REVERSING THE ACCRUALS

REVERSINGTHE ACCRUALS

InstitutionAffiliated:

Datesubjected:

  1. Prepare an analysis that accounts for the change in the Deferred Subscriber Acquisition Costs account on the balance sheet for each of the fiscal years from Year 4 through Year 7 by using Amortization of Subscriber Acquisition Costs and Deferred Subscriber Acquisition Costs accounts from the Statements of Cash Flows.

DETAILS

YEAR 4

$ ‘000’

YEAR 5

$ ‘000’

YEAR 6

$ ‘000’

YEAR 7

$ ‘000’

Deferred Subscriber Acquisition (net)

26,392

77,229

314,181

385,221

Amortization of Subscriber Acquisition Costs

17,922

60,924

126,072

59,189

Accumulated Deferred Subscriber Acquisition

44,314

138,153

440,253

59,189

Less:

Increment observed in the Statement of Cash Flows

(37,424)

(111,761)

(363,024)

(130,229)

Values represented in Balance sheet for a previous period

6,890

26,392

77,229

314,181

AOLCompany structures the figures for deferred subscriber acquisitioncosts in a manner that they are capitalized and amortized each periodbut in year 7, the company changed its policy. It, therefore, showsthe value stated in the worksheet above of $385,229 would have beenpresent in the balance sheet statement if the company would havestill continued incorporating the accounting practice of capitalizingand amortizing rather than writing it off in one financial period.

Thenegative values of deferred subscriber acquisition costs in thestatement of Cash Flows shows that the deferred subscriberacquisition costs increased each period. Since deferred subscriberacquisition is treated as an asset in the comparative balance sheetand any increase in an asset results to a decrease in cash and cashequivalents of a company. The negative value represents continuousincrease in the deferred subscriber acquisition.

Thetable above, therefore, represents a scenario whereby the companycontinues to capitalize and amortize the deferred subscriberacquisition costs. The values obtained represents the deferredsubscriber acquisition costs for the period ended as they areindicated in the balance sheet statement as net figures.

  1. Compare the Subscriber Acquisition Costs amortized from part a with total marketing Expenses on the Income Statement. Calculate the percentage that this amortization bears to total marketing expenses for each of the fiscal years from Year 3 to Year 7.

DETAILS

YEAR 4

YEAR 5

YEAR 6

YEAR 7

Amortization of Subscriber Acquisition Costs

17,922

60,924

126,072

59,189

Marketing Expenses

23,548

77,064

212,710

409,260

Boththe amortization of subscriber acquisition costs and marketingexpenses of AOL Company are increasing as the year’s progressexcept amortization in the Year 7. It can be as a result to thechange in accounting policy and procedure of dealing with thesubscriber acquisition costs. Marketing expenses has an increasingtrend in the value used though the percentage is decreasing from 69%,64% and 48% respectively from Year 4 to Year 7. It can be as a resultof the company strategizing to increase its marketing and customerbase in spite of the large acquisition costs so as to continue makingprofits and controlling the online services industry.

Thepercentage of amortization of deferred subscriber acquisition coststo the total marketing expenses will be as follows

Percentage of amortization against the total marketing expenses

= 76.11%

= 79.06%

= 59.27%

= 14.46%

Thecalculations above indicate a continuous decrease of the ratiobetween amortization of deferred subscriber acquisition costs andmarketing expenses. The decrease in the percentage is as a result ofthe declining amortization values. The deferred subscriberacquisitions are capitalized hence resulting to a lower value in thenext financial period after capitalization of the costs. It,therefore, results to a reduction in the amortization value.Marketing expenses, on the other hand, are increasing as the companytries to not only hold and create loyal customers from the existingones but also increase customer volumes.

  1. Prepare an analysis of the change in the Product Development Costs on the Balance Sheet account for each of the fiscal years from Year 4 to Year 7, given that the costs capitalized were $5,131,000,$13,054,000, $32,735,000 and $55,363,000 respectively, and cost amortized were $1,134,000, $2,017,000, $7,354,000 and $27,195,000 respectively

DETAILS

YEAR 4

$ ‘000’

YEAR 5

$ ‘000’

YEAR 6

$ ‘000’

YEAR 7

$ ‘000’

Product Development Costs (net)

7,912

18,949

44,330

72,498

Amortization of Product Development Costs

1,134

2,017

7,354

27,195

Accumulated Product Development Costs

9,046

20,966

51,684

99,693

Less:

Increment observed in the Statement of Cash Flows

(5,131)

(13,054)

(32,735)

(55,363)

Values represented in Balance sheet for a previous period

3,915

7,912

18,949

44,330

ProductDevelopment Costs reflected in the statement of cash flows indicatethe increment per financial year that is observed.

