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Archive for the ‘Accounting’ Category

In early February, when Facebook’s IPO seemed imminent, Anup Srivastava, an assistant professor of accounting information and management, put together an interactive valuation tool that let people explore how tweaking different projections would affect the stock’s valuation. Built into that were Srivastava’s own projections. Projections that, as the stock’s price has sunk ever lower, have largely been proven true.

“We predicted a best case valuation of $25 billion,” Srivastava said. “The firm raised $16 billion dollars, and retained $7 billion. Facebook’s post-money valuation stands at $41 billion today, implying a pre-money valuation at $34 billion.

“That is not far away from $25 billion what we predicted, certainly a far cry from $100 billion that the market valued just nine months back.”

There’s a hidden message in FB’s continued slide, too, one that could apply to many more stocks. “The example shows that cash is king, and any valuation other than based on cash flows is unlikely to sustain for long,” Srivastava remarked.

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Groupon

When the JOBS Act was passed last month, it contained a provision that was largely overlooked. Companies are now allowed to submit confidential drafts of their IPO documents to the SEC. That sounds innocuous enough, but if you remember what happened with Groupon—as the Wall Street Journal does—it feels a bit less innocent.

The problem with Groupon was their accounting measures gave a distorted view of their actual performance. If Groupon had filed after the JOBS Act was passed, the questionable provision of the law would have kept those accounting measures secret until the IPO documents were filed publicly. There would have been no chance for the public to critique Groupon’s documents. That concerns investors and accountants, including Anup Srivastava, an assistant professor of accounting.

“Approximately a year back, we raised concerns about Groupon’s accounting practices. We specifically pointed out problems with Groupon’s revenue and expense recognition policies,” Srivastava said.

“As expected, Groupon has since ‘restated’ its past financial performance, by reporting lower revenues and higher operating expenses. In common terms, when a firm restates its financial statements, it basically conveys, ‘oops, we made a mistake!’ and ‘sorry, you invested in our firms, based on wrong performance indicators!’ ”

Those actions have accountants questioning the wisdom of including the confidentiality provision in the JOBS Act. “Some may argue that Groupon’s example provides confirming evidence against the JOBS Act’s provisions,” Srivastava said. “While we agree with the directional effect, we do not yet have a large enough sample to conduct a systematic study to draw that conclusion.”

While there may not be ample evidence to condemn those provisions at this point, there is evidence for the directional effect to which Srivastava referred. IPOs are happening at younger and younger companies, according to a widely-cited 2004 paper by Eugene Fama and Kenneth French. Furthermore, Srivastava said his own recent research indicates that young companies are investing less in assets with high recovery values, meaning investors are left with little to liquidate if the company fails.

“In that context, the JOBS Act’s provisions, which permit a potential IPO firm a mechanism to avoid a public scrutiny of its accounting policies, seem inconsistent with above research,” he said. “For example, we have raised issues with Facebook’s accounting, since its accounting policies are publicly available. The JOBS Act provisions appear to contradict the spirit of Securities Act of 1933 and Sarbanes Oxley Act of 2002, that detailed disclosures result in greater transparency, greater investor protection, and more efficient allocation of capital.”

Photo by swanksalot.

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Much of the buzz surrounding the Facebook IPO stems from its sheer size. With a speculated valuation of $75 billion to $100 billion, it would be on par with companies such as Bank of America ($75 billion), Amazon ($90 billion), and McDonald’s ($100 billion). But do the numbers bear that out? Based on past earnings, speculation would price Facebook at 75 to 100 times earnings, or in the same territory as Google.

Anup Srivastava, an assistant professor of accounting information and management, thinks those numbers are too dear. “My best case scenario valuation is $25 billion,” he said. “This is based on the firm’s revenues reaching approximately $21 billion in ten years’ time from approximately $4 billion today, and the firm maintaining a high return on assets of approximately 20 percent.”

It is difficult to say what exact number the market will bear, but for those who like to speculate, Srivastava has developed a Facebook valuation tool, available in either an interactive web version or a downloadable Excel spreadsheet.

Facebook valuation tool
open in a new window

From an accounting perspective, Facebook isn’t facing the same scrutiny as Groupon, which employed some clever accounting to polish its image. Still, Srivastava is not entirely satisfied with Facebook’s filings.

