Long-Lived Assets
Asset in financial statement analysis may be used as measure of:
1.Wealth
2.Investment
3.Input in Production function
Definition for one may not be consistent for other;
- R&D expenditures certainly measure investment but they are not “wealth” which can be used as security.
Under GAAP, intangible assets such as R&D are not recognized.
This model “suffers” in high-tech information economy where many assets of companies are based on
In-house R&D - intellectual capital
Customer base (marketing costs expensed not capitalized)
"Churn rate” becomes important
Capitalize versus Expense Decision affects levels and patterns of
Income, ROl and CFO/CFI
Need to be able to adjust from one to another.
e.g.Capitalization of Interest
generally overstates Times Interest Earned Ratio as interest expense is decreased (and expensed as depreciation).
Ratio Reported = EBIT I Interest expense
Adjust as follows
(EBIT + amortization of capitalized interest) I (interest expense + Capitalized Interest)
Problem:How to obtain amortization of capitalized interest
estimate by looking at previous years capitalization
ignore assuming it is relatively small
calculate ratio on cash basis (CFO + interest + tax paid) I (interest paid)
Adjusting for Capitalization / Expense
R & D Expenditure : Amount paid for R & D
Capitalize —> Expense
Under Capitalization: Reported R&D Expense = R&D amortization
Reported Balance Sheet = Unamortized R & D
Adjustments
Income Statement: Reduce income by [R & D Expenditure - R & D Amortization
i.e. R & D Expense = R & D Expenditure
Balance Sheet:Decrease Assets/Equity by Unamortized R & D
Cash Flow Statement
Decrease CFO by R & D Expenditure
Increase CFI by R & D Expenditure
Expense —> Capitalize
Under Expensing:Reported R&D Expense = R&D Expenditure
No Balance Sheet
First Step: Choose number of years to amortize Assume 3
Adjustments
Income Statement[1]: Reduce income by
[1/3 ( R & D Expenset+ R & D Expenset-1+ R & D Expenset-2) - R & D Expenset]
i.e. Adjusted R&D Expense = 1/3 (R&D Expenset + R&D Expenset-1 + R&D Expenset-2)
Balance Sheet[2]: Increase Assets/Equity by
[2/3 R&D Expenset+ 1/3 R&D Expenset-1]
Cash Flow Statement
Increase CFO by R & D Expense
Decrease CFI by R & D Expense
Fixed Assets - 1
1 / 2 / 3 / 4 / 5 / 6 / 7 / TotalExpenditure(cash paid) / 900 / 1200 / 1500 / 1200 / 900 / 5700
Expense
No asset
Expense / 900 / 1200 / 1500 / 1200 / 900 / 5700
CFO / -900 / -1200 / -1500 / -1200 / -900 / 0 / 0 / -5700
Capitalize and amortize over 3 years
Asset / 600 / 1100 / 1400 / 1300 / 1000 / 300 / 0
Expense / 300 / 700 / 1200 / 1300 / 1200 / 700 / 300 / 5700
CFO / 0 / 0 / 0 / 0 / 0 / 0 / 0 / 0
CFI / -900 / -1200 / -1500 / -1200 / -900 / 0 / 0 / -5700
Other Income / 2000 / 2000 / 2000 / 2000 / 2000 / 2000 / 2000
Other Assets/Equity / 1500 / 1500 / 1500 / 1500 / 1500 / 1500 / 1500
Expense / Income / 1100 / 800 / 500 / 800 / 1100 / 2000 / 2000
Capitalize / Income / 1700 / 1300 / 800 / 700 / 800 / 1300 / 1700
Expense / Assets/Equity / 1500 / 1500 / 1500 / 1500 / 1500 / 1500 / 1500
Capitalize / Assets/Equity / 2100 / 2600 / 2900 / 2800 / 2500 / 1800 / 1500
Expense / ROA/ROE / 73% / 53% / 33% / 53% / 73% / 133% / 133%
Capitalize / ROA/ROE / 81% / 50% / 28% / 25% / 32% / 72% / 113%
Fixed Assets - 1
B A R R O N' SJuly 6, 1981
Lost and Found
SafeCard’s Accounting Rates a Hard Look
By ABRAHAM J. BRILOFF
ONE company that seemingly is cashing in on the cashless society is SafeCard Services Inc. Two weeks ago, SafeCard, which makes its headquarters in Fort Lauderdale, Fla., reported results for the six months ended April 30, 1981: revenues up 72%, profits ahead 66%. Those impressive gains, though, were merely an extension of a long upswing of the 12-year-old company’s rapid and substantial growth. In the past five years, for example, revenues have climbed from $1.2 million to $16.2 million, while earnings soared nearly tenfold, to 53.1 million, or 59 cents a share.
