Making Sense of Google’s Financial Statements (#BusinessyBrunette HBX Week 3)

Welcome to #BusinessyBrunette! I am currently studying Harvard Business School’s HBX CORe, their online pre-MBA program teaching the fundamentals of financial accounting, business analytics, and economics. Every week I‘ll write up what I’ve learned — making it meaningful & accessible for artists, activists, geeks, nerds, fans, and anyone else who doesn’t fit the MBA Mould. I’m learning as I go, so feel free to critique, comment, tell me if I’ve messed up or did well, mash up, and share! [See the rest of the series here]

Financial Accounting 2 & 3: Recording Transactions & Financial Statements

This section makes use of examples from Business Accounting v 2.0, which is licensed CC-BY-NC-SA but whose original publisher has since requested to remove attribution.

If you are anything like childhood (and sometimes current) me, you may have found financial statements rather boring and inaccessible. No colors, no pictures, no real explanations of what was the deal with all these numbers. Even more recently, despite my entrepreneurial interests, I was scared off by the prospect of preparing financial statements. If I couldn’t read one how was I supposed to write one? What do these numbers mean? WHAT IS THIS GOBBLEDYGOOK AAAAAHHHHH

After going through HBX, I learned: it’s not really all that hard. In fact, knowing how to read financial statements is a very useful skill, not just for anyone who wants to run a business, but also anyone who wants to understand how a business or an organization works. For instance, if you read about Google’s release of their financial data and wanted to know if the reports and analysis are accurate, you can go directly to their financials and see the numbers for yourself.

In fact, we’ll explore Google’s balance sheet and income statement right here! They’ll have their Conference Call for the Fourth Quarter 2015 financials by the time this post is out (Feb 1) but we can get prepared beforehand by learning about how these statements work and practicing on their Third Quarter financials.

Financial Accounting: The Crash Course

The purpose of the balance sheet and the income statement is to give an overview of how your business has performed over a period of time. It is the end product of an accounting process that goes:

1. Identifying Transactions: Knowing what’s happening with your business (What just got sold? What did you buy? Who do you owe?)
2. Understanding Transactions: Understanding the effect those transactions have on your business (Selling an item for cash increases your Cash account and reduces Inventory! A Deferred Revenue situation, like a subscription, goes in chunks from Liabilities to Revenue with each issue sent out!)
3. Creating Journal entry: Writing out each transaction in double-entry style, with each transaction incurring an equal debit and credit (Technically “debit” just means “left side” and “credit” means “right”. Why this is is still a matter of discussion with our class, so if you’re confused, you’re not alone.)
4. Posting to T-Accounts: Taking all the information from journal entries and organizing them into their own accounts
5. Creating Trial Balance: Taking all that data from the T-Accounts and making an overall master document, making sure that all the debits are the same as all the credits
6. Creating Financial Statements: Separating out the information from the trial balance into a number of financial statements, including (but not only!) balance sheets and income statements

Each business will tend to have their own sets of accounts for their needs, but here are some common ones:

• Cash: Money you have at hand to use — not just literal cash, but also cheques and bank account deposits
• Accounts Receivable and Payable: Money that is either owed to you by a customer (Receivable) or that you owe a third party (Payable)
• Inventory: What you have to sell or exchange into cash
• Unearned/Deferred Revenue: When a customer prepays you for a service or product and you are yet to deliver it (e.g. giftcards)
• Prepaid Expenses: Anything the business buys upfront that gets released/claimed in stages (e.g. subscriptions to services)

All of these accounts fall into one of 5 categories:

• Assets: Anything you can use to earn more money for your business. Examples: Cash, Inventory, Equipment, Prepaid Expenses, Accounts/Notes/Interest Receivable
• Liabilities: Anything that involves your business owing money, products, or services to others. Examples: Accounts Payable, Wages Payable, Short-Term/Long-Term Debt, Deferred Revenue
• Owner’s/Shareholder’s Equity: Any money contributed towards the business by the owners or shareholders. Examples: Common/Preferred/Treasury Stock, Paid-In Capital, Retained Earnings
• Revenue: Money well and truly earned from the business that you can then choose to reinvest or keep. Examples: Sales, Rent Revenue (if you’re the landlord)
• Expenses: Money that’s gone out towards the business. Examples: Cost of Goods Sold, Interest and Rent Expenses, Depreciation

Assets and Expenses increase on Debits and decrease on Credits, which means that if your Asset or Expense account grew (for instance, you just got paid Cash) you’d write that amount in Debits, and if you had to take out something from that account (for instance, you selling something also means a loss in Inventory) you’d write that in Credits. Liabilities, Owner’s Equity, and Revenue increase on Credits and decrease on Debits; so for instance if you owe a supplier money that amount goes towards your Credits, and then gets taken off once you pay it off.

