FSA Case: American Online

Name
Avantika Gupta
Alok Dhawal
Harsh Misra
Deepthi Arumalla
Ravi Jewani
e: American Online
Roll No
2008a19
2008b28
2008c
2008a36
Prior to 1995, why was America online (AOL) so successful in the commercial onlin

The reasons for the success of AOL were manifold. Not only was it a pioneer in many new o
retain and capture customers. The following are a few reasons for the 4 million users it ha
1. AOL found ways to coordinate its pricing and compete on nonprice dimensions, such as inno
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 f

Supply a unique product or service at a cost that was easy to understand by the c
Superior product variety : AOL offered a lot of added services to the customers.
Superior customer service
Investment in brand image

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

AOL generated revenues from the following means:

1. Consumers : Through membership fees and usage per month
2. Content Providers
3. Merchandisers : Through advertising, commissions on merchandise sales and other trans
4. Other Businesses: Through sale of network and production services.

AOL pursued continuous investment in the following to position itself as a leader in the de
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. Thu
in an environment when the other service providers had complex rate structures.
2. AOL invested in specialized retention programs including regularly scheduled online even
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
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 o
the entrepreneurs 20% of the revenue but in return demanded exclusive contracts with the
Thus the content available on AOL was not available anywhere else. This attracted new as w
commercial online industry relative to its competitors CompuServe and Prodigy?

neer in many new offerings to the customers, it also pursued aggressive marketing to
million users it had by the end of October 1995
ensions, such as innovation or brand image.

rior to 1995. AOL followed the following principles to become a differentiator.

nderstand by the customer and at the same time the customer was ready to pay premium..
o the customers.

that encompassed

sales and other transactions

s a leader in the development of mass medium for interactive services:

d and anticipate. Thus customers did not feel cheated when dealing with AOL
structures.
cheduled online events and conferences, online promotion of upcoming events
re programs.
to attract and retain customers. The co-marketing companies bundled the AOL
customers.
at the newest stars of cyberspace entered into contracts with them. AOL paid
ve contracts with them.
is attracted new as well as existing customers to AOL.
premium..
As of 1995, what are the key changes taking place in the commercial online industr

The commercial online industry was undergoing a change during 1995. The various facts about the in
1. Online consumer service industry represented $1.1 billion revenues in 1994 and the reve
2. Market leaders AOL, CompuServe and Prodigy served 8.5million of the existing subscribe
as middlemen till now.
3. Microsoft with MSN allowed all the content providers to be their own publisher. They char
rest to the content owners.
4. The coming up of the World Wide Web posed a major threat to AOL's customer base. He
everyone with a computer was his/her own publisher.
5. Content providers were becoming increasingly interested in these alternate distribution c
earn higher revenues
6. Products by different players were becoming more or less identical. Hence, bra
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 comp
service providers such as long distance and regional telephone companies, had enhanced t
various media companies, had entered or announced plans to enter the online services and
The competitive environment required the following:
a. Additional pricing programs and increased spending on marketing, content pro
b. It would limit AOL’s opportunities to enter into and/or renew agreements with c
c. It would limit the ability of AOL to grow its subscriber base; and result in increa
d. the costs to acquire customers would go higher and the price which customers
e. The oligopoly would end soon due to the arrival of additional distribution avenu
f. The proprietary services and contents will move to the Web sites. The Web will
2. There will be a reduction in profits due to the following reasons:
a. The customer retention will become costlier and customers will switch compani
problem in funding its growth and also will have to cut its prices to retain its custo
b. The alternative of getting higher revenues and greater control over their produ
MSN and the business of AOL will shrink.
c. The company will have the pressure of increasing the stake of the original cont
d. The cost of operations of the company will increase due to higher investments
other product development costs.
e. The margins that the company had wil shrink. This makes the condition of AOL
cial online industry? How are they likely to affect AOL’s future prospects?

us facts about the industry at this time were:

in 1994 and the revenues were expected to grow by 30% to $1.4billion in 1995
he existing subscribers amongst themselves. This oligopoly had very successfully acted

publisher. They charged only 30% from the site owners as commission and passed the

s customer base. Here the role of middlemen was shrunk further. On the internet

ternate distribution channels which gave them greater control over their products and

entical. Hence, brand name and services which were important to the customers in

. The existing competitors and the new enterants like MSN, and Internet
nies, had enhanced their service offerings. Internet directory services and
e online services and Internet markets, resulting in greater competition for AOL.

arketing, content procurement and product development.

