.
Upon initial reflection, one might conclude that the dilemma facing tech firms seeking to accurately reflect their value is identical to that of professional service companies. Professional service entities primarily invest into human capital, rather than into tangible, physical assets which create a robust balance sheet. Authors Govindarajan, Rajgopal and Srivastava do not, however, proffer any suggestion that tech firms should be viewed as identical accounting models to traditional professional services organizations. They assert instead that tech firms (and actually all companies which invest primarily in the digital side of their operations) require a dynamic and enhanced financial reporting approach, which not only appends essential information and disclosures to core financial statements, but furnishes crucial, time-sensitive transparency to its stakeholder audience. They assert, furthermore, that conventional accounting statements do not furnish the frequency or speed of information delivery which the digital economy necessitates.
Resources transcend assets:
The basic premise of the article is that existing accounting tools need supplementation, if they are to be able to appropriately convey the full potential of a tech firm’s value to investors, shareholders and capital markets. The authors argue that the inherent market dynamics for companies whose “product” consists, first and foremost, of an innovative and unique digital idea-based platform, require supplementary, targeted metrics which measure and communicate company value in a more immediate manner, unconstrained by predetermined, generally-accepted accounting periods. These market metrics/resources (or as the article calls them, “building blocks”) are defined as: i) research and development, ii) brands, iii) organizational strategy, iv) peer and supplier networks, v) customer and social relationships, vi) computerized data and software, and vii) human capital. The categories serve as resources designed to strengthen the underlying "network effects" which make or break any tech firm seeking to dominate its segment of the digital market.
MY ANALYSIS OF THE ARTICLE
I. Reporting value
Clearly, all seven of the “resource” categories listed above have undisputed strategic importance for any contemporary digital company. Equally, all of these enumerated operational elements share a fundamental reporting difficulty, in their inability to be accurately capitalized within a balance sheet format.
On the income statement side, these sizable investment expenditures for indispensable strategic priorities virtually ensure that promising tech newcomers show significant losses in their early years of operation. Investment into these non-SOFP, resource categories serves to strengthen the company’s all-important network of relationships (be they with partners, employees, users or technology), without which it has no chance for real competitive advantage. Despite the indisputable importance of these categories to the overall assessment of a tech company’s financial condition, accounting professionals are handicapped in their ability to succinctly codify them, while working within the current limitations of established accounting guidelines and formats.
My question for the authors regarding this reporting conundrum, were they to be my professors in an accounting class, would be why is there not a convention to place these intangible, long-term assets under goodwill or fixed assets on the balance sheet? According to what I can ascertain from my personal study of reporting practices, it is perfectly acceptable for an acquiring company to reflect its anticipated purchase of another entity under goodwill on its balance sheet, so why should the same option not be feasible for the seller?
II. Earnings don’t matter?
“Investors thus have no choice but to disregard earnings in their investment decisions.” *Govindarajan, Rajgopal and Srivastava
I struggled with the underlying logic behind the authors’ cited proprietary research conclusion that income statement strength does not often sway stock price. The professors’ research claims to illustrate that only “2.4% of variation in stock returns for a 21st century company” can be attributed to its reported earnings. The HBR article does not provide any detail regarding exactly how this research was conducted, or which assumptions, methodology, or data it deployed. There are so many subjective and objective market indicators which affect changes in stock price, that to isolate and quantify the amount of weight given to any single metric seems unrealistic, at best.
Stock price performance is a notoriously fickle phenomenon which even the most illustrious equity experts concede is nearly impossible to predict or link flawlessly to one clearly predominant bellwether; moreover, the article specifically recounts historical instances wherein stock price increased by 20% contemporaneously with a company’s first report of profit post its initial launch, as occurred in the case of both Yelp and Twitter. Such marked price increases would seem to illustrate, without question, that earnings and profitability still have profound impact for equity investors and their decision-making, even in the brave new world of Silicon Valley.
The supposition that the new financial metrics required to scrutinize the sustainability of a tech firm’s operations cannot be found within the current vernacular of GAAP statements, logically dictates that the language of accounting must adapt. The professors who wrote this article obviously view accounting as a living, evolving language, i.e., one that must progress in order to successfully reflect the entities and marketplace valuations it strives to evaluate and describe. Any language can only communicate meaning if the language’s users can convey concepts in a coherent, useful manner. Given this, financial reporting, and the statements it relies upon, cannot afford to be static or irrelevant without the risk of becoming virtually useless to the external audience for whom they are designed.
