When Should Advertising Be Capitalized?

The IRS and FASB have specific guidelines companies should follow.

THE QUESTION OF WHEN TO CAPITALIZE ADVERTISING costs has long presented a problem for CPAs. While the easy solution is for companies to expense advertising as it is incurred, both the IRS and FASB say in some circumstances it should be capitalized.

THE MOST FORMIDABLE BARRIER A COMPANY FACES to taking a tax deduction for advertising expenditures is the 1992 Indopco decision. The IRS has not, however, been very aggressive in applying Indopco to advertising, announcing in revenue ruling 92-80 that the decision would not affect a company’s ability to deduct advertising under IRC section 162(a).

IN THE 1998 RJR NABISCO CASE, THE IRS distinguished between the costs of developing advertising campaigns and the costs of executing them. The IRS argued that campaign development costs created long-term benefits for a particular brand of cigarettes. The Tax Court found the position in conflict with several Treasury regulations.

FOR FINANCIAL REPORTING PURPOSES, THE PROBLEM CPAs face with advertising expenditures is whether a future economic benefit exists. SOP 93-7 provides guidance on how to account for advertising expenditures and says costs should generally be expensed either as they are incurred or the first time the advertising takes place.

SOME FASB PRONOUNCEMENTS GIVE CPAs GUIDANCE on reporting advertising costs for specific items or industries. Some of the affected industries include cable television, lenders, insurance companies and real estate entities.

LARRY MAPLES, CPA, DBA, is professor of accounting at Tennessee Technological University, Cookeville. His e-mail address is lmaples@tntech.edu . MELANIE EARLES, CPA, DBA, is assistant professor of accounting at Tennessee Technological University. Her e-mail address is mearles@tntech.edu .

Should you or shouldn't you? Tax and accounting authorities acknowledge that it is difficult for CPAs to establish criteria about when a company should capitalize advertising costs. Many suggest that the reasonable solution is for a company to expense advertising as it is incurred. Despite this, both the IRS and FASB believe it is possible to identify circumstances in which companies should capitalize advertising. Complicating the tax picture, recent IRS rulings and court briefs send conflicting signals. For financial reporting purposes, FASB generally sets limited criteria for capitalization but allows some exceptions for specific industries. CPAs responsible for deciding how to handle a particular advertising expenditure may find this review of the current tax and accounting rules will help them make choices in the gray areas.


The most formidable barrier a company faces to taking a tax deduction for advertising expenditures is the significant long-term benefit criterion, a qualifier found in the Indopco decision (503 U.S. 79, 87 [1992]). Some advertising undoubtedly creates for a company significant benefits that extend beyond the current tax year, so the crucial issue CPAs face is not whether long-term benefits exist but how to measure them. Although the IRS has not been shy about using Indopco to require a company to capitalize expenditures in some areas, it also has sought to allay fears in the business community that Indopco will lead to increased scrutiny of advertising expenditures.

In revenue ruling 92-80, 1992-2 C.B. 57, the IRS announced that Indopco would not affect a company's ability to deduct advertising under IRC section 162(a). So even if a company's advertising has a future impact, as is the case with institutional or goodwill advertising, the IRS has elected not to use Indopco as a precedent. The IRS has not said it is allowing a deduction because of the difficulty of separating current from future benefits. Even if advertising is directed solely at future patronage or goodwill, a company can still deduct the cost, unless the future benefits are significantly beyond those of normal advertising.

The U.S. Supreme Court previously held in Lincoln Savings and Loan Association (71-1 USTC 9476, 403 U.S. 345,554 [1971]) that businesses must capitalize expenditures that create or enhance a separate and distinct asset. The Court strengthened this standard in Indopco, when it said the separate-and-distinct-asset standard is a sufficient though not a necessary condition for capitalization. Interestingly, the IRS appears to be reaching back to the earlier and weaker standard in the positions it has taken recently. The likely reason is that it is easier to draw a line in the sand using the separate and distinct test than it is applying the significant long-term benefit test. Despite its apparent retreat, the IRS has not been very successful in sustaining this position in the courts.


