SEC Fines AOL, Scrutinizes Net Firms

America Online (AOL) has been slapped with a cease and desist order by the U.S. Securities and Exchange Commission (SEC) and has agreed to pay a civil penalty to settle charges in the amount of $3.5 million (US$).

At issue were AOL’s inaccurate financial reports from 1994, 1995 and 1996. The company reported profits instead of losses for six of eight quarters by deferring advertising costs associated with acquiring new subscribers rather than showing them as expenses.

Reality, Not Hopes

Although AOL did not admit fault, the SEC says the giant Internet Service Provider (ISP) “violated the reporting and books and records provisions of the federal securities laws in connection with its accounting for certain advertising costs during fiscal years 1995 and 1996.”

This judgment is the first time the SEC has brought an enforcement action against a public company for improper capitalization of advertising costs associated with soliciting new customers.

SEC Director of Enforcement Richard H. Walker said, “This action reflects the Commission’s close scrutiny of accounting practices in the technology industry to make certain that the financial disclosure of companies in this area reflect present reality, not hopes about the future.”

According to the SEC, AOL spent $185 million sending promotional computer disks to potential subscribers, and then improperly capitalized the costs.

Even though the infraction occurred several years ago, Monday’s announcement by the SEC was the agency’s first public comment since the incident came under investigation.

Determining Factors

The Accounting Standards Executive Committee Statement of Position 93-7 (SOP 93-7) requires that any estimates a company makes about future net revenue be based on “reliable information,” which can include “verifiable historical patterns of results for the entity.”

The SEC says that AOL did not have this verifiable data because the company was operating in a developing business sector characterized by rapid technological change, competition was increasing, and the company was experiencing negative cash flow.

In addition, because AOL’s business model was still evolving, according to the SEC, the company’s customer retention rates were still unpredictable, its product pricing was subject to potential change, and the extraordinarily rapid growth in AOL’s customer base was causing significant changes to its customer demographics.

These factors, and the fact that AOL could not reliably predict future costs of obtaining revenue, led the SEC to conclude that “AOL did not have sufficient reliable evidence that its capitalized advertising costs were recoverable.”

All told, the SEC says that AOL improperly capitalized $385 million in advertising expenses. The costs were written off in their entirety in September 1996.

Under the agreement to pay the penalty, the Dulles, Virginia-based AOL admitted no wrongdoing and accepted a “cease-and-desist” order against violating financial reporting requirements in the future.

Second Violation

In early 1997, after AOL reported hefty profits, the SEC took a second look at the company’s books and determined that AOL had prematurely reported millions of dollars of revenue from a major deal. As a result, AOL had to retroactively erase its quarterly profit.

Now, at a time when many e-tailers are struggling financially, strong earnings reports can go a long way toward bolstering their public images with investors and consumers.

However, SEC Chairman Arthur Levitt, Jr. has cracked down on both Internet and brick-and-mortar companies that inaccurately report earnings.

“The broader point is to teach the message that we’re paying very careful attention to what’s going on in the accounting practices in the Internet business,” said Thomas Newkirk, associate director of the SEC enforcement division.

Blue Skies

On the same day the SEC penalized AOL for past activities, the company proudly predicted blue skies for next year. In a strategically timed statement, company president Bob Pittman said once AOL completes its merger with Time Warner, Inc., the company will have combined revenues of $40 billion in 2001, and cash flow will grow 30 percent in the first year.

Most analysts say Monday’s ruling by the SEC will do little to tarnish the company’s image, but it will send a clear message to start-ups that may be playing fast and loose with their own books.