What accounting approach has AOL used in the past that it is now changing (related to the $385 million)?.
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 would recognize, of course, revenues of $20 million. The associated cost is:.
20/55 x [$10 million] = $3.64 million.
A mini-Income Statement for the Company would be as follows:.
Revenues 20.00.
Adv. Costs 3.64.
Income 16.36.
Notice that the percentage of revenues realized is used to determine the percentage of expenses to be recognized. Also note how crucial the assumption about the total expected revenues is in determining the income. Suppose AOL's estimate of $55 million in revenues over the two-year period is wrong. Suppose, instead, that the revenues are $30 million. Income should have been:.
Revenues 20.00.
Adv. Costs 6.67 20/30 x [$10 million] = $6.67.
Income 13.33.
2. What was AOL's rationale for using the past accounting approach? What accounting principle(s) was it following?.
