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Twitter's shady accounting

October 8, 2013: 5:00 AM ET

Why is Twitter using the same accounting tricks that have been criticized so many times before?

twitter-hq-620xaFORTUNE -- When it comes to its bottom line, Twitter would like potential investors to put on some heavily tinted rose-colored glasses.

In the registration statement for its upcoming IPO, which was filed on Thursday, Twitter said through the "eyes of management" the company had a profit of just over $21 million in the first six months of the year. That's probably how Twitter's execs would like potential investors to see it. Through an accountant's eyes, though, Twitter actually lost just over $69 million.

The difference has to with an unorthodox accounting term called "adjusted EBITDA." Companies have long tried to steer investors toward metrics that make their results as good as possible. EBITDA is the most popular one, which stands for earnings before interest, taxes, depreciation, and amortization. Some have questioned the logic of looking at earnings without all these costs. Tax, for instance, is a real cash expense that all companies have to pay.

MORE: 3 ways Twitter's IPO won't be like Facebook

But Twitter says it excludes even more expenses when its management looks at earnings. That's where adjusted EBITDA comes in. On top of the other stuff, Twitter's metric excludes stock-based compensation as well. Without that adjustment, Twitter's management wouldn't be able to say the company looks profitable, at least to them.

Using typical EBITDA, Twitter still had a loss of around $14 million for the first six months of the year. Exclude the $35 million of restricted stock units that Twitter handed out to employees, an expense that official accounting rules require companies to include when computing their bottom lines, and that's how you get to the gain of $21 million.

Other social media companies have professed their love for adjusted EBITDA as well. LinkedIn (LNKD), for instance, used adjusted EBITDA in its 2011 IPO filing, boosting its bottom line to $64 million, from an official $5 million, in the first nine months of 2011. But not all use it. Facebook (FB) eschewed the use of any alternative measures of its bottom line when it went public.

Some have argued that it makes sense to exclude stock-based compensation because it's a non-cash expense. And Twitter says the expense is rapidly shrinking. It estimates its stock-based compensation will drop to less than $11 million in 2017, from $185 million this year.

Along the way, though, the company projects stock grants will cost the company $325 million. And even after that, the company will have to pay its employees. It just won't pay them with stock. Warren Buffett and others have argued that companies that exclude stock-based compensation from their expenses are using phony accounting.

"It's like the employees are working for free," says Jack Ciesielski, the publisher of The Analyst's Accounting Observer. "It's silly."

MORE: Twitter's IPO will not be done in secret

And while excluding depreciation may make sense for companies that have large one-time expenses, most of Twitter's depreciation expenses have to do with computer servers. Twitter spent $60 million on servers or server space in the first six months of the year alone. Use adjusted EBITDA, and that expense completely disappears from Twitter's financial statements.

The real silly thing is that the Securities and Exchange Commission allows this. The SEC's rules state that companies can include the adjusted figures in their IPO filings, alongside the official numbers, as long as the company's management includes a statement as to why they are useful. Twitter says it prefers adjusted EBITDA because it shows underlying trends that "could otherwise be masked by the effect of the expenses" that Twitter likes to exclude.

In the end, the effect of those expenses is that they add up to fact that Twitter is very unprofitable, and that's not an underlying trend that Twitter likes, or at least wants you to notice on the eve of its $1 billion IPO. Who would?

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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