By C. Richard Baker
In Brief
Adapting Proven Rules to a New Phenomenon
When Internet company stock prices entered a period of volatility in 1999, both the financial press and the SEC took notice. The SEC also took action, asking FASB’s Emerging Issues Task Force (EITF) to address a number of their concerns regarding accounting for Internet activities. The EITF put those issues on its technical agenda and began addressing them systematically.
As the line between traditional companies and Internet entities becomes increasingly blurred, the SEC and EITF’s positions on the accounting practices of Internet pioneers will affect all businesses. Several issues remain to be considered, but from the conclusions it has already reached, it would appear that with few exceptions the EITF found ways to make the accounting rules that worked for the “old economy” work just as well for the “new economy.”
Internet companies have done more than accelerate transaction processing—they have resurrected old accounting issues that call for today’s accounting and auditing professionals to apply yesterday’s methods of accounting for certain types of transactions.
The growing number of companies with Internet activities has prompted the SEC to address accounting for these activities. In October 1999, SEC Chief Accountant Lynn Turner sent a letter to Tim Lucas, FASB director of research and technical activities, requesting that FASB’s Emerging Issues Task Force (EITF) consider a number of issues related to accounting for Internet activities. The EITF responded by placing these issues on its technical agenda, and it has reached consensus views on many of them.
The SEC staff focused on certain situations where—
Some issues are a function of the new business models used by Internet companies, while others have broader application (e.g., questions about accounting for barter transactions and coupon and rebate programs). In general, the SEC staff has taken the position that Internet companies should follow established accounting practices when they engage in transactions that are similar to those entered into by companies without Internet activities.
The issues raised by the SEC staff warrant consideration from the accounting and financial reporting community. They constitute a challenge and an opportunity for improving financial reporting in a new segment of the economy. The SEC staff also feels that the resulting guidance should address classification and disclosure issues in addition to recognition and measurement questions. This concern has been prompted by the high volatility in Internet company shares, combined with a perception that their underlying fundamentals are not well understood.
Turner’s letter outlined 20 issues in five categories:
The SEC staff assigned each issue a priority level of 1, 2, or 3. The SEC Staff asked the EITF to address the five level 1 issues on an expedited basis and the six level 2 issues and the five level 3 issues on a timely basis. The four remaining issues would be addressed through SEC staff announcement bulletins (SAB).
In response to the SEC letter, the EITF assigned issue numbers to most of the items. Thus far, the EITF has resolved 10 issues through consensus (see the Exhibit). Three issues are still under consideration, five are inactive, one has been dropped from consideration, and one issue was referred to the AICPA Accounting Standards Executive Committee (AcSEC). In reaching its consensus views, the EITF relied on FASB Concept Statements, FASB Statements of Financial Accounting Standards (SFAS), APB Opinions, AcSEC Statements of Position (SOP), and other similar guidance.
Gross vs. Net
The six issues included in this category address the question of whether revenues should be presented on a gross basis, with rebates, coupons, incentives, and other costs treated as operating expenses, or whether these types of items should be netted against revenue. The issue is not just a matter of financial statement display—it cuts directly to the definition of revenue in the new economy. For example, companies like Priceline or eBay may report revenues based on the full price of the products they sell (e.g., airline tickets or collectibles), or they may report as revenue only the commissions that they earn from those sales. Because such companies are often valued on a multiple of revenues rather than a multiple of earnings, the revenue presentation becomes important.
Issue 1: Should a company that acts as a distributor or reseller of products or services record revenues as gross or net? The SEC staff assigned this issue a priority level of 1 and the EITF placed it on its technical agenda as Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.” The FASB staff summarized this issue as follows:
The issue is whether a company should recognize revenue in the amount of the gross amount billed to the customer because it has earned revenue from the sale of the goods or services or whether the company should recognize revenue based on the net amount retained (the amount paid by the customer, as defined above, less the amount paid to the vendor-manufacturer) because, in substance, it has earned a commission from the vendor-manufacturer of the goods or services on the sale. [This is] an increasingly important issue because investors appear to value the stock of certain companies based on a multiple of gross revenues rather than a multiple of gross profit or earnings.
The EITF reached a consensus on Issue No. 99-19 at its July 2000 meeting. Its resolution was influenced by SAB 101, in which the SEC staff said that if a company acts as an agent or broker, without assuming the risks and rewards of ownership of the product, revenues should be reported net, not gross.
