Case: America Online Inc. , Topic: Strategy Analysis Prior to 1995, AOL was so successful in the commercial online industry relative to its competitors CompuServe and Prodigy primarily because of its pricing rate structure which was the easiest for customers to understand and plan for ahead of time. CompuServe and Prodigy offered the same pricing as AOL for its standard service, but, charged additional fees for premium services and downloading which made it more difficult for customers to anticipate their monthly spending. The key changes taking changes taking place in the online industry in 1995 are the introduction of the Microsoft network and the coming of use of the Internet World Wide Web which offered alternative channels to content providers that provided more control over their offerings and potentially higher revenues. Microsoft Network took only a 30% commission fee (versus 80% taken by AOL from its content providers' revenues) from its content providers and offered providers the option of choosing any format and font to display their content (versus the standard screen displays offered by AOL and its rivals). Also, the per-hour pricing policy offered by Microsoft was superior to AOL's.
With the development underway of a way to provide on-line currency collection, the World Wide Web offered huge incentives for providers to start publishing material on the internet by their own means without having to go through a middle-man such as an online provider. Both of these offerings do not bode well for AOL's future prospects due to the huge incentives for customers and content providers to switch to these alternative distribution channels. Prior to 1995, there is substantial evidence in the case (Exhibit 2 in the case) to suggest that the benefits of the expense of the free-trial CD marketing programs in acquiring customers will accrue over multiple periods. The average lifetime of a user was projected to be approximately 32 months (prior to 1995) and this makes a strong case, in my opinion, for capitalizing these expenses, as AOL did. With the advent of competition, as discussed earlier, compounded with the difficulty of retaining retail customers, especially online, it is highly unlikely that AOL's customers are likely to stay for an extended period of time just because of the initial inducements. Hence, I would recommend that the accounting policy be changed gradually over the course of two to three years starting this year by decreasing the amortizable life of the subscriber acquisition costs from 24 months to 0 months linearly (example, 24 to 15 to 8 to 0) - i.
e. , until the costs are completely expense. If subscriber acquisition costs are written off (expense) instead of being capitalized, the value of the asset created by this cost will not show up on the balance sheet as part of the total assets of the firm. This, in turn, creates ripple effects for the measurement of capital and profitability ratios for the firm. The balance sheet would show a reduction in the amount of assets by $130, 473 million (See Appendix C. 1).
The profitability ratios (ROE, ROA and ROC) are much better when the costs are capitalized (See Appendix C. 2). Expensing subscriber acquisition costs increases expenses in the income statement by $51, 467 million and causes the operating income and net income to be much lower than if they were capitalized. The operating income and net income consists of loss of $19, 294 million and $33, 647 respectively in the case of capitalization versus a loss of $70, 131 million and $84, 484 respectively in the case of expending (See Appendix B).
However, there is a superior tax benefit if one were to expense - the differential tax benefit between the two approaches is $17, 285 million (See Appendix C. 3). Appendix AA. 1 Case Discussion Questions 1. Prior to 1995, why was AOL so successful in the commercial online industry relative to its competitors CompuServe and Prodigy? 2.
As of 1995, what are the key changes taking place in the commercial online industry? How are they likely to affect AOL's future prospects? 3. Was AOL's policy to capitalize subscriber acquisition costs justified prior to 1995? 4. Given the changes discussed in question 2, do you think AOL should change its accounting policy as of 1995? Is the company's response consistent with your view? 5. What would be the effect on AOL's 1995 balance sheet if all capitalized subscriber acquisition costs were written off? 6. If AOL expense all the subscriber acquisition costs incurred in fiscal 1995 during the same year, what would be the effect on its income statement? Appendix BB. 1 Adjustments to Operating Income and Net Income When the Subscriber Acquisition Costs are expense (versus capitalized) the operating income and net income need to be adjusted by adding back the Amortization of Subscriber Acquisition Costs (that was subtracted out when the expenses were capitalized) and subtracting out the current year's Subscriber Acquisition Costs.
Adjusted Operating Earnings = Operating Earnings +Amortization of Subscriber Acquisition Costs -Current Year's Subscriber Acquisition Costs = (19, 294) + 60, 294 - 111, 761 = $ (70, 131) Million Adjusted Net Income = Net Income +Amortization of Subscriber Acquisition Costs -Current Year's Subscriber Acquisition Costs = (33, 647) + 60, 294 - 111, 761 = $ (84, 484) Million Appendix CC. 1 Valuing the Subscriber Acquisition Costs Asset The Subscriber Acquisition Costs are amortized over an amortizable life of 24 months. The value of the Subscriber Acquisition Cost asset is calculated using the following estimate: So, in the case of an asset with a five-year life, the value of the asset is obtained by cumulating 1/5 th of the expenses from 4 years ago, 2/5 th of the expenses from 3 years ago, 3/5 th of the expenses from 2 years ago, 4/5 th of the expenses from last year and this year's entire expense. Year Subscriber Acquisition Costs (Millions) Un amortized Portion Amortization this Year (St Line) (Millions) 1995 (Current Year) $111, 761 100% $111, 761 $55, 8801994 $37, 424 50% $18, 712 $18, 7121993 $10, 685 0 $0 -Value of Subscriber Acquisition Costs Asset: $130, 473 $74, 592 C. 2 Calculation of Book Value of Assets/Equity/Capital, ROA, ROE and ROC When Subscriber Acquisition Costs are expense, the following changes need to be made to the Book Value of Assets, Book Value of Capital and Book Value of Equity: Adjusted Book Value of Assets = Book Value of Assets - Value of Subscriber Acquisition Costs Asset = $406, 464 M- $130, 473 M = $275, 991 Million Adjusted Book Value of Equity = Book Value of Equity - Value of Subscriber Acquisition Costs Asset = $217, 944 M- $130, 473 M = $87, 471 Million Adjusted Book Value of Capital = Book Value of Capital - Value of Subscriber Acquisition Costs Asset = $239, 754 M- $130, 473 M = $109, 281 Million Subscriber Acquisition Costs Capitalized Subscriber Acquisition Costs Expensed Return on Assets (ROA) (19, 294) (1-. 34) /406, 464 = -3.
13% (70, 131) (1-. 34) / 275, 991 = -17%Return on Equity (ROE) (33, 647) /217, 944 = -15. 44% (84, 484) /87, 471 = -97%Return on Capital (ROC) (19, 294) (1-. 34) / (21, 810+217, 944) = -5. 31% (70, 131) (1-. 34) /109, 281 = -42%C.
3 Differential Tax Benefit Subscriber Acquisition Costs in 1995 = $111, 761 million Amortization of Subscriber Acquisition Costs in 1995 = $60, 924 million Tax Deduction if Subscriber Acquisition Costs were expense = $111, 761 million 0. 34 = $ 37, 999 million Tax Deduction if Subscriber Acquisition Costs were capitalized = $60, 924 million 0. 34 = $ 20, 714 million By expending instead of capitalizing, AOL is able to derive a much larger tax benefit ($37, 999 million instead of $20, 714 million). The differential tax benefit can be written as: Differential Tax Benefit = $37, 999 - $20, 714 = $17, 285 million.