META Lesson 2: Accounting Inconsistencies and Consequences

In my last post, I used Facebook's recent troubles to talk about the importance of corporate governance, and how we, as investors, have abandoned the power to change management at many younger tech companies in return for being able to invest in young tech companies, with growth potential and well-regarded founders. In this post, I will revisit Facebook's most recent earnings report, and argue that while it contained disappointing news on growth and profitability, the bad news was exaggerated by systematic inconsistencies in how accountants categorize expenses, skewing earnings and invested capital down in firms that don't fit the accounting prototype. That skewing can affect valuation and pricing judgments about these firms, and correcting accounting inconsistencies is a key step towards leveling the playing field.

Accounting 101

   I am not an accountant, and have no desire to be one, but I have used their output (accounting statements) as raw material in valuation and corporate finance. As I look at accounting from the outside, I see the primary role of accounting as recording and reporting, in a consistent and standardized form, the answers to three basic questions:

  1. What does a business own? List out the assets that a business has invested in, and how much it spent on those investments and perhaps what these assets are worth today.
  2. What does the business owe? Specify the contractual commitments that a business has to meet, to stay in business. Simply put, this should include all borrowings, but is not restricted to (Read more...)