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?
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.
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?
4. Optional Question
a. Explain what is meant by a “round-trip” transaction.
b. The complaint (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 the Sarbanes-Oxley Act, do you think the managers did anything wrong? How might the false certifications affect audit work?