Chapter 2 America Online, Inc. Teaching Note Introduction The America Online (AOL) case is a comprehensive financial-statement analysis case. It enables students to do strategic analysis, accounting analysis, financial analysis a: and prospective analysis in a rich context. It can he used either as the first case in a course. on financial; statement analysis to set up the course framework or towards the end of the course as a comprehensive case. If it is used at the beginning, the instructor should be prepared for a discussion that raises more questions than answers. However, it can he an excellent way to motivate the students to learn the course tools. If the case is used at the end, the instructor should challenge the students to do an in-depth analysis and come to concrete conclusions. The base can also be used to focus on the relationship between a firm's business strategy and its accounting policy choices. Finally, the case has also been used very successfully in the auditing context. Here, the focus would be to evaluate the risks faced by the auditor given the changing business conditions and their accounting implications. Questions for students The following questions will guide students through the material: 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 jut stifled 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 affect on AOL's 1995 balance sheet if all the capitalized subscriber acquisition costs were written off? If AOL. expensed all the subscriber acquisition costs incurred in fiscal 1995 during the same year, what would be the effect on its income statement? 6. AOL's share price &s of November 8, 1995 was $81.63. In October 1995, the company issued $100 million worth of new shares (1.71:3 million shares at $58.73 dollars per share). Its book value as of June 30, 1995 was $217.944 million. Assuming that there is no change in AOL's book value other than that due to the new share issue; compute AOL's market to book ratio as of November 8, 1995. 7. Assuming a perpetual average growth rate in book value of 15% per year, calculate the long-run average return on equity needed to be earned by AOL to justify its market to book ratio as of November 8, 1995.
8. Based on your analysis in questions 1-5, do you think that the return on equity and growth rate assumptions implied by AOL's market to book ratio are realistic?
Case analysis and teaching strategy Question 1 At the time of the case, AOL was the dominant player in the commercial online services industry with bigger market share than its two main rivals—Prodigy and CompuServe. AOL had a subscriber base of close to 4 million people. The instructor can begin the discussion by asking the class to discuss the reasons for AOL's success. Students will list several factors—easy-to-use interface, successful marketing programs to attract new subscribers, and relationships with high quality content-providers. In a sense, these factors are mutually reinforcing. An easy-to-use interface allowed AOL to market its services to the growing population of nontechnical computer users. Aggressive marketing programs enabled AOL to attract at large subscriber base. This large subscriber base, in turn, provided the company with the bargaining power to negotiate exclusive contracts with high quality contentproviders. Heavy in investment in marketing programs, therefore, was one of the most important factors behind the success of AOL. AOL's market position prior to 1995 made it possible for the company to recoup its investment in marketing programs...