It’s no secret that here at New Constructs we love the financial footnotes and Management’sfinancial footnotes and Management’s (“MD&A”). Tucked before and after the financial statements, these often-unread notes can be hundreds of pages of boring accounting jargon and legalese, but they contain important information on items such as non-recurring expenses, off balance sheet arrangements, and pension obligations.

For most companies, Note 1 to the consolidated financial statements will be titled “Summary of Significant Accounting Policies” or some variant thereof. It’s an innocuous title, but this footnote contains a wealth of important information about how all the headline numbers in the financial statements are actually calculated. If you want to understand the underlying economics of the company’s business, you have to understand its accounting policies.

Buried in the footnotes and MD&A, you can find where reported expenses understate true costs, red flags for earnings manipulation and significant differences that need to be reconciled when comparing companies.

Reported Expenses Understate True Costs: Netflix (NFLX)

We’ve written about Netflix’s (NFLX) content costs a few times in the past. It’s no secret that we think the streaming video company’s rising costs to license its content will make it almost impossible for the stock to live up to its lofty valuation. What many investors don’t realize, however, is that NFLX’s accounting policies actually understate the real cash expense of building its content library.

For its streaming content, Netflix follows Accounting Standards Codification (ASC) 920, which determines how broadcasters should account for the licensing of films, TV shows, and other video rights. Essentially, the standard requires that companies create an asset and a liability when they buy the rights to a show or movie from a third party, and then amortize the asset over the life of the license. The amortization is what gets recorded as an expense on the income statement, rather than the actual amount paid for the license.

Figure 1 shows the difference between the cash Netflix has paid to add to its streaming content library in each year and the expense recognized for the amortization of streaming content and changes to streaming content liabilities.

Figure 1: Reported Content Costs Vs. Actual Cash Paid For New Content

Sources: New Constructs, LLC and company filings.

Key points from Figure 1:

  • In just four years, the difference between reported content costs and the actual cash payments for new content is nearly $1 billion.
  • In 2014 alone Netflix paid $500 million more to add to its library than it recognized in expenses.
  • These differences represented about 10% of expenses and would have reduced EPS from $4.32 to -$1.31 in 2014
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