Social Media\'s Phony Accounting For 26 million digital farmers working their fi

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Social Media's Phony Accounting

For 26 million digital farmers working their fields and crops on Zyngas popular game FarmVille, obtaining a virtual tractor, seeder or harvester can be transformative. A make-believe tractor, for example, ­allows you to plow four plots at a time. Its the kind of productivity that laptop-bound farmers dream of.

The problem is that earning enough FarmVille currency to afford heavy farm equipment takes time. But like other social gaming companies, Zynga allows users to speed up the process by converting real dollars from their credit card and PayPal accounts into the FarmVille currency used to buy virtual goods. A hot rod tractor, for example, costs 55 in Farm Cash, which translates into $10 in real U.S. money.

For Zynga, which also owns CityVille, Zynga Poker, Mafia Wars and Words With Friends, virtual tractor sales are big business. The fledgling San Francisco company likely sells millions of tractors each year (that compares with 190,000 real tractors sold in 2011 in the U.S. and Canada). Sales of virtual goods, from FarmVille hay to Mafia Wars assault rifles, accounted for nearly all of Zyngas $1.1 billion in 2011 revenues–and 12% of revenue for Zyngas distributor, Facebook.

Which makes it very helpful that both have the same friend in the ­accounting business: Ernst & Young, the public auditor for Zynga and Facebook.

Ernst & Young wrote the book on accounting for virtual goods, literally. The third-largest accounting firm ­behind PricewaterhouseCoopers and Deloitte, it leads its rivals in the technology and burgeoning social media space. Neither the Financial ­Accounting Standards Board nor the Securities & Exchange Commission has issued rules for the likes of livestock love potions and virtual harvesters, so an E&Y document (updated this past March) lays out three revenue-recognition models it deems consistent with Generally Accepted Accounting Principles.

Such publications are well worth E&Y s effort, since its Strategic Growth Markets consulting unit helps companies develop their financial systems, controls and accounting policies well before they are ready to come public. Which is potentially problematic. A firm that consults on byzantine accounting rules for unusual revenue streams and also offers independent auditing services for the same companies? The ghosts of Arthur Andersen and Enron shudder.

Sarbanes-Oxley, of course, was supposed to fix such conflicts. But just as it handcuffed the IPO market, Sarbox blew it here, too. While it wisely bans an accounting firm from simultaneously auditing a public company and selling it most consulting services–the toxic combo that torpedoed Arthur Andersen and thousands of Enrons innocent shareholders–it doesnt prevent an accounting firm from first consulting on technical and internal ­accounting issues for a startup and later, when that emerging company is getting ready to go public, segueing into a role as independent auditor, potentially auditing its own work.

So did E&Y consult for Facebook and Zynga before becoming their ­independent auditor? It wont say. Stephen Blowers, E&Ys Americas Vice Chair of Independence, does say that before an audit client goes ­public his team conducts an extensive review of all the work E&Y did for the company during the three years of audited statements in the IPO, as well as an extra year before that, to make sure it has complied with all the SECs auditor-independence rules. We are confident of our independence, he adds.

Facebook, Zynga and Groupon, another E&Y auditing client that was recently scrutinized for its aggressive accounting (see box, p. 154), also wouldnt say what consulting E&Y did for them before becoming their auditor. And you wont find it in SEC filings; it doesnt ever have to be disclosed. The situation does not instill confidence that a fresh set of eyes have looked at the numbers, says former SEC chief accountant Lynn Turner.

There are hints. In its 2011 annual report, Zynga quotes from E&Ys guide liberally and verbatim in explaining why it recognizes revenue from the sale of virtual durables like FarmVille tractors at a slow pace, and dollars from the sale of consumables like energy immediately.

The common denominator in Ernst & Youngs new social gaming accounting rules appears to be that significant discretion is left up to management when it comes to the timing of revenue recognition. E&Y basically gets to make up the rules in this brand-new area as it goes along. And those rules drive the stock price.

Heres how the virtual-goods accounting game is played. If you buy and hold Facebook credits (used to buy virtual goods in games on Facebook) Facebook treats the purchase as deferred revenue–the same way a retailer would book the sale of a gift card–until you spend your credits. When you buy FarmVilles hot rod tractor, you use your Facebook credits or charge $10 (which, unseen to you, buys 100 Facebook credits that are converted to 55 in Farm Cash). Facebook sends $7 to Zynga and keeps 30%–$3–as a processing fee, moving that $3 from deferred revenue into current revenue.

