America Online is in hot water as regulators investigate its booking of ad revenue. Yet experts, noting that the nuances of such accounting are often murky, differ about how hot the temperature really is.
The timing of the probes of its online advertising deals is bad, coming amid a rash of corporate accounting scandals that have investigators eager to crack down on questionable bookkeeping.
”(Regulators) are under much more pressure to bring significant cases against well-known multinational companies,” says Jacob Frenkel, a former senior counsel in the Securities and Exchange Commission’s enforcement division, now at law firm Smith Gambrell & Russell.
Yet, proving complex deals were improper can be tricky, especially when independent auditors sign off on them, which AOL says is the case. Some experts say accounting inevitably involves gray areas and that accountants often disagree on proper ways to book revenue. Others, however, say common sense dictates an overriding rule: Firms simply shouldn’t do anything that could mislead investors.
Both the SEC and the Justice Department are investigating many of AOL’s aggressive advertising deals from the past few years. Some are also the subject of an internal probe by parent company AOL Time Warner, scheduled to be finished by the end of the month.
Stock may take hit
Whatever the outcome, the investigations likely will depress AOL stock for at least several months, analysts say.
The deals under scrutiny involve less than 5% of AOL’s ad revenue from the time, so the financial impact will be small even if the company has to restate some results, as seems likely. Still, ”it causes concern and uncertainty because of the potential for shareholder lawsuits and the (financial) liability attached to them,” says analyst Fred Moran of Jefferies & Co.
The SEC and Justice probes were triggered by a July Washington Post report that AOL artificially inflated ad revenue to meet Wall Street expectations while working to close its Time Warner merger in early 2001.
Among other things, AOL reportedly sold ads for eBay and booked the revenue as its own, converted a legal settlement into an ad deal and counted stock warrants gained for brokering software sales as ad and commerce revenue.
Bala Dharan, accounting professor at Rice University, says those incidents ”might be a slam dunk” for investigators. ”In my opinion, all of them were much more aggressive than most companies would have done and were motivated by needing to meet targets,” he says.
AOL says its accounting was blessed by auditors Ernst & Young.
But Joshua Ronen, accounting professor at New York University, believes AOL can take little refuge in its auditors’ endorsement. ”Auditors unfortunately give in to the companies,” he says.
Frenkel disagrees, saying an auditor’s OK can be significant, especially if the issues are fuzzy. But, he adds, that’s the case only ”if the company made a full and truthful disclosure to the auditor.”
AOL’s woes deepened last month when an internal investigation revealed it might have improperly reported $49 million in ad and commerce revenue from three other transactions. David Colburn, head of the business affairs division responsible for AOL’s big ad deals, was fired last month.
AOL Time Warner CEO Richard Parsons, who announced the discovery of the additional questionable deals, vowed to restore integrity to AOL’s accounting practices. He did not identify the transactions, but people familiar with the matter say one involves a deal with phone giant WorldCom. AOL bought network capacity from WorldCom, which, in turn, bought AOL ads.
The SEC is also investigating the WorldCom deal, a similar AOL deal with Qwest and other reciprocal deals to determine if they involved ”round-tripping,” in which revenue is inflated on both sides of a deal, making the overstatement a wash financially but letting the companies impress Wall Street.
The practice was common among dot-com companies, whose stock traded on revenue growth, as well as with phone companies to swap capacity. The SEC has cracked down on round-tripping, forcing dozens of restatements and passing a rule in 2000 more clearly barring the practice.
AOL did many reciprocal deals in its advertising boom, selling ads to companies such as Circuit City and Blockbuster, for instance, in exchange for in-store promotion. Regulators must determine whether such deals were set at ”fair market value” by examining similar industry transactions.
”It’s very hard to prove,” Dharan says. In the volatile Web ad business, ”each deal is so unique. The SEC may not be interested in looking at every company’s strategic intention.”
But Mark Cheffers, CEO of AccountingMalpractice.com, says regulators have broad leeway.
”They can apply fundamental economic principles, which include conservatism. They have to evaluate the intent of the transaction and what either side gained. With financial misrepresentation, you know it when you see it.”
Investigators are subpoenaing AOL documents and will be looking for e-mail messages that might reveal that the company was bent on meeting earnings projections and knew its accounting was improper. Such evidence of intent would be essential for Justice to bring criminal charges but not for the SEC to seek sanctions.
In the end, a criminal case is unlikely, experts say.
”Accounting interpretations are not fodder for criminal cases,” Frenkel says, ”especially if AOL had extensive discussions about the accounting treatment.”
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