Amortization of intangibles, and non-GAAP earnings

The main purpose of this case is to give students a clear understanding that accounting changes associated with acquisitions are treated prospectively rather than retrospectively. It is now clear that they are treated prospectively for purposes of recognition on the financial statements, with minimal retrospective disclosure going back two years.

Although the focus of this case is on how to account for the changes in revenue arising from an acquisition, we cannot completely ignore the importance of intangible assets such as goodwill. Footnote 9 indicates that during the seven months it was owned by Microsoft in FY2017, LinkedIn generated operating losses of $948 million. It may seem odd that Microsoft paid almost $27 billion for a business that generates such large losses. Actually, the bulk of LinkedIns operating losses are what Wall Street analysts call GAAP or accounting income (as opposed to non-GAAP income). They relate to the requirement that a portion of the acquisition price be amortized or expensed over a number of years. In the Managements Discussion and Analysis (MD&A) section of the annual report, Microsoft discloses that the bulk of LinkedIn losses were indeed related to amortization of intangible assets (please see table 4).

Table 4. MD&A Disclosure about the nature of LinkedIns operating losses.

MANAGEMENTS DISCUSSION AND ANALYSIS

c

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (p.26)

Operating income included an operating loss of $948 million related to the acquisition of LinkedIn, including $866 million of amortization of intangible assets.

The brief MD&A disclosure above says a lot about the nature of LinkedIns losses. As you will calculate in the brief Work Schedule 3 below, the vast majority of LinkedIns operating losses are attributable to the amortization of intangible assets. You may recall that, using the indirect method, these non-cash losses are removed net income to derive operating cash flows. Wall Street analysts, and some company press-releases, similarly remove these accounting or accrual losses. Removing the amortization of intangibles from gross operating losses results in a much smaller loss, which Microsoft refers to as LinkedIns non-GAAP earnings.

Work Schedule 3. Analysis of LinkedIn GAAP and non-GAAP operating losses	(millions)
LinkedIn 2017 GAAP operating loss (enter as negative amount in parentheses)
Less operating loss related to amortization of intangibles (enter as positive amount)
LinkedIn 2017 non-GAAP loss, excluding amortization of intangibles (Sum of the two amounts)

To summarize, while LinkedIn is generating large GAAP operating losses for Microsoft, the company and analysts are judging the success of the acquisition based on the adjusted non-GAAP earnings. We note that while LinkedIn generated large accounting losses for Microsoft in 2017, it is close to breakeven using the non-GAAP measure (Learning Objective 10). By the second quarter of 2018, LinkedIn was in fact generating significant non-GAAP operating profits.