In July 2002, the SEC reviewed revenue transactions by the America Online (AOL) unit of Time Warner to determine whether the company used “unconventional” ad deals to increase revenue to meet expectations of Wall Street analysts. An article appearing in The Washington Post on July 18, 2002, alleged that AOL had manipu-lated its ad revenue when it was waiting for approval of its merger with Time Warner, which owns CNN cable news, HBO, Warner Brothers, and Time magazine.
The new company known as AOL Time Warner was created on January 11, 2001. As a result of the merger, American Online and Time Warner each became a wholly owned subsidiary of AOL Time Warner. In 2003, the name of the company was changed to Time Warner. 9, 10, 11
A Washington Post reporter reviewed a number of AOL’s revenue transactions from July 2000 to March 2002. Without the unconventional deals described in the article, quarterly earnings per share would not have met analysts’ forecasts for two quarters in 2000. According to the Post, during this time, “Investors punished companies whose earnings were off by even a cent.” 12 AOL employees interviewed for the article said that the company was under tremendous pressure to meet its revenue targets due to the $112 billion merger pending with Time Warner. Ad revenue became very important to the Internet division as competition from other Internet service providers hurt AOL’s monthly subscriber fees. Unfortunately, the contracts for the advertising services were with dot-com companies, which also were suffering from declining sales and many of which did not have the cash to pay for the ads they had agreed to buy from AOL.
The unconventional deals include a variety of methods to increase revenue.
AOL’s business affairs department contacted companies that were unable to pay for their long-term ad contracts and renegotiated the terms, requiring the companies to make one-time payments to renegotiate or get out of the contracts. AOL recognized all revenue for the renegotiated contracts immediately as ad revenue. Earlier, in September 2000, AOL had used another unconventional ad deal to generate revenue. It recorded ad revenue based on a lawsuit settlement. AOL purchased Movie Fone in 1999, which had won a $26.8 million settlement from Wembley PLC, a British entertainment company, but had not yet collected the claim. Instead of collecting the settlement, AOL offered Wembley the opportunity to buy $23.8 million in online ads (a good deal for Wembley because it saved $3 million).
Because AOL was short of advertising revenue for the quarter ending on September 30, 2000, it had to create the Wembley ads and air them before the end of the quarter. Wembley considered the proposal for some time, but AOL could not wait for its decision because this revenue had to be booked in September 2000. Without
Wembley’s knowledge, AOL took artwork from Wembley’s British website (24 Dogs.com, an online greyhound racing website) and created banner and button ads using the artwork and started running them on various AOL sites. Within an hour of posting the greyhound ads, the Wembley website crashed, due to the traffic generated by the AOL ads.
Despite AOL’s action, Wembley reached an ad agreement with it that generated $16.4 million in ad revenue for the September 30, 2000, quarter, effectively takinga nonoperating gain on a lawsuit settlement and converting it to a more valuable operating revenue number. 13
a. Evaluate the revenue recognition policies used by AOL. Are the policies consistent with the applicable financial reporting framework?
b. How would the auditor discover the misstatements in the financial statements?
c. Describe how the audit risk model could be used in the AOL audit to consider the pending acquisition and the decline in sales revenue.