Internet Accounting Issues

A Summary

May 2001

 

 

 

 

 

 

 

Table of Contents

Overview *

Transition *

Advertising Barter Transactions *

Gross Versus Net Revenue Recorded in Transactions *

Shipping and Handling Fees and Costs *

Sales Incentives *

Consideration From a Vendor to a Reseller *

Service Outages *

Website Development Costs *

Computer Files That are Essentially Films, Music, or Other Content *

Arrangements with Up-Front Payments *

Customer Origination and Acquisition Costs *

Amortization Periods of Intangible Assets *

Exchange of Equity Instruments for Goods or Services *

Revenue Arrangements With Multiple Deliverables *

"Points" and Other Time/Volume-Based Offers *

Software that Resides on the Vendor’s or a Third-Party’s Server *

Revenue Recognition for Auction Sites *

Access and Maintenance of Websites *

Advertising Arrangements with Guaranteed Minimums *

Segment Information *

Disclosures About Revenues *

Overview

The rapid growth in the number of companies that provide infrastructure to and goods and services on the Internet ("Internet companies") during 1997-1999 spurred an increase in related accounting issues. While many of these issues are the same as those that companies in the non-cyber world face, Internet companies are forced to address them more frequently. And because measuring revenue growth is considered by some to be a significant bellwether of progress for these companies, proper accounting for that revenue growth is an important concern. The majority of issues considered to be "Internet accounting issues" are those related to revenue recognition and income statement classification.

The importance of the accounting issues first brought to light by Internet companies has not gone unnoticed by accounting standard-setter organizations. In October 1999, the SEC staff sent a letter to the FASB’s Emerging Issues Task Force (EITF) describing various Internet accounting issues, many of which have been added to the EITF’s agenda at the SEC’s request. Conclusions reached by the EITF on these issues apply to not just Internet companies but to all companies.

Several important revenue recognition issues, including some of those raised in the SEC staff’s letter to the EITF, were addressed by Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, which was issued in December 1999. In October 2000, the SEC staff issued a Frequently Asked Questions (FAQ) document on SAB 101. For further information, refer to our Summary of Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (Updated for Frequently Asked Questions) (SCORE Retrieval File No. BB4154).

This Summary primarily addresses those issues that have either already been addressed or that are currently under consideration by the EITF and describes our approach for many of them. Transition for EITF consensuses is generally prospective, however, for some issues, such as "gross versus net" revenue presentation, reclassification of prior period income statements is required. This Summary also highlights, where applicable, issues addressed in SAB 101 and the SEC staff’s current views on various issues that it expressed in its letter to the EITF or in other documents such as speeches. We will be updating this Summary (which reflects developments through the April 18-19, 2001 EITF meeting) as definitive guidance on those issues is discussed and others arise.

The following categories more fully describe the four basic types of Internet companies described in this Summary.

Internet Service Providers (ISPs) - These are most often telephone and, more recently, cable TV companies that charge a monthly fee for providing access (often unlimited) to the Internet, as opposed to individual call-up charges. The largest such company is AOL Time Warner, which is also one of the largest content providers and Internet portal companies. Its monthly subscriber revenues are derived from both Internet service and content.

Internet Portal Companies (IPCs) - These companies generally provide extensive content on their websites, often with no subscription fee, and either provide their own search engine and/or access to other widely-used search engines. Their revenues usually are derived from individual contractual arrangements with advertisers or other content providers in which guarantees are made as to the number of "hits" on the website or the advertiser’s banner, or a button is placed on the IPC’s website in varying degrees of prominence. These buttons and banners generally allow "click-through" to the advertiser’s or provider’s website. Examples of IPCs are Yahoo!, Excite, and Lycos.

Internet Commerce Companies (ICCs) - These are defined narrowly as companies that conduct business only through the Internet, such as product sales (e.g., Amazon.com) or service providers. Others, such as eBay, facilitate transactions between others and collect a fee per transaction. Virtually all companies now have websites; however, in an effort to maintain good relations with retailers and other distributors, many do not yet sell over the Internet. They maintain a site for information and promotional purposes only and provide a list of distributors. Others use the Internet as an alternate sales channel. Other e-commerce companies are business-to-business (B2B) companies that supplant the traditional materials procurement process with Internet-enabled processes.

Other Internet-Related Companies - These companies, although tied to or dependent on the Internet for business, do not do anything out of the ordinary, but because of the fast changing dynamics of this emerging industry, may engage in unusual terms or conditions in their contracts. Examples of companies that are Internet-related are Cisco Systems, JDS Uniphase, Oracle, and Lucent Technologies. They produce products tied to and dependent on the growth of the Internet, but generally are not visible to the consumer. They provide the hardware and software infrastructure of the Internet.

Transition

The EITF is expected to address most of the issues discussed in this Summary and consensuses have already been reached on many of them. Generally, the EITF is silent as to transition which allows companies to adopt consensuses prospectively (i.e., for transactions that occur after the consensus is reached) or as a cumulative catch-up adjustment in accordance with APB Opinion No. 20, Accounting Changes. However, if transition is specified in the consensus, that transition should be followed. For accounting changes that impact net income, where the EITF is silent on transition, we recommend that companies consider electing to make the change by a cumulative catch-up adjustment. The benefit of this treatment, for example, is where adopting an EITF consensus would result in delayed revenue recognition because revenue recognized prior to the accounting change gets "recycled" into revenue after the change and thus would not adversely impact the trend in earnings. For accounting changes that affect income statement presentation, the EITF generally requires retroactive reclassification.

Advertising Barter Transactions

An advertising barter arrangement exists when two companies enter into a non-cash transaction to exchange advertising with each other. These arrangements are often referred to as banner for banner, button for button, click-through for click-through, reciprocal advertising, or co-marketing arrangements. A typical transaction might arise when Company A advertises on Company B’s website and Company B advertises on Company A’s website. The advertisements may be in the form of an image appearing on the website describing the other website, or products and/or services offered on the website (banner for banner), or a link to the other website (click-through for click-through). Some entities record an equal amount of revenue (for the web space they own and "sell") and expense (for the web space they "purchase" from the other entity). Typically, this has no effect on income (although it could, if different periods are involved) but may have a significant impact on revenue and perhaps, the stock price.

The issue is whether barter transactions that involve a nonmonetary exchange of advertising should result in recorded revenues and expenses, and if so, whether those revenues and expenses should be recognized at the more readily determinable fair value of the advertising surrendered or received in the exchange.

At the January 19–20, 2000 meeting, the EITF reached a consensus that revenue and expense should be recognized at fair value from an advertising barter transaction only if the fair value of the advertising surrendered in the transaction is determinable based on the entity's own historical practice of receiving cash for similar advertising from buyers unrelated to the counterparty in the barter transaction. An exchange between the parties to a barter transaction of offsetting monetary consideration, such as a swap of checks for equal amounts, does not evidence the fair value of the transaction. If the fair value of the advertising surrendered in the barter transaction is not determinable within the limits of this Issue, the barter transaction should be recorded based on the carrying amount of the advertising surrendered, which likely will be zero.

The population of prior cash transactions that should be analyzed to determine fair value should not exceed six months prior to the date of the barter transaction. If economic circumstances have changed such that the prior six months cash transactions are not representative of current fair value for the advertising surrendered, then a shorter, more representational period should be used. In addition, it is inappropriate to consider cash transactions subsequent to the barter transaction to determine fair value.

For advertising surrendered for cash to be considered "similar" to the advertising being surrendered in the barter transaction, the advertising surrendered must have been in the same media and within the same advertising vehicle (e.g., same publication, same website, or same broadcast channel) as the advertising in the barter transaction. In addition, the characteristics of the advertising surrendered for cash must be reasonably similar to that being surrendered in the barter transaction with respect to:

a. Circulation, exposure, or saturation within an intended market;

b. Timing (time of day, day of week, daily, weekly, 24 hours a day/7 days a week, and season of the year);

c. Prominence (page on website, section of periodical, location on page, and size of advertisement);

d. Demographics of readers, viewers, or customers, and

e. Duration (length of time advertising will be displayed).

Additionally, in determining whether a cash transaction is similar, the quantity or volume (e.g., the number of impressions) of advertising surrendered in a qualifying past cash transaction can only evidence the fair value of an equivalent quantity or volume of advertising surrendered in subsequent barter transactions (i.e., a cash transaction for 1,000 impressions can be used to support a barter transaction up to 1,000 impressions). Consider the following example:

Example 1:

An Internet company has one cash transaction for 1,000 advertising impressions at $1.00 per impression or $1,000. This company shortly thereafter enters into a barter advertising arrangement for 2,000 similar impressions for which the company believes that fair value of the transaction is $1.00 per impression or $2,000. The revenue (and advertising expense) on the barter transaction is limited to $1,000 because the quantity of the cash transaction is only 1,000 impressions. On the other hand, had the company entered into a barter advertising transaction for 500 similar impressions, revenue on the barter transaction would be $500.

When a cash transaction has been used to support an equivalent quantity and dollar amount of barter revenue that transaction cannot serve as evidence of fair value for any other barter transaction (i.e., barter revenue would not be more than equal to a company’s total revenue from cash transactions). To illustrate, using the facts in the above example:

Example 2:

An Internet company enters into two barter transactions. The first barter transaction is for 500 impressions at $1.00 per impression and the company used the only similar cash transaction of 1,000 impressions to support the fair value of the barter. The company enters into another barter advertising arrangement for 1,200 impressions. The revenue on the second barter transaction is limited to $500 because that is the remaining amount of the quantity (500 impressions) of the prior similar cash transaction that is not older than six months from the date of the second barter transaction. On a cumulative basis the company would record $1,000 in advertising revenue, $1,000 in barter revenue and $1,000 in barter advertising expense. The value of the remaining 700 impressions on the second transaction is not recognized nor would it be recognized at a later date if additional similar cash transactions occur in the future.

Pursuant to the consensus, companies should disclose the amount of revenue and expense recognized from advertising barter transactions for each income statement period presented. In addition, if an entity engages in advertising barter transactions for which the fair value is not determinable within the limits of this EITF Issue, information regarding the volume and type of advertising surrendered and received (such as the number of equivalent pages, the number of minutes, or the overall percentage of advertising volume) should be disclosed for each income statement period presented. An example disclosure for Example 2 above follows:

The Company recorded barter revenue and expense of $1,000 during the year ended December 31, 200X. In 200X, the Company also entered into barter transactions that did not result in revenue recognition, because fair value was not determinable under the criteria established by the EITF, for 700 advertising impressions on its auction website, representing 41% of its total volume of advertising impressions.

Gross Versus Net Revenue Recorded in Transactions

Internet companies often must address the issue of whether to record revenue at the gross amount billed or the net amount received. Many Internet companies do not stock inventory and may employ independent warehouses or fulfillment houses to drop-ship merchandise to customers on their behalf. These companies also may offer services that will be provided by an independent service provider. However, this issue is not limited to Internet companies. For example, travel agents, magazine subscription brokers, and retailers that sell goods through catalogs or that sell goods on consignment may face similar issues. How companies recognize revenue for the goods and services they offer is an important issue because many investors appear to value Internet companies based on a multiple of gross revenues rather than a multiple of gross profit or earnings. While net income does not differ based on whether a company reports revenue on a gross basis or a net basis, some believe that the financial statement presentation could affect the company’s stock price.

The issue is whether an Internet 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 less the amount paid to the supplier) because, in substance, it has earned a commission from the supplier of the goods or services on the sale.

