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FSA Case: Ameri Name Avantika Gupta Alok Dhawal Harsh Misra Deepthi Arumalla Ravi Jewani

AOL Assignment

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Page 1: AOL Assignment

FSA Case: American Online

Name Roll NoAvantika Gupta 2008a19Alok Dhawal 2008b28Harsh Misra 2008cDeepthi Arumalla 2008a36Ravi Jewani

Page 2: AOL Assignment

Prior to 1995, why was America online (AOL) so successful in the commercial online industry relative to its competitors CompuServe and Prodigy?

The reasons for the success of AOL were manifold. Not only was it a pioneer in many new offerings to the customers, it also pursued aggressive marketing to retain and capture customers. The following are a few reasons for the 4 million users it had by the end of October 1995

1. AOL found ways to coordinate its pricing and compete on nonprice dimensions, such as innovation or brand image.2. It also had the first mover advantage.

AOL followed the differentiation strategy.This strategy gave AOL added benefits in becoming the market leader prior to 1995. AOL followed the following principles to become a differentiator.

Supply a unique product or service at a cost that was easy to understand by the customer and at the same time the customer was ready to pay premium..Superior product variety : AOL offered a lot of added services to the customers.Superior customer serviceInvestment in brand image

American online was a leader in the development of new mass medium that encompassed 1. Online services 2. Internet3. Multimedia and other interactive tecnologies

AOL generated revenues from the following means:1. Consumers : Through membership fees and usage per month2. Content Providers3. Merchandisers : Through advertising, commissions on merchandise sales and other transactions4. Other Businesses: Through sale of network and production services.

AOL pursued continuous investment in the following to position itself as a leader in the development of mass medium for interactive services:1. Growth of its existing online service and related businesses. 2. Ability to provide a full range of interactive services.3. Technological flexibility.

The strategies that AOL followed were:1. AOL’s rate structure was the easiest for the customers to understand and anticipate. Thus customers did not feel cheated when dealing with AOL in an environment when the other service providers had complex rate structures.2. AOL invested in specialized retention programs including regularly scheduled online events and conferences, online promotion of upcoming events and new features and the addition of new content, services and software programs. 3. AOL ventured into various Direct Marketing and Co-Marketing efforts to attract and retain customers. The co-marketing companies bundled the AOL software with their computer products, facilitating easy trial use by the customers.4. AOL had entered into a number of joint ventures. They made sure that the newest stars of cyberspace entered into contracts with them. AOL paid the entrepreneurs 20% of the revenue but in return demanded exclusive contracts with them. Thus the content available on AOL was not available anywhere else. This attracted new as well as existing customers to AOL.

Page 3: AOL Assignment

Prior to 1995, why was America online (AOL) so successful in the commercial online industry relative to its competitors CompuServe and Prodigy?

The reasons for the success of AOL were manifold. Not only was it a pioneer in many new offerings to the customers, it also pursued aggressive marketing to retain and capture customers. The following are a few reasons for the 4 million users it had by the end of October 1995

1. AOL found ways to coordinate its pricing and compete on nonprice dimensions, such as innovation or brand image.

This strategy gave AOL added benefits in becoming the market leader prior to 1995. AOL followed the following principles to become a differentiator.

Supply a unique product or service at a cost that was easy to understand by the customer and at the same time the customer was ready to pay premium..

3. Merchandisers : Through advertising, commissions on merchandise sales and other transactions

AOL pursued continuous investment in the following to position itself as a leader in the development of mass medium for interactive services:

1. AOL’s rate structure was the easiest for the customers to understand and anticipate. Thus customers did not feel cheated when dealing with AOL

2. AOL invested in specialized retention programs including regularly scheduled online events and conferences, online promotion of upcoming events

3. AOL ventured into various Direct Marketing and Co-Marketing efforts to attract and retain customers. The co-marketing companies bundled the AOL

4. AOL had entered into a number of joint ventures. They made sure that the newest stars of cyberspace entered into contracts with them. AOL paid

Thus the content available on AOL was not available anywhere else. This attracted new as well as existing customers to AOL.

Page 4: AOL Assignment

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?

The commercial online industry was undergoing a change during 1995. The various facts about the industry at this time were:1. Online consumer service industry represented $1.1 billion revenues in 1994 and the revenues were expected to grow by 30% to $1.4billion in 19952. Market leaders AOL, CompuServe and Prodigy served 8.5million of the existing subscribers amongst themselves. This oligopoly had very successfully acted as middlemen till now.3. Microsoft with MSN allowed all the content providers to be their own publisher. They charged only 30% from the site owners as commission and passed the rest to the content owners.4. The coming up of the World Wide Web posed a major threat to AOL's customer base. Here the role of middlemen was shrunk further. On the internet everyone with a computer was his/her own publisher. 5. Content providers were becoming increasingly interested in these alternate distribution channels which gave them greater control over their products and earn higher revenues6. Products by different players were becoming more or less identical. Hence, brand name and services which were important to the customers in the earlier years now mattered less.

