Asset-V1 MITx+15.516x+1T2022+type@asset+block@Class 4 Intangible Assets Cash Flow
Asset-V1 MITx+15.516x+1T2022+type@asset+block@Class 4 Intangible Assets Cash Flow
John Core
MIT Sloan School of Management
Tangible assets vs. intangible assets
• Move from tangible assets (Hertz’s cars) to intangible assets.
• Tangible assets are things you can touch (e.g., inventory and PPE). Tangible assets
have physical substance.
• Intangible assets are things you cannot touch (e.g., patents and brand value).
Intangible assets do not have physical substance.
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Tangible assets vs. intangible assets
• Move from tangible assets (Hertz’s cars) to intangible assets.
• Tangible assets are things you can touch (e.g., inventory and PPE). Tangible assets
have physical substance.
• Intangible assets are things you cannot touch (e.g., patents and brand value).
Intangible assets do not have physical substance.
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Intangible assets
▪ Investing in R&D and other intangible assets is conceptually similar to CAPEX.
▪ What are the rules for the costs of internally developed intangible assets under US
GAAP?
▪ The costs of internally developed intangible assets are expensed (as opposed to
capitalized and put on balance sheet as an asset).
▪ Logic?
▪ Future economic benefit not reliably measurable.
▪ Compare to “tangible” asset like building
▪ Exceptions:
▪ Certain software development expenditures
▪ Intangibles purchased from another company (more later)
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Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Book value
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Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Let’s estimate the market value of Microsoft’s assets
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Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Let’s estimate the market value of Microsoft’s assets
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Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Let’s estimate the market value of Microsoft’s assets
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Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Let’s estimate the market value of Microsoft’s assets
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Microsoft
As of June 2019 Microsoft had a market capitalization of $1,037 billion, while their book
value of equity was only $103 billion.
How is it that $934 billion of market value is missing from total assets and book value of
equity?
▪ Valuable intangible assets are off-balance sheet
▪ Intangible assets include:
▪ Intellectual property (Patents, Copyrights, Trademarks)
▪ Licenses, Franchise rights
▪ Brand value
▪ Customer lists
▪ Goodwill
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Intangible assets
▪ As noted above, under US GAAP, the costs of internally developed intangible assets
are expensed (as opposed to capitalized and put on balance sheet as an asset).
▪ Exceptions:
▪ Certain software development expenditures
▪ Intangibles purchased from another company (more later)
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Accounting rules for capitalizing software
development costs (not on exam)
▪ Once development has reached a phase where completion of the software is likely,
costs are capitalized.
▪ After costs are capitalized, they are expensed over the useful life of the software.
▪ The rules are slightly looser for software developed for internal use than for software
developed for external customers.
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Variation in practice
Mulford and Roberts (2006) find that 71% of US software firms do not capitalize any of
their software development costs.
▪ These companies in essence assume that all of the costs occur before the
completion of the software is likely.
Bottom line: there is much discretion and judgement involved in whether and how much
are capitalized.
• Intuition: Where does research stop and development begin?
• Benefits of expensing everything:
• It is costly to keep track of what to capitalize, and
• Investors do not complain about conservative expensing of R&D.
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Depreciation of PPE and Amortization of Intangibles
Suppose a company buys a server for $100K. Assume that there is no residual value.
If the useful life is 5 years, how much depreciation expense per year?
$20K
If the useful life is 2 years, how much depreciation expense per year?
$50K
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Depreciation of PPE and Amortization of Intangibles
Suppose a company capitalizes $100K of software costs. Assume that there is no
residual value.
If the useful life is 5 years, how much amortization expense per year?
$20K
If the useful life is 2 years, how much amortization expense per year?
$50K
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Athena Health and Cerner
Healthcare information companies.
Business is electronic health records, billing, and other services to hospitals.
They are continually investing large amounts in software.
They use the software to provide services (“internal use software”).
Information at 12/31/2017 ($millions):
% of % of
Athena sales Cerner sales
Revenues 1,220 100.0% 5,142 100.0%
Software development costs 173 14.2% 605 11.8%
Software costs capitalized 83 6.8% 274 5.3%
Useful life 2 years 5 years
Software amortization expense 71 5.8% 173 3.4%
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“Pro Forma” Capitalization of Software Development
Costs
▪ We will now take the perspective of an analyst covering Athena and Cerner
▪ Create “pro forma” estimates that adjust earnings assuming different accounting
▪ Parallel to consulting or valuation: Adjust to make “apples to apples”
▪ Athena has a 2 year useful life, whereas Cerner has a 5 year useful life.
▪ We are going to adjust Cerner “pro forma” to have a 2 year useful life.
▪ To make the adjustment, we need 2 years of past data on software costs capitalized.
▪ Could adjust Athena, but harder – will see why in example.
▪ What other costs does GAAP require expensing that an investor might argue for
capitalizing?