This can seem rather counter-intuitive; Assets increase money but Expenses take it away, how can they both be Debits? Wouldn’t Revenue be a Debit? To tell the truth, this is something that the rest of us at HBX are also trying to parse, and we’ve all come up with our own logic for this.

What works for me is understanding that Assets increase on Debits and Liabilities increase on Credit, but to reflect that in double-entry accounting, the other side needs to be the reverse. So if an Asset is also a Revenue (getting cash from someone, for example), the Cash (Assets) account is debited, and to balance it out, the Sales (Revenue) account is credited. At the same time, the loss in Inventory (Assets) account is credited with the amount that it cost — and that amount is recorded in Costs of Goods Sold (Expenses) as a debit. (If you have any other system that works for you, feel free to share.)

So you’d write out your journal entries (usually instead of or in addition to entry numbers, you’d have dates):

(cc-by-nc-sa Anonymous, Business Accounting v 2.0)

Then you take those journal entries and chuck them into T-Accounts organized by type (which also usually have dates as well as beginning balances from the last cycle):

(cc-by-nc-sa Anonymous, Business Accounting v 2.0)

And then you take the overall total of those accounts and organize them into a Trial Balance, writing the totals in where those accounts increase (Assets and Expenses in Debits, Liabilities, Owner’s Equity, and Revenue in Credits):

(cc-by-nc-sa Anonymous, Business Accounting v 2.0)

Basically, everything in the Trial Balance is the totals of all the transactions that happen within particular accounts, and because of the double-entry accounting system, debits and credits should add up.

This is what people mean by “balancing the books” — it’s not about whether you run a profit! It is solely about whether debits equal credits! You could very well be in the red (have a negative balance) and still “balance the books” if both debits and credits are the same. If they’re not, something went wrong in your accounting, and you need to go back to your T-Accounts, journal entries, or even receipts to find the error.

Revenue and Expenses are technically sub-accounts of Owner’s Equity, based on the Accounting Equation of Assets = Liabilities + Owner’s Equity, but they’re considered separate accounts for the purposes of making balance sheets and income statements — which are NOT the same thing!

A balance sheet is the total of all “real” or “permanent” accounts — Assets, Liabilities, and Owner’s Equity — up to a specific point in time. They’re called “real” or “permanent” because they contain information about what your business has to work with from before, right now, and onwards. So if you ended the year with $5000 in Assets and $6000 in Liabilities, those $5000 and $6000 carry over to the next year.

The first important part is the date because you need to know how current this information is. The balance sheet will display your business standing at the date specified. It’s also called a Statement of Financial Position for this reason.

The ordering of the next few sections depends on whose standards you follow. If you are in the U.S., you’d go with the Generally Accepted Accounting Principles (GAAP) set by the Federal Accounting Standards Advisory Board. If you’re elsewhere in the world, you’d go with the International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board. The main differences are:

GAAP: Assets first, Owner’s Equity last, everything ordered by liquidity, Current accounts first
IFRS: Liabilities first, Owner’s Equity is the first section in Liabilities, everything ordered by reverse liquidity, Non-Current accounts first

Liquidity basically means how easy or fast it is for the account to be converted to cash. A Cash account is already, well, Cash, so it’s the most liquid; meanwhile, Property, Plant, and Equipment (PP&E) won’t be sold off for cash anytime soon, so it’s relatively lower in liquidity. With liabilities, you’d think of which would need to get paid off first: Accounts Payable, which indicates money you owe to third parties, would be more liquid than Deferred Income Tax, which can take a while to be paid off.

Current and Non-Current refers to when that asset or liability will be converted into cash or other assets. If an account is Current, it means that it will be converted within either a year or one operating cycle, whichever is longer. (Operating cycles can range from monthly, quarterly, semi-annually, or annually, depending on the business.) Anything longer than that will be Non-Current. If an account is processed in chunks over a period of time, such as a long-term debt, the upcoming chunk — whatever you’re paying off this coming year — will be Current while the rest will be in Non-Current.

