BUSINESSWEEK ONLINE:   Business Week ebiz


Business Week e.biz
COMPANY CLOSEUP By Nanette Byrnes June 29, 1999


A Net Bookseller's Biggest Edge Could Be...Bookkeeping
The accounting rules let Amazon quickly write off major expenses, while those of earthbound rivals can drag down earnings for years

When it comes to the rivalry between online booksellers and the corner bookstore, the world of difference between the two is obvious. A customer who logs onto Amazon.com can order a copy of Hannibal, buy a PalmPilot, or check out the latest musical mixture from the Chemical Brothers, all at 2 a.m. Walk into a Barnes & Noble, and a person can ask questions of a sales clerk, buy a book, or just sit down and read a few pages.

But there's also a back-office difference that's giving Net companies a significant advantage: accounting rules. Devised decades before the Internet Revolution, rules that accountants now use to size up online startups are often not the same as those applied to traditional brick-and-mortar rivals. They're using rules for pre-Net startups and applying them to Net companies. The result: Money-losing Net companies get to take larger write-offs today -- and can set themselves up for a rosier future of low costs and big revenue. Meanwhile, older brick-and-mortar rivals face a tougher standard.

 

The standards virtually assure Net companies a rosier performance than terrestrial competitors
 

Check out the differences: First, big Net expenses, like technology spending, have a short lifespan. The accounting rulebook says anything that's quickly obsolete or has a lifespan that's hard to predict should be written off quickly. Net companies, therefore, can rapidly write off their most basic and biggest expenses -- marketing and technology, the building blocks of a Net business. Brick-and-mortars, on the other hand, typically can't write off their most basic and major expenses as quickly, such as costs for buildings and overhead. Besides, in today's investing environment, no one expects Net companies to make money, so they're not penalized for that, either.

A second major difference: When it comes to mergers and acquisitions, online companies are often buying young, untested properties, which can also be written off quickly. Earthbound companies, though, must typically write those expenses off over years, or even decades. Here's another: Online companies often push back their revenue, accounting for it later -- so they are conservative and adjust for their short operating history. Brick-and-mortars, however, have more established histories and must often account for their revenues more quickly.

What this all adds up to is a formula that virtually ensures Net companies will, in the future, show a rosier performance compared with their terrestrial competitors. The balance-sheet advantage also allows Net companies to pay much lower taxes, since their accounting shows that they're not making much money, if any, at all.

TOO YOUNG TO JUDGE. Marie Toulanis, chief financial officer for B&N online -- formerly CFO for Barnes & Nobles' brick-and-mortar operations -- acknowledges the accounting gap. She says it sets up Net companies to exhibit a better performance over time. They "won't have the burden of these costs over the long horizon," she says. "Brick-and-mortars have to continually invest and would have those costs."

Why all the accounting differences? E-businesses are still too young to have their own accounting rules -- and there are no hard-and-fast trends emerging yet on which to base new ones. It's tough, for example, to judge the shelf life of many dot.com expenses, like online marketing costs.

 

Net companies' earnings may be depressed today by M&A write-offs, but future earnings are set up to sparkle
 

While investors in Net companies don't expect profits, investors in brick-and-mortar rivals wallop their companies for even the slightest earnings disappointment. Says Peter Osborne, an audit partner and E-commerce specialist for Deloitte & Touche in Silicon Valley: "It's this disparate expectation that's allowing Amazon to be a fierce competitor, because it's not playing by the same rules."

Consider the rules governing mergers and acquisitions. Because acquired companies and assets are often quite new and untested, accountants typically write such costs off quickly. But here's the rub: These same accountants often tally revenue for Net companies over the longest period possible -- again because there's no real track record against which to make judgments. The result: a formula that guarantees a Web advantage, where expenses are taken right away and revenue is pushed off. That depresses today's earnings but sets up future earnings to sparkle. Brick-and-mortars, on the other hand, must do the opposite: recognize revenue based on established patterns. Plus their up-front expensing of costs generally puts a drag on their earnings for years.

