A Blueprint for Digital Companies’ Financial Reporting (August 3, 2018)
Harvard Business Review (HBR), link to source:
Investor Problem: Digital businesses are stuck in Old World Accounting & Financial Reporting. It is widely known that transparency in financial reporting for digital companies is frequently too…cloudy. Risk, intrinsic value, and potential value are difficult assess – causing poor investment decisions. Sometimes critical information is reported, but in obscure or inconsistent footnotes. This makes it challenging for current and prospective investors to make informed choices.
Management Trade-offs: The cost of compliance for financial reporting isn’t cheap. And companies certainly deserve to protect their competitive interests.
Solution: New Standards that balance Improved Transparency / Cost of Compliance are needed. Three luminaries from the academic community propose a blueprint to improve standards that govern financial reporting. Vijay Govindarajan (Dartmout), Shivaram Rajagopal (Colunmia), and Anup Srivastava (University of Calgary) make the case that today’s standards for disclosures fall short for in three key areas:
1. Disclosure on Revenue Drivers. Transparency over how digital operating activities translate to reported revenue needs improvement. This is opaque based on SEC standards today.
Example: Publicly traded social media companies, such as @Facebook or @Twitter
How do (a) active users, (b) geographic distribution, (c) customer retention, and (d) customer engagement (time on the site or mobile) directly and indirectly impact revenue? All too often it is unclear. While companies are reporting key operating activities, the link to revenue remains a mystery for many digital businesses including Facebook.
2. Visibility into Cash Outlays. Improved visibility into three operating categories is needed: (a) Current Operations, (b) Future Projects, and (c) One-time, special, or extraordinary items. Vijay et al, propose that a “Statement of Outlays” with several changes are needed to separately present the following:
(a) Current Operations. All outlays should be included expenses in calculation of operating profits; and the company should present fixed and variable costs, and where possible, identify the unit of activity with the variable cost. “Unlike current accounting rules, which treats inhouse soft outlays as expenses and considers all inhouse hard outlays and acquired soft assets as capital expenditures…”
(b) Future Projects. A clear distinction in separate and separate rules for the treatment of investment and maintenance outlays. The prevailing assumption hear is that investment outlays may offer future returns, and in turn, may offer an investment premium – compared to operating expenses.
(c) One-time, special, and extraordinary items. The usage of non-GAAP reporting that excludes items is a common financial reporting practice, with complex reconciliation. Investor uses non-GAAP. In effect, non-Generally Accepted Accounting Principles have become generally accepted by investors for assessing underlying and potential value of securities. Vijay et al propose that a standard for the non-GAAP calculations, particularly EBITDA, be directly calculated
3. Lifetime Value of Asset Units. Think of a daily user of Facebook or LinkedIn subscriber. Or in the Enterprise Software sector: Term of a Enterprise Subscription Agreement. Each has a specific expected or potential “life” measurement.
What are the implied future benefits of this blueprint?
1. Improved consistency in equity analyst projects and recommendations.
2. A step toward ending short-term-ism by paving the way for understanding sustainable profits – and potentially changes in practices for earnings guidance.
3. Improved Management credibility and reputation.
A Winning Approach to Changing Embroiled Financial Reporting Standards
Vijay et al recognize and acknowledge that the standards and rule marking process is slow. Changes are not expected anytime soon.
To that end, they propose the changes are reflected as:
- A supplementary document to an Income Statement
- Included in Management Discussion & Analysis (M&DA)
- Should be unaudited figures, tables, and charts
- Not subject to litigation for making forward-looking statements
Otherwise, Management may likely resist adopting such changes.
Potential Criticisms Against the Blueprint
1. Criticism: Some companies are already providing such information in their annual reports. Response: Too frequently such information is obscured in footnotes and not-standardized across companies causing distortion in comparisons across companies with like-business models and in the same industry.
2. Criticism: If this blueprint would actually create value, then it would be already employed by public companies. Response: History has proven that may be the case for select companies where Named Executives and Boards of Directors hold themselves to a higher standard – however, again, it is inconsistent. And the general tend is dictated by the Cost of Compliance. Companies tend to only do what is required.
3. Criticism: Companies might report biased numbers, or miscategorize expenses, to portray better than actual performance. Response: Investors would be able to fine-tune their assessment of performance over time, having the information is a superior alternative to not having it all, and finally management reputation and credibility is staked on it.
4. Criticism: Disclosure could reveal private and confidential information to competitors, customers, partners, or regulators. Response: Vijay et al assert their belief that the benefits of efficiency of capital allocation in markets, outweigh the costs.
#AlignedValue opinion: I agree with Mr. Govindarajan, Mr. Rajagopal, and Mr. Srivastava’s proposal. I applaud their effort in seeking and developing a solution that balances the challenge/opportunity/solution set across the combined Investors/Analysts/Management/Regulators community. And I hereby pledge my support to the pursuit of this change. Hats-off, gentlemen. The $100T question is: How do you intend to put your case to action?