At the July 19–20, 2000 meeting, the EITF reached a consensus on Issue 99-19, Reporting Revenue as a Principal versus Net as an Agent, which supplements SAB 101. Issue 99-19 indicates that whether a company should recognize revenue gross or net is a matter of judgment that depends on the relevant facts and circumstances and that the following factors or indicators should be considered in the evaluation. None of the indicators should be considered presumptive or determinative; however, the relative strength of each indicator should be considered.

Indicators of Gross Revenue Reporting

  1. The company is the primary obligor in the arrangement
  2. The company has general inventory risk (before customer order is placed or upon customer return)
  3. The company has latitude in establishing price
  4. The company changes the product or performs part of the service
  5. The company has discretion in supplier selection
  6. The company is involved in the determination of product or service specifications
  7. The company has physical loss inventory risk (after customer order or during shipping)
  8. The company has credit risk.

Indicators of Net Revenue Reporting

  1. The supplier (not the company) is the primary obligor in the arrangement
  2. The amount the company earns is fixed
  3. The supplier (and not the company) has credit risk.

The minutes and the EITF Abstracts for Issue 99-19 include a detailed explanation of each indicator and provide several examples that illustrate the application of those indicators that should be considered when determining whether revenue should be recorded gross or net. Accordingly, reference should be made to the consensuses in evaluating a specific situation.

The SEC Observer reminded registrants that Regulation S-X, Rule 5-03(b)(1), requires separate presentation in the income statement of revenues from the sale of products and revenues from the provision of services. Because commissions and fees earned from activities reported net are service revenues, this may often have the effect of requiring separate presentation of revenues reported gross and revenues reported net (i.e., gross revenue (product sales) and net revenue (distributor sales) should be separate line items).

Voluntary disclosure of gross transaction volume for those revenues reported net may be useful to users of financial statements. If appropriate, such disclosure is permitted under the consensus either parenthetically on the face of the income statement or in the notes to the financial statements. However, if gross amounts are disclosed on the face of the income statement, they should not be characterized as revenues (a description such as "gross billings" may be appropriate), nor should they be reported in a column that sums to net income or loss.

SEC registrants should apply the consensus in Issue 99-19 no later than the required implementation date for SAB 101, which, as amended by SAB 101B, is the fourth quarter of a registrant's fiscal year beginning after December 15, 1999. Nonregistrants should apply the consensus no later than in annual financial statements for the fiscal year beginning after December 15, 1999. Upon application of the consensus, comparative financial statements for prior periods should be reclassified to comply with the classification guidelines of this Issue. If it is impracticable to reclassify prior-period financial statements, disclosure should be made of both the reasons why reclassification was not made and the effect of the reclassification on the current period.

The SEC Observer noted that in Topic D-85, the SEC staff indicated that registrants should retroactively apply the guidance in SAB 101 regarding income statement classification to all periods presented in their next financial statements (whether interim or annual) filed with the SEC after January 20, 2000, if that information is available. The SEC Observer indicated that that same guidance applies to any income statement reclassifications required by Issue 99-19. The SEC Observer also noted that companies registering shares in an initial public offering are expected to comply with SAB 101 at the time they file their initial registration statement with the SEC.

Shipping and Handling Fees and Costs

Shipping and handling costs are incurred by most Internet product sellers; however, diversity in practice exists regarding the income statement classification of amounts charged to customers for shipping and handling, as well as for costs incurred related to shipping and handling. Many sellers charge customers for shipping and handling in amounts that exceed the related costs incurred. Some display the charges to customers as revenues and the costs as expenses, while others net the costs and revenues.

The components of shipping and handling costs, and the determination of the amounts billed to customers for shipping and handling, may differ from company to company. Some companies define shipping and handling costs as only those costs incurred for a third-party shipper to transport products to the customer. Other companies include as shipping and handling costs a portion of internal costs (e.g., salaries and overhead related to the activities to prepare goods for shipment). In addition, some companies charge customers only for amounts that are a direct reimbursement for shipping and, if discernible, direct incremental handling costs; however, many other companies charge customers for shipping and handling in amounts that are not a direct pass-through of costs.

At the July 19–20, 2000 meeting, the EITF reached a consensus on Issue 00-10, Accounting for Shipping and Handling Fees and Costs. The consensus states that all amounts billed to a customer in a sale transaction related to shipping and handling, if any, represent revenues earned for the goods provided and should be classified as revenue (even if the amounts billed are a direct pass-through of costs when the seller is acting as an agent for its customers). However, Issue 00-10 only applies to shipping and handling fees and costs by companies that record revenue based on the gross amount billed to customers under Issue 99-19.

At the September 20–21, 2000 meeting, the EITF continued its discussion of the classification of shipping and handling costs. The EITF reached a consensus that the classification of shipping and handling costs is an accounting policy decision that should be disclosed pursuant to APB Opinion No. 22, Disclosures of Accounting Policies. A company may adopt a policy of including shipping and handling costs in cost of sales (the classification preferred by the SEC staff). However, if shipping costs or handling costs are significant and are not included in cost of sales (i.e., if those costs are accounted for together or separately on other income statement line items), a company should disclose both the amount(s) of such costs and the line item(s) on the income statement that include them.

The EITF observed that there would be some diversity in the types of costs companies include in "shipping and handling," but decided not to provide additional guidance. In addition, the EITF reached a consensus that it is not appropriate to net shipping and handling costs against revenues because doing so would be inconsistent with its consensus that all amounts billed to customers related to shipping and handling should be classified as revenue.

SEC registrants should apply the consensus in Issue 00-10 no later than the required implementation date for SAB 101, which, as amended by SAB 101B, is the fourth quarter of a registrant's fiscal year beginning after December 15, 1999. Nonregistrants should apply the consensus no later than in annual financial statements for the fiscal year beginning after December 15, 1999. Upon application of the consensus, comparative financial statements for prior periods should be reclassified to comply with the classification guidelines of this Issue. If it is impracticable to reclassify prior-period financial statements, disclosure should be made of both the reasons why reclassification was not made and the effect of the reclassification on the current period.

The SEC Observer noted that in Topic D-85, the SEC staff indicated that registrants should retroactively apply the guidance in SAB 101 regarding income statement classification to all periods presented in their next financial statements (whether interim or annual) filed with the SEC after January 20, 2000, if that information is available. The SEC Observer indicated that that same guidance applies to reclassifications of shipping and handling revenues required by Issue 00-10.

Sales Incentives

Many Internet companies offer sales incentives including discounts, coupons, rebates, and free products or services, such as in certain introductory offers. Some believe these arrangements should be accounted for as a sale at full price, with the recognition of marketing expense for the amount of the discount while others believe the discount should be reflected as a reduction of the sales price. At the May 17-18, 2000 meeting, the EITF reached a consensus on EITF Issue 00-14, Accounting for Certain Sales Incentives. Issue 00-14 addresses the recognition, measurement, and income statement classification for sales incentives offered voluntarily by a vendor without charge to customers that can be used in, or that are exercisable by a customer as a result of, a single exchange transaction and includes the following:

However, Issue 00-14 does not address the following types of sales incentives:

The EITF reached a consensus that, for the types of sale incentives included within the scope of this Issue, the "cost" of a sales incentive that will not result in a loss on the sale of a product or service, should be recognized at the latter of the following:

a. The date at which the related revenue is recorded by the vendor

b. The date at which the sales incentive is offered (which would be the case when the sales incentive offer is made after the vendor has recognized revenue; for example, when a manufacturer issues coupons offering discounts on a product that it already has sold to retailers).

For sales incentives resulting in the right to a refund or rebate (e.g., purchase of software for $200 would entitle the customer to a $50 rebate if the customer mails in the rebate form), the EITF reached a consensus that a vendor should recognize a liability (or "deferred revenue") for those sales incentives at the latter of (a) or (b) above based on the estimated amount of refunds or rebates that will be claimed by customers. If the amount of future rebates or refunds cannot be reasonably and reliably estimated, a liability (or "deferred revenue") should be recognized for the maximum potential amount of the refund or rebate (i.e., the liability should be recognized for all customers buying the product subject to the rebate). The ability to make a reasonable and reliable estimate of the amount of future rebates or refunds depends on many factors and circumstances that will vary from case to case. The EITF reached a consensus that the following factors may impair a vendor's ability to make a reasonable and reliable estimate:

a. Relatively long periods in which a particular rebate or refund may be claimed

b. The absence of historical experience with similar types of sales incentive programs with similar products or the inability to apply such experience because of changing circumstances

c. The absence of a large volume of relatively homogeneous transactions.

With regard to the income statement classification of sales incentives, the EITF reached a consensus that, when recognized, a cash sales incentive should be classified as a reduction of revenue. (A cash sales incentive includes virtually all sales incentives designed to effectively reduce the sales price to the customer including coupons and rebates.) However, a non-cash sales incentive (e.g., a gift certificate for a free weekend at a hotel that will be honored by a another, unrelated entity) should be recognized as an expense and not as a reduction of revenue. The EITF did not address the classification of that expense, but the SEC staff has indicated that they believe that the cost of a non-cash sales incentive should be classified as cost of goods sold.

For sales incentives that will result in a loss on the sale of a product or service, the EITF reached a consensus that a vendor should not recognize a liability for the sales incentive prior to the date at which the related revenue is recognized by the vendor. However, the EITF observed that the offer of a sales incentive that will result in a loss on the sale of a product may indicate an impairment of existing inventory.

The following example illustrates the application of Issue 00-14:

In an attempt to expand its subscriber base, Internet Service Provider offers a $400 rebate to purchasers of new computers who contract for three years of Internet service. The cost of the rebate is borne by both Internet Service Provider and PC Retailer. PC Retailer provides advertising and marketing for the arrangement. The arrangement includes a cancellation fee to the ISP equal to a pro rata portion of the rebate based on the length of time the customer used the service.

In this case, the cost of the rebate should be recorded as a reduction of revenue for both Internet Service Provider and PC Retailer based on the relative amounts of the cost borne by each. PC Retailer would record its cost of the rebate at the point of sale and Internet Service Provider likely would defer its cost of the rebate and amortize it as a reduction of revenue over the term of the service arrangement with the customer (in this case, three years).

If the ISP had offered a free computer (a non-cash sales incentive) to customers who contract for Internet service, the cost of the computer would be deferred and amortized to cost of sales over the term of the service arrangement with the customer.

At the April 18-19, 2001 meeting, the EITF agreed to change the transition date for Issue 00-14. Companies should now apply the guidance in Issue 00-14 no later than in annual or interim financial statements for periods beginning after December 15, 2001. Earlier adoption is encouraged. Upon application of the consensus, financial statements for prior periods presented for comparative purposes should be reclassified accordingly. If it is impracticable to reclassify prior-period financial statements, disclosure should be made of the reasons why reclassification was not made and the effect of the reclassification on the current period.

Financial statements for prior periods presented for comparative purposes should be reclassified to comply with the income statement display requirements. If it is impracticable to reclassify prior-period financial statements, disclosure should be made of the reasons why reclassification was not made and the effect of the reclassification on the current period. See Issue 00-14 for additional transition guidance with regard to accounting changes that will result in a change in net income.

