The Securities and Exchange Commission has initiated a fact-finding investigation into AOL Time Warner's financial reporting practices, CEO Richard Parsons disclosed during the company's second-quarter earnings announcement.

This revelation dampened what would otherwise have been positive news: the media giant posted its first profit since the landmark merger and exceeded Wall Street's revenue projections. However, while broader markets experienced their strongest single-day rally in over a decade, AOL TW shares declined by 15 cents. This contrasted sharply with competitors—Viacom surged over 7%, MGM climbed more than 6%, and both Disney and Vivendi rose above 5%.

During an analyst conference call, Parsons explained that the regulatory examination followed Washington Post reports raising questions about certain AOL business practices from 2000-2001. The articles highlighted several concerns: AOL allegedly accepted advertising purchases from a British entertainment firm instead of collecting an arbitration settlement, inappropriately transferred revenue between divisions, and recorded eBay advertising sales as its own income.

AOL shares slipped 1.3% to $11.40, with additional declines in after-hours trading as the regulatory news overshadowed otherwise solid quarterly results. The online division showed continued struggles while the film studio delivered exceptional performance, particularly in home entertainment.

The company reported $394 million in income for the quarter, reversing a $734 million loss from the previous year. Cash earnings remained steady when excluding one-time items, while revenue climbed 10% to $10.6 billion.

Parsons noted that Ernst & Young, AOL TW's auditor, had approved nearly all questioned transactions initially and subsequently reaffirmed in writing that the accounting treatment was proper. He stated that company executives proactively contacted the SEC both before and after the Post's coverage, and the regulator indicated it was conducting a fact-finding inquiry requiring the company's cooperation.

Such SEC investigations into entertainment companies remain relatively rare. Apart from the high-profile securities fraud case involving MGM owner Giancarlo Parretti in the early 1990s, similar inquiries have been uncommon over the past decade.

Parsons praised Jeff Bewkes and Don Logan, recently elevated to senior positions overseeing content and subscription operations. He also defended departing COO Bob Pittman against recent criticism and expressed support for Chairman Steve Case, describing him as a valuable strategic advisor despite growing scrutiny over his limited visibility as AOL struggled.

AOL's cash flow dropped 27% despite a 20% revenue increase aided by price increases. Online advertising remained weak, marketing expenses rose, and the iplanet deal termination created additional pressure. No immediate plans exist for carriage agreements with external cable operators, though executives suggested year-over-year comparisons should improve by the fourth quarter.

The filmed entertainment division excelled with 31% cash flow growth and 26% revenue gains, driven by home video releases of "Harry Potter and the Sorcerer's Stone" and "Ocean's Eleven," plus theatrical releases including "Scooby Doo." Warner Home Video achieved record quarterly revenue exceeding $1 billion.

Time Warner Cable saw 12% cash flow growth and 18% revenue gains, supported by digital cable channel launches and increased advertising. Executives indicated infrastructure upgrades are largely complete, positioning the unit for improved margins. Average subscriber revenue reached $62 monthly.

Television networks experienced a 5% cash flow decline despite 7% revenue growth, with HBO gains offset by increased costs at Turner networks and reduced payments from bankrupt Adelphia Communications.

Warner Music posted 17% cash flow growth with 4% revenue gains, while publishing achieved 14% cash flow growth on 8% higher revenue.

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