w agreements with content providers and distribution partners
; and result in increased attrition in the Company's subscriber base
ice which customers pay for services would go lower.
nal distribution avenues for the subscribers.
b sites. The Web will enable everybody with a computer to be his own publisher.

s will switch companies and hence, AOL will have

ces to retain its customers
ntrol over their product will allure content providers to move to the Web and

e of the original content owner as far as the original revenues are concerned.
higher investments in technology and heavy advertising and the increase in

the condition of AOL serious as it has a huge deferred customer acquisition costs balance in its books. As the fu
n its books. As the future becomes riskier and the company’s business will be more competitive.
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 custom
1. Separate registration numbers and passwords were issued to customers that could be us
They cost more than $40 per new subscriber in 1994. A one time cost from which revenue/v
2. AOL aggressively marketed its online service both directly and indirectly. The company a
3. To retain new subscribers and increase customer loyalty & satisfaction, AOL invested in s

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 ex
such aggressive accounting was attributed to the bundling & direct mail marketing which ha
b. During September 1995, the company modified the components of subscriber acquisition
acquisition costs as incurred.

Analysis
a. It is not advisable for AOL to capitalize the marketing costs because in 1995 there were n
Web was being established. This would definitely impact the sales of the company and wou
b. Instead of amortizing the Acquisition Costs for 15 months, if we treat it as an expense, we
the Income statement shows a loss for the period. CompuServe, on the other hand,did not c
c. Capitalizing the expenditure for 2 years contained an implicit assumption that the custom
for the coming two years. This was unlikely with the online industry as it was in its growth s
had acquired most of its customers in the last 36 months, to anticipate that they would rem
d. Through these steps the management wanted to improve their earnings position so that
e. If these costs were not amortized over the years, their cash flows from operating activitie

As per accounting principles, capitalization for marketing expenditures was allowed. Compu
Prior to 1995, when AOL was writing off the marketing expense in 15 months looked justifie
 ied prior to 1995?

s and maximize customer subscription life.

omers that could be used to generate a new AOL account.
st from which revenue/value can be generated in the coming years, could be capitalized as per accounting princ
directly. The company also paid for the free trial expenses.
ction, AOL invested in specialized “Retention Programmes”.

ut 15 months. It was extended to 24 months from July 1, 1995. The reason for
mail marketing which had shown a longer response time.
of subscriber acquisition costs deferred & decided to expense certain subscriber

se in 1995 there were new enterants such as Microsoft and also the World Wide
f the company and would reflect in the Revenue Statement.
eat it as an expense, we find that for the period of 1993-1995
he other hand,did not capitalize these subscriber acquisitions costs.
umption that the customer acquired with that expense, would remain loyal to AOL
as it was in its growth stage and there were threats from the new entrants. AOL
ate that they would remain with the company for 24 months on an average was too optimistic.
rnings position so that the share price of AOL shares would shoot up in the market.
from operating activities would be affected adversely.

es was allowed. CompuServe follows conservatism rather than matching principle.

5 months looked justified as it had acquired most of its customers in the last 36 months and had seen the trend
 per accounting principles of matching costs with revenue.

d had seen the trend that they do stick on for atleast 12 -15 months.
Given the changes discussed in question 2, do you think AOL should change its acc
view?
The industry was becoming increasingly cometitve. The various factors that pose
1. New entrants into the industry made customer retention u
2. Product pricing had to change, as there were more attrac
3. Decreased profitability likely to be experienced by AOL in
4. Diminishing leadership in the industry due to other compe

It does not look feasible for AOL to anticipate that customers would remain with them for a
match the amortization costs over those months. Hence, matching principle would fail and i
of accounting when competition grows in the industry.
AOL should probably shift from matching principle to conservative principle of accounting, a

Steps that need to be taken are:

1. All the customer acquisition costs and advertising expens
2. On the basis of conservative principle, the company shou
3. Since, there is a lot of competition in this industry, so, th
4. Future revenues per customer should be pessimistically f

A look at the following table tells us that there is a need for conservative account

Particulars Amount (1995)

Amount2 (1994)
% Growth
Cash and cash equivalents 45,378 43,891 3%
Trade accounts receivable 32,176 8,547 276%
Prepaid expenses and other current25,327
assets 5,753 340%
Product development costs, net 18,914 7,912 139%
Deferred subscriber acquisition costs,
77,229
net 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
deferred costs have risen over 100% and even 400%. This shows that the policy of the com

The company’s response is not consistent to our views. Instead of reducing the a
d change its accounting policy as of 1995? Is the company’s response consistent with your

factors that posed a threat to AOL were:

ustomer retention unpredictable.
e were more attractive options like MSN in the market which posed a threat to the existing cost structure.
perienced by AOL in view of higher costs of acquisitions.
due to other competitors starting to capitalise there marketing expenses.