  1. Compare Amortization of Product Development Costs with Total Product Development Expenses in the Income Statement. Calculate the percentage that amortization bears to Total Product Development Expenses for each of the fiscal years from Year 3 to Year 7

DETAILS

YEAR 4

$ ‘000’

YEAR 5

$ ‘000’

YEAR 6

$ ‘000’

YEAR 7

$ ‘000’

Amortization of Product Development Costs

1,134

2,017

7,354

27,195

Total Product Development Expenses

5,288

14,263

53,817

58,208

Percentage of amortization bears to Total Product Development Expenses

21.44%

14.14%

13.74%

46.72%

Amortizationof the Product Development Cost is increasing as time progresses andit denotes the increase in the value of product development costsbeing amortized. The percentage of the amortization of the productdevelopment costs against total product development expenses has adecreasing trend in its first years and thereafter, it starts toincrease.

  1. Recompute the Income (Loss) from Operations in the Income Statement for AOL for each of the fiscal years Year 4 to Year 7 assuming that:

  1. The company expensed Subscriber Acquisition Costs and Product Development Costs in the year incurred instead of capitalizing, then amortizing the costs.

Inthis case scenario, the only affected period by the deferredsubscriber acquisition costs is Year 7 while the product developmentcosts will affect all the periods. The values of product developmentcosts expensed will be the values recorded in the statement of cashflows since it indicates the cash outflow incurred in each financialperiod. All the other values will remain as they are in the previousincome statement.

Extractof the comparative Income Statement

AOL,Inc

ComparativeIncome Statement,

(Amountin thousands)

(Case7.4)

Year 3

$’000

Year 4

$’000

Year 5

$’000

Year 6

$’000

Year 7

$’000

Total Revenue

51,984

115,722

394,290

1,093,854

1,685,228

Cost of revenue

28,820

69,043

229,724

627,372

1,040,762

Marketing Expenses

9,745

23,548

77,064

212,710

409,260

Product Development Expenses

1,831

5,131

13,054

32,631

56,795

Administrative Expenses

8,581

13,667

42,700

110,653

193,537

Acquired Research &amp Development

50,335

16,981

Amortization of Goodwill

1,653

7,078

6,549

Restructuring charge

48,627

Contract Termination charge

24,506

Settlement charge

24,204

Total Costs and Expenses

48,977

111,389

376,100

1,007,425

1,780,036

Income (Loss) from Operations

3,007

4,333

18,190

86,429

(94,808)

SinceProduct Development costs are to be expenses in the financial periodthey are incurred, the costs used are the ones presently reflected inthe statement of Cash Flows and remove the write off figure of thedeferred subscriber acquisition costs.

  1. Excludes Acquired Research and Development Costs and the write-off of Subscriber Acquisition Costs from the income from Operations because of its materiality and non-recurring nature.

Extractof the comparative Income Statement

AOL,Inc

ComparativeIncome Statement,

(Amountin thousands)

(Case7.4)

Year 3

$’000

Year 4

$’000

Year 5

$’000

Year 6

$’000

Year 7

$’000

Total Revenue

51,984

115,722

394,290

1,093,854

1,685,228

Cost of revenue

28,820

69,043

229,724

627,372

1,040,762

Marketing Expenses

9,745

23,548

77,064

212,710

409,260

Product Development Expenses

2,913

5,288

14,263

53,817

58,208

Administrative Expenses

8,581

13,667

42,700

110,653

193,537

Amortization of Goodwill

1,653

7,078

6,549

Restructuring charge

48,627

Contract Termination charge

24,506

Settlement charge

24,204

Total Costs and Expenses

50,059

111,546

365,404

1,011,625

1,805,653

Income (Loss) from Operations

1,925

4,176

28,886

82,229

(120,425)

Theresultant will be as shown above as the respective costs for AcquiredResearch and Development Costs and the write-off of SubscriberAcquisition Costs.

  1. In May, Year 10, eight months prior to the merger of AOL and Time Warner, AOL was fined $3.5 million by the Securities and Exchange Commission to settle charges that it misled investors by following the policy of capitalizing and amortizing subscriber acquisition costs. Comment on both

  1. Timing of the settlement

  2. SEC requirement that AOL restate earnings during the periods that the firm capitalized subscriber acquisition costs.

TheSecurities and Exchange Commission action to charge $3.5 million toAOL Inc during the merging period could prove detrimental to thecompany. The company has a poor financial performance projection ascontinuous losses are expected before the company retracts and startsgaining profits. It could result to the liquidation of the company ormajor problems in the acquisition process. There is a high chancethat Time Warner would retract from the acquisition of AOL Inc oroffer a lower price for the merger.

Capitalizationof the deferred subscriber acquisition costs resulted to inflation ofthe company’s values profit generated and, therefore, could haveinduced investors to invest more hoping better financial performance.It is considered misrepresentation of material facts. SEC has a rightto seek for the direction of AOL to repay the investors from theperiod they commenced capitalization. However, this should only holdif the company had not disclosed the information of capitalizing andamortizing of the specified costs in the notes to financialstatements.