In a recent case, RJR Nabisco (76 TCM 71 [1998]), the IRS distinguished between the costs of developing ad campaigns and the costs of executing them. In effect, the IRS argued that campaign development costs (the image and message to be conveyed) created long-term benefits for a particular brand of cigarettes. In contrast, the costs of executing the campaign, such as specific magazine ads to implement a theme, for example, should be currently deductible, according to the IRS. The commissioner's position was that developing a packaging design campaign enhanced a separate and distinct asset— brand equity. The Tax Court agreed that campaign development costs "created intangible assets that are inseparable from brand equity and goodwill." But the creation of such intangibles does not result in a deduction, because goodwill is traditionally a benefit associated with ordinary business advertising.

The primary problem the Tax Court had with the IRS position was that it conflicted with Treasury regulations sections 1.162-1(a) and 1.162-20(a)(2) and revenue ruling 92-80. Goodwill, understood as "the expectancy of continued patronage," is a traditional benefit of ordinary business advertising according to the IRS. Thus, the Tax Court felt the IRS should be precluded from advancing a position in conflict with a recent revenue ruling.

It appears the IRS might have been able to prevail without those self-imposed restrictions. In an earlier case, the IRS convinced the Tax Court that marketing costs a company incurs to create an intangible asset should be capitalized. In Briarcliff Candy Corp. (31 TCM 171 [1972]), the Tax Court held that the company's expenses to develop suburban markets for its products were "not advertising directed at the promotion of its product but advertising directed at establishing new channels of distribution." Thus, they should be capitalized. On appeal, however, the Second Circuit Court of Appeals found no authority for capitalizing a self-developed intangible asset. Developing new distribution channels would not qualify under the separate-and-distinct-asset test. The Second Circuit conceded that a future benefit was created, but said the question was academic because the IRS was on record as saying creation of a marketing intangible was a normal benefit of product advertising.


The IRS has ruled that advertising must be capitalized only in unusual circumstances where it is directed at obtaining future benefits greater than those associated with ordinary product advertising or institutional or goodwill advertising. The only example the IRS provided was a claims court decision involving an electric company's advertising to allay public fears about nuclear power ( Cleveland Electric Illuminating Co., 85-1 USTC 9128, 7 Cls Ct 220). The court required the company to capitalize the expenditure because it believed Cleveland Electric intended to obtain future benefits significantly beyond normal product or goodwill advertising. Such a campaign is not product advertising and may not even represent goodwill advertising if that term is narrowly defined. But it is difficult to see a meaningful distinction between promotions that tout a company's name and those that make the market friendlier for one of its products. It does not take much imagination to see the IRS requiring companies to capitalize any advertising directed at improving the bottom line but not directly connected to product promotion. Consider, for example, the current campaign major tobacco companies are waging to convince the public to oppose increased cigarette taxes.

Tangible assets. Expenses for advertising that produces tangible assets are subject to capitalization. In Best Lock Corp. (31 TC 1217 [1959]), billboards, signs, display cabinets and a collage the company created to advertise building materials had to be capitalized. But the courts have differed on whether a company must capitalize the costs of developing a sales catalog. For more insight, CPAs can compare Best Lock Corp. with E. H. Sheldon and Co. (214 F.2d 655 [CA-6.1954]).