▪ R&D more generally
▪ Marketing and advertising
▪ Employee training
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Pro Forma Software Development Capitalization
How would this impact the accounting statements?
▪ First we gather Cerner’s software costs capitalized for 2015-2017
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Pro Forma Software Development Capitalization
How would this impact the accounting statements?
▪ First we gather Cerner’s software costs capitalized for 2015-2017
▪ Now we assume that Cerner’s software has a 2 year useful life (instead of 5 useful life)
▪ If the useful life is 2 years:
▪ 2015 costs capitalized will be amortized over 2016 and 2017.
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Pro Forma Software Development Capitalization
How would this impact the accounting statements?
▪ First we gather Cerner’s software costs capitalized for 2015-2017
▪ Now we assume that Cerner’s software has a 2 year useful life (instead of 5 useful life)
▪ If the useful life is 2 years:
▪ 2015 costs capitalized will be amortized over 2016 and 2017.
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Pro Forma Software Development Capitalization
How would this impact the accounting statements?
▪ The first line of the table shows Cerner’s software costs capitalized for 2015-2017
▪ Now we assume that Cerner’s software has a 2 year useful life (instead of 5 useful life)
▪ If the useful life is 2 years:
▪ 2015 costs capitalized will be amortized over 2016 and 2017.
▪ 2016 costs capitalized will be amortized over 2017 and 2018.
2015 2016 2017
Software costs capitalized 265 294 274
Amortize 2015 costs 132 132
Amortize 2016 costs 147
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Pro Forma Software Development Capitalization
How would this impact the accounting statements?
▪ The first line of the table shows Cerner’s Software costs capitalized for 2015-2017
▪ Now we assume that Cerner’s software has a 2 year useful life (instead of 5 useful life)
▪ If the useful life is 2 years:
▪ 2015 costs capitalized will be amortized over 2016 and 2017.
▪ 2016 costs capitalized will be amortized over 2017 and 2018.
2015 2016 2017
Software costs capitalized 265 294 274
Amortize 2015 costs 132 132
Amortize 2016 costs 147
Total to be amortized 279
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Athena Health and Cerner pro forma
Healthcare information companies.
Business is electronic health records, billing, and other services to hospitals.
They are continually investing large amounts in software.
They use the software to provide services (“internal use software”).
Information at 12/31/2017 ($millions):
% of Cerner % of
Athena sales Pro Forma sales
Revenues 1,220 100.0% 5,142 100.0%
Software development costs 173 14.2% 605 11.8%
Software costs capitalized 83 6.8% 274 5.3%
Useful life 2 years 2 years
Software amortization expense 71 5.8% 279 5.4%
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Take-Aways
▪ Intangible assets are a large part of firm value for technology companies like Microsoft.
▪ We will see in the acquisitions class that intangible assets go on balance sheet when a
company buys them from another company.
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15.516x Financial Accounting
Statement of Cash Flows
John Core
MIT Sloan School of Management
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This class: Statement of Cash Flows
Understand how cash flow from operations reconciles with net income
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Motivation -- Recall Peters Company example
NI = CFO + Accruals
Performance Measure Year 1 Year 2 Total
Net Income…………… 3 7 10
Accruals……………….. -5 5 0
Accruals “reverse”:
Low accruals → higher future net income
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Motivation
NI = CFO +Accruals (Example 2)
Performance Measure Year 1 Year 2 Total
Net Income…………… 7 3 10
Accruals……………….. 5 -5 0
Accruals “reverse”:
High accruals → lower future net income Over the long-term, accruals sum to 0.
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Motivation
Net income (NI) =
Cash flow from operations (CFO) + Accruals
▪ Higher future NI
▪ Lower future NI
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Recall Financial Statement Links
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Recall Peters company, year 1
Prepd Cont
Cash
SCF A/R Inv A/P DefRev WPay R/E
Rent Cap
1 24 Stock issue 24
2 -12 Prepaid rent 12
2A -6 -6 Rent Exp
3 10 10
4 20 Rev 4 24 Revenue
4A -5 -5 COGS
5 -6 Wages 4 - 10 Wage
6 Def Rev 6 exp
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7 -1 Div -1 Dividend
EB 31 4 6 5 10 6 4 24 2
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Financial statement links
A = L + SE
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Amazon’s Performance
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Amazon’s Performance
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Statement of Cash Flows:
Three Sections
1. Operating: Primary business activities
▪ Selling goods or rendering services
▪ Interest income, dividends received
The statement sums to the actual change in cash and cash equivalents during the year
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Amazon’s Net Income and Cash Flow from Operations
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Major Differences between Amazon CFO and Net Income
Exhibit 2 of the case shows that 2016 Net Income is $2 billion, and Operating
Cash Flows are $16 billion. What are the major differences?