Issue 2: Should a company that swaps website advertising with another company record advertising revenue and expense? This issue, dealing with the question of gross versus net revenue display, was given a priority level of 1. It is a common practice for Internet companies to swap advertising on each other’s websites. If revenues and expenses are recognized in a barter transaction, the amounts would ordinarily be equal, as long as the bartered advertisements are of equal value; consequently, net income would not be affected. Nonetheless, revenues would be enhanced, possibly affecting market valuation. The EITF placed this issue on its technical agenda under EITF Issue No. 99-17, “Accounting for Advertising Barter Transactions,” and summarized it as follows:
Some [Internet] entities record an equal amount of revenue and expense for the [advertising] space they sell and for the space they purchase resulting in no effect on net income or cash flows. To the extent that revenues include barter transactions for which there is no ultimate realization in cash and no effect on net income, the practice may lead to overstated revenues and artificially inflated market capitalization. The issue is whether Internet barter transactions that involve a nonmonetary exchange of rights to place advertisements on web sites result in recorded revenues and expenses.
At its January 2000 meeting, the EITF reached a consensus that revenue and expense should be recognized in a barter transaction only if the fair value of the advertising exchanged is determinable based on a company’s historical practice of cash sales of similar types of advertising with buyers unrelated to the counterparty in the barter transaction. This consensus may curb the practice of recognizing revenue from bartered advertising transactions. The historical practice of cash sales must have occurred no more than six months prior to the barter transaction. Because previous cash sales are used to benchmark the fair value of the barter transaction, barter revenues and expenses can be recognized only up to the amount of the previous cash sale. Moreover, the bartered advertisement must be essentially the same as the advertisement sold for cash (e.g., same type of advertisement, same website).
Issue 3: Should discounts or rebates offered to purchasers of personal computers in combination with Internet service contracts be treated as a reduction of revenues or as a marketing expense? Discounts and rebates are usually deducted from gross revenues to arrive at a net revenue figure that is the basis of revenue reporting. Internet companies, however, do not always follow this treatment. Discounts and rebates have been reflected as operating expenses rather than as reductions of revenue.
The SEC staff did not assign a priority level to this issue, but indicated that discounts of this nature should be recorded as reductions of revenues. Because Issues 3, 5, 6, and 20 all have aspects in common, the EITF combined them into Issue No. 00-14, “Accounting for Coupons, Rebates, and Discounts,”
At its May 2000 meeting, the EITF reached a consensus that discounts and rebates should be treated as reductions of revenue and not as marketing or promotional expenses. At its July 2000 meeting, the transition date was revised to correspond with the implementation date for SAB 101. The accounting for coupons should follow established accounting practices in other industries; that is, a marketing expense and a related liability equal to the estimated value of coupons that will be redeemed should be recorded in the period of issuance.
Issue 4: Should shipping and handling fees collected from customers be included in revenues or netted against shipping expense? Internet companies often arrange for the delivery of products and typically treat customer delivery charges as credits against sales and administrative expenses, although some Internet companies include delivery charges among revenues. The SEC staff assigned this issue a priority level of 2, and the EITF added it to its technical agenda as Issue No. 00-10, “Accounting for Shipping and Handling Revenues and Costs.” The FASB staff summarized the issue as follows:
Many sellers charge customers for shipping and handling in amounts that are not a direct pass-through of costs. Some display the charges to customers as revenues and the costs as selling expenses, while others net the costs and revenues. The SEC staff notes that companies generally do not provide any separate disclosure of shipping revenues and costs (for example, by reporting shipping revenue and costs as separate line items, or by providing footnote disclosure of the gross shipping revenues and costs). Additionally, companies appear to classify shipping and handling expenses inconsistently within expenses. Some companies include shipping and handling expenses in cost of goods sold, while others include shipping and handling expenses in selling expenses. The Issue is how shipping and handling costs should be reported.
The EITF reached a consensus on this issue at their July 2000 meeting; however, the issue was reopened at the September 2000 meeting. The EITF concluded that all amounts billed to a customer for shipping and handling could be classified as revenue if properly disclosed as such, and that all costs incurred by the seller for shipping and handling should be classified as cost of goods sold.