These changes led to the following consequences on AOL's prospects:1. The online services and Internet markets become highly competitive. The existing competitors and the new enterants like MSN, and Internet service providers such as long distance and regional telephone companies, had enhanced their service offerings. Internet directory services and various media companies, had entered or announced plans to enter the online services and Internet markets, resulting in greater competition for AOL. The competitive environment required the following:

a. Additional pricing programs and increased spending on marketing, content procurement and product development.b. It would limit AOL’s opportunities to enter into and/or renew agreements with content providers and distribution partnersc. It would limit the ability of AOL to grow its subscriber base; and result in increased attrition in the Company's subscriber based. the costs to acquire customers would go higher and the price which customers pay for services would go lower.e. The oligopoly would end soon due to the arrival of additional distribution avenues for the subscribers.f. The proprietary services and contents will move to the Web sites. The Web will enable everybody with a computer to be his own publisher.

2. There will be a reduction in profits due to the following reasons:a. The customer retention will become costlier and customers will switch companies and hence, AOL will have problem in funding its growth and also will have to cut its prices to retain its customers

MSN and the business of AOL will shrink.c. The company will have the pressure of increasing the stake of the original content owner as far as the original revenues are concerned.d. The cost of operations of the company will increase due to higher investments in technology and heavy advertising and the increase in other product development costs.e. The margins that the company had wil shrink. This makes the condition of AOL serious as it has a huge deferred customer acquisition costs balance in its books. As the future becomes riskier and the company’s business will be more competitive.

b. The alternative of getting higher revenues and greater control over their product will allure content providers to move to the Web and

Page 5: AOL Assignment

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?

The commercial online industry was undergoing a change during 1995. The various facts about the industry at this time were:1. Online consumer service industry represented $1.1 billion revenues in 1994 and the revenues were expected to grow by 30% to $1.4billion in 19952. Market leaders AOL, CompuServe and Prodigy served 8.5million of the existing subscribers amongst themselves. This oligopoly had very successfully acted

3. Microsoft with MSN allowed all the content providers to be their own publisher. They charged only 30% from the site owners as commission and passed the

4. The coming up of the World Wide Web posed a major threat to AOL's customer base. Here the role of middlemen was shrunk further. On the internet

5. Content providers were becoming increasingly interested in these alternate distribution channels which gave them greater control over their products and

6. Products by different players were becoming more or less identical. Hence, brand name and services which were important to the customers in

1. The online services and Internet markets become highly competitive. The existing competitors and the new enterants like MSN, and Internet service providers such as long distance and regional telephone companies, had enhanced their service offerings. Internet directory services and various media companies, had entered or announced plans to enter the online services and Internet markets, resulting in greater competition for AOL.

a. Additional pricing programs and increased spending on marketing, content procurement and product development.b. It would limit AOL’s opportunities to enter into and/or renew agreements with content providers and distribution partnersc. It would limit the ability of AOL to grow its subscriber base; and result in increased attrition in the Company's subscriber based. the costs to acquire customers would go higher and the price which customers pay for services would go lower.e. The oligopoly would end soon due to the arrival of additional distribution avenues for the subscribers.f. The proprietary services and contents will move to the Web sites. The Web will enable everybody with a computer to be his own publisher.

a. The customer retention will become costlier and customers will switch companies and hence, AOL will have problem in funding its growth and also will have to cut its prices to retain its customers

c. The company will have the pressure of increasing the stake of the original content owner as far as the original revenues are concerned.d. The cost of operations of the company will increase due to higher investments in technology and heavy advertising and the increase in

e. The margins that the company had wil shrink. This makes the condition of AOL serious as it has a huge deferred customer acquisition costs balance in its books. As the future becomes riskier and the company’s business will be more competitive.

b. The alternative of getting higher revenues and greater control over their product will allure content providers to move to the Web and

Page 6: AOL Assignment

e. The margins that the company had wil shrink. This makes the condition of AOL serious as it has a huge deferred customer acquisition costs balance in its books. As the future becomes riskier and the company’s business will be more competitive.

Page 7: AOL Assignment

Was AOL’s policy to capitalize subscriber acquisition costs justified prior to 1995?

