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GOOGLE INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included under Item 8 of this Annual Report on Form 10-K. Overview Google is a global technology leader focused on improving the ways people connect with information. We aspire to build products and provide services that improve the lives of billions of people globally. Our mission is to organize the world's information and make it universally accessible and useful. Our innovations in web search and advertising have made our website a top internet property and our brand one of the most recognized in the world. Our Motorola business is comprised of two operating segments. The Mobile segment is focused on mobile wireless devices and related products and services. The Home segment is focused on technologies and devices that provide video entertainment services to consumers by enabling subscribers to access a variety of interactive digital television services. We generate revenue primarily by delivering relevant, cost-effective online advertising. Businesses use our AdWords program to promote their products and services with targeted advertising. In addition, the third parties that comprise the Google Network use our AdSense program to deliver relevant ads that generate revenues and enhance the user experience. We also generate revenues from Motorola by selling hardware products. In December 2012, we entered into an agreement with Arris and certain other persons providing for the disposition of our Motorola Home segment. The transaction is expected to close in 2013. Trends in Our Businesses Advertising transactions continue to shift from offline to online as the digital economy evolves. This has contributed to the rapid growth of our business since inception, resulting in substantially increased revenues, and we expect that our business will continue to grow. However, our revenue growth rate has generally declined over time, and it could do so in the future as a result of a number of factors, including increasing competition, our investments in new business strategies, products, services, and technologies, changes in our product mix, query growth rates and how users make queries, challenges in maintaining our growth rate as our revenues increase to higher levels, and the evolution of the online advertising market, including the increasing variety of online platforms for advertising, and other markets in which we participate. Mobile search queries and mobile commerce are growing dramatically around the world, and consumers are using multiple devices to access information. Over time these trends have resulted in changes in our product mix, including a significant increase in mobile search queries and a deceleration in the growth of desktop queries. We expect that our revenue growth rate will continue to be affected by evolving consumer preferences, as well as by advertising trends, the acceptance by mobile users of our products and services, and our ability to create a seamless experience for both users and advertisers in a multi-screen environment. In addition, if there is a further general economic downturn, this may result in fewer commercial queries by our users and may cause advertisers to reduce the amount they spend on online advertising, including the amount they are willing to pay for each click or impression, which could negatively affect the growth rate of our revenues. We plan to continue to invest aggressively in our core areas of strategic focus. The main focus of our advertising programs is to provide relevant and useful advertising to our users, reflecting our commitment to constantly improve their overall web experience. As a result, we expect to continue to take steps to improve the relevance of the ads displayed on our websites and our Google Network Members' websites. These steps include not displaying ads that generate low click-through rates or that send users to irrelevant or otherwise low quality websites, updating our advertising policies and ensuring their compliance, and terminating our relationships with those Google Network Members whose websites do not meet our quality requirements. We may also continue to take steps to reduce the number of accidental clicks by our users. These steps could negatively affect the growth rate of our revenues. 30-------------------------------------------------------------------------------- Table of Contents Both seasonal fluctuations in internet usage and traditional retail seasonality have affected, and are likely to continue to affect, our business. Internet usage generally slows during the summer months, and commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenues, as well as aggregate paid click and average cost-per-click growth rates. The operating margin we realize on revenues generated from ads placed on our Google Network Members' websites through our AdSense program is significantly lower than the operating margin we realize from revenues generated from ads placed on our websites because most of the advertiser fees from ads served on Google Network Members' websites are shared with our Google Network Members. For the past five years, growth in advertising revenues from our websites has generally exceeded that from our Google Network