Exhibit 1: Tax Conflicts in Advertising Costs

Type of Advertising Expense/Capitalize Deciding Factors Case/Ruling
Free samples Expense Court refused to allocate expenditures between those to build up future business and those to maintain current business. Northwestern Yeast 5 BTA 232, 237 (1926)
Free samples Capitalize Indecisive about whether expenditures were for goodwill or research/experimentation; expenditures had indeterminate useful life. Marko Durovic 76-2 USTC &9732 542 F.2d 1328 (1976)
Catalog Expense Ordinary and necessary business expense. Future benefits could not be determined precisely. Indefinite useful life. E. H. Sheldon & Co. 214 F.2d 655, 659 (1954)
Catalog Capitalize Taxpayer deducted preparation costs incurred during the two tax years preceding publication. Court said the costs had no effect on earning income for those two years but would best benefit several years in the future. Best Lock Corp. 31 TC 1217, 123 (1959)
Catalog Capitalize Benefits derived from costs of trade catalog were not fully realized and were exhausted in year of payment. Revenue ruling 68-360
Package design Expense Future benefits obtained were not significantly beyond those traditionally associated with institutional goodwill advertising. RJR Nabisco, Inc. 76 TCM 71 (1998)
Package design Capitalize Package design costs create an asset with either no ascertainable useful life or an ascertainable useful life that extends beyond the tax year in which they are incurred. Revenue procedure 97-35
New channels of distribution Expense Expenditures were ordinary and necessary to preserve and continue existing business. Briarcliff Candy Corp. 73-1 USTC &9288
New channels of distribution Capitalize Advertising directed at new outlets for the sale of an entity's products are not "ordinary" within IRC section 162(a). Acquired contracts had indefinite life; capitalized with no amortization allowed. Briarcliff Candy Corp. 31 TCM 171 (1972)


To the extent advertising is classified as a start-up expenditure, companies are required to capitalize it. For example, a new business that buys ads to promote its opening should clearly capitalize the cost. However, an established company may find it difficult to distinguish expanding the business from starting a new trade or business.

In NCNB Corp. (1982-2 USTC 9469 [CA-4, 1982]) expenses the bank incurred to develop branch bank facilities were considered expenditures to expand an existing business. Another bank's advertising and start-up costs related to handling MasterCard accounts were deductible because the new system allowed the bank to carry on its old business of making loans in a new way ( Colorado Springs National Bank , 74-2 USTC 9809 [CA-10, 1974]). In the same vein, advertising and other costs associated with expanding a line of restaurants through a preexisting subsidiary were deductible. (See LTR 8423005.) However, the IRS said a manufacturer of fragrances, cosmetics, clothing and accessories began a new trade or business when it opened its first retail outlet. The IRS required capitalization only on the company's first store, however, because the opening of subsequent retail stores was considered an expansion of the company's existing business. (See LTR 9331001.)

More recent developments indicate a changed mood. The IRS convinced the Tax Court that mutual fund giant Fidelity should not be allowed to deduct initial costs, including marketing, of launching a new group of funds ( FMR Corp. and Subsidiaries v. Commissioner , 110 TC 30 [1998]; also see TAM 9825005). A mutual fund opening more funds can clearly be construed as expanding an existing business under earlier reasoning. However, using the wide Indopco net, the Tax Court concluded that capitalization was proper because Fidelity's expenditures produced a significant future benefit. The IRS actions in the Fidelity case show it is not reluctant to use Indopco to force capitalization of advertising in a start-up context, although based on other cases it has apparently decided to forego using the ruling to analyze other advertising expenditures. (For a summary of tax cases dealing with advertising costs, see exhibit 1.)


For financial reporting purposes, the practical problem CPAs face with advertising expenditures is not only one of measurement but also of uncertainty about whether an actual future economic benefit exists. FASB Concepts Statement no. 6, Elements of Financial Statements , defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Paragraphs 175 and 176 discuss the concept of future economic benefits, including those that may arise from advertising:

"Uncertainty about business and economic outcomes often clouds whether...particular items that might be assets have the capacity to provide future economic benefits to the entity.... For example, business enterprises...advertise, develop markets...and spend significant funds to do so. The uncertainty is not about the intent to increase future economic benefits but about whether and, if so, to what extent they succeed in doing so. Certain expenditures for...advertising...are examples of the kinds of items for which assessments of future economic benefits may be especially uncertain."

