What Internet Revenue Recognition Reform Means to Investors (News) November 19, 1999


What Internet Revenue Recognition Reform Means to Investors

By Brian Graney (TMF Panic)
November 19, 1999

The faint rumblings of what could potentially turn into a full-fledged stock market uproar were heard on Wall Street this week as a Credit Suisse First Boston research report directed attention to the issue of Internet revenues and how they are reported on regulators' mandated financial statements. The aim of the report was to pass along incremental information about proposals (and proposals only) by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission's (SEC) accounting staff for new guidance that could effectively lower the amount of revenue Internet companies are allowed to recognize for filing purposes.

While the analysts at CS First Boston rightly stressed that any possible revision of the revenue recognition guidelines is still pretty much in the thinking stage, it's not too hard to imagine business journalists latching onto this horse and riding it hard if the proposals develop into honest-to-God accounting mandates at some point down the road. For the most part, the business press has relied on a standard equation when the issue of accounting has cropped up in the same sentence as an Internet company. Briefly, Internet Company + Accounting Issues = Fraud.

One need only refer to the journalistic carpet-bombing endured by America Online in 1996 for its use of amortized subscriber acquisition costs to see how this unfortunate equation has been applied to Internet companies in the past. Of course, America Online's practices were actually allowable under the FASB guidelines; they just were not thought to be completely on the level by some observers. Changing the rules in the middle of the game, as the current proposals suggest, could open up a whole slew of new editorial possibilities. In effect, keeping track of which Internet players stay in-bounds and which consistently run outside the revenue recognition touchline could end up being the equivalent of a Full Employment Act for financial reporters.

For Internet investors, the proposals are important from the unavoidable point of view that many folks rely on revenue multiples in comparing one Internet valuation to another. For better or for worse, revenue is the one accounting concept that shows up with almost universal regularity on Internet companies' income statements. (Then again, revenue generation itself is not necessarily a prerequisite for every self-proclaimed Internet company floating around out there.)

Among the 20 recognition issues that are being considered by FASB and the SEC are biggies such as gross versus net revenues, the accounting of barter transactions such as Web advertising swaps, and the practice of treating rebates as expenses rather than reductions in the revenue account. Changing the guidelines would likely produce a cavalcade of restatements from Web firms, rendering much of today's revenue multiple-based analysis useless. This would not be a first for FASB, which through new rules earlier this decade destroyed much of the relevance of comparative book value analysis by socking industrial giants with huge post-retirement healthcare liability write-offs.

But besides possibly ridding the planet of an analytical notion that is rather faulty and unreliable to begin with, the net effect of the proposed accounting changes to Internet companies' actual businesses would be zilch. As CS First Boston notes, "[N]one of these changes would affect the economics of a business or its value if that value is based on cash flows, returns on capital and trends in these measures, as we believe all financial assets ultimately are valued."

From this viewpoint, the implementation of revenue recognition proposals could quite possibly be the best development for Internet investors since the invention of the real-time Web-based conference call. By forcing investors to focus on the actual underlying cash economics of the Internet business at hand instead of malleable Generally Accepted Accounting Principles (GAAP) constructs, the regulators may end up doing investors a huge favor in the long run.

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