For companies that would have been required to adopt Issue 00-14 under the original transition guidance, the SEC Observer stated that following disclosures should be made in financial statements filed with the SEC prior to adoption:

  1. All disclosures required by SAB 74 (Topic 11M), including the anticipated effects of any reclassifications of prior period financial statements presented. If application of the consensuses will require a reduction of previously reported revenue, an explicit statement to that effect should be included in the SAB 74 disclosures.
  2. If incentives subject to the guidance in this Issue have not been classified in the income statement consistent with the consensus, disclosure of the amounts of such incentives for the current period and, if practicable, all other periods presented, and the line item in the statement of operations on which they are classified.
  3. If a registrant's historical accounting policy for the recognition of incentives (i.e., when incentives are recognized and in what amount) subject to this Issue is different from that provided for by the consensus, disclosure of the recognition policy followed, and a rollforward of the deferred revenue balance, if any, related to sales incentives for all fiscal periods of fiscal years beginning after December 15, 1999.

Consideration From a Vendor to a Reseller

Since the EITF reached a consensus on Issue 00-14, numerous questions have been raised regarding the accounting and income statement classification of costs, other than those directly addressed in Issue 00-14, that a vendor incurs (typically a manufacturer) to or on behalf of a reseller (typically a retailer) in connection with the reseller's purchase or promotion of the vendor's products. These types of arrangements are the subject of Issue 00-25, Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products.

Examples of such arrangements include (a) "slotting fees," in which a vendor pays a fee to a retailer to obtain space for the vendor's products on the retailer's store shelves, (b) cooperative advertising arrangements, in which a vendor agrees to reimburse a retailer for a portion of costs incurred by the retailer to advertise the vendor's products, and (c) "buydowns," in which a vendor agrees to reimburse a retailer up to a specified amount for shortfalls in the sales price received by the retailer for the vendor's products over a specified period of time.

The basic issue is whether such payments should be classified as an expense (like the cost of other marketing programs) or as a reduction of revenue. In addition, practice is mixed as to whether certain payments should be deferred and amortized over the period of benefit (if any) or expensed as incurred. Issue 00-25 does not address whether up-front nonrefundable consideration from a vendor to a reseller for "shelf space" results in an asset or an expense for the vendor. Accordingly, this Issue does not address how to measure or when to recognize the payments, only the appropriate classification of the payments in the vendor’s income statement.

After discussing Issue 00-25 at several meetings, the EITF finally reached a consensus at the April 18-19, 2001 meeting. Under the consensus, consideration from a vendor to a reseller of the vendor's products is presumed to be a reduction of the selling prices of the vendor's products and, therefore, should be characterized as a reduction of revenue when recognized in the vendor's income statement. That presumption is overcome and the consideration should be characterized as a cost incurred if, and to the extent that, a benefit is or will be received from the recipient of the consideration that meets both of the following conditions:

  1. The vendor receives, or will receive, an identifiable benefit (goods or services) in return for the consideration. In order to meet this condition, the identified benefit must be sufficiently separable from the recipient's purchase of the vendor's products such that the vendor could have entered into an exchange transaction with a party other than a purchaser of its products in order to receive that benefit.

b. The vendor can reasonably estimate the fair value of the benefit identified under condition (a). If the amount of consideration paid by the vendor exceeds the estimated fair value of the benefit received, that excess amount should be characterized as a reduction of revenue when recognized in the vendor's income statement

The EITF observed that the separability aspect of condition (a) will generally require slotting fees and similar product development or placement fees to be characterized as a reduction of revenue. Buydowns could never meet the separability aspect of condition (a) and therefore should always be characterized as a reduction of revenue.

Under Issue 00-25, if amounts are required to be characterized as a reduction of revenue, a presumption exists that no portion of those amounts should be recharacterized as an expense. However, if a vendor can demonstrate that characterization of those amounts as a reduction of revenue results in negative revenue for a specific customer on a cumulative basis (i.e., since the inception of the customer relationship), then the amount of the cumulative shortfall may be recharacterized as an expense.

See Issue 00-25 for additional details and an exhibit that includes 13 examples of applying the consensus to programs such as pricing adjustments to major customers, advertising allowances, cooperative advertising, nonrefundable slotting fees, and reimbursement of promotion-related payroll costs.

The consensus on Issue 00-25 should be applied no later than in annual or interim financial statements for periods beginning after December 15, 2001. Earlier adoption is encouraged. Financial statements for prior periods presented for comparative purposes should be reclassified to comply with the income statement display requirements under the consensus. If it is impracticable to reclassify prior-period financial statements, disclosure should be made of the reasons why reclassification was not made and the effect of the reclassification on the current period.

Service Outages

Many Internet companies have experienced service outages. These services outages may result in costs such as refunds to customers/members, costs to correct the problem that caused the outage, and damage claims. The issues are when should these costs be recognized and whether the refunds that are not required but are given as a gesture of goodwill should be classified as a reduction of revenues or as marketing expense. In its October 1999 letter to the EITF, the SEC staff indicated that it believes that the facts and circumstances surrounding these situations are likely to be very diverse, making the development of general guidance difficult and that the EITF should not give this issue high priority. We believe that each situation needs to be analyzed separately to determine the appropriate accounting; if the cost to repair the website is similar to a warranty cost, then warranty accounting is appropriate, however, if it represents rebates to customers it generally should be recognized as a reduction of revenue. Sometimes, Internet retail companies ("e-tailers") also experience problems with website orders. In certain of these instances, e-tailers may issue a refund on the customer’s purchases or issue a credit voucher entitling the customer to free merchandise in the future. The cost of any such refunds or credit vouchers generally would be characterized in the income statement as a reduction of revenue consistent with Issue 00-14.

Website Development Costs

Many companies incurs substantial costs to develop websites. These costs include costs to develop the software to run the website, to populate the website with content, and to purchase hardware. The types of companies that are developing websites are very diverse and include Internet service companies, portal companies, retail companies (solely Internet ("click"), part Internet and part traditional ("click and mortar"), and traditional retail stores ("brick and mortar")), manufacturers, distributors, financial services, and other service companies. The websites are being used to promote a business and/or entire industries, to sell products and/or services, to provide customer service, and to provide information to the public or to employees. The issues are whether such costs should be capitalized and if so, what guidance should be followed.

At the March 16, 2000 meeting, the EITF reached a consensus on Issue 00-2, Accounting for Web Site Development Costs. The consensus is described below:

Costs Incurred in the Planning Stage

The EITF reached a consensus that, regardless of whether the website planning activities specifically relate to software, all costs incurred in the planning stage should be expensed as incurred.

Costs Incurred in the Website Application and Infrastructure Development Stage

SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, provides guidance for distinguishing between internal-use software and software to be sold, leased, or otherwise marketed. A key aspect of the definition of internal-use software is that it excludes software for which a plan exists or for which a plan is being developed to market the software externally. The EITF reached a consensus that all costs relating to software used to operate a website should be accounted for under SOP 98-1 unless a plan exists or is being developed to market the software externally, in which case the costs relating to the software should be accounted for under FASB Statement No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. Costs incurred for website hosting, which involve the payment of a specified periodic fee to an Internet service provider in return for hosting the website on its server(s) connected to the Internet, generally would be expensed over the period of benefit.

The website application and infrastructure development stage involves acquiring or developing hardware and software to operate the website. The cost of hardware is outside the scope of this Issue. We believe that such costs should be capitalized as a fixed asset. Further, we believe that any costs that are considered process reengineering costs should be expensed as incurred pursuant to EITF Issue 97-13, Accounting for Costs Incurred in Connection with a Consulting Contract or an Internal Project That Combines Business Process Reengineering and Information Technology Transformation.

Costs Incurred to Develop Graphics

Under Issue 00-2, graphics include the overall design of the website (use of borders, background and text colors, fonts, frames, buttons, and so forth) that affect the "look and feel" of the website and generally remain consistent regardless of changes made to the content. The EITF reached a consensus that graphics are a component of software and that the costs of developing initial graphics should be accounted for under SOP 98-1 for internal-use software, and under Statement 86 for software marketed externally. Modifications to graphics after a website is launched should be evaluated to determine whether the modifications represent maintenance or enhancements of the website. The accounting for maintenance and enhancements is discussed below.

Costs Incurred in the Operating Stage

Costs incurred during the operating stage include training, administration, maintenance, and other costs to operate an existing website. The EITF reached a consensus that the costs of operating a website should not be accounted for differently from the costs of other operations; that is, those costs should be expensed as incurred. However, costs incurred in the operation stage that involve providing additional functions or features to the website should be accounted for as, in effect, new software. That is, costs of upgrades and enhancements that add functionality should be expensed or capitalized based on the general model of SOP 98-1 (which requires certain costs relating to upgrades and enhancements to be capitalized if it is probable that they will result in added functionality) or, for software that is marketed, Statement 86 (which applies its software capitalization model to "product enhancements," which include improvements that extend the life or significantly improve the marketability of a product). The EITF observed that the determination of whether a change to website software results in (a) an upgrade or enhancement, if internal-use software, or (b) a product enhancement, if externally-marketed software, is a matter of judgment based on the specific facts and circumstances. The EITF also observed that SOP 98-1 indicates that entities that cannot separate internal costs on a reasonably cost-effective basis between maintenance and relatively minor upgrades and enhancements must expense such costs as incurred.

Income Statement Classification

In a speech at the December 2000 AICPA Conference on Current SEC Developments, the SEC staff noted that the costs of designing, updating, and maintaining websites generally should not be included in an income statement caption entitled "Product Development Costs" unless such costs are incurred in the development of products that the reporting company intends to sell (typically it is not the website itself that is the product to be sold). A more appropriate income statement caption for these costs, if they are to be reported as a separate line item, would be simply "Website Development Costs."

The EITF also provided practical guidance in the form of an exhibit that illustrates the application of the consensuses to specific website development costs. That exhibit is summarized below.

Website Development Activity

Accounting Required by Issue 00-2

Planning Stage

 

Develop a business, project plan, or both. This may include identification of specific goals for the website (e.g., to provide information, supplant manual processes, conduct e-commerce, and so forth), a competitive analysis, identification of the target audience, creation of time and cost budgets, and estimates of the risks and benefits.

Expense as incurred.

Determine the functionalities (e.g., order placement, order and shipment tracking, search engine, e-mail, chat rooms, and so forth) of the website.

Expense as incurred.

Identify necessary hardware (e.g., the server) and web applications. Web applications are the software needed for the website's functionalities. Examples of web applications are search engines, interfaces with inventory or other back-end systems, as well as systems for registration and authentication of users, commerce, content management, usage analysis, and so forth.

Expense as incurred.

Determine that the technology necessary to achieve the desired functionalities exists. Factors might include, for example, target audience numbers, user traffic patterns, response time expectations, and security requirements.

Expense as incurred.

Explore alternatives for achieving functionalities (e.g., internal versus external resources, custom-developed versus licensed software, company-owned versus third-party-hosted applications and servers).

Expense as incurred.

Conceptually formulate and/or identify graphics and content (refer to Graphics and Content Development Stages for further discussion).

Expense as incurred.

Invite vendors to demonstrate how their web applications, hardware, or service will help achieve the website's functionalities.

Expense as incurred.

Selection of external vendors or consultants.

Expense as incurred.

Identify internal resources for work on the website design and development.

Expense as incurred.

Identify software tools and packages required for development purposes.

Expense as incurred.

Address legal considerations such as privacy, copyright, trademark, and compliance.

Expense as incurred.

