Advertising expenditures can be capitalized ... well at least sometimes.

The tobacco industry presently is under attack for its influence on youth. Advertising plays a vital role in that influence. In fact, the tobacco industry is second only to the automobile industry in annual spending on advertising. And it is this advertising, contend opponents, that is especially

enticing to youth. The tobacco industry advertising debate acknowledges that advertising can be very effective in enhancing sales levels, both in current and future periods. The fact that annually more than $100 billion is spent by corporations on advertising seems to indicate that the benefits are real. Information Resources, Inc., a Chicago-based market research firm, believes that "you can an quantify with a 90% confidence level that certain sales increments are attributable to specific investments in advertising."(1)

Considerable debate among the accounting profession has ensued regarding the propriety of capitalizing advertising expenditures. Proponents argue that advertising expenditures create probable future economic benefits that are controlled by the enterprise, and thus those expenditures meet the definition of an asset, as contained in Statement of Financial Accounting Concepts No.6, "Elements of Financial Statements." Opponents argue that the benefits from advertising are uncertain, are not measurable with reasonable accuracy, and therefore should be expensed as incurred.

The purpose of this paper is not to discuss the propriety of selected advertising nor to rehash the capitalization versus expensing arguments. Rather the paper summarizes existing pronouncements dealing with the accounting for advertising expenditures and highlights their inconsistencies. In general, the form of advertising and the specific industry doing the advertising determine the proper method of accounting for these expenditures.

Form of Advertising

AICPA Statement of Position (SOP) No. 93-7, "Reporting on Advertising Costs," issued in December 1993, provides broad accounting guidance for advertising expenditures. With SOP 93-7, the form of the advertising is the determining factor in its prop.er accounting. That is, SOP 93-7 segregates all advertising into two forms: direct-response advertising and all others.

Direct-Response Advertising

With direct-response advertising, the incremental direct costs of the advertising incurred are capitalized if the primary purpose of the advertising was to elicit sales to customers who specifically responded to the advertising and the advertising resulted in probable future benefits.

The amount capitalized includes the incremental direct cost of the advertising incurred in transactions with third parties (e.g., costs of idea development, writing advertising copy, artwork, printing, magazine space and mailing) and the portion of employees' total compensation and payroll-related fringe benefits for the time spent performing direct response advertising activities. To satisfy the requirements of linking customers and probable economic benefits to specific direct-response advertising, a means of documenting that response is required. Customers, for example, can be matched to the advertising campaign through files containing customer names; coded order forms, coupons, or response cards; and a log of customers who made phone calls to a number appearing in an advertisement, linking those calls to the advertisement. Probable future benefits requires persuasive evidence verifying that this advertising campaign is similar to past campaigns of the entity which resulted in future benefits.

Once the advertising cost has met the capitalization criteria, it must be amortized over the estimated period benefited on a cost-pool-by-cost-pool basis. The amortization amount is the ratio that the current period revenues for the direct-response advertising cost-pool bear to the total of current and estimated future period revenues for that direct-response advertising cost-pool. The amounts are not to be discounted to net present value. Since the estimated amounts of future revenues for that cost-pool may increase or decrease over time, the ratio should be recalculated at each reporting date.

All Other Forms of Advertising

All other advertising costs should be expensed in the periods in which the costs are incurred or when the advertising first takes place, depending upon the advertising activity. The costs of producing advertisements (which include the costs of idea development, writing advertising copy, artwork, printing, audio and video crews, actors, and other costs) should be expensed as incurred during production rather than when the advertising takes place. Communicating advertising costs (including magazine space, television airtime, billboard space and distribution costs), on the other hand, should be reported as an expense only when the item or service has been received.

Tangible assets, including billboards, can be used for several advertising campaigns. Consequently, the costs for such assets should be capitalized and amortized over their expected useful lives. That periodic amortization becomes an advertising cost if the tangible asset is used for advertising.

Exceptions to SOP 93-7's Broad Guidance

Aspects of other authoritative documents, while offering no broad guidance, provide direction on reporting advertising expenditures in connection with the purpose of the advertising. Many of these other documents were issued by the Financial Accounting Standards Board and are contained in Category A of AICPA Statement of Auditing Standards (SAS) No. 69, "The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles in the Independent Auditor's Report." SOP 93-7 did not modify those documents. Those documents principally relate to advertising expenditures in selected industries, represent exceptions to SOP 93-7's broad guidance, are illustrated in Figure 1 and discussed below.

All Advertising Must Be Expensed

Several of the documents contradicting SOP 93-7 require that advertising expenditures be expensed currently, regardless of the form of advertising. The expensing of advertising costs frequently is justified by arguing that uncertain assessments of future economic benefits preclude their recognition as assets.

Leases and Loans. Statement of Financial Accounting Standards (SFAS) No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," requires that "initial direct costs shall not include costs related to activities performed by the lessor for advertising [and] soliciting potential leases." Therefore, advertising costs related to loans and leases should be reported as expenses when incurred, regardless of the form of advertising. Consequently, lessor and banks that engage in direct response advertising cannot capitalize those expenditures as suggested by SOP 937.

