Dr. Maddah ENMG 602 Intro. to Financial Eng g 11/03/08. Using the Accounting Framework: AOL (Chapter 5, Antle)

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1 Dr. Maddah ENMG 602 Intro. to Financial Eng g 11/03/08 Using the Accounting Framework: AOL (Chapter 5, Antle) AOL s business environment America Online was the leader in providing internet connections in 1997 with 8.6 million subscribers. AOL had two sources of revenue (i) online service revenue generated from customer subscription to online service, and (ii) other revenues from e-commerce and advertising. Rapid changes occurred in the manner in which subscription revenue was generated which shifted AOL strategy to focusing on increasing nonsubscription revenues. Nonsubscription revenues are difficult to estimate. Revenue uncertainty was combined with fierce competition. However, AOL s revenue was growing rapidly (from $39 million in 1992 to $1.6 billion in 1997). AOL s balance sheet Looking at AOL s balance sheets on June and 1997, total assets declined by around $112 million over the period. This can be serious for a growing internet company. What happened? o AOL may have incurred heavy losses due to competition. o AOL may have distributed assets to shareholders. o AOL may have used assets to pay debt. 1

Since liabilities increased by $273, we can rule out that AOL used assets to pay off debt. The accounting identity tells us that stockholder s equity should have declined.

2 Since liabilities increased by $273, we can rule out that AOL used assets to pay off debt. The accounting identity tells us that stockholder s equity should have declined. It did decrease by $385 million. A closer look at shareholder s equity indicates that AOL issued additional common stocks leading to an increase of $98 million in par and addition paid-in capital. 2

3 Another equity account, unrealized gain on available-forsale securities also increased by $17 million. The decrease in equity came from a decrease in accumulated deficit (retained earnings) of $499 million, from ($8) to ($507) million. This indicates that no dividend was paid in The income statement will help explain this decrease. AOL s income statement Looking at AOL s income statement for the period June June 30, 1997, the revenues are around $1.7 billion (increasing from $1.1 billion in 1996). 3

4 The increase in revenue indicates that competition didn t hurt AOL too badly in It must be that expenses increased significantly in Looking at expenses, all of these are normal expenses (cost of revenues, marketing, etc.) except for the $ 385 million write-off of deferred subscriber acquisition costs. Deferred subscriber acquisition costs Footnote 2 explains that these costs are attributed to marketing programs that result in subscriber registrations. E.g., the cost of identifying target customers, preparing freetrial disks, and mailing disks to target customers. Prior to October 1, 1996, these expenditures were recorded as an asset and amortized monthly over a period < 24 months. Footnote 3 explains that AOL changed to a flat-rate pricing and reduced reliance on online subscriber revenues. This created uncertainty as to whether these expenditures created an asset (i.e., produced a future benefit). As a result, after October 1, 1996, started expensing these costs as incurred (i.e., as usual advertising costs). The corresponding asset was written-off as follows. Deferred subscriber acquisition expense 385,221,000 Deferred subscriber acquisition cost 385,221,000 4

5 AOL s statement of cash flow 5

6 Cash flow from operations was a positive $123 million. Cash flow from financing activities provided cash of $79 million (consistent with our earlier analysis of equity). Investing activities used cash of $197 million. This is to be expected from a growing company. The overall increase in cash is $6 million. How could AOL s income statement show such a large loss, yet have a positive cash flow? The write-off (expense) of the $385 million in deferred subscriber acquisition costs is a non-cash expense which is added back to net income in calculating net cash. This and other non-cash expenses added up to $530 million! Articulating the financial statements: Analysis of the deferred subscriber acquisition costs account Looking at the balance sheet, we see that deferred subscriber acquisition costs asset decreased from $314 million on June 30, 1996 to $0 on June 30, This is a result of writing-off this asset. However, the income statement indicates a write-off cost of $385 million (which is different than $314 million). This is due to changes of the deferred subscriber asset during the accounting period prior to writing it off. 6

7 The statement of cash flows indicates an amortization of subscriber acquisition costs of $59 million and an increase in the subscriber acquisition asset of $130 million. The following T-account analysis summarizes the changes to the subscriber acquisition asset. Starting balance (06/30/96) Period additional costs Ending balance (06/30/97) before write-off Amortization in period Write-off Ending balance (06/30/97) after write-off The difference between the additional costs ($130 million) and amortization ($59 million) helps explain how the subscriber acquisition account reached $314 million in It was building-up over the years! Final thoughts AOL s example shows the risk of taking accounting numbers at their face value without understanding the underlying institutional context and accounting convention. For example, looking at net income and total asset historical plots on June, could suggest that AOL is heading to bankruptcy, which is not the case. In fact, AOL stock price was not affected by the decline in net income in 1997 because it was justified. 7

8 A better picture of AOL situation could be drawn by plotting restated net income and total assets as if AOL has never deferred subscriber acquisition costs. These plots indicate that by deferring subscriber acquisition costs AOL was over-estimating its net income in years prior to

Dr. Maddah ENMG 602 Intro. to Financial Eng g 10/07/09. Introduction to Financial Accounting (Chapter 1, Antle)

Dr. Maddah ENMG 602 Intro. to Financial Eng g 10/07/09 Introduction to Financial Accounting (Chapter 1, Antle) What is accounting? Accounting is the act of gathering and reporting the financial history