Decoding advertising costs.

The advertisements we see and hear every day represent annual purchases of more than $100 billion of media space and time. Despite advertising's size and its strategic significance, it's rare to find accounting and control systems that properly oversee these expenditures. Marshall Garber, CPA a principal of Entec, a New York City consulting firm, reveals how accounting and auditing can provide entities with the means to reliably track and control advertising spending.

The growth of the advertising industry that began with the advent of television sponsorship in the 1950s has created unique circumstances that require tailored accounting and control systems - systems that exist but thus far have not been universally employed by CPAs. The result: Most advertisers do not have a certifiable measure of the amount of advertising they receive versus what they pay for.

THE ADVERTISER'S

PERSPECTIVE

Advertising expenditures include critical variables such as the types of media employed, when and for how long an ad runs as well as gross and net costs. Without systems to track these costs and the variables that make them up, advertisers must make crucial marketing and spending decisions with incomplete information.

Each year, advertisers wrestle with the dilemma of building sales by increasing advertising or raising profits by cutting it. Virtually no other cost offers such dynamic options, creating a control problem. Given the volatility of advertising spending, it is critical to develop specialized controls.

CREATING A COMMON

CURRENCY

There is general agreement advertising creates future benefits. However, there is widespread disagreement about how to account for them. Some advertisers capitalize advertising costs and amortize them over the expected future periods they will presumably generate sales. Others simply expense the cost in the period the advertising runs. The result is a wide divergence of reporting practices.

In December 1993, the American Institute of CPAs accounting standards executive committee issued Statement of Position no. 93-7, Reporting on Advertising Costs, which resolved the problem. AcSEC concluded that although advertising might result in probable future economic benefits, in most cases those benefits would not be measurable with sufficient reliability to meet the definition of an asset. Therefore, advertising should be expensed as it is incurred. This dramatically reduced the financial statement presentation options and created a long-overdue common currency for financial reporting on advertising costs.

COST CONTROL BASICS

It doesn't matter what time of day a piece of furniture is bought. But variables such as the time of day an advertisement runs or the program an advertiser sponsor and its audience demographics can influence advertising costs.

To manage these costs, advertising agencies maintain specialized client accounting systems. If advertisers properly manage two operations - accounting and auditing - these systems hold the key to both the agency's and the advertiser's control over expenditures.

CREATING A COMMON

ACCOUNTING

Most advertisers do not adequately use the information in their advertising billing, partly because of misunderstandings over the role of billing terms. Advertising agencies offer clients a range of billing terms, known as "profiles." Advertisers often choose the wrong profiles in a misguided effort to control costs. In fact, profiles can be a good cost-management tool when used correctly.

The billing profile helps advertisers establish the information and reporting rules supporting the billing activity. The advertiser's billing records should match the agency's records. Billing profiles should be set to bill on an accrual or "as ordered" basis.

For advertisers, this matching principle establishes a key control. It links the advertiser's books to the agency's so both can work from seamless information systems to manage advertising expenditures jointly. Additionally it synchronizes the analytical information critical to the management of this cost to the advertiser's books of account.

Most advertisers overlook the accrual approach because it appears to favor the agency - from a cash perspective - by allowing it to bill costs whether or not it has paid its suppliers. But cash control really is accomplished by managing the timing of payments to the agency, not the timing of billing from the agency.

MYTHS OF ADVERTISING

AUDITS

While the principles of law governing agency relationships entitle an advertiser to audit its agency's handling of the advertiser's money, the CPA is responsible for adapting audit techniques.

Some advertisers audit their agencies and others don't. Those that do usually regard the audit as an additional control over the advertising process. For advertisers, auditing their agencies should not be a control but the control. Advertisers have no other means to verify receipt and measure the value of media placements or performance. It is critical for practitioners to conduct a comprehensive audit of their clients' advertising agency's systems and records.

However, most advertiser's and CPAs need a better understanding of the objectives of this type of audit and the methods necessary to accomplish them. Too often audits rely heavily on sampling a handful of transactions that cannot confirm what advertisers want to know: Did they get what they paid for?

In many instances the answer is no. Audits of agencies' books of account can uncover costly anomalies, providing a compelling motive to adopt improved control systems. In the hands of a CPA with a clear set of audit objectives, an advertising audit can easily provide an advertiser with a competitive advantage over organizations that do not adequately manage this process.

SETTING AUDIT OBJECTIVES

An audit can provide a wide range of controls over advertising financing. At a minimum it should

* Establish the reliability of the agency's control system.

* Provide the basis for managing cash.

* Validate the billing.

Validate billing. Successful validation of agency billing requires substantiating three functions: the accounting, the receipt and the performance of the advertising. This can be done using the same approach used to audit businesses. Instead of merely testing transactions, CPAs should concentrate on testing the accounts that define the entity. The accounting for a client's advertising campaign is presented in exhibit 1, page 103. The approach for auditing this entity is diagrammed in exhibit 2, below.

Test the accounting. To rely on the testing of accounts to validate key billing characteristics, auditors must make certain the accounts tested form a complete entity. They must first establish the client's cash position with the agency. This amount then can be used to balance the asset and liability accounts in the agency's subsidiary ledgers against the billing in its journals, creating a balancing set of records to audit.

Once this has been done, auditors should reconcile the billing and receivables in the agency's books with the advertiser's. This establishes the key transactions needed to validate the billing in the agency's system, while permitting auditors to verify them by applying standard audit tests.

Test for receipt. The responsibility for confirming receipt of advertising rests with the agency. The audit should verify it is performing this function by testing disbursements to the media as well as the inventory and liability accounts supporting the billing.

Test for performance. Substantiating the performance of media expenditures is the most helpful part of the audit process for the advertiser, yet the most challenging for the auditor. Each media category, such as network TV, spot TV, radio or magazines, is evaluated against unique and often complex performance measures over fiscal periods that usually do not coincide with the advertiser's fiscal year.

To audit media performance, auditors must understand the performance measure for each media type and apply appropriate audit steps to each. Exhibit 3, above, offers some examples.

THE UNIQUE NATURE

OF ADVERTISING

The accounting profession must move quickly to adjust its techniques to accommodate the unique nature of advertising spending. Current methods do not allow advertisers to accurately judge the value of this strategic expenditure. Some practitioners already are taking advantage of the improvements in controls systems and surely all will do so in the future.