Some accountants claim that advertising costs should generally be expensed when they are incurred. Proponents of the expense-as-incurred approach argue that any future benefits that may be derived from advertising expenditures are uncertain. Thus, advertising costs should not be capitalized.

Others believe that selected advertising costs should be capitalized. Proponents of selective capitalization argue that many advertising costs have future benefits that are both identifiable and measurable. They reason that capitalization encourages managers to maximize long-term, not simply short-term profits. Because a manager's performance is often assessed on the basis of short-term profits, some managers may eliminate or reduce advertising expenditures in the current period unless advertising costs are capitalized.

A task force was appointed by the Accounting Standards Executive Committee (AcSEC) to study accounting policy issues related to capitalizing advertising costs. A draft SOP, approved by AcSEC in June 1991, has been forwarded to the FASB for comment and will be issued for public exposure.

This article reports on the diversity of current practices for accounting for advertising costs, explains the ambiguity of current authoritative guidance, and reports on the thinking presently reflected in the proposed SOP.

The Need for Comprehensive

Guidance

Several situation-specific standards rather than one comprehensive standard guide the numerous practices that are presently used to account for advertising costs. Because it has been given piecemeal, the guidance is somewhat inconsistent in its philosophy. Some pronouncements specifically allow or require the capitalization of advertising costs. For example, APBO 28, "Interim Financial Reporting," allows deferral of advertising costs within a fiscal year if the benefit of an expenditure clearly extends beyond the interim period in which the expenditure is made. Also, SFAS 53, "Financial Reporting by Producers and Distributors of Motion Picture Films," requires capitalization of pre-release and early release advertising costs if those costs are expected to benefit the film in future markets.

Other pronouncements may be interpreted as allowing the capitalization of advertising costs. For example, SFAS 60, "Accounting and Reporting by Insurance Enterprises," requires capitalizing costs that vary with and are primarily related to the acquisition of new and renewal insurance contracts. One may argue that advertising costs constitute a portion of "acquisition costs" if those costs are necessary in the sale of the policy. Also, SFAS 67, "Accounting for Costs and Initial Rental Operations of Real Estate Projects," states that costs incurred to sell real estate projects should be capitalized if those costs are recoverable from the sale of the real estate project and are incurred for tangible assets that are used throughout the selling period to aid in the sale of the project. Whether advertising costs are comprehend by this wording is unclear. However, it could be argued that advertising costs should be capitalized in this case because the company expects to recover all related costs, including advertising expenditures.

Other GAAP, however, require advertising costs to be charged against income when incurred. For example, APBO 28 states that advertising costs in interim reports should be expensed if the benefits do not clearly extend beyond the interim period in which the expenditure is made. Also, SFAS 13, "Accounting for Leases," as amended, requires that advertising costs pertaining to leases be expensed in the period incurred. Similarly, SFAS 51, Financial Reporting by Cable Television Companies, requires that costs of advertising targeted toward acquisition of new customers be expensed when incurred. This disparity in standards indicates a need for comprehensive guidance.

The Current State: Variety in

Practice

The term "advertising costs" often connotes advertisements found in magazines, television, and other media. It is a term, however, that includes a broader spectrum of costs such as catalog costs, promotional expenditures for both new and established products, costs incurred by publishers to obtain subscriptions, costs of printing manufacturer and retailer coupons, and marketing and underwriting costs related to generating new insurance policies.

Figure 1 reports examples of advertising costs that are presently being capitalized by large public enterprises. These examples are among those considered by the task force in its consideration of current practice. As the figure shows, the types of costs being capitalized are quite diverse.

Figure 1 also shows that three amortization methods are being used: 1) amortization over an arbitrary period; 2) amortization over the life of the capitalized asset or the period of the promotion, and 3) amortization based on related revenue. Moreover, different amortization methods are used for the same type of advertising cost. For example, promotional costs and membership acquisition costs are amortized sometimes over an arbitrary period, sometimes over the life of the asset, and sometimes based on related revenue. Also, some catalog costs are amortized over an arbitrary period while others are amortized based on related revenue. This variation is further evidence of the need for comprehensive guidance.

An Alternative: Selective

Capitalization

Most business professionals agree that advertising gives rise to an intangible asset. Several reasons may explain why sales may occur in a future period as a result of advertising in the current period. First, advertising impressions may build up over time until the customer is eventually persuaded to make a purchase. Second, advertising may be instrumental in introducing a product to a consumer who later develops brand loyalty. Third, the customer may not

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immediately be in the market for the product but will file the memory of the advertising in the back of his or her mind until he or she is in the market for the product.

Numerous empirical studies show a carry-over effect of advertising. Using multi-variate correlation and multiple regression techniques, these studies suggest that advertising benefits do indeed extend to future periods. Also, research studies using econometric models have shown that advertising has a positive effect on the market value of the firm. Thus, there is considerable empirical support for capitalizing advertising expenditures.

Though there is widespread belief that many advertising expenditures give rise to an intangible asset, the real issue is how to measure the benefit. Many researchers have sought to measure the benefits according to industry. Findings have suggested that advertising effectiveness diminishes at reasonably stable rates within an industry. For example, advertising effectiveness in the beer industry declines at an annual rate of 40% to 50%, in the cigarette industry at a rate of 35% to 45%, and in the automotive industry at nearly a 100% rate.

In a study of five industries, it was found that advertising effectiveness varied considerably between firms in different industries. Based on the study's findings, advertising in the food industry and in the drugs and cosmetics industry whould be amortized over about 5.5 years whereas advertising effectiveness in the automotive, tobacco, and soap and cleaners industries was short-lived and did not justify amortization. Because the duration of effectiveness of advertising varies considerably, many have suggested that some form of selective capitalization would be an appropriate policy.

