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May 1994

Reporting on advertising costs. (includes related articles)

by Finger, Andrew D.

    Abstract- The new statement of position (SOP) issued by the AICPA's Accounting Standards Executive Committee (AcSEC) severely limits the methods available to companies for allocating the cost of advertising to expense. According to the SOP, all entities must expense the costs of all advertising either the first time that the advertising takes place or within the periods in which advertising costs were incurred. Exempted from this rule is direct-response advertising that results in 'probable future economic benefits' and that which aims to generate sales to customers who could be proven to have responded to the advertising. Other types of advertising not covered by the new SOP are those for which guidance is provided by pronouncements appearing above AICPA SOPs in the generally accepted accounting principles hierarchy of Statement of Accounting Standards No. 28.

The AICPA's Accounting Standards Executive Committee (AcSEC) recently issued a statement of position, SOP 93-7, Reporting on Advertising Costs. The SOP applies to advertising of all entities except advertising for which guidance is provided by pronouncements that are above AICPA SOPs in the GAAP hierarchy of SAS No. 69. It does not apply to financial statements for interim periods. APB Opinion No. 28, Interim Financial Reporting, paragraphs 15 and 16, provides guidance for interim periods. The SOP is effective for years beginning on or after June 15, 1994, and amends AICPA SOPs that include guidance for advertising to conform to the guidance in the SOP.

The SOP is intended to be the first step in a multi-step AcSEC project on reporting the costs of activities undertaken to create probable future economic benefits through the development of intangible assets, such as advertising, pre-opening, start-up, and similar activities.

Summary of the SOP

The guidance in the SOP is based on the premise that most advertising may result in probable future economic benefits that meet the definition of an asset in FASB Concept Statement No. 6, Elements of Financial Statements. However, AcSEC concluded that those assets, (with the exception of assets resulting from certain direct-response advertising) would not meet the recognition criteria of reliability in FASB Concept Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. Under Concept Statement No. 5, to be reliable, the information must be representationally faithful, verifiable, and neutral. AcSEC concluded that for most advertising, the probable future economic benefits are not measurable with the degree of reliability required to report an asset in the financial statements. The exception is direct-response advertising that may result in probable future economic benefits that are measurable with the degree of reliability required to report an asset in the financial statements. However, readers are cautioned that though the SOP includes lengthy discussions about direct-response advertising, most advertising does not qualify for capitalization beyond the first showing.

The SOP requires the following:

* Generally, the costs of all advertising should be expensed either in the periods in which those costs are incurred or the first time the advertising takes place.

* The exception is direct-response advertising a) whose primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising and b) that results in probable future economic benefits (future benefits).

The future benefits are probable future revenues the entity would not have without the advertising in excess of the costs to be incurred in realizing those revenues.

Demonstrating that direct-response advertising will result in future benefits requires persuasive evidence that its effects will be similar to the effects of responses to past direct-response advertising that resulted in future benefits.

Showing that a customer responded to direct-response advertising requires documentation linking the advertising to the sale, including a record that can identify the customer and the advertising that elicited the direct response. Such a record may include a file indicating the customer name and related direct-response advertisement; a coded order form, coupon, or response card included with an advertisement indicating the customer name; or a log of customers who have made phone calls to a number appearing in an advertisement.

Industry statistics would not be considered objective evidence that direct response advertising will result in future benefits.

The costs of advertising directed to all prospective customers, not only the portion of the costs attributable to individuals who become customers, should be used to report such assets initially. The costs eligible for capitalization include only incremental direct costs of the direct-response advertising.

The amounts of direct-response advertising reported as assets should be amortized over the estimated period of the benefits, based on the proportion of current period revenue from the advertisement to probable future revenue, subject to a net realizable value test. The realizability of amounts at which the future benefits of direct-response advertising are reported as assets should be evaluated at each reporting date.

* Costs of communicating advertisements, such as the costs of magazine space and television air time, should not be reported as expenses before the item or service has been received.

* The financial statements should disclose--

-The accounting policy for reporting advertising, including whether it is expensed as incurred or the first time the advertising takes place.

-Total advertising expense, with separate disclosure of amounts written down to net realizable value.

-Total advertising reported as assets in each balance sheet presented.

The two accompanying sidebars illustrate the accounting under the SOP.

AcSEC's Deliberations

AcSEC's deliberations of the SOP were contentious, and at times it appeared the project might be terminated. The four alternatives considered by AcSEC on the key issues included expensing advertising (other than direct response advertising that qualified for capitalization) a) as incurred, b) the first time the advertising is shown for its intended purpose, c) over the estimated life of the advertising campaign, or d) over the estimated life of the advertising campaign, but not to exceed one year. AcSEC eventually reached a supermajority on the issue, by compromising to permit either a) or b).

