America Online.

Inc Case Study

Q1. Prior to 1995, why was America Online so successful in the commercial online
industry relative to its competitors CompuServe and Prodigy?

America Online (AOL) was successful because it provided a broad range of features (online
community, educational domains, news and personal finance information, interactive travel
and shopping services, entertainment and childrens programming) that met the needs of its
4M subscribers. In addition, it was to easy for subscribers to understand its rate structure
(monthly fee of 9.95 which included up to five hours each month plus an addition hour was
2.95) compared to its competitors.

Furthermore, AOL realised that its primary revenue driver were membership fees. Many of
AOLs initiatives concentrated on attracting and retaining subscribers. These included direct
mail packets with AOL software disks, television and print advertising featuring a toll-free
telephone for ordering the AOL software and bundling AOL software with computer
products.

Finally, AOL had a strong business strategy. It was planning on exploiting new business
opportunities, investing in the growth of its existing services, providing a greater range of
interactive services, all whilst maintaining technological flexibility.

Q2. As of 1995, what are the key changes taking place in the commercial online
industry? How are the likely to affect AOLs future prospects?

Online consumer services industry represents 1.1B in revenue in 1994, and is expected to
grow by 30% to 1.4B. AOL, CompuServe and Prodigy have capitalised on this revenue by
successfully acting as middlemen between content providers and subscribers. However there
are certain changes taking place in the industry that are likely to affect AOLs prospects. The
introduction of the internet world wide web, and the entrance of Microsoft Network means
that content providers have alternative distribution channels, apart from AOL, CompuServe
and Prodigy. Many content providers are transferring over to MSN and the internet world
wide web because these avenues allow them more creative control, and potentially higher
revenues. The migration of content providers to these alternative distribution channels is
potentially damaging to AOL, as they can only retain subscribers if they offer unique quality
content.

Q3. Was AOLs policy to capitalise subscriber acquisition costs justified prior to 1995?

The capitalisation of marketing costs is not usually appropriate as they cannot be
distinguished from the genuine running of a business.

However it can be argued that it is appropriate for AOL to capitalise and amortise subscriber
acquisition costs as these costs were AOLs most significant expense. They were the leader in
the industry and it is clear that the costs in attracting the subscribers would be beneficial to
AOL over the amortisation period. In recognising these costs, AOL followed the matching
principle - recognise expenses as the capitalised cost is being used up. They matched the
spreading out of costs over a period (12 or 18 months) in which they expected revenue to be
earned (the average customer remained with AOL for 30 months or more). CompuServe and
Prodigy also followed similar accounting policies.

Q4. Given the changes discussed in Q2, do you think AOL should change its accounting
policy as of 1995? Is the companys response consistent with your view?

AOLs change in accounting policy was to increase the period over which subscriber
acquisition costs would be amortised over from 15-18 months to 24 months. The explanation
provided by AOL was that the company was following standard accounting procedures, in
that they were matching the timing of expenses with the period over which the revenue would
be recognised. AOL predicted that the average life an account had climbed to 41 months
from 25 months in 1992.

I dont think that this change in accounting policy is appropriately justified for the following
reasons:
The projected lifetime subscriber period is conjecture and hasnt yet been proven
Corporate insiders have sold shares, betting that the stock will go down - this is
indication that they are not confident in the companys future prospects
Uncertainty surrounds AOLs subscriber retention rates as competition (Internet
World Wide Web and Microsoft) is emerging in this industry

Q5. What would be the effect on AOLs 1994 and 1995 ending balance sheets if the
company had followed the policy of expensing subscriber acquisition outlays instead of
capitalising them? What would be the effect of expensing subscriber acquisition costs on
AOLs 1995 income statement?

The effect on the 1994 and 1995 balance sheets if the company had expensed subscriber
acquisition outlays instead of capitalising would be a lower value for assets. The company
recorded 77,229,000 and 26,392,000 worth of deferred subscriber acquisition costs in 1995
and 1994 respectively.

The effect of expensing subscriber acquisition costs on AOLs 1995 income statement is the
difference between the asset values recorded in 1994 and 1995. That is an expense of
50,837,000 would be recorded.