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arisen against the Company in the ordinary course
of business. In the opinion of management, these Year ended June 30,
proceedings will not have a material effect on the
1995 1994 1993
¬nancial position of the Company.
(in thousands)
Interest income $3,920 $1,646 $572
7. Notes Payable Interest expense (1,054) (575) (172)
Other 157 703 (29)
Notes payable at June 30, 1995 totaled $3,023 $1,774 $371
approximately $18 million and consist primarily of
81
Strategy Analysis




2-49 Part 2 Business Analysis and Valuation Tools




9. Income Taxes Deferred income taxes arise because of differ-
ences in the treatment of income and expense items
for ¬nancial reporting and income tax purposes, pri-
The provision for income taxes is attributable
marily relating to deferred subscriber acquisition
to:
and product development costs.
As of June 30, 1995, the Company has net
Year ended June 30,
operating loss carryforwards of approximately $109
1995 1994 1993
million for tax purposes which will be available, sub-
(in thousands)
ject to certain annual limitations, to offset future tax-
Income before
$1,897 able income. If not used, these loss carryforwards
extraordinary item $15,169 $3,832
will expire between 2001 and 2010. To the extent
Tax bene¬t arising
that net operating loss carryforwards, when realized,
from net operat-
America Online




relate to stock option deductions, the resulting bene-
ing loss carry-
forward ” ” (1,133) ¬ts will be credited to stockholders™ equity.
$15,169 $3,832 $ 764 The Company™s income tax provision was com-
puted on the federal statutory rate and the average
Current $ ” $ ” $ 765
Deferred 15,169 3,832 759 state statutory rates, net of the related federal bene-
¬t.
$15,169 $3,832 $ 764
Effective July 1, 1993 the Company changed its
The provision for income taxes differs from the method of accounting for income taxes from the
amount computed by applying the statutory federal deferred method to the liability method required by
income tax rate to income before provision for FASB Statement No. 109, “Accounting for Income
income taxes and extraordinary item. The sources Taxes.” As permitted under the new rules, prior
and tax effects of the differences are as follows: years™ ¬nancial statements have not been restated.
No increase to net income resulted from the
Year ended June 30,
cumulative effect of adopting Statement No. 109 as
1995 1994 1993 of July 1, 1993. The deferred tax asset increased by
approximately $5,965,000 as a result of the adop-
(in thousands)
tion. Similarly, the deferred tax liability, stockholders™
Income tax at the
federal statutory equity and the valuation allowance increased by
rate of 34% $ (6,283) $2,170 $ 781 approximately $3,173,000, $759,000 and
State income tax, net $2,033,000, respectively.
of federal bene¬t 1,597 403 200
Deferred income taxes re¬‚ect the net tax effects
Losses relating to
of temporary differences between the carrying
RCC ” 1,259 916
amounts of assets and liabilities for ¬nancial report-
Nondeductible
merger expenses 750 ” ” ing purposes and the amounts used for income tax
Nondeductible purposes. Signi¬cant components of the Company™s
charge for pur- deferred tax liabilities and assets are as follows:
chased research
and development 17,114 ” ”
Loss, for which no
tax bene¬t was
derived 1,632 ” ”
Other 359 ” ”
$15,169 $3,832 $1,897
82 Strategy Analysis




2-50
Strategy Analysis




13. Subsequent Event
Year ended June 30,
1995 1994
On August 23, 1995, the Company entered
(in thousands)
into a stock purchase agreement to purchase
Deferred tax liabilities:
Ubique, Ltd., an Israeli company. The Company has
Capitalized software costs $ 7,008 $ 2,962
agreed to pay approximately $15 million ($1.5 mil-
Deferred member acquisi-
lion in cash and $13.5 million in common stock) in
tion costs 28,619 9,880
the transaction, which is to be accounted for under
Net deferred tax liabilities $35,627 $12,842
the purchase method of accounting. Subject to the
Deferred tax assets:
results of an in-process valuation, a substantial por-
Net operating loss carry-
tion of the purchase price may be allocated to in-
forwards $39,000 $17,510
process research and development and charged to
Total deferred tax assets 39,000 17,510




America Online
the Company™s operations in the ¬rst quarter of ¬s-
Valuation allowance for
cal 1996.
deferred assets (3,373) (4,668)
Net deferred tax assets $35,627 $12,842




QUARTERLY INFORMATION (unaudited)

Quarter Ended
September 30 December 31 March 31 June 30 Total
Fiscal 1995a
Online service revenues $50,056 $69,712 $99,814 $138,916 $358,498
Other revenues 6,880 6,683 9,290 12,939 35,792
Total revenues 56,936 76,395 109,104 151,855 394,290
Income (loss) from operations 4,623 (35,258) 233 11,108 (19,294)
Net income (loss) 1,481 (38,730) (2,587) 6,189 (33,647)
Net income (loss) per share b $ 0.04 $ (0.20) $ ( 0.07) $ 0.13 $ (0.99)

Fiscal 1994
Online service revenues $14,299 $20,292 $28,853 $37,549 $100,993
Other revenues 4,780 4,239 2,836 2,874 14,729
Total revenues 19,079 24,531 31,689 40,423 115,722

