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 Statement1: 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 Sheet2: 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]
•
2
i.e. Adjusted R&D Expense = 1/n (R&D Expenset + R&D Expenset-1 + .. R&D Expenset-(n-1))
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
Expenditure(cash paid)
900
1200
1500
1200
900
5700
Expense
No asset
Expense
900
1200
1500
1200
900
5700
-900
-1200
-1500
-1200
-900
0
0
Asset
600
1100
1400
1300
1000
300
0
Expense
300
700
1200
1300
1200
700
300
5700
CFO
CFI
0
-900
0
-1200
0
-1500
0
-1200
0
-900
0
0
0
0
0
-5700
Other Income
Other Assets/Equity
2000
1500
2000
1500
2000
1500
2000
1500
2000
1500
2000
1500
2000
1500
CFO
6
7
Total
-5700
Capitalize and amortize over 3 years
Expense
Capitalize
Income
Income
1100
1700
800
1300
500
800
800
700
1100
800
2000
1300
2000
1700
Expense
Capitalize
Assets/Equity
Assets/Equity
1500
2100
1500
2600
1500
2900
1500
2800
1500
2500
1500
1800
1500
1500
Expense
Capitalize
ROA/ROE
ROA/ROE
73%
81%
53%
50%
33%
28%
53%
25%
73%
32%
133%
72%
133%
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 creditcard 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 HotLine 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
Income Statement
Fiscal Year Ended
October 31
1979
1980
REVENUES
Direct mail marketing services
Sales of service programs
Sales of merchandise
Interest & other income
EXPENSES
Cost of service programs
Cost of merchandise
General Expenses
Other Expenses
Income Before Tax
6 months
ended
April 30
1981
10.0
1.9
0.6
12.5
15.3
0.8
16.1
11.4
0.8
12.2
5.1
2.0
1.5
0.2
8.8
7.9
2.3
0.1
10.3
6.3
1.4
7.7
3.7
5.8
4.5
1.7
2.0
2.7
3.1
2.2
2.3
Taxes
Current
Deferred
Net Income
TABLE II
SafeCard Services
Balance Sheet
ASSETS
Cash
Accounts Receivable
Prepaid Expenses
Current Assets
As of October 31
1978
1979
1980
As of
April 30
1981
3.9
2.5
3.4
9.8
7.2
2.3
4.8
14.3
7.1
6.6
9
22.7
10.1
1.6
9.8
21.5
0.4
3.9
14.1
0.4
4.9
19.6
0.6
11.4
34.7
0.7
15.2
37.4
LIABILITIES & EQUITY
Accounts payable
Accrued expenses
Allowance for cancellations
Current Liabilities
0.3
0.1
1.1
1.5
0.6
1.6
2.2
1.8
0.1
4.7
6.6
0.6
3.6
4.2
Customer advance payments
Deferred taxes
Deferred credits
4.2
2.2
7.9
5.3
3.9
11.4
10.1
6.7
23.4
10.7
8.9
23.8
6.2
14.1
8.2
19.6
11.3
34.7
13.6
37.4
PP&E
Deferred charges & other
Shareholders Equity
Fixed Assets - 5
SafeCard
As of October 31, 1980
15.3
Asset
7.9
7.4
Direct mail revenues
Cost of service
% stay
1
2
3
4
5
6
7
8
9
10
Rate
5%
8%
10%
12%
20.4
100%
90%
80%
70%
60%
50%
7.40
7.40
7.40
7.40
7.40
7.40
7.40
7.40
7.40
7.40
6.66
5.99
5.39
4.86
4.37
3.93
3.54
3.19
2.87
2.58
5.92
4.74
3.79
3.03
2.42
1.94
1.55
1.24
0.99
0.79
5.18
3.63
2.54
1.78
1.24
0.87
0.61
0.43
0.30
0.21
4.44
2.66
1.60
0.96
0.58
0.35
0.21
0.12
0.07
0.04
3.70
1.85
0.93
0.46
0.23
0.12
0.06
0.03
0.01
0.01
PRESENT VALUE
$34.90
$22.12
$14.54
$31.02
$20.09
$13.45
$28.82
$18.92
$12.81
$26.87
$17.86
$12.22
$9.83
$9.22
$8.86
$8.52
$6.72
$6.38
$6.16
$5.97
$57.14
$49.65
$45.47
$41.81
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
Income (loss) from Operations
1993
1,925
1994
4,176
1995
(21,449)
1996
65,243
1997
(505,646)
3,243
(7,038)
10,685
6,890
6,890
(17,922)
37,424
26,392
26,392
(60,924)
111,761
77,229
77,229
(126,072)
363,024
314,181
314,181
(59,189)
130,229
385,221
7,038
(10,685)
17,922
(37,424)
60,924
(111,761)
126,072
(363,024)
(1,722)
(15,326)
(72,286)
(171,709)
59,189
(130,229)
385,221
(191,465)
Total
(455,751)
Deferred Subscriber Acquisition
Costs
Opening Balance
less Amortization
plus additions
Closing Balance
Adjusted
Add back amortization
Subtract actual expenditure
One shot writeoff
Adjusted Income
Fixed Assets - 7
(452,508)
(3,243)
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