Sunday, July 3, 2011

Accounting Standards Are Behind the times ZYNGA, LNKD, GRPN

New York - If we needed more evidence on yet another poor accounting standard all we need to look at, is Wall Streets newest company Zynga. A maker of online computer games for facebook.

The company has a peculiar revenue recognition system which is based on GAAP principles from an older time. The principles here have clearly lagged technology and are so fundamentally behind that Zynga's GAAP earnings are merely useless. We can see an accountant sitting in his desk as he dreams up this GAAP revenue recognition principle. Of course all the other accountants agree because revenue recognition has been a sore issue over the last ten years especially for tech companies.

Zynga had $235 million of GAAP revenue but when we take a closer look we realize the poor treatment of the accounting initiative. After recognizing deferred revenue the company actually had 22% more revenue.

The company is recognizing revenue on its products as if it owns a gym and members are payinha yearly fee with a first time payment larger then other payments. The accounting treatment if someone paid $200 for a gym membership and a $25 monthly fee would be to recognize the $25 over each month and $200 over the expected life of the contract. For a gym it likely would not make sense to do much more than a year. So (1/12) of that $200 would be recognized over each month instead of at the beginning of the contact. This makes sense, since if the gym breaks down the member will want his $200 back. Risks have not been transferred.
To apply the accounting treatment of stores like BestBuy to the residents of Farmville is asinine accounting standards.

What Zynga does and likely no fault of their own because Ernst Young audited their financial statements and applied this backward accounting standard.

When the resident of Farmville buys an item the company does not recognize the revenue until that item is used by the player. This may appear to make sense on the surface but it is very un-intuitive. For one thing if the item can only be used once its likely to be used right away and if it is not used then its likely the person will never use it so might as well recognize it right away. To wait until the person uses it and try to match it with when its earned on a computer game like this is out right idiotic.

The second form of revenue from the company is when a user purchases "durable virtual goods" which can be used for as long as the player plays the game. The company now estimates this revenue over the amount of time they expect the player to play. Which is currently over 12 months. So this revenue and cash given which is purchased takes time to recognize.

Again if you were an accountant this may make sense for a second but it is extremely un-intuitive. Lets give an absurd example but Farmville itself is an even absurder example. And an even absurder practice is applying revenue recognition laws for the use of product in a virtual game.

But here is the example. Lets imagine that no-one in the world is allowed to leave their house except one person named Josh . In order for everyone to leave their house they must register with this Josh and they pay him a 1 time fee of $10. Now the person is free to leave their house at their choosing and will never need to speak to this person again.

First does it make sense to recognize this $10 over the life of this person because he can now live and walk around and the service being provided has not yet been completed? Just because this $10 now is for a service of a certain amount of time and the person can still use the service does not mean the revenue recognition cycle is not complete.

Furthermore do we have to wait for the person to walk outside their house before we recognize revenue? Does it really matter if someone sits in their home for a year then comes out. How does it affect what money we earned?

For the resident of Farmville to apply general accounting standards may be the dumbest thing Ernst Young has ever done. And they have been the accountant for several missed frauds.

If you think our example was ridiculous then you would also think waiting for the residents of Farmville having to use virtual items before real cash to be realized is even more ridiculous.

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