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JILT 2001 (3) - Manly and Leonard

 

 


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New Financial
Reporting Regulations for E-Commerce Companies
 

Tracy Manly
Assistant Professor of Accounting
University of Tulsa, USA
Tracy-manly@utulsa.edu

Lori N K Leonard
Assistant Professor or MIS
University of Tulsa, USA
Lori-leonard@tulsa.edu
 

Abstract

The Internet provides a mechanism for business growth, yet it creates challenges for many organisations. Conducting business on the Internet, both providing information and buying-and-selling, creates a huge expense in the form of information technology and personnel time. Given these expenses, organisations focus on showing revenue in the short-term, which they believe to be an indicator of the potential future profits that the organisation will encounter from the use of the Internet and World Wide Web (WWW) technology. However, recent accounting practices have shown that revenue reported from some Internet companies may not truly meet the traditional accounting definition of 'revenue'. If the standard definition is not being used, then investors and potential investors may be being misled about the true company performance. In response to the diversity of accounting practices used by e-commerce firms, regulators have issued new guidelines that directly impact their future financial reports. This paper addresses the problematic accounting practices of some Internet companies and what accounting regulators in the US and UK have done in response.

Keywords: Internet, Accounting Practices, E-commerce, Financial Reporting Regulations.


This is a Refereed article published on 7 November 2001.

Citation: Manly, T and Leonard, L, 'New Financial Reporting Regulations for E-Commerce Companies', Refereed article, 2001 (3)The Journal of Information, Law and Technology (JILT). <http://elj.warwick.ac.uk/jilt/01-3/manly.html>.New citation as at 1/1/04: <http://www2.warwick.ac.uk/fac/soc/law/elj/jilt/2001_3/manly/>.



1. Introduction

If an organisation is doing business, it is doing it on or with the help of the Internet. The Internet is an extension of business and will shape the future of business (Dugan, 2000, Ferrell, 1999). Internet technology influences every discipline (Amar, 1999). For some fields, the Internet forces a revision of the fundamental guiding principles that have been utilized for years. For the accounting field, technology and the Internet are among the greatest changes to be faced (Alles et al, 2000).

With the commercialisation of the Internet in the early 1990s came the concept of electronic commerce (e-commerce), the buying and selling of goods/services electronically, and electronic business (e-business), the conducting of business (activities) electronically (Napier et al, 2001). E-commerce and e-business change the dynamic of the Internet. The Internet is no longer just for Information departments; every aspect of business is involved (Ferrell, 1999). With a quarter billion machines connected to the Internet (Ferrell, 1999), Internet technology takes on many new roles. The Internet offers the opportunity for organisations to conduct business both internally and externally through e-business/e-commerce. It has long been understood that e-commerce would shake up the foundation principles and practices of business (Amar, 1999). When discussing the internal accounting and finance operations of an organisation, the majority of individuals first think about the redesigning of those practices to better fit and/or exploit the Internet, i.e. the introduction of accounting and financial information systems and the auditing of electronic transactions (Greenstein and Feinman, 2000, Keegan, 1998, Turban et al, 2000). However, the internal systems and record keeping were not the only part of accounting affected by the introduction of the Internet. Companies engaging in e-commerce also made changes to their external financial reports as compared to their traditional business counterparts.

Dugan (2000) reports that forty percent of organisations indicate that their biggest benefit from the use of Internet technology is increased revenue, but companies that are still evolving their Web site presence are not showing huge revenues. Over fourteen percent of organisations report that their entire business was fundamentally changed with the use of the Internet, and that Internet commerce sales accounted for nearly fourteen percent of total sales. Customers and competition are increasingly leading businesses to the Internet. Organisations focus on showing sales and revenue in the short-term, which they believe will translate into potential future profits from the use of the Internet. Most organisations engaged primarily in e-commerce are not showing a profit. Since these companies need outside funding to survive, this leaves them in a difficult position. Some e-commerce firms used questionable accounting practices that stretched the 'grey areas' of existing financial accounting rules. Investors and potential investors focus on the financial results presented by organisations. Those numbers do not show a profit as of yet, but they do indicate a substantial revenue flow; that appears promising to the investors. Recent investigations have shown that revenue reported from an Internet company may not truly meet the standard accounting definition of 'revenue'. Individual and institutional investors provide substantial backing for Internet endeavours, but they may be being misled about the true prospects for future profitability. They expect that the Internet technology is not going to show an immediate profit, but they would like to know that eventually they will receive a return on their investment. Regulators in the US and UK have responded to the need for investors to have transparent information from e-commerce companies by issuing new standards.

