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Asset-V1 MITx+15.516x+1T2022+type@asset+block@Class 4 Intangible Assets Cash Flow

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15.

516x Financial Accounting


Intangible Assets

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.

2
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.

3
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)
4
Consider Microsoft’s balance sheet at 6/30/2019 ($billions)

Book value

Total Liabilities 184

Total S/E 103

Total Liab & Equity 287

5
Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Let’s estimate the market value of Microsoft’s assets

Book value Market value

Total Liabilities 184

Total S/E 103

Total Liab & Equity 287

6
Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Let’s estimate the market value of Microsoft’s assets

Book value Market value

Total Liabilities 184 At 6/30/2019


Microsoft has 7.643
Total S/E 103 1,037 billion shares
outstanding and its
Total Liab & Equity 287 price is $135.68.

7
Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Let’s estimate the market value of Microsoft’s assets

Book value Market value Assume that market


value of liabilities =
Total Liabilities 184 184 book value. We will
see in a later class
Total S/E 103 1,037 that this assumption
is reasonable.
Total Liab & Equity 287

8
Consider Microsoft’s balance sheet at 6/30/2019 ($billions)
Let’s estimate the market value of Microsoft’s assets

Book value Market value

Total Liabilities 184 184

Total S/E 103 1,037


$934 billion market value is
Total Liab & Equity 287 1,221 missing from total assets.

9
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

10
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)

11
Accounting rules for capitalizing software
development costs (not on exam)

▪ Costs are expensed in the research / preliminary development phase.

▪ 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.

12
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.

Although IFRS encourages capitalization of development costs more broadly, Mazzi,


Slack, Tsalavoutas, and Tsoligkas (2019) find that over 60% of companies do not.

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.
13
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

14
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

15
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%

16
“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
17
Pro Forma Software Development Capitalization
How would this impact the accounting statements?
▪ First we gather Cerner’s software costs capitalized for 2015-2017

2015 2016 2017


Software costs capitalized 265 294 274

18
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.

2015 2016 2017


Software costs capitalized 265 294 274

19
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.

2015 2016 2017


Software costs capitalized 265 294 274
Amortize 2015 costs 132 132

50% of 2015 costs capitalized 50% of 2015 costs capitalized

20
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

50% of 2016 costs capitalized

21
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

22
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%

23
Take-Aways
▪ Intangible assets are a large part of firm value for technology companies like Microsoft.

▪ In general, investments in intangible assets are expensed under US GAAP.

▪ An exception is software development costs, but company practice varies greatly.

▪ We did an example of making software development expense comparable by adjusting


Cerner’s useful life assumptions.

▪ We will see in the acquisitions class that intangible assets go on balance sheet when a
company buys them from another company.

24
15.516x Financial Accounting
Statement of Cash Flows

John Core
MIT Sloan School of Management

25
This class: Statement of Cash Flows

Understand the purpose of the statement of cash flows

Understand the three sections of the statement

Understand how cash flow from operations reconciles with net income

26
Motivation -- Recall Peters Company example
NI = CFO + Accruals
Performance Measure Year 1 Year 2 Total

Net Income…………… 3 7 10

Minus: Cash Flow from


Operations (CFO)……. 8 2 10

Accruals……………….. -5 5 0
Accruals “reverse”:
Low accruals → higher future net income

27
Motivation
NI = CFO +Accruals (Example 2)
Performance Measure Year 1 Year 2 Total

Net Income…………… 7 3 10

Minus: Cash Flow from


Operations (CFO)……. 2 8 10

Accruals……………….. 5 -5 0
Accruals “reverse”:
High accruals → lower future net income Over the long-term, accruals sum to 0.