Website Application and Infrastructure Development Stage

The discussion of website application and infrastructure development assumes that any software is developed for the entity's internal needs and no plan exists or is being developed to market the software externally. Software for which a plan exists or is being developed to market the software externally is subject to Statement 86, and costs associated with the development of that software should be expensed until technological feasibility is established.

Acquire or develop the software tools required for the development work (e.g., HTML editor, software to convert existing data to HTML form, graphics software, multimedia software, and so forth).

Costs incurred to purchase software tools, or costs incurred during the application development stage for internally developed tools, generally should be capitalized unless they are used in research and development and (1) do not have any alternative future uses or (2) are internally developed and represent a pilot project or are being used in a specific research and development project.

Obtain and register an Internet domain name.

Generally, capitalize under APB 17.

Acquire or develop software necessary for general website operations, including server operating system software, Internet server software, web browser software, and Internet protocol software.

Generally, capitalize under SOP 98-1.

Develop or acquire and customize code for web applications (e.g., catalog software, search engines, order processing systems, sales tax calculation software, payment systems, shipment tracking applications or interfaces, e-mail software, and related security features).

Generally, capitalize under SOP 98-1.

Develop or acquire and customize database software and software to integrate distributed applications (e.g., corporate databases, accounting systems) into web applications.

Generally, capitalize under SOP 98-1.

Develop HTML websites or develop templates and write code to automatically create HTML pages.

Generally, capitalize under SOP 98-1.

Purchase the web and application server(s), Internet connection (bandwidth), routers, staging servers (where preliminary changes to the website are made in a test environment), and production servers (accessible to customers using the website). Alternatively, these services may be provided by a third party via a hosting arrangement.

Acquisitions of servers and related hardware infrastructure are outside the scope of this Issue. Payments for hosting arrangements should be expensed over the period of benefit.

Install developed applications on the web server(s).

Generally, capitalize under SOP 98-1.

Initial creation of hypertext links to other websites or to destinations within the website. Depending on the site, links may be extensive or minimal.

Generally, capitalize under SOP 98-1.

Test the website applications (e.g., stress testing).

Generally, capitalize under SOP 98-1.

Graphics and Content Development Stages

 

Create initial graphics for the website. Graphics include the design or layout of each page (i.e., the graphical user interface), color, images, and the overall "look and feel" and "usability" of the website. Creation of graphics may involve coding of software, either directly or through the use of graphic software tools. The amount of coding depends on the complexity of the graphics.

Initial graphics are part of the software and generally should be capitalized under SOP 98-1.

Create content or populate databases. Content may be created or acquired to populate databases or websites. Content may be acquired from unrelated parties or may be internally developed.

To be addressed in EITF Issue 00-20 (see discussion below).

Enter initial content into the website. Content is text or graphical information (exclusive of initial graphics described above) on the website which may include information on the entity, products offered, information sources that the user subscribes to, and so forth. Content may originate from databases that must be converted to HTML pages or databases that are linked to HTML pages through integration software. Content also may be coded directly into websites.

SOP 98-1 specifies that "data conversion costs" should be expensed as incurred. Similarly, costs to input content into a website generally should be expensed as incurred. Software used to integrate a database with a website generally should be capitalized under SOP 98-1.

Operating Stage

 

Train employees involved in support of the website.

Generally, expense as incurred under SOP 98-1.

Register the website with Internet search engines.

Expense as incurred. These expenditures represent advertising costs and are expensed as incurred under SOP 93-7.

Perform user administration activities.

Generally, expense as incurred under SOP 98-1.

Update site graphics (for updates of graphics related to major enhancements, see below).

Generally, expense as incurred under SOP 98-1.

Perform regular backups.

Generally, expense as incurred under SOP 98-1.

Create new links.

Generally, expense as incurred under SOP 98-1.

Verify that links are functioning properly and update existing links (i.e., link management or maintenance).

Generally, expense as incurred under SOP 98-1.

Add additional functionalities or features.

Generally, capitalize if they meet the definition of "upgrades and enhancements" under SOP 98-1.

Perform routine security reviews of the website and, if applicable, of the third-party host.

Generally, expense as incurred under SOP 98-1.

Perform usage analysis.

Generally, expense as incurred under SOP 98-1.

Costs Incurred to Develop or Acquire Database Content

Database content refers to information included on the website, which may be textual or graphical in nature (although the specific graphics described above are excluded from content). For example, articles, product photos, maps, and stock quotes and charts are all forms of database content. Database content may reside in separate databases that are integrated into (or accessed from) the website with software, or it may be coded directly into the website.

Many Internet companies derive revenues from making database content and other collections of information available to users. Those collections of information may be made available electronically or otherwise and they may be purchased from unrelated parties or may be originated (created) internally. Alternatively, some Internet companies provide free database content access to users and derive revenues by selling either advertising to be shown to, or demographic information on, the user population. Practice is mixed as to how the costs of developing or acquiring database content and other collections of information should be accounted for. Some companies capitalize and amortize such costs over the period of expected benefit whereas other companies expense such costs as incurred. In addition, practice is mixed as to the types of costs that qualify for capitalization (e.g., the extent to which internal costs can be capitalized).

At the September 20–21, 2000 meeting, the EITF briefly discussed EITF Issue 00-20, Accounting for the Costs Incurred to Acquire or Originate Information for Database Content and Other Collections of Information, but was not asked to reach a consensus. The EITF instructed the FASB staff to obtain more information on the types of databases being used by companies as well as the methods that companies are using to account for the costs to acquire or originate the database content. Further discussion is expected at a future meeting.

We believe that costs incurred internally to develop database content generally should be expensed as incurred. However, it may be appropriate to capitalize costs to acquire database content that is expected to be used for a reasonable period of time (i.e., at least one year). Additionally, we believe consideration should be given to whether costs relating to websites that are constantly refined should be expensed as incurred.

Computer Files That are Essentially Films, Music, or Other Content

Vendors may sell software or the rights to use software that is essentially a new medium to distribute music. The issue, raised in the SEC staff’s October 1999 letter to the EITF, is whether the websites and files or information available on websites should be considered software, and therefore, subject to the provisions of SOP 97-2, SOP 98-1, and/or Statement 86.

In EITF Issue 96-6, Accounting for the Film and Software Costs Associated with Developing Entertainment and Educational Software Products, the SEC staff expressed its view that the costs of software products that include film elements should be accounted for under the provisions of Statement 86. As such, revenue from the sale of these products should be accounted for under the provisions of SOP 97-2. By analogy, the SEC staff believes that guidance should be applied to software with other embedded elements, such as music. However, Issue 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. In those cases it is unclear whether a company purchasing the rights to distribute music in the .mp3 format should account for those costs under FASB Statement No. 50, Financial Reporting in the Record and Music Industry, or Statement 86. Similarly, it is not clear whether the revenue from the sales of .mp3 files falls under SOP 97-2.

The accounting for the costs of computer files that are essentially films, music, or other content may be addressed in EITF Issue 00-20, Accounting for Costs Incurred to Acquire or Originate Information for Database Content and Other Collections of Information. (See discussion of Issue 00-20 under "Website Development Costs" above.)

Arrangements with Up-Front Payments

Many Internet companies enter into complex arrangements that make it difficult to understand the underlying economics of the transaction. At the inception of these arrangements, the purchaser expects that the benefit (direct or indirect) it will receive over the term of the contract will equal or exceed its costs over the term of the contract. Internet companies typically enter into these contracts to increase user traffic on websites.

One type of arrangement is that an Internet company makes an up-front payment for long-term contractual rights (e.g., Internet distribution rights) that are intended to be exploited only through Internet operations. The payment for the contractual rights meets the definition of a long-term asset, but the measurement of the probable economic benefits is difficult. Some companies have asserted that these rights are immediately impaired under FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, as their best estimate of the expected cash flows would indicate the asset is not recoverable. Certain other contracts may be partially executory in nature and would not be covered by Statement 121.

Statement 121 requires a company to write down an asset to fair value when an impairment exists. Determining whether an impairment exists is based on the company’s undiscounted estimated future cash flows. One method commonly employed for determining an asset’s fair value is to use the estimated discounted future cash flows of the asset. Many Internet start-up companies have limited cash flows or may not be able to identify the cash flows related to the asset, and thus believe the ultimate (estimated future discounted) cash flows will be less than the asset’s carrying amount. However, the SEC staff has indicated that an up-front payment in exchange for contractual rights represents the fair value of that transaction and, accordingly, it would not be appropriate to record an impairment charge at the outset of the arrangement (analogous to accounting for goodwill in a purchase business combination). The SEC staff believes an impairment should not be recorded unless it can be shown that conditions have changed since the execution of the contract and that change in condition has resulted in a change in fair value that gives rise to an impairment.

Another type of transaction involves advertising arrangements (sometimes with other Internet companies) in which one company 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 SEC 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 that would subsequently be expensed pursuant to SOP 93-7, Reporting on Advertising Costs. The SEC staff discussed this issue at the December 1998 AICPA Conference on Current SEC Developments.

The issue of when an acquirer or purchaser of rights under executory contracts should recognize impairment is being addressed by EITF Issue 99-14, Recognition by a Purchaser of Losses on Firmly Committed Executory Contracts. The EITF Issue Summary for Issue 99-14 includes the following example (which will be discussed at a future meeting) of how this issue relates to an Internet company.

Company C (purchaser), an ISP, enters into an arrangement with an Internet access company, Company D. For a fixed up-front cash payment, Company C becomes a premier search provider for search and navigation on Company D's network of Internet products and services. Company C's objective in entering into the agreement is to increase user traffic on its system. Company D commits to list Company C as a premier search provider on Company D's website, providing the user with the ability to click through to Company C's website. Company C, in turn, will be able to generate revenues through the sale of advertising space on its website. This ability is enhanced by the increased traffic resulting from the agreement with Company D.

At the contract's inception, Company C estimates that the incremental advertising revenues over the period of the agreement are not sufficient to cover the total up-front cash payment and the estimated direct selling and costs of sales. However, Company C expects that the contract with Company D will increase its market capitalization because the incremental number of users of Company C's services enhance Company C's prospects for reaching the critical mass of users necessary for Company C to be profitable in the future. Subsequent to the signing of the initial agreement, incremental advertising revenues have not met Company C's initial expectations, decreasing the value of the remaining contractual right asset to Company C. Such circumstances could result in Company C having to recognize an impairment charge.

The EITF began its discussion of Issue 99-14 at the November 17-18, 1999 meeting. At that meeting, the EITF expressed a preference that companies that enter into executory contracts should evaluate them for impairment using a Statement 121 approach. (However, a consensus or tentative conclusion was not reached.) The SEC staff expressed significant concerns about this preference at the meeting because it believes executory contracts, as long as the company has not exited the activity, do not result in current losses so the outcome of the deliberations is not currently predictable. Under current practice, losses on executory contracts such as operating leases generally are not recognized unless a sublease is entered into (see FASB Technical Bulletin No. 79-15, Accounting for Loss on a Sublease Not Involving the Disposal of a Segment) or the company is exiting the activity (see EITF Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)). We believe this accounting is appropriate and should not be changed unless a consensus is reached establishing a new requirement. If the EITF decides an impairment loss could be recognized in certain circumstances, it is likely it would provide guidance on when and how to recognize it. Further discussion is expected at a future meeting.