Members' websites. This trend has had a positive impact on our operating margins, and we expect that this will continue for the foreseeable future, although the relative rate of growth in revenues from our websites compared to the rate of growth in revenues from our Google Network Members' websites may vary over time. Also, the margins on advertising revenues from mobile devices and other newer advertising formats are generally lower than those from desktop computers and tablets. We expect this trend to continue to pressure our margins, particularly if we fail to realize the opportunities we anticipate with the transition to a dynamic multi-screen environment. We conduct our Motorola business in highly competitive markets, facing both new and established competitors. The markets for many of our products are characterized by rapidly changing technologies, frequent new product introductions, changing consumer trends, short product life cycles, consumer loyalty and evolving industry standards. Market disruptions caused by new technologies, the entry of new competitors, consolidations among our customers and competitors, changes in regulatory requirements, changes in economic conditions, supply chain interruptions or other factors, can introduce volatility into our businesses. Meeting all of these challenges requires consistent operational planning and execution and investment in technology, resulting in innovative products that meet the needs of our customers around the world. From an overall business perspective, we continue to invest aggressively in our systems, data centers, corporate facilities, information technology infrastructure, and employees. We increased our hiring in 2012, and we may continue to do so and to provide competitive compensation programs for our employees. Our full-time employee headcount was 32,467 at December 31, 2011 and 53,861 at December 31, 2012, which includes 16,317 headcount from Motorola. Acquisitions will also remain an important component of our strategy and use of capital, and we expect our current pace of acquisitions to continue. We expect our cost of revenues will increase in dollars and may increase as a percentage of revenues in future periods, primarily as a result of forecasted increases in traffic acquisition costs, manufacturing and inventory-related costs, data center costs, content acquisition costs, credit card and other transaction fees, and other costs. In particular, traffic acquisition costs as a percentage of advertising revenues may increase in the future if we are unable to continue to improve the monetization or generation of revenues from traffic on our websites and our Google Network Members' websites. As we expand our advertising programs and other products to international markets, we continue to increase our exposure to fluctuations in foreign currency to U.S. dollar exchange rates. We have a foreign exchange risk management program that is designed to reduce our exposure to fluctuations in foreign currency exchange rates. However, this program will not fully offset the effect of fluctuations on our revenues and earnings. Results of Operations We completed our acquisition of Motorola on May 22, 2012 (the acquisition date). The operating results of Motorola were included in our Consolidated Statements of Income from the acquisition date through December 31, 2012. In December 2012, we entered into an agreement for the disposition of the Motorola Home segment and the related financial results are presented as net loss from discontinued operations in the Consolidated Statements of Income. 31-------------------------------------------------------------------------------- Table of Contents Subsequent to the acquisition in May 2012, we initiated a restructuring plan in our Motorola business. See Note 9 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further discussion of this restructuring plan and the associated restructuring charges. We continue to evaluate our plans and further restructuring actions may occur, which may cause us to incur additional restructuring charges, some of which may be significant. The following table presents our historical operating results as a percentage of revenues for the periods indicated: Year Ended December 31, 2010 2011 2012 Consolidated Statements of Income Data: Revenues: Google (advertising and other) 100.0 % 100.0 % 91.8 % Motorola Mobile (hardware and other) 0 0 8.2 Total revenues 100.0 % 100.0 % 100.0 % Costs and expenses: Cost of revenues-Google (advertising and other) 35.5 34.8 34.2 Cost of revenues-Motorola Mobile (hardware and other) 0 0 6.9 Research and development 12.8 13.6 13.5 Sales and marketing 9.5 12.1 12.2 General and administrative 6.8 7.2 7.8 Charge related to the resolution of Department of Justice investigation 0 1.3 0 Total costs and expenses 64.6 69.0 74.6 Income from operations 35.4 31.0 25.4 Interest and other income, net 1.4 1.5 1.3 Income from continuing operations before income taxes 36.8 32.5 26.7 Provision for income taxes 7.8 6.8 5.2 Net income from continuing operations 29.0 25.7 21.5 Net loss from discontinued operations 0 0 (0.1 ) Net income 29.0 % 25.7 % 21.4 % Revenues The following table presents our revenues, by revenue source, for the periods presented (in millions): Year Ended December 31, 2010 