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Accounting for dotcoms

Michael Kavanagh writes on the latest developments in financial reporting of Internet companies

AS THE share price volatility of the technology sector continues, more emphasis and scrutiny is now being directed towards the quality of Internet companies' financial reporting. A number of recent cases have helped highlight this is sue. America Online was fined $3.5 million by the SEC following the discovery of accounting irregularities in its advertising accounts. MicroStrategy was forced to withdraw and reissue its financial statements (turning a $12.6 million profit into a $35 million loss) due to its treatment of reciprocal deals. This lead to an immediate 63 per cent collapse in its share price.

The ``new economy'' companies often have high market capital values which are not supported by assets or profits. Many are loss-making and derive their values from anticipated future revenue. This, and certain accounting issues unique to Internet compani es present challenges to both the accounting and auditing professions. Some have accused the standard setters of being slow to react. However, to be fair to the UK Accounting Standards Board (ASB) and the Auditing Practices Board (APB), the issues are co mplex and need detailed consideration and consultation prior to issue of guidance on them.

Barter transactions

These are becoming increasingly common among Internet companies, partly due to the low revenues generated from operations and the significant costs incurred in the early years of trading. A typical transaction arises where two Internet companies place ad vertisements on each other's websites. Such an exchange gives rise to the question of what amount, if any, should be reported as turnover (often cited as a significant measure of performance for Internet companies).

The ASB issued a draft UITF Abstract recently which concludes that turnover and costs in respect of such transactions should not be recognised unless there is persuasive evidence of the value at which, if the advertising had not been exchanged, it would have been sold for cash in a similar transaction. In these circumstances, that value should be included in turnover and costs. The draft Abstract states that evidence of the value of advertising exchanged will exist only where the entity has a history of selling similar advertising for cash, and where substantially all of the turnover from advertising within the accounting period is represented by cash sales.

In other words, a start-up company may, for example, enter into barter arrangements merely to fill available space on its website which it cannot otherwise dispose of to third parties for settlement in cash. This cannot be recognised as generating income . However, if a company is well established and has a track record of selling comparable advertisements on its website to third parties for cash settlement, then values can be attributed to this barter transaction and it can be included in turnover and c ost of sales.There is a growing trend for companies which provide services to Internet companies to seek payment for such services by obtaining an equity stake in the Internet company. Internet companies commonly grant share options to employees. The ASB recently published a discussion document which intends to radically change current methods of accounting for the granting of such ``share-based payments''. The proposals will potentially lead to major reductions in the profits of Internet companies, thu s leading investors to mark share prices down. One thing is clear, we can expect the mother of all battles between industry and the ASB.

The Paper proposes that transactions involving share-based payments should be measured at the fair value of the shares or share options at vesting date. Vesting date is the date upon which the other party (the employee or supplier), having performed all of the services or provided all of the goods necessary, becomes unconditionally entitled to the options or shares. In most cases, an option-pricing model should be applied to establish the fair value of an option.

At present, where a company purchases employee services by issuing share options, in many cases no expense is recognised in the company's profit and loss (P&L) account. In contrast, applying the proposals in the discussion paper would result in a charge to the P&L account. The potential effect is startling -- a UK research company found that the profits of 145 large US companies would have been one-third lower in 1998 if the latent value of option awards had been taken into account.

Costs of developing a website

The ASB issued a Draft UITF Abstract on October 19 titled Website development costs. However, it is currently being considered by the ASB. Costs relating to the development of a website may potentially be capitalised if the site is designed directly to g enerate revenue. This is consistent with the official definition of an asset -- ``a right or other access to future economic benefits controlled by an entity as a result of past transactions or events''. In other words, the entity has to receive economic benefits at least as great as the proposed capitalised amount. Costs for other sites, such as those which act purely as a means for a company to advertise products and services, should normally be expensed as incurred.

Should the development of the website be deemed to qualify as an asset the costs directly related to the installation of the website may be considered capital in nature, and treated as a tangible fixed asset in accordance with FRS 15 Tangible Fixed Asset s. These would include the cost of hardware, and of software which provides the website with its operational ability, and encryption software to be used for credit card transactions.

The question of whether to capitalise such costs as design, content and appearance of the website is one on which opinions vary. The draft UITF suggests capitalisation if the following criteria are met:

a) the expenditure is separately identifiable;

b) the technical feasibility and commercial viability of the website have been assessed with reasonable certainty in the light of factors such as likely market conditions (including competing products), public opinion, and possible legislation;

c) the aggregate of the costs and future costs to be incurred on the website is reasonably expected to be exceeded by the profit on future sales or other revenues arising directly from the website; and

d) adequate resources exist, or are reasonably expected to be available, to enable the website project to be completed and to provide any consequential increases in working capital.

Others would feel that there are few opportunities for capitalisation of such costs, especially if they are internal. It should be remembered that the UITF is at draft stage and may change prior to adoption.

In view of the rate of technological change in the sector, any costs which are capitalised should be amortised over a relatively short period and the useful economic life reviewed at the end of each reporting period.

Domain names

The cost of registering a domain name will normally be small. However, in certain cases, domain names have been registered by so-called `cyber-squatters'. Substantial costs have in the past been incurred by companies in acquiring rights to domain names w hich have been obtained by these cyber-squatters.

Where a pre-existing name unrelated to that of the business is purchased, the external direct costs of its acquisition may be capitalised if it is to be used in a new business. This could be deemed to be separate intellectual property. If it is acquired in order to protect an existing business or brand, it should not be capitalised as it would not meet the definition of an asset as discussed previously. However, no official guidance is yet forthcoming on this issue.

When determining the useful economic life, future revenue which is likely to be generated under the name needs to be considered. The rapid pace of change in the technology sector, together with companies being in their early stages of trading, indicates that a more prudent view should be taken. As with websites, periods of no more than three years would seem appropriate.

These are just some of the issues facing the so-called ``new economy'' companies. For all of us, and particularly accountants, it raises a number of issues and poses a number of problems. An attempt has been made to deal with some of these but there is l ittle doubt that more will arise in this rapidly changing environment.

(Edited extracts from Accounting & Business, a journal of ACCA, London.)