The EITF has also begun debating Issue 00-26, Recognition by a Seller of Losses on Firmly Committed Executory Contracts, which addresses loss recognition issues associated with accounting for such arrangements from the seller’s perspective. At the January 17–18, 2001 meeting, the EITF expressed support for developing criteria under which a seller should recognize a loss under a firmly committed executory contract that will be executed by the seller and not otherwise terminated before full performance occurs and that was initially entered into at fair value ("loss contracts"). However, certain EITF members suggested that any methodology developed under this Issue should limit a loss contract liability to the amount that would be paid to terminate, transfer, or otherwise liquidate the contract.

The EITF recognized that due to the broad scope of this Issue, any model developed could be inconsistent with other authoritative guidance for specific transactions or industries and asked the FASB staff to identify potential conflicts. Certain EITF members observed that any model developed for this Issue should include a mechanism that ensures that a loss is not recognized twice (i.e., through recognition of a loss contract liability and an impairment of assets or leases used to provide the goods or services under the contract). Other EITF members suggested that any proposed methodology should address when, and how, individual contracts should be combined, as well as provide indicators of when a contract should be reviewed for possible loss recognition. Further discussion is expected at a future meeting.

Customer Origination and Acquisition Costs

Internet companies often make large investments in building a customer or membership base. A few examples of this are:

In each of these cases, a question may arise as to whether the costs represent customer origination or acquisition costs or costs of building a membership listing that qualify for capitalization, by analogy to FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. In its October 1999 letter to the EITF, the SEC staff indicated that it believes that most companies appear to be expensing such costs as incurred; therefore, diversity in practice, at least with respect to Internet companies, appears to be limited.

Nonetheless, due to the magnitude and complexity of customer acquisition activities in recent years, AcSEC has recently added this issue its agenda with the goal of providing comprehensive guidance for the accounting and disclosure for customer acquisition activities. As a part of the project, AcSEC is expected to address key issues such as:

This project may also address direct-response advertising in SOP 93-7. In March 2001, the FASB considered a prospectus for the project and expressed concerns about whether AcSEC should undertake the project. Alternatives explored by the FASB included the FASB undertaking the project, with the AICPA perhaps developing initial background information that might assist the Board in its project, if any. The FASB asked AcSEC to revise the prospectus to clarify the scope of the project, define the potential asset, and indicate the anticipated direction of the project. The FASB will reconsider the prospectus after those revisions are made.

Amortization Periods of Intangible Assets

Determining an amortization period for websites, domain names, and goodwill requires considerable judgment given the uncertainty of the success of a company, as well as the volatility in the Internet environment.

The SEC staff has taken the position that unrealistically long amortization periods for intangibles and goodwill inflate earnings and fail to accurately reflect the diminishing value of acquired assets. The SEC staff expressed particular concern in situations where a long amortization period is assigned to goodwill and intangibles in an industry that has little earnings visibility and low barriers to entry. The SEC staff will challenge an unrealistically short amortization period. The SEC staff does not find arguments that justify an amortization life solely on the basis of industry practice to be persuasive. Further, the SEC staff may request that registrants furnish evidence supporting the factors that are specific to that business. Further, Therefore, we believe that it is important for companies to consider all relevant information, such as the specific nature of the asset and how it will use the asset in determining its economic useful life. Some examples of specific application are provided below:

The amortization period for capitalized costs for development of the websites should be based on the economic useful life of the website which generally should be short, for example, three to five years. The three to five years should be used only as a general guide. The actual life should be determined based on factors such as the stage of the company (established/young) and the purpose of the website. Additionally, there may be instances in which a company develops a website for a third-party to be used for a specific purpose and for a specified period of time (e.g., a website may be developed to launch a new product; once the advertising of this new product is completed the website will no longer exist). In such instances, we believe that the amortization life should be based on the specified period of time in the arrangement or an estimate of the time in which the specific purpose will be fulfilled.

The amortization period for the cost of domain names acquired from a third party should be based on the estimated economic useful life of the asset. When determining the estimated useful life, the future revenue to be generated from the asset should be considered. We have seen instances in which the amortization period ranged from two to ten years, however, the appropriate period must be determined based on the facts and circumstances.

The goodwill amortization period should generally be short given the low barriers to entry, the rapid level of change in the industry, and the failure rate of start-up companies in this arena. The SEC staff’s general expectations are three to five years. We believe that the goodwill life should not be shorter than the life of the longest identified intangible asset, unless such intangible assets represent an insignificant piece of the total purchase price. (Companies should keep abreast of the FASB’s business combinations project which is expected to result in a new non-amortization, impairment-only approach. A final Statement is expected in July 2001.)

Internet companies (especially ISPs) frequently acquire groups of subscriber accounts or customer lists in a business combination. These accounts or lists typically are measured at the present value of the estimated net cash flows from the contracts (including expected renewals) and amortized over the life expectancy of the subscriber base. Because of customer attrition, the benefit of customer relationships within a large group of subscriber accounts often tends to dissipate, sometimes at a more rapid rate in the earlier periods following the acquisition, such that the future cash flows directly attributable to the acquired accounts declines on an accelerated basis. In this circumstance, an accelerated method of amortization, rather than the straight-line method, would be a more appropriate method of amortizing such costs.

Other intangible assets may also be present and these would have to be analyzed on a case by case basis. Generally, a starting assumption of a three to five year amortization life would be reasonable.

Exchange of Equity Instruments for Goods or Services

Many well-established companies are entering into transactions with start-up Internet companies under which the established companies provide services or a combination of cash and services in exchange for an equity interest (common stock, preferred stock, warrants, and/or stock options) in the start-up Internet companies. Often the services provided include advertising, traditional print, radio and TV ads or, alternatively, banners, buttons, or click-throughs on the established company’s website. These transactions involve both mature public Internet companies, as well as other more traditional media and entertainment companies.

While certain transactions that involve the exchange of equity instruments for goods or services are straightforward, others are more complex in that the exchange spans several periods and the issuance of the equity instruments is contingent upon service or delivery of goods that must be completed by the grantee (i.e., the goods or services provider) in order to vest in the equity instrument. Additionally, transactions are becoming common in practice where a fully vested, nonforfeitable equity instrument issued to a grantee contains terms that may vary based on the achievement of a performance condition or certain market conditions. For example, a fully vested stock option may be issued to a grantee that contains a provision that the exercise price will be reduced if the grantee completes a project by a specified date. In certain cases, the fair value of the goods or services to be received may be more reliably measurable than the fair value of the goods or services to be given as consideration.

These issues impact both the issuer of the equity instrument (typically the start-up Internet company) and the recipient of the equity instrument (typically the established company). Therefore, our discussion on the issue is divided into two sections: accounting by the issuer (grantor) and accounting by the recipient (grantee).

Accounting by the Issuer

FASB Statement No. 123, Accounting for Stock Based Compensation, and EITF Issue 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, address transactions where equity instruments are issued to nonemployees in exchange for goods or services. In addition, the EITF has added Issue 00-18, Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees, to its agenda which addresses certain measurement date issues not contemplated under Issue 96-18; however, no consensuses have been reached to date.

Determining the Measurement Date

The first step in accounting for equity instruments issued to other than employees is to determine whether the measurement date is fixed or variable. Most Internet companies want to have a fixed measurement date at the inception of the arrangement (before the services are complete) so that periodic revaluations of the equity instrument and associated expense volatility are not necessary. Although Statement 123 establishes the measurement principles for nonemployee transactions, Issue 96-18 addresses the date the issuer should use to measure the fair value of the equity instruments (the measurement date).

The measurement date for the equity instruments under Issue 96-18 is generally either the date of grant (i.e., a fixed award) or the vesting date (i.e., a variable award where the charge goes up or down as the price of the stock changes). For unvested options, in order to fix the measurement date prior to vesting, a performance commitment must exist. A performance commitment is a commitment under which performance by the counterparty to earn the equity instrument is probable because of a sufficiently large disincentive ("penalty") for nonperformance. The penalty must be large enough to require the counterparty to perform in accordance with the agreement. In general, this penalty should be a specified cash penalty; forfeiture of the equity instruments or the potential of being sued are not sufficient disincentives.

In cases where warrants are granted to a customer as an inducement to enter into a long-term (e.g., greater than, say, one year) sales contract and the warrants vest as sales are made to the customer, it is highly unlikely that a penalty could be large enough to make performance probable because the customer may at some point no longer need or be able to use the product. Furthermore, a slow down in the economy or decrease in the issuer’s stock price may affect the economics of the arrangement such that the customer may ultimately believe it is more beneficial and economical to cancel the transaction and pay the penalty. Accordingly, the penalty typically is inadequate in this situation because for a long-term sales contract it would not necessarily deter the customer from nonperformance and the measurement date would be variable.

At the July 19-20, 2000 meeting, the EITF began discussing Issue 00-18, Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees, which includes the following two issues related to the accounting by the issuer:

  1. If fully vested, exercisable, nonforfeitable equity instruments are issued at the date the issuer and recipient enter into an agreement for goods or services (no specific performance is required by the recipient to retain those equity instruments), the period(s) and manner in which the issuer should recognize the measured cost of the transaction; and
  2. If fully vested, nonforfeitable equity instruments are granted that are exercisable by the recipient only after a specified period of time, and the terms of the agreement provide for earlier exercisability if the recipient achieves specified performance conditions, how the issuer should measure and recognize the equity instruments at the arrangement date, and thereafter, if the recipient achieves the performance condition and exercisability is accelerated.

On the first issue, a majority of the EITF members agreed that by eliminating any obligation on the part of the counterparty to earn the equity instruments, a measurement date has been reached. Further, the EITF expressed a view that the issuer should recognize the equity instruments when they are issued (in most cases, when the agreement is entered into). The EITF generally agreed that whether the corresponding cost is an immediate expense or a prepaid asset (or whether the asset should be classified as contra-equity) depends on the facts and circumstances.

On the second issue, a majority of the EITF members agreed that the issuer should measure the fair value of the equity instruments at the date of grant and should recognize that measured cost under the same guidance as under the first issue above. Under this view, footnote 5 in Issue 96-18 would need to be amended to eliminate the reference to immediate exercisability. A majority of the EITF agreed that if, subsequent to the arrangement date, the recipient performs as specified and exercisability is accelerated, the issuer should measure and account for the increase in the fair value of the equity instruments resulting from the acceleration of exercisability using "modification accounting" (as described in paragraph 35 of Statement 123). That is, the adjustment would be measured at the date of the revision of the quantity or terms of the equity instrument as the difference between (a) the then-current fair value of the revised instruments utilizing the then-known quantity and terms and (b) the then-current fair value of the old equity instruments immediately before the adjustment.

However, the EITF did not reach a consensus on either of these issues, and further discussion of Issue 00-18 is expected at a future meeting.

Measuring the Fair Value of Equity Instruments

Once a measurement date is determined, the next step is to measure the fair value of the equity instrument. Statement 123 requires all transactions (except those entered into with employees that are covered by APB Opinion No. 25, Accounting for Stock Issued to Employees) in which goods or services are received for the issuance of equity instruments to be accounted for based on the fair value of the goods or services received or the fair value of the equity instruments issued, whichever is more reliably measurable.

Companies should assess whether the fair value of the goods or services received is more reliably measurable than the fair value of the equity instruments issued; however, in most cases, it typically would be important to determine the fair value of the equity instruments issued. Statement 123 defines fair value as follows:

The amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times that market price. If a quoted market price is not available, the estimate of fair value should be based on the best information available in the circumstances. The estimate of fair value should consider prices for similar assets or similar liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using discount rates commensurate with the risks involved, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis.

