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)

Fixed Assets - 1 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

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)]

Fixed Assets - 2 1 2 3 4 5 6 7 Total

Expenditure(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 - 3 B A R R O N' S July 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.

Fixed Assets - 4 TABLE I SafeCard Services 6 months Income Statement Fiscal Year Ended ended October 31 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 As of Balance Sheet As of October 31 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 Prepaid Expenses 3.4 4.8 9 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

Fixed Assets - 5 SafeCard As of Direct October15.3 Asset 20.4 Costmail of 7.9 service 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 PRESEN 5% $57.14 $34.90 T VALUE$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

Fixed Assets - 6 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 Total Income (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)

Fixed Assets - 7 Fixed Assets - 8 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 - 9