2011 2012 Google: Advertising revenues: Google websites $ 19,444 $ 26,145 $ 31,221 Google Network Members' websites 8,792 10,386 12,465 Total advertising revenues 28,236 36,531 43,686 Other revenues 1,085 1,374 2,353 Total Google revenues (advertising and other) $ 29,321 $ 37,905 $ 46,039 Motorola Mobile: Total Motorola Mobile revenues (hardware and other) 0 0 4,136 Total revenues $ 29,321 $ 37,905 $ 50,175 32 -------------------------------------------------------------------------------- Table of Contents The following table presents our revenues, by business, as a percentage of total revenues for the periods presented: Year Ended December 31, 2010 2011 2012 Google (advertising and other) 100 % 100 % 92 % Motorola Mobile (hardware and other) 0 % 0 % 8 % Total revenues 100 % 100 % 100 % The following table presents our Google revenues, by revenue source, as a percentage of total Google revenues for the periods presented: Year Ended December 31, 2010 2011 2012 Advertising revenues: Google websites 66 % 69 % 68 % Google Network Members' websites 30 % 27 % 27 % Total advertising revenues 96 % 96 % 95 % Google websites as % of advertising revenues 69 % 72 % 71 % Google Network Members' websites as % of advertising revenues 31 % 28 % 29 % Other revenues 4 % 4 % 5 % Our revenues increased $12,270 million from 2011 to 2012. This increase resulted primarily from an increase in advertising revenues generated by Google websites and Google Network Members' websites and, to a lesser extent, an increase in other revenues driven by hardware product sales. The increase in advertising revenues for Google websites and Google Network Members' websites resulted primarily from an increase in the number of paid clicks through our advertising programs, partially offset by a decrease in the average cost-per-click paid by our advertisers. The increase in the number of paid clicks generated through our advertising programs was due to an increase in aggregate traffic including mobile queries, certain monetization improvements including new ad formats, the continued global expansion of our products, advertisers, and user base, as well as an increase in the number of Google Network Members. The decrease in the average cost-per-click paid by our advertisers was driven by various factors, such as the general strengthening of the U.S dollar compared to certain foreign currencies (primarily the Euro), the revenue shift mix between Google websites and Google Network Members' websites, the changes in platform mix due to traffic growth in mobile devices, where the average cost-per-click is typically lower compared to desktop computers and tablets, and the changes in geographical mix due to traffic growth in emerging markets, where the average cost-per-click is typically lower compared to more mature markets. In addition, the increase in our revenues from 2011 to 2012 resulted from the inclusion of revenues from our Motorola Mobile business of $4,136 million. Our revenues increased $8,584 million from 2010 to 2011. This increase resulted primarily from an increase in advertising revenues generated by Google websites and Google Network Members' websites. The increase in advertising revenues for Google websites and Google Network Members' websites resulted primarily from an increase in the number of paid clicks through our advertising programs and, to a lesser extent, an increase in the average cost-per-click paid by our advertisers. The increase in the number of paid clicks generated through our advertising programs was due to an increase in aggregate traffic, certain monetization improvements including new ad formats, and the continued global expansion of our products, and our advertiser and user base, as well as an increase in the number of Google Network Members. The increase in the average cost-per-click paid by our advertisers was primarily driven by the increased spending from advertisers and a general weakening of the U.S dollar compared to foreign currencies (primarily the Euro, Japanese yen, and British pound), partially offset by the 33 -------------------------------------------------------------------------------- Table of Contents changes in geographical mix due to traffic growth in emerging markets, where the average cost-per-click is typically lower, compared to more mature markets. In addition, the increase in advertising revenues for Google Network Members' websites from 2010 to 2011 was partially offset by the loss of a search partnership and, to a lesser extent, by a search quality improvement made during the first quarter of 2011. Improvements in our ability to ultimately monetize increased traffic primarily relate to enhancing the end user experience, including providing end users with ads that are more relevant to their search queries or to the content on the Google Network Members' websites they visit. For instance, these improvements include increasing site links to be full size links with the URL (uniform resource locator), moving a portion of the first line of the ad to the heading to better promote the content of the ad, providing an option to preview the ad, and moving the ad's URL to a separate line below the heading for greater page format consistency. Aggregate paid clicks on Google websites and Google Network Members' websites