Over the thousands of years that people have conducted business with each other, they have adopted new tools and technologies (Perry and Schneider, 2001). The advent of the Internet and WWW has improved existing business processes and created new business opportunities. The purpose of this paper is to detail the changes in financial reporting regulations for Internet companies. The new requirements for measuring revenues and expenses are presented, and the implications of the new rules for the future of Internet companies are discussed.

2. Financial Reporting Regulation in the US and UK

Regulators that establish requirements for the reporting of financial results have recently issued several new initiatives targeted at the practices of e-commerce firms. The creation of regulations for financial reporting in the US and UK combine both legislative authority and the work of private organisations. The issuing organisations and their responsibilities are discussed below and represented in Table 1. In the United States, a private, independent board, the Financial Accounting Standards Board (FASB), guided by the Financial Accounting Standards Advisory Council (FASAC), primarily sets the accounting regulations. Specifically, the Emerging Issues Task Force (EITF), a separate board that is a division of the FASB, responds to unique accounting situations that lack formal guidance in existing standards. One objective of the EITF is to provide guidance before divergent accounting practices become pervasive. When the EITF reaches a consensus on a particular topic, generally no further action by the FASB is warranted. The FASB obtains authority to establish guidelines for financial reporting from the Securities and Exchange Commission (SEC). The Securities Act of 1933 and the Securities Exchange Act of 1934 delegate the responsibility of enforcing securities laws and formulating accounting standards to the SEC. However, the SEC chooses to recognise the pronouncements of the FASB as the authoritative literature on accounting standards and therefore mainly supervises the FASB without direct intervention. Corporations whose securities are publicly traded are required to comply with standards issued by the FASB and enforced by the SEC. Corporations that do not comply face action by the SEC including refusal to allow trading of securities.

The UK Companies Act of 1985, and amended in 1989, requires firms to provide financial statements that comply with 'accounting standards' and disclose any departures from those standards along with the accompanying reasons. Departures should only be made when they are necessary to provide a 'true and fair view' of the underlying transactions of the firm. In 1990, a system for developing standards was created which included an independent standard-setting board and an oversight board, the Accounting Standards Board (ASB) and the Financial Reporting Council (FRC), respectively. Similar to the US structure, the ASB also has a separate branch that targets the most recent accounting concerns called the Urgent Issues Task Force (UITF). The financial reporting regulations set by the ASB extends to all limited liability companies, not just those that are publicly traded. Enforcement of accounting regulation in the UK is governed by the FRC's Financial Reporting Review Panel and the Department of Trade and Industry. The Review Panel is empowered by the Companies Act to go to the courts to have a firm revise its financial reports, if necessary.


 

United States

United Kingdom

Legislative authority to regulate accounting standards

Securities Act of 1933 and Securities Exchange Act of 1934

Companies Act of 1985, amended by Companies Act of 1989

Private, independent standard-setting board

Financial Accounting Standards Board (FASB) guided by the Financial Accounting Standards Advisory Council (FASAC)

Accounting Standards Board (ASB) guided by the Financial Reporting Council (FRC)

Division of standard-setting board charged with addressing current topics

Emerging Issues Task Force (EITF)

Urgent Issues Task Force (UITF)

Enforcement of financial reporting rules

Securities and Exchange Commission (SEC)

