GEMBA 8 - FINR - Individual Assignment - Prof. BARTOV
Gianluigi Guida

1. What accounting approach has AOL used in the past that it is now changing (related to the $385 million)?

AOL was spreading quarterly marketing expenses over two years rather than expensing as incurred. 2. What was AOL’s rationale for using the past accounting approach? What accounting principle(s) was it following?

AOL rationale for the past approach was that spreading the marketing costs over two years was a justifiable way to match those expenses with the revenues that would have emerged as a consequence of such expenses. AOL was using the "Matching Principle" thus under the accrual basis of accounting.

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 way earnings are defined and to what are attributed. High quality earnings are created as a consequence of higher sales or lower costs within a conservative accounting approach. Earnings defined within an aggressive accounting approach can not be defined "High Quality" 4. Which financial statements were affected by the charge? How?

The Income Statement is affected by the new cost given by the consolidation of all past deferred marketing expenses. Costs increased by $385 million. The Balance Sheet is affected be the cancellation within the assets of the "deferred subscriber acquisition costs". Assets decreased by $314 million. The Cash Flow Statement is based on the Indirect Method and thus contains references to the Net Income, which in turn is affected by the charge, and to the write-­‐off of the deferred acquisition costs within the reconciliation adjustments.

The charge is contained with negative sign within the Net Income and positive sign within the reconciliation adjustments so it has no effect on the actual cash flow. The Statement of Retained Earnings and Distribution to Shareholders is also GEMBA8 -­‐ FINR-­‐ Individual Assignment

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affected as a consequence of the impact on the Accumulated Deficit. 5. Which financial ratios will be affected by the charge?

All financial ratios using directly or indirectly the following elements:

•
•

Costs and Expenses (affecting Income) Stockholders' Equity

Such ratios includes: •
•
•
•
•

Debt to Equity ratio Equity ratio Return on Assets Return on Sales Return on Equity

6. What was the cash impact of the charge?

There was no cash impact of the charge. 7. Why does Mr. Vohra, an analyst (see column one, last paragraph), say that “The earnings numbers were meaningless – they were a house of cards”?

The earnings were high because they were affected by the accounting approach which did not expense the full cost of marketing activities. It was as if such expenses were assets that could be turned into liquidity by creating new client acquisitions. However there was no guarantee that this would happen and thus the actual value of the deferred acquisitions was questionable.

8. What was “aggressive” about AOL’s accounting approach (see column two, paragraph two)?

The use of the "matching principle" was aggressive and inappropriate because there was no evidence or track record in AOL history that marketing expenses would generate client acquisitions with a certain confidence.

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9.

It is reported (paragraph 3) that AOL’s share price rose on the news of the accounting change.

(a) Do you think that accounting changes drive stock prices?

A conservative accounting approach with credible high quality of earning is likely to be appreciated by the market.

(b) What else might have caused AOL’s share price to move upward?

New competitive business model and pricing might have improved the earnings outlook. 10.

AOL mentions (column one, paragraph two) a charge of $75 million. Explain the nature of this charge and how it will affect the financial statements.

The charge is related to the costs of a restructuring plan associated with AOL's change in business model. The charge will affect the Income Statement by adding the related costs and, as a consequence, initially reducing the earnings.

11.

PRINT THE BALANCE SHEET, INCOME STATEMENT, AND NOTES 1-­‐6.

12. Fill in the columns in the table below.

RATIO BALANCE SHEET RATIOS (1) Current Ratio

(2) Current Ratio

(exclude Deferred Revenue from the denominator)

(3) P&E/Total Assets

(4) Def. Subscriber Acquisition Costs/Total Assets

(5) Debt / Equity

(6) Equity / Total Assets

INCOME STATEMENT RATIOS

(7) Gross Margin (as a percent)

(8) Total Costs & Expenses/ Revenues (In the numerator, include only those operating

expenses that were reported in both years.)