28
Motivation
Net income (NI) =
Cash flow from operations (CFO) + Accruals

Accrual “stock-picking” strategy (not on exam):


▪ Buy low accrual stocks (Hi CFO/ Low NI): Type ‘A’

▪ Higher future NI

▪ Sell high accrual stocks (Hi NI / Lo CFO): Type ‘B’

▪ Lower future NI

Return to zero-investment / “hedge” strategy:


▪ What “should it be”? 0% if market understands future NI difference
▪ In practice: about 10% per year

29
Recall Financial Statement Links

30
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
6
7 -1 Div -1 Dividend
EB 31 4 6 5 10 6 4 24 2

31
Financial statement links
A = L + SE

Δ means change from last year to this year.


Δ A = ΔL + ΔSE ΔA means this year’s assets minus last year’s assets

ΔCash = – ΔNon-Cash Assets + ΔL + ΔSE


Amazon’s Performance
▪ How would you evaluate Amazon’s performance from 2014 to 2016?

▪ How about over the last twenty years?

▪ Is Amazon a profitable company?

33
Amazon’s Performance

34
Amazon’s Performance

Measure 2016 2015 2014


Sales 135,987 107,006 88,988

Net Income 2,371 596 -241

Operating cash flow (CFO) 16,443 11,920 6,842

Investing cash flow -9,876 -6,450 -5,065

Financing cash flow -2,911 -3,763 4,432

35
Statement of Cash Flows:
Three Sections
1. Operating: Primary business activities
▪ Selling goods or rendering services
▪ Interest income, dividends received

2. Investing: Acquiring and selling productive assets


▪ Acquisition and disposal of PPE
▪ Purchase/sale of securities: other firms’ stock or debt

3. Financing: Related to external sources of financing


▪ Issuing stock or debt
▪ Payment of dividends and repayment of debt

The statement sums to the actual change in cash and cash equivalents during the year
36
Amazon’s Net Income and Cash Flow from Operations

37
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

38
Zsa Zsa Co – Depreciation Expense
Contra-Asset to record reduction in PPE Values

Assets = Liab S/E


Cash PPE – AccDep = R/E
1/1/06 –20,000 20,000
12/31/06 3,000 –3,000
12/31/07 3,000 –3,000
. . .
. . .
12/31/10 3,000 –3,000

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!

39
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

(6,737– 0)/5 = 1,347 million per year

40
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

41
Amazon’s investing activities –
Purchases of PP&E

42
Why is depreciation increasing over time?
More PP&E (gross) → more depreciation

Why is Amazon growing its PPE?

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.

43
Big tech to get its head out of cloud frenzy
(WSJ, Sept. 29, 2018)

The enormous, “hyperscale” networks owned by Alphabet Inc.’s Google,


Amazon.com, Microsoft and Facebook demand a staggering amount of capital
expenditures.

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.

44
Effect of stock based compensation?
Use the BSE to account for paying an employee $1,000 in cash.

Assets = Liab S/E


Cash PPE – AccDep = CC + R/E
-1,000 -1,000 (wage expense)

Use the BSE to account for selling $1,000 in stock.


1,000 1,000 (stock issuance)

Use the BSE to account for paying an employee $1,000 in stock.


1,000 -1,000 (wage expense)

45
What is working capital?
Working Capital is:
Current Assets - Current Liabilities

Non-Cash Working Capital is:


Current Assets - Cash - Current Liabilities

The non-cash working capital accounts we have covered are:


Accounts Receivable
Inventory
Prepaid Assets

Accounts Payable
Unearned Revenues
46
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

Does this transaction affect cash?


Yes

Does this transaction affect net income?


No
We need to subtract $1,000 from the net income to get CFO.

47
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.

Cash Unearned Revenue


$1,000 $1,000

Does this transaction affect cash?


Yes

Does this transaction affect net income?


No
We need to add $1,000 to net income to get CFO.

