Netflix's Accounting Rules Are Hidden Risk for Investors

BOSTON (TheStreet) -- You know the news by now: Netflix customers are running for the movie-theater exits as content costs are skyrocketing and expansion plans overseas will lead to losses in the first half of 2012. It's Netflix's worst quarter. And it all blew apart in three months.

I read through the investor letter from Chief Executive Officer Reed Hastings and David Wells, the finance chief. My first thought: I wish all companies provided this sort of transparency and explanations. It had to be done, though, because of damage control following the Qwikster repricing/renaming mess.

I read further, trying to make heads or tails of the income and cash flow statements, and I started to wonder how content costs were accounted for. I recalled in Whitney Tilson's excellent short thesis on Netflix, in which he said higher costs of streaming content and the way they're amortized could be inflating profits.

In late 2010, Tilson pointed out that Netflix's "acquisition of streaming content" on the cash flow statement wasn't immediately being recognized under "acquisition of streaming content library" as an expense in the income statement.

For the third quarter of that year, Tilson noted that even though streaming-content costs were $115 million (up 74%), the associated amortization expenses increased only 17%. He noted in his presentation that from the first quarter of 2007 through the third quarter of 2009, acquisition costs were roughly equal to the amortization expense. Yet, starting in the fourth quarter of 2009 (when streaming-content costs started to accelerate), the two diverged. (See chart below.)

Fast forward to the most recent release from Monday, and we see the same trend, but to an even greater extent. In the four quarters through September, Netflix spent more than $1.5 billion on streaming content, but amortized only $483 million, or 32%, of it. Tilson theorized last year that Netflix's huge streaming costs eventually will be amortized and "therefore appear as an expense on Netflix's income statement, causing a significant decline in margins and profits."

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