America Online, Inc

Case Analysis
4/25/2011

a. Prior to 1995, why was America Online (AOL) so successful in the commercial online industry relative to its competitors, CompuServe and Prodigy?
Answer: AOLs subscription base was more than those of CompuServe andProdigy combined, two rival online service providers, making AOL the number one consumer onlineservice provider in the United States. The reasons for AOL to be really successful relative to its competitors are below: y The higher quality of content available on AOL was a major attraction for customers. Also AOL had exclusive contracts with content providers thereby ensuring those contents are unavailable through competitors. AOL was the biggest online service provider with a huge customer base. They leveraged this and ensured that majority share (80%) of the revenue generated by the content provider sites were retained by AOL resulting in increased profits for AOL. AOLs rate structure was the easiest for consumers to understand and anticipate. As Internet charges were much higher those days, a simple easy to understand rate structure provided AOL a competitive advantage over its competitors. AOL customers had peace of mind since there were no surprises. Unlike competitors, AOLs didnt additionally charge their customers for content & downloads. AOL spent a lot on attracting new customers i.e. AOL pursued an aggressive marketing strategy using both independent & co-marketing efforts. To ensure that new customers as well as existing customers are retained, AOL invested in AOL invested in specialized retention programs including regularly scheduledonline events and conferences, regular addition of new content, services, and software programs etc.

y y

America Online, Inc FTMBA 2011

b. As of 1995, what are the key changes taking place in the commercial online industry? How are they likely to affect AOLs future prospects?
Answer: As of 1995, there were major changes taking place in the commercial online industry that would not only seriously impact the future prospects of AOL. Some the key changes are listed below: y With the advent of the Internet World Wide Web and the entranceof Microsoft Network (MSN), content providers had alternative distribution channelswhich offered greater control over their products and potentially higher revenues. The dependency on online service providers was reduced to a major extent resulting in content providers demanding a higher share of the revenues from AOL. This will result in huge revenue loss for AOL since AOL traditionally retained 80% of the revenue generated by content provider sites. Microsoft lurked the vast potential of the Internet World Wide Web, wherethe middlemans role was shrunk still further. On the Internet, everyone with a computerwas his/her own publisher. Customers would sign up for an Internet on-ramp service, ofthe sort offered by PST, Netcom, or MCI. Once on the net, the subscriber used browsingsoftware like Netscape or Spyglass to roam the worlds databases. Subscribers had a credible alternative for the services that were provided the online service providers, resulting in major difficulties in retaining existing customers and adding new customers. The above changes threatened the business model of AOL and in fact are a major threat for its existence.

c. Was AOLs policy to capitalize subscriber acquisition costs justified prior to 1995?
Answer: I believe AOLs policy to capitalize subscriber acquisition costs were justified prior to 1995. The amount spent on subscriber acquisition costs were recovered over a period through the subscription charges paid by them. Also based on the situation that prevailed before 1995, more favorable to AOL, there was more certainty in terms of recovering the amount spent on subscriber acquisition costs. Exhibit 2 User Metrics also supports this argument. Hence I believe AOLs policy to capitalize subscriber acquisition costs were justified prior to 1995

d. Given the changes discussed in question b, do you think AOL should change its accounting policy as of 1995? Is the companys response consistent with your view?
Answer:By 1995 AOL was finding it difficult to recover its subscriber acquisition costs and hence the new situation meant a more conservative accounting. However AOL
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America Online, Inc FTMBA 2011

decided to extend the period over which these costs were amortized from 18 to 24 months. Maybe AOL was ignoring the increased financial risks or was aggressive in its financial reporting. AOLs decision to capitalize subscriber acquisition costs meant it was less painful for AOL's management to continue to spend large amounts of money on this activity, even though the risks of not recovering those expenditures increase significantly.

e. 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 capitalizing them? What would be the effect of expensing subscriber acquisition costs on AOLs 1995 income statement?
Answer:AOL spent $111.761 M on subscriber acquisition costs in the fiscal year ending June 30, 1995. In addition 60.924 M was recognized as an expense that year. If the entire amount spent was expensed, therefore expenses would go up by $ 50.837 M, leading to a reduction in profit before taxes by the same amount. On the balance sheet, AOL recorded a deferred subscriber acquisition cost asset of $77.229 million. Under an immediate expensing policy, this asset will be written off. On the other side of the balance sheet, owners' equity and deferred taxes will together go down by; the same amount. (Once again, one has to make an assumption about the tax rates to arrive at the. exact split between the two figures.)

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