9/29/2014
`
`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`
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`
`Letter From the Chief Accountant:
`Accounting Issues Related to
`Internet Operations
`
`Mr. Timothy S. Lucas
`Director of Research and Technical Activities
`Financial Accounting Standards Board
`401 Merritt 7
`P.O. Box 5116
`Norwalk, CT 06856-5116
`
`Dear Mr. Lucas:
`
`October 18, 1999
`
`As we discussed at the EITF meeting on September 23, the SEC staff has
`been developing a list of issues that have arisen in internet businesses. We
`have finished preparing that list, and it is attached to this letter. The list
`includes those issues that we believe warrant consideration by the EITF (or
`another standard-setting body). As discussed at the EITF meeting, we have
`also suggested priority levels for addressing each of the issues (priority
`levels 1-3). It would be helpful if the level 1 items could be dealt with first.
`However, we believe that all of the issues should eventually be addressed.
`
`As you may recall, at the EITF meeting I expressed support for setting up a
`working group to focus on internet issues. We hope to be able to discuss
`the issues in the attached list and the possible formation of a working group
`with the EITF Agenda Committee before the November EITF meeting. As
`you will note, there are several issues that we believe can best be
`addressed by staff announcements. If the working group (or the EITF
`Agenda Committee, if a decision is reached not to form a working group)
`agrees that staff announcements are an appropriate way to resolve these
`issues, we hope that such announcements can be made at the November
`EITF meeting. Other issues could be added to the EITF Agenda (or the
`agendas of other standard-setting bodies) for discussion at the November
`and subsequent meetings.
`
`After you have had a chance to review the issues, please let us know your
`thoughts about setting up a working group. If you have any questions
`about the issues in the attached list, please contact Scott Taub in the Office
`of the Chief Accountant at 202-942-4409.
`
`Sincerely,
`
`Lynn E. Turner
`Chief Accountant
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`http://www.sec.gov/info/accountants/staffletters/calt1018.htm
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`9/29/2014
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`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`
`Issues in Accounting for Internet Activities
`
`This memo describes accounting issues the SEC staff is aware of that have
`arisen in companies with internet activities. The list has been compiled
`based upon a review of issues the SEC staff has dealt with in registrant
`filings, as well as issues identified through input from accounting firms. The
`issues discussed are all issues in which 1) there appears to be a diversity in
`practice, 2) the situation does not appear to be addressed in the accounting
`literature, and/or 3) the SEC staff is concerned that the developing practice
`may be inappropriate under generally accepted accounting principles.
`
`Some of the issues arise due to the new business models used in internet
`operations, while others are issues that also exist in businesses with no
`internet operations. For example, advertising partnerships, coupon and
`rebate programs, and complex equity instruments, while perhaps more
`common in internet businesses, were in use long before the internet. As a
`general rule, the SEC staff believes that internet companies engaging in
`transactions that are similar to transactions entered into by traditional
`companies should follow the already established accounting models for
`those transactions.
`
`We believe that all of the issues discussed warrant further consideration by
`the accounting and financial reporting community. Each issue represents an
`area in which investors would benefit from the improved financial
`information and consistency that would come out of providing additional
`guidance on the issue. In order to maximize the benefits of providing such
`guidance, we believe it is important that any guidance address not only
`recognition and measurement questions, but also classification and
`disclosures.
`
`For each issue, we have added comments from the SEC staff regarding the
`issue, and an assessment of the priority of addressing the issue.
`
`Gross vs. Net – Some of the more significant issues facing internet
`businesses surround whether to present grossed-up revenues and cost
`of sales, or merely report the net profit as revenues, similar to a
`commission. The significance is enhanced due to the importance often
`placed on the revenue line in the valuation of internet stocks.
`
`1. The question of gross vs. net revenue and cost display has arisen
`several times in connection with an internet company that distributes
`or resells third party products or services. Because the internet is a
`new distribution model, and can be used in the distribution of tangible
`assets, intangible assets, and services, the existing practices used for
`making this determination are not always sufficient.
`
`SEC Staff Comments: This seems to be a key issue. Priority level 1.
`
`2. Many internet companies enter into advertising barter transactions
`with each other, in which they exchange rights to place
`advertisements on each others' websites. There is diversity in practice
`in accounting for these transactions. The staff believes a prerequisite
`to reflecting these transactions in the accounting records is that the
`value of the transaction must be reliably measurable. In addition, the
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`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`staff believes registrants should be making transparent disclosure that
`will clearly convey to investors the accounting being used.
`
`SEC Staff Comments: There have been a number of press articles on
`this issue, illustrating its importance. Priority level 1.