increased approximately 34% from 2011 to 2012 and approximately 25% from 2010 to 2011. Average cost-per-click on Google websites and Google Network Members' websites decreased approximately 12% from 2011 to 2012 and increased approximately 3% from 2010 to 2011. The rate of change in aggregate paid clicks and average cost-per-click, and their correlation with the rate of change in revenues, has fluctuated and may fluctuate in the future because of various factors, including the revenue growth rates on our websites compared to those of our Google Network Members, advertiser competition for keywords, changes in foreign currency exchange rates, seasonality, the fees advertisers are willing to pay based on how they manage their advertising costs, changes in advertising quality or formats, and general economic conditions. In addition, traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels, including mobile devices, also contributes to these fluctuations. Changes in aggregate paid clicks and average cost-per-click may not be indicative of our performance or advertiser experiences in any specific geographic market, vertical, or industry. We believe that the increase in the number of paid clicks on Google websites and Google Network Members' websites is substantially the result of our commitment to improving the relevance and quality of both our search results and the advertisements displayed, which we believe results in a better user experience, which in turn results in more searches, advertisers, and Google Network Members and other partners. Revenues by Geography The following table presents our Google domestic and international revenues as a percentage of Google revenues, determined based on the billing addresses of our customers for our Google business: Year Ended December 31, 2010 2011 2012 United States 48 % 46 % 46 % United Kingdom 11 % 11 % 11 % Rest of the world 41 % 43 % 43 % The following table presents our consolidated domestic and international revenues as a percentage of consolidated revenues, determined based on the billing addresses of our customers for our Google business, and shipping addresses of our customers for our Motorola Mobile business: Year Ended December 31, 2010 2011 2012 United States 48 % 46 % 47 % United Kingdom 11 % 11 % 10 % Rest of the world 41 % 43 % 43 % The growth in revenues from the United States as a percentage of consolidated revenues from 2011 to 2012 was primarily as a result of the inclusion of Motorola Mobile revenues which were primarily generated in the United States. 34 -------------------------------------------------------------------------------- Table of Contents The general strengthening of the U.S. dollar relative to certain foreign currencies (primarily the Euro) from 2011 to 2012 had an unfavorable impact on our international revenues. Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $68 million or 1.4% higher and our revenues from the rest of the world would have been approximately $1,211 million or 5.6% higher in 2012. This is before consideration of hedging gains of $18 million and $199 million recognized to revenues from the United Kingdom and the rest of the world in 2012. The general weakening of the U.S. dollar relative to certain foreign currencies (primarily the Euro, Japanese yen, and British pound) from 2010 to 2011 had a favorable impact on our international revenues. Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $129 million, or 3.2%, lower and our revenues from the rest of the world would have been approximately $834 million, or 5.1%, lower in 2011. This is before consideration of hedging gains of $9 million and $34 million recognized to revenues from the United Kingdom and the rest of the world in 2011. Although we expect to continue to make investments in international markets, these investments may not result in an increase in our international revenues as a percentage of total revenues in 2013 or thereafter. See Note 15 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information about geographic areas. Costs and Expenses Cost of Revenues Cost of revenues consists primarily of traffic acquisition costs. Traffic acquisition costs consist of amounts ultimately paid to our Google Network Members under AdSense arrangements and to certain other partners (our distribution partners) who distribute our toolbar and other products (collectively referred to as access points) or otherwise direct search queries to our website (collectively referred to as distribution arrangements). These amounts are primarily based on the revenue share and fixed fee arrangements with our Google Network Members and distribution partners. Certain distribution arrangements require us to pay our partners based on a fee per access point delivered and not exclusively-or at all-based on revenue share. These fees are non-refundable. Further, these arrangements are terminable at will, although under the terms of certain contracts we or our distribution partners may be subject to penalties in the event of early termination. We recognize fees under these arrangements over the estimated useful lives of the access points (approximately two years) to the extent we can reasonably estimate those lives and they are longer than one year, or based on any contractual revenue share, if