BUSINESSWEEK ONLINE : DECEMBER 11, 2000 ISSUE
BUSINESS WEEK E.BIZ -- NET WORTH The End of Fuzzy Math? Regulators should force e-tailers to report costs like mainstream retailers Poring over Amazon.com Inc.'s (AMZN) financial books is getting to be as intriguing as zipping through the latest Elmore Leonard thriller. On Oct. 24, the company disclosed that the Securities & Exchange Commission has made ''informal inquiries'' into how the company comes up with the revenue figures it gives to investors every quarter. It turns out the company counts as revenue stock that it receives in other Net players in exchange for promoting them on Amazon's Web site. Although the practice is permitted under standard accounting rules, experts say the SEC could ultimately determine that Amazon is being overly aggressive. ''It seems more like an investment than revenues,'' says analyst Sirine Hafez of the Center for Financial Research & Analysis, an independent research organization. The SEC declined comment. There's another controversial accounting practice at Amazon and other online retailers that has received less attention so far. The issue is how companies should account for fulfillment costs--the expenses involved in buying and maintaining warehouses and paying employees who receive supplies and package orders for shipment. E-tailers' closest cousins, catalog companies and direct marketers, tend to put these expenses into a line on the income statement called cost of goods sold. But Amazon, drugstore.com Inc. (DSCM), and some other online retailers put fulfillment costs into selling, general, and administrative (SG&A) expenses. While the practice doesn't affect the bottom line, it does make e-tailers' gross margins look fatter than they otherwise would. Execs who pay attention to this sort of topic think there's no good excuse for this kind of accounting. ''They have lousy businesses and they're trying to hide it,'' says Patrick Byrne, chief executive of OverStock.com Inc., an e-commerce site that buys merchandise from troubled e-tailers and then sells it online. The issue is particularly critical this Christmas season. While investors used to focus myopically on revenue growth at Net companies, they're now looking for companies that are on their way to profitability. With the capital markets closed up tighter than a drum, people want to know whether Amazon, drugstore.com, eToys Inc. (ETYS), and others are going to be able to generate cash from their own businesses. Gross margin is one of the key measures of whether a business has potential or not. The traditional accounting theory is that SG&A expenses should be largely fixed so that as revenue and gross profits increase the company moves toward profitability. Any variation in accounting practices can have an impact on gross margins. Amazon's gross margin will be about 24% this year, but it would be about 14% if it changed the way it counted fulfillment costs, according to analysts' estimates. Drugstore.com's gross margins would fall from 5% to negative 15%. And eToys' gross margins would drop from 20% to negative 7%. Understanding the effect on margins is critical, because ''fulfillment costs in this business are much higher than any of us expected,'' says Lehman Bros. Inc. analyst Holly Becker. Securities regulators have tried to get the issue cleared up. In 1999, the SEC's chief accountant, Lynn E. Turner, asked the Financial Accounting Standards Board to figure out how to standardize the way companies keep their books. ''There is diversity in practice that should be eliminated,'' Turner wrote. This summer, it looked like FASB was close to a decision that would help investors. Douglas Reynolds, a practice fellow at the board, says it reached a ''tentative conclusion'' in May that fulfillment expenses should be included in cost of goods sold. But that never happened. This fall, FASB reversed its decision and essentially punted. It said that companies could put these expenses into the cost of goods sold--or they could put them someplace else on the income statement. If companies put the expenses someplace else, they need to break out the exact costs and quantify them in a footnote. Ultimately, FASB decided that companies were accounting for these expenses in so many different ways that it was too complicated to create a universal standard. So how many online retailers are going to change their accounting practices with the new rules scheduled to take effect for most companies this quarter? Few, if any. Amazon, for example, will ''continue with our current practices,'' says Tim Stone, director of investor relations at Amazon, which has been breaking out its fulfillment costs. Drugstore.com and eToys don't plan to change their accounting, either. FASB and some others argue that the ruling provides investors with additional clarity. But this smacks of hypocrisy. If a group of professional accountants decided that it's too complicated for them to figure out a standard, it's simply not realistic to expect your average investor to deduce costs from accounting footnotes. ''It's not a good solution,'' says Roman L. Weil, a professor of accounting at the University of Chicago's Graduate School of Business. ''It's a stop-gap.'' The SEC has not formally objected to the FASB decision, but the securities regulator thinks the ruling is not ideal. ''To have two companies account for the same thing differently cannot be the best thing for investors,'' says Scott A. Taub, a professional accounting fellow at the SEC. Regulators have gone out of their way to help New Economy companies with pledges of no taxes and light regulation. That's sound public policy. But with investors putting billions of dollars at risk to help finance technology companies, it's essential for regulators and accountants to do everything they can to make sure these companies' financial books are fair and understandable. So far, on the issue of fulfillment costs, that's not the case. By PETER ELSTROM, peter_elstrom@ebiz.businessweek.com _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					e.biz Contents for Dec. 11, 2000 issue RELATED ITEMS The End of Fuzzy Math? TABLE: Amazon's Books Critical Numbers of the Month (.pdf) INTERACT E-Mail to Business Week Online

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