AOL'S SEARCH FOR WIGGLE ROOM
In 1994, the American Institute of Certified Public Accountants created an exception to the general rule that advertising expenditures must be expensed, rather than capitalized.
The new rule permitted companies to capitalize outlays for direct mail, a form of advertising that makes an offer and solicits a direct response. To qualify for this special treatment, however, a direct mailer needed to demonstrate that it possessed historical evidence sufficient to predict response rates and, by extension, the revenue that the advertising would generate.America Online (AOL), a leader in the then-young field of interactive media, quickly adopted the new accounting method. To attract subscribers, AOL mailed millions of solicitations and, through arrangements with computer manufacturers, gave away free trial subscriptions. The company did not recognize these costs as incurred. Instead, AOL capitalized the expenditures, then amortized them over periods of 12 to 18 months. By the end of its fiscal year ending June 30, 1994, AOL’s balance sheet showed $37 million of subscriber capitalized acquisition costs. Thanks to the AICPA’s exception for direct response advertising, AOL reported a $6.2 million net profit in fiscal 1994 instead of a loss of around $6 million.
AOL defended its accounting practice by arguing that its average subscriber remained on its system for 32 months, far longer than its maximum 18-month amortization period. The more conservative approach of expensing subscriber acquisition costs as incurred was the path chosen by AOL’s largest competitor, however. CompuServe reasoned that its subscribers, like AOL’s, could cancel at any time. Moreover, there was no way to predict how competition might heat up in an infant industry.
As early as October 1994, Forbes contributor Gary Samuels was voicing the skepticism of some security analysts toward AOL’s reported earnings.1 Investors lost none of their enthusiasm for the trendy Internet stock, however.
Between the month in which Samuels’s article appeared and April 1996, AOL shares rose by 624%.Along the way, deferred subscriber acquisition costs on the company’s balance sheet grew from $37 million in fiscal 1994 to $77 million in fiscal 1995. In fiscal 1996, the company squeezed out even bigger reported profits by extending the amortization period for its capitalized costs to 24 months. That change boosted net income by $48 million.
Pumping up earnings did not prevent the air from beginning to come out of AOL’s stock, however. From its May 7, 1996, peak, the shares plunged by 67% through October 14, 1996. AOL precipitated the decline by cutting the price of its online service by 63%. The move represented a competitive response to rival providers’ low rates, as well as to the migration of online services to the Internet, where most information and entertainment was offered to subscribers at no charge.
Investors did not buy AOL’s story that reduced fees would generate enough new subscribers to offset the revenue loss.2 A decision by International Business Machines and Sears, Roebuck & Co. to divest their jointly owned Prodigy Services venture underscored the lack of profitability in online services. AOL’s accounting made its earnings look better than rival CompuServe’s, but the industry’s underlying economic reality was equally bad for all online providers.
By the end of fiscal 1996, AOL’s capitalized subscriber acquisition costs had mushroomed to $314 million. On October 29, 1996, the company finally faced up to reality. The company announced that it would retroactively expense all of its capitalized subscriber acquisition costs and expense all future marketing outlays. Management linked the abandonment of its former practice to a new pricing policy.
Defending the integrity of the previous accounting approach, an AOL spokesman commented, “Look at the track record.
For the past 16 quarters, this company delivered on expectations of revenues, profits, and sub- scribers.”3 This statement skated over the fact that all of the profits that the company had delivered, since inception, were wiped out by a $385 million one-time charge that accompanied the change in accounting policy.More than three-and-a-half years later, AOL agreed to pay $3.5 million to settle SEC charges that it had exaggerated its earnings. The company also agreed to restate its fiscal 1995 and 1996 financials. In place of the onetime charge of $385 million, analysts would henceforth see the subscriber acquisition costs allocated to the periods in which they were incurred.
According to the SEC, AOL had never qualified for the exemption to the general rule that advertising costs must be expensed. Amortization was permitted “only when persuasive historical evidence exists that allows the entity to reliably predict future net revenues that will be obtained as a result of the advertising.”4 The environment in which AOL operated in the mid- 1990s, said the commission, was not sufficiently stable to make its estimates of future revenue reliable. Repeating a recurrent theme in the annals of financial reporting controversies, AOL had initially managed to report net income, to which investors duly assigned a price-earnings multiple, by exploiting the not yet well defined accounting rules of a new industry.
As it happened, the wipeout of that income did not cause AOL to follow the path to extinction trod by countless other companies in similar circumstances. By the time the company settled the SEC’s charges in 2000, its shares were trading at 38 times their low point following the accounting change. Building its subscriber base had been staggeringly expensive, but AOL had survived to become by far the largest provider of Internet access in the United States.
Analysts hoping to get a clear picture of the company’s financial performance were not out of the woods, however.
Partly to justify its earlier practice of capitalizing subscriber acquisition costs, AOL had traditionally disclosed its acquisition cost per customer and the number of canceled subscriptions. After switching to the more conservative approach of expensing its marketing expenditures, the company cut back to divulging only total market expenses and net subscriber growth. While disclosure of these details was not mandatory under the accounting rules, analysts complained that without the information they could not satisfactorily assess the value of AOL’s customer base.5 Once again, AOL was shown up by CompuServe, which continued to disclose the percentage of subscribers remaining on its system for 3, 6, 9, and 12 months. The company justified the reduced information flow by arguing that as a result of stepped-up emphasis on advertising revenues, subscriptions would play a smaller role in its success in the future.Still, AOL could not seem to shake its image as an aggressive exploiter of wiggle room in the accounting rules. In 1998, the company raised some eyebrows by employing aggressive accounting while the controversy over its subscriber acquisition costs was still fresh in investors’ minds. Through a clever gambit, management avoided booking as a one-time gain AOL’s profit of approximately $380 million on the exchange of its ANS Communications network-services business for CompuServe’s online unit.
As noted in Chapter 3, investors attach little significance to nonrecurring profits and losses in valuing stocks. Therefore, a public company has a strong incentive to aggregate cumulative losses into a one-time event and to break up a unique, nonrecurring gain into smaller pieces and recognize it over several years. AOL achieved the latter effect by structuring the swap of companies as a sale-leaseback, based on its agreement to use ANS’s services for five years following the transaction.
Sale-leaseback accounting is more commonly used for individual assets, such as railcars and buildings. AOL’s use of it for an entire operating company was nonetheless permissible. Several accountants commented, however, that it was unprecedented in their experience.6