A BIG TAX BREAK. Just ask Toulanis. She says the company is still expensing goodwill, or the premium it paid over asset value, from its 1987 acquisition of the B. Dalton bookstore chain. The company's 1998 share of the $59 million that it's writing off over 40 years -- for goodwill and trade names acquired -- was $3.3 million. By contrast, properties that Amazon buys have often been around only for a matter of months. Any goodwill from those purchases will, like expenses, be written off very quickly since there's no way to know what their long-term value might have been.

And the Net edge doesn't stop with expense accounting. For traditional merchants, inventory and the cost of financing it are major expenses that most Net companies don't have to worry about. The $945 million in inventory Barnes & Noble carried at the end of last year was 32 times what Amazon held in its single warehouse.

Bottom line: Thanks to accounting differences, Net companies get a tax break. Look at Amazon, which has recorded no profits since its inception, despite strong revenue growth. No profits, no corporate income tax. But Barnes & Noble, unable to charge off up front its major expenses, made money and paid $64 million of it to the IRS last year -- an effective tax rate of 41%.

All of these differences can be galling for traditional managers. Says Patrick J. McGovern, founder and chairman of International Data Group, a publisher whose properties include PC World magazine and the "For Dummies" series of self-help books: "We invested $70 million over the last three years [in IDG's ongoing businesses]. On our profit-and-loss statement, that's $70 million of losses, and that lowers your value." However, McGovern points out, "in an Internet company, that [investment] creates more value."

Not all types of companies can get that advantage. In book retailing, for example, accountants look at revenue pretty much the same way they do for all companies.

 

The worry: Investors might think Net companies are more efficient, rather than accounting-enhanced
 

But when it comes to expenses, it's a different story. Last year, for example, Amazon.com spent $133 million on marketing and sales, including spending for things such as promotion and public relations. At 22% of sales, marketing was the Seattle-based company's largest expense and was written off entirely and right away. At Amazon, even the longest-lived expense is off the books within three years. That's in sharp contrast with terrestrial retailers, who usually find themselves writing off their large expenses, and consequently dragging down earnings, for many years.

B&N's biggest expense last year was "cost of sales and occupancy" -- the cost of such things as rental expenses, store improvements, and maintenance. That cost amounted to $2.1 billion, or 71% of sales. And it included some, but not all, of B&N's rent and remodeling expenses for brick-and-mortar storefronts. Toulanis contrasts a Net company's quickly taken marketing costs with the cost to a brick-and-mortar of building new stores. B&N, for example, writes off the leases of its stores over 10 to 15 years. That's a decade-plus of depressed earnings.

The worry in all of this? That in the future, investors, forgetting the history of these expenses, might assume Net companies are more efficient and better managed, without realizing that some of their strong numbers are accounting-enhanced. If Internet companies' stocks continue to enjoy their current high valuation as measured by price-to-earnings ratios, for example, Amazon's valuation could easily be even higher than Barnes & Noble's in the future, when real earnings kick in. Says Steven M.H. Wallman, who formerly sat on the Securities & Exchange Commission and is now a senior fellow at the Brookings Institution, the Washington-based think tank: "Amazon's earnings in the future will be proportionately increased, dollar-for-dollar, to the extent that Amazon has already expensed the construction of its 'virtual' store. Barnes & Noble's expenses for brick-and-mortar buildings will continue into the future, depressing earnings for years to come. Until our accounting system recognizes that these two companies are basically in the same business, it's not going to be a fair comparison."

Even so, don't expect accounting rules to change anytime soon. Dominating the debate at the SEC and accounting's regulatory body, the Financial Accounting Standards Board, are more pressing concerns, such as how to properly account for stock options. Still, some of the differences will likely work themselves out with time. Says Brian Cooper, senior manager at Ernst & Young: "It's not black and white. It's still an evolving industry." For now, though, investor beware.

Byrnes covers corporations and accounting for Business Week


_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _




WEB POINTERS
To try the sites of the companies mentioned in this story, click here:
Amazon
Barnes & Noble


Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
Terms of Use   Privacy Policy