`
`3. ISP's and PC retailers are currently offering a $400 rebate to
`purchasers of new PC's who contract for three years of internet
`service. It appears that most of the rebate cost is borne by the ISP
`while a portion is borne by the PC retailer, that the retailer provides
`advertising and marketing for the arrangement, and that the rebate,
`or a portion thereof, must be returned by the consumer to the ISP if
`the consumer breaks the contract with the ISP. Some ISPs and
`retailers believe their portion of the cost of the rebate should be a
`marketing expense, as opposed to a reduction of revenues. The SEC
`staff generally believes that such rebates should be considered a
`reduction of revenues.
`
`SEC Staff Comments: The SEC staff believes that a staff
`announcement indicating that discounts like these should be
`accounted for as reductions of revenue is appropriate.
`
`4. Shipping and handling costs are a major expense for internet product
`sellers. Most 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 staff believes that
`practice for non-internet mail-order companies is to net the revenues
`and expenses, although diversity may exist. In either situation, we
`note that companies generally do not provide any separate disclosure
`of shipping revenues and costs (e.g., by reporting shipping revenue
`and costs as separate line items, or by providing footnote disclosure of
`the gross shipping revenues and costs).
`
`SEC Staff Comments: There is diversity in practice that should be
`eliminated. However, because the issue relates to a smaller portion of
`revenues and costs then some others in this section, it can be
`addressed after some of those issues. Priority level 2.
`
`5. Some internet companies have concluded that a free or heavily
`discounted product or service, as is provided in introductory offers
`(e.g. free month of service, 6 CDs for a penny) should be accounted
`for as a sale at full price, with the recognition of marketing expense
`for the discount. The staff notes that an AICPA Technical Practice Aid
`(Section 5100.07, "One-Cent Sales") addresses this issue, concluding
`that "The practice of crediting sales and charging advertising expense
`for the difference between the normal sales price and the "bargain
`day" sales price of merchandise is not acceptable for financial
`reporting."
`
`SEC Staff Comments: The SEC staff believes that a staff
`announcement indicating that discounts like these should be
`accounted for as reductions of revenue is appropriate.
`
`6. Several internet-based businesses have experienced service outages
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`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`recently. Related costs may include refunds to customers/members,
`costs to correct the problem that caused the outage, and damage
`claims. Issues could include when to accrue the refunds and costs,
`whether refunds that are not required but are given as a gesture of
`goodwill are reductions of revenues or a marketing expense, etc.
`
`SEC Staff Comments: The facts and circumstances surrounding
`these situations are likely to be very diverse, making the development
`of general guidance difficult. Priority level 3.
`
`Definition of Software – We have noted several issues that relate to
`whether websites themselves and files or information available on
`websites should be considered software, and therefore be subject to the
`provisions of SOPs 97-2 and 98-1 and/or SFAS 86.
`
`7. In EITF Issue 96-6, the SEC staff expressed its view that the costs of
`software products that include film elements should be accounted for
`under the provisions of SFAS 86. As such, revenue from the sale of
`such products should be accounted for under the provisions of SOP
`97-2. By analogy, the staff believes that guidance should be applied to
`software with other embedded elements, such as music. However,
`EITF 96-6 did not discuss accounting for the costs of computer files
`that are essentially films (e.g., mpeg, realvideo), music (e.g., mp3),
`or other content. A number of questions may arise with relation to
`these files, including whether a company purchasing the rights to
`distribute music in the .mp3 format should account for those costs
`under SFAS 50 or 86. Similarly, it is not clear whether the revenue
`from the sales of .mp3 files falls under SOP 97-2.
`
`SEC Staff Comments: As the areas of software, film, music, etc
`continue to converge, it is important to be able to identify which
`accounting models apply to various transactions. In addition, resolving
`this issue may be necessary in order to resolve issue 8 below.
`Priority level 2.
`
`8. Costs of developing a website including the costs of developing
`services that are offered to visitors (chat rooms, search engines, e-
`mail, calendars, etc.) are significant costs for many internet
`businesses. The SEC staff believes that a large portion of such costs
`should be accounted for in accordance with SOP 98-1, as software
`developed for internal use. The staff notes that SOP 98-1, paragraph
`15 states that "If software is used by the vendor in providing the
`service but the customer does not acquire the software or the future
`right to use it, the software is covered by this SOP."
`
`SEC Staff Comments: This is a key issue, given that it is the largest
`cost for many internet businesses. Priority level 1.
`
`Revenue Recognition – As with any new business model, issues exist
`regarding the recognition of revenue for various types of internet
`activities.
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`9.