Definition of Software
Issue 7: Should the accounting for products distributed via the Internet, such as music, follow pronouncements regarding software development or those of the music industry? Turner’s letter addresses the question of whether websites, or information available on websites, should be deemed to be software and therefore be subject to the provisions of SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed; SOP 97-2, “Software Revenue Recognition”; and SOP 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.”
The SEC staff assigned this issue a priority level of 2. Although the EITF initially considered this issue along with Issue 8, it subsequently decided to deal with it separately and assigned it a temporary number, Issue No. 00-x1, “Accounting for the Costs of Computer Files that Are Essentially Films, Music, or Other Content.” Although it is currently inactive pending resolution of other issues, the SEC staff has indicated that the costs of software products that include audio and video elements should be accounted for under the provisions of SFAS 86 and SOP 97-2. In other words, the accounting should follow pronouncements dealing with software development.
Issue 8: Should the costs of website development be expensed similar to software developed for internal use in accordance with SOP 98-1? The SEC Staff assigned this issue a priority level of 1 and the EITF added it to its technical agenda as Issue No. 00-2, “Accounting for Web Site Development Costs.” The FASB staff summarized the issue as follows:
Costs of developing a web site, including … chat rooms, search engines, e-mail, calendars, and so forth … should be accounted for in accordance with SOP 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” as software developed for internal use.
At its March 2000 meeting, the EITF reached a consensus that accounting for website development costs should follow the provisions of SOP 98-1. Both EITF Issue No. 00-2 and AICPA SOP 98-1 are complex. Essentially, the accounting depends upon the stage of the development activity. During the planning stage, website development costs should be expensed as incurred. During the infrastructure development stage, costs should be capitalized. During the operating stage, costs should be expensed as incurred and the amortization of capitalized costs should begin. EITF Issue No. 00-2 offers further guidance regarding websites.
Revenue Recognition
The revenue recognition practices of Internet companies are of particular concern because of the emphasis investors place on their revenues. In late 1999, the SEC issued SAB 101, “Revenue Recognition in Financial Statements,” which reiterated that revenue should not be recognized until it is realized, or realizable, and earned. This does not occur until four criteria have been met:
Resolution of revenue recognition issues for Internet activities should follow the provisions of SAB 101.
Issue 9: How should an Internet auction site account for up-front and back-end fees? The SEC staff recommended that the FASB staff issue an announcement that up-front fees should be recognized over the period of performance, normally the listing period. The SEC staff assigned back-end fees a priority level of 3, and indicated that the facts and circumstances of auction websites vary, making guidance on accounting treatment difficult. The FASB staff concluded that SAB 101 provides sufficient guidance regarding revenue recognition for up-front and back-end fees—that is, they should be recognized over the period of performance—and that there is no need for further EITF action. The EITF has retained this inactive issue on its agenda as Issue No. 00-x2, “Accounting for Front-End and Back-End Fees.”
Issue 10: How should arrangements that include the right to use software stored on another company’s hardware be accounted for? The SEC staff assigned this issue a priority level of 2 and the EITF added the issue to its technical agenda as Issue No. 00-3, “Application of AICPA Statement of Position 97-2, Software Revenue Recognition, to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware.” The FASB staff summarized the issue as follows:
Some purchasers of software do not actually receive the software. Rather, the software application resides on the vendor’s or a third party’s server, and the customer accesses the software on an as-needed basis over the Internet. Thus, the customer is paying for two elements: the right to use the software and the storage of the software on someone else’s hardware [hosting]…. When the vendor also provides the hosting, several revenue recognition issues may arise. First, there may be transactions structured in the form of a service agreement providing Internet access to the specified site, without a corresponding software license. In such instances, it may not be clear how to apply SOP 97-2. Second, when the transaction is viewed as a software license with a service element, it isn’t clear how to evaluate the delivery requirement of SOP 97-2.
At its March 2000 meeting, the EITF reached a consensus that SOP 97-2 applies to software-hosting arrangements only if the customer has a contractual right to take possession of the software at any time during the hosting period without a significant penalty and if it is feasible for the customer to either run the software on its own hardware or contract with a third party to host the software. If not, then the hosting arrangement is a service contract and falls outside the scope of SOP 97-2. If the hosting arrangement falls within the scope of SOP 97-2, then delivery of the software occurs when the customer has the ability to take immediate possession of it. If there are multiple elements to the product or service, revenue should be recognized as delivered on an element-by-element basis, proportionate to the relative fair values of the elements and vendor-specific objective evidence (VSOE) used to determine relative fair values.