AOL’s biggest expenditure was the cost of attracting new subscribers and maximize customer subscription life. 1. Separate registration numbers and passwords were issued to customers that could be used to generate a new AOL account.They cost more than $40 per new subscriber in 1994. A one time cost from which revenue/value can be generated in the coming years, could be capitalized as per accounting principles of matching costs with revenue. 2. AOL aggressively marketed its online service both directly and indirectly. The company also paid for the free trial expenses. 3. To retain new subscribers and increase customer loyalty & satisfaction, AOL invested in specialized “Retention Programmes”.

The noteable accounting procedures followed by AOL were as follows:a. AOL's amortization period for subscriber acquisition costs was about 15 months. It was extended to 24 months from July 1, 1995. The reason for such aggressive accounting was attributed to the bundling & direct mail marketing which had shown a longer response time.b. During September 1995, the company modified the components of subscriber acquisition costs deferred & decided to expense certain subscriber acquisition costs as incurred.

Analysisa. It is not advisable for AOL to capitalize the marketing costs because in 1995 there were new enterants such as Microsoft and also the World Wide Web was being established. This would definitely impact the sales of the company and would reflect in the Revenue Statement. b. Instead of amortizing the Acquisition Costs for 15 months, if we treat it as an expense, we find that for the period of 1993-1995the Income statement shows a loss for the period. CompuServe, on the other hand,did not capitalize these subscriber acquisitions costs.c. Capitalizing the expenditure for 2 years contained an implicit assumption that the customer acquired with that expense, would remain loyal to AOL for the coming two years. This was unlikely with the online industry as it was in its growth stage and there were threats from the new entrants. AOL had acquired most of its customers in the last 36 months, to anticipate that they would remain with the company for 24 months on an average was too optimistic. d. Through these steps the management wanted to improve their earnings position so that the share price of AOL shares would shoot up in the market. e. If these costs were not amortized over the years, their cash flows from operating activities would be affected adversely.

As per accounting principles, capitalization for marketing expenditures was allowed. CompuServe follows conservatism rather than matching principle. Prior to 1995, when AOL was writing off the marketing expense in 15 months looked justified as it had acquired most of its customers in the last 36 months and had seen the trend that they do stick on for atleast 12 -15 months.

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Page 9: AOL Assignment

AOL’s biggest expenditure was the cost of attracting new subscribers and maximize customer subscription life. 1. Separate registration numbers and passwords were issued to customers that could be used to generate a new AOL account.They cost more than $40 per new subscriber in 1994. A one time cost from which revenue/value can be generated in the coming years, could be capitalized as per accounting principles of matching costs with revenue. 2. AOL aggressively marketed its online service both directly and indirectly. The company also paid for the free trial expenses. 3. To retain new subscribers and increase customer loyalty & satisfaction, AOL invested in specialized “Retention Programmes”.

a. AOL's amortization period for subscriber acquisition costs was about 15 months. It was extended to 24 months from July 1, 1995. The reason for such aggressive accounting was attributed to the bundling & direct mail marketing which had shown a longer response time.b. During September 1995, the company modified the components of subscriber acquisition costs deferred & decided to expense certain subscriber

a. It is not advisable for AOL to capitalize the marketing costs because in 1995 there were new enterants such as Microsoft and also the World Wide Web was being established. This would definitely impact the sales of the company and would reflect in the Revenue Statement. b. Instead of amortizing the Acquisition Costs for 15 months, if we treat it as an expense, we find that for the period of 1993-1995the Income statement shows a loss for the period. CompuServe, on the other hand,did not capitalize these subscriber acquisitions costs.c. Capitalizing the expenditure for 2 years contained an implicit assumption that the customer acquired with that expense, would remain loyal to AOL for the coming two years. This was unlikely with the online industry as it was in its growth stage and there were threats from the new entrants. AOL had acquired most of its customers in the last 36 months, to anticipate that they would remain with the company for 24 months on an average was too optimistic. d. Through these steps the management wanted to improve their earnings position so that the share price of AOL shares would shoot up in the market. e. If these costs were not amortized over the years, their cash flows from operating activities would be affected adversely.

As per accounting principles, capitalization for marketing expenditures was allowed. CompuServe follows conservatism rather than matching principle. Prior to 1995, when AOL was writing off the marketing expense in 15 months looked justified as it had acquired most of its customers in the last 36 months and had seen the trend that they do stick on for atleast 12 -15 months.

Page 10: AOL Assignment

They cost more than $40 per new subscriber in 1994. A one time cost from which revenue/value can be generated in the coming years, could be capitalized as per accounting principles of matching costs with revenue.