greater. Otherwise, the fees are charged to expense as incurred. The estimated useful life of the access points is based on the historical average period of time they generate traffic and revenues. Cost of revenues also includes the expenses associated with the operation of our data centers, including depreciation, labor, energy, and bandwidth costs, credit card and other transaction fees related to processing customer transactions, amortization of acquired intangible assets, as well as content acquisition costs. We have entered into arrangements with certain content providers under which we distribute or license their video and other content. In a number of these arrangements, we display ads on the pages of our websites from which the content is viewed and share most of the fees these ads generate with the content providers. We also license content on the pages of our web sites from which the content is sold and share most of the fees these sales generate with content providers. To the extent we are obligated to make guaranteed minimum revenue share payments to our content providers, we recognize as content acquisition costs the contractual revenue share amount or on a straight-line basis, whichever is greater, over the terms of the agreements. In addition, cost of revenues includes manufacturing and inventory-related costs from our Motorola Mobile business. 35-------------------------------------------------------------------------------- Table of Contents The following tables present our cost of revenues and cost of revenues as a percentage of revenues by business, and our traffic acquisition costs, and traffic acquisition costs as a percentage of advertising revenues in the Google business, for the periods presented (dollars in millions): Year Ended December 31, 2010 2011 2012 Cost of revenues-Google (advertising and other) $ 10,417 $ 13,188 $ 17,176 Cost of revenues-Motorola Mobile (hardware and other) 0 0 3,458 Cost of revenues-Google (advertising and other) as a percentage of Google revenues 35.5 % 34.8 % 37.3 % Cost of revenues-Motorola Mobile (hardware and other) as a percentage of Motorola Mobile revenues 0 0 83.6 % Year Ended December 31, 2010 2011 2012 Traffic acquisition costs related to AdSense arrangements $ 6,162 $ 7,294 $ 8,791 Traffic acquisition costs related to distribution arrangements 1,155 1,517 2,165 Total traffic acquisition costs $ 7,317 $ 8,811 $ 10,956 Traffic acquisition costs as a percentage of advertising revenues 25.9 % 24.1 % 25.1 % Cost of revenues increased $7,446 million from 2011 to 2012. The increase was primarily related to the inclusion of manufacturing and inventory-related costs from our Motorola Mobile business of $3,458 million. Additionally, there was an increase in traffic acquisition costs of $2,145 million resulting from more advertiser fees generated through our AdSense program, more traffic directed to our websites, as well as more distribution fees paid. The remaining increase was primarily driven by increase in data center costs, hardware product costs and content acquisition costs. The increase in traffic acquisition costs as a percentage of advertising revenues was primarily the result of a greater increase in traffic acquisition costs related to distribution arrangements compared to the increase in advertising revenues generated by Google websites. The increase in Google cost of revenues as a percentage of Google revenues was also driven by an increase in hardware product costs. Cost of revenues increased $2,771 million from 2010 to 2011. The increase was primarily related to an increase in traffic acquisition costs of $1,132 million resulting from more advertiser fees generated through our AdSense program. The increase was also related to an increase in traffic acquisition costs of $362 million from our distribution arrangements as a result of more traffic directed to our websites, as well as more distribution fees paid. The decrease in traffic acquisition costs as a percentage of advertising revenues was primarily due to an increase in the proportion of advertising revenues from our websites compared to our Google Network Members' websites, more revenues realized from Google Network Members to whom we pay less revenue share, and, to a lesser extent, expiration of an AdSense arrangement under which we paid guaranteed minimum revenue share. In addition, there was an increase in data center costs of $784 million, primarily resulting from the depreciation of additional information technology assets and data center buildings and an increase in labor, energy, and bandwidth costs, and an increase in content acquisition costs of $236 million, primarily related to content displayed on YouTube, partially offset by a decrease in mobile phone costs. 