SafeCard’s business is as simple as it is profitable. The company provides 3.5 million subscribers with a credit-card loss-notification service. For an annual fee of $I2, the company will inform credit-card issuers, should those cards be stolen or otherwise go astray. The merits of its services are outside my ken. But what is well within my competence is whether SafeCard’s operations are as profitable as its reported results would seem to suggest An analysis of the company’s public financial statements and conversations with SafeCard’s management and accountants leave, in my mind, room for serious doubt
SafeCard actually offers several services. There is a date reminder service, by which forgetful people can be reminded of birthdays, anniversaries and the like; some 1.4 million persons, we’re told, have signed up for this one. It also sells an information-reference service (400,000 subscribers) and one for registering personal property, for. easy identification should it be lost or stolen. Via an 82%-owned subsidiary the company also his tried its hand at developing commercially (though thus far without notable success) the giant Malaysian prawn, which it describes as a freshwater crustacean resembling a shrimp.
The Key Footnote
But its oldest and most important activity — accounting easily for 80% of revenues—is the Hot-Line service for lost credit cards. To promote this business, SafeCard has worked out arrangements with various credit-card issuers. These include a dozen major oil companies (Atlantic Richfield and Gulf among them)1 department stores (including Penney and Sears), banks and others. Recently, SafeCard took over the "Protection Plus” credit-loss notification service of Citicorp.
Let’s turn to SafeCard’s accounting. The numbers are not difficult to comprehend. Safe-Card’s consolidated statements of earnings for the past two years and recent six months can be found in Table I and the realized balance sheets in Table II. The key to SafeCard’s accounting is spelled out in the following footnote, which appeared in the company’s fiscal 1980 annual report:
“The company receives an advance payment from customers who subscribe to its services. The subscription period and advance payment is generally for the ensuing twelve-month period: multi-year subscriptions not being material. Accordingly, these advance payments, less an appropriate provision for cancellations, are deferred and amortized over the subscription period. Commissions paid in connection with such revenues are also deferred and amortized over the same twelve-month period. Most customers enroll for a twelve-month period; however, based upon the company’s experience, the majority of customers renew their subscriptions for additional years beyond the initial twelve-month enrolment period. Accordingly, marketing costs directly related to enrolling these customers are deferred and amortized over the anticipated benefit period, generally three to ten years, principally on a declining balance basis, depending upon the depth of experience that the company has had with each of its programs. All amounts deferred are continually monitored, and if required. are adjusted when the future benefit period is
In 1980 the company began amortizing costs in connection with new customers of its Hot-Line program over a ten-year program with the related income benefit period. Under this method, it is anticipated that approximately 80% of the costs would be amortized in five years. Prior to 1980, these costs were being amortized over a three-year period in a manner which approximated the declining-balance method. No change in the estimated benefit period was made was made for those costs for which amortization began prior to 1980. The effects on the results of operations on the change for 1980 was not material.
