Yahoo, Google and Internet Math --- Revenue Is Counted Differently
By the Web-Search Powerhouses, Creating Confusion for Investors
By Scott Thurm and Kevin J. Delaney
May 10, 2004
The Wall Street Journal
http://online.wsj.com/article/0,,SB108415195909406432,00.html
YAHOO INC. reported first-quarter revenue of $758 million. Looked at another way,
Yahoo said revenue totaled $550 million. Rival Google Inc. said its first-quarter revenue
totaled $390 million. Or maybe it was really $652 million.
Confused? Pity the investors trying to place a value on Google for its highly anticipated
initial public stock offering.
For guidance, many look at Yahoo, another Internet company with a similar business to
Google's and which has been public since 1996. But Yahoo and Google don't count
revenue the same way, making it hard to compare many aspects of the two companies'
finances. Google uses a more-conservative definition that has the effect of damping its
revenue and increasing its profit margins.
The differences demonstrate that accounting standards may be "generally accepted," but
they aren't always uniformly interpreted. And details about revenue-recognition policies
buried in the fine print of financial statements can trip up less-than-seasoned investors.
In this case, the difference revolves around the way that Yahoo and Google treat revenue
from small-text advertisements that they place on other companies' Web sites. The two
Internet companies effectively act as technological intermediaries and quasi-advertising
agencies, bringing together Web publishers and advertisers. Yahoo and Google get paid
each time an Internet user clicks on an ad, then give some of that money to the Web
publisher on whose site the ad appeared. (Yahoo and Google also accept ads for their
own sites, and both companies account for them in the same way.)
In accounting terms, however, that is where the similarities end. Yahoo counts as revenue
the "gross" amount it is paid. It counts its payment to the publisher as an expense, labeled
as a "traffic acquisition cost." Google, by contrast, counts as revenue only the "net"
amount remaining, after it pays the Web publisher.
Here's how it works in practice: XYZ Corp. places ads on the sites of UVW Corp.,
through Yahoo, and RST Corp., through Google. Both ads generate $5 in revenue, with
$3 going to the publishers. Yahoo would count $5 revenue and book a $3 expense. But
Google would record only $2 in revenue.
Experts say the difference shows how accounting practices are still evolving in relatively
new forms of commerce such as the Internet. There isn't a universal right answer, they
say; the proper accounting depends on the specifics of the advertising contracts.
"Financial reporting in this area is fluid right now," says Paul R. Brown, an accounting
professor at New York University's Stern School of Business.
Indeed, until Jan. 1, the same distinction between "gross" and "net" revenue could be seen
within two units of InterActiveCorp, the New York-based Internet company.
InterActiveCorp's Expedia travel-agency unit reports revenue on a "net" basis, after
paying airlines and hotels. But InterActiveCorp's Hotels.com unit traditionally reported
revenue on a gross basis, recording the entire price of a hotel room, including the portion
it paid to the hotel operator. Hotels.com switched to reporting net revenue beginning this
year, according to a filing with the Securities and Exchange Commission.
In the case of Yahoo and Google, the proper accounting treatment depends on whether
the company is merely an "agent" facilitating a deal, or a "principal" that stands to lose
money, if, for example, an advertiser fails to pay.
A Yahoo spokeswoman says the company reports gross revenue "based on our
interpretation of the accounting guidance and our contractual terms." In SEC filings,
Yahoo says it must use gross revenue because it is "the primary obligor" to the
publishers.
Although it uses "gross" revenue in its financial reporting, Yahoo stresses its "net"
revenue in presentations to analysts and investors. The spokeswoman says Yahoo
considers the net figure "of more transparent economic value to investors."
Analysts generally agree. "We actually take a net revenue perspective on their numbers,"
says Jeetil Patel of Deutsche Bank Securities Inc. Mr. Patel says using net revenue makes
it easier to understand Yahoo's different businesses and compare current with past results.
