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.

Questions to Answer

1. What is the general treatment of advertising and promotion costs?

2. Why are these costs normally expensed in the period incurred even though they are incurred with the intention of generating future revenues?

3. Why did they expense these costs over a two-year period?

4. Why did AOL choose a different approach?

5. Why did the company decided to change its method?

6. What do you think about the civil penalty of $3.5 million leveled by the SEC four years after AOL changed its method?

7. What is the SEC’s role in the financial reporting process?