Prior to 1995, when AOL was writing off the marketing expense in 15 months looked justified as it had acquired most of its customers in the last 36 months and had seen the trend that they do stick on for atleast 12 -15 months.

Page 11: AOL Assignment

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?

The industry was becoming increasingly cometitve. The various factors that posed a threat to AOL were:1. New entrants into the industry made customer retention unpredictable.2. Product pricing had to change, as there were more attractive options like MSN in the market which posed a threat to the existing cost structure.3. Decreased profitability likely to be experienced by AOL in view of higher costs of acquisitions.4. Diminishing leadership in the industry due to other competitors starting to capitalise there marketing expenses.

It does not look feasible for AOL to anticipate that customers would remain with them for a period of 12-18 months and accrue revenue to them to match the amortization costs over those months. Hence, matching principle would fail and it appears to be prudent to follow conservative principle of accounting when competition grows in the industry. AOL should probably shift from matching principle to conservative principle of accounting, and expense the customer acquisitions costs as and when they are incurred.

Steps that need to be taken are:1. All the customer acquisition costs and advertising expenses should be reported as incurred on a conservative basis, rather than capitalized. This would have the impact of decreasing the assets and increasing the expenses.2. On the basis of conservative principle, the company should reduce the goodwill amortization period.3. Since, there is a lot of competition in this industry, so, the product development costs should also be capitalized for a shorter period.4. Future revenues per customer should be pessimistically forecasted due to increasing competition.

A look at the following table tells us that there is a need for conservative accounting policy.

Particulars Amount (1Amount2 (% GrowthCash and cash equivalents 45,378 43,891 3%Trade accounts receivable 32,176 8,547 276%Prepaid expenses and other current ass 25,327 5,753 340%Product development costs, net 18,914 7,912 139%Deferred subscriber acquisition costs, 77,229 26,392 193%Trade accounts payable 84,639 15,642 441%Deferred revenue 20,021 4,488 346%Deferred income taxes 35,627 12,842 177%

The table shows that where the cash and cash equivalents for the company has grown by 3.39%, the trade receivables, product development costs, deferred costs have risen over 100% and even 400%. This shows that the policy of the company has to change and it cannot increase the period of deferment.

The company’s response is not consistent to our views. Instead of reducing the amortization period from 12-18 months, AOL chose to increase the same to 24 months irrespective of the nature of the customer acquisition.

Page 12: AOL Assignment

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

The industry was becoming increasingly cometitve. The various factors that posed a threat to AOL were:1. New entrants into the industry made customer retention unpredictable.2. Product pricing had to change, as there were more attractive options like MSN in the market which posed a threat to the existing cost structure.3. Decreased profitability likely to be experienced by AOL in view of higher costs of acquisitions.4. Diminishing leadership in the industry due to other competitors starting to capitalise there marketing expenses.

It does not look feasible for AOL to anticipate that customers would remain with them for a period of 12-18 months and accrue revenue to them to match the amortization costs over those months. Hence, matching principle would fail and it appears to be prudent to follow conservative principle

AOL should probably shift from matching principle to conservative principle of accounting, and expense the customer acquisitions costs as and when they are incurred.

1. All the customer acquisition costs and advertising expenses should be reported as incurred on a conservative basis, rather than capitalized. This would have the impact of decreasing the assets and increasing the expenses.2. On the basis of conservative principle, the company should reduce the goodwill amortization period.3. Since, there is a lot of competition in this industry, so, the product development costs should also be capitalized for a shorter period.4. Future revenues per customer should be pessimistically forecasted due to increasing competition.

A look at the following table tells us that there is a need for conservative accounting policy.

The table shows that where the cash and cash equivalents for the company has grown by 3.39%, the trade receivables, product development costs, deferred costs have risen over 100% and even 400%. This shows that the policy of the company has to change and it cannot increase the period of deferment.

The company’s response is not consistent to our views. Instead of reducing the amortization period from 12-18 months, AOL chose to increase the same to 24 months irrespective of the nature of the customer acquisition.

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1. All the customer acquisition costs and advertising expenses should be reported as incurred on a conservative basis, rather than capitalized. This would have the impact of decreasing the assets and increasing the expenses.

The company’s response is not consistent to our views. Instead of reducing the amortization period from 12-18 months, AOL chose to increase the same to 24 months irrespective of the nature of the customer acquisition.

Page 14: AOL Assignment

What would be the effect on AOL’s 1995 balance sheet of 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?

