Introduction:

On December 8, 2016, for Microsoft Corporation (Microsoft) bought LinkedIn Corporation ("LinkedIn") for $27 billion in cash. LinkedIn continued to operate, as a subsidiary of Microsoft.

The financial reports for LinkedIn Corporation ("LinkedIn") and Microsoft Corporation ("Microsoft") illustrate how accounting standards related to acquisitions and intangible assets can affect the comparability of revenues, earnings, and assets over time. This case is suitable for use in advanced accounting or financial statement analysis courses.

LinkedIn Corporation

According to a LinkedIn company history[1], LinkedIn was started in by Reid Hoffman and a few former colleagues in 2002, and launched its website in 2003. It first became profitable in 2006. It began international operations in 2008, with an office in London and Spanish and French versions of its website. By 2010, it had 90 million members, and around 1,000 employees in ten offices around the world. It became a public company, listed on the New York Stock exchange, in 2011. By the end of 2013, when it was ten years old, it had 225 million members.

In 2015, according to the 2015 Form 10-K, LinkedIn acquired Lynda.com, a company that offered a library of professional training courses and videos, for approximately $1.5 billion in a part-cash, part-stock purchase.

The 2015 LinkedIn Form 10-K (p.4) describes the company as follows:

We are the world's largest professional network on the Internet with over400 millionmembers in over200countries and territories as of the date of this Annual Report on Form 10-K. We believe we are the most extensive, accurate and accessible network focused on professionals. LinkedIn's value proposition for our members and customers is simple: connect to opportunity. Members use our platform to stay connected and informed, advance their career and work smarter.

We provide many of our products at no cost to members with the belief that our freemium business model drives the most value for our members. In return, member growth and engagement strengthens the network effect that can benefit each individual LinkedIn member.

The critical mass of our network also enables us to create value for our customers through three distinct product lines: Talent Solutions, which includes Hiring and Learning & Development, Marketing Solutions, and Premium Subscriptions. Our products are sold through two channels, an offline field sales organization that engages both large and small enterprise customers; and an online channel where enterprise customers, small business, and individual members purchase products on a self-serve basis. We seek to create reciprocal value with our products between members and customers. We believe this builds mutually aligned incentives and marketplace dynamics supporting our long-term financial objectives of sustainable revenue and earnings growth.

According to the 2015 Form 10-K, LinkedIn obtained revenues from a combination of fees for certain services and from selling the ability to market to its membership base. The company described its product lines as "Talent Solutions, Marketing Solutions, and Premium Subscriptions":

Our Talent Solutions include Hiring and Learning & Development ("L&D"). Hiring provides products to recruiters that enable them to attract, recruit, and hire talent. L&D, from our acquisition of Lynda.com, provides subscriptions to enterprises and individuals to online education courses. Our Marketing Solutions enable enterprises and individuals to advertise to our member base through relevant content. Our Premium Subscriptions (inclusive of Sales Solutions) enable professionals to manage their professional identity, grow their network, and connect with talent, while Sales Navigator, our premium social selling solution, enables sales professionals to find leads and generate sales. (p.43)

As a technology company, LinkedIn had developed a variety of intangible assets. It had developed a variety of trade secrets, copyrights, trademarks, patents, and other forms of intellectual property (LinkedIn 2015 From 10-K, p. 12).

Table 1 shows key financial statistics for LinkedIn, drawn from both its SEC filings on Form 10-k for 2014 and 2015, and its last quarterly report (September 30, 2016) before being acquired by Microsoft. The company typically reported both income on a U.S. GAAP basis, and "adjusted EBITDA". The Adjusted EBITDA data do not include various factors which reduce net GAAP income, including depreciation, amortization, interest expenses, stock compensation expenses, and income taxes.

One thing that affected the fiscal 2015 and 2016 data is the acquisition of Lynda.Com on May 14, 2015 for about $1.5 billion in cash and stock. (2015 Form 10-K, pages 86-87). LinkedIn allocated $1,126 million to goodwill, and the following significant amounts to various definite-lived intangible assets:

$ 164 million to enterprise subscriber relationships (4-year life)

$ 57 million to individual subscriber relationships (2-year life)

$98 million to "Content", with a 3-year life

$39 million to developed technology (2-year life)

Because the acquisition occurred part way through LinkedIn's year, LinkedIn only recorded revenues and expenses from Lynda.Com from May 14, 2015 through December 31, 2015. LinkedIn included $107 million of Lynda.com revenue, and a net loss of $82 million related to Lynda.com in its 2015 Form 10-K, and nothing in the 2014 data. However, on a pro forma basis, LinkedIn indicated what its revenues and net income would have been if Lynda.com had been acquired at January 1, 2014.