When does Zynga get to recognize its $7 in revenues? FASB doesnt have social media standards, but its broader guidelines hold that revenue should not be recognized until it is both realized (or realizable) and earned. In other words, even if a company has cash in hand, it cant be counted as current revenue until the company has delivered the product or service its being paid for.

E&Y has stepped into the void, proposing three different models for social gaming companies to pick from: game-based, in which revenue is recognized very slowly, over the life of the game; user-based, a faster scheme that lasts over the time a typical user sticks with the game; and speedy item-based, rooted on the properties of specific virtual goods. Using the last method, Zynga recognizes revenues from consumable virtual items like energy immediately and revenues from durable ones like tractors over the time a player is projected to stick with a game­.

When you think about it, this makes sense. But selecting an accounting method is only part of the game here. All these revenue-recognition methods are dependent on management estimates of the life of a game, a customer or a virtual item–thats wide latitude to interpret consumer behavior in a new and fast-changing business. Tweaking ­estimates can make a big difference to the bottom line.

For example, in its fourth amended registration statement, filed with the SEC in October of 2011, Zynga noted that during the first half of last year it estimated the blended average paying player life for a game as 15 months, down from 19 months a year earlier. The shorter player life increased GAAP revenue for the six months by $27.3 million, turning a loss for the six months ended June 30, 2011 into a net profit of $18.1 million. Well-timed: This change came just before Zynga went public in mid-December at $10 a share.

From our perspective, the inconsistent application of useful lives and resulting depreciation does more to confuse the economics of the business, says Rick Summer, senior equity analyst at Morningstar, and it is also a poor proxy for cash flow.

Summer prefers an entirely different, non-GAAP metric, bookings, which Zynga itself touts in its press releases. It counts all revenue from virtual goods sales at the time the player purchases them, providing investors a read on the pulse of business momentum regardless of the timing of revenue recognition. For 2011 Zyngas bookings were a record $1.16 billion, up 38% year-over-year–producing a non-GAAP net income of $303 million. Pay no attention to Zyngas official net loss of $404 million for 2011, as reported to the SEC under GAAP. (Note that Zyngas non-GAAP-earnings number also excludes depreciation, amortization and Zyngas considerable stock-based compensation expenses.)

Such flexibility underscores why an independent auditor is critical for shareholders. The Big Four public accounting firms all provide services to growth companies that might one day go public. Besides being profitable, it gives them an inside track to an auditing appointment, which can produce hundreds of millions in revenue over decades. (During the ­Sarbanes-Oxley debate the ac­coun­tants beat down attempts to force a company to switch its auditing firm every five years.)

But E&Y is the most brazen in how it communicates this relationship. PricewaterhouseCoopers Roadmap for an IPO guide, for ­example, stresses the importance of auditor independence, mentioning it five times. By contrast, Ernst & Youngs latest Guide to Going Public emphasizes its role as a business advisor and client advocate, while never once mentioning auditor independence. The clear message: Advocate first, auditor second.

It doesnt hurt that many of the people E&Y is pitching for business once sat on the E&Y side of the table. The firms CPAs are often lured by options-wielding clients to work in-house. The chief accounting officers at Facebook and Zynga are both E&Y alums. (Villanova University ­accounting professor Anthony H. Catanach cites such incestuous relationships as a key reason E&Y audit client Lehman Bros. saw its balance sheet collapse. The technique Lehman used to hide debt and a growing liquidity crisis was created by a Lehman CFO who was a former E&Y partner–leading E&Y partners to assume it was legit.) Sarbanes-Oxley now bars an auditor from moving to a company hes directly auditing but not to other companies that are audited by his firm.

Confused yet? Zyngas investors surely are. And as long as firms like E&Y have wide latitude to judge the accounting rules at companies where they legally may have created such creative structures, rest assured that such confusion will grow as rapidly as FarmVilles virtual kudzu.

Revenues, Half Off

Groupon shows how social media companies can game the numbers.

Social media accounting games arent limited to games companies. Witness Ernst & Youngs lightning-rod client, Groupon.

Before going public last November in what was then the largest initial public offering of an Internet stock since Google , Groupon amended its registration statement eight times. One SEC-mandated restatement forced it to change an E&Y-sanctioned method of reporting revenue, reducing sales by more than 50%.

Heres what was behind that: Groupon had initially counted the gross amount its members paid for a deal as revenue, without first deducting the share (typically half or more) that it sends on to local merchants. On their Grumpy Old Accountants blog, accounting profs Anthony H. Catanach Jr. of Villanova and J. Edward Ketz of Penn State slammed this approach as obviously wrong and in violation of the Generally Accepted Accounting Principles that public companies must use in their SEC filings. They sent their analysis to the SEC as a whistleblower complaint, and the SEC agreed.

