AOL Case Study 1. What accounting approach has AOL used in the past that it is now changing (related to the $385 million)? Prior to October 1, 1996, AOL accounted for the cost of direct response advertising as “Deferred Subscriber Acquisition Costs,” i. e.
, it recognized (reported) the costs of mailing out diskettes allowing you to sign-on to AOL for 100 free minutes as an asset on its Balance Sheet. In accounting, we say that the costs were “capitalized,” meaning reported on the Balance Sheet as an asset. This is in contrast to the costs being “expensed,” flowing to the Income Statement immediately as an expense.
The asset, Deferred Subscriber Acquisition Costs was amortized, beginning the month after such costs were incurred, over a period determined by calculating the ratio of current revenues related to direct response advertising versus the total expected revenues related to this advertising, or twenty-four months, whichever was shorter. For example, supposed AOL spent $10 million for advertising costs and expected to generate a total of $55 million in revenues as a result of such expenditures over a two-year period.
Suppose in the first year, $20 million in revenues occurred as a result of this advertising program.
AOL would recognize, of course, revenues of $20 million. The associated cost is: 20/55 x [$10 million] = $3. 64 million. A mini-Income Statement for the Company would be as follows: Revenues 20.
00 Adv. Costs 3. 64 Income 16. 36 Notice that the percentage of revenues realized is used to determine the percentage of expenses to be recognized. Also note how crucial the assumption about the total expected revenues is in determining the income. Suppose AOL’s estimate of $55 million in revenues over the two-year period is wrong.
Suppose, instead, that the revenues are $30 million.
Income should have been: Revenues 20. 00 Adv. Costs 6. 67 20/30 x [$10 million] = $6.
67 Income 13. 33 2. What was AOL’s rationale for using the past accounting approach? What accounting principle(s) was it following? AOL was simply attempting to follow the matching principle. If AOL’s management had been correct in its estimate of the number of customers it would get as a result of the mailing campaign and the length of time these customers would remain with the Company, then AOL’s accounting treatment (capitalizing the costs as an asset) would have been appropriate.
However, because the number of customers and the average subscription time were different than anticipated, AOL’s accounting treatment turned out to be wrong – booking these charges as assets for a two-year period violated the matching principle.
3. What do you think is meant by the term the “quality of earnings” (see page two of article, top paragraph). What, in your opinion, would constitute “high” quality earnings? “Quality of earnings” refers to the extent to which the income number describes the economic reality of the company.
A “high” earnings quality is obtained if the accounting rules selected by a firm generate an income number that closely relates to its economic performance (as measured, for example, by its stock price performance). “Low” earnings quality results if the company produces financial reports that make the company appear to be far more profitable than it actually is.
4. Which financial statements were affected by the charge? How? The Balance Sheet and the Income Statement were affected. When AOL elected to write off the “Deferred Subscriber Acquisition Costs” asset from the Balance Sheet, it recorded an expense of $385,221,000 ($4. 3 per share). This reduced both asset account and net income. Journal Entry: Subscriber Acquisition Cost Expense (an expense) $385.
2 million Deferred Subscriber Acquisitions Costs (the asset) $385. 2 million 5. Which financial ratios will be affected by the charge? Any ratios that involve assets, Retained Earnings and Net Income will be affected. Since some of the “Deferred Subscriber Acquisitions Costs” will presumably reverse within a year, they would have been held as current assets.
Thus the Current Ratio would decrease as a result of the write-off.
The Debt/Equity ratio will increase as a result of the write off, since Retained Earnings will reflect the expense. All profitability ratios, Return on Sales, Return on Assets, Return on Equity and EPS, will decline as a result of the lower net income. 6. What was the cash impact of the charge? As noted in the journal entry in (4) above, there is no cash impact of the charge. (The cash was spent back when the mailing campaign was conducted – a couple of years ago. ) 7.
Why does Mr.
Vohra, an analyst say that “The earnings numbers were meaningless – they were a house of cards”? Reporting subscriber acquisition costs as an asset allowed AOL’s management lots of discretion in determining net income because the amount capitalized and the level of the amortization expense are both determined by managers. As a result, it was not clear whether AOL’s income number is a good measure of the economic performance of the firm. Managers could have taken advantage of this situation, distorting the income number in order to get some personal benefits (e. g. higher bonuses, a higher stock price which would add to their personal wealth, etc.
). 8. What was “aggressive” about AOL’s accounting approach Reporting subscriber acquisition costs as an asset rather than an expense is “aggressive” (as opposed to “conservative”). As noted above, capitalizing costs as assets may result in reporting a higher income than should actually be recognized on the Income Statement. 9.
It is reported (paragraph 3) that AOL’s share price rose on the news of the accounting change. (a) Do you think that accounting changes drive stock prices?
Comment. In a rational market, stock prices are determined by the ability of the firm to generate cash flows in the future. Accounting changes that do not affect future cash flows should not affect stock prices. (b) What else might have caused AOL’s share price to move upward? Many reasons might explain the change in the stock price, including: (i). Investors interpret this change as a sign that management’s view about the prospects of the firm have improved; consequently they revise their expectations upward, bidding up the stock price.
Investors believe that this is the appropriate manner to report these costs. Switching to this new procedure thus reduces expected litigation costs. (iii). This improved disclosure increases the informativeness of earnings, which allows investors to predict future cash flows more accurately.
Investors, disliking uncertainty, are now willing to invest in AOL for a lower (expected) return and thus bid up the stock price. 10. AOL mentions a charge of $75 million. Explain the nature of this charge and how it will affect the financial statements.
The $75 mil.
consists of two components: (1) $48,627,000 is restructuring charge whose components are: Write-off of impaired assets and discontinued businesses $31,215,000, Severance and personnel related $8,734,000, and Other expenses $8,678,000. (2) $24,506,000 a contract termination charge, consisting of unconditional payments associated with terminating certain information provider contracts which became uneconomical as a result of the introduction of flat-rate pricing in December 1996.