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:
Adv. Costs 3.64
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:
Adv. Costs 6.67 20/30 x [$10 million] = $6.67
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 ($4.03 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...