Financial Statement Analysis
1. Why did regulators take a closer look at Demand Media’s accounting?
Demand Media capitalizes the fees paid to freelance writers over five years instead of expensing the costs as incurred. Typically, web media companies expense content creation costs as incurred. Demand’s unorthodox approach to accounting for writer expenses as acquiring and amortizing intangible assets spreads Demand Media’s expenses over time and reduces its current losses on its income statement. Thus, Demand Media’s accounting could be considered misleading to investors of the IPO.
2. Is the company’s capitalization accounting policy justified? If yes, why yes? If not, why not?
We do not believe Demand Media’s capitalization accounting policy is justified. Although it is a reasonable assumption that Demand’s web content can attract traffic and earn advertising revenue over a few years, the capitalization accounting policy is too aggressive and inappropriate.
1) The policy is not in line with industry practice. Other web publishers such as AOL and Yahoo! expense content creation costs when they are incurred.
2) Demand Media has not established a track record that its content generates revenue for five years. The driver to creating their content is exploiting the search engine optimization process. Search engines such as Google have indicated they are examining the practices of such “content farms.”
3) Demand’s policy significantly reduces the company’s reported losses on its income statement. This is likely a strategic decision to use accounting to gain preferential treatment in capital markets.
3. Does the company’s capitalization accounting policy always inflate income, relative to the expensing policy? Explain why.
Capitalizing content expenditures as assets on the balance sheet inflates income in the short-term, but may deflate income down the road once the firm is amortizing costs of many years. Demand’s approach spreads the reporting of content creation
Demand Media capitalizes the fees paid to freelance writers over five years instead of expensing the costs as incurred. Typically, web media companies expense content creation costs as incurred. Demand’s unorthodox approach to accounting for writer expenses as acquiring and amortizing intangible assets spreads Demand Media’s expenses over time and reduces its current losses on its income statement. Thus, Demand Media’s accounting could be considered misleading to investors of the IPO.
2. Is the company’s capitalization accounting policy justified? If yes, why yes? If not, why not?
We do not believe Demand Media’s capitalization accounting policy is justified. Although it is a reasonable assumption that Demand’s web content can attract traffic and earn advertising revenue over a few years, the capitalization accounting policy is too aggressive and inappropriate.
1) The policy is not in line with industry practice. Other web publishers such as AOL and Yahoo! expense content creation costs when they are incurred.
2) Demand Media has not established a track record that its content generates revenue for five years. The driver to creating their content is exploiting the search engine optimization process. Search engines such as Google have indicated they are examining the practices of such “content farms.”
3) Demand’s policy significantly reduces the company’s reported losses on its income statement. This is likely a strategic decision to use accounting to gain preferential treatment in capital markets.
3. Does the company’s capitalization accounting policy always inflate income, relative to the expensing policy? Explain why.
Capitalizing content expenditures as assets on the balance sheet inflates income in the short-term, but may deflate income down the road once the firm is amortizing costs of many years. Demand’s approach spreads the reporting of content creation