When valuing stock awards granted to nonemployees, Statement 123’s minimum value method (that excludes volatility) is not an acceptable method. The following methods are ways to apply the above methods for valuing equity instruments for which a public market does not exist:

  1. Obtaining a formal appraisal from an independent valuation expert or investment banker.

In addition to the initial valuation, the issuer of the equity instrument may require periodic revaluations in situations where the measurement date, under Issue 96-18, is not fixed (see discussion on measurement date under Issue 96-18 later in the section).

Ideally, the valuation should be made contemporaneous with the issuance of the equity instruments. In one fact pattern discussed by the SEC staff at the December 2000 AICPA Conference on Current SEC Developments, a company issuing equity instruments obtained in July 2000 a valuation of October 1999 equity grants based on a multiple of the grantor’s revenue for the 12 months prior to October 1999, while an investment banker performed in April 2000 a separate valuation, using a multiple of the grantor’s 2001 projected revenues. The SEC staff did not believe a valuation, performed 9 months after the initial equity grants and based on "inappropriate" revenue streams, provided persuasive evidence of the equity grants’ fair value as of October 1999.

Other problems or concerns that the SEC staff has seen in reviewing appraisals include:

2. Applying valuation techniques such as a Black-Scholes model for options and warrants.

To value options, a private company may use an estimation model, such as Black-Scholes. Our valuation tool, EY/Options, may be used to perform the calculation. The estimation models require the input of several highly subjective variables. It may be difficult for a start-up Internet company to obtain relevant and sufficient history to determine these input factors and obtain meaningful results. Expected volatility, which is a measure of the amount by which a stock price is expected to fluctuate, may be a particular challenge. Generally, expected volatility is estimated based on historical volatility. However, historical stock prices usually will not be available for a private company, and some young public companies may have insufficient trading history. In these situations, companies may use the pattern and level of historical volatility of a comparable public entity in the same industry. Statement 123 expressly allows that practice. For example, a company with only a one year trading history may grant an option with a five year life. In order to more appropriately predict the expected volatility of the stock, the company could consider the historical volatility of a comparable company in the same industry for the first five years the stock of that company was publicly traded. According to the SEC staff, the use of overall volatility measures typically would not be appropriate. For example, using the volatility of the NASDAQ 100 index to value common stock warrants issued by an Internet start-up company would not be appropriate because the volatility of well-established NASDAQ companies could not be expected to equal that of an Internet start-up company. Due to the large effect on the option valuation from even small changes to the subjective input assumptions, it is important for companies to carefully choose the assumptions used in the valuation to ensure that the results are meaningful.

  1. Using comparable independent third-party transactions.
  2. In some instances, other equity transactions of the company with independent third-parties involving comparable instruments may be referenced to determine the current value of the equity granted. Recent cash transactions involving an independent third-party provide objective evidence to determine the value of an equity instrument. However, the independent third-party transaction should be a stand-alone equity transaction and not part of a multiple-deliverable arrangement (see separate section on Revenue Arrangements with Multiple Deliverables). Occasionally, the only significant sales of company securities that might provide a relevant common stock pricing reference are convertible preferred shares. Careful consideration should be given to the respective terms of the two securities, with the help of an independent appraiser if possible, before using the convertible preferred stock as a basis for estimating the value of the related common stock. The rights for conversion, dividends, voting, and liquidation preferences are among those that need to be compared and analyzed. To the degree that the rights of the common stock are substantively similar to those of the convertible preferred stock, its value also should be similar. Where significant differences in value are considered appropriate, perhaps most often for liquidation preferences, objective evidence should support this. In many cases, a liquidation preference may have little or no value if a company is in the process of registering its common stock and the preferred stock is mandatorily converted to common stock on a one-for-one basis at the IPO date.

  3. Using the value of the goods or services.

Statement 123 asserts that the fair value of goods or services received from suppliers other than employees frequently is reliably measurable and therefore indicates the fair value of the equity instruments issued. In some cases, the goods or services received may be from well-established companies (e.g., media companies) and therefore, the issuing company may value the equity instruments issued based on the value of the services received. However, this may be more reliably measurable when the services provided represent more traditional advertising such as radio or television broadcasts or print media. This assumes the issuer would be able to obtain this information. Further, assuming that both parties would ideally use the same value, a question that arises in this situation is whether the media company should use its full rate card in determining the value of the services (and the equity instrument) or whether a discount from the full rate should be applied. Most traditional media companies have used the lowest discounted rate (i.e., bottom of the rate card). The rationale for the discount is that the advertising to be provided by the media company may not be considered prime advertising (i.e., it may be considered excess space). The best evidence of fair value would be to base the value of the services (advertising) on what the advertising objectively would be sold for in a cash transaction.

While all of the above methods used to measure the fair value of equity instruments are acceptable, the SEC staff indicated in a speech at the December 2000 AICPA Conference on Current SEC Developments that it believes a valuation, regardless of the method used, generally should include the following, among other items:

Balance Sheet Presentation

Questions often arise as to the appropriate balance sheet presentation of arrangements where unvested, forfeitable equity instruments are issued to a counterparty as consideration for future services. Prior to an SEC staff announcement made at the July 19-20, 2000 EITF meeting, practice was mixed as to whether such transactions are recorded at the measurement date. Some registrants made no entries until performance occurred, while others recorded the fair value of the equity instruments as equity at the measurement date and recorded the offset either as an asset or as a reduction of stockholders' equity (contra-equity).

As announced in EITF Topic D-90, the SEC staff believes that if the issuer receives a right to receive future services in exchange for unvested, forfeitable equity instruments, those equity instruments should be treated as unissued for accounting purposes until the future services are received (i.e., the instruments are not considered issued until they vest). Consequently, there would be no recognition at the measurement date and no entry should be recorded. The SEC staff will not enforce compliance with this guidance for arrangements entered into before July 20, 2000.

Income Statement Classification

At the December 2000 AICPA Conference on Current SEC Developments, the SEC staff discussed the appropriate income statement classification of the cost of equity instruments issued to non-employees. The SEC staff has consistently held that when equity instruments are issued to customers or potential customers in arrangements where the instrument will not vest or become exercisable without purchases by the recipient, the related cost must be reported as a sales discount – in other words, as a reduction of revenue.

Further, the SEC staff does not believe that undue emphasis should be placed on non-cash sales discounts on the face of the income statement. Unless cash-based sales discounts are otherwise presented as a reconciling item between gross revenue and net revenue, non-cash sales discounts generally should not be presented as a separate line item reconciling gross to net revenue. Similarly, when equity instruments are issued to suppliers or potential suppliers, and the instruments will not vest or become exercisable unless the recipient provides goods or services to the issuer, the cost of the equity instrument should be reported as a cost of the related goods or services. (The SEC staff’s position is consistent with Issue 96-18.)

In some circumstances, companies may wish to present separate line items within the income statement for the apparent purpose of emphasizing that a portion of the sales discounts or expenses did not involve a cash outlay. However, in certain instances, the SEC staff has objected to presentations and disclosures that put undue emphasis on revenue, gross margin, or other income statement measures before reductions for the costs of equity instruments issued to customers or suppliers.

Some companies also have issued equity instruments in arrangements that do not appear to require any performance from the counterparty. Some have argued that the lack of such a performance requirement indicates that the cost should be recorded as a marketing or even a non-operating expense, as opposed to a cost of sales or a reduction of revenue. However, the SEC staff is extremely skeptical of transactions that do not appear to require any performance from the potential customer or supplier in order for the options to vest and/or become exercisable. In the absence of any required future performance, the SEC staff presumes that the issuance of such equity instruments relates to past transactions between the entities and asks that the cost be classified accordingly (generally as a reduction of revenue if the company has sold products or services to the customer in the past).

In order to show that the issuance of equity in these situations is not related to past transactions, the SEC staff believes there should be evidence that the issuer has or will receive from the counterparty a direct benefit in return for the equity instrument that is separable from other business relationships between the issuer and counterparty. Furthermore, the SEC staff considers whether there is sufficient, objective, and reliable evidence that indicates that the fair value of such a benefit is at least as great as the fair value of the equity instruments.

In very rare and limited circumstances (e.g., when there was both no performance commitment and no past relationship between the companies) the SEC staff has accepted classification of the cost of the equity instruments as a marketing expense if such classification appeared reasonable, so long as detailed and transparent disclosures of the transaction, including the lack of any required performance and the fact that no consideration was received for the instrument, are made.

In addition, whenever significant amounts of equity instruments have been issued to business partners, the SEC staff believes that MD&A should include sufficient discussion of the effects of these non-cash transactions on the results of operations, why they are used, and what effect their use has on the comparability of the results of operations in the periods presented.

Accounting by the Recipient

The accounting for equity instruments received in exchange for services is a multi-step process: determining the measurement date to value the transaction, determining how to measure fair value, determining when and at what amount to recognize revenue, and determining how to account for subsequent changes in the value of the equity instrument received (if the measurement date is not fixed). The accounting for the equity instruments received is governed by EITF Issue 00-8, Accounting by a Grantee for an Equity Instrument to Be Received in Conjunction with Providing Goods or Services. The accounting for the revenue recognition is governed primarily by FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, and SAB 101 (provided that the transaction is not specifically addressed in other accounting literature) and the accounting for nonmonetary transactions involving the receipt of equity instruments is governed by APB Opinion No. 29, Accounting for Nonmonetary Transactions.

The consensus in Issue 00-8 was based on the consensus in Issue 96-18. The measurement requirements in each of the consensuses essentially mirror one another; however, in some instances, the guidance in Issue 96-18 is more developed than in Issue 00-8. In those situations, the best starting point would be to analogize to Issue 96-18. For example, Issue 00-8 does not address the timing of revenue recognition whereas Issue 96-18 states that costs should be recognized in the same manner as if it were a cash transaction. FASB Concepts Statement 5 and SAB 101 describe the general rules for revenue recognition in cash transactions.

Issue 00-8 applies to all grants and to modifications of existing grants that occur after March 16, 2000. The notion "modifications of existing grants" does not include changes to the quantity or terms of an equity instrument that occur when any originally unknown quantity or term becomes known pursuant to the terms of the original instruments.

Consistent with Issue 96-18, Issue 00-8 states that the measurement date is the earlier of the date on which the services are complete or the date at which a commitment for performance by the counterparty to earn the equity instruments is reached (a performance commitment). If on the measurement date the quantity or any of the terms of the equity instrument are dependent on the achievement of a market condition, then the grantee should measure revenue based on the fair value of the equity instruments inclusive of the adjustment provisions. That fair value would be calculated as the fair value of the equity instruments without regard to the market condition plus the fair value of the commitment to change the quantity or terms of the equity instruments if the market condition is met. That is, the existence of a market condition that, if achieved, results in an adjustment to an equity instrument generally affects the value of the instrument. As noted in footnote 10 to Statement 123, pricing models have been adapted to value many of those path-dependent equity instruments.

Additionally, if on the measurement date the quantity or any of the terms of the equity instruments are dependent on the achievement of grantee performance conditions (beyond those conditions for which a performance commitment exists), changes in the fair value of the equity instrument that result from an adjustment to the instrument upon the achievement of a performance condition should be measured as additional revenue from the transaction using a methodology consistent with Statement 123 "modification accounting." Changes in the fair value of the equity instruments after the measurement date unrelated to the achievement of performance conditions should be accounted for in accordance with any relevant literature on the accounting and reporting for investments in equity instruments, such as APB 18 and Statement 115. In addition, consideration should be given to whether the instrument meets the definition of a derivative under Statement 133.