Millions2014201420152015

As reportedProformaAsreportedPro Forma

Revenues2,2182,3562,9913,073

Net Income(Loss)(16)(173)(166)(177)

Microsoft History

Microsoft was founded in 1975 by Bill Gates and Paul Allen. It began producing its DOS operating system in 1981 and Windows in 1985.It first went public in 1986. Over time, it became so dominant in software for personal computers that the U.S. government sued it for antitrust violations in 1998. That case was settled in 2001. Over time, the company branched out into producing Xbox gaming consoles (2001), the Bing search engine (2009), the Windows phone (2009), and Surface tablets (2012).[2]

Microsoft in 2018 was one of the world's most valuable companies. According to Fortune, in March of 2018 Microsoft was the fourth most valuable U.S. publicly traded company, with a market capitalization of $717 billion.[3]

While Microsoft had many successes over the years, it did not universally succeed in every area. In particular, Apple and Samsung smartphones were more successful than Microsoft's Windows Phone. On April 24, 2014, Microsoft paid $9.5 billion to buy Nokia's phone business. The phone business did not work out well, and Microsoft took write-offs totaling over $11 billion related to this business in fiscal 2015 and 2016[DT1].

In 2016, Microsoft's Form 10-K indicated it operated in 190 countries, and offered a range of products. These included operating systems, software such as its Office products, video games, devices such as tablets and gaming consoles, and cloud-based services.

Its Form 10-K indicated that it saw the following as its areas for future growth:

"Delivering new productivity and business processes to improve how people communicate, collaborate, learn, work, play, and interact with one another."

"Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals."

"Establishing the Windows platform across servers and devices, both our own and third-party, and the cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market."

"Developing new devices that have increasingly natural ways to interact with them, including speech, pen, gesture, and augmented reality holograms."

"Applying machine learning to make technology more intuitive and able to act on our behalf to understand and interpret our needs using natural methods of communication."

In 2016, Microsoft was profitable, but its 2016 revenue was about $8 billion lower than in 2015. Its 2016 profits of approximately $16 billion were higher than 2015's, but were significantly below the 2014 and 2013 net income of around $22 billion. These results may have made the prospects of a major acquisition more attractive to Microsoft.

The Acquisition of LinkedIn

LinkedIn faced various challenges in 2016. Its 2015 Form 10-K noted such potential risk factors as the growing competition in social networks, the challenges of adapting its platform for use on mobile devices, and the need to continue to develop new products. The company warned that it expected its rate of revenue growth to slow in the future. It also noted that, due to the costs of investing in long-term growth, it had had operating losses in 2015, and expected to have operating losses in 2016 as well on a U.S. GAAP basis.

LinkedIn's stock fell significantly in 2016 from its highs in previous years. Its stock price, which had been as high as $276.18 in the first quarter of 2015 fell to $225.18 as of December 31, 2015, per the 2015 Form 10-K. On February 5, 2016, the stock fell to $108.38 after a disappointing report of future earnings and revenue prospects.[4]

According to news reports, serious discussions began between LinkedIn and Microsoft that same month, February, 2016, with a meeting between the two companies' CEOs. Over the next several months, LinkedIn also had talks with three other potential buyers: Salesforce, Google, and Facebook. As a result of the bidding between these companies, the price per share that LinkedIn's shareholders received increased from an initial offer of around $160 per share to Microsoft's eventual winning offer of $196 per share.[5]

On June 13, 2016 Microsoft and LinkedIn announced that the two companies agreed on a friendly acquisition of LinkedIn by Microsoft.In an interview, Microsoft CEO Satya Nadella said that he long admired LinkedIn and had been contemplating an acquisition for a long time.[6]LinkedIn founder Reid Hoffman also supported the acquisition and eventually joined Microsoft's board.[7]In its press release announcing the acquisition, Microsoft made it clear that it was buying LinkedIn for its long term strategic potential, rather than for its immediate contribution to the bottom line:

Microsoft expects the acquisition to have minimal dilution of ~1 percent to non-GAAP earnings per share for the remainder of fiscal year 2017 post-closing and for fiscal year 2018 based on the expected close date, and become accretive to Microsoft's non-GAAP earnings per share in Microsoft's fiscal year 2019 or less than two years post-closing.[8]

The acquisition closed on December 8, 2016 for a final price of $27 billion in cash.[9]This was one of the largest tech acquisitions ever made.[10]Microsoft's fiscal year ends on June 30, 2017 so the first fiscal year affected by the LinkedIn purchase was 2017.

