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AOL saga opens old dot-com wounds

Unconventional business arrangements are coming home to roost for erstwhile Internet stars such as AOL Time Warner, with regulators zeroing in on bad barter deals.

Unconventional business arrangements are coming home to roost for erstwhile Internet stars such as AOL Time Warner, which this month joined the lengthening list of companies under investigation for alleged accounting fraud.

In this and other cases, regulators are zeroing in on controversial practices including, but not limited to, trading products and services for stock rather than cash. Known as barter, such transactions soared in popularity along with the Internet-driven bull run of the late 1990s, only to plunge into disrepute as the bottom fell out of the market.

Analysts and regulators have been sifting through the dot-com rubble for more than two years in search of bad barter deals, a practice that for many came to epitomize the inflated promises of the dot-com era. While the barter shakeout began some time ago, it has gained new momentum amid a wave of accounting scandals among Fortune 500 companies that has led investors and regulators to put earnings and financial reports under the microscope.

"I think you will have a slew of companies that will be coming out and being identified as a target because they accounted for bartering one way or another," said Youssef Squali, an analyst at First Albany.

In a sign of further investigations to come, the FBI, the United States Attorney's Office for the Northern District of California and the Securities and Exchange Commission on Friday launched a hot line for people to report possible securities fraud. The location of the hot line, based in the San Francisco area, is partly symbolic. But it could help open the doors for regulators to more fully scrutinize accounting practices among Internet companies, dead or alive.

Already, several companies have found themselves the subject of barter-related woes.

Companies that have recently come under scrutiny over their use of barter deals include Homestore.com, which earlier this year disclosed that barter revenue inappropriately boosted its 2000 revenue by 27 percent and 54 percent for the first nine months of 2001. The company has been under investigation by the SEC since January and was hit with a class action lawsuit earlier this month from the pension fund for the California teacher's union, which is a major investor.

Bankrupt energy giant Enron was also involved in barter, which became increasingly common in the telecommunications sector in the late 1990s. Companies would routinely barter network capacity, booking the purchase of capacity as a capital expense and eroding cash flow on their financial statements.

"Everyone was pushing the limits," said James Preissler, an analyst at Investec. "You could get such a high multiple of revenue. A 10 percent increase in revenue is a fairly meaningful increase in market cap."

If barter was widespread, it was particularly popular among dot-coms, which distinguished themselves as ready partners on both sides of such deals. Start-ups and established companies such as AOL and Amazon.com routinely paid out or accepted stock in barter deals as a way to preserve cash and score potentially enormous investment gains.

For start-ups struggling for recognition, a deal with a large partner such as AOL could be a deciding factor in their ability to go public, making some such arrangements extremely cozy.

AOL was among the most prolific in inking such deals. As late as mid-2000, it agreed to a five-year, $200 million ad deal with Homestore that included only $20 million in cash upfront, with the balance paid in stock, loan guarantees and advertising. That same year, AOL renegotiated an $89 million multiyear ad contract with now-defunct online health site DrKoop.com, accepting stock instead of cash.

Those deals came together on the eve of the dot-com implosion, even as investors had already begun to seriously question the value of deals done in stock rather than cash.

Barter became so maligned that the July 2001 edition of Harvard Business Review proclaimed them "minefields." The article stated that companies still brazen enough to report barter as revenue were "more likely to feature manipulation of company accounts."

New Economy, new standards?
"Companies in new industries, such as those in the Internet sector, may engage in business transactions that were uncommon in the Old Economy, such as the advertising barters popular among Web sites," the article, by David S. Young stated. "Accounting standards, which tend to be anchored in the Old Economy, may be silent, or at least ambiguous, on important transactions, thus providing corporate managers with considerable scope for manipulation."

Barter deals are not illegal if they follow rules outlined by the Financial Accounting Standards Board (FASB), which has implemented specific guidelines for online advertising barter agreements. According to the FASB's Emerging Issues Task Force No.99-17, companies are allowed to count barter transactions as revenue as long as they value the ad swap like a typical cash deal.

In other words, companies can book barter deals to boost revenue if they account for the swap as an expense as well. The FASB requires companies that sell advertising on a regular basis to determine the value of the barter based on its existing advertising rates. That's an attempt to prevent companies from rates based on arbitrary measurements.