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`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`Auction sites usually charge both up-front (listing) fees and back-end
`(transaction-based) fees. The staff understands that the listing fees
`are being recognized as revenue when the item is originally listed,
`despite the requirement for the auction site to maintain the listing for
`duration of the auction. In addition, some auction sites recognize the
`back-end fees as revenue at the end of the auction despite the fact
`that the seller is entitled to a refund of the fee if the transaction
`between the buyer and seller doesn't close (Note: the auction house
`is merely a facilitator and takes no part in assisting in closing the
`transaction). Given that many popular sites have recently started up
`auction sites, this issue may become more prevalent.
`
`SEC Staff Comments on Front-end: The SEC staff believes that a
`staff announcement indicating that fees like this should be
`recognized over the listing period, which is the period of
`performance, is appropriate.
`
`SEC Staff Comments on Back-end: The facts and circumstances of
`the agreements between the auction site, the buyers, and the sellers
`may vary significantly, making it difficult to provide applicable
`guidance. Priority level 3.
`
`10. 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. The latter service is often
`referred to as "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.
`
`SEC Staff Comments: This type of arrangement seems to be
`growing in popularity, although it is not all that common at this
`point. Priority level 2.
`
`11. An internet business may provide customers with services that
`include access to a website, maintenance of a website, or publication
`of certain information on a website for a period of time. Certain
`companies have argued that because the incremental costs of
`maintaining the website and/or providing access to it are minimal (or
`even zero), this ongoing requirement should not preclude up-front
`revenue recognition. The staff has historically objected to up-front
`revenue recognition in these cases, even with an accrual of the
`related costs.
`
`SEC Staff Comments: The SEC staff believes that a staff
`announcement indicating that fees like this should be recognized
`over the performance period, which would be the period over which
`the company has agreed to maintain the website or listing, is
`appropriate.
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`9/29/2014
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`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`
`
`12. Many internet companies enter into various types of advertising
`arrangements (sometimes with other internet companies) to provide
`advertising services over a period of time. These 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. This
`issue could show up in various other industries as well (sales reps
`who guarantee they will reach a certain level of sales, advertising in
`other kinds of media, etc).
`
`SEC Staff Comments: The terms of these arrangements vary
`somewhat from contract to contract. The issues that arise in some,
`but not all, of these contracts may be addressed in the planned Staff
`Accounting Bulletin on revenue recognition issues. Once the SAB is
`released, consideration of this issue would be appropriate. Priority
`level 3.
`
`13. There are a growing number of "point" and other loyalty programs
`being developed in internet businesses (similar to the airline and
`hotel industry programs). There are several well-known companies
`whose business model involves 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 them 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. Several issues related to these
`programs have arisen.
`
`a. The program operators believe that their customers are the
`companies for whom they provide advertising and marketing
`services. They view the redemption of the points or other
`reward as the "cost of sales," not as a revenue-generating
`activity. Therefore, they do not believe the fact that delivery
`under the reward occurs later should require revenue deferral.
`The staff has accepted this argument only when the contracts
`with the business partners do not require the issuance or offer
`of any award, and speak merely to performing the advertising,
`marketing, or customer acquisition activities. In other cases,
`the staff has required that some amount of revenue be deferred
`until the points are redeemed to reflect that the substance of
`the arrangement involves multiple elements, one of which has
`not yet occurred. The same issue could also exist in customer
`acquisition programs. For example, offers exist where an ISP
`offers 6 months of free service to people who open accounts at
`certain on-line brokerages.
`b. When revenue is recognized up front with an accrual of the
`redemption costs, a question arises as to whether companies
`should estimate "breakage" (the amount of rewards the will
`expire unused). Many web-based businesses have loyalty
`programs that would also face this issue. For example, many
`sites issue rewards that can be used towards future purchases
`at the site. In recording the liability for those rewards, some
`argue that the gross amount of the rewards issued should be
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`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`recorded, while others believe that the recorded amount should
`be reduced for an estimate of the rewards that will not be used,
`if this "breakage" can be reliably estimated.
`
`SEC Staff Comments: Priority level 2.
`
`Prepaid/Intangible Assets vs. Period Costs – Internet businesses
`often make payments to obtain members or customers or to obtain
`advertising space, distribution rights, supply agreements, etc. In some
`cases, the questions of whether to capitalize or expense such costs and
`of assessing impairment of the rights obtained is not straightforward.
`Although similar payments are made by companies that do not have
`internet operations, the frequency with which this issue arises is higher
`in internet companies.