FRC's Financial Reporting Review Panel and the Department of Trade and Industry

Table 1: Financial Reporting Authority in the US and UK


3. Revenue Recognition Regulations

In the e-commerce era, capital providers anxious to take part in the 'new economy' put aside traditional methods for valuing companies. Several hallmark measures such as earnings per share and the price earnings ratio were abandoned because almost none of the Internet firms had shown a profit. Thus, in order to find some means of analysing and comparing potential investments, market participants began to focus heavily on revenues. Conventional analysis that determined stock value based on the price-to-earnings ratio was replaced by evaluating firms' price-to-revenues ratios. (Higher ratios demonstrate a greater premium for a particular stock given past performance). Investor focus on these measures creates an incentive for firms to increase reported revenues even when there is no corresponding increase in profits. Greater revenues can make a stock appear to be a good value because it decreases the overall ratio of market price to total revenues. E-commerce companies used several accounting methods to boost financial accounting revenues. The following sections discuss those accounting methods and the corresponding new financial reporting regulations.

3.1 Barter Transactions

3.1.1 Issue

Barter transactions are trades of Internet advertising space between firms. For many newer companies, barter is a good way to build brand awareness without straining cash resources. These transactions are common for all types of media; however, they usually account for a small percentage of total sales (i.e., less than five percent). In contrast, some e-commerce firms get up to half of their revenues from barter transactions (Kahn, 2000, Alpert, 1999). When companies agree to trade advertising space, each records an established amount for the sale and the corresponding expense. The transaction has no effect on net income, but does bolster revenues, which are closely followed (as discussed previously). The recognition for barter is not consistent because some firms choose to completely exclude the trades from the financial reports (Alpert, 1999).

3.1.2 Regulation

Financial reporting regulators in the US and UK responded to the diversity in reporting of barter of advertising transactions with official rulings, EITF 99-17[ 1] and UITF 26, respectively. The consensus opinions of the two bodies are essentially the same. The primary guideline put forward by the EITF is that barter transactions should only be recorded when the fair value of the advertising space can be determined. Determination of fair value is governed by the recent history of cash sales to separate parties for similar advertising. In the case where similar advertising has been sold for cash, recorded barter transactions are limited to the amount of those prior cash sales. Therefore, the guidelines prohibit a firm from using one cash sale for space to determine fair value for multiple subsequent barter transactions. The regulations also prohibit a cash swap between parties as determination of fair value when the transaction is in substance barter.

The UITF provisions require that barter transactions only be formally recognised when the advertising would have been sold for cash if it had not been exchanged. A company has evidence that the space could have been sold for cash when it has a history of selling similar space for cash, and when substantially all other advertising revenues for the period are from cash sales. Both the EITF and UITF call for disclosure in the notes to the financial statements of barter transactions recorded in current revenues and other barter transactions that were not recorded. Therefore, fewer barter transactions can be recorded as revenues and investors must be clearly informed about the barter transactions.

3.2 Gross or Net Revenues

3.2.1 Issue

Internet retailers of goods and services must choose between reporting the sale at the gross amount with a corresponding charge for the cost of the good or service provided or at the net amount retained. At issue is whether the company takes control of the goods or services or acts as an agent for a third-party provider. For example, Priceline.com included in its revenues the full amount customers paid for travel services and then charged cost of goods sold for the amount paid to airlines, hotels, and car rental agencies. Traditional travel agencies usually record revenue as the net difference between the two as a fee. Again, there is no effect on the net income, but the difference in reported revenues is huge. When Priceline.com reported 1999 third quarter revenues of $152 million, its market price-to-revenue ratio was 23; however, if revenues had been reported at net ($18 million) the market price-to-revenue ratio jumps to 214. Price multiples this high would certainly cause investors to investigate whether the stock was overvalued.