Issue 11: How should revenues associated with providing access to, or maintenance of, a website, or publishing information on a website, be accounted for? The SEC staff did not indicate a priority level for this issue but it did recommend that the FASB staff issue an announcement that such fees should be recognized over the performance period (the period over which the company agrees to maintain the website or the information on it). The FASB staff concluded that SAB 101 provides adequate guidance regarding revenue recognition for fees like this and that further EITF action was not needed. The EITF has retained this inactive issue on its agenda as Issue No. 00-x3, “Accounting for Access, Maintenance, and Publication Fees.”
Issue 12: How should advertising revenue contingent upon “hits,” “viewings,” or “click-throughs” be accounted for? The SEC staff assigned this issue a priority level of 3 and the FASB staff summarized it as follows: [Internet advertising] arrangements often include guarantees on “hits,” “viewings,” or “click-throughs.” It isn’t clear how the provider of the advertising takes progress towards these minimums into account in assessing revenue recognition. … the terms of these arrangements vary somewhat from contract to contract. To the extent that payment for these arrangements is made with equity securities, any consensus reached should be reconciled with the consensus in EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and … EITF Issue No. 99-Q, “Accounting by the Holder of an Instrument (That Does Not Meet the Definition of a Derivative Instrument) with Conversion or Exercisability Terms That Are Variable Based upon Future Events.”
The EITF has placed this issue on its technical agenda as Issue No. 00-x4, “Accounting for Advertising or Other Arrangements Where the Service Provider Guarantees a Specified Amount of Activity,” pending further progress on active issues.
Issue 13: How should “point” and other loyalty programs be accounted for? The SEC staff assigned this issue a priority level of 2 and the EITF added it to its technical agenda as Issue No. 00-22, “Accounting for ‘Points’ and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future.” The FASB staff summarized the issue as follows:
There is a growing number of “point” and other loyalty programs being developed in Internet businesses.… There are companies whose business models involve building a membership list through this kind of program. In some cases, the program operator may sell points to its business partners, who then issue those points to their customers based on purchases or other actions. In other cases, the program operator awards the points in order to encourage its members to take actions that will generate payments from business partners to the program operator. … The Issue is scoped broadly to include all industries that utilize point or other loyalty programs, including the airline and hospitality industries.
The EITF has not yet reached a consensus on this issue. Specific industries would be excluded from the scope of this issue to the extent that they are addressed by higher level GAAP; however, not much guidance currently exists. For example, the AICPA Industry Audit Guide Audits of Airlines does not address accounting for frequent-flyer programs.
Prepaid/Intangible Assets vs. Period Costs
Companies with Internet activities may make payments to build up a customer base, obtain advertising space, secure distribution rights, or enter into supply agreements. The question of whether to capitalize or expense such costs is not always clear; neither is how to assess impairment of a capitalized intangible right. In some cases, companies assert that Internet distribution rights are immediately impaired because their best estimate of the expected cash flows indicates that the asset is not recoverable. Expensing such costs is a conservative treatment, but the SEC staff is concerned that aggressive expensing of such costs can lead to future earnings management.
Issue 14: How should a company assess the impairment of capitalized Internet distribution costs? The SEC staff assigned this issue a priority level of 1. Because this issue has similarities with situations in which there is an economic loss on a firmly committed contract, the EITF has combined it and Issue 15 under EITF Issue No. 99-14, “Recognition of Losses on Firmly Committed Executory Contracts.” The EITF has yet to reach a consensus on this issue, which the FASB staff summarized as follows:
FASB Technical Bulletin No. 79-15, “Accounting for Loss on a Sublease Not Involving the Disposal of a Segment,” states that “the general principle of recognizing losses on transactions and the applicability of that general principle to contracts that are expected to result in a loss are well established” (paragraph 2). Nevertheless, in numerous situations explicit loss recognition guidance is not provided; for example, whether to recognize a loss on an operating lease when a lessee expects to continue utilizing the leased asset, and Internet arrangements (such as a fixed up-front cash payment to become a sole search provider). The issue is whether, and, if so, under what conditions, a loss should be recognized on firmly committed executory contracts.
Issue 15: How should up-front payments made in exchange for certain advertising services provided over a period of time be accounted for? The EITF has not yet reached consensus on Issue No. 99-14, which combines Issues 14 and 15. The SEC staff has indicated that there should not be an automatic presumption of impairment leading to an immediate write-off of up-front payments and that impairment should not be recognized unless conditions have changed since making the up-front payment.