Owner’s Equity tends to be laid out pretty similarly whether you use the GAAP system or the IFRS system. You’d usually start with Common Stock/Paid In Capital(proceeds from stock that you sold to shareholders), Partner Capital (for partnership-style businesses), or Contributed Capital (if you’re a sole business owner). Then there’d be other kinds of stock, like Preferred Stock or Treasury Stock. Lastly, there’s Retained Earnings, which is a special case, because it’s the link between your balance sheet and your income statement.

An income statement, sometimes also known as a profit & loss statement, describes the accumulation of all nominal accounts — Revenues and Expenses — over a period of time. The main difference between a balance sheet and an income statement is that the income statement resets to zero after each accounting period.

It’s kind of like the odometer in a car. You could keep it running and have an overall number of how many miles you’ve ever driven in this car, just like a balance sheet. Or you could reset it after every trip and just take note of how far you drive per trip, like an income statement. (Or you could be like this device below and keep track of both numbers in one place, which is sort of like how Retained Earnings work — we’ll get to that soon.)

(cc-by-sa Cybergothiche)

The formats for income statements are pretty similar between GAAP and IFRS; usually, companies have their own ways of organizing and naming their information. There is a general framework common across most income statements:

1. Gross Profit: This is usually a version of Sales Revenue minus Cost of Goods Sold. That’s it! This is not where we go into operation costs or stuff like interest paid, that comes later. Not all businesses will have this — for instance, service-oriented businesses may find it hard to quantify “costs of goods sold” when there’s no physical product sold, and we’ll see with Google’s statements that they’ve decided to call this section something else. But the basic principle holds: it’s the costs and earnings of whatever it is they’re selling.
2. Operating Expenses: This is where we get into the costs of running a business — administration, wages, marketing, rent, insurance, and so on. This only covers anything directly related to running a business: other costs such as interest expenses or foreign exchange losses come later.
3. Operating Income: Gross Profit minus Operating Expenses. This number helps us see if the company’s making enough money to run itself. If the Operating Income is low, or in the negatives, that’s a sign that the business is either spending too much on expenses or not making enough in revenue to cover for it. Maybe they have some expensive equipment they’re not using, or they’re trying to sell something that isn’t well-received, or they’re paying too much for a service they could get at a better rate.
4. Other Income and Expenses: Here we get to stuff that isn’t directly related to the core work of the business, but affects their accounts anyway. For instance, if you run a cafe, and every so often you rent out your kitchen to an indie baker to make cakes for their small business, the money you get from that rent goes here (since your core business isn’t renting out kitchen space). This is also where expenses associated with interest, foreign exchange, and various other financial instruments also get accounted for.
5. Income/Profit Before Taxes: Operating Income plus Other Income. Pretty straightforward.
6. Tax Expenses: How much tax you owe, which is usually dependent on how much profit you’ve made so far. An overly simplified method is to multiply your pre-tax profit with your local income tax rate; in reality, this can usually differ based on your area.
7. Net Income: Profit Before Taxes minus Tax Expense; the amount you have earned for yourself. This is also known as the Bottom Line because this is the number most people are interested in and usually sits at the bottom of the statement. This becomes Retained Earnings!

The process of turning Net Income into Retained Earnings is called Closing the Account. After the end of every accounting period, Revenues & Expenses are closed, the Net Income amount gets transferred to the Retained Earnings section in the balance sheet, and everything in the income statement is reset to zero. So just like that odometer above, the “trip odometer”/income statement is reset, but the “overall odometer”/balance sheet keeps a running tally.

Great! That’s the fundamentals sorted. Now that you know the basics of how some financial statements work, let’s go look at Alphabet’s (Google’s parent company) financials and see if we can make sense of them. We’ll be looking specifically at their Form 10-Q for the quarterly period ending September 30, 2015. Note that while Google is now technically a part of Alphabet, this Form 10-Q is still under their name.

Making Sense of Google’s Financials

Let’s start with the balance sheet:

Note: I trimmed out information about Sept 30 2015 for clarity.

The first interesting thing (of many, I’m sure) about the way Google did their accounting is that they split up their Current Assets by liquidity. The most liquid items — Cash & Cash Equivalents and Marketable Securities (such as common stock or government bonds that Google has bought) — have their own subtotal before all the other assets, which have considerably less worth. They have a lot of money on hand that’s ready to go almost instantly (at the very least, within the coming year).

The other major assets are property and equipment — which makes sense, it’s likely all their servers and hardware and such — and goodwill, which is the value of the company’s brand name, customer base, and overall reputation. You’d normally only really see this when companies change hands and the buyer company is hoping to bank on their purchase’s pre-existing customers and reputation. It makes sense for Google to consider goodwill as an asset, given their status as a household name, and it probably became accountable when they shifted towards being a subsidiary of a larger company. (Though the dollar amount — $15,599 million —is curious. What happened to the other 1 million?)