`
`14. Businesses often make payments for long-term contractual rights
`(e.g., internet distribution rights) that are intended to be exploited
`only through internet operations. The contractual rights meet the
`definition of an asset, but the measurement of the probable
`economic benefits is difficult. Some companies have asserted that
`these rights are immediately impaired, as their best estimate of the
`expected cash flows would indicate the asset is not recoverable. The
`SEC staff has objected in these situations, and believes impairment
`should not be recorded unless it can be shown that conditions have
`changed since the execution of the contract. The evaluation of
`impairment of these kinds of assets is complicated because, as
`discussed above, the contractual rights purchased may be covered
`by different accounting standards, depending on the subject of the
`rights.
`
`SEC Staff Comments: EITF Issue 99-14 discusses whether
`impairment of such contracts should be assessed, but not how.
`Guidance on how to assess impairment is critical, and should be
`provided either as implementation guidance to Issue 99-14 or in a
`separate issue. Priority level 1.
`
`15. Many internet companies enter into various types of advertising
`arrangements (sometimes with other internet companies) in which
`one entity pays the other an up-front fee (or guarantees certain
`minimum payments over the course of the contract) in exchange for
`certain advertising services over a period of time. The payers in
`these arrangements have at times recognized an immediate loss on
`signing the contract, arguing that the expected benefits are less than
`the up-front or guaranteed payments. The staff has indicated that it
`views these payments as being similar to payments made for
`physical advertising space, and that any up-front payment should be
`treated as prepaid advertising costs. This issue was discussed in Paul
`Kepple's speech last December.
`
`SEC Staff Comments: Guidance on these arrangements can be
`provided along with guidance on Issue 14 above.
`
`16. Internet businesses often make large investments in building a
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`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`customer or membership base. Several examples of this are:
`
`a. Sites that give users rewards (points, products, discounts,
`services) in exchange for setting up an account with the site.
`b. Sites that make payments to business partners for referring
`new customers or members.
`c. Businesses that give users a PC and internet service for free if
`they are willing to spend a certain minimum amount of time on
`the internet each month and are willing to have advertisements
`reside permanently on their computer.
`
`In each of these cases, a question may arise as to whether the costs
`represent customer acquisition costs or costs of building a
`membership listing that qualify for capitalization, e.g., by analogy to
`SFAS 91.
`
`SEC Staff Comments: Most companies appear to be expensing such
`costs as incurred; therefore, there is little diversity in practice to
`make it urgent that this issue be addressed. If and when the issue is
`addressed, the model should apply broadly to costs of building
`customer and membership lists. Priority level 3.
`
`Miscellaneous Issues
`
`17. The 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 in EITF Issues 96-18
`and 98-5. For the holders, the instruments may be within the scope
`of SFAS 133. However, because one or more of the underlyings are
`often based on the holder's or issuer's performance, SFAS 133 will
`not always apply. In addition, it isn't clear that the change in fair
`value of the instrument should be entirely recognized as a derivative
`holding gain or loss, vs. an increase or decrease in revenues or
`operating expenses.
`
`SEC Staff Comments: This issue seems to fit well with other issues
`being considered by the DIG. Resolution before SFAS 133 must be
`adopted would be helpful. Priority level 2.
`
`18. SFAS 131 defines segments based on the information reviewed by
`top management in making decisions. Therefore, if top management
`reviews information about the internet portion of a company's
`business separate from other operations, the internet operations
`should be considered a separate operating segment.
`
`SEC Staff Comments: Ensuring that SFAS 131 is properly applied in
`this area and others will likely be a focus of the SEC staff.
`
`19. The staff has noted that classification of expenses between various
`categories (costs of sales, marketing, sales, R&D) sometimes varies
`significantly amongst internet companies for costs that appear
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`Letter From the SEC Chief Accountant re: Accounting Issues in Internet Operations
`similar. Examples include website development costs and expenses
`related to the various contractual rights discussed above.
`
`SEC Staff Comments: It is difficult to identify common elements
`between the classification issues that have arisen, making the
`preparation of general guidance difficult. Priority level 3.
`
`20. Common practice when a company prints a coupon in the newspaper
`is to record a liability and marketing expense for the estimated
`amount of coupons that will be redeemed. The internet provides
`several new methods of distributing coupons that may raise
`questions within the existing accounting models. For example:
`
`a. Product or service providers post coupons on-line, often for long
`periods of time.
`b. Internet retailers or service providers send e-mails inviting the
`receiver to get a discount on a purchase.
`
`SEC Staff Comments: The area of accounting for coupons, rebates,
`and discounts is growing more significant, but it is not limited to
`internet businesses. Developing a robust model to account for these
`arrangements would be helpful. Priority level 2.
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`http://www.sec.gov/info/accountants/staffletters/calt1018.htm
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`Home | Previous Page
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`Modified: 12/23/1999
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