TABLE ISafeCard Services
Income Statement / Fiscal Year Ended October 31 / 6 months ended April 30
REVENUES / 1979 / 1980 / 1981
Direct mail marketing services
Sales of service programs / 10.0 / 15.3 / 11.4
Sales of merchandise / 1.9 / - / -
Interest & other income / 0.6 / 0.8 / 0.8
12.5 / 16.1 / 12.2
EXPENSES
Cost of service programs / 5.1 / 7.9 / 6.3
Cost of merchandise / 2.0 / - / -
General Expenses / 1.5 / 2.3 / 1.4
Other Expenses / 0.2 / 0.1 / -
8.8 / 10.3 / 7.7
Income Before Tax / 3.7 / 5.8 / 4.5
Taxes
Current / - / - / -
Deferred / 1.7 / 2.7 / 2.2
Net Income / 2.0 / 3.1 / 2.3
TABLE II
SafeCard Services
Balance Sheet / As of October 31 / As of
April 30
1978 / 1979 / 1980 / 1981
ASSETS
Cash / 3.9 / 7.2 / 7.1 / 10.1
Accounts Receivable / 2.5 / 2.3 / 6.6 / 1.6
Deferred charges & other / 3.4 / 4.8 / 9.0 / 9.8
Current Assets / 9.8 / 14.3 / 22.7 / 21.5
PP&E / 0.4 / 0.4 / 0.6 / 0.7
Deferred charges & other / 3.9 / 4.9 / 11.4 / 15.2
14.1 / 19.6 / 34.7 / 37.4
LIABILITIES & EQUITY
Accounts payable / 0.3 / 0.6 / 1.8 / 0.6
Accrued expenses / 0.1 / - / 0.1 / -
Allowance for cancellations / 1.1 / 1.6 / 4.7 / 3.6
Current Liabilities / 1.5 / 2.2 / 6.6 / 4.2
Customer advance payments / 4.2 / 5.3 / 10.1 / 10.7
Deferred taxes / 2.2 / 3.9 / 6.7 / 8.9
Deferred credits / 7.9 / 11.4 / 23.4 / 23.8
Shareholders Equity / 6.2 / 8.2 / 11.3 / 13.6
14.1 / 19.6 / 34.7 / 37.4
SafeCard
As of October 31, 1980Direct mail revenues / 15.3 / Asset / 20.4
Cost of service / 7.9
7.4
% stay / 100% / 90% / 80% / 70% / 60% / 50%
1 / 7.40 / 6.66 / 5.92 / 5.18 / 4.44 / 3.70
2 / 7.40 / 5.99 / 4.74 / 3.63 / 2.66 / 1.85
3 / 7.40 / 5.39 / 3.79 / 2.54 / 1.60 / 0.93
4 / 7.40 / 4.86 / 3.03 / 1.78 / 0.96 / 0.46
5 / 7.40 / 4.37 / 2.42 / 1.24 / 0.58 / 0.23
6 / 7.40 / 3.93 / 1.94 / 0.87 / 0.35 / 0.12
7 / 7.40 / 3.54 / 1.55 / 0.61 / 0.21 / 0.06
8 / 7.40 / 3.19 / 1.24 / 0.43 / 0.12 / 0.03
9 / 7.40 / 2.87 / 0.99 / 0.30 / 0.07 / 0.01
10 / 7.40 / 2.58 / 0.79 / 0.21 / 0.04 / 0.01
Rate / PRESENT VALUE
5% / $57.14 / $34.90 / $22.12 / $14.54 / $9.83 / $6.72
8% / $49.65 / $31.02 / $20.09 / $13.45 / $9.22 / $6.38
10% / $45.47 / $28.82 / $18.92 / $12.81 / $8.86 / $6.16
12% / $41.81 / $26.87 / $17.86 / $12.22 / $8.52 / $5.97
America Online Inc.
Annual Report June 30, 1996
Notes to Financial Statements
-- Summary of Significant Accounting Policies
Deferred Subscriber Acquisition Costs
The Company expenses the costs of advertising as incurred, except direct response advertising, which is classified as deferred subscriber acquisition costs. Direct response advertising consists solely of the costs of marketing programs which result in subscriber registrations without further effort required by the Company. These costs, which relate directly to subscriber solicitations, principally include the printing, production and shipping of starter kits and the costs of obtaining qualified prospects by various targeted direct marketing programs and from third parties. To dare all deferred subscriber acquisition costs have been incurred for the solicitation of specifically identifiable prospects. No indirect costs are included in deferred subscriber acquisition costs.
The deferred costs are amortized, beginning the month after such costs are 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 is shorter. All other costs related to the acquisition of subscribers, as well as general marketing costs, are expensed as incurred.
On a quarterly basis, management reviews the estimated future operating results of the Company’s subscriber base in order to evaluate the recoverability of deferred subscriber acquisition costs and the related amortization period. It is possible that management’s future assessments of the recoverability and amortization period of deferred subscriber acquisition costs may change based upon actual results and other factors.
Effective July 1, 1995, the Company modified the components of subscriber acquisition costs deferred, and changed the period over which it amortizes subscriber acquisition costs. The period over which the Company amortizes subscriber acquisition costs was changed from twelve and eighteen months to the period described previously in order to more appropriately match subscriber acquisition costs with associated online service revenues. The effect of this change in accounting estimate for the year ended June 30, 1996, was to increase net income by $48,106,000 ($.45 per share).