The EITF also observed that in accordance with APB 29, 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 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 materially favorable or unfavorable impact on revenues. In addition, whenever significant amounts of equity instruments have been received from business partners, the SEC staff believes that MD&A should include sufficient discussion of the effects of these non-cash transactions on the results of operations, why they are used, and what effect their use has on the comparability of the results of operations in the periods presented.

The following example illustrates the application of the measurement date guidance in Issue 00-8 for a transaction in which a performance commitment exists prior to the time that the grantee's performance is complete and the terms of the equity instrument are subject to adjustment after the measurement date based on the achievement of specified performance conditions.

On 1/1/X2, Company grants Service Provider 100,000 options with a life of 2 years. The options vest if Service Provider advertises products of Company on Service Provider's website for 18 months ending 6/30/X3. Company also agrees that if Service Provider provides 3 million "hits" or "click-throughs" during the first year of the agreement, the life of the options will be extended from 2 years to 5 years. If Service Provider fails to provide the agreed upon minimum of 18 months of advertising through 6/30/X3, Service Provider will pay Company specified monetary damages that, in the circumstances, constitute a "sufficiently large disincentive for nonperformance."

Service Provider would measure the 100,000 stock options for revenue recognition purposes on the performance commitment date of 1/1/X2 using the 2-year option life. Assume that at the measurement date (1/1/X2) the fair value of the options is $400,000. On 12/1/X2, Service Provider has provided 3 million "hits" and the life of the option is adjusted to 5 years. Service Provider would measure additional revenue pursuant to the achievement of the performance condition as the difference between the fair value of the adjusted instrument at 12/1/X2 (i.e., the option with the 5-year life assumed to be $700,000) and the then fair value of the old instrument at 12/1/X2 (i.e., the option with the 2-year life, which is assumed to be $570,000). Accordingly, additional revenue of $130,000 would be measured. The remaining $170,000 increase in fair value of the instrument should be accounted for in accordance with the relevant literature on the accounting and reporting for investments in equity instruments, such as APB 18, Statement 115, and Statement 133.

In certain circumstances, it may be difficult to value an equity instrument received from a privately-held company. However, that does not relieve a company from the requirement of valuing the transaction. In a speech at the December 1999 AICPA Conference on Current SEC Developments, the SEC staff stated that it understands that "some recipients of equity-based compensation, particularly equity of private companies, may be ascribing little or no value to such consideration, even though the fair value of the consideration may be substantially higher." Generally, the SEC staff believes this would not be acceptable. Refer to the section above on accounting by the issuer for guidance on valuing equity instruments for which a public market does not exist. Because the transaction will result in revenue recognition by the grantee, particular care should be given to ensure the value is reasonable.

At the July 19-20, 2000 meeting, the EITF began discussing Issue 00-18 which, in addition to addressing several issues concerning the accounting by the issuer, addresses the recipient's accounting for the contingent right to receive an equity instrument when a performance commitment by the recipient exists prior to the receipt (vesting) of the equity instrument. A majority of the EITF members agreed that the recipient should account for the arrangement as an executory contract (i.e., generally no accounting before performance) in the same manner as it would if the issuer had agreed to pay cash (upon vesting) for the goods or services. Further discussion of Issue 00-18 is expected at a future meeting.

Revenue Arrangements With Multiple Deliverables

The ease of an Internet company’s ability to provide goods and services at different points in time or over different periods of time has resulted in many Internet companies entering into complex purchase and sale arrangements. These arrangements may involve the delivery of more than one product, the provision of multiple services, or a combination of both. In other cases, these arrangements may involve the right to use certain intangible assets over a period of time (e.g., a license). Each revenue-generating activity may be considered a separate "element" or "deliverable" if certain conditions are met.

These arrangements may require payment as goods are delivered or services are provided or they may involve either an up-front fee or an up-front fee coupled with a continuing payment stream. A continuing payment stream generally corresponds to the provision of services or delivery of products over time or a license term. The continuing payments may be fixed, variable based on future performance, or a combination of fixed and variable.

Issue 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, addresses how to account for multiple-deliverable revenue arrangements and focuses on when a revenue arrangement should be separated into different revenue-generating deliverables or "units of accounting" and if so, how the arrangement consideration should be allocated to the different deliverables or units of accounting.

An example of a multiple-deliverable arrangement would be a company that provides a service (e.g., Internet access) that requires the use of specific equipment to obtain the service. The equipment generally is sold to the customer and is bundled with the continuing service for a stated period as part of one fixed-fee arrangement. The issue is whether the equipment and the service can be accounted for separately and if so, how the arrangement consideration would be allocated to the two deliverables.

After discussing the Issue for several meetings, the EITF reached a tentative conclusion on Issue 00-21 at the April 18-19, 2001 meeting as part of a delicate compromise with the SEC staff. The EITF will discuss this Issue at a future meeting.

Under the tentative conclusion, a revenue arrangement with multiple deliverables should be divided into separate units of accounting based on the deliverables in the arrangement if (1) there is objective and reliable evidence of fair value to allocate the arrangement consideration to the deliverables in the arrangement and (2) the deliverable meets either of the following criteria, at the inception of the arrangement:

  1. The deliverable does not affect the quality of use or the value to the customer of other deliverables in the arrangement that could (given the characteristics of the deliverables or according to the contractual terms of the arrangement) be delivered before the deliverable being evaluated.
  2. The deliverable could be purchased from another unrelated vendor without diminishing the quality of use or the value to the customer of the remaining deliverables in the arrangement.

If neither criterion (a) nor criterion (b) is met, the deliverable being evaluated would not qualify to be a separate unit of accounting within the revenue arrangement. Instead, that deliverable would be combined with the other items within the arrangement and the appropriate revenue recognition then would be determined for those combined deliverables as a single revenue accounting unit.

Regarding inconsequential and perfunctory deliverables (i.e., "small" or "incidental" deliverables), the EITF tentatively concluded that vendor may adopt a policy of excluding a deliverable from the revenue accounting for an arrangement (and therefore account for the item as an accrued cost) if it meets all of the following conditions:

          1. The deliverable does not affect the quality of use or the value to the customer of other deliverables in the arrangement or could be purchased by the customer from another unrelated vendor without diminishing the quality of use or value of the other deliverables in the arrangement.
          2. Any vendor obligation relating to nonperformance (failure to provide the deliverable being evaluated) would not result in a refund, revenue reversal, or concession.
          3. The deliverable is inconsequential or perfunctory. In order to consider the deliverable inconsequential or perfunctory, the vendor should have a demonstrated history of providing the deliverable in a timely manner and reliably estimating the cost of providing that deliverable.

The EITF also tentatively concluded that the presence of contractual terms that provide the customer with return, refund, or concession rights does not preclude a vendor from recognizing revenue on a relative fair value basis for previously delivered items that have been identified as separate units of accounting if the vendor is able to make reasonable and reliable estimates of the likelihood of completing performance under the arrangement and that performance is probable. The consensus will provide several factors that would indicate that a vendor is unable to make a reasonable and reliable estimate of the amount of future refunds, concessions, or returns resulting from the vendor's failure to complete performance under the arrangement.

If a vendor is not able to make a reasonable and reliable estimate of the likelihood of completing performance, as well as the related forfeiture, refund or other concession, under the arrangement, revenue should not be recognized for the portion of the allocated fee that is subject to forfeiture, refund, or other concession. Revenue that is initially not recognized would be recognized either when the return, concession, or refund privilege has expired (for example, upon delivery of the remaining items in an arrangement).

The final consensus is expected to include several disclosure requirements.

Existing Guidance

Pending a final consensus on Issue 00-21, the FAQ document on SAB 101 issued in October 2000 indicates that companies should use a "reasoned method of accounting" for multiple-deliverable arrangements that is applied consistently and disclosed appropriately. Question 4 of the FAQ document indicates that the SEC staff has stated that it will not object to a method that includes the following conditions:

  1. To be considered a separate element, the product or service in question represents a separate earnings process. The SEC staff notes that determining whether an obligation represents a separate element requires significant judgment. The SEC staff also notes that the best indicator that a separate element exists is that a vendor sells or could readily sell that element unaccompanied by other elements.
  2. Revenue is allocated among the elements based on the fair value of the elements. The fair values used for the allocations should be reliable, verifiable and objectively determinable. The SEC staff does not believe that allocating revenue among the elements based solely on cost plus a profit margin that is not specific to the particular product or service is acceptable because, in the absence of other evidence of fair value, there is no objective means to verify what a profit margin should be for the particular element(s). Additional guidance on allocating among elements may be found in SOP 81-1, SOP 97-2, and SOP 98-9. If sufficient evidence of the fair values of the individual elements does not exist, revenue would not be allocated among them until that evidence exists. Instead, the revenue would be recognized as earned using revenue recognition principles applicable to the entire arrangement as if it were a single element arrangement.
  3. If an undelivered element is essential to the functionality of a delivered element, no revenue allocated to the delivered element is recognized until that undelivered element is delivered.

If the above criteria are met, companies would essentially have a "safe harbor" to allocate revenue to the different deliverables in a multiple-deliverable arrangement. However, we understand that the SEC staff would not necessarily object to allocating revenue even if not all of the above guidelines were present provided that companies arrive at well-reasoned basis of accounting. This would have to be based on the specific facts and circumstances that should be well-documented and companies should monitor EITF activities on this issue.

In addition to the guidance in the FAQ document, we believe the following should be helpful until the EITF reaches a final consensus on Issue 00-21:

As discussed above, the FAQ document indicates the SEC staff’s view that an allocation of the arrangement fee based solely on cost plus "normal" profit margins or similar measures is not acceptable because, in the absence of other evidence of fair value, there are no objective means to verify if the profit margin specific to the particular service or product approximates the "normal" profit margin.

In addition, the FAQ document reminds companies that prices listed in a multiple-deliverable arrangement with a customer may not be representative of the fair value of those deliverables because the prices of the different components of the arrangement can be altered in negotiations and still result in the same aggregate consideration.

"Points" and Other Time/Volume-Based Offers

Many Internet companies have developed business models that involve building a membership list through the use of "points" and other time/volume-based offers. The objective of such offers is to build brand loyalty and increase sales volume. These offers typically are structured so that a specified volume of transactions, or membership over a specified time period, is required in order for a customer or program member to earn sufficient award credits to redeem an award. Each time a customer or program member purchases a product or service, or performs an action specified as part of the loyalty program requirements, he or she earns award credits that, subject to specified minimum thresholds, may be redeemed in the future for awards such as free, or deeply discounted, products or services.

Issue 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, addresses vendor-sponsored programs that offer awards consisting of the vendor's products or services, broad-based programs operated by program operators whose business consists solely of administering the loyalty program, and combination programs operated by vendors for their own customers as well as other participating vendors and their customers.

The basic issue is whether a portion of revenue associated with the product or service being sold should be deferred or if revenue could be recognized in full at the time of sale with an accrual for the incremental costs of the award.

Issue 00-22 is expected to provide guidance on how a vendor should account for the following three types of offers to customers:

  1. Free or discounted products or services delivered by the vendor that are redeemable (become earned) only if the customer completes a specified cumulative level of revenue transactions or remains a customer for a specified time period (e.g., accumulating "points" which can be redeemed for free merchandise).
  2. Free or discounted products or services from the vendor that is redeemable by the customer at a future date without a further exchange transaction with the vendor (e.g., purchasing software and receiving a coupon for a year of free Internet service).
  3. Cash rebates or refunds if the customer completes a specified cumulative level of revenue transactions or remains a customer for a specified time period (e.g., a rebate of 1% of on-line purchases over $1,000 per year).