3.2.2 Regulation

In the US, EITF 99-19 provides guidance for Internet sellers on the appropriate way to recognise revenue. Generally, revenues should be reported as gross amounts when the retailer has the primary responsibility for fulfilling the transaction and bears the accompanying risk. The opinion outlines specific indicators (shown in Table 2) that point toward either gross or net reporting of revenue. None of the indicators is considered to be presumptive or determinative, but each should be considered on relative strength. Currently, there are no official regulations in the UK; however, the ASB has issued a discussion memorandum on the overall topic of revenue recognition.


Indicators of Gross Reporting

Indicators of Net Reporting

The company is the primary obligor in the arrangement.

The supplier (not the company) is the primary obligor.

The company has general inventory risk or physical loss inventory risk.

The supplier (not the company) has credit risk.

The company had latitude in establishing price.

The amount the company earns is fixed.

The company changes the product or performs part of the service.

 

The company has discretion in supplier selection.

 

The company is involved in the determination of product or service specification.

 

The company has credit risk.

 

Table 2: Indicators for Gross vs. Net Reporting for Internet Companies


3.3 Promotions, Coupons, Giveaways

3.3.1 Issue

Another issue that previously lacked clear direction from standard setters is the accounting for certain sales incentives. In these transactions, companies offer a discount, rebate or other promotional item as part of the sale. Previously, most companies would reduce the recorded revenue by the incentive as a matter of practice. However, many Internet companies chose to record the sale at the full price and then deduct the cost of the promotion as a marketing expense (Baker, 2001). This is another example of an accounting choice that has no effect on earnings but serves to increase revenues.

3.3.2 Regulation

In the US, the EITF addresses this practice in Issue No. 00-14. The consensus opinion of the EITF requires different treatment for cash discounts and free products or services. The rules call for a reduction in revenues for cash sales incentives; however, sales incentives that offer free products or services should be recorded at the full amount of sale less a charge for the giveaway. No specific UK regulations have been issued on this topic.

3.4 Timing of Revenues

3.4.1 Issue

In addition to questions raised about the amount of reported revenues of e-commerce firms, other inquiries were raised about when revenues should be recorded for certain transactions. For example, companies that sponsor on-line auctions were recording the entire listing fee at the beginning of the contract when the revenue should have been spread out over the entire listing period. Other businesses (e.g. travel clubs) that require membership fees had similar problems.

3.4.2 Regulation

SEC Staff Accounting Bulletin 101 addresses revenue recognition for all types of firms in the US The SEC intended for the bulletin to be a summary of existing accounting rules compiled in one location. However, many firms founds that they were not in compliance and were forced to restate past financial statements. Internet firms' restatement had a particularly high impact on stock price because of the intense focus on revenue. One Internet firm, Microstrategy, saw its stock price drop from a high of $225 to $25 after changing 1999 revenues (MacDonald, 2000). The ASB in the UK has similarly issued a discussion memorandum on revenue recognition, but it has not yet been formalized into an official pronouncement.

4. Costs and Expenses Regulation

In addition to the diversity of reporting practices for revenues, regulators have examined other issues surrounding the classification of expenses for e-commerce firms. Although few e-commerce ventures have shown profit, investors and capital providers are still interested in the types of costs incurred by e-commerce companies and the potential benefit that might come from those investments.

4.1 Fulfillment Costs

4.1.1 Issue

Differing practices were adopted for classifying certain fulfillment charges (e.g., warehousing, packaging and shipping) as either cost of goods sold or marketing expenses. Traditionally, most companies included fulfillment charges in cost of goods sold; however, in the absence of official guidelines some e-commerce companies began to move the charges into marketing expenses. Market participants were perceived to expect large marketing expenses from e-commerce firms building customer awareness. Thus, some e-commerce companies operating at narrow gross profit margins (sales minus cost of goods sold) could boost profit margins by shifting fulfillment costs to marketing expenses.