Issue 16: How should investments in building up a customer or membership base be accounted for? The SEC staff assigned this issue a priority level of 3 and noted that most companies appear to be expensing these costs as incurred, so there may be little diversity in practice. The EITF decided not to address this issue, but suggested that AcSEC consider it.
Miscellaneous Issues
Issue 17: Does the accounting by holders for financial instruments with exercisability terms that are variable-based future events, such an IPO, fall under the provisions of SFAS 133? The SEC staff assigned this issue a priority level of 2 and the EITF addressed it in Issue No. 00-8, “Accounting by a Grantee for an Equity Instrument to be Received in Conjunction with Providing Goods or Services.” The FASB staff summarized the issue as follows:
Instruments often have conversion or exercisability terms that are variable based upon future events, such as the attainment of certain sales levels or a successful IPO. The issuer’s accounting does not appear to raise new issues as it is covered by EITF Issues No. 96-18, “Accounting for Equity Instruments that Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” and No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios.” For the holders, the instruments may be within the scope of SFAS 133, Accounting for Derivative Instruments and Hedging Activities. However, because one or more of the underlyings are often based on the holder or issuer’s performance, SFAS 133 will not always apply.
At its March 2000 meeting, the EITF reached a consensus that the provisions of SFAS 133 would apply when an equity instrument is received in conjunction with providing goods or services. Subsequently, the EITF decided to add the following paragraph to the Issue No. 00-8 consensus:
In accordance with paragraph 28 of APB Opinion 29, the Task Force observed that companies should disclose, in each period’s financial statements, the amount of gross operating revenue recognized as a result of nonmonetary transactions addressed by Issue No. 00-8. Furthermore, the SEC Observer reminded registrants of the requirement under Item 303(a)(3)(ii) of Regulation S-K to disclose known trends or uncertainties that have had or that a registrant reasonably expects to have a material favorable or unfavorable impact on revenues.
Issue 18: Should Internet operations be treated as a separate operating segment in accordance with SFAS 131? The SEC did not assign a priority level to this issue but indicated that the staff would be monitoring it. The FASB staff believes that SFAS 131, “Disclosures About Segments of an Enterprise and Related Information,” and the related FASB staff Implementation Guide, “Segment Information: Guidance on Applying Statement 131,” provide sufficient guidance on this issue.
Issue 19: Should there be more comparability between Internet companies in the classification of expenses by category? The SEC staff assigned this a priority level of 3 and the FASB staff summarized the SEC’s concerns as follows:
The SEC staff noted that classification of expenses between various categories (for example, cost of sales, marketing, sales, and R&D) sometimes varies significantly among Internet companies for costs that appear similar. … [I]t is difficult to identify common elements between the classification issues that have arisen, making the preparation of general guidance difficult. Furthermore, EITF consensuses normally do not specify how expense items should be classified on the income statement, and classification conventions frequently develop based on industry practice.
The EITF decided that this inactive item should remain on the agenda pending further progress on related active issues.
Issue 20: How should companies account for on-line coupons? The SEC staff assigned this issue a priority level of 2 and the EITF included it with Issues 3, 5, and 6 as Issue No. 00-14.
Nothing New About the ‘New Economy’?
From the manner in which the SEC has articulated the issues in its letter to the EITF and the manner in which the EITF has addressed them, it is difficult to conclude that the issues are really new. Most issues appear to be resolvable by applying previous accounting pronouncements to the facts and circumstances of the Internet environment. Companies operating in the fast-paced Internet environment may think that their transactions require new accounting, but this assertion of uniqueness may not be supportable.
Although the list of issues raised by the SEC staff appears to be complex, the EITF worked to resolve them based on interpretations and guidance found in existing accounting pronouncements. The advent of the “new economy” does not appear to require radical changes to the traditional accounting model. The SEC staff wanted the issues addressed by the EITF because of perceived abuses and inconsistencies. Rapidly expanding Internet companies tend to focus on their technology and marketing, not the quality of their accounting. Consequently, inconsistencies may result from a lack of knowledge rather than attempts to mislead. Nevertheless, the likelihood of aggressive revenue recognition practices to sustain the growth of Internet companies means that the provisions of SAB 101 are particularly pertinent.
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