Google, by contrast, says in its SEC filing that it reports net revenue because "we are not
the principal to transactions." Instead, Google says users view the ads on the Web sites of
independent publishers, who determine what ads they accept. A Google spokeswoman
declined to elaborate, citing the quiet period around the pending IPO.
"You have to know what all the mechanics are under the transaction to be able to say that
is right or that's not right," says Jack Ciesielski, publisher of Analyst's Accounting
Observer.
The accounting choices result in very different images for investors. For those who value
companies based on revenue, or revenue growth, Yahoo's formal presentation makes its
revenue appear to be larger, and growing faster. Yahoo's as-reported gross revenue grew
168% in the first quarter; net revenue grew a robust, but less-impressive, 94%.
Likewise, Google's choice of net revenue slows its growth rate, because revenue from the
ads Google places on other sites is increasing faster than total revenue. In the first
quarter, Google's revenue grew 122%. On a gross basis, however, revenue grew 162%.
When it comes to profit margins, the accounting choices create the opposite impression:
Yahoo's accounting makes its profit margins appear smaller, and Google's makes its
appear larger.
In the first quarter, for example, Yahoo reported a 17% operating-profit margin. Count
only net revenue, however, and operating profits soar to 24%. Google reported a 40%
operating-profit margin. Include gross revenue, and the operating margin slips to 24%.
The profit margins "are much more impressive if you report on a net-revenue basis," says
Mark Mahaney, an analyst at American Technology Research in Greenwich, Conn.
The revenue-recognition issue doesn't affect the bottom line, where Yahoo reported $101
million in first-quarter net income, and Google reported $64 million.
But a different accounting choice by Google has a big effect there. That was Google's
decision to reassess the value of stock options it has granted since 2001. In essence,
Google said in its filing that it now believes it granted those options, mostly to
employees, at lower exercise prices than they were really worth. Last year, for example,
Google said it distributed nearly 20 million stock options, at an average exercise price of
$2.65 a share. But details in the filing suggest Google now thinks its own stock was
valued at roughly $31 a share last year.
As a result, Google said it had to recognize an expense for these underpriced options. In
the first-quarter, its stock-compensation expense totaled $76 million, which reduced
Google's net income by more than half from what it otherwise would have been.
So what is an investor to do? Mr. Mahaney recommends valuing Google, and other
Internet companies, based on their free-cash flow, or cash generated from operations
minus capital expenditures. "That removes a substantial amount of the distortions caused
by different tax rates and what companies choose to include in terms of options and what
they don't," he says.
On that basis, Yahoo looks considerably stronger than Google. Mr. Mahaney projects that
Yahoo will generate $838 million in free-cash flow this year, compared with Google's
$476 million.
--Different Ways, Different Means
Google and Yahoo use similar accounting methods for most items on
their
income statements, but Yahoo counts certain revenue and sales costs
that
Google excludes. Here's how both companies stack up using each other's
methods:
Google's first quarter of 2004 revenue and expenses, in millions
Net
income
Operating and
other expenses
Sales
costs
$64
$273
$53
$64
$273
$316
Total
Using Google's accounting
$390
Using Yahoo's accounting
$652
Yahoo's first quarter of 2004 revenue and expenses, in millions
Net
income
Operating and
other expenses
Sales
costs
$101
$375
$74
$101
$375
$282
Total
Using Google's accounting
$550
Using Yahoo's accounting
$758
Source: the companies' SEC filings
QUESTIONS:
1.) What is revenue? What is an expense? Describe the revenue recognition and matching
principles.
2.) Explain the primary and secondary qualities of decision usefulness. What property (or
properties) of decision usefulness is (are) being compromised by different accounting
methods at Yahoo and Google?
3.) Explain the different accounting methods being used for revenue and expense
recognition at Yahoo and Google. What differences result in the financial statements?
4.) Explain the difference between recognizing revenue at the gross amount and
recognizing revenue at the net amount. Using authoritative guidance, explain when each
method is appropriate.