III. A world without depreciation
A particularly fascinating concept for me within this HBR article is the discussion of depreciation in tech firms’ present-day, accounting landscape. The article states that, because generally accepted accounting practices dictate that assets always depreciate a) with use and b) over time, these parochial accounting practices are ill-equipped to accurately represent the true assets of tech firms.
Successful tech companies amass assets whose value actually increases with use. This “negative depreciation” exists because the essential network of business relationships and information flows is to tech firms, what production efficiency is to a manufacturing company. Web traffic and strategic alliances develop over time, and with constant nurturing, but cannot be flagged by investors simply through a review of the statements shown in the company’s standard 10K. The inherent shortcoming of financial audits for the prevailing tech marketplace reality is that they do not check for the invaluable “network advantages” which are the single most critical resource for a) maintaining corporate financial viability, and b) signaling value to savvy tech investors.
IV. Increasing returns to scale
IPO’s of major digital companies reveal that high purchase prices are paid for companies like Linkedin and WhatsApp, despite the former's reporting of huge losses immediately prior to being acquired by Microsoft in 2016, and the latter's showing zero revenues or profits before being bought by Facebook in 2014. These high-profile acquisitions demonstrate, according to the authors, that capital markets recognize and highly value the intangible, uncapitalized assets indigenous to these digital companies. Likewise, the purchasers clearly perceived evidence of value creation which the income statements of both companies did not expose. The article further explains that the draw for these purchasers is the ability of Linkedin and WhatsApp to achieve “increasing returns to scale” on their intangible assets.
The increasing returns to scale paradigm exists within the production process of a company when its output increases by a proportion greater than that of its inputs The value growth for Linkedin and WhatsApp were powered by the networks they already had in place, not by incremental increases in their production costs, in stark contrast to that of the traditional production model for industrial firms. Indeed, the high level of expenses incurred by these two loss-heavy digital firms were incurred in order to create the intangible assets which make up the networks so critical to their future success; these same, sought-after productive assets make their own loss-ridden income statements virtually disingenuous from a market valuation perspective.
The augmentation of a company’s return to scale is a function of its unique set of “network effects”. A network effect in the tech realm is any situation wherein every new user taking part in a service platform a) provides distinct advantages to all the users already participating, and b) concomitantly obtains value in return from the existing users of the platform. This effect is the hallmark of the most successful digital platforms, and provides the basis for the increasing returns to scale which they enjoy. The interconnectedness of digital apps yields these essential network effects, regardless of whether or not a subscription to a company’s platform is free of charge. As a prospective business model, these effects are tantalizingly attractive for start-ups and industry behemoths alike, but for an accountant, they represent a powerful creation of value which defies codification through current GAAP methods.
V. Winner-takes-all rewards
The article only cursorily examines the important consideration of how flagrantly a tech sector company’s level of market dominance affects its market valuation in an IPO, acquisition or stock price. The authors describe market domination as a desirable, intangible asset for any tech company trying to create value. Even though negative scrutiny or judgement regarding the appropriateness of monopolistic behavior by prominent tech companies might go beyond the purview of my particular assay into the HBR article's logic, surely the article’s naming of market dominance as a clear indicator of value in capital markets means that monopoly must be included in the list of market factors which cannot be transparently accounted for within the existing financial accounting reporting model.
As the European Union's competition commissioner, Margrethe Vestager, stated:
“Small businesses are saying: ‘We rely on a platform for our business but something happened, we don’t know why, we don’t know how and we don’t know who to turn to’. It’s the equivalent if you have a bricks-and-mortar shop and someone comes, paints your windows, takes down your sign, closes the door. Obviously you can’t do business any more.” *Margrethe Vestager, European Union Commissioner
The HBR article states definitively that “the most important aim for digital companies is to achieve market leadership, create network effects, and command a “winner-take-all” profit structure.” This acknowledgement that corporate pursuit of monopolistic control within the market is of paramount strategic value must demand that our new accounting language have a means of reflecting that monopolistic attribute. In fact, the article implicitly suggests that every business decision and activity seeks to align itself with the specific goal of achieving an iron-clad, controlling grip upon the key network effects which dictate the rules of the tech marketplace.
