Ethical Obligations and Decision-Making in Accounting: Text and Cases 3rd Edition by Steven Mintz,Roselyn Morris

تمرين 1

America Online (AOL)
Background 1
In May 2000, America Online Inc. (AOL), the world's biggest Internet service provider (ISP) at the time, settled charges that it improperly accounted for certain advertising costs. This was the first time that the SEC had brought such an enforcement case against a public company for improper capitalization of advertising related to soliciting new customers, and it was meant as a warning to Internet start-up companies trying to draw in new customers.
The company reported profits for six of eight quarters during fiscal 1995 and 1996 instead of the losses that it would have reported had advertising costs associated with acquiring new customers been accounted for as expenses instead of being deferred, according to the SEC. "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 reflects present reality, not hopes for the future," said Richard Walker, head of the agency's enforcement division.
AOL Subscribers
During fiscal year 1996, AOL had nearly $1.1 billion in revenues, and at June 30, 1996, had approximately 6.2 million subscribers worldwide. AOL's common stock was registered with the SEC pursuant to Section 12(b) of the Exchange Act and was listed on the NYSE.
During its fiscal years ended June 30, 1995, and June 30, 1996, AOL rapidly expanded its customer base as an ISP through extensive advertising efforts. These efforts involved, among other things, distributing millions of computer disks containing AOL start-up software to potential AOL sub-scribers, as well as bundling AOL software with computer equipment. Largely as a result of its extensive advertising expenditures, this period was characterized by negative cash flows from operations.
For fiscal years 1995 and 1996, AOL capitalized most of the costs of acquiring new subscribers as "deferred member-ship acquisition costs" (DMAC)-including the costs associated with sending disks to potential customers and the fees paid to computer equipment manufacturers that bundled AOL software onto their equipment-and reported those costs as an asset on its balance sheet, instead of expensing the costs as incurred. Substantially all customers were derived from this direct marketing program. For fiscal years 1993, 1994, and 1995, AOL (generally) amortized DMAC on a straight-line basis over a 12-month period. Beginning July 1, 1995, the company increased that amortization period to 24 months.
During fiscal year 1996, while the amount of DMAC reported on AOL's balance sheet grew from $77 million to $314 million, the uncertainties in the Internet marketplace became more pronounced. First, AOL's costs of subscriber acquisition increased substantially, as the response rate to its disk mailings decreased. Moreover, AOL's competition continued to increase, including competition from ISPs offering unlimited Internet access for a flat monthly fee. To increasing numbers of Internet users, this unlimited access pricing was an attractive alternative to AOL's pricing plan, which charged customers on an hourly basis, and AOL's senior management was actively considering adoption of some variant of unlimited access pricing. In part as a result of this competition, AOL experienced declining rates of customer retention throughout fiscal year 1996. AOL introduced a modification to its pricing plan, offering a lower hourly rate for heavy users, on July 1, 1996, in hopes of improving customer retention. But AOL disclosed in its 1996 Form 10-K filed with the SEC: "The Company cannot predict the overall future rate of retention."
Accounting for Advertising Costs
At July 1, 1994, the beginning of AOL's 1995 fiscal year, June 30, 1995, and June 30, 1996, the DMAC on AOL's balance sheets were $26, $77, and $314 million, respectively, or 17, 19, and 33 percent of total assets and 26, 35, and 61 percent of shareholders' equity. Had these costs been properly expensed as incurred, AOL's 1995 reported pretax loss would have increased from $21 to $98 million (including the write-off of DMAC that existed as of the end of fiscal year 1994), and AOL's 1996 reported pretax income of $62 million would have been decreased to a pretax loss of $175 million. On a quarterly basis, the effect of capitalizing DMAC was that AOL reported profits for six of eight quarters in fiscal years 1995 and 1996, rather than losses that it would have reported had the costs been expensed as incurred.
On October 29, 1996, AOL announced that as of September 30, 1996, it would write off all capitalized costs of membership acquisition carried as an asset at September 30, 1996, and would expense as incurred all such costs going forward from October 1, 1996. AOL charged retained earnings in a one-time charge for all improperly capitalized costs through September 30, 1996 in the amount of $385 million to write off the DMAC asset. The company stated that the write-off was necessary to reflect changes in its evolving business model, including reduced reliance on subscribers' fees as the company developed other revenue sources. AOL had responded to competitive pressure by adopting an unlimited-use pricing plan and, by writing off DMAC, acknowledged that it could not rely on its revenue history under a different pricing model as support for the recoverability of DMAC. But the increasing competition and rapid changes in AOL's marketing merely confirmed that AOL, given its volatile business environment, could not comply with the requirements of AICPA Statement of Position (SOP) 93-7. 2
The general rule as set forth in SOP 93-7 is that "the costs of advertising should be expensed either as incurred or the first time the advertising takes place." To meet the requirements of the narrow exception to this general rule (allowing capitalization), an entity must operate in a sufficiently stable business environment that the historical evidence upon which it bases its recoverability analysis is relevant and reliable. 3 AOL did not meet the essential requirements of SOP 93-7 because the unstable business environment precluded reliable forecasts of future net revenues. AOL was not operating in a stable environment, and its business was characterized during the relevant period by the following factors:
• AOL was operating in a nascent business sector characterized by rapid technological change.
