WorldCom & AOL

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

The times,
they're changin'.

Stephen Case did exactly what WorldCom did. The worldCom CEO will most likely den up in jail, but Case was applauded by Wall Street.

Henry C.k. Liu

Despite SEC Scold, AOL Makes Out Like a Bandit
                                        By Adam Lashinsky
                                        Silicon Valley Columnist
                                        5/16/00 7:00 AM ET
 

The Securities and Exchange Commission sent a clear signal Monday to those who practice New Economy accounting when it administered a $3.5 million wrist-slap to America Online (AOL:NYSE - news). Despite the headline, the real story is that crime pays. Well, if not actual crime, maximum pushing of the envelope on accounting rules.

This final chapter in the AOL accounting saga conveys the message clearly to astute entrepreneurs: Flout the rules as long as you're honest about the rules you're abusing. Then, during the time it takes the authorities to stop you, your company can maintain the appearance (if not the reality) of profitability during a crucial building-up phase. And, on the strength of that apparent profit, you can keep raising money.

To boil down some complicated and relatively ancient history, in the mid-1990s AOL got into numbers-crunching hot water because it attempted to capitalize its marketing expenses -- largely the cost of flooding the nation with diskettes to sign up members to its online service. AOL argued that the cost of its continual direct-marketing blitz should go on its balance sheet and be written off as capital expenses, first over a one-year and later a two-year time period. This is a hazy area, but accountants generally prefer to see routine outlays, such as marketing costs, treated as current costs, which are immediately deducted from the bottom line.

AOL effectively was pretending that its diskette deluge looked like the capital outlay a steel company might make for a steel mill, one that would have a predictable lifetime and generate predictable revenue. But capitalized expenses depreciate and detract from earnings over time, while advertising and other current expenses hit the bottom line right away. The difference to AOL's bottom line was dramatic: It meant showing a profit, rather than a loss, as it funded the huge customer signup campaigns that made it the online leader.

But to many, it looked like AOL was breaking the spirit, if not the letter, of accounting law. "The logic is that if the steel company goes out of business, it could very well sell that steel mill," Timothy Lucas, director of research for the industry group Financial Accounting Standards Board, told TSC's Joe Bousquin. "It's a little more difficult to sell an intangible" like AOL's customer base.

So how big a deal was AOL's "deferred membership acquisition costs," the "asset" the company recorded on its balance sheet at the time? By the middle of 1996, the "asset" was $314 million, or 33% of total assets, according to the SEC's order released Monday.

The end of the story isn't really the good part. AOL eventually restated results for several years, turning tens of millions of dollars of reported earnings into hundreds of millions of dollars of losses. And Monday, the SEC said AOL will pay a $3.5 million civil fine connected with the case. (Context: VarsityBooks.com (VSTY:Nasdaq - news), an online college textbook seller, will pay an AOL subsidiary $9 million over three years in a marketing deal. In other words, just one year of this cookie-cutter deal for AOL nearly covers its entire punishment with the SEC.)

It's the middle of the story that's better than the finale -- and the part others may risk emulating. During the precise time that AOL was aggressively interpreting the accounting rules, it was also building up its business and its war chest. Following its 1993 initial public offering, the company raised $54 million in April 1995, by selling a 5% stake to Bertelsmann; $139.5 million in a secondary stock offering that October; and $28 million in a financing with Mitsui (MITSY:Nasdaq ADR - news) the following May. All this from a company that was moving rapidly toward profitability as far as the public was concerned.

Let's be clear about one thing: AOL wasn't being dishonest or fraudulent. It put out its interpretation for all to see, and didn't get swatted down for some time. This isn't to say other companies will be able to emulate AOL's behavior. After all, AOL was early -- early to push the envelope, early to benefit from the realization that it was OK to not be profitable and early to demonstrate that when the SEC acts, it acts slowly.

This isn't necessarily a model for other companies.

"As a lawyer, you never want to advise a client to push the law," says Randy Komisar, a recovering lawyer in Silicon Valley who serves as an adviser to numerous startups. "On the other hand, in a gray area you build up a paper trail and defend yourself. And if worse comes to worse, you write a check. That's the moral of the story."