“We all benefit every day from the tech giants’ services, but, as Julian Birkinshaw and Ben Laurance argued in the previous issue we need new and better antitrust regulation to address issues arising from their enormous market power. For starters, competition authorities need to look closely at the likely effects of their acquisitions. The power of big tech also comes with other important downsides: fake news and filter bubbles, fraud, cyberbullying, interference in elections, tax avoidance and the reinforcement of inequality, to name but some. In short, the challenge of the tech companies’ self-reinforcing market dominance is only set to grow.” *Patrick Barwise, Emeritus Professor of Management and Marketing at London Business School
Since the four most vital qualitative characteristics for financial reporting are understandability, relevance, reliability and comparability, according to the International Accounting Standards Board’s Memorandum of Understanding of 2006, any accounting model which does not effectively communicate fully transparent details regarding these four vital characteristics must be grossly incomplete. My personal take away from the article’s delineation of the ubiquitousness of the "winner-takes-all' virtue in tech, is that current auditing practices require speedy adaptation and expansion in order to represent business activities which actively support tax avoidance by huge corporations. Objectively, any de facto normalization of such monopolistic management practices, by not establishing an accounting language for them, clearly does not benefit regulators, investors or the economy at large.
VI. In Conclusion
Tech firms use data as the raw material to be shaped and deployed by increasingly innovative and efficient digital platforms. This shaping requires the presence of human interpretation, which is synonymous with the extrapolation of conclusions in order to solve problems, produce desirable outcomes, and provide in-demand services for customers. Extrapolations from data are achieved by algorithmic computer models. Digital operations are only as good, or financially valuable, as the algorithms which drive them, and thus in turn, as the human brain power and data inputs which drive the model.
In the past, our economy was propelled forward by industrial, manufacturing-driven businesses which primarily created tangible, physical items for sale, rather than the virtual, problem-solving applications which now predominate. The new and more intangible realm of idea-based platforms relies upon human capital’s critical thinking ability to drive its operations by matching users with the solutions they seek. The problem-solving task is encoded into computers, and then presents itself to users in the form of a user-focussed, digital platform. This type of business operation does not lend itself to the bean-counting world of traditional notions of operational profitability or asset coverage ratios.
Historically, a company could reasonably measure its current and future viability by the magnitude of its tangible assets, and the straightforward performance metric of its net cash flow or net income. In the world of tech, however, it is the intangible assets which hold sway, and these assets currently are not currently assiduously inventoried. This means that the quantitative measurability of equity value requires a human, qualitative assessment based upon a myriad of network and strategic factors, often unique to a specific platform’s market habitat. I would expect that the continued proliferation of idea-based tech firms will cause an unavoidable shift towards the use of qualitative, rather than strictly quantitative assessments.
I feel that this shift in methodology was not for me satisfactorily articulated in this relatively short article, but rather only hinted at whilst cataloguing the many limitations of our traditional financial accounting models for this brave new world of tech. I would assert that, in future, investors will have to become more well-versed in the accounting methodology which has historically been associated with the domain of managerial accounting; in the tech marketplace, only such a subjective, corporate insider’s perspective is adequately prepared to ascertain the ideal weighting of relevant market factors needed to formulate a meaningful valuation analysis.
Finally, my only frustration with this otherwise thought-provoking article is that it does not delve more deeply into concrete examples of proposed amendments to current reporting practices, but rather simply alludes to the inevitability of their development. Since economic trends show that the bulk of future companies will emerge as primarily digital in their scope and operations, accounting academics and professionals must soon define clear, generally accepted practices and guidelines for how to best gauge and report the new tech financial metrics in a consistent, standardized way.
Given that GAAP’s established principles and methodology have, to date, comprised the historical fulcrum upon which financial markets and sound business practices hinge, the future of financial reporting in the digital economy must surely consist of a hybrid system, which includes the same tried-and-true reporting statements, carefully coupled with more dynamic and simultaneous qualitative disclosures. Such a hybrid model could better keep pace with the rapid vicissitudes of our expanding information economy, and its ever-shifting context for determination of value for all stakeholders. Whatever a new set of principles might look like, they would hopefully contribute to a reporting equilibrium which balances innovative competition, with responsible managerial and regulatory oversight.
By Gigi Williamson
Marecage Consulting Group, LLC
San Francisco, CA
April 27, 2020