“I would have preferred to see a detailed break-up of cash flow from operations,” he said. “I would have also preferred to detailed break-up of non-current assets, to examine whether firm is capitalizing any expenditures that it should expense. Net income of exactly $1 billion raises a red flag. It is difficult to achieve an exact number without manipulation. Maybe the firm underachieved the threshold and managed its earnings upward. Maybe the firm overachieved the threshold but deposited some earnings in cookie jars to show higher earnings in future.”

Srivastava offers another cautionary note to prospective investors. “Investors should take into account the deep in-the-money options held by management,” which if exercised could potentially dilute the value of outstanding shares. Furthermore, one share of common stock will have only one-tenth the voting rights of shares held by controlling shareholders, he pointed out. “I do research in this area, and this extreme anti-takeover protection mechanism of dual-class share structure concerns me, because I believe in the motto ‘absolute power corrupts absolutely.’ ”

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Lockheed aircraft corporation stock certificate from 1968

A few weeks ago, the New York Times published a piece about the tax benefits companies are deriving from stock options granted to executives just after the market collapsed in 2008. The story was succinctly summarized in these two lines:

Thanks to a quirk in tax law, companies can claim a tax deduction in future years that is much bigger than the value of the stock options when they were granted to executives. This tax break will deprive the federal government of tens of billions of dollars in revenue over the next decade.

Stock options are typically cashed in at higher prices than they were issued. The legal oddity to which they refer gives firms a tax deduction based on the price at which they were cashed in—the higher price—rather than the lower price at which it was issued.

Anup Srivastava, an assistant professor of accounting and information management, says it’s not as straightforward as the article makes it out to be. “Yes, firms will save taxes, but IRS will more than make up for it by collecting taxes from executives,” he said.

It’s well known that people pay at higher tax rates than corporations, sometimes much higher—GE, for example, didn’t pay any taxes last year. Yet the IRS won’t lose out because of most executives who cash in stock options sell their stock right away. This means they typically have to pay the normal income tax rate on the price difference between when the option was granted and when it was cashed in, Srivastava said. Since most executives are already in the highest tax bracked—35 percent—they will end up paying the full rate. And since many firms don’t pay taxes at the statutory rate, the income generated from taxing executives’ gains on options will likely be higher than the tax savings firms can obtain at their marginal rate, he said.

“In fact, the higher the difference between prices at which options are cashed in and prices at which options were granted, the higher the benefit IRS derives,” Srivastava said. “This difference increases as the grant price becomes lower. Thus, the lower the grant prices set during the recessionary periods, the higher the ‘net’ benefit IRS derives.”

Photo by Team Civil Air Patrol.

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Groupon reached a milestone today—its stock price dipped below its IPO price.  Not exactly the most auspicious achievement.  After launching at $20 per share and peaking at around $26 after the start of trading Monday, its hovering around $17 per share today.

Groupon

Groupon is not alone in its post-IPO woes. There have been 41 tech IPOs this year, but the new class of companies has lost 13.1 percent of their value so far this year, according to the New York Times. LinkedIn, for example, has ridden a veritable roller coaster since its offering, plunging as low as $63.71 on June 20, peaking at $109.97 less than a month later, and dropping to around $66 per share as of this writing.

Much of that hints at the broader uncertainties in this market, and the desire for investors to keep their money in what they see as safer stocks. But the consensus on Groupon seems to be different from the rest. Analysts are questioning everything from the company’s business model to its growth prospects in Europe. To top if off, online coupon company has been plagued by bad press recently surrounding its deals. Many of the deals sell too well for small business owners to keep up with demand, forcing them to hire extra help and sapping profits.

To top it off, Groupon’s accounting practices in the run up to the IPO were not well received. Our own Anup Srivastava, an assistant professor of accounting, laid out a detailed critique of the company that should be required reading for any potential investor.

Today’s low may not be the best bellwether for the company—trading before holidays is often notoriously light, and today is no exception—but it certainly doesn’t bode well.  The next few months may well be crucial to the company’s future.

Photo by swanksalot.

