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

 As AOL has always been focusing on aggressively attracting new clients and managed to achieve a high retention rate, due to AOL’s proven track record of customer loyalty and positive word-of-mouth, it built up a relatively large customer base (4m customers by end of Oct 1995).
 AOL aggressively marketed its online service using direct mail packets with AOL software disks and entered co-marketing efforts with computer magazine publishers and PC hard- and software providers in order to distribute their software. New customers could easily activate their accounts with the provided keys and passwords by just providing their credit card information, which, compared to AOL’s competitors constituted the easiest acquisition process for new customers.
 Continuous investments in the development of new online services and additional contents that met customers’ needs and expectations yielded an additional competitive advantage. Those included real-time conferences, interactive communications, public bulletin boards, electronic mail, electronic magazines and newspapers, online education (real-time interactive classes, library), shopping and travelling (vacation booking, travel information and services), information services (world’s, sport, stock market news, internet access), etc.
 AOL built on a strong network of partner-companies which resulted in the broadened compatibility of AOL’s services with various devices and software solutions of their partners. Prominent examples are named with Commodore(1985), Apple(1989), Windows(1993) and programs, e.g. eWorld, NewtonMail and various more. In addition to that, AOL forged various strategic alliances with, for example, American Express, Reuters, Shoppers Express and National Education Association which enabled customers to seamlessly utilize all services provided.
 By providing special-interest sites, AOL was able to keep customers online for a longer time and increase revenues which distinguished AOL from its competitors. Customers interest in this content also contributed significantly to customer retention rates.
 A simple fee structure (9.95$ per 5 hours each months and 2.95$ per each additional hour) and transparent pricing policy helped customers easily understand their costs and reduced their fear of hidden charges.

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?

 With historic growth rates of 30% (1995 year over year) and an explosion of the market size being predicted for the near future, outlooks for total market potential were very good.
 In implementing its strategy, as of 1995, AOL was seeking to invest in growth of existing services and to maintain technological flexibility in order to achieve the strategic goal of becoming a full range provider of interactive online services. As of 1995, AOL was very successful in positioning as middlemen between customers and content providers. At the same time, AOL remained largely dependent on membership subscription fees with its business model being potentially vulnerable to future technological developments.
 The more flexible and more competitive policy of new entrant MSN (i.e. to offer content providers a higher level of control over their products and a higher level of freedom in decision making) might lead to a redistribution of market shares. Without modifying their business models, including adapting their pricing policies and contractual terms for content providers to compete with MSN, online service providers including AOL were facing the threat of losing their unique competitive advantages.
 The advent of Internet World Wide Web then gave content providers an alternative choice of carrying their core activities in more preferable ways in terms of independence in publishing content, control over their products and generating direct revenues. Without AOL adjusting its business model to the new technological advances, the company is likely to encounter customer churn and consequently lose its strategic alliance network.

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

In general, costs that are directly related to generating future revenues can be capitalized. Prior to 1995, AOL adopted an aggressive accounting policy by capitalizing its subscriber acquisition costs of around $40 per new subscriber, including direct mail, advertising, start-up kits and bundling costs. This was justified for the following reasons:

 Given, that only directly related costs (i.e. printing of prospects and production of CDs) were included in the capitalized acquisition costs and those costs could directly be matched with a newly acquired customer (because the new customer had to use the provided registration keys and passwords to create his account), the number of new customers directly resulting this marketing measure could exactly be counted.
 Subscriber acquisition costs were amortized over a period of twelve and eighteen months, depending on the acquisition method, which is justified, if the average lifetime of a customer equals or exceeds the amortization period. As AOL’s metrics suggest that the average lifetime of a customer is 30+ months, this practice seems justified.
However, at the same time the lack of historic data providing sufficient proof of AOL’s projections and the fact that historic rates were not observable, since AOL added most of its customers in the past 36 months, rise doubt about the adequateness of such a long amortization period matching the period of revenue realization.

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?

 Given the challenges and threats mentioned above, the useful life of a customer might have become questionable and could indeed decrease to a level well below 30+, which was assumed prior to that.
 However, during September 1995, AOL changed the amortization period for subscriber acquisition costs deferred from 12 and 18 months to 24 months. So it did not question the useful life by shortening the amortization period, but did even prolong it.
 This change might have been conducted in order to meet the ambitious growth targets of the company or to even make AOL’s accounts look better in the face of the current threats and to be more appealing to investors (creative accounting).This change had a positive impact on operating margins.
 If AOL would instead have responded to the uprising threats by shortening the amortization period, AOL’s marketing expenses would have increased from 1996 on even more considering the significant intensification of subscriber acquisition activity in the attempt to be competitive.

5. What would be the effect 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?

 If all the subscriber acquisition costs capitalized as of June 30, 1995 ($ 77.229m) were written off, assets would decrease by that amount, an amortization expense would be incurred in the statement of operations (same amount), resulting in an income (loss) before tax of $ (69,315) and thereby stockholder’s equity would decrease by the same amount of the write-off to $ 140.715m.
 AOL actually spent $111.761m on subscriber acquisition costs in the fiscal year ending June 30, 1995 (as shown in the cash flow statement). From that amount, AOL amortized already $60.924m in FY 1995. The difference between both amounts ($ 50.837m) would be the additional effect on the income statement, if all the subscriber acquisition costs incurred in FY 1995 were expensed. This would lead to a reduction in profit before taxes by that amount in the income statement (balance sheet / equity would be affected accordingly). Resulting income (loss) before tax would decrease even more to $ (69.315m) and total stockholder’s equity would decrease to $ 167.107m if AOL expensed all subscriber acquisition costs incurred in fiscal 1995.