(9) Return on Sales (Net Income (*)/ Sales)

(*) before taxes

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1997

1996

0,58

0,92

0,83

1,06

0,28 0 5,61 0,15

38%

0,12 0,33 0,87 0,53

42%

1.01

0,92

-­‐0,30

0,06

Gianluigi Guida

********NOTE: ALL $ AMOUNTS MENTIONED BELOW ARE IN THOUSANDS********

FINANCIAL ANALYSIS

(a) Based on the change in the current ratio, is AOL more or less liquid in June 1997 as compared with the prior yearend?

Based on the current ratio AOL is less liquid in June 1997 as compared to with the prior yearend.

(b) The current ratio is recomputed in (2) above. Why might it make more sense to consider this version of the current ratio rather than that in (1)?

The aim of the current ratio is to give an indication of the ability of the company to pay back its short term debt. Because deferred revenues consist of prepaid service fees paid in advance, they may not be considered as liabilities. (c) AOL’s P&E account went up considerably in 1997. Based on what you can discern from the balance sheet, how do you think it paid for this new property and equipment?

In 1997, $297 million is reported as "Other accrued expenses and liabilities", with an increase of $169 million compared with the previous year. New Property and Equipment bought in 1998 is thus likely paid through short term payables/debts. (d) What costs are included in the asset “deferred subscriber acquisition costs”? (Refer to the footnotes.) What is “deferred” about these costs?

"Deferred subscriber acquisition costs" are the costs related to the marketing programs for the (potential) acquisition of clients. Both the impact of the costs and the (potential) revenue due to the acquisition are deferred, consistently with the "matching principle".

(e) What is the nature of the assets “product development costs”? What is the critical point that has to be reached before such costs are capitalized?

Product development costs are the costs, including direct labor and related overheads, incurred for the development of the software, for Windows and Mac, to enable and contribute to the functionality of the service being sold. Product development costs are capitalized after the technological feasibility has been established. Capitalization applies until the software has completed beta testing and becomes generally available.

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(f) How had AOL’s capital structure changed in 1997 versus 1996? (Consider the change in the Debt/Equity ratio.)

Debts dramatically increased over equities as the Debt/Equity ratio becomes 561% vs. 87% of 1996. (g) What was the main cause of the capital structure change that you noted in (f)?

This is mainly a consequence of the accumulated deficit raised to $507 million mainly due to the charge of $385 million for the write-­‐off of deferred acquisition costs.

(h) How did AOL’s gross margin change? Why do you think this might have occurred?

Gross margin decreased from 42% in 1996 to 38% in 1997.

This may be the consequence of lower margins associated to the new business model based on flat rates. The new business model may also be the reason for the steady increase in the revenues.

The company has also completed the merger and acquisition of other companies which could also have led to some impacts in sales as well as in the operating margin.

(i) Based on ratio (8) above, what was the cost of generating each sales dollar in 1997? 1996?

The ratio (8) represent actually the cost of generating each sales dollar. Thus to generate one sales dollar in 1997 $1,01 would be needed while in 1996 $0,92 would be needed. (j) Considering only those costs and expenses present in both years, what was the major source of the additional costs?

There was mainly an increase in the Marketing costs which is the consequence of the fact that such costs are no longer spread over a 24 month period. There was also a considerable increase in the General and Administrative costs, $193 million in 1997, with an increase of 75% compared to previous year. Although the absolute value of the increase in the cost of revenues is high, it is just slightly over proportional to the increase of revenue.

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(k) What was AOL’s profit margin (as a percentage) in 1997? in 1996?

Profit margin was -­‐30% in 1997 and 3% in 1996.

(l) What would AOL’s profit margin (as a percentage) have been in 1997 if it hadn’t reported the write-­‐off of deferred subscriber acquisition costs, the restructuring charge, the contract termination charge and the settlement charge?

Removing from the Cost and Expenses in the Income Statement, (1) the write-­‐off of deferred subscriber acquisition costs, (2) the restructuring charge, (3) the contract termination charge and (4) the settlement charge, then the profit margin would have been -­‐1%. Even with these corrections, the profit margin of 1997 should not be compared with profit margin of 1996 because marketing costs are expensed in different way in the two years.

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