• AOL's business model was evolving.
• Extraordinarily rapid growth in AOL's customer base caused significant changes to its customer demographics.
• AOL's customer retention rates were unpredictable.
• AOL's product pricing was subject to potential change.
• AOL could not reliably predict future costs of obtaining revenues.
• AOL's competition was increasing.
• AOL was experiencing negative cash flow.
SEC Ruling
Due to the previously mentioned factors, AOL did not have sufficient reliable evidence that its DMAC asset was recoverable, and therefore AOL did not satisfy the capitalization and amortization requirements of SOP 93-7. As a consequence, AOL's financial statements as filed with the commission in quarterly reports on Form 10-Q and annual reports on Form 10-K, from the quarter that began July 1, 1994, through the quarter beginning July 1, 1996, were rendered inaccurate by AOL's accounting treatment for DMAC. Therefore, AOL violated Section 13(a) of the Exchange Act that requires issuers of registered securities to file with the commission factually accurate annual and quarterly reports. Financial statements incorporated in commission filings must comply with Regulation S-X, which in turn requires conformity with GAAP. The filing of a periodic report containing inaccurate information constitutes a violation of these regulations.
Registered companies are also required to make and keep books, records, and accounts that accurately reflect the transactions and disposition of their assets. AOL violated Section 13(b) of the Exchange Act during its fiscal years 1995 and 1996, and the quarter beginning July 1, 1996, by recording as an asset advertising costs that could not be capitalized in accordance with the requirements of SOP 93-7.
In settlement of the matter in a cease-and-desist order with the SEC, AOL agreed to pay $3.5 million to settle financial reporting violations. AOL ultimately combined with Time Warner in January 2001.
Questions
1. From an accounting principles perspective, why was it wrong to capitalize the advertising costs? What do you think was the motivation for AOL's original treatment of those costs?
2. Using Kohlberg's Six Stages of Moral Development, at which stage was AOL at when it made the decision to capitalize the advertising costs? Explain why. Include in your discussion what would it have done if it reasoned at stages 2 through 5.
3. Assume that the external auditors for AOL went along with the accounting for capitalized costs right up to the company's announcement on October 29, 1996. Explain what AICPA rules of conduct would have been violated by the auditors.
Optional Question
4. On March 21, 2005, the SEC charged Time Warner, Inc. (formerly known as AOL Time Warner) with materially overstating online advertising revenue and the number of its Internet subscribers by employing fraudulent round- trip transactions that boosted its online advertising revenue to mask the fact that it also experienced a business slowdown. With the round-trip transactions, the company effectively funded its own online advertising revenue by giving the counterparties the means to pay for advertising that they would not otherwise have purchased from Time Warner. To conceal the true nature of the transactions, the company typically structured and documented round-trips as if they were two or more separate, bona fide transactions, conducted at arm's length and reflecting each party's independent business purpose. The company delivered mostly untargeted, less desirable, remnant online advertising to the round-trip advertisers, and the round-trip advertisers often had little or no ability to control the quantity, quality, and sometimes even the content of the online advertising they received. Because the round-trip customers effectively were paying for the online advertising with the company's funds, the customers seldom, if ever, complained. Review Accounting and Auditing Enforcement Release No. 2829 issued on May 19, 2008, by the
SEC that explains the commissions findings in its action against four officers of AOL, 4 and answer the following questions:
a. Explain what is meant by a "round-trip" transaction.
b. The original complaint against the company (http://www.sec.gov/litigation/complaints/comp19147.pdf) cites three round-trip transactions between AOL and other parties. Choose one and explain why AOL's accounting did not conform to GAAP.
c. The SEC filings do not address corporate governance failings at AOL in any meaningful way. With respect to the round-trip transactions, the complaint states that "senior finance managers (i.e., CEO and CFO) at AOL signed client representation letters to Ernst Young claiming that the advertising revenues were being properly recognized." Given that the falsification of certifications in the representation letter occurred prior to passage of SOX, do you think the managers did anything wrong? How might the false certifications affect audit work?
1 Additional materials available on the AOL case can be found in Litigation Release No. 16552, www.sec.gov/litigation/litreleases/lr16552.htm.
2 AICPA Statements of Position are part of the authoritative literature in the GAAP Codification.
3 American Institute of CPAs, Accounting Standards Executive Committee, Statement of Position ( SOP ) 93-7 , Reporting on Advertising Costs, www.aicpa.org.
4 U.S. District Court of Southern District of New York, Securities and Exchange Commission v. David M. Colburn, Eric L. Keller, James F. MacGuidwin, and Jay B. Rappaport , 08 CV 4611, www.sec.gov/litigation/complaints/2008/comp20586_colburn.pdf.