Digital media and marketing

As digital and social media continue to claim a larger share of the overall advertising and marketing landscape, accounting managers and other financial executives at digital media and marketing companies can sometimes encounter confusion about how to properly record, recognize, and report revenue from these fast-growing and still-evolving revenue streams.

Although the applicable guidance – Accounting Standards Codification (ASC) 606, “Revenue From Contracts With Customers” – is detailed and specific, it nevertheless is still subject to some interpretation and management judgment. Variations in contract details can significantly alter the relevant revenue recognition processes and requirements. As a result, compliance with U.S. generally accepted accounting principles (U.S. GAAP) often involves an analysis of each deliverable in a customer contract or statement of work.

For digital media and marketing companies, the most significant questions during this effort tend to arise in three areas:

1. Correctly defining and identifying performance obligations
2. Measuring progress on performance obligations that are satisfied over time rather than at a single point in time
3. Distinguishing between revenue earned as an agent for a client and revenue earned as a principal to a transaction

To improve and expedite their financial reporting, finance and accounting executives in digital media and marketing companies should develop a solid general understanding of these three topics.

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.

Another area of concern relates to contracts that are satisfied over a period rather than at a single point in time. Examples include ongoing digital media and marketing planning services or long-running campaigns with multiple elements rather than a single component.

The first step is to determine if, in fact, the contract requires revenue recognition over time. According to paragraph 606-10-25-27 of the standard, a performance obligation is satisfied over time if one of the following conditions is met:

• The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
• The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
• The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.

The underlying principle of ASC 606 is that revenue is recognized only when a performance obligation is met – that is, when the promised goods or services are delivered – not necessarily when the sale is made. For contracts that involve multiple performance obligations, or for performance obligations that are completed over a period rather than a point in time, the company must recognize revenue in a way that corresponds to the value that is being transferred to the customer.

Thus, a company that provides ongoing digital media planning and management services on a long-term contract would need to measure progress toward completion of that contract in each reporting period to recognize the appropriate amount of revenue in the period.

It might seem that the simplest way to do this would be to allocate revenue in equal installments over the life of the contract, such as an annual contract in which revenue is recognized in 12 monthly increments. For contracts that are ongoing and consistent, with no significant variations in the way services are delivered, such time-based, straight-line revenue recognition might be appropriate.

In many cases, however, such an approach is insufficient, since the value associated with each performance obligation is not delivered evenly across the life of a contract. For example, in a long-term contract for managing website and e-commerce operations, the initial client onboarding, site design, and implementation are likely to require considerably more time, effort, and resources than the ongoing site operation, maintenance, and support phases that occur later.

The two broad methods that ASC 606 provides for allocating value over time are inputs and outputs. Using the input method, revenue is recognized using measures that correspond to either the level of staff effort expended to satisfy the performance obligation or the amount of other costs incurred. It often is the case that companies do not have sophisticated time-tracking mechanisms in place to determine the level of staff effort. Therefore, it is imperative that accounting and finance teams work closely with their operations personnel to capture the relevant inputs. This often includes project status meetings on a recurring basis or data input forms that can be completed by project-facing personnel.

Under the output method, on the other hand, revenue is recognized based on the relative value that is transferred to the customer as the performance obligation is delivered over time. Typically, this value allocation is linked to the completion of specific deliverables or contract phases. Like the input method already noted, the output method commonly requires interaction with project managers to determine the status of projects. Accounting and finance personnel should be interacting with the project managers on a frequent basis to determine the status of projects. The key to the output method is to analyze the actual progress of the project, as opposed to what the contract schedule might state.

In either case, it typically is not appropriate to simply recognize revenue in accordance with contract billing terms unless the company also can demonstrate input or output measurements that support such an approach. In other words, revenue must be recognized as it is earned, not necessarily as it is billed.

Lastly, accounting and finance personnel must work with their project managers and sales teams to identify any contract modifications or changes in statements of work. Often digital media and marketing companies are asked to update the original contracts or statements of work because of changes in the desired work product from the customer. Capturing these changes in the contracts is important to determining revenue recognition. For more guidance on accounting for contract modifications, see ASC 606-10-25-10 through 25-13.

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.