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Facebook's Biggest Surprise -- No Funny Numbers

NEW YORK (TheStreet) -- In the two weeks since Facebook's IPO prospectus first surfaced to almost hysterical hype, the document has been scoured by the best brains in accounting and finance.

They have sought to find some hidden time bomb, some rattling skeleton that might cast a shadow over this $5 billion stock offering, one of the biggest of all time.

Well, here's the surprising, man-bites-dog verdict: Facebook's debut as a public company is actually getting praise from an unlikely source -- not so much for what's in the prospectus, but for what's not there. Unlike a growing number of companies, especially (but by no means exclusively) in Silicon Valley, Facebook doesn't resort to non-GAAP financial metrics, which critics among analysts and accountants have long contended are subject to abuse.

The abuses of non-GAAP metrics require regulatory action -- as I'll be coming to in a moment. But, first, let's bask in the glow of this good news.

The lack of fancy accounting is one less hurdle that Facebook has to surmount as it faces its debut in the markets, which is expected in a few months. It means that Facebook is not likely to draw the kind of criticism that has beset the coupon-generator Groupon (GRPN), which was skewered last year for trying to use what it called "adjusted consolidated segment operating income," a non-GAAP metric that obscured the company's marketing costs.

J. Edward Ketz, an accounting professor and co-author of the Grumpy Old Accountants blog, has been a vociferous critic of Groupon. But he believes that Facebook -- which, he notes, was audited by the same firm, Ernst & Young -- uses straitlaced GAAP-compliant metrics, and none of Groupon's smoke-and-mirrors.

As a matter of fact, he has gone on his widely followed blog, which he writes with fellow prof Anthony H. Catanach Jr., to proclaim that Facebook gets an "A" for its straightforward accounting. They noted that Facebook "does NOT use the term EBITDA (earnings before interest, taxes, depreciation and amortization) or adjusted EBITDA anywhere in its securities filing" -- suggesting that Facebook has "absolutely no problem reporting its performance using income amounts computed using generally accepted accounting principles (GAAP). When was the last time we saw an Internet company NOT make excuses about how GAAP failed to reflect reality for their operations?"

What's more, he notes, Facebook actually recognizes revenue in a simple, straightforward manner. "There are no multiple deliverable issues as in the case of LinkedIn (LNKD), or the 'gross vs. net' questions that plagued Groupon," he points out. There's also no hocus-pocus in reporting cash flow, no "special items" or off-balance-sheet transactions.

Now, that doesn't mean that everything is perfect in the Facebook prospectus. Ketz notes that compensation levels, which include a hefty amount of stock-based income, may raise questions as to whether executive compensation is excessive. And then there is the matter of how Facebook defines users. Not long after the prospectus was released, Barry Ritholtz pointed out on his blog that Facebook seems to be grossly inflating the number of people it counts as "active users."

But Ketz pointed out to me that he doesn't believe that Facebook should be valued on the basis of its user count or any other non-GAAP metric. "Valuation depends on future cash flows and I don't see what users, however defined, tells me about future cash flows," he says.

Groupon ultimately abandoned the "adjusted consolidated" yadda yadda metric after it drew regulatory scrutiny, which didn't do its earnings much good, but that didn't convert Ketz into a fan. In a blog post in August, he pointed to continuing accounting issues at Groupon and referred to "the deafening silence in the accounting, auditing, and investment communities about the company's questionable basic accounting practices and lack of internal reporting controls."

Ketz has similarly been critical of the IPO prospectus generated last year by Zynga (ZNGA), an Internet game developer that whose financial statements have relied on "adjusted EBITDA," a non-GAAP measure he considers worthless. In one blog post, he and Catanach pointed out that "Zynga is actually trying to map the virtual world of fantasy and dreams to the real world of cold cash and hard knocks" -- and not succeeding terribly well.

Non-GAAP measures have been the bane of Silicon Valley and Internet firms over the years, and have been the cause of confusion and angst on many occasions. They have been the bane of the Internet retailer Overstock.com (OSTK), whose use of non-GAAP measures has been severely criticized by former Crazy Eddie accounting mastermind Sam Antar, as he has recounted in detail on his blog. Although Overstock CEO Patrick Byrne once criticized EBITDA as "the stupidest thing I ever heard emanate from Wall Street," he subsequently used that non-GAAP measure -- and he has never been confronted with his criticism of EBITDA at the company's quarterly conference calls.

Gradient Analytics, an independent research firm that has skewered Overstock's accounting in the past (and fought a costly legal battle as a result), recently issued reports blasting use of non-GAAP metrics at two widely divergent companies: TeleTech Holdings (TTEC), a business process outsourcing company, and Mohawk Industries (MHK), a floor-coverings manufacturer. In a research report a couple of weeks ago, Gradient analyst Nicholas Yee opined that the "non-GAAP 'adjusted earnings' figures provided by [Mohawk] management may not be compliant with Regulation G's prohibition against eliminating income statement items that are recurring in nature."

As for TeleTech, Gradient analyst Daniel Stone expressed similar misgivings about "the firm's non-GAAP disclosure practices, which appear to run counter to SEC Regulation G and may not be representative of the true economic performance of the firm." In a report released Jan. 24, Stone noted that TeleTech "routinely adds back restructuring charges, acquisition related expenses, and other regularly recurring items in computing non-GAAP profit measures -- which appears to be contrary to the requirements of SEC Regulation G."

That's not the kind of stuff you generally read in research reports generated by brokerages, which tend to swallow non-GAAP measures without any in-depth analysis. Gradient mainly sells its research to money management outfits, including hedge funds and short-sellers. So the wonders of non-GAAP accounting are usually not apparent to investors, unless they follow accounting blogs or are adept at analyzing financial statements themselves.

Clearly, the Securities and Exchange Commission needs to do a more scrupulous job of policing financial reports, especially when they utilize non-GAAP measures that either violate the rules or are misleading. But the accounting industry also has a responsibility. The Groupon-Facebook dichotomy, in which one accounting firm was responsible for two dramatically different approaches to GAAP, demonstrates the need for actual people at accounting firms taking personal as well as corporate responsibility for the financial statements that they audit. The partner at the accounting firm responsible for each audit should sign the auditor's statement in every SEC filing.

That's not happening, of course -- the accounting firms would never put up with it -- but it certainly deserves to be put on the "to do" list when sanity finally returns to financial regulation.

Meanwhile, props to Facebook for being a financial-statement mensch. I'm no fan of that company's privacy practices, and I agree with Barry Ritholtz that its definition of "active user" is questionable. But at least it's not playing any GAAP games.

Gary Weiss's forthcoming book, AYN RAND NATION: The Hidden Struggle for America's Soul, will be published by St. Martin's Press on February 28, 2012.

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Gary Weiss has covered Wall Street wrongdoing for almost a quarter century. His coverage of stock fraud at BusinessWeek won many awards, and included a cover story, �The Mob on Wall Street,� which exposed mob infiltration of brokerages. He uncovered the Salomon Brothers bond-trading scandal, and wrote extensively on the dangers posed by hedge funds, Internet fraud and out-of-control leverage. He was a contributing editor at Conde Nast Porfolio, writing about the people most intimately involved in the financial crisis, from Timothy Geithner to Bernard Madoff. His book "Born to Steal" (Warner Books: 2003), described the Mafia's takeover of brokerage houses in the 1990s. "Wall Street Versus America" (Portfolio: 2006) was an account of investor rip-offs. He blogs at garyweiss.blogspot.com.

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