Actual Balance Sheet for years ended 30th JuneParticulars Amount(1995)

Total Revenues: 394,290Costs and other expenses:Cost of Revenues 229,724Marketing 77,064All other expenses 106,796Total Costs & Expenses (including amortisation of goodwill): 413,584Income (loss) from Operations -19,294Othe Income, Net 3,023Merger Expenses -2,207Income before Provision for IT & Extraordinary Item -18,478Provision for Income Taxes -15,169Income (loss) before Extraordinary Item -33,647Extraordinary Item (Tax Benefit)Net Income (loss) -33,647EPS (loss):Income before Extraordinary Item -0.99Net Income (loss) -0.99Weighted Average Shares Outstanding 33,986

Balance Sheet Adjusted for AmortizationParticulars Amount(1995)

1995Total Revenues: 394,290Cost and other expensesCost of Revenues 229,724Marketing 89,733All other expenses 106,796Total Costs & Expenses (including amortisation of goodwill): 426,253Income (loss) from Operations -31,963Othe Income, Net 3,023Merger Expenses -2,207Income before Provision for IT & Extraordinary Item -31,147Provision for Income Taxes -15,169Income (loss) before Extraordinary Item -46,316Extraordinary Item (Tax Benefit)Net Income (loss) -46,316EPS (loss):Income before Extraordinary Item -1.36Net Income (loss) -1.36Weighted Average Shares Outstanding 33,986

Page 15: AOL Assignment

What would be the effect on AOL’s 1995 balance sheet of 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?

Amount(1994) Amount(1993)

115,722 51,984

69,043 28,82023,548 9,74518,523 11,494

111,114 50,0594,608 1,9251,774 371

6,382 2,296-3,832 -1,8972,550 399

1,1332,550 1,532

0.07 0.010.07 0.05

34,208 29,286

Amount(1994) Amount(1993)1994 1993

115,722 51,984

69,043 28,82026,390 12,181 12,669 2,842 2,43618,523 11,494

113,956 52,4951,766 -5111,774 371

3,540 -140-3,832 -1,897

-292 -2,0371,133

-292 -904

-0.01 -0.07-0.01 -0.03

34,208 29,286

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AOL’s share price as of November 8, 1995 was $81.63. In October 1995, the company issued $100 million worth of new shares (1.713 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 due to the new share issue, compute AOL’s market to book ratio as November 8, 1995.

Due to the issue of fresh shares in October 2005, the book value of equity has increased. The total book value of equity can be calculated and also the book value per share. Market to Book ratio has been calculated from the market price on November 8 2005. The calculations are given in the following table:

Particulars AmountNew shares issued in Oct 1.713Total BV 100.000BV per share 58.377

Book value in June 217.944No. of shares in june 33.986BV per share 6.413

Total BV in Nov 317.944Total No. of shares on Nov 35.699BV per share 8.906

MP per share 81.630

Market/Book ratio 9.165

Page 17: AOL Assignment

AOL’s share price as of November 8, 1995 was $81.63. In October 1995, the company issued $100 million worth of new shares (1.713 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 due to the new

Due to the issue of fresh shares in October 2005, the book value of equity has increased. The total book value of equity can be calculated and also the book value per share. Market to Book ratio has been calculated from the market price on November 8 2005. The calculations are given in the following table:

Page 18: AOL Assignment

Due to the issue of fresh shares in October 2005, the book value of equity has increased. The total book value of equity can be calculated and also the book value per share. Market to Book ratio has been calculated from the market price on November 8 2005. The calculations are given in the following table:

Page 19: AOL Assignment

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.

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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

Page 21: AOL Assignment

Based on your analysis in questions 1-5, do you think the return on equity and growth rates assumptions implied by AOL’s market to book ratio realistic?

From the following observations, we can conclude that ROE and growth rate assumptions were overstated.1. AOL amortized its customer acquisition and amortization expenses. Its competitors would soon enter into similar accounting procedures. 2. AOL amortized its software development costs over five years, which is unrealistic given the fast changing nature of the industry.3. AOL capitalizes its product development costs, direct labor and related overhead for software gave AOL more reported profits than its competitors

So the growth projections seem to be doubtful. They are only based on the companies perception and accounting standards but not the reality and facts.

Page 22: AOL Assignment

Based on your analysis in questions 1-5, do you think the return on equity and growth rates assumptions implied by AOL’s market to book ratio realistic?

From the following observations, we can conclude that ROE and growth rate assumptions were overstated.1. AOL amortized its customer acquisition and amortization expenses. Its competitors would soon enter into similar accounting procedures. 2. AOL amortized its software development costs over five years, which is unrealistic given the fast changing nature of the industry.3. AOL capitalizes its product development costs, direct labor and related overhead for software gave AOL more reported profits than its competitors

So the growth projections seem to be doubtful. They are only based on the companies perception and accounting standards but not the reality and facts.