Applying 20th-century financial reporting rules to 21st-century businesses means that reported losses are not always losses. They might even indicate a growing firm.
The most important regulation in financial reporting, at least in the US capital markets, can be traced to the stock market crash of October 1929. Public confidence in the markets was shaken. Congress held hearings to identify the cause of the crash and to search for solutions. One of the solutions was the passing of The Securities Act of 1933, which requires public companies to “tell the truth about their business, the securities they are selling, and the risks involved in investing in those securities.” An integral part of this truth-telling exercise was the provision of an audited financial report by the firms, inclusive of an income statement, at least on an annual basis. Most companies didn’t report an income statement before, so this was the first time for many.
Income statements provide details of a firm’s performance over a year. Over time, earnings – the bottom line of an income statement – emerged as the most important output of a financial reporting system. Share prices would react to earnings per share (EPS), chief executives’ compensation would be tied to profits, banks would give loans based on whether profits exceed debt servicing obligations, and suppliers would extend credit based on the company’s profitability. In this 20th-century world, the reporting of a loss would be catastrophic for the firm, as suppliers and banks might cut back on credit and the shareholders would dump the company’s stock. But this is no longer the case.
Value and revenues
Today, almost 40% of firms listed on US stock exchanges report losses year after year, survive well, and even grow faster than the profit-making firms. They include household names like Twitter, Uber, and Airbnb. Amazon, now a trillion-dollar company, reported losses for almost a decade. In addition, numerous unicorns appear each year – companies with valuations exceeding a billion dollars – almost always reporting losses. What has changed? Why, in the 21st century, do losses no longer mean losses?
The reason is that earnings or profits are not a singular metric that could be recorded based on a single transaction. It is obtained by subtracting numerous expense line items from revenues, both of which are calculated after applying a diverse, and often inconsistent, set of accounting conventions.
Revenue recognition requires fulfilment of two conditions: an objective determination of the value of goods and services that have been delivered, and the customer payments being probable. These conditions, however well intended, cause the first point of departure for revenues from numerous events that create value for modern firms. These are events that could create a recurring stream of cash flows, but cannot be recognized as revenues – because no delivery has occurred. The signing of an exclusive partnership with a tech giant, the granting of a patent, approval of a blockbuster drug by the Food and Drug Administration (FDA), securing an influencer’s endorsement of a new product, or even a social media company signing up a million new subscribers: none can be recognized as revenues.
While this limitation applies to all companies, it is especially important for modern technology companies that build a probable future stream of cash flows through a series of serendipitous events that increase the value and marketability of their ideas. It is why we hear about pre-revenue companies with billion-dollar valuations – WhatsApp was purchased by Facebook for about $17 billion when it had never earned any revenues.
Expenses and earnings
On the other side of the financial equation, expenses are calculated using numerous, inconsistent conventions. Most costs associated with the procurement and production of physical goods are initially capitalized and presented in an inventory account. These assets are then reduced and reported as expenses when the product is sold. A similar concept is applied to investments in property, plant and equipment (PP&E). Purchase, delivery and installation costs are initially capitalized in the PP&E account and then retired through a depreciation expense account over the expected period of use of PP&E. Thus, the costs related to physical assets are recognized as expenses in different periods from when they were purchased; that is, when those assets produce revenues.
Over the last 25 years, another class of outlays has emerged as the most important one for modern technology companies. These expenses are recognized immediately, and not necessarily when they produce revenues. They include: research and development (R&D) expenses, process improvement, information technology, software development, advertising, organizational strategy, acquisition of customers, brand building, and hiring and training personnel. To the extent that these investments are made in expectation of future benefits, the earnings – calculated as revenues minus expenses – become meaningless in assessing firms’ true profitability. The concept of profit margin becomes meaningless too, as it provides no indication of what future profit margins will look like. In that regard, tech companies are utterly different to businesses such as Walmart, where profit margins would be highly stable and predictive of future profit margins in a steady-state economy.
The non-correspondence between revenues and value-creating activities, and the immediate expensing of future-oriented investments, increasingly applies to firms listed in the last 30 years, which now constitute over 80% of all public firms in the US. As a result, newer cohorts’ profits and profit margins – especially when negative – offer few clues as to future profits. Investors start ignoring the so-called losses, firms start reporting what are known as non-GAAP numbers (see ‘Mind the GAAP’, Dialogue Q4 2022), and executive compensation is increasingly tied either to stock or stock options, or to a highly adjusted earnings number.
That is why reporting losses year after year is not catastrophic, as it used to be in the 20th century. On the contrary, it could be a sign of a growing firm. A modern technology firm has two aims. First, to create a library of intellectual properties and assets, such as subscriber network, so that it is an attractive acquisition target for another tech giant. Or second, to rapidly expand its market and market share to become the sole supplier in the market, and earn winner-takes-all profits – consider how LinkedIn or Facebook have established themselves as the sole suppliers in their markets. As an investor or a stakeholder in a company, you are better off studying whether a firm can dominate the market it is trying to create, rather than focusing rigidly on its losses.
