Accounting rules

I just read a great HBR article that was posted within my WhatsApp investing group. The theme of the article is a topic that has been discussed here before, which is that accounting rules don’t effectively measure the results of digital/software companies as they typically incur heavy expenses in advance of the resulting revenue. They incur heavy R&D costs to build the software and high sales costs to acquire customers. However, once they have a great product that their customers love, their costs as a percentage of revenue will drop sharply as they don’t need to invest as heavily into building the software and creating demand. In the meantime, they have minimal revenue during this high spend phase. This is the opposite of the “matching principle” in accounting where you try to match the expenses with the revenue (typically this is done by capitalizing costs into assets and depreciating them to better match to the related revenue). Current accounting rules don’t allow you to capitalize network effects, long-term recurring revenue from a loyal customer, R&D used to build the software, etc. Therefore, investors need to focus less on PE ratios and book value, while focusing more on revenue growth, dollar expansion rate, new customers, product enhancements, TAM, margin trends, etc. See link and a few highlights below:…

Recent research lets us make an even bolder claim: accounting earnings are practically irrelevant for digital companies. Our current financial accounting model cannot capture the principle value creator for digital companies: increasing return to scale on intangible investments.

digital companies often have assets that are intangible in nature, and many have ecosystems that extend beyond the company’s boundaries. Consider Amazon’s Buttons and Alexa powered Echo, Uber’s cars, and Airbnb’s residential properties, for example. Many digital companies have no physical products and have no inventory to report. Therefore, the balance sheets of physical and digital companies present entirely different pictures. Contrast Walmart’s $160 billion of hard assets for its $300 billion valuation against Facebook’s $9 billion dollars of hard assets for its $500 billion valuation.

The building blocks for 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 purpose of these intangible investments is no different from that of an industrial company’s factories and buildings. Yet, for the digital company, investments in its building blocks are not capitalized as assets; they are treated as expenses in calculation of profits. So the more a digital company invests in building its future, the higher its reported losses. Investors thus have no choice but to disregard earnings in their investment decisions.

In another study, we show that earnings explains only 2.4% of variation in stock returns for a 21st century company — which means that almost 98% of the variation in companies’ annual stock returns are not explained by their annual earnings.

we argued that, in contrast to physical assets that depreciate with use, intangible assets might enhance 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 powered by the network in place, not by increments of operating costs. Therefore the most important aim for digital companies is to achieve market leadership, create network effects, and command a “winner-take-all” profit structure.

Yet 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 negative depreciation expense in accounting parlance. So the fundamental idea behind the success of digital companies (the increasing returns to scale) goes against a basic tenet of financial accounting (assets depreciate with use).

But for digital companies, the bulk of the cost of building an idea-based platform is reported as an expense in its initial years, when they have little revenue. In later years, when they actually earn revenues on an established platform, they have fewer expenses to report. In both phases, the calculation of earnings does not reflect the true costs of revenues.

Our work has found that investors look for certain cues about the success of a company’s business model, such as acquisition of major customers, introduction of new products and services, technology, marketing, and distribution alliances, new subscriber counts, revenue per subscriber numbers, customer dropouts, and geographical distribution of customers.


This reminds me of a presentation I attended last year by Dr Eric Topol, MD about the digital future of medicine. He stated that:

The world’s largest taxi company…owns no taxis (Uber)

The world’s largest voice/video communications companies…own no telco (Skype)

The world’s most popular media company…owns no content (Facebook)

The world’s largest lodging company…owns no property (AirBNB)

The world’s most valuable retailer…owns no inventory (Alibaba)

The world’s largest mobile software vendors…don’t write the apps (Apple, Google)

We are truly in the midst of a digital revolution.