Various articles suggested that the LinkedIn acquisition could be a good strategic fit for Microsoft. Microsoft had the money to help fund LinkedIn's product development, and Microsoft's product lines would benefit from access to the LinkedIn customer base, while LinkedIn's products would benefit with greater integration of Microsoft's Office and Outlook products.[11]

Microsoft's Accounting for the Purchase of LinkedIn

A key accounting decision is how to allocate the purchase price, which in this case was approximately $27 billion. Microsoft's 2018 Form 10-K indicates it allocated $16,803 million of the purchase price to goodwill, and another $7,887 million to intangible assets. The values and lives of the major intangible assets acquired were as follows:

Type$(millions)Life

Customer-related$3,6077 years

Marketing-related (tradenames)2,14820 years

Technology-based2,1093 years

Contract-based235 years

Totals7,8879 years on average

Microsoft included operating results from LinkedIn in its consolidated income statements and cash flow statements from the December 6, 2016 date of acquisition onwards, as required by GAAP. In addition, as required by U.S. GAAP, Microsoft's 2017 Form 10-K reported pro forma information about what its revenues and net income would have if LinkedIn had been acquired on the first day of the year ending June 30, 2016.

MillionsFY2016FY2016FY2017FY 2017

As reportedProformaAs reportedPro Forma

Revenues85,32088,65289,95091,668

Net Income(Loss)16,79815,38321,20420,894

LinkedIn's performance after being acquired

Because it was no longer an independent company, LinkedIn did not file any financial statements after its last Form 10-Q, for the nine months ended September 30, 2016. However, information from Microsoft's Management's Discussion and Analysis in the Form 10-K for the year ended June 30, 2018 gives some information about LinkedIn's revenues and operating expenses.

As required by U.S. GAAP, Microsoft included LinkedIn's revenues and expenses in its consolidated income statements from the date of acquisition onwards. For Microsoft, this meant 204 days of LinkedIn results were included in its June 30, 2017 financial results, and a full year's worth of LinkedIn's results were included in the June 30, 2018 income statement. As shown in Table 1, Microsoft reported that LinkedIn revenues for these two periods were $2,271 and $5,300 million, respectively, and that operating losses from LinkedIn were $924 and $987 million, respectively. Included in these figures were amortization expenses of $866 and $1,500.

According to a CBS News story^[12]on February 1, 2018, over a year after the acquisition, Microsoft's CFO and CEO were "effusive" about LinkedIn's performance, and said it had been performing better than expected. They claimed that not only was LinkedIn's revenue growing, but LinkedIn was also helping Microsoft's other product lines.

Microsoft's change in revenue recognition policy

In 2018, Microsoft chose be an early adopter of a FASB standard with effects on the timing of revenue on Windows 10. Microsoft restated its financial statements for the two prior years to reflect this change. According to the 2018 Form 10-K:

We elected to early adopt the standard effective July1,2017, using the full retrospective method, which required us to restate each prior reporting period presented. We implemented internal controls and key system functionality to enable the preparation of financial information on adoption.

The most significant impact of the standard relates to our accounting for software license revenue. Specifically, for Windows 10, we recognize revenue predominantly at the time of billing and delivery rather than ratably over the life of the related device. For certain multi-year commercial software subscriptions that include both distinct software licenses and SA, we recognize license revenue at the time of contract execution rather than over the subscription period. Due to the complexity of certain of our commercial license subscription contracts, the actual revenue recognition treatment required under the standard depends on contract-specific terms and in some instances may vary from recognition at the time of billing. Revenue recognition related to our hardware, cloud offerings (such as Office 365), LinkedIn, and professional services remains substantially unchanged.

For 2017, the restatement resulted in $6,621 million additional revenue, $2,467 additional tax expense, and $4,285 additional net income, compared to what was originally reported. For 2016, the restatement added $5,834 million to previously reported revenues, $2,147 to income tax expense, and $3,741 to previously reported net income.

Requirements

Using the FASB Codification

In this case, LinkedIn and Microsoft followed GAAP. Your task is to identify the exact part of the FASB codification that contains the applicable rules.For each question, cite the section number, and cut and paste the rule into your answer.What section of the codification requires:

1. Internally developed intangible assets should NOT usually be recorded as assets?
2. As of the date of an acquisition, the acquirer should allocate the purchase price to assets acquired based on their fair values?
3. Companies must amortize intangible assets with a definite life over their useful lives?
4. Goodwill should not be amortized?
5. Income from an acquired subsidiary should be reported by the acquirer from the date of acquisition onwards
6. A pro forma disclosure is required by an acquirer of revenues and income as if the acquisition had occurred as of the first day of the prior year.
7. Changes in accounting principles should be reflected retrospectively, by restating prior years.