In response to variety in practice, concern expressed by the SEC, encouragement from the FASB, and empirical research findings, a task force was established by AcSEC to study accounting policies related to advertising costs. As a result, AcSEC is preparing an SOP, which is expected to be released for exposure in the second half of 1991. The current thinking of AcSEC would allow the capitalization of the costs of direct response advertising for which a probable future economic benefit is demonstrated. A subsequent write-off period of no more than one year is under discussion, but with perhaps longer periods if very specific criteria are met. The proposed SOP defines direct response advertising and the nature of disclosures that should be made.

In order to effectively implement the practice of capitalizing certain advertising costs, some implementation issues must be addressed.

Which Costs Should Be

Capitalized?

Research has shown that some advertising costs have future benefits and should be capitalized, while the benefits of other advertising costs are too uncertain to justify any accounting treatment other than an immediate charge to expense. The greatest question has been whether operational criteria can be established to decide which advertising costs should be capitalized. Results of empirical research have provided some insights regarding which advertising themes and layouts are most effective as to memorability, interest, importance, attraction, and understandability. These empirical findings suggest that industry characteristics, the type of advertising, and the newness of the product are factors that should be considered in deciding which costs should be capitalized.

The current AcSEC thinking is that only incremental direct costs of direct response advertising incurred with independent third-parties or represented by payroll and payroll related costs of employees would qualify for capitalization.

Amortization Term and Method

Various proposals have been developed to estimate the rate of loss of an advertising asset. Four methods for amortizing an advertising asset have been proposed: straight-line, advertising awareness models, experimental design, and multiple regression.

Straight-line amortization allocates advertising costs over some arbitrary period. Although the exact period of future benefit is unknown, reasonable estimates can be made. This method is the simplest to apply. Figure 1 shows that some advertising costs are presently amortized on a straight-line basis over periods ranging from one to three years.

Advertising awareness models predict advertising exposure and the diminishing response rate of advertisements. Under these models, costs are allocated to the same period in which revenues are expected and are based on the decay of advertising effectiveness. The advertising asset is charged to expense when it has been forgotten by the consumer. The advantage of advertising awareness models is availability. The validity and reliability of those models, however, are doubtful. Because these models stress awareness rather than a positive attitude toward the product, there is doubt regarding whether the model is measuring the desired attribute. Consumer awareness does not necessarily indicate a positive attitude toward the product. Also, bias is introduced through the interview with the consumer.

The experimental design method uses an adaptation of sample models developed by the marketing department to estimate the advertising asset. This method has the greatest accuracy of the three mathematical models and is the most efficient predictor of the value of the advertising asset. Too much reliance, however, is placed on the most recent period, and the cross of applying this method exceed the benefits derived unless the data is already available from the marketing department.

The multiple regression method develops an equation based on the relationship of advertising to sales over several years. This method is simple, and many appropriate computer programs are available. Multiple regression, however, has several potential pitfalls. First, the method assumes that relationships among variables remain the same. Second, the user may overlook the basic assumptions of multiple regression. For multiple regression to be valid, a linear relationship should exist between sales and the dependent variables. Third, high correlation among variables does not guarantee a cause and effect relationship. Finally, a variable cannot be predicted outside the relevant range (area of observations).

All of the mathematical models have significant limitations, so the straight-line method has frequently been adopted. The proposed SOP, however, as presently being considered would require amortization in relationship to current and future period revenue streams, and generally over no more than a one-year period.

Tax Implications

Authors Flesher and Saroosh argue that one reason advertising costs are ordinarily expensed is because of tax considerations. At the present time, advertising expenditures represent an immediate tax shelter. Present tax laws that allow expenditure of advertising costs result in substantial tax subsidies. If the practice of capitalizing advertising costs with subsequent write-offs is adopted by AcSEC, many fear that the IRS would follow with similar regulations that would reduce or eliminate this subsidy. Advertising expenditures of many entities are often as great as earnings. Thus, the effects of such a change in tax policy could be great, especially during the transition years.

The advertising industry has, in fact, expressed concern about the possibility of capitalizing advertising costs. The task force and AcSEC have been subjected to a barrage of objections from advertising agency industry associations, users of heavy advertising, and CPAs. These objections did not involve the nature of the asset or its measurability. The only objection has been with respect to how the IRS will view the guidance ultimately given in the SOP. The dread fear of the advertising industry is that the IRS will require capitalization of advertising.

Would such a change, in fact, produce a change in tax policy? A conclusive answer to that question is not possible. Japanese and Korean businesses already must write off advertising expenditures over three years. In the U.S., early drafts of the last two tax reform acts have contained similar provisions. There are numerous examples, however, of alternative accounting treatments for financial reporting and tax reporting purposes.

The Matter Now Rests with

AcSEC

After all the discussion, AcSEC has now crystallized its thinking. Its proposal, which apparently has been significantly influenced by the SEC, is to narrowly limit the advertising costs that may be capitalized by introducing the notion mentioned earlier of direct response advertising. Direct response means there must be traceable connection between the specific advertisement or promotional material and the response of a customer. The costs of institutional advertising would not qualify and the costs of television advertisements as currently constructed would probably not qualify.

It will be interesting to see the comments that the proposed accounting receives. Businesses that have been capitalizing significant amounts of advertising for magazine and television may be puzzled by the narrow definition. Businesses don't expend such funds without expectation of future economic benefit, which, apparently for the sake of objectivity and measurability, the accounting fraternity has chosen to ignore.

By James H. Thompson, Oklaboma City University; Margaret A. Hoskins, Henderson State University; and Dale L. Flesher, University of Mississippi