Regarding the first two types of offers, some EITF members expressed a preference for an accounting approach that would allocate a portion of the revenue on the transaction to the product or service that may be delivered in the future, while other EITF members expressed a preference for an accounting approach that would be based on the significance of the value of the award products or services as compared to the value of the transactions necessary to earn the awards. If the value of the award products or services is insignificant in relation to the value of the transactions necessary to earn the awards, a liability would be recorded for the estimated cost of the award products or services.

At the January 17–18, 2001 meeting, the EITF reached a consensus (affirming a prior tentative conclusion) on accounting for the third type of offer above. Under the consensus, a vendor should recognize a cash rebate or refund obligation as a reduction of revenue based on a systematic and rational allocation of the cost of the rebates or refunds to each of the underlying revenue transactions that result in progress by the customer toward earning the rebate or refund. Measurement of the total cash rebate or refund obligation should be based on the estimated number of customers that will ultimately earn and claim rebates or refunds under the offer (that is, "breakage" should be considered if it can be reasonably estimated). However, if the amount of future cash rebates or refunds cannot be reasonably estimated, a liability should be recognized for the maximum potential amount of the refund or rebate. The ability to make a reasonable estimate of the amount of future cash rebates or refunds depends on many factors and circumstances that will vary from case to case (see Issue 00-22 for factors that may impair a vendor’s ability to make reasonable estimates).

In some cases, the relative size of the cash rebate or refund changes based on the volume of purchases. For example, the rebate may be 10% of total consideration if more than 100 units are purchased but may increase to 20% if more than 200 units are purchased. If the volume of a customer's future purchases cannot be reasonably estimated, the maximum potential cash rebate or refund factor should be used to record a liability (20% in the example). In contrast, if the volume of a customer's future purchases can be reasonably estimated, the estimated amount of cash to be rebated or refunded should be recognized as a liability.

The EITF also reached a consensus that changes in the estimated amount of cash rebates or refunds and retroactive changes by a vendor to a previous offer (an increase or a decrease in the rebate amount that is applied retroactively) should be recognized using a cumulative catch-up adjustment. That is, the vendor would adjust the balance of its rebate obligation to the revised estimate immediately. The vendor would then reduce revenue on future sales based on the revised refund obligation rate as computed (see Issue 00-22 for an example).

The EITF consensus on cash rebates and refunds should be applied no later than quarters ending after February 15, 2001. The effect of application should be reported on a cumulative effect basis as a reduction of revenue. Upon application of the consensus, rebate or refund amounts reported as an expense in prior-period financial statements presented for comparative purposes should be reclassified to comply with the income statement display requirements (i.e., presented as a reduction of revenue).

Also at the January 17–18, 2001 meeting, the EITF discussed the Working Group's observations and general direction with regard to the accounting for "points" and other time/volume-based offers by program operators but was not asked to reach a consensus. The Working Group preliminarily believes that the sale of award credits by a program operator to other vendors is a multiple-deliverable revenue arrangement in which the deliverables consist of the award product(s) or service(s) and certain other services provided by the program operator to the sponsor. If the deliverables under the arrangement cannot be identified or the fair value of the deliverables other than the award product(s) or service(s) is not determinable, Working Group members expressed a preference for developing a revenue recognition approach with respect to these loyalty program arrangements that is either similar to the residual approach found in SOP 98-9 or based on the program operator's proportionate performance under the arrangement.

The EITF also raised concerns about whether the deliverables offered by a program operator are indeed separable and about the timing of revenue recognition for credits that may not be redeemed. Accordingly, the EITF requested that the FASB staff and the Working Group consider those concerns as well as the interaction between Issue 00-21 and Issue 00-22. Further discussion is expected at a future meeting.

Software that Resides on the Vendor’s or a Third-Party’s Server

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 (1) the right to use the software and (2) the storage of the software on someone else's hardware (often referred to as hosting). The question is whether that transaction is in the scope of SOP 97-2.

At the March 16, 2000 meeting, the EITF reached a consensus on Issue 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 consensus states that a software element covered by SOP 97-2 is only present in a hosting arrangement if the customer has the contractual right to take possession of the software at anytime during the hosting period without significant penalty and it is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software. Therefore, SOP 97-2 only applies to hosting arrangements in which the customer has such an option. Arrangements that do not give the customer such an option are service contracts and are outside the scope of SOP 97-2. The EITF observed that hosting arrangements that are service arrangements may include multiple elements that affect how revenue should be attributed.

The EITF reached a consensus that for those hosting arrangements in which the customer has the option, as described above, to take possession of the software, delivery of the software occurs when the customer has the ability to take immediate possession of the software. The EITF observed that if the software element is within the scope of SOP 97-2, all of the SOP's requirements for recognizing revenue, including vendor-specific objective evidence (VSOE) of fair value and the requirement that the fee allocated to the software element not be subject to forfeiture, refund, or other concession must be met in order to recognize revenue upon delivery for the portion of the fee allocated to the software element. The portion of the fee allocated to the hosting element should be recognized as the service is provided. The EITF noted that hosting arrangements that are within the scope of SOP 97-2 may also include other elements, such as specified or unspecified upgrade rights, in addition to the software product and the hosting service.

The EITF observed that if the vendor sells, leases, or licenses software that is within the scope of SOP 97-2, then the development costs of such software should be accounted for in accordance with Statement 86. Conversely, if the vendor never sells, leases, or licenses the software in an arrangement within the scope of SOP 97-2, then the software is utilized in providing services and the development costs of the software should be accounted for in accordance with SOP 98-1. However, if during such software’s development or modification, the vendor develops a substantive plan to sell, lease, or otherwise market the software externally, the development costs of the software should be accounted for in accordance with Statement 86.

Revenue Recognition for Auction Sites

It has become increasingly popular for Internet companies to sponsor auction sites or to be in business for the sole purpose of running an auction site. The Internet company (an auction house in this case) is a facilitator in the transaction. The auction house does not take title to the goods and does not assist in closing the transaction. The auction house merely provides a website for people to list their goods for auction. Internet auction houses usually charge both up-front (listing) fees and back-end (transaction-based) fees.

To the extent that the front-end or back-end fees are not payment for separate deliverables (i.e., the fee does not relate to a specific product delivered or service performed that represents the culmination of a separate earnings process), SAB 101 and the SAB 101 FAQ document provide guidance on when to recognize revenue. Specifically, Questions 5, 6, and 7 of SAB 101, and Question 10 in the SAB 101 FAQ document provide guidance on the issue of revenue recognition in connection with front-end fees. Generally, we believe that up-front listing fees should be recognized over the listing period, which is the period of performance. We generally believe that nonrefundable, back-end transaction fees should be recognized when the underlying sale transaction occurs because facilitation of that sale represents the earnings process. If the back-end fee is refundable until some later event occurs (e.g., after the underlying sale is completed), Question 7 of SAB 101 provides relevant guidance. If the auction site has continuing involvement with the transaction after initially facilitating the sale, then the earnings process may not be complete and some or all of the fee may need to be deferred, depending on the relevant facts and circumstances.

Access and Maintenance of Websites

Internet companies 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 Internet 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. In accordance with SAB 101, up-front fees like this (even if nonrefundable) generally should be recognized over the performance period, which would be the period over which the Internet company has agreed to maintain the website or listing, as appropriate. The fee generally should not be recognized up-front because the earnings process is not yet complete because the company has a continuing performance obligation under the terms of the arrangement. If the fee relates to a separate deliverable, the accounting for that fee is expected to be addressed in Issue 00-21.

Advertising Arrangements with Guaranteed Minimums

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 minimum guarantees on "hits," "viewings," or "click-throughs." A typical example is where an Internet company guarantees a certain number of impressions over a certain period of time. The payment for the advertising may be made up-front or based on a payment plan (usually separate from the "delivery" progress of the impression). If the Internet company does not deliver the required number of minimum impressions, the arrangement may be extended to achieve the minimums and additional impressions also may be delivered. Some Internet companies may not recognize revenue until the guarantee is achieved while others may assess the likelihood of achieving the guaranteed minimum and recognize revenue ratably over the hosting period. Some situations may be analogous to the contingent rent for lessors issue discussed in Question 8 of SAB 101 (for example, if no amounts become due if a guaranteed minimum number of hits or clickthroughs is not achieved). Accordingly, revenue would not be recognized until the guaranteed minimum is achieved. The terms of these arrangements vary somewhat from contract to contract and therefore the facts and circumstances of each arrangement need to be analyzed to assess when revenue should be recognized.

Segment Information

One significant focus of SEC staff reviews during 2001 will be to evaluate whether registrants have complied completely with all the disclosure requirements of FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information. Statement 131 defines an operating segment as a component of an enterprise that engages in business activities from which it may earn revenues and incur expenses, whose operating results are regularly reviewed by the enterprise's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. Segments may be aggregated in the disclosure only to the limited extent permitted by Statement 131.

According to the SEC staff’s October 1999 letter to the EITF, if the chief operating decision maker 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. On a few occasions, the SEC staff has requested copies of all reports furnished to the chief operating decision maker if the reported segments did not appear realistic for management's assessment of a company's performance or conflicted with that officer's public statements describing the company. The SEC staff also has reviewed analysts' reports, interviews by management with the press, and other public information to evaluate consistency with segment disclosures in the financial statements. Where that information revealed different or additional segments, the SEC has required amendment of the company’s filings to comply with Statement 131.

Disclosures About Revenues

Most of the disclosure requirements in SAB 101 are applicable to Internet companies. Specifically, SAB 101 requires that a registrant always disclose its revenue recognition policy. Also, if a company has a different policy for different types of revenue transactions (e.g., barter transactions), the policy for each material types of transaction should be disclosed. If a company has sales transactions that include multiple deliverables, the revenue recognition policy for each deliverable as well as the policy for determining and valuing the deliverables should be disclosed. SAB 101 also points out that Regulation S-X requires companies to disclose the various types of revenue they generate (e.g., revenue from products versus services) separately on the face of the income statement. In addition, SAB 101 indicates that the SEC staff believes that the costs relating to each type of revenue also should be disclosed on the face of the income statement. Other disclosure requirements of SAB 101 possibly could apply as well (refer to SAB 101 for further details).

The SEC staff believes all public companies should review the completeness and accuracy of disclosures concerning their sources of revenues, method of accounting for revenues, and material considerations in evaluating the quality and uncertainties surrounding their revenue generating activity. Disclosures should be concise and to the point; more disclosure is not necessarily better. Descriptive information about the effects of variations in revenue generating activities and practices, or changes in the magnitude of specific uncertainties, should be provided in MD&A. Accounting policies, material assumptions and estimates, and significant quantitative information about revenues should be included in notes to the financial statements.

Based on the March 31, 2001 edition of Current Accounting and Disclosure Issues issued by the Division of Corporation Finance, specific disclosures the SEC staff expects to see include the following:

Disaggregate product and service information

Disclose when revenue is recognized (examples)

If revenue is recognized over the service period, based on progress toward completion, or based on separate contract elements or milestones, disclose how the period's revenue is measured

Disclose material assumptions, estimates and uncertainties