Impact of GAAP rules on comparability of LinkedIn income over time

1. LinkedIn's September 30, 2016 Form 10-Q balance sheet data reported certain items very differently from the way that Microsoft allocated its purchase price to LinkedIn's assets and liabilities as of December 6, 2016.
2. Compare intangible assets, as reported as of September 30 and December 6. What is the difference in amount, and why do you think this occurred?
3. Compare goodwill, as reported as of the two dates. What is the difference, and why do you think it occurred?
4. Compare shareholder's equity as of September 30, 2016 to the purchase price paid by Microsoft of $27 billion.
5. What is the difference in amount?
6. Why do you think that the balance sheet equity amount is so far below the amount Microsoft was willing to pay?
7. Compare the annualized income statement data for LinkedIn in Table 1 for 2016 to the annualized income statement data of LinkedIn after acquisition by Microsoft in Table 1 for the years ended June 30, 2017 and 2018, and answer the following questions?
8. What is the trend in LinkedIn revenues? Is this consistent with the idea that LinkedIn would benefit by being part of Microsoft?
9. What is the trend in LinkedIn depreciation nd amortization expenses? What do you think explains the difference in the level of these expenses before and after the acquisition date?
10. What is the trend in LinkedIn operating income? What might explain this trend?
11. Explain why you agree, or disagree, with the following statement: LinkedIn was doing far better under its own management than under Microsoft, because the annualized net operating loss for 2016 was only $65 million, but the losses ballooned to $1,635 million in Microsoft's fiscal 2017, and were still $987 million in fiscal 2018. Since LinkedIn's revenues grew, the increased losses must be because management allowed excessive expenses."

Impact of accounting rules on comparability of Microsoft revenues and income

10.The reported revenues of Microsoft include LinkedIn revenues only from December 6, 2016. Compute the percentage growth in Microsoft revenues, in 2014, 2015, 2016, 2017, and 2018, using the following different sets of data:

a.The revenues in the first line of Table 2, which are those originally reported in its Form 10-K's for those years

b.The revenues for Microsoft in Table 2, using the restated revenue data where applicable, and the originally reported data for 2014 and 2015.

c.The same revenues as in "a", but adjust the data for what the impact would have been if LinkedIn revenues had been included since the beginning of 2014. (To do this, use the pro forma revenue data for the 2016 and 2017 years, and use LinkedIn reported revenues for 2015 and 2014 to supplement the Microsoft income data.)

d.The same revenues as in "b", but adjust the data for what the impact would have been if LinkedIn revenues had been included since the beginning of 2014,

11.The reported net income of Microsoft includes LinkedIn data only from December 6, 2016. Compute the percentage growth in Microsoft net income in 2016, 2017, and 2018, using the following different sets of data:

a.The net income data in the first section of Table 2, which were originally reported in its Form 10-K's for those years

b.The net income for Microsoft in the second section of Table 2, using the restated net income data where applicable

c.If you were an analyst, trying to predict future growth, which of these sets of growth rates would you find most useful? Explain your answer.

Critical Thinking about GAAP

Critical Thinking about GAAP

1. One purpose of financial accounting is to provide readers with comparable information to evaluate trends. GAAP requires companies that change accounting principles to restate prior years' results, in the interest of comparability. Microsoft made such a change in 2018. However, GAAP does not require companies to fully restate prior year results after a major acquisition, instead simply requiring pro forma disclosure of revenues and net income as of the start of the prior year.

Discuss whether you feel this difference in the rules about restating prior year results is appropriate. If you do not feel it is appropriate, what change would you suggest in accounting rules?

1. One objective of financial accounting is to provide relevant information for decision-making, including investment decisions by shareholders and potential shareholders. In this case, the balance sheet of LinkedIn showed a shareholders' equity at September 30, 2016 that was much smaller than what Microsoft, after a bidding process, paid for that equity.
2. Discuss whether you feel that the accounting process resulted in a misleading presentation of LinkedIn's equity at September, 30, 2016.
3. If you feel the accounting process could be improved, suggest a way of improving it. If you feel no improvement is feasible or desirable, explain your opinion.
4. One objective of financial accounting is providing relevant information about the operating success or failure of companies. In this case, the measurement of LinkedIn's expenses was very different before and after it was acquired by Microsoft, due principally to differences in the amount of amortization of intangible assets.
5. Discuss whether you believe the measurement of income was better before, or after, the acquisition date? Explain your answer.
6. LinkedIn chose to disclose an alternative measure of its operations, "Adjusted EBITDA." This measure ignores depreciation, amortization, interest, income taxes, and stock compensation expense.
7. Would this measure have been affected the same way as net income by the acquisition accounting done by Microsoft?
8. Do you feel that ignoring amortization provides better information for investors than including amortization? Explain your answer.