Question

America Online (AOL) is a leader in the Internet access provider industry. In 1996, the company changed a controversial accounting method involving the treatment of the cost of advertising and free trials. The following is an excerpt from a May 15, 2000, CNET News.com article:

America Online will pay a civil penalty of $3.5 million as part of a settlement with the Securities and Exchange Commission over the accounting of advertising costs. According to the SEC, the Internet and media giant improperly reported most of the costs of acquiring new subscribers – such as the expense of sending computer disks to potential customers – as an asset. As a result, the SEC said AOL posted a profit for six of eight quarters in 1995 and 1996 but would have recorded a loss if the company followed recommended accounting practices.

AOL, backed by its auditor, defended the accounting method of capitalizing these costs arguing that spreading the costs over two years was a justifiable way to match expenses against revenue flows that would emerge later. In 1996, AOL switched to expensing these costs in the period incurred.

Consider the general treatment of advertising and promotion costs.  

• Why are these costs normally expensed in the period incurred even though they are incurred with the intention of generating future revenues?  
• Why did they expense these costs over a two-year period?  
• Then discuss the possible reasons why AOL chose a different approach followed by a discussion of the possible reasons why the company decided to change its method. Also include the civil penalty of $3.5 million leveled by the SEC four years after AOL changed its method.  

Answer 1

Advertising costs are incurred in the present but the benefits are derived in the future. This is because the payment for these activities in done in at present year, but the advertisement happens over the period of time.
They expensed these costs over two years so that they could show more profits in the current year. If they show the entire amount as an expense in the current year, their earnings will be showing a reduced number. So to average it they expensed it for a two year period.
The reason why AOL chose to show the samples sent as assets rather than the expense is because if they show it as an expense, their net profit might go down. Suppose they show these items in the balance sheet as assets, then the value of the company increases, and the profits are also shown as good. The reason why they would have changed their accounting system could be that the SEC might have asked them to do it.
There was a case file in the U.S court against AOL by SEC, the reason for payment of 3.5million after 4 years is that the court takes time to investigate and analyse the case and then give a verdict.