Arguably, advertising expenditures have the same problem as research and development costs, which FASB addressed in Statement no. 2, Accounting for Research and Development Costs . That is, a company charges research and development costs to expense as they are incurred because it is uncertain about the amount of future benefits and the time period over which they will be realized.

Statement of Position 93-7, Reporting on Advertising Costs , provides CPAs with broad guidance on advertising expenditures. It says advertising costs should be expensed, either as they are incurred or the first time the advertising takes place. The two primary costs of advertising are production and communication. Advertising production costs include idea development, advertising copywriting, artwork, printing, audio and video crews, actors and other related costs. Communication costs are those for magazine space, television airtime and billboard space. SOP 93-7 provides two exceptions:

1. Direct response advertising that meets certain criteria should be capitalized.

2. A company's obligation for advertising expenditures it will make subsequent to recognizing revenues related to those costs should be accrued and the costs expensed when the company recognizes the related revenues.

An example of the latter is cooperative advertising, where an entity agrees to reimburse customers for some or all of their advertising costs. This might apply to an appliance manufacturer that reimburses retailers for newspaper advertising that features its products. In these situations, the company should accrue the advertising costs and expense them as related revenue is recognized.

A company should capitalize and amortize direct response advertising if

  • Its primary purpose is to elicit sales from customers who can be shown to have responded specifically to the advertising.

  • It results in probable future economic benefits.

To meet the first requirement, companies must have a way to document that customers have responded to specific advertising. This might include coded order forms, coupons or response cards; files indicating customer names and the advertisement; or a log of customers who called a particular phone number appearing in an ad. To meet the second requirement, companies must present documentation of benefits from previous direct response advertising campaigns. Industry statistics will not suffice in the absence of a specific entity's operating history.

Some FASB pronouncements and audit guides provide CPAs with guidance on reporting advertising for specific items or industries. There is, however, some inconsistency between these sources. Pronouncements that allow capitalization seem to do so because there is a clear, demonstrable cause and effect relationship between the assets acquired and the costs incurred. Pronouncements that prohibit capitalization appear to do so because there is no demonstrable causal relationship—the amounts capitalized would be immaterial or the cost of obtaining the information would outweigh the benefits of reporting it.


CPAs should be aware that in several industries companies may expense advertising costs when they are incurred, even direct response advertising. A company may expense advertising done in connection with extended warranty and product maintenance contracts when it is incurred, according to FASB Technical Bulletin 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts . FASB Statement no. 51, Financial Reporting by Cable Television Companies , says all advertising related to acquiring new cable television subscribers should be expensed when it is incurred, regardless of its form. Under FASB Statement no. 91, on leases and loans, all advertising costs an entity incurs related to soliciting potential borrowers should be expensed when incurred.

Under FASB Statement no. 60, Accounting and Reporting by Insurance Enterprises , stock life and property and liability insurance companies should capitalize policy acquisition activities. Statement no. 60 is unclear about whether advertising is a policy acquisition activity, but the industry audit guide Audits of Stock Life Insurance Companies says it is. Costs a company incurs to rent or sell real estate projects should be capitalized if they will be realized when the project is sold or rented. FASB Statement no. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects , says companies should expense the capitalized costs in the period revenue is recognized. The flowchart in exhibit 2, above, summarizes the accounting treatment of advertising costs for financial reporting purposes.

Exhibit 2: Financial Reporting Treatment of Advertising Expenditures



In deciding how to handle advertising expenditures, CPAs should beware the easy assumption that advertising is always expensed. While expensing is the norm for tax and financial reporting purposes, both the tax and accounting authorities have created a number of exceptions that cloud the issue. Although the IRS has eschewed the use of the broad power granted it by the Indopco case as it applies to advertising costs, it continues to push for capitalization in some situations. The accounting authorities have also adopted a seemingly straightforward rule that companies must expense advertising unless it is direct response advertising. CPAs should, however, keep a watchful eye on specific industry exceptions to that rule.

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