Effects on Practice

Currently, practice is diverse. Other than certain industries covered by specific pronouncements, such as FASB Statement No. 51, Financial Reporting by Cable Television Companies, there has been no authoritative accounting literature for advertising. (Entities which are covered by specific FASB Statements, ARB Opinions, and Opinions of the Accounting Principles Board--category (a) GAAP--will continue to follow those pronouncements.) Current practice includes the four alternatives considered by AcSEC, as well as expensing advertising at other points over the continuum covered by those alternatives.

Under the SOP, most advertising will be expensed at least as early and usually earlier than it would have been without the SOP. For example, some entities that produce television commercials to be used over a six- month period currently amortize those costs over that six-month period. Under the SOP, those costs must be expensed either as incurred or the first time the commercial is shown. Also, some entities develop print advertisements to be used in, say, 10 different magazines. Some of those entities currently allocate one-tenth of the cost of developing the advertisement to each magazine and expense that cost when the advertisement runs in that particular magazine. Further, some entities may amortize those costs over the expected period the advertisement will generate revenues, or, if the advertisement will run in three consecutive issues, they may amortize one-third of the costs allocated to that magazine each time the advertisement runs. Under the SOP, all costs of producing the advertisement will be expensed as incurred or the first time the advertisement runs in the first magazine. Under current practice for most entities and under the SOP, the costs of the advertisement space in the magazine would not be expensed until the advertisement has run.

For direct-response advertising eligible for capitalization under the SOP, many entities have been and will continue to capitalize such costs, perhaps modifying their policies for cost basis and amortization. Those that have not been capitalizing direct-response advertising will begin to. For some entities, the SOP may encourage new methods of tracking information and require new methods of record keeping.

For most entities, the SOP will provide clearer guidance than currently exists. For auditors, it will establish guidelines for an area that previously relied on subjective management estimates. For financial statement users, it will increase comparability among different entities. However, the SOP is not a cookbook and subjective judgements by both reporting entities and auditors will be required.

By permitting advertising (other than direct-response advertising) to be expensed either as incurred or the first time the advertising takes place, AcSEC is permitting an alternative, but one that must be applied consistently.

The Trend

Some conclusions in the SOP, such as what is required for capitalization of advertising, are based on conceptual principles. Other conclusions, such as limiting advertising eligible for capitalization to direct- response advertising, are based on arbitrary practical cuts. The conclusions in the SOP represent the current trend of keeping "soft assets" off the balance sheet and requiring the realizability of reported assets. The completion of future phases of the project are at least a few years off and can not be predicted. However, if the advertising project is any indication, there will be more specific accounting guidance and less soft assets on the balance sheet in the future.


Facts: SureFire Soft Drink Company hires Johnny Pop to act in a major ad campaign that will first be shown during the Super Bowl on the Accountants Sports Network (ASN), and subsequently on several other networks through the year. SureFire incurs $10 million of production costs in November and December of 19X1, including $2 million paid to Mr. Pop. In addition, SureFire buys two minutes of January 1992 ad time from ASN for $1 million. SureFire's year end is December 31.


* SOP 88-1, Accounting for Developmental and Preoperating Costs, Purchases and Exchanges of Take-off and Landing Slots, and Airframe Modifications, paragraph 22.

* SOP 89-5, Financial Accounting and Reporting by Providers of Prepaid Health Care Services, paragraph 55.

* SOP 90-8, Financial Accounting and Reporting by Continuing Care Retirement Communities, paragraph 15.


Facts: Envelope Stuffers Inc. conducts a June 1, 19X1, direct mail ad campaign for its highly successful product, glow-in-the-dark sunglasses. Envelope mails one million solicitations at a cost of $400,000 (40 cents per solicitation). Envelope's records show that historically, 2% of all mailings result in the sale of one pair of glasses at a sales price of $60 and a gross profit of $52. Ninety percent of all the sales occur before June 30 and 10% occur after June 30. Envelope's year end is June 30.

Question: How should Envelope account for the transaction?

Answer: At June 50, 19X1, Envelope should capitalize $40,000 in advertising costs ($400,000 in total costs x 10% of costs expected to result in revenues after June 30, 19X1.) and expense the remaining $360,000 in advertising costs. A net realizable value (NRV) test at June 30, 19X1 would be applied by comparing the $40,000 in reported assets with their NRV of $104,000 (1,000,000 pieces mailed x .02 response rate x $52 gross profit per piece x 10% of response expected after June 30, 19X1). Since the NRV exceeds the carrying amount of the asset, no write down would be required.

Joel Tanenbaum, CPA, a technical manager of the AICPA accounting standards division, was assigned to the task force that assisted in developing the SOP. Andrew D. Finger, CPA, is a partner in Cohen & Company, a member of the advertising task force, and a former member of AcSEC.

The views of Mr. Tanenbaum as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process, and deliberation.

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