When 60 Minutes correspondent Lesley Stahl asked Groupon founder and CEO Andrew Mason in January whether this counted as a bush league mistake, the 31-year-old entrepreneur blithely responded: A bush league mistake that our auditors looked at. Smart people can get this stuff wrong. Were inventing a new industry.

Ketz still doesnt buy it. This was no bush league mistake, he says. It was a deliberate attempt to present the numbers in the most favorable light possible. (Citing client confidentiality, E&Y declined any comment on Groupon.)

The SEC also pushed moneylosing Groupon to remove from its offering document a non-GAAP metric it had invented called adjusted consolidated segment operating income. Whats that? Income when marketing, acquisition and stock-based compensation expenses arent counted–a misleading measure, considering that high marketing ­expenses are one of the risks of Groupons business model.

The foibles continue. A few weeks ago Groupon revised fourth-quarter 2011 earnings downward, saying it had underestimated the rate at which buyers would demand refunds for higher-priced purchases and had set aside inadequate ­reserves. Management also admitted that in preparing its 2011 year-end financial reports it had discovered a material weakness in its financial reporting process and said it is beefing up its internal accounting procedures and staff. (Because E&Y is now its auditor, Groupon is legally required to bring in a different firm to work on internal procedures. It is using KPMG.)

Since that announcement Groupons stock has fallen to $13.56–more than 30% below its $20 IPO price.

The timing of Groupons latest accounting revelations is significant. According to Catanach and Ketz, discovering and then assigning the material weakness to the fourth quarter ­allowed Groupon and E&Y to avoid the embarrassment of admitting that the financial statements included in the ­companys IPO filing were incorrect.

This isnt the first time an E&Y client has had big problems reserving for returns. In February the Public Company Accounting Oversight Board, which regulates auditors, imposed a $2 million penalty, its largest ever, on E&Y for allowing Medicis Pharmaceutical Corp. to use an incorrect method of reserving for the return of unsold drugs. (E&Y said it cooperated with the PCAOB and has made changes to its policies and procedures to address the regulators concerns.)

Just another example of why accounting, in the eyes of investors, too often can resemble a shell game. –F.M.

The Financial Accounting Standards Board has issued accounting pronouncements that affect how accounting transactions should be treated. These pronouncements may affect all companies or just specific industries, but no pronouncements have been issued that affect social media companies, like Zynga and Facebook. In the Forbes article, “Social Media's Phony Accounting,” written by Francine McKenna, the author discusses how these new rules are being invented. Read the article and then:

Discuss the methods that have been invented and how management estimates can manipulate the resulting income from these transactions. Provide examples to support your opinion.

Should these invented rules be implemented without authoritative approval?

Should these new rules be labeled as Generally Accepted Accounting Principles (GAAP)?

Explanation / Answer

Discuss the methods that have been invented and how management estimates can manipulate the resulting income from these transactions. Provide examples to support your opinion.

Answer:Social media companies such as Facebook, Zynga, and Groupon have had to pioneer their way through the unregulated industry in a means to record revenue with in the current accounting protocols in a means to produce financial reporting. Game; user-based, a faster scheme that lasts over the time a typical user sticks with the game; and speedy item-based, rooted on the properties of specific virtual goods. (McKenna, F., 2012). The virtual industry has been a fast-paced one. The rules are being invented as they go along. Take for example: Zynga amended its fourth quarter statement for 2011 changing the blended average paying player life of a game from 19 months to 15 months. This turned a loss into a profit for the company due to the timing of the adjustment. But selecting an accounting method is only part of the game here. All these revenue- recognition methods are dependent on management estimates of the life of a game (McKenna, F., 2012).

Answer: No, The industry is evolving on a daily basis. Rules still need to be put into place so that the financial information remains consistent. “ FASB doesn’t have social media standards, but its broader guidelines hold that revenue should not be recognized until it is both realized (and realizable) and earned. In other words, even if a company has cash in hand, it can’t be counted as current revenue until the company has delivered the product or service it’s being paid for (McKenna, F., 2012)

Answer: I do not believe these rules should be labeled as Generally Accepted Accounting Principles. There is a process that needs to be adhered to before rules become part of GAAP. These rules have to be run through the FASB, put on the agenda, researched before it is considered a GAAP.

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