Their liabilities are a little more evenly spread out, though notice the way they name their accounts. Wages/Salaries Payable are most likely listed under “Accrued compensation and benefits”, and there’s also something called “Commitments and contingencies” that doesn’t have an associated value. This contains funds set aside in case of “potential negative economic events” such as lawsuits, and it’s pretty common for companies to not declare a dollar amount, drawing attention to their notes instead.

Their accounts seem a little sparse on detail here, but if you scroll down their document to the Notes section, you’ll see more specific information for particular accounts, such as property and equipment (land, IT assets, construction, leasehold, furnishings, and depreciation), a Notes Receivable from Lenovo connected to Google’s sale of Motorola Mobile, intangibles (patents, customer relationships, trade names), tax information, and the effects of foreign exchange on their accounts.

Their equity section is pretty straightforward: stock options and retained earnings. Notice the numbers after this section (Liabilities + Equity) and compare them to the numbers after Assets:

Assets = Liabilities + Owner’s Equity
$130,426 million = $130,426 million
Their books are balanced!

Now let’s look at their income statement:

Note: I trimmed out the Nine Months Ended column as well as information about stockholders.

Here we get a comparison of the same three-month period for Revenues and Expenses in 2014 and 2015. This can be useful to see how your business is doing over the years.

Also here you start seeing (parentheses)! These usually indicate a loss or a negative — so you’d need to take away that number from the rest to get your final total.

As mentioned earlier, Google doesn’t use Sales minus Costs of Goods Sold. Instead, they have an upfront Revenues amount — based on their Notes, it’s primarily advertising with a small amount from sales of apps, hardware, and subscriptions — and then they take away all operational expenses, organized here by amount. Their most expensive expense, more than twice the second-highest account, is “Cost of expenses” — according to the Notes:

Cost of revenues consists of traffic acquisition costs which are the advertising revenues shared with our Google Network Members and the amounts paid to our distribution partners who distribute our browser or otherwise direct search queries to our website.

They also count the costs of data center operations, content licensing, credit card fees, hardware inventory, and revenue share with mobile carriers (amongst others) in this account.

The Revenues amount ($16,523M or $18,675M) minus the Costs and Expenses amount ($12,799M or $13,967M) becomes the Income from Operations amount ($3,724M or $4,708<). Granted, these are in the millions, so they’re not as small as they seem. But it does show that Google spends a lot on their expenses, particularly advertising revenue — if you’ve ever gotten money off a Google or YouTube ad, you are part of this account — and not nearly as much on Research & Development or Sales & Marketing.

They still make enough to get by and seem to be decreasing costs some: even though their costs in 2015 are higher than in 2014, they earned more too (both in revenue and in net income), and their expenses were a smaller proportion of their revenue (74% vs 77%). Similarly, their Net Income grew from 2014 to 2015, especially since they no longer had to deal with a $185 million loss from discontinued operations (the Motorola Mobile sale).

You’ll notice here that the Net Income amount here doesn’t match the Retained Earnings amount in the balance sheet. This is mostly because we’re comparing two different timeframes: up till December 31 2014, and up till September 30, 2014. Also, I have trimmed out information about income & expenses from stock options from the income statement screenshot, so that’d affect the total numbers too.

The Notes section is just as interesting here as it was for the balance sheet. For instance, there is this chart about the proportion of net income compared to revenue:

This matches up our earlier calculations about the proportion of expenses to revenue and more usefully demonstrates the jump in income for Google between 2014 and 2015. It also shows that the loss from the sale of Motorola Mobile didn’t make that much of a difference to their accounts, only taking away about 1% of their income. They won’t miss it.

Great! Now you know the basics of reading financial statements. Not only do you understand how businesses build these statements and the thinking process that goes behind them, you can also find the impact of any newsworthy incidents related to the company — for instance, the sale of Motorola Mobile in early 2014 showed up a lot in these documents.

Now when you read a news story about a company, or you get involved with a non-profit organization, or even want to contemplate starting your own business, you’ll know what people mean when they talk about revenue or expenses, you’ll be able to sort out the truth from the BS, and you’ll know where to start researching for more information.

What other insight did you get from Google’s financial statements? Do you have statements of your own you’d like to analyze? How do you write out your financial statements? Feel free to share!

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