36-------------------------------------------------------------------------------- Table of Contents We expect cost of revenues will increase in dollar amount and may increase as a percentage of total revenues in 2013 and in future periods, primarily as a result of increases in traffic acquisition costs, data center costs, manufacturing and inventory-related costs, content acquisition costs, credit card and other transaction fees, and other costs. Traffic acquisition costs as a percentage of advertising revenues may fluctuate in the future based on a number of factors, including the following: • The relative growth rates of revenues from our websites and from our Google Network Members' websites. • Whether we are able to enter into more AdSense arrangements that provide for lower revenue share obligations or whether increased competition for arrangements with existing and potential Google Network Members results in less favorable revenue share arrangements. • Whether we are able to continue to improve the monetization of traffic on our websites and our Google Network Members' websites. • The relative growth rates of expenses associated with distribution arrangements and the related revenues generated, including whether we share with certain existing and new distribution partners, including mobile distribution partners, proportionately more of the aggregate advertising fees that we earn from paid clicks derived from search queries these partners direct to our websites. Research and Development The following table presents our research and development expenses, and research and development expenses as a percentage of our revenues for the periods presented (dollars in millions): Year Ended December 31, 2010 2011 2012 Research and development expenses $ 3,762 $ 5,162 $ 6,793 Research and development expenses as a percentage of total revenues 12.8 % 13.6 % 13.5 % Research and development expenses consist primarily of compensation and related costs for personnel responsible for the research and development of new and existing products and services. We expense research and development costs as incurred. Research and development expenses increased $1,631 million from 2011 to 2012, which includes $710 million related to Motorola Mobile. The remaining increase of $921 million was primarily due to an increase in labor and facilities-related costs of $359 million, largely as a result of a 15% increase in research and development headcount, an increase in stock-based compensation expense of $213 million, an increase in depreciation and equipment-related expenses of $147 million, and an increase in professional services expense of $66 million. Research and development expenses increased $1,400 million from 2010 to 2011. This increase was primarily due to an increase in labor and facilities-related costs of $875 million, largely as a result of a 23% increase in research and development headcount, including headcount from acquisitions, as well as an increase in employee base salaries of approximately 10%. In addition, there was an increase in stock-based compensation expense of $200 million. We expect that research and development expenses will increase in dollar amount and may increase as a percentage of total revenues in 2013 and future periods because we expect to continue to invest in building the necessary employee and system infrastructure required to support the development of new, and improve existing, products and services. 37-------------------------------------------------------------------------------- Table of Contents Sales and Marketing The following table presents our sales and marketing expenses, and sales and marketing expenses as a percentage of total revenues for the periods presented (dollars in millions): Year Ended December 31, 2010 2011 2012 Sales and marketing expenses $ 2,799 $ 4,589 $ 6,143 Sales and marketing expenses as a percentage of total revenues 9.5 % 12.1 % 12.2 % Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in customer service, sales, and sales support functions, as well as advertising and promotional expenditures. Sales and marketing expenses increased $1,554 million from 2011 to 2012, which includes $678 million related to Motorola Mobile. The remaining increase of $876 million was primarily due to an increase in labor and facilities-related costs of $390 million, largely as a result of a 14% increase in sales and marketing headcount, as well as an increase in advertising and promotional expenses of $288 million. In addition, there was an increase in stock-based compensation expense of $87 million. Sales and marketing expenses increased $1,790 million from 2010 to 2011. This increase was primarily due to an increase in labor and facilities-related costs of $787 million, largely as a result of a 36% increase in sales and marketing headcount, including headcount from acquisitions, as well as an increase in employee base salaries of approximately 10%. In addition, there was an increase in advertising and promotional expenses of $700 million. We expect that sales and marketing expenses will increase in dollar amount and may increase as a percentage of total revenues in 2013 and future periods, as we expand our business globally, increase advertising and promotional expenditures in connection with new and existing products, and increase the level of service we provide to our advertisers, Google Network Members, and other partners. General and Administrative The following table presents our general and administrative expenses, and general and administrative expenses as a percentage of total revenues for the periods presented (dollars in millions): Year Ended December 31, 2010 2011 2012 General and administrative expenses $ 1,962 $ 2,724 $ 3,845 General and administrative expenses as a percentage of total revenues 6.8 % 7.2 % 7.8 % General and administrative expenses consist primarily of compensation and related costs for personnel and facilities, and include costs related to our facilities, finance, human resources, information technology, and legal organizations, and fees for professional services. Professional services are principally comprised of outside legal, audit, information technology consulting, and outsourcing services. General and administrative expenses also include amortization of certain acquired intangible assets. General and administrative expenses increased $1,121 million from 2011 to 2012, which includes $364 million related to Motorola Mobile. The remaining increase of $757 million was primarily due to an increase in amortization of acquired intangible assets of $274 million, an increase in professional services expense of $147 million, the majority of which was related to legal costs, an increase in labor and facilities-related costs of $122 million, primarily as a result of a 11% increase in general and administrative headcount, as well as an increase in stock-based compensation expense of $89 million. General and administrative expenses increased $762 million from 2010 to 2011. This increase was primarily due to an increase in labor and facilities-related costs of $350 million, primarily as a result of a 37% increase in general and administrative headcount and an increase in employee base salaries of approximately 10%, as well as an increase in expense related to professional services of $260 million, the majority of which were related to consulting services and legal costs. In addition, there was an increase in stock-based compensation of $116 million. 38 -------------------------------------------------------------------------------- Table of Contents As we expand our business and incur additional expenses, we expect general and administrative expenses will increase in dollar amount and may increase as a percentage of total revenues in 2013 and future periods. Charge Related to the Resolution of Department of Justice Investigation In connection with a resolution of an investigation by the United States Department of Justice into the use of Google advertising by certain advertisers, we accrued $500 million during the first quarter of 2011, which was paid in August 2011 upon final resolution of that matter. Stock-Based Compensation The following table presents our stock-based compensation, and stock-based compensation as a percentage of revenues for the periods presented (dollars in millions): Year Ended December 31, 2010 2011 2012 Stock-based compensation $ 1,376 $ 1,974 $ 2,649 Stock-based compensation as a percentage of total revenues 4.7 % 5.2 % 5.3 % Stock-based compensation increased $675 million from 2011 to 2012. This increase was primarily due to additional stock awards issued to existing and new employees, awards issued in connection with the acquisition of Motorola, and acceleration of certain awards resulting from Motorola restructuring. Additionally, stock-based compensation expense for the Motorola Home segment was included in net loss from discontinued operations. Stock-based compensation increased $598 million from 2010 to 2011. This increase was largely due to additional stock awards issued to existing and new employees. We estimate stock-based compensation to be approximately $2.5 billion in 2013 and $2.7 billion thereafter. This estimate does not include expenses to be recognized related to employee stock awards that are granted after December 31, 2012 or non-employee stock awards that have been or may be granted. In addition, to the extent forfeiture rates are different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations. Interest and Other Income, Net Interest and other income, net, increased $42 million from 2011 to 2012. This increase was primarily driven by a gain on divestiture of business of $188 million in 2012, an impairment charge related to equity investments of $110 million in 2011, partially offset by an increase in foreign currency exchange loss of $152 million and a decrease in interest income of $99 million. Interest and other income, net increased $169 million from 2010 to 2011. This increase was primarily driven by an increase in interest income of $233 million due to an increase in our cash and investment balances and higher yields, as well as an increase in net realized gains on sales of available-for-sale investments of $69 million, partially offset by an increase in interest expense of $53 million primarily related to our long-term debt program. In addition, we recorded an impairment charge of $110 million related to certain equity investments during the year ended December 31, 2011. The costs of our foreign exchange hedging activities that we recognized to interest and other income, net are primarily a function of the notional amount of the option and forward contracts and their related duration, the movement of the foreign exchange rates relative to the strike prices of the contracts, as well as the volatility of the foreign exchange rates. As we expand our international business, we believe costs related to hedging activities under our foreign exchange risk management program may increase in dollar amount in 2013 and future periods. 