Question

Please search the news that AOL agreed to pay a $3.5 million fine to SEC for improper accounting practices in 1995 and 1996.

• What is "Direct Response/Mail Advertising"?
• How did AOL report the Direct Response Advertising costs in 1995 and 1996?
• Was the recording and the subsequent change of "Direct Response Advertising" correct? If not, what accounting principles does it violate? Why?
• What were the effects on net income and total assets? (i.e., How much net income were reported for year 1995? If the Direct Response Advertising costs were reported correctly for year 1995, how much net income would have been reported for year 1995?)

Answer 1

AOL was one of the early pioneers of the Internet in the mid-1990s, and the most recognized brand on the web in the United States. It originally provided a dial-up service to millions of Americans, as well as providing a web portal, e-mail, instant messaging and later a web browser following its purchase of Netscape AOL has a global portfolio of media brands and advertising solutions across mobile, desktop, and TV. Solutions include brand integration and sponsorships through its in-house branded content arm, Partner Studio by AOL, as well as data and programmatic offerings through ad technology stack, ONE by AOL.

a) What is "Direct Response/Mail Advertising"?

Promotional method in which a prospective customer is urged to respond immediately and directly to the advertiser, through the use of a 'device' provided in the advertisement. These devices (called direct response mechanisms) include a (1) coupon to cut and mail, (2) business reply card, (3) toll-free telephone number, or, on the internet, (4) hotspot to click. Most retail sale advertisements are direct response ads in one way or the other.

successful elements of direct response marketing are:

• Trackable
• Measurable
• Targeted
• Makes a specific offer
• Clearly outlines the benefits
• Has a clear call-to-action
• Personalized

In connection with a cease-and-desist order issued by the Commission today in a settled administrative proceeding against America Online, Inc. ("AOL"), the Commission filed a related action for civil penalties against AOL in the United States District Court for the District of Columbia. In settlement of that matter, AOL has consented to the entry of an order requiring that it pay a civil penalty of $3,500,000.

In the cease-and-desist order, In the Matter of America Online, Inc. [34-42781] the Commission found that AOL 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. During that period, AOL capitalized most of the costs of acquiring new subscribers -- including the costs associated with sending computer disks to potential customers -- and reported those costs as an asset on its balance sheet, instead of expensing them as incurred. AOL reported profits for six of eight quarters in fiscal years 1995 and 1996, rather than the losses it would have reported had the costs been expensed as incurred. The advertising costs improperly capitalized by AOL reached approximately $385 million by September 30, 1996, when AOL wrote them off in their entirety.

Accounting rules do not allow a company to capitalize "direct response advertising costs" unless it can demonstrate from its past experience that future net revenues from customers obtained through the advertising will exceed the amount of capitalized costs. See Accounting Standards Executive Committee Statement of Position 93-7 ("SOP 93-7"). The Commission found that AOL could not meet this requirement because the volatile and unstable nature of the Internet marketplace precluded reliable predictions of future net revenues. Specifically, the Commission found that AOL's 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; and
• AOL was experiencing negative cash flow.

Due to these factors, according to the Commission's findings, AOL did not have sufficient reliable evidence that its capitalized advertising costs were recoverable to satisfy the requirements of SOP 93-7. 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 consequently rendered inaccurate by AOL's accounting treatment for direct response advertising costs. Therefore the Commission found that AOL violated Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder. The Commission also found that AOL violated Section 13(b)(2)(A) 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.

Without admitting or denying the allegations in the Commission's complaint and its findings in the Order Instituting Proceedings, AOL has agreed to settle the Commission's claims by: (1) consenting to the entry of an administrative order requiring that it cease and desist from violations of Exchange Act Sections 13(a) and 13(b)(2)(A) and Exchange Act Rules 13a-1 and 13a-13, and (2) consenting to the entry of an order of the U.S. District Court requiring AOL to pay a civil penalty of $3,500,000.

The Securities and Exchange Commission (SEC) filed a complaint in U.S. District Court in Washington DC against America Online (AOL) for civil penalties for improperly capitalized costs of advertising for new subscribers, and reporting those costs as an asset on its balance sheet. The SEC stated that these costs should have been treated as an expense.

The SEC and AOL also simultaneously settled the action. AOL agreed to pay a fine of $3.5 Million. AOL did not admit to any wrong doing. The action and settlement do not pertain to any financial results reported by AOL since FY 1997.

AOL has spent heavily on direct mail advertising, including distribution of disks containing AOL software. In 1995 and 1996 AOL capitalized these costs.

In October, 1996, AOL discontinued capitalizing customer acquisition costs and took a one-time charge of $385 million in the first quarter of fiscal 1997.

AOL reported profits for six of eight quarters in 1995 and 1996, rather than the losses it would have reported had the costs been expensed as incurred.

SEC Director of Enforcement Richard Walker stated in a press release that "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."