Related reading:

In depth on Groupon’s accounting practices

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Groupon

After years of gangbuster growth, Groupon has had a difficult past few months. Revenue growth has been flat. Their COO left for Google after just five months with the company. CEO Andrew Mason caught flack for his internal memo—which was promptly leaked—that violated the SEC mandated quiet period that precedes an IPO. And speaking of the IPO, the date has been pushed back more than once. On top of it all, the company has tried to introduce a series of, ahem, non-standard accounting practices.

Anup Srivastava, an assistant professor of accounting information and management who teaches a course on securities analysis (FINC-463), detailed for me the many ways Groupon configures its balance sheet to produce apparent profits instead of losses. Among them is the most public accounting issue—the insistence that customer acquisition costs not be included in revenue calculations. “By excluding customer acquisition costs, Groupon tried to have its cake and eat it, too,” Srivastava said. Groupon also reports revenue from the entire price of a deal, not the amount it nets. So though Groupon’s cut of a $30 deal may only be $15, they report the entire $30. These two representations—along with others—portray the startup as having higher revenue than generally accepted accounting principles (GAAP) would otherwise report.

With Groupon’s IPO set for November 4, Srivastava’s take of the company’s accounting practices offers prospective investors some sobering perspective.  Read on for the complete Q&A.

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iCloudWhen Apple announced its new iCloud service, it wasn’t just acknowledging the power of cloud computing or even the failures of their previous fee-based MobileMe cloud service (though they did exactly that). Instead, the decision to provide free iCloud services to every user of a device running iOS 5 or Mac OS X Lion reflects an extension of Apple’s long held strategy of selling premium-priced hardware while throwing in software for free.

For as long as Apple has been selling computers, people have debated whether the company is at heart a software maker or a hardware purveyor. In reality, the two are not disparate parts of the company, something which sets it apart from many of its competitors in the technology world.

Apple’s priced hardware, free software strategy is similar to the Gillette razor metaphor, but in reverse. Where many companies provide free or subsidized hardware to spur sales of software, services, or another commodity—think HP with printers and ink, Google with Android and advertisements, Microsoft with Xbox and game licensing—Apple is subsidizing the iCloud service to sell more iPhones, iPads, and Macs.

Apple is not the first company to experiment with offering free services to sell more hardware. Many luxury car manufacturers throw in a few years of free maintenance on top of the usual warranty to entice buyers and justify the price premium.  But these free services merely make continued operation easier. Apple’s free iCloud service differs by substantially expanding the functionality of every iPhone, iPad, and Mac, rather than providing a mere tune up.

iCloud isn’t Apple’s only freebie. Software updates for the operating system that runs iPhones, iPads, and other small devices, iOS, are also offered free of charge. In practice, this means about two to three years of software updates are included in the up front cost of the hardware before it becomes obsolete. Apple also appears to be moving in the same direction with its Mac lineup by offering Lion for $29 per user, down substantially from previous major Mac OS X versions, which sold at $129 per machine. To be sure, Apple never received $129 per updated Mac. Mac OS X has never required a serial number, nor has it phoned home to ensure only one license existed per computer, so many users purchased one copy and installed it on every computer they owned. In moving to the cheaper, per user approach, Apple seems to be both acknowledging how people used and installed the software and recognizing that their profits come primarily from new hardware purchases, not paid OS updates.

A recent change implemented by the Financial Accounting Standards Board may have enabled Apple to offer free software updates that add substantial functionality without running afoul of regulators. In the past, if a company wanted to add functionality via software updates, it had two options: One, charge for the update, or two, recognize revenue from the initial sale over many quarters. The iPhone went on sale before the rule change, and Apple conservatively decided to spread the revenue over two years to allow for free software updates. This meant they were sitting on a large pile of unrecognized revenue, though, which was not ideal. Under the new rules, Apple can recognize more of the revenue up front. Accounting rules are no long complicating free software upgrades.

Apple’s bundling of free software and services with premium hardware will only offer a competitive advantage if all three work together seamlessly. Given the difficulties Apple had in running its cloud-based MobileMe product, that’s not a foregone conclusion. But on the other hand, Apple may well have learned from its past mistakes in the cloud. If so, iCloud, iOS, and Lion could help Apple stay on top.

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