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Accounting vs. Economic Depreciation: AOL

News

Disgruntled shareholders of America Online Inc. (AOL) filed a lawsuit seeking class-action status asking for damages, arising from the company's controversial accounting practices. The lawsuit alleges that 18 directors and the company's auditors (Ernst & Young LLP) violated federal securities laws. It seeks to recover damages for all holders of AOL stock between Aug. 10, 1995, and Oct. 29, 1996. The lawsuit also alleges that AOL misrepresented the success of its recently closed Internet-access unit and overestimated its subscriber growth. (WSJ, February 25, 1997)

AOL had announced a one-time $385 million charge to write down the outstanding expenses that it has yet to amortize. (CNNfn, October 28, 1996)

Analysis

I would like to use this news to discuss the difference between accounting and economic depreciation and the impact on the value of a company.

Assets are depreciated, as opposed to expensed, if they are expected to generate value over a period of more than one year. Thus, investments in physical equipment are depreciated over the life of the asset. The number of years used for, say, tax purposes, is determined by the government according to a set depreciation schedule.

This is accounting depreciation, and is not necessarily the true deprecation in the value of the asset. The true reduction in the value of a physical asset is referred to as economic deprecation. Obviously, to make it easier to calculate, at least for tax purposes, the government establishes these standards.

Now let us go to advertising. Technically, if advertising produces cash-flow effects over more than one year, it should be capitalized, not expensed. However, the majority of companies expense it, while some, legally, capitalize.

The next question is: "Should it matter what type of accounting is used?" If the company is public and trades on a stock market, it should not matter. The role of financial markets is to collect information on companies and aggregate this information into a single number, which is the market price of the stock. Such a price would be a "fair’ measure of a company’s true worth if the market functions reasonably well, like the ones in the U.S. (New York Stock Exchange, Nasdaq, etc.). Thus, a company cannot fool the investors about its true value by simply adopting a different legal accounting practice. Of course, if the company is fabricating these accounting numbers without being caught, then the market would not necessarily be able to discover the "lie," neither would an investor analyzing these financial figures.

In the case of AOL, the practice was public knowledge, and, thus, the market price should reflect the true value of the cash flows. The argument for expensing it runs as follows: if a company does not expense advertising expenditure, it can show positive profit, as opposed to negative, on its books. But that is a myopic valuation approach. An investor needs to examine future cash flows beyond the next few years. In a sense, that’s one of the most important roles of a financial market.

In the case of a company that doesn’t trade on a market, a naive person might be fooled by the accounting profits. Yet, a professional evaluator should recognize the accounting practice and come up with a value for the company irrespective of how the company itself counts its beans.

Note that a similar problem exists with Research & Development (R&D) expenditures, which technically should be amortized, although it’s a common accounting practice to expense them.

DEPRECIATION SCHEDULES

By Alex Tajirain