4.1.2 Regulation

In the US, ETIF 00-10 addresses the accounting for shipping and handling fees and costs. In this consensus opinion, the EITF directs firms to record amounts paid by customers for shipping and handling in revenues. The corresponding costs to fulfill orders should be shown in cost of goods sold. Any fulfillment costs not included in cost of goods sold should be disclosed in the notes accompanying the financial statements. Both the amount of fulfillment costs and the category of costs should be explained. Currently, there are no regulations in the UK to govern this.

4.2 Website Development Costs

4.2.1 Issue

E-commerce firms, as well as traditional firms, incur substantial costs in developing websites for a variety of business purposes. Treatment of these costs in financial reports has taken a number of approaches including:

  1. expensing costs;

  2. capitalising costs; and

  3. a mixture of expensing and capitalising.

4.2.2 Regulation

US accounting regulators issued EITF 00-2 in early 2000 followed in the UK by the issuance of UITF 29 in February 2001. Both pronouncements separate the costs of activities to create a website into categories as follows:

  • planning;

  • application and infrastructure stage;

  • design and graphics development; and

  • content development.

After the development of the website, costs will also be incurred to operate and maintain it. Each of the regulating bodies designates that costs incurred in the planning stage should be expensed on the current period income statement. Costs incurred in stages two through four should be capitalised (recorded as an asset) and then depreciated over the expected useful life. Capitalising of costs should occur when those costs are expected to bring economic benefits to future periods. The criteria established by UITF 29 state that this would be the case only if the website would be able to generate revenues directly (e.g. accept orders). The threshold in the US does not seem to be that restrictive as other websites might also provide future benefit without directly generating revenue (e.g. website for shipping company that allows shipments to be traced). Therefore, costs for activities two through four may also be charged to current income when the future benefits are uncertain or do not meet the regulatory guidelines. In both countries, subsequent costs to operate the website should be expensed in the current period.

5. Conclusion

The Internet dazzle hides many serious problems. Therefore, many dot-com organizations are facing serious problems. Paul (2001) reported that sixty-seven percent of Americans believe that dot-com problems are caused by irrational exuberance and the search for fast cash and fifty-six percent believe it is a result of poor business plans. Fast cash can mean many things but it may have led investors to overlook some red flags (Blakeley, 2001) that may arise in dot-com organizations: failure to pay according to invoice, excess cash burn rate, dim prospects for near term profits, etc. With the constant changes and advancements in information technology (i.e., the Internet) (Koss, 2001) comes a need for new policies.

Many new accounting regulations have been established to govern Internet-based companies. The regulations outlined in this paper cover reporting of revenue (barter transactions, gross or net revenues, promotions and giveaways, and timing of revenue), and costs and expenses (fulfilment costs and website development costs). Each of these regulations has a direct bearing on Internet companies and e-commerce.

Throughout the e-commerce era, some Internet companies have been following the traditional accounting practices so the previously outlined regulations will not substantially change their reported revenues. However, those companies may have been disadvantaged by others using questionable accounting practices to boost revenues. Clearly, they were not on a level playing field. Once all Internet organizations have their financial reporting standardized, how will e-commerce change? Since Internet-based companies need investors and attract investors through showing revenue in the short-term, what will happen to these companies once they must show 'true' revenue amounts?

Dot-com organizations will suffer the most. They have no traditional store front to back them when their revenues slump and their profits are still zero. Their stock prices will drop due to the lower revenues being generated, and ultimately, they will lose investors. So the question becomes, what is the future of dot-coms? Will the new accounting regulations be the 'death' of them? Only those companies that have strong financial results and a large number of sales can continue to attract capital. Weak results can no longer be camouflaged with accounting treatments.

E-commerce will also be affected. Past accounting practices such as moving fulfillment costs to marketing expenses have made products sold over the Web appear more profitable than products sold via traditional channels. The change in reporting will now show the true Web profits. Until results can be examined using consistent accounting practices, investors will not know which outlet is more profitable.

The future is uncertain for all Internet companies. Accounting regulations, the onset of new Internet laws, etc. are only the beginning of what Internet companies will have to face. Future dot-coms and other Internet-based companies will have the advantage of learning from past e-commerce mistakes.