Reported / 1993 / 1994 / 1995 / 1996 / 1997 / TotalIncome (loss) from Operations / 1,925 / 4,176 / (21,449) / 65,243 / (505,646) / (455,751)
Deferred Subscriber Acquisition Costs
Opening Balance / 3,243 / 6,890 / 26,392 / 77,229 / 314,181
less Amortization / (7,038) / (17,922) / (60,924) / (126,072) / (59,189)
plus additions / 10,685 / 37,424 / 111,761 / 363,024 / 130,229
Closing Balance / 6,890 / 26,392 / 77,229 / 314,181 / 385,221
Adjusted
Add back amortization / 7,038 / 17,922 / 60,924 / 126,072 / 59,189
Subtract actual expenditure / (10,685) / (37,424) / (111,761) / (363,024) / (130,229)
One shot writeoff / 385,221
Adjusted Income / (1,722) / (15,326) / (72,286) / (171,709) / (191,465) / (452,508)
(3,243)
AOL Pays a Fine to Settle a Charge That It Inflated Profits
By FLOYD NORRIS
New York Times May 16, 2000
America Online Inc. agreed to pay a fine of $3.5 million and to restate its books from 1995 and 1996 yesterday after the Securities and Exchange Commission charged that the company had improperly inflated profits by hundreds of millions of dollars.
The settlement, in which America Online neither admitted nor denied wrongdoing, recalls a time -- less than four years ago -- when the company’s very survival seemed to be in question. That is a far cry from now, when it is viewed as an Internet powerhouse and is in the process of acquiring Time Warner, a far larger company in terms of revenue but one that is viewed by investors as being worth less than AOL.
For America Online, which stopped using the disputed accounting method in 1996, the settlement is probably of minimal import now. But the settlement nonetheless could have an impact on other companies in young and rapidly changing industries because the commission’s position will force them to deduct all promotional expenses from earnings immediately.
Thomas Newkirk, the associate director of the commission’s enforcement division, said the action was an indication “of how important we view accounting games, particularly in the dot-coin area.” He noted that many Internet companies were spending large sums for promotion and added, “there is a suspicion that some of those expenses may not be properly accounted for.”
Richard Walker, the commission’s director of enforcement, said it was trying to ensure that financial reports of technology companies “reflect present reality, not hopes about the future.”
The specific issue in the AOL case concerned an accounting rule adopted in 1995 that carved out a small exception from the rule that advertising and promotional costs must be expensed -- that is, deducted from profits -- when they are incurred. The exception, the SEC said, allowed the capitalization of direct-response advertising costs “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."
America Online had a model to make such forecasts, but the SEC concluded it was unreliable because AOL’s business was growing and changing so rapidly. “To meet the requirements,” the commission said, “an entity must operate in a sufficiently stable business environment that the historical evidence upon which it bases its recoverability analysis is relevant and reliable.”
AOL had grown rapidly during the period covered by the SEC action, with the share price rising, as the company was able to report profits. But in October 1996, the company abruptly changed accounting policies and wrote off $3 85 million in deferred marketing costs. That write-off wiped out all the profits the company had previously reported. It came after AOL’s stock price had fallen 65 percent in five months, on concerns about increased competition.
The reality, however, turned out to be that America Online’s spending to get new customers had been wise, and enough of those customers have proved loyal to the company to make it easily the largest supplier of Internet access in the country.
The company’s stock is now trading at 38 times what it was when the new accounting policy was announced, having split four times since then. Yesterday the stock rose $3.25, to $58.50.
America Online said it would restate its books to remove the $385 million write-off and instead apportion those costs during the earlier periods when they were incurred.
There was no explanation from the SEC or the company as to why the settlement came so long after the facts were known. But it appeared that the company had resisted a settlement and gave in only after it became clear that the SEC would bring a case anyway.
Depreciation Ratios
Average Age % =Accumulated Depreciation
Ending Gross Investment
Average Depreciable Life =Ending Gross Investment
Depreciation Expense
Average Age =Accumulated Depreciation
Depreciation Expense
Impairments
effect is to
1.lower future depreciation
2.lower assets/equity
Future ROA and ROE increase
Fixed Assets - 1
[1]General case: Reduce Income by
[1/n (R&D Expenset + R&D Expenset-1 + .. R & D Expenset-(n-1)) - R&D Expenset]
i.e. Adjusted R&D Expense = 1/n (R&D Expenset + R&D Expenset-1 + .. R&D Expenset-(n-1))
[2]Increase Assets/Equity by [(n-1)/n R&D Expenset+ (n-2)/n R&D Expenset-1 +... 1/n R&D Expenset-(n-2)]