▪ Depreciation $8 billion
▪ Stock-Based Compensation $3 billion
▪ Changes in Operating Assets and Liabilities $4 billion
▪ Inventories, A/R net and other -$5 billion
▪ A/P, net unearned revenue and other $9 billion
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Zsa Zsa Co – Depreciation Expense
Contra-Asset to record reduction in PPE Values
Note that depreciation does not affect cash. Depreciation allocates expenses to
periods to match the firm’s use of PPE but does not require cash outflows!
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Depreciation expense in 2016
How much cash did Amazon pay for property, plant, and equipment in 2016? Use the BSE to
account for the transaction.
Assets = Liab S/E
Cash PPE – AccDep = R/E
-6,737 6,737
Assuming a 5-year useful life and $0 salvage value, use the BSE to account for depreciation on
these assets in the next year.
1,347 -1,347
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Why is depreciation increasing over time?
More PP&E (gross) → more depreciation
The balance sheet indicates that PP&E (net) grew by $8 billion in 2016.
The Investing section of the statement of cash flows indicates that over the last 3
years:
▪ Amazon purchased over $16 billion in PP&E
(sum of $6.7, $4.6, and $4.9 billion).
▪ Amazon did not sell any material amounts of fixed assets
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Amazon’s investing activities –
Purchases of PP&E
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Why is depreciation increasing over time?
More PP&E (gross) → more depreciation
Its sales have grown from $88.9 billion to $135 billion (24% annualized).
Amazon anticipates rapid future growth, and it needs to grow its fixed assets to
support this growth.
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Big tech to get its head out of cloud frenzy
(WSJ, Sept. 29, 2018)
The four aforementioned companies spent a total of $34.7 billion in the first six
months of this year—up 59% from the same period last year.
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Effect of stock based compensation?
Use the BSE to account for paying an employee $1,000 in cash.
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What is working capital?
Working Capital is:
Current Assets - Current Liabilities
Accounts Payable
Unearned Revenues
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Why do changes in working capital affect CFO?
Current assets example: Suppose Amazon buys $1,000 of inventory for cash. Use the BSE to
account for this transaction.
Cash Inventory
-$1,000 $1,000
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Why do changes in working capital affect CFO?
Current liabilities example: Suppose Amazon sells $1,000 of services and receives cash before
providing the service. Use the BSE to account for this transaction.
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To arrive at CFO from Net Income
▪ Recall that CFO = NI – Accruals
▪ Starting with NI, add/subtract accruals to get CFO
▪ Arrive at CFO
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Amazon’s NI to CFO
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FAANG Stocks
Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG).
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Netflix earnings: Where accounting meets showbiz
(Barrons 8/24/18)
This trailblazer’s earnings are largely a creation of accounting practices. As Netflix
pours piles of cash into original shows, its cash flow is quite negative.
Netflix has earnings on its income statement, amid the negative cash flow,
because accounting rules allow showbiz companies to capitalize their production
expenses.
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Netflix vs. Amazon 2016
(amounts as a % of sales)
Measure Netflix Amazon
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What is Amazon doing with its CFO?
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What is Amazon doing with its CFO?
Financing?
Raised over $6 billion in debt in 2014… Why when they have a lot of cash?
In 2016 cash increased from $14 billion to $19 billion in cash – perhaps saving
cash for an acquisition (Whole Foods?)
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Impact of Product Life Cycle on Cash Flows
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Amazon focus on Free Cash Flow
Free cash flows are driven primarily by increasing operating income and
efficiently managing working capital and cash capital expenditures.”
Definition:
Operating cash flow – capital expenditures = Free cash flow
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Free Cash Flow
Amazon:
$16.4 billion – $6.7 billion = $9.7 billion
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Non-GAAP Performance Measures
Free cash flow is an example of a non-GAAP performance measure.
Operating cash flow and capital expenditures are GAAP performance measures:
• They are required to be shown on financial statements
• They are required to be computed according to GAAP
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Netflix vs. Amazon 2016
(amounts as a % of sales)
Measure Netflix Amazon
Net Income 2.1% 1.7%
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Tesla Hits the Bull’s-Eye (WSJ Oct. 25, 2018)
“Thanks largely to stretched accounts payable, Tesla even generated record free
cash flow of $881 million.”
Why does “stretched accounts payable” increase free cash flow (FCF)?
▪ Since free cash flow = CFO – capital expenditures, Tesla also increased FCF.
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Summary
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Ode to Cash Flow
Though my bottom line is black,
I am flat upon my back
My cash flows out
and my customers pay slow.
The growth of my receivables
is almost unbelievable;
The result is certain – unremitting woe!
And I hear the banker utter
an ominous low mutter,
“Watch cash flow!”
Source: H. S. Bailey, cited in R. Green “Are More Chryslers in the Offing?” Forbes (2) 1981, p. 69.
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Practice transactions Goal: Arrive at CFO, starting from NI Selling PPE is an
investing cash flow
NI CFO Adjust. to NI
(CFO - NI)
1. Incur $100 in depreciation expense. -100 0 +100
2. Sell $200 PPE with $100 acc. dep. for $200. +100 0 -100
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