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 expenses over many periods rather than recognize expenses in their entirety in the current period, pushing expenses incurred today out into the future.
4. To the best of your knowledge, how much net income was inflated or deflated in 2009? How much net income was inflated or deflated in the first nine months of 2010? Assume the tax rate is zero.
At the end of 2008, the net value of media content was reported to be $29.233 million and accumulated amortization was $12.378 million. At the end of 2009, the value of net media content was reported to be $36.686 million and accumulated amortization was $19.933 million. Accumulated amortization increased by a net of $7.555 million and the net value of media content increased by $7.453 million. This implies that Demand acquired $15.008 million of media in 2009. Under typical web media accounting practices, Demand should be expensing $15.008 million instead of $7.555 million for content creation expenses. This inflates EBIT by $7.453 million.
At the end of the first nine months of 2010, the value of net media content was reported to be $57.510 million and the accumulated amortization was $30.144 million. Accumulated amortization increased by a net of $10.211 million and the net value of media content increased by $20.824 million. This implies that the company acquired $31.035 million. Under typical web media accounting practices, Demand Media should be expensing $31.035 million instead of $10.211 million. This inflates EBIT by $20.824 million.
5. Which accounting policy would you use if you were the company’s CEO? Explain why.
Since the SEC took no action and allowed the IPO to go forward, we would use the current accounting approach to reduce losses on the income statement. Investors grant higher valuations and are more interested in investing in early stage companies with higher revenue growth and lower expenses (and therefore better margins) today. Reduced losses today and high operating cash flow helps Demand Media to raise capital from the financial markets to grow operations. This accounting method served to meet the firm’s capital market goals.
6. The company has been losing money every year, yet it generated significantly positive operating cash flows every single year. What is going on between negative earnings and positive cash flows? As a potential investor, which number would you trust when valuing the company (explain why)?
Earnings on the income statement includes Demand Media’s $32.1 million depreciation and amortization expenses, which more accurately represents the health of the company. The seemingly strong Operating Cash Flow of $39.231 million in 2009 is misleading because the figure is excluding the company’s heavy content creation expenses by adding back depreciation and amortization. These expenses are instead allocated to Cash Flow from Investing Activities. As an investor, we would value the earnings number because the $18 million loss in operating income is more indicative of company health than the $39.231 million gain in OCF.
7. Suppose the company goes IPO without changing its accounting policy, as an investor, would you buy its stock? Why?
No, even with aggressive accounting, Demand Media’s questionable business model is not generating earnings. Demand Media’s revenue is driven by advertising revenue generated by traffic to articles that were written for the specific purpose of exploiting search engine optimization procedures. If search engines change their algorithms or blacklist Demand Media’s websites, then Demand Media’s business will be significantly harmed.
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