Slideshow: Top Unique Accounting Techniques for IPO Candidates

Usually, people with a strong creative streak get steered into professions like fine arts or fiction writing.

But judging from the IPO filings I’ve been reading over the past few months, career advisors should consider a new job category: accounting.

From novel income recognition metrics to the introduction of new asset classes for durable and consumable virtual goods, venture-backed Internet companies have organized their numbers in some notably creative ways. While some, such as Groupon’s now-abandoned metric for income that does not account for marketing costs, have already attracted their share of scrutiny, others may prove more resilient.

In the following slideshow, we look at four public or soon-to-be-public companies – Zynga, Groupon, Pandora Media and RenRen – and the interesting and sometimes controversial approach each has taken for measuring performance. We’ll look at how it can help investors gauge the company’s performance, as well as ways in which the approach could confuse or mislead.

[Slideshow]

[slide title=”Groupon”]

Accounting metric: Adjusted consolidated segment operating income (ACSOI)

How it works: A metric of income that excludes marketing expenses, stock-based compensation and acquisition items.

For example, in an early IPO prospectus, Groupon reported ACSOI of almost $82 million for the first quarter, after stripping out some $180 million of expenses.

How it helps gauge performance: An income metric that excludes one-time events, such as acquisitions, and removes stock-based compensation can help investors understand the cash flow of the core business. Groupon’s exclusion of marketing costs, however, takes the concept one step further.

Red flag: Well, everybody could be wildly profitable if they were just able to exclude the core cost of running their business (which, in Groupon’s case, is marketing). Groupon later abandoned ACSOI under pressure from the SEC and backlash from potential investors.

[slide title=”Pandora”]

Accounting metric: Accrued royalties

How it works:  Pandora makes royalty payments on the songs it plays.  That means that for every new or increasingly active listener in its roster, the company incurs greater royalty costs. Accrued royalties are payments the company owes to music copyright holders, but has not yet paid.

How it helps gauge performance:  Investors can track how much Pandora owes copyright owners from quarter to quarter.

As of the end of October, for instance, Pandora had accrued royalties of $25.6 million, up from $18.1 million in January.

Red flag: Critics have argued that Pandora can make current earnings look better than they really are by classifying expenses as accrued royalties, payable at a later date.

[slide title=”Zynga”]

Accounting metric: Consumable and durable virtual goods revenues

How it works: Zynga makes most of its money through sales of virtual goods, which are divided in two categories: consumable and durable.  Something that’s consumable, such as energy units in the game Cityville, would be consumable. Something that a user gets to keep for the duration of the game, such as, say, a tractor in Farmville, would be durable.

The company recognized revenues from consumable virtual goods up front. Revenues from durable goods are recognized over the course of game usage.

How it helps gauge performance: Scratching my head on this one. Since it basically costs nothing to produce a virtual good and nothing to make it available for the duration of the game, it’s unclear how investors are served by the durable vs. consumable distinction.

Red flag: Having two categories of virtual goods seems to make it easier for Zynga to fluff up earnings in some periods and downplay them in others.

For one, the period over which durable virtual goods revenues can be recognized can be easily revised. In September, 2010, Zynga estimated the life of a durable virtual good was 18 months. A year later, it cut the “weighted average life” of a durable virtual good to 15 months. This, the company says in its IPO filing, resulted in a net increase of $48.5 million in income in the first nine months of this year.

Additionally, the durable virtual goods classification makes it difficult to determine the extent to which the
company’s growing revenues are coming from current buyers or from those who bought goods in previous quarters. With purchases recognized over 15 months, some revenues recorded in November, for instance, were actually from players who bought stuff as far back as August, 2010. It’s also interesting to note that Zynga attributes a revenue increase of more than $300 million between the first nine months of 2010 and 2011 to purchases in FarmVille, FrontierVille and Cityville, all games which, if memory serves, saw their usage peak several quarters ago.

[slide title=”Renren”]

Unusual accounting approach:  Warning investors of “limited accounting personnel and other resources for addressing internal control over financial reporting.”

How it works: A lot of companies try to present their numbers in the best possible light. Chinese social networking site Renren, however, took the unusual step of telling investors in its IPO filing that that those numbers might not actually be accurate.

Renren warned that it and its accountant had identified “one material weakness and one significant deficiency” in its internal control over financial reporting, creating “a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”

How it helps gauge performance: If one subscribes to the idea that the more disclosure, the better, than an argument could be made that it’s better to disclose potential inaccuracies in financial statements than to leave investors uninformed.

Red flag: Well, to state the obvious, investors will have to take positive financial reports with a grain of salt. Moreover, while Renren’s disclosure of accounting issues didn’t prevent it from having a blockbuster IPO, the stock has tanked since then. Shares are now selling for under $4, after peaking around $24 after the offering, following disappointing third quarter results.

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