Prior to October 1, 1996, AOL accounted for the cost of direct response advertising as “Deferred Subscriber Acquisition Costs,” i.e., it recognized (reported) the costs of mailing out diskettes allowing you to sign-on to AOL for 100 free minutes as an asset on its Balance Sheet. In accounting, we say that the costs were “capitalized,” meaning reported on the Balance Sheet as an asset. This is in contrast to the costs being “expensed,” flowing to the Income Statement immediately as an expense.

The asset, Deferred Subscriber Acquisition Costs was amortized, beginning the month after such costs were incurred, over a period determined by calculating the ratio of current revenues related to direct response advertising versus the total expected revenues related to this advertising, or twenty-four months, whichever was shorter.

For example, supposed AOL spent $10 million for advertising costs and expected to generate a total of $55 million in revenues as a result of such expenditures over a two-year period. Suppose in the first year, $20 million in revenues occurred as a result of this advertising program. AOL wou

(iii). This improved disclosure increases the informativeness of earnings, which allows investors to predict future cash flows more accurately. Investors, disliking uncertainty, are now willing to invest in AOL for a lower (expected) return and thus bid up the stock price.

ld recognize, of course, revenues of $20 million. The associated cost is:

As noted in the journal entry in (4) above, there is no cash impact of the charge. (The cash was spent back when the mailing campaign was conducted - a couple of years ago.)

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

Reporting subscriber acquisition costs as an asset allowed AOL’s management lots of discretion in determining net income because the amount capitalized and the level of the amortization expense are both determined by managers. As a result, it was not clear whether AOL’s income number is a good measure of the economic performance of the firm. Managers could have taken advantage of this situation, distorting the income number in order to get some personal benefits (e.g., higher bonuses, a higher stock price which would add to their personal wealth, etc.).

(1) $48,627,000 is restructuring charge whose components are: Write-off of impaired assets and discontinued businesses $31,215,000, Severance and personnel related $8,734,000, and Other expenses $8,678,000.

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