Case 4-1
America Online (AOL)
Background
In May 2000, America Online Inc. (AOL), the world’s biggest Internet services provider at the time, settled
charges that it improperly accounted for certain advertising costs. This was the first time the SEC had
brought such an enforcement case against a public company for improper capitalization of advertising
related to soliciting new customers and 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
it would have reported had advertising costs associated with acquiring new customers been accounted for
as expenses instead of being deferred, according to the Securities and Exchange Commission. “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 Internet service provider through extensive advertising efforts. These efforts involved, among other
things, distributing millions of computer disks containing AOL start-up software to potential AOL
subscribers, 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 membership 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 service
providers 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 rate, 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 been 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.
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.1 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 AOL did not, therefore, satisfy the capitalization and amortization requirements of
1
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 generally
accepted accounting principles. 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 these costs?
Advertising expenditures are recorded as expenses when the ads are run. A prepayment of a future ad
would be recorded as an asset until the ad is run. The reason advertising is recorded as an expense and not
The motivation for AOL’s treatment may have been to report less of a net loss or net profits for the eight
quarters that it capitalized the advertising expenses. AOL was spending 17 to 33 percent of total assets in
direct marketing program (to mail software disks to potential customers and to pay fees to computer
equipment manufacturers that bundled AOL software onto their equipment) to acquire new customers.
2. Using Kohlberg’s Six Stages of Moral Development, at which stage was AOL 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.
AOL appears to reasoning at stage 2. At stage 2, AOL would follow the accounting rules only if following
those rules would satisfy AOL’s needs to stay the biggest Internet service provider and a glamour stock on
Wall Stock. Since following GAAP and expensing the advertising costs would generate losses, AOL opted
to capitalize the costs to report a smaller net loss or higher profit. At stage 3, AOL would be motivated by
fairness to others. Thus, AOL would be concerned with being fair to its shareholders and the new Internet
3. Assume that the 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?
If the auditors went along with AOL’s accounting treatment of capitalizing advertising costs, the auditors
would have violated Rule 201 (Due Care), and Rule 203, (Professional standards — following GAAP).
4. Optional Question
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 slow-down. 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
a. Explain what is meant by a “round-trip” transaction.
A round-trip transaction is a form of barter that involves a company selling a good (asset) or service
(revenue or expense) to another company while at the same agreeing to buy back the same or similar good
b. The complaint (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.
The complaint lists vendor transactions, business acquisitions, and settlements of business disputes as the
different forms of AOL round-trip transactions. The vendor transactions included AOL agreeing to pay
inflated prices or forgo discounts for goods and services purchased when the vendor purchased amounts of
online advertising equal to markups or forgone discounts. The business acquisitions included an increased
GAAP does not allow revenue to be recorded when “the essence of the transaction is merely a circular flow
of cash and customer does not need or want the goods or services provided, would not normally purchase
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 the Sarbanes-Oxley Act,
do you think the managers did anything wrong? How might the false certifications affect audit
work?
The corporate governance systems failed at AOL. Possible lapses could include allowing the senior finance
managers to override internal controls or to negotiate agreements that were effectively round-trip
transactions, implicating weak accounting processes for recording advertising revenue which allowed