Why Financial Statements Don’t Work for Digital Companies Summary (Harvard Business Review)

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Traditional Accounting, Meet Digital Finance

The titans of the multinational corporate community have made buying digital companies who consistently report annual losses a standard practice. At least, this is how might appear on the surface.

The reality is that most accounting models do not account for the fundamental components which provide a digital company’s true value. What are these components?

  • Research and development
  • Branding
  • Organizational Strategy
  • Peer/supplier networks
  • Customer relationships
  • Data and software
  • Human capital

Current accounting model utilizes two documents to value a company, the balance sheet and the income statement. The problem is, these documents were developed to value industrial companies rooted in physical assets, not the modern-day digital organizations revolutionizing the world. These firms are built on intangible investments.

Let’s look at this a bit closer.

Balance Sheets

The balance sheet represents a company’s productive assets. To qualify, assets must be:

  • Physical
  • Under direct ownership of the company
  • Within the company’s confines

Digital Valuation

The balance sheet of Walmart vs. Facebook represents how inaccurate these documents can be for company valuation.

Long story short: Investments in these intangible components provide value the way a factory might, yet are treated as expenses rather than capitalized assets. This artificially inflates the reported losses, rendering it near useless to investors.

Digital Companies Focus on Increasing Returns to Scale

Traditional finance tells us that assets depreciate over time. Digital strategies typically employ some form of network effect, deriving profits from increasing network size and scope to achieve market leadership. Industrial companies are subject to incremental increases in operating costs. This is not a flat standard of course, as professional services companies do require investment in physical assets such as office space to grow a “network.”

The Future Accounting Model?

Nobody knows for sure what this might look like, but here are a few ideas of what to look for regarding a company’s business model:

  • Acquisition of major customers
  • New products/services
  • Technology
  • Distribution alliances
  • Customer geographical distribution

Intangible investments can be made somewhat transparent by companies if they submit regular reports in customer relationships/marketing, information technology, and addition and development of talent.

It’s not all-encompassing, but companies must develop new ways forward in properly representing their value, as it’s clear that industrial-age accounting is nowhere near up to the task of handling a digital age market.

 

Read the full article “Why Financial Statements Don’t Work for Digital Companies Summary” read here.