Law-Abiding Porn Enthusiasts in Utah Dealt a Blow

Henry Blodget crucifies Demand Media today for their accounting treatment for the cost of their “army of freelance writers” as the company attempts to go public.

But before we get to that, first a little quick and dirty for those of you that don’t surf the web all day (like some people we know). Demand Media runs “content farms” like eHow, Livestrong.com and Cracked. To put it simply, the idea is that aggregating freelancers in this fashion is much more efficient “sly, lots of people take exception with this model.

As we said, Demand is trying to go public and Kara Swisher at All Things Digital writes that the latest draft of the S-1 attempts to explain some questions the SEC had on its “capitalized media content.”

Currently, using a concept of “long-lived” content, Demand has been amortizing those expenses over five years, since it says it continues to generate revenue on that material over that much time.

As the company noted in its S-1 filing:

“Capitalized media content is amortized on a straight-line basis over five years, representing the Company’s estimate of the pattern that the underlying economic benefits are expected to be realized and based on its estimates of the projected cash flows from advertising revenues expected to be generated by the deployment of its content. These estimates are based on the Company’s plans and projections, comparison of the economic returns generated by its content of comparable quality and an analysis of historical cash flows generated by that content to date.”

If you find that last paragraph hard to read, it’s because it is hard to read. Demand is essentially saying that their content is extra-special and will be making them money down the road, unlike the drivel you read elsewhere. Accordingly, this situation calls a useful life of five years and for the amortization expense to recognized over that life. That’s where Henry loses it (at least that’s the vision we have), writing that despite it being a “theoretically reasonable judgment” this whole notion of not recognizing content/editorial expenses (aka: bloggers) immediately is “bogus”:

• It’s unusual and aggressive. Other publishers don’t account for editorial costs this way

• It makes the company “profitable” when it’s actually hemorraging cash, so it is obviously a gimmick used to spruce up the financial statements

• It leads to an instant argument/interrogation about how long a writer’s content will ACTUALLY be valuable (and Demand Media hasn’t even been around for five years, so confidently saying “five years” begs more questions)

• It is an EASY knock against a company that is controversial anyway

For these reasons, Demand Media should just drop this accounting immediately.

But going back to Swisher, the company has an explanation – it’s mathematical! So, it just works, mmmkay?

To be allowed to expense over five years, Demand said, the company has to use a sophisticated algorithmic platform–which other content creators do not have–to provide proof of “probable economic benefits” from that content over that time.

Since Demand has long claimed that it has a new and innovative approach to content creation, it is making the case to investors that it needs to have the correct accounting for that approach.

OH! Since you have rocket scientists on the job, it’s totally legit. NOW WE GET IT. But despite having someone John Nash-esque on staff, the company admits that there is a big catch:

Changes from the five year useful life we currently use to amortize our capitalized content would have a significant impact on our financial statements. For example, if underlying assumptions were to change such that our estimate of the weighted average useful life of our media content was higher by one year from January 1, 2010, our net loss would decrease by approximately $1.6 million for the nine months ended September 30, 2010, and would increase by approximately $2.4 million should the weighted average useful life be reduced by one year.

In other words, if the company can’t use five year amortization for its content, things will get ugly fast (Blodget illustrates with an example). The whole thing has caused enough of a ruckus that the IPO is being put off until next year which, considering there’s probably lots of tricky stuff involved (x’s and y’s and whatnot), seems like a good idea.