What about depreciation? One reason these companies invest so much is that they have to in order to stay competitive. It's not like you've built a factory and then can use it for 20 or 30 years. How do you go about constructing a depreciation schedule for intangible assets?
Fantastic treatment and a great refresher of your Valuation course treatment of these accounting issues. I'm glad Meta breaks out Reality Labs' investment separately, because using these principles I think one could take a more nuanced and personal view of the expected return on that investment by separately capitalizing using different assumptions - as a longer term investment, for example, depreciate the Reality Labs R&D over 5 years instead of the 3 yr assumption for the rest of the R&D, or even capitalize only a portion of the expense to reflect an assumption of the riskiness of the bet and likelihood of realizing cash flows based on it.
« and capitalizing brand-name advertising will require separating advertising expenses into portions intended to sustain and increase current sales (operating expense) and for building brand name (capital expense). »
Often it’s nigh impossible to decide between the two. For instance, when there’s the FIFA world cup, I’m a soccer fan and Coca Cola runs soccer ads I may right now buy more Coke (and maybe drop that habit again after the World Cup is over, but this is besides the point). As a soccer fan I will also have a positive association with Coca Cola by the nice ads they are running, so this is brand-building which has a longer effect than my personal Coke consumption over the weeks of the FIFA world cup. Therefore, it’s both. But if it can be both, it appears safer to put it with operating expenses, because…
« Accountants will use the argument that the benefits are uncertain, true for some of these expenses, like R&D, but also true for many investments in fixed assets (factories, capacity etc) that are currently treated as capital expenses. »
… the argument cannot principally be about whether the R&D expense has benefits, but it should be about what the balance sheet is supposed to tell me, that is, _the liquidating value of a company_. The $12,741 Meta spent for Reality Labs in operating expenses in the last twelve months may have given rise to little that could be sold with a profit should the company be liquidated. How could anybody put a price to their prototype VR/AR glasses ? Whereas with data centres, equipment etc, just like with factories, this can be done with the price it took the company to get them/construct them, and this asset is then depreciated over time and should the company be liquidated, a price-tag could be put to it. The balance sheet is for estimating the liquidating value of a company. Price to book would become meaningless were one to inflate book value with expenses that never resulted in anything that could be sold for a profit on liquidation (that is, the hypothetical case thereof).
Further, the $32.6 billion Meta spent on R&D should not be capitalised as expenses because management made clear that the bulk of it, some 80 %, go into sustaining and developing the Familiy of Apps, like improving the AI and the corresponding Discovery Engine of Instagram and Facebook. And they talk on earnings calls about how implementing this update to AI and that update resulted in so-and-so better percentage ad-targetting, and how they could observe this almost online. So, these are operating expenses, because that’s the expense that improves the profits of the company in the actual, present quarter. Wanting to capitalise those expenses does not suit tech companies better, it suits them worse, because a tech company without constant R&D as part of the operating business is done.
Thanks for the article, it's always great to learn and get a reminder from a first principles' perspective.
What about depreciation? One reason these companies invest so much is that they have to in order to stay competitive. It's not like you've built a factory and then can use it for 20 or 30 years. How do you go about constructing a depreciation schedule for intangible assets?
Fantastic treatment and a great refresher of your Valuation course treatment of these accounting issues. I'm glad Meta breaks out Reality Labs' investment separately, because using these principles I think one could take a more nuanced and personal view of the expected return on that investment by separately capitalizing using different assumptions - as a longer term investment, for example, depreciate the Reality Labs R&D over 5 years instead of the 3 yr assumption for the rest of the R&D, or even capitalize only a portion of the expense to reflect an assumption of the riskiness of the bet and likelihood of realizing cash flows based on it.
Absolutely loving your content Aswath, would you be open to allowing us to share it with our 60k+ audience as well?
Thank you, this is a very interesting article !
Two observations I’d like to make :
« and capitalizing brand-name advertising will require separating advertising expenses into portions intended to sustain and increase current sales (operating expense) and for building brand name (capital expense). »
Often it’s nigh impossible to decide between the two. For instance, when there’s the FIFA world cup, I’m a soccer fan and Coca Cola runs soccer ads I may right now buy more Coke (and maybe drop that habit again after the World Cup is over, but this is besides the point). As a soccer fan I will also have a positive association with Coca Cola by the nice ads they are running, so this is brand-building which has a longer effect than my personal Coke consumption over the weeks of the FIFA world cup. Therefore, it’s both. But if it can be both, it appears safer to put it with operating expenses, because…
« Accountants will use the argument that the benefits are uncertain, true for some of these expenses, like R&D, but also true for many investments in fixed assets (factories, capacity etc) that are currently treated as capital expenses. »
… the argument cannot principally be about whether the R&D expense has benefits, but it should be about what the balance sheet is supposed to tell me, that is, _the liquidating value of a company_. The $12,741 Meta spent for Reality Labs in operating expenses in the last twelve months may have given rise to little that could be sold with a profit should the company be liquidated. How could anybody put a price to their prototype VR/AR glasses ? Whereas with data centres, equipment etc, just like with factories, this can be done with the price it took the company to get them/construct them, and this asset is then depreciated over time and should the company be liquidated, a price-tag could be put to it. The balance sheet is for estimating the liquidating value of a company. Price to book would become meaningless were one to inflate book value with expenses that never resulted in anything that could be sold for a profit on liquidation (that is, the hypothetical case thereof).
Further, the $32.6 billion Meta spent on R&D should not be capitalised as expenses because management made clear that the bulk of it, some 80 %, go into sustaining and developing the Familiy of Apps, like improving the AI and the corresponding Discovery Engine of Instagram and Facebook. And they talk on earnings calls about how implementing this update to AI and that update resulted in so-and-so better percentage ad-targetting, and how they could observe this almost online. So, these are operating expenses, because that’s the expense that improves the profits of the company in the actual, present quarter. Wanting to capitalise those expenses does not suit tech companies better, it suits them worse, because a tech company without constant R&D as part of the operating business is done.