Aol Controversial Accounting Policies Flashcard
AOL ASSIGNMENT There were two accounting policies used by AOL that were considered aggressive, as well as controversial. The first was to amortize its software development costs and the second was to capitalize subscriber acquisition costs. The lifetime, for amortization purposes, which AOL assigned to software development costs was five years. This was considered by many to be an exceptionally long time considering the pace at which technology was progressing during that period of time.
However, none of the regulatory or advisory agencies had established an absolute useful life designation, and the only available reference point at that time was the FASB Statement #86 of August 1985. It established that costs for internally developed software could be capitalized only from the point of “technological feasibility”, and therefore all planning, designing, coding and testing should be expensed. It further stated that the capitalization costs “could be amortized for up to 60 months”.
It seems that AOL may have used Statement #86 to determine its amortization period. The second accounting policy termed overly aggressive was AOL’s capitalization of subscriber acquisition costs. These were costs associated with actually enticing and enrolling new customers into AOL’s program and were for direct mail, advertising, and start-up kits. The only advertising/marketing costs AOL did expense were the amounts relating to the free first ten hours that was given to each new subscriber.
The amortization period for the expenses of the direct marketing programs was twelve months. Also included in capitalization, but with an eighteen month amortization period, were so-called “bundling costs” for co-marketing efforts with magazine publishers and PC producers. These time frames for amortization were well known in the industry, even if they were controversial. But then in July 1995, the periods for both marketing categories were increased to 24 months, and that generated questions from industry analysts, which in turn forced AOL into a defensive position.
The rationale presented was that AOL was continuing to follow the same standard accounting practice as in previous years by matching the subscriber acquisition costs (SAC) to revenue receipts which would be generated over several years. According to CFO Lennert Leader, both the software development expenses and the SACs produced customer accounts that lasted a long time. Leader said the new projected average life of an AOL account was 41 months, up from a previous 25 months in 1992, hence the increased amortization periods were justified. There may be some validity to the given explanation.
At the time, AOL discs seemed to proliferate by the thousands. They would come in the mail addressed to Resident, and they were on the counter as freebies at the market, the drugstore and the hairdresser. Friends gave them to friends after receiving a second or third copy. After a while, you would just throw them away because you could only get one free 10 hour subscription. So there was no true way to determine how many discs were actually generating new customers. Bottom line, the explanation doesn’t hold water, and it sure doesn’t make it ok to have capitalized those expenses.
The 4th quarter 2002 report for AOL TIME WARNER had a one-time charge of $45. 538 billion for impairment of goodwill. Of that, $33. 489 billion was attributed to AOL’s lower than expected performance, including the continued decline in the online advertising market. This write down was in addition to the 1st quarter goodwill impairment charge of $54 billion. Both of these write downs resulted from the implementation of FAS142 which required annual testing of impairment to goodwill (and other intangible assets) instead of annual amortization.
The 4th quarter 2008 report for AOL TIME WARNER had a one-time charge of $2. 207 billion again for impairment of goodwill in the AOL segment. The notes to the statement declared this was “because asset value based on a discounted cash flow analysis produced fair value below book value. Then in the 2nd quarter of 2010, the spun-off AOL Inc reported a goodwill impairment of $1. 4144 billion which was (according to the Q2 notes) due to selling off nearly all assets of Bebo, net assets increasing significantly, and the significant stock price drop since April.
Of all these impairment charges, the most significant was probably the 2002 charge because it was a shock to everyone in the market. Besides being the largest of the write downs, it also showed that AOL, the principal in the merger, was actually the least valued firm. That truth had been hidden behind some fancy accounting policies which ultimately wreaked havoc on the consolidated financial health. And, unfortunately, it set the tone for the remaining life of the merged duo, as it was the beginning of a tortured downhill slide.
The impairments of 2008 and 2010, on the other hand, were not unexpected and were really not important to the total picture. The 2008 amount was just one more piece of the merger financial mess and the 2010 was a bump in the restructuring process. At the merger announcement in January, 2000, the parent company, AOL TIME WARNER, had a combined capitalization of $350 billion. The merger called for AOL stockholders to own 55% of the new company and Time Warner stockholders to own 45% because it was thought that AOL had the greater equity value.
As the year 2000 progressed, the stock prices for both companies dropped consistently as analysts considered the implications of the merger. By the official date of finalization, 1/11/01, TWX stock had dropped to $141. 69 (down from $221. 25 on Jan 3, 2000), and the market cap was around $210 billion. However, a stock drop in the U. S. market is not historically unusual for impending mergers. So, all things considered, it looked like this might be a great combination. But in the period following the official merger, financial problems would start to beset the newly formed parent company.
