Internet firm revenue recognition issues

By Jack Ciesielski, CPA, CFA
President, R.G. Associates, Inc.
Member, AICPA Financial Accounting Standards Advisory Committee
Member, MACPA Board of Directors

Recently, lots of press was devoted to several revenue recognition practices of e-tailers. The practices in question: gross vs. net revenues, and the treatment of advertising barter transactions. I've put together an outline of the issues that might be helpful in understanding what the fuss is all about. Financial statement users ought to be most aware of this: accounting for revenues is not an area where a lot of ink has been spilled by standard setters on an industry-by-industry basis — and it needn't be. The general concept involved in revenue recognition is this: a firm should recognize revenue only when it's completed its end of a bargain. When goods are involved, that usually means they've been delivered and return of the goods is unlikely. When services are involved, it usually means that work has been performed to a customer's satisfaction. And the footnotes to the financial statements should explain clearly how a firm accounts for its revenue recognition practices.

There is no reason why Internet firms should deviate from these basic principles. Just because goods or services are sold over a different medium, revenue recognition criteria shouldn't differ.

I. Gross vs. net revenues

Say that Sears buys a washing machine and resells it at a higher price. Sears has ownership and title to that washing machine until it's sold; it's included in Sears' inventory until it's sold. If that washing machine is destroyed while it's still in inventory, Sears would have to eat the loss. No one would likely argue that Sears should record only its gross profit on the sale as revenue, instead of the washing machine's retail value.

Suppose Sears were to buy an airline ticket in the hopes of selling it for a higher price to a customer. If the plane takes off without Sears selling that ticket, Sears is faced with the loss. If they sell the ticket, then Sears would include the total ticket price to the customer in their revenues. It's no different than the washing machine — and whether they sell the ticket or the washing machine over the Internet makes no difference, either.

Suppose Sears merely brokered the marriage of the buyer and seller of the ticket or the washing machine for a percentage of the transaction's value; it never took title to either good, had no risk of loss, and never held it in inventory. Including the full retail value of the transaction, be it airline ticket or washing machine, in revenues wouldn't make sense: they never sold something they owned. Instead, the commission realized by Sears for brokering the transaction is the revenue.

The SEC has been concerned that some firms are mixing the two kinds of transactions: reporting as full-fledged sales transactions that are in substance only brokered arrangements. The reason firms would be prone to do this is because Internet firms are likely to valued on the basis of revenues, since earnings don't exist for most of them.

Users of financial statements should closely examine the revenue recognition footnote of Internet commerce firms - and if it is not clear as to what are their practices, management should be questioned vigorously. If their revenue recognition practices seem inconsistent with the way the firm is known to do business, then they may be a candidate for a revised policy — and a revision of reported revenues.

II. Advertising barter transactions

Another concern of the SEC is that Internet firms are trading advertising on each other's websites and reporting such transactions as a grossing-up of both revenues and expenses - which consequently could make revenues look much larger, swelling market capitalizations as well. There is no effect on earnings in such transactions, and no cash effect. But an illusion of "hugeness" can be created, which may not be very likely to be deserved.

There's nothing new about advertising barter transactions — they're very common in the television and radio broadcasting industries, and have been for years. Internet players that have employed such arrangements include America Online, Go2Net, InfoSpace, Inktomi, and Sportsline.com.

The Emerging Issues Task Force (EITF) of the FASB discussed this topic at its November 18 meeting. Three views on the subject were presented:

VIEW A: Revenues and expenses should not be recognized from advertising barter transactions. The hard line. Problem is, there could be genuine transactions and economic activity that doesn't get reported in the financial statements because of a prohibition like this.
VIEW B: Revenues and expenses should be recognized from advertising barter transactions at the more readily determinable fair value of the advertising surrendered or received in the exchange. The other extreme. The trouble here is that anything goes: an advertising card might be the only determinant of fair value available — and it's rare that anyone pays the full rate card for advertising. Those rates could be jimmied around to achieve a desired result, as well.
VIEW C: Revenues and expenses should be recognized from advertising barter transactions at the fair value of the advertising surrendered or received only when an entity has a historical practice of receiving or paying cash for similar advertising transactions. The sensible compromise. A firm would have to have some established practice of paying or receiving cash in such transactions before it could recognize them on a non-cash basis. It brings a little more "show me" to View B, but is less restrictive than View A.

Conclusion of the EITF: View C rules. There will have to be some other kinks worked out — for instance, how much evidence is needed to show that there is a historical practice of paying or receiving cash in these circumstances.

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