The growing number of companies with Internet activities has prompted the SEC to address accounting for these activities already in October 1999. The SEC Chief Accountant back then, Lynn Turner, sent a letter to the FASB director of research and technical activities requesting that FASB consider a number of issues related to accounting for Internet activities. But have new specific guidelines been provided?
One issue related to accounting for Internet activities is the choice between using gross versus net revenue and cost display. This issue is still open to the company interpretation. Should companies report the amount received from the end-user as revenue and the amount paid to the supplier as cost of sales (expense), or report just the net amount as revenue (as if that amount were a commission paid by the supplier for generating a sale)? Those two methods are different in their essence: Gross reporting treats the transaction as the company purchasing a product or service from the supplier and then selling that product or service to the end-user while net reporting relates to the transaction as the end-user making a purchase from the supplier with the company acting as a sales agent. In order to make this determination there is a need to evaluate the relationships between the supplier, the company and the end customer.
The same logic is used for the case of Yahoo and Google: the proper accounting method depends on the company’s perception of its business. Is the company acting as an “agent” for a deal, or as a “principal” taking the risk to lose money?
It seems to me a bit absurd that FASB leaves this issue open to the personal interpretation of companies. For FASB, as long as a company keeps consistency in its reporting method, the company is following the principles. However, this situation of diversity in practice confuses investors and other financial statements users. I think that FASB should provide additional, specific guidance on the issue, guidance that will result in consistency and unity and won’t leave room for personal interpretations. A situation like that would improve the financial information presented and make the life of investors easier.
In light of different revenue reporting methods by similar companies, a good way to remove the distortions is to value the companies based on their historical free cash flow. This is cash flow from operations minus capital expenditures. A company with consistent generation of free cash flow is a more favorable investment than the opposite.
To go one step further, dividends can also be included in subtracting from the net operating cash flow. Companies with historical dividend payments cannot easily reduce or suspend dividends without causing shareholder pain. In this case however, both Yahoo and Google does not pay out dividends.