The first issue of major effect was the FASB implementation of SFAS142 which required annual testing of impairment to goodwill (and other intangible assets) instead of annual amortization. This ruling became effective for the year 2000, just twelve months after the official merger. It forced AOL TIME WARNER to take a one- time charge against income of $54 billion in the first quarter of 2002, and an additional $45. 538 billion in the last quarter of 2002. This was an astounding amount of nearly $100 billion dollars, predominantly attributable to the erosion of AOL’s market value.
In the second quarter of 2000, AOL settled with the SEC with regard to its’ previously discussed controversial accounting policies. AOL agreed to pay a $3. 5 million fine and to reissue earnings statements for years 1995 and 1996. By so doing, it wiped out all the profits the company had made. In the 4th quarter of 2002, AOL registered its’ first decrease in subscriptions with a loss of 200,000 members. Every quarter after that showed additional losses, until at the spin off in December 2009, AOL reported only 5 million current subscribers.
The financial injury to the parent company was so great that in 2003 management decided to drop AOL from the parent name, (becoming simply Time Warner) in the hopes that this might help stop the flow of red ink. But it didn’t. If you review the stock price chart, it can be seen that from the very beginning of the merger, the stock skidded downhill quickly and has never been able to recoup. When there were successful maneuvers, the benefits were counter balanced by AOL’s continuing losses.
In 2006, with its’ primary business eroding because subscribers were opting in to faster cable connections, AOL began transitioning into a content/advertising based revenue company. But, as noted in the 2006 10K MDA, “advertising revenues , in large part, are generated from the traffic to and usage of the AOL service…Therefore, the decline in subscribers also could have an adverse impact on AOL’s advertising revenues…”. AOL also began divestiture of its European segments with the sale of the French and United Kingdom access service units at a pretax gain of 769 million.
Restructuring of AOL, including layoffs, asset write offs and facility closures had a cost of $222 million, with more to come in 2007. Total revenue for AOL in 2006 was $7. 866 billion…a mere 18% of the total company revenues! Net Income for 2006 was $6. 552 billion, shareholders equity was $60. 389 billion, and earnings were $1. 57 per share. The MDA in the 10K of 2007 states that “advertising on the AOL network was negatively impacted by certain trends including accelerated fragmentation of online audiences, downward pricing pressures on advertising inventory as well as shifts in the mix of sold inventory to lower priced inventory…” etc.
So many words being used to try and put a positive slant on the fact that AOL’s revenues had declined further to $5. 181 billion. Net Income for 2007 was way down from 2006 at $4. 387 billion, shareholders equity was also down at $58. 536 billion, and earnings were $1. 18 per share. Perhaps the one good thing was that AOL sold off its German segment at a pretax gain of $668 million. One further note in the MDA was that the company anticipated that Operating Income at the AOL segment for the first quarter of 2008 would be less than for the comparable period in 2007.
In the 4th quarter of 2008, the parent company performed a Goodwill impairment test on its AOL segment which resulted in the announcement in January 2009 that it would be necessary to take a write down of $2. 207 billion. This was apparently the last time that TIME WARNER was willing to announce another decline in the stature of AOL, because CEO Bewkes also announced that the company was looking at a spinoff of all or part of AOL. In an overall view, AOL started as the significant entity in this merger, but gradually became of less and less importance, and eventually was no more than a thorn.
The effect of AOL’s many issues during the life of the merger caused a continuous downslide in stock price and resultant market valuation. See attached tables and charts. When the December 9 date for the AOL spinoff arrived, shareholders of record on Nov. 27, 2009 received 1 share of AOL for every 11 shares of Time Warner owned. There were 1. 058 billion shares issued for AOL. Fractional shares were sold on the open market for $23. 1128 per share, and the cash earnings were distributed to shareholders accordingly.
Generally, the stock price for Time Warner had remained fairly stable in the high twenties to low thirties during 2010 and the first three quarters of 2011. But in the last quarter of 2011 and to date in 2012, the stock has had a mini surge and traded at $37. 32 on March 1. AOL has not faired quite as well, although not altogether that terrible. Through the end of 2010, AOL’s stock fluctuated from low to mid twenties, but then nosedived in the third quarter of 2011 to its lowest price of $10. 22 on August 10.
Subsequently, it too has experienced a mini strengthening and traded at $18. 19 on March 1. The future business outlook for AOL is still shaky, but improving. Today it is valued at $1. 77 billion, and hopefully they have used their bad experiences to rebuild. They will likely continue to purchase other companies who can contribute to their growth by providing either new customer avenues or enhanced technologies. AOL looks like a good bet right now because of its management team and its value, but only time will tell.