ain with them for a period of 12-18 months and accrue revenue to them to
iple would fail and it appears to be prudent to follow conservative principle

ple of accounting, and expense the customer acquisitions costs as and when they are incurred.

advertising expenses should be reported as incurred on a conservative basis, rather than capitalized. This wou
, the company should reduce the goodwill amortization period.
this industry, so, the product development costs should also be capitalized for a shorter period.
be pessimistically forecasted due to increasing competition.

servative accounting policy.

any has grown by 3.39%, the trade receivables, product development costs,
e policy of the company has to change and it cannot increase the period of deferment.

of reducing the amortization period from 12-18 months, AOL chose to increase the same to 24 mon
sistent with your

cost structure.

capitalized. This would have the impact of decreasing the assets and increasing the expenses.

he same to 24 months irrespective of the nature of the customer acquisition.

What would be the effect on AOL’s 1995 balance sheet of all the capitalized subscr
acquisition costs incurred in fiscal 1995 during the same year, what would be the e

Actual Balance Sheet for years ended 30th June

Particulars Amount(1995)

Total Revenues: 394,290

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

Balance Sheet Adjusted for Amortization

Particulars Amount(1995)
1995
Total Revenues: 394,290
Cost and other expenses
Cost of Revenues 229,724
Marketing 89,733
All other expenses 106,796
Total Costs & Expenses (including amortisation of goodwill): 426,253
Income (loss) from Operations -31,963
Othe Income, Net 3,023
Merger Expenses -2,207
Income before Provision for IT & Extraordinary Item -31,147
Provision for Income Taxes -15,169
Income (loss) before Extraordinary Item -46,316
Extraordinary Item (Tax Benefit)
Net Income (loss) -46,316
EPS (loss):
Income before Extraordinary Item -1.36
Net Income (loss) -1.36
Weighted Average Shares Outstanding 33,986
 all the capitalized subscriber acquisition costs were written off? If AOL expensed all the su
year, what would be the effect on its income statement?

Amount(1994)Amount(1993)

115,722 51,984

69,043 28,820
23,548 9,745
18,523 11,494
111,114 50,059
4,608 1,925
1,774 371

6,382 2,296
-3,832 -1,897
2,550 399
1,133
2,550 1,532

0.07 0.01
0.07 0.05
34,208 29,286

Amount(1994)
Amount(1993)
1994 1993
115,722 51,984

69,043 28,820
26,390 12,181 12,669 2,842 2,436
18,523 11,494
113,956 52,495
1,766 -511
1,774 371

3,540 -140
-3,832 -1,897
-292 -2,037
1,133
-292 -904

-0.01 -0.07
-0.01 -0.03
34,208 29,286
AOL expensed all the subscriber
 AOL’s share price as of November 8, 1995 was $81.63. In October 1995, the compa
dollars per share). Its book value as of June 30, 1995 was $217.944 million. Assumi
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. T

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

Book value in June 217.944

No. of shares in june 33.986
BV per share 6.413

Total BV in Nov 317.944

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

MP per share 81.630

Market/Book ratio 9.165

r 1995, the company issued $100 million worth of new shares (1.713 million shares at $58.
44 million. Assuming that there is no change in AOL’s book value other than due to the new

ity has increased. The total book value of equity can be calculated and also the book value per sha
on shares at $58.73
an due to the new

book value per share. Market to Book ratio has been calculated from the market price on Novembe
price on November 8 2005. The calculations are given in the following table:
Assuming a perpetual average growth rate in book value of 15% per year, calculate
its market to book ratio as of November 8, 1995.
er year, calculate the long-run average return on equity needed to be earned by AOL to jus
ned by AOL to justify
Based on your analysis in questions 1-5, do you think the return on equity and grow

From the following observations, we can conclude that ROE and growth rate assumptions
1. AOL amortized its customer acquisition and amortization expenses. Its competitors would
2. AOL amortized its software development costs over five years, which is unrealistic given
3. AOL capitalizes its product development costs, direct labor and related overhead for softw

So the growth projections seem to be doubtful. They are only based on the companies per
n equity and growth rates assumptions implied by AOL’s market to book ratio realistic?

rate assumptions were overstated.

ts competitors would soon enter into similar accounting procedures.
h is unrealistic given the fast changing nature of the industry.
ed overhead for software gave AOL more reported profits than its competitors

the companies perception and accounting standards but not the reality and facts.
atio realistic?