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Despite accounting miscues, Time Warner's balance sheet appears healthy, and the company's attention will focus more on governance and investor confidence and less on cash flow and finances. One in a series of ''corporate cleanup'' profiles.
Marie Leone, CFO.com | US
October 22, 2003
A company beset by accounting problems, by any other name, is still, well, under investigation. So goes the story of Time Warner Inc., which recently dropped the AOL tag from its corporate title. Executives at the media giant certainly didn't rename the company to sidestep alleged accounting improprieties at its online division — but the name change probably didn't hurt.
The AOL name-dropping, which became effective on October 16, should help boost the confidence of Time Warner employees, partners, and investors. Indeed, jettisoning the online moniker will clear up confusion between brand and corporate identities, as well as emphasize that management does not support all of AOL's aggressive accounting strategies — some of which are currently under investigation by the Securities and Exchange Commission and the Department of Justice.
The federal probes primarily focus on accounting and disclosure practices at AOL, including advertising arrangements and methods used by the online unit to report its subscriber numbers. Recall that the company's accounting problems came to a head in January, when Time Warner's amended 10-Q reported that it would restate two year's worth of results by $190 million. (Though this was the largest accounting restatement in U.S. history, the financial impact of the adjustment represented just 1 percent of AOL's revenues for the period in question.)
Still unresolved, however, is a row between the SEC and AOL over an intercompany advertising transaction involving Bertelsmann AG's interest in AOL Europe. The commission contends that AOL inflated advertising revenues by booking an advertising barter deal worth $400 million as revenue. AOL management and the company's auditors, Ernst & Young LLP, maintain that the accounting treatment is correct in light of current information.
Time Warner also faces pending shareholder litigation that could affect company operations, according to the top brass. As of August, about 40 class action and shareholder derivative lawsuits had been filed, accusing executives and board members with breaching fiduciary duties.
But despite the accounting miscues, Time Warner's balance sheet appears healthy. For the first six months of 2003, the company generated $3.8 billion in cash flow from operations and threw off $2.5 billion in free cash flow, while increasing revenues by 6 percent to $21 billion. Net income for the first half of the year was $1.5 billion.
As a result, Time Warner's cleanup efforts will concentrate more on governance and restoring investor confidence than on cash flow and finances. Indeed, AOL Time Warner's stock price dropped from 76 at the time of the 2001 merger to 16 in September 2003.
As expected, the corporate brand lost some footing, too. According to BrandEconomics CEO Al Ehrbar, the value of the AOL Time Warner brand declined in several categories during the 18 months prior to June 2002 when the company was sorting out the restatement. For instance, AOL slipped 9 percent when measured for "trustworthiness," declined 25 percent in its "high quality" ranking, and sunk 60 percent in "prestige."
Rebuilding brand equity and investor confidence may prove a tough assignment — even tougher after a missed opportunity in May 2002, says Harvard Business School professor Quinn Mills. The board of directors named Richard Parsons CEO, and "with the whole country watching," recalls Mills, Parsons "requested the company chairmanship, too."
Mills insists that the board should have used the occasion to announce that it would split the positions of chairman and CEO, sending a clear signal to investors — and other companies — that Time Warner was committed to good corporate governance. He also blames the SEC, Congress, and the Bush Administration for remaining silent when Parsons made his request. In essence, says Mills, their silence was an indirect approval of the dual-role structure — and the inherent conflict of interest it creates.
Six months after Parsons became chief executive, the board combined the two top positions and unanimously elected Parsons to both posts. Perhaps sensing a need, the board "reaffirmed its strong governance measures," pointing out that executive sessions of all non-management directors would be held without the CEO and other management present.
While Mills would split one job in two, Joel Goldhar would "break up the company into AOL, Time, and Warner." Goldhar, a professor at the Stuart Graduate School of Business at the Illinois Institute of Technology, maintains that this is "the only way to 'clean up' both the books and the brand image."
Like other experts, Goldhar saw trouble in the merger between the original companies. His argument wasn't focused on the often-debated overvaluation of pre-merger AOL (although he contends that based on a replacement value of between $25 billion and $35 billion, AOL was grossly overvalued at more $60 billion).
By Goldhar's lights, size did not generate economies of scale in the AOL-Time Warner merger. The vertical integration of strategic business units — in this case, production and distribution companies — did not add to profitability, says Goldhar, because the units operate in each other's businesses. The same advantages could have been gained through partnership or marketing contracts.
More importantly, Goldhar says that a breakup would encourage transparency in financial reporting. "Some companies," he maintains, "create complex financial and organizational structures to reduce transparency."
Did the Brand Take a Licking?
Brand expert Neil Morgan, a professor at the University of North Carolina's Kenan-Flagler Business School, doesn't think that the specter of investigations, restatements, and lawsuits will require much image cleanup. He maintains that the lasting negative effects associated with federal accounting investigations have been diluted over the past two years because, frankly, they have become commonplace. The same goes for restatements and protracted lawsuits — until the courts imposes damage awards.
What's more, he doesn't believe the AOL brand hurt the Time Warner brand at all. Morgan believes that erasing the moniker, or even spinning off the online company, probably would be driven by corporate politics or culture and not commercial reasons tied to brand value.
Time Warner managers shouldn't worry about looking bad by defying the SEC either, at least not in the case of the Bertelsmann deals. "I would recommend pushing back if the case is defensible," says Charles Lundelius, a securities and accounting expert with Annapolis-based FTI Consulting and the former CFO of Unimark Inc. and Markman Co.
Lundelius advocates a lot of "give and take" between the SEC staff and company executives during an investigation. "Finding that gray area is healthy," he says, and so is" reaching a compromise" on subjective accounting calls. In a post-Enron environment, he muses, both the SEC and company executives tend to be more strict in their interpretation of generally accepted accounting principles
Amy Hutton agrees. A professor at Dartmouth's Tuck School of Business, Hutton says the SEC has the advantage of 20/20 hindsight. She speculates that the SEC staff may think that AOL Time Warner was not conservative enough with the Bertelsmann accounting treatment, but adds that "the SEC might not have investigated the issue at all if the 'good times' had continued."
She reckons that the SEC may be playing a weak hand regarding the Bertelsmann transactions. If the deals turn out to be simply Old Economy-style barters and are valued fairly, they can be recognized as revenue under FAS 63. The bigger problems might be whether details of the Bertelsmann barter were properly disclosed — and that this is not the first time AOL has had to clean up after messy accounting.
In the late 1990s, AOL incorrectly booked subscriber acquisition costs after introducing flat-rate pricing for online services. An audit enforcement action resulted in a charge of $385 million in 1998, to represent the balance of deferred subscriber acquisition costs dating back to September 1996, and the company was slapped with a fine.
But to their credit, AOL executives cleaned up the company's image and its books; soon afterward they orchestrated one of the biggest merger deals in U.S. history. The question remains: Can Time Warner make history repeat itself?