"Barter is legal and generally accepted," said Safa Rashtchy, an analyst at U.S. Bancorp Piper Jaffray. "It's OK as long as you take care of the expense side."

The FASB rules also allow securities to be swapped for advertising, which many companies have done. However, reporting the equity sales as advertising revenue remains controversial.

A number of companies have already come under scrutiny for allegedly pushing the limits of what's considered sound bartering agreements and what could be construed as misleading. Companies that allegedly failed to balance revenue from barter with equal reporting on the expense side have come under investigation by federal regulators, as have deals that traded advertising space for ownership stakes.

In October 2000, online retail giant Amazon came under informal inquiry by the SEC for deals in which it traded advertising for equity. Some investors filed a class action lawsuit alleging the company failed to disclose its barter agreements were equity deals, not deals where cash changed hands. Amazon played down the inquiry, telling investors that its accounting remained conservative.

The SEC settled one case against Amazon and retailer Ashford.com with fines. A class action lawsuit is still pending against Amazon, alleging the company did not report its advertising deals with start-ups were based on equity instead of cash.

In February, online marketing company L90 became the target of an SEC inquiry because of its connection to barter. The SEC is investigating the Los Angeles-based company's deals with Homestore and others, and the investigation sparked L90's audit committee and board of directors to conduct an internal investigation.

The internal probe, which concluded in May, resulted in a reduction of revenue for 2000 and 2001 of approximately $8.3 million. It also caused Los Angeles-based new media company eUniverse to back out of an L90 acquisition, which was planned for March 21.

Some companies, such as Yahoo, kept their reliance on barter deals below 10 percent of revenue. Others relied on it much more heavily.

Women's site iVillage and Latino site Starmedia disclosed that at one time, barter transactions accounted for 20 percent to 35 percent of their overall revenues. Starmedia in 2001 was forced to restate its earnings to account for revenue that should have been considered barter, among other accounting improprieties.

Beyond new media
Questions about barter go beyond dot-com media companies.

Global Crossing filed bankruptcy documents in the spring showing that the fiber-optic networking giant inflated sales by altering a $30 million deal last year with sports marketing company IMG Worldwide.

Under the February 2001 deal with IMG's online division, TWI Interactive, the companies agreed to exchange $15 million over five years. TWI wanted Global Crossing to provide Web site management, and Global Crossing wanted TWI's advertising and marketing services.

TWI originally wanted a straight barter deal with no cash exchange, but Global Crossing required an equal exchange of cash, according to documents submitted by TWI. At the time, executives at Global Crossing were closing deals with other companies that involved similar swaps but also required cash exchanges, booking revenue from the transactions over the life of the contracts.

For AOL, the key issue is whether the media giant inappropriately accounted for its advertising revenue. In a series of reports by The Washington Post, AOL allegedly reported equity sales as ad revenue. Most Internet companies at that time witnessed their online advertising revenues plummet, but AOL Time Warner executives maintained the online giant's business was stronger than ever. The reports also alleged that other improprieties included bartering ads for computer equipment and shifting revenue from other divisions to boost ad revenue.

Some investors are getting edgy. On Monday, New York law firm Kaplan Fox filed a class action shareholder lawsuit against AOL Time Warner alleging that company officers misrepresented the dour situation of AOL's online advertising business. The suit further alleges that AOL artificially boosted its advertising revenue from one-time investment gains. The lawsuit cited the Post reports to bolster its claims.

AOL Time Warner management has said accounting firm Ernst & Young re-reviewed all of the deals outlined in the reports and confirmed that the transactions were in accordance with accounting standards.

At the center of the recent AOL inquiry is its deal with PurchasePro. The online giant took a stake in PurchasePro in exchange for selling advertising for the company but accounted sales in PurchasePro stock as advertising revenue, according to reports. Equity sales should be booked as one-time investment gains instead of revenue.

It is now up to the Justice Department and the SEC to determine whether or not AOL's accounting methods for those deals were improper.

While barter is figuring more prominently in regulatory inquiries, some analysts downplayed the current concerns, saying they believe the worst may be over.

"There was a ton of focus on barter deals on the Internet," said Derek Brown, an analyst at WR Hambrecht. "Many companies that we're talking about faced the music some time ago. I suspect to a large degree those issues may already have been addressed in investors' minds."

Rachel Konrad contributed to this report.