48
To arrive at CFO from Net Income
▪ Recall that CFO = NI – Accruals
▪ Starting with NI, add/subtract accruals to get CFO

▪ Start with Net Income


1) Add non cash expenses: expenses that reduce NI but did not require cash
(e.g., depreciation expense and stock compensation)
2) Add/Subtract: any gains or losses associated with investing activities (e.g.,
PP&E disposal)
3) Add/Subtract: changes in non-cash working capital accounts

▪ Arrive at CFO

49
Amazon’s NI to CFO

Measure 2016 2015 2014

Net Income 2,371 596 -241

Depreciation 8,116 6,281 4,746

Stock compensation 2,975 2,119 1,497

Other (935) 367 (134)

Change in WC 3,916 2,557 974

Operating cash flow (CFO) 16,443 11,920 6,842

50
FAANG Stocks
Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG).

51
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.

(Note: R&D is expensed, but investment in original shows is capitalized.)

52
Netflix vs. Amazon 2016
(amounts as a % of sales)
Measure Netflix Amazon

Net Income 2.1% 1.7%

Operating cash flow (CFO) -16.7% 12.1%

Sales (billions) $8.8 $136.0

This is an example of a “common-size” financial statement.


Because Amazon is much larger than Netflix, we scale NI and CFO by sales to compare them.

53
What is Amazon doing with its CFO?

Measure 2016 2015 2014

Beginning cash 15,890 14,557 8,658

Operating cash flow (CFO) 16,443 11,920 6,842

Investing cash flow -9,876 -6,450 -5,065

Financing cash flow -2,911 -3,763 4,432

Ending cash 19,334 15,890 14,557


What is Amazon doing with its CFO?
Investing?

They are buying lots of fixed assets

They also bought some marketable securities.

55
What is Amazon doing with its CFO?
Financing?

Not paying dividends

Raised over $6 billion in debt in 2014… Why when they have a lot of cash?

Some repayments on debt

In 2016 cash increased from $14 billion to $19 billion in cash – perhaps saving
cash for an acquisition (Whole Foods?)

56
Impact of Product Life Cycle on Cash Flows

Where is Amazon on this graph?

57
Amazon focus on Free Cash Flow

“Our financial focus is on long-term, sustainable growth in free cash flows.

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

58
Free Cash Flow

Operating cash flow – capital expenditures = Free cash flow

Amazon:
$16.4 billion – $6.7 billion = $9.7 billion

This is an example of a non-GAAP performance measure.

What does free cash flow mean?


It is the change in cash that can be paid to debtholders and stockholders.

What if it were negative (as in Netflix)?


The company either has to use existing cash or raise extra cash from
debtholders and stockholders.

59
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

Amazon’s free cash flow is an example of a non-GAAP performance measure:


▪ It is not required ; Amazon voluntarily discloses it.
▪ It can be computed in a variety of ways.

More on non-GAAP performance measures in upcoming classes.

60
Netflix vs. Amazon 2016
(amounts as a % of sales)
Measure Netflix Amazon
Net Income 2.1% 1.7%

Operating cash flow (CFO) -16.7% 12.1%

Investing cash flow 0.6% -7.3%

Financing cash flow 12.5% -2.1%

Free cash flow -18.8% 7.1%

Sales (billions) $8.8 $136.0

61
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.”

What does “Thanks to stretched accounts payable” mean?


▪ By not paying off accounts payable, Tesla increased CFO.

Why does “stretched accounts payable” increase free cash flow (FCF)?
▪ Since free cash flow = CFO – capital expenditures, Tesla also increased FCF.

62
Summary

SCF summarizes the sources and uses of cash

▪ Often useful in analyzing a company’s growth, financial health, etc.

▪ Way to evaluate managerial performance: is net income backed up by CFO?

CFO needed for long-term survival of a firm

▪ Future investments are paid for through CFO

▪ You can’t pay bills with net income! Liquidity matters

63
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.

64
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

3. Sell $100 on account (ignore COGS).


+100 0 -100

4. Collect $100 account receivable.


0 +100 +100

5. Receive $100 for goods to be delivered.


0 +100 +100

6. Deliver $100 in goods (ignore COGS).


+100 0 -100

65

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