What did AOL's accountants do wrong? Not much.

What did AOL's accountants do wrong? Not much.

What did AOL's accountants do wrong? Not much.

Moneybox
Commentary about business and finance.
Aug. 1 2002 5:10 PM

AOL, A-OK

What did AOL's accountants do wrong? Not much.

Talk about getting no love from your hometown paper. On July 18 and 19, the Washington Post published an 8,500-word exposé on the accounting lapses of the Dulles, Va.-based AOL division of AOL Time Warner. The following week the SEC announced it was opening a "fact-finding" inquiry into the matter, which AOL Time Warner CEO Richard Parsons and most impartial observers attributed to the Post series. On Wednesday came word that the Justice Department is also investigating. AOL shares, which fell 25 percent in the week after the Post series, promptly dropped 7 percent.

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So what did the Post uncover to justify all the uproar? Very little, it turns out. The best indication of that is in the Post's headline: "Unconventional Transactions Boosted Sales." Even if that statement is literally true—and based on the Post's reporting, it seems to be—there's nothing wrong with "unconventional transactions" as long as you don't abuse accounting rules to make them happen. What's missing from the Post article is any evidence that AOL did.

Consider the two most creative types of transactions the Post found. The first involved converting outstanding legal claims into advertising revenue. AOL had purchased a company, MovieFone, which held a $23 million legal claim over its former parent, the British conglomerate Wembley, PLC. Instead of going to court to force Wembley to pay, AOL struck a deal in which the British company would buy a more or less equivalent amount of advertising on AOL.

The second type of transaction occurred as AOL began losing dot-com advertising during the dot-com meltdown. Rather than sit by idly as one dot-com after another broke its long-term commitment, AOL marketing officials pre-emptively renegotiated shorter-term contracts, for which they charged a restructuring fee.

In both situations AOL booked the revenue as ad revenue, pretty much how you'd expect them to. And in fact, none of the accounting experts the Post quotes argues that AOL accounted for the revenue incorrectly. What the experts do argue is that AOL's accounting was insufficiently transparent because it failed to disclose that many of these revenues were unlikely to recur. "It appears that a significant part of AOL's ad business was in jeopardy and it should have said so publicly. They have an obligation to disclose what is happening to the present client base," reads one typical Post quote, from Duke law professor James Cox.

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Cox's gripe isn't quite the stuff of Oliver Stone movies, but it's not insignificant. AOL claims that the revenues in question were so small a percentage of its overall revenue that they were "immaterial." And there's decent precedent to support that claim. For years, companies weren't held responsible for accounting errors so small they might plausibly have overlooked them, a bar which was commonly set at around 5 percent. The problem was that during the '90s, company after company exploited this "materiality" norm, deliberately introducing or overlooking errors they knew existed. So in 1999, the SEC issued a "guidance" clamping down on accounting errors when the effect was to mislead investors—even if they technically fell below the 5 percent threshold.

But in this case, the boost to AOL revenue really was immaterial. The classic example of a company abusing materiality is—surprise!—Enron. In 1997 Arthur Andersen took issue with the $105 million in earnings that its client was reporting, arguing that Enron's income only added up to $54 million according to its calculations. Enron's financial officers responded that the error was less than 8 percent of normalized income—i.e., income averaged over several years—and therefore immaterial. Andersen backed down, even though the error represented more than half of Enron's income that year. In other words, Enron actually made up profits and justified it by invoking materiality. By contrast, AOL simply failed to note that revenues that represented less than 5 percent of its annual advertising revenue probably wouldn't recur the following year. That hardly seems a damnable offense.

And it's tough to believe that investors could have been misled by this omission. The Post argues that AOL fudged its ad revenues because failing to meet quarterly revenue targets would have had a devastating effect on its stock price. That's partially true—failing to meet quarterly targets can have a devastating effect on your stock price. But the reason was that most investors assumed companies were already fudging their numbers. The network component manufacturer Cisco Systems' knack for reporting earnings per share at exactly one penny above expectations was so legendary—it managed to accomplish the feat 14 straight quarters—that its stock took a beating when it finally came up short in late 2000. As one stockbroker told the Harvard Business Review, "Things must be pretty bad if Cisco can't manage to come up with one lousy penny."

Other AOL transactions weren't even very aggressive once you get past the Post's breathless style. One Post allegation relates to an arrangement by which AOL served as an advertising broker for eBay. (AOL occasionally sold ads on rival sites when those companies didn't have large sales staffs of their own.) There's nothing wrong with this relationship per se—brokers routinely sell everything from real estate to artwork on behalf of third parties. What's suspicious is that AOL booked the gross revenue from the eBay ad sales as its own, not just its commission.

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But even this situation is ambiguous. It turns out that companies selling things for other companies can book the revenues the way AOL did as long as they shoulder financial risk in the transaction—making them, in technical terms, the "principal" rather than the "agent." As the Post points out, for example, a company like Priceline can book revenues from the plane tickets it sells because it first buys the tickets from airlines, meaning it has to eat the cost if doesn't move them. In this vein, AOL told the Post it shared some "credit risks" with eBay, though it declined to be more specific, and internal documents revealed that AOL anticipated having to pay eBay $40 million to $45 million whether or not it sold the ads. On top of that, eBay's accounting of the ad sales suggests it shared AOL's interpretation of the two companies' relationship.

But the thing to bear in mind is that even the worst-case scenario—that AOL had no business booking the revenue as its own but did anyway—isn't especially serious. After all, AOL never actually counted its eBay ad revenues as profits. The revenues were cancelled out elsewhere on the balance sheet as expenses owed to eBay. Under pressure from the SEC, the for-profit school-management company Edison recently admitted that it did a much more audacious version of what the Post claims AOL did: It counted the salaries school districts pay their teachers as its own revenue, even though the districts pay those salaries directly to teachers rather than to Edison first. And yet the SEC meted out no punishment and levied no fine. It simply asked Edison to stop.

As this sidebar indicates, another Post charge, involving a deal with the Golf Channel, is even weaker.

So why are the Justice Department and SEC now investigating? Two reasons. First, this isn't the first time AOL's accounting hasn't been as transparent as it could be. In May 2000, AOL agreed to pay the SEC a $3.5 million fine after being accused of improperly accounting for the way it distributed free disks. Given AOL's history, it's possible there's something dastardly going on here, even if the Post didn't find it. But more important, when a major newspaper like the Post devotes thousands of words to exposing unflattering, if ultimately defensible, accounting practices during one of the worst waves of accounting fraud in history, the SEC and Justice Department can't not follow up.