Cable Television. SFAS No. 51, "Financial Reporting by Cable Television Companies," requires direct selling costs to be reported as expenses when incurred. Direct selling costs include local advertising targeted (but not necessarily direct response advertising) for acquisition of new subscribers. Thus, all advertising related to acquisition of new cable television subscribers, regardless of its form, must be expensed currently. However, SFAS No. 51 allows companies to recognize hookup revenue to the extent of direct selling costs incurred. By so doing, the revenue generated is matched with the costs incurred. This matching occurs currently rather than over the term of the subscription contract. Either way, matching is achieved, with no income effect at the time the advertising takes place. But SFAS No. 51 does conflict with SOP 93-7 by requiring current period matching as opposed to matching over the revenue period (for direct response advertising only).

Extended Warranties. According to FASB Technical Bulletin No. 90-1, "Accounting for Separately Priced Extended Warranty and Product Maintenance," only those costs directly related to the acquisition of a contract (i.e., incremental direct acquisition costs) are to be deferred and charged to expense in proportion to the revenue recognized. All other costs, including all forms of advertising, should be charged to expense as incurred.

All Advertising Must Be Capitalized

Other pronouncements by the FASB require advertising expenses to be capitalized. These pronouncements seemingly prefer capitalizing over expensing due to matching concerns and not because these expenditures represent probable future economic benefits.

Motion Pictures. With SFAS No. 53, "Financial Reporting by Producers and Distributors of Motion Picture Films," costs incurred to exploit a firm that clearly benefit future periods shall be included in film inventory costs. Those costs are subsequently amortized based on the ratio that gross film revenues for the current period bear to total anticipated film revenues. Exploitation costs are costs incurred during the final production phase and during films release periods in both primary and secondary markets. Film prints, and pre-release and early advertising that is expected to benefit the film in future markets are examples of exploitation costs. However, local advertising cost that are not expected to clearly benefit the film in future markets shall be expensed currently. Consequently, SFAS No. 53 distinguishes advertising costs between capitalizing or expensing based upon perceived future benefits to be received, rather than the form of that advertising.

Insurance Enterprises. Probable future economic benefits of policy acquisition activities are reported as assets at cost and amortized in proportion to premium revenue reported under SAFS No. 60, "Accounting and Reporting by Insurance Enterprises." Acquisition costs are those costs that vary with and are primarily related to the acquisition of insurance contracts, and can include agent and broker commissions, certain underwriting and policy issues costs, and medical and inspection fees. SFAS No. 60 does not however indicate whether or not acquisition activities include advertising activities.

Real Estate Projects. Costs incurred to rent or sell real estate projects, under SFAS No. 67, "Accounting for Costs and Initial Rental Operations," are reported as assets if their costs are realizable form the sale or rental of the project. These capitalized selling costs are then expensed in the period which the related revenue is recognized as earned. Examples of such capitalized costs include costs of model units and their furnishings, sales/rental facilities and brochures, advertising, and "grand openings."

Suggestions and Conclusions

Inconsistency exists in accounting for advertising costs. In fact, diversity in the treatment of advertising costs was the reason the AICPA issued SOP 93-7. Public confidence in standard setting is never enhanced by the continued use of inconsistent accounting treatments for similar events. But until the FASB and AICPA reach consensus, accountants should be aware that advertising costs can be both capitalized and expensed, depending upon the form of the advertising and the industry doing the advertising.

In the interim, however, advertisement accounting inconsistencies can provide management on opportunity to manage earnings through the choice of the form and timing of specific advertising. Initially, the choice of form of advertising has income effects. Direct response advertising costs (unless related to leases and loans, cable television companies and extended warranty and product maintenance contracts) can be capitalized. The costs are then amortized over the revenue recognition period, with no current income effect. All other advertising forms (with the exception of advertising related to exploitation costs for motion pictures, policy acquisition activities for insurance companies, and sale/rental of real estate projects) must be expensed as incurred. Consequently, those companies able to utilize direct response and other forms of advertising can manage their earnings through their advertising selections.

Finally, companies that cannot (or choose not to) use direct-response advertising are still able to manage earnings, at least on a limited scale. That is, APB Opinion No. 28, "Interim Financial Reporting', allows "advertising costs [to be] deferred within a fiscal year if the benefits of an expenditure made clearly extend beyond the interim period in which the expenditure is made." Companies therefore can defer advertising costs during interim periods and only follow the more restrictive SOP 93-7 at fiscal year-end. Major advertising campaigns could be scheduled just prior, or subsequent to year-end. And if none of the advertisements have "run for the first time" then those costs may be capitalized at year-end in accordance with SOP 93-7. Those capitalized costs can then be amortized over the remaining fiscal year under APB Opinion No. 28.

Footnote

1 John Kimelman, "Free Tony the Tiger," Financial World (September 1993), pp. 50-52.