Income from operations 531 520 1,931 1,626 4,608
Net income 303 70 1,272 905 2,550
Net income per shareb $ 0.01 $” $ 0.03 $ 0.02 $ 0.07
a. Historical financial information for amounts previously reported in fiscal 1995 has been adjusted to account for pooling of interest
transactions.
b. The sum of per-share earnings (loss) does not equal earnings (loss) per share for the year due to equivalent share calculations which are
impacted by the Company™s loss in 1995 and by fluctuations in the Company™s common stock market prices.
3
3 Ov e rv ie w o f Ac c ou n t ing An al ys i s
chapter



T he purpose of accounting analysis is to evaluate the degree to which
a ¬rm™s accounting captures its underlying business reality.1 By identifying places where
there is accounting ¬‚exibility, and by evaluating the appropriateness of the ¬rm™s ac-
counting policies and estimates, analysts can assess the degree of distortion in a ¬rm™s
accounting numbers. Another important skill is recasting a ¬rm™s accounting numbers
Business Analysis and 2
Valuation Tools


using cash ¬‚ow and footnote information to “undo” any accounting distortions. Sound
accounting analysis improves the reliability of conclusions from ¬nancial analysis, the
next step in ¬nancial statement analysis.


THE INSTITUTIONAL FRAMEWORK
FOR FINANCIAL REPORTING
There is typically a separation between ownership and management in public corpora-
tions. Financial statements serve as the vehicle through which owners keep track of their
¬rms™ ¬nancial situation. On a periodic basis, ¬rms typically produce three ¬nancial re-
ports : (1) an income statement that describes the operating performance during a time
period, (2) a balance sheet that states the ¬rm™s assets and how they are ¬nanced, and (3)
a cash ¬‚ow statement (or in some countries, a funds ¬‚ow statement) that summarizes the
cash ¬‚ows of the ¬rm. These statements are accompanied by several footnotes and a
message and narrative discussion written by the management.
To evaluate effectively the quality of a ¬rm™s ¬nancial statement data, the analyst
needs to ¬rst understand the basic features of ¬nancial reporting and the institutional
framework that governs them, as discussed in the following sections.


Building Blocks of Accrual Accounting
One of the fundamental features of corporate ¬nancial reports is that they are prepared
using accrual rather than cash accounting. Unlike cash accounting, accrual accounting
distinguishes between the recording of costs and bene¬ts associated with economic ac-
tivities and the actual payment and receipt of cash. Net income is the primary periodic
performance index under accrual accounting. To compute net income, the effects of eco-
nomic transactions are recorded on the basis of expected, not necessarily actual, cash re-
ceipts and payments. Expected cash receipts from the delivery of products or services
are recognized as revenues, and expected cash out¬‚ows associated with these revenues
are recognized as expenses.

3-1




83
84 Overview of Accounting Analysis




3-2
Overview of Accounting Analysis




While there are many rules and conventions that govern a ¬rm™s preparation of ¬nan-
cial statements, there are only a few conceptual building blocks that form the foundation
of accrual accounting. The principles that de¬ne a ¬rm™s assets, liabilities, equities, rev-
enues, and expenses are as follows2:
• Assets are economic resources owned by a firm that (a) are likely to produce future
economic benefits and (b) are measurable with a reasonable degree of certainty.
• Liabilities are economic obligations of a firm arising from benefits received in the
past that are (a) required to be met with a reasonable degree of certainty and (b) at
a reasonably well-defined time in the future.
• Equity is the difference between a firm™s net assets and its liabilities.
The de¬nitions of assets, liabilities, and equity lead to the fundamental relationship
that governs a ¬rm™s balance sheet:
Assets = Liabilities + Equity
While the balance sheet is a summary at one point in time, the income statement sum-
marizes a ¬rm™s revenues and expenses and its gains and losses arising from changes in
assets and liabilities in accord with the following de¬nitions:
• Revenues are economic resources earned during a time period. Revenue recogni-
tion is governed by the realization principle, which proposes that revenues should
be recognized when (a) the firm has provided all, or substantially all, the goods or
services to be delivered to the customer and (b) the customer has paid cash or is
expected to pay cash with a reasonable degree of certainty.
• Expenses are economic resources used up in a time period. Expense recognition is
governed by the matching and the conservatism principles. Under these principles,
expenses are (a) costs directly associated with revenues recognized in the same pe-
riod, or (b) costs associated with benefits that are consumed in this time period, or
(c) resources whose future benefits are not reasonably certain.
• Profit is the difference between a firm™s revenues and expenses in a time period.3
Chapters 4 through 7 discuss the key isues to consider for analyzing accounting poli-
cies and estimates re¬‚ected in the ¬nancial statements. The chapters present each ¬nancial
statement account type (assets, liabilities, equity, revenues, and expenses) separately to re-
¬‚ect the way that analysts typically approach ¬nancial statements. Obviously, however,
there are close links between these types of accounts; these are noted where appropriate.


Delegation of Reporting to Management
While the basic de¬nitions of the elements of a ¬rm™s ¬nancial statements are simple,
their application in practice often involves complex judgments. For example, how
should revenues be recognized when a ¬rm sells land to customers and also provides
customer ¬nancing? If revenue is recognized before cash is collected, how should
85
Overview of Accounting Analysis



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