Digital media and marketing

Most accounting managers are familiar with the five-step revenue recognition process that the Financial Accounting Standards Board (FASB) spelled out in Accounting Standards Update (ASU) 2014-09, “Revenue From Contracts With Customers (Topic 606)”:

• Step 1: Identify the contract(s) with a customer.
• Step 2: Identify the performance obligations in the contract.
• Step 3: Determine the transaction price.
• Step 4: Allocate the transaction price to the performance obligations in the contract.
• Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

The second step of this process, identifying performance obligations, is where differences in interpretation can begin to cause variations in how revenue is recognized. The FASB guidance defines a performance obligation as “a promise in a contract with a customer to transfer to the customer … a good or service … that is distinct.” If the contract encompasses more than a single service, the seller must determine whether each service is distinct on its own or is part of a larger group of services that cannot be logically separated.

A good or service is considered distinct if it meets two conditions. First, the customer must be capable of benefiting from the good or service by itself or using other resources that are readily available to the customer. Second, the good or service must be distinct within the context of the contract – that is, it must be separately identifiable from the other promises in the contract.

For example, if a digital media company designs and hosts a customer’s website that the customer could host on its own or by using a third-party hosting service, the design and hosting functions might be recognized as separate performance obligations. In such an instance, even if the contract is billed as a single transaction, the transaction price would need to be allocated to each performance obligation based on their relative standalone selling price.

On the other hand, if the site provides features that cannot function properly unless they are hosted on the media company’s servers, the design and hosting functions might be considered a single performance obligation. The general principle is that any good or service that provides a distinct and separable value to the customer typically would be recognized as a separate performance obligation. On the other hand, if the individual goods or services are highly interdependent or interrelated, or provide no value unless they are integrated, they might need to be combined into a single performance obligation.

Many digital media companies offer a broad package of marketing services, including digital media planning and strategy; creative services; website design; website hosting, operations, and maintenance; customer fulfillment and e-commerce services; email deployment; search engine optimization and management; social media campaigns; and various other software, programming, and technology services. For revenue recognition purposes, management must determine whether such a package is a single performance obligation or whether certain components of the package are performance obligations that should be recognized separately from the others.

It also is important to understand the customer’s point of view in the context of the contracted work. If a customer views individual promised goods or services as inputs to a combined output provided by the digital media company, the company might be providing a significant service of integrating various services, in which case the package of services might need to be considered one performance obligation.

ASC 606 provides a detailed discussion of various factors and special situations that can affect how performance obligations are identified and defined. Those details can be found in paragraphs 606-10-25-19 through 25-21 of ASC 606.

Like conventional print and broadcast advertising agencies, digital media and marketing companies often generate a significant portion of their revenue from commissions earned on the purchase of ad space or other digital advertising services from third-party vendors. For revenue recognition purposes, this raises the question of whether the agency is acting as an agent on behalf of its clients or incurring the relevant costs as a principal purchaser of the ads in the transaction.

If the company is acting as an agent, its revenue is recorded net of the costs paid to the vendor, typically in an amount equal to the agreed-upon commission. For example, a contract with a customer stipulates that the company is to arrange for advertising with certain media platforms at a specified percentage up to a certain dollar value on behalf of the customer. In some instances, however, the agency could be acting as principal. In such cases, the revenue is recorded at gross value.

ASC 606 provides detailed guidance for making this principal-versus-agent determination in paragraphs 606-10-55-36 through 55-45. The underlying principle is whether the company controls the ads before they are delivered to its customer. The standard lists several indicators of control companies should consider, such as which entity is primarily responsible for determining the acceptability of the specified good or service. Other factors to consider include whether the entity has inventory risk before transferring the good or service to the customer, or whether the entity has discretion in establishing prices for the specified goods or services. Indicators such as these could suggest the company controls the ads and, therefore, is acting as principal rather than agent.

It is important to note, however, that no single indicator outweighs the others. A variety of factors might need to be considered. The correct determination depends on the answers to several questions, such as:

• Is the ad spend a separate performance obligation, or is it part of a larger single performance obligation that includes integration of services such as identifying the appropriate platforms, determining the most advantageous amount of ad spend, and producing the materials to be marketed? If the group services are integrated and considered one distinct performance obligation, it is possible the company controls the package services, which would result in gross presentation.
• Is the ad price set directly by the vendor, with the agency receiving a commission as a set percentage of the spend? Or does the agency have discretion in setting the price the client pays, regardless of the third-party vendor costs? The latter situation would be more indicative of principal presentation.
• Does the agency purchase ad space directly – on its own initiative – prior to a customer’s acceptance? If so, the company is incurring inventory and pricing risk by purchasing media directly from the vendor, and it is therefore most likely acting as a principal.
• Are the decisions about which social platforms or other media to be used in ad campaigns determined by the customer (which might indicate the company is acting as agent)? Or are specific purchase decisions made by the agency as part of a bundled package or “white glove” service (which might be an indicator for treatment as a principal)?

Because of the many variables involved, each revenue recognition decision is specific to the circumstances of that situation. Rather than looking for detailed or comprehensive guidelines that address every possible question, accounting managers and other financial executives in digital media and marketing companies should develop a fundamental understanding of the various factors involved, particularly those that relate to identifying performance obligations, recognizing revenue that is earned over time, and distinguishing between agent and principal transactions. Accounting and finance teams also should establish processes and controls for determining the inputs and outputs to best capture the proper revenue recognition pattern.

By understanding these key revenue recognition principles and seeking qualified professional guidance as necessary, digital media and marketing company executives will be better prepared to answer audit questions. Even more important, they will be able to provide the users of their financial statements with accurate, timely, and useful information they can rely on to make crucial decisions.