Tuesday, 21 January 2014

1998-America Online's Fancy Accounting Methods

Not for the first time, high flying America Online is using fancy accounting methods, creating dollops of extra earnings that carry the stock higher.

The provider of on-line services has assured analysts that it has its auditors' blessing for a controversial, seldom-used sale-leaseback transaction that accompanied a $430 million asset swap in January. America Online also has persuaded Wall Street to accept an unusual rationale for treating some capital gains from stock sales as regular earnings. 

 Says Lennert Leader, chief financial officer, "The Internet group of companies is doing business in very new ways that have not been tested in terms of business norms and accounting. We really are out there on the cutting edge having to pioneer new territory."

For some, however, the issue rings alarm bells. In 1996, America Online had to write off $385 million of deferred marketing costs, erasing many quarters of past profits. In 1997's fourth quarter, after AOL adopted what it called gold-standard accounting policies, the Securities and Exchange Commission forced it to make $32 million of accounting adjustments.

"Having fessed up, it seems to me they would be the last type of company that would want to raise red flags again. But this leaseback transaction does raise flags," says Paul Brown, chairman of the accounting department at New York University's Stern School of Business. He is co-editing a textbook that will feature America Online's earlier mishaps.

This year's leaseback transaction will contribute five cents out of 19 cents a share of estimated profit for the June quarter, calculates CIBC Oppenheimer analyst Henry Blodget. But he adds, "In our opinion, it's not an example of them cooking the books."

At issue is how America Online should account for the sale of its ANS Communications network-services unit to WorldCom in January. Essentially, America Online swapped ANS for CompuServe's on-line division, which it valued at around $280 million, plus nearly $150 million in cash. It also contracted to use ANS's services for another five years.

If ANS had been sold outright, America Online would have had to report an outsize one-time gain of roughly $380 million, which, of course, wouldn't have helped future earnings. Analysts generally disregard one-time gains in valuing stocks.

But by treating the transaction as a sale-leaseback, the company can spread the gain over five years, getting it into operating income. Profit thus will rise about $76 million a year, or 20 cents a share. It is common to sell and lease back hard assets such as buildings or railcars. But several accountants said they had never heard of anyone doing that with a whole company.

In fact, SEC rules allow the sale-leaseback of an operating company if -- as America Online is doing with ANS -- the seller continues to use the operating company's services. "The sale-leaseback transaction is somewhat unique, but our auditors advised us that this is mandatory accounting," Mr. Leader says.

Another issue is how analysts should treat America Online's stock profits. In the quarter ended Sept. 30, AOL showed four cents a share of gains on the sale of stock in Internet search firm Excite that it held in its portfolio. The gains were treated conventionally, as nonrecurring earnings that didn't add to operating profit.

But in each of the two latest quarters, America Online encouraged analysts to include in their earnings calculations two cents a share of gains on the sale of stock and warrants.

How come? In doing business and forging alliances on the Internet, AOL sometimes takes a company's stock as payment. It took stock instead of cash in a marketing agreement with Excite about a year ago. AOL quite reasonably considers such stock-sale gains "payment for services rendered," says Friedman Billings Ramsey analyst Ulric Weil, an AOL bull.

Financial officer Mr. Leader notes AOL didn't report any capital gains as part of operating income. But it did try to educate the Street that certain stock sales would be a normal event -- used, he says, "to offset investment losses and other expenses."

Unluckily for the many bears, America Online remains richly priced. At 77 3/8 Tuesday, its stock trades at 86 times estimated profit of 90 cents a share for the coming fiscal year starting in July.

Says analyst David Simons of the Internet research firm, Digital Video Investments: "Bullishness tends to have a blind eye about quality of earnings."

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