Footnotes

1.Pronouncements from standard-setting bodies are included in references.

References

Accounting Standards Board Urgent Issues Task Force (2000a), Barter Transactions for Advertising, UITF Abstract 26, London, England, ASB.

Accounting Standards Board Urgent Issues Task Force (2000b), Website Development Costs, UITF Abstract 29, London, England, ASB.

Accounting Standards Board (2001), Revenue Recognition, Discussion Paper, London, England, ASB.

Alles, M, Kogan, A and Vasarhelyi, M A (2000), 'Accounting in 2015,' CPA Journal, November (70:11), pp.14-20.

Alpert, B (1999), 'How Internet Ad Barter Generates Over Half of Some Firms' Revenues,' Barron's , May (79, 22), p.45.

Amar, A D (1999), 'E-Business: Selection and Adaptation of Products and Services for the Internet Commerce,' Mid-Atlantic Journal of Business, March (35, 1), pp.5-9.

Baker, C (2001), 'SEC and EITF Initiatives on Internet Accounting,' The CPA Journal, July (71, 7), pp.24-33.

Blakely, S (2001), 'Red Flags That May Signal Your Dot-Com Customer is Falling From Cyberspace and Into Insolvency,' Business Credit, January (103, 1), pp.33-34.

Dugan, S M (2000), 'Where Will E-Business Take You?,' InfoWorld, 3 April (22,14), pp.49-52.

Ferrell, K (1999), 'Tomorrow.net: Don't Think About the Internet as Technology; Think About It as the Future of Your Business,' Chief Executive, 15 March, pp.4-9.

Financial Accounting Standards Board Emerging Issues Task Force (1999a), Accounting for Advertising Barter Transactions, EITF 99-17, Stamford, CT, FASB.

Financial Accounting Standards Board Emerging Issues Task Force (1999b), Reporting Revenue Gross as a Principal or Net as an Agent, EITF 99-19, Stamford, CT, FASB.

Financial Accounting Standards Board Emerging Issues Task Force (2000a), Accounting for Web Site Development Costs, EITF 00-2, Stamford, CT, FASB.

Financial Accounting Standards Board Emerging Issues Task Force (2000b), Accounting for Shipping and Handling Fees and Costs, EITF 00-10, Stamford, CT, FASB.

Financial Accounting Standards Board Emerging Issues Task Force (2000c), Accounting for Certain Sales Incentives, EITF 00-14, Stamford, CT, FASB.

Greenstein, M and Feinman, T M (2000), Electronic Commerce: Security, Risk Management and Control, McGraw-Hill Companies, Inc.

Kahn, J (2000), 'Presto Chango! Sales are Huge!,' Fortune, 20 March (141, 6), pp.90-96.

Keegan, D P (1998), 'The Virtual Countinghouse: Finance Transformed by Electronics,' in Leebaert, D (ed), The Future of the Electronic Marketplace, Massachusetts, Massachusetts Institute of Technology.

Koss, J P (2001), 'The Technology Advance: Infinity?,' Beverage World, 15 June, p.104.

MacDonald, E (2000), 'Are Those Revenues for Real?,' Forbes, 29 May, pp.108-110.

Napier, H A, Judd P J, Rivers, O N and Wagner, S W (2001), Creating a Winning E-Business, Massachusetts, Course Technology.

Paul, P (2001), 'Dot-Flop Deserved,' American Demographics, June, p.27.

Perry, J T and Schneider, G P (2001), New Perspectives on E-Commerce, Massachusetts, Course Technology.

Securities and Exchange Commission (1999), Revenue Recognition in Financial Statements, SEC Staff Accounting Bulletin No.101, Washington, DC, SEC.

Turban, E, Lee, J, King, D and Chung, H M (2000), Electronic Commerce: A Managerial Perspective, New Jersey, Prentice-Hall, Inc.

 

 

 

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