39-------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes The following table presents our provision for income taxes, and effective tax rate for the periods presented (dollars in millions): Year Ended December 31, 2010 2011 2012 Provision for income taxes $ 2,291 $ 2,589 $ 2,598 Effective tax rate 21.2 % 21.0 % 19.4 % Our provision for income taxes increased from 2011 to 2012, primarily as a result of increases in federal income taxes, driven by higher taxable income year over year and expiration of the federal research and development credit, partially offset by proportionately more earnings realized in countries that have lower statutory tax rates. Our effective tax rate decreased from 2011 to 2012, primarily as a result of proportionately more earnings realized in countries that have lower statutory tax rates as well as a discrete item related to an investigation by the Department of Justice recognized in 2011, which was not deductible for income tax purposes. Our provision for income taxes increased from 2010 to 2011, primarily as a result of increases in federal income taxes, driven by higher taxable income year over year, partially offset by proportionately more earnings realized in countries that have lower statutory tax rates. Our effective tax rate decreased from 2010 to 2011, primarily as a result of proportionately more earnings realized in countries that have lower statutory tax rates, a decrease in state income taxes, and an increase in federal research and development credits recognized in 2011, partially offset by recognition of a charge related to the resolution of an investigation by the Department of Justice which is not deductible for tax purposes. The federal research and development credit expired on December 31, 2011. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law. Under this act, the federal research and development credit was retroactively extended for amounts paid or incurred after December 31, 2011 and before January 1, 2014. The effects of these changes in the tax law will result in a tax benefit which will be recognized in the first quarter of 2013, which is the quarter in which the law was enacted. Our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates. Our effective tax rate could also fluctuate due to the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service (IRS) and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. See Critical Accounting Policies and Estimates below for additional information about our provision for income taxes. A reconciliation of the federal statutory income tax rate to our effective tax rate is set forth in Note 14 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Net Loss from Discontinued Operations In December 2012, we entered into an agreement with Arris and certain other persons providing for the disposition of the Motorola Home business for total consideration of approximately $2.35 billion in cash and common stock, subject to certain adjustments. The transaction is expected to close in 2013. As a result, the 40 -------------------------------------------------------------------------------- Table of Contents following financial information of Motorola Home was presented as net loss from discontinued operations in the Consolidated Statements of Income. Year Ended December 31, 2012 (In millions) Revenues $ 2,028 Loss from discontinued operations before income taxes (22 ) Provision for income taxes (29 ) Net loss from discontinued operations $ (51 ) Quarterly Results of Operations You should read the following tables presenting our quarterly results of operations in conjunction with the consolidated financial statements and related notes included in Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. You should also keep in mind that our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. Please note that previously reported quarters have been adjusted to show discontinued operations for the disposition of the Motorola Home business. 41 -------------------------------------------------------------------------------- Table of Contents The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2012. This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for fair presentation of our consolidated financial position and operating results for the quarters presented. Both seasonal fluctuations in internet usage and traditional retail seasonality have affected, and are likely to continue to affect, our business. Internet usage generally slows during the summer months, and commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. Quarter Ended Mar 31, Jun 30, Sep 30, Dec 31, Mar 31, Jun 30, Sep 30, Dec 31, 2011 2011 2011 2011 2012 2012 2012 2012 (Inmillions, except per share amounts) (unaudited) Consolidated Statements of Income Data: Revenues: Google (advertising and other) $ 8,575 $ 9,026 $ 9,720 $ 10,584 $ 10,645 $ 10,964 $ 11,526 $ 12,905 Motorola Mobile (hardware and other) 0 0 0 0 0 843 1,778 1,514 Total revenues 8,575 9,026 9,720 10,584 10,645 11,807 13,304 14,419 Costs and expenses: Cost of revenues-Google (advertising and other) 2,936 3,172 3,378 3,702 3,789 3,984 4,440 4,963 Cost of revenues-Motorola Mobile (hardware and other) 0 0 0 0 0 693 1,515 1,250 Research and development 1,226 1,234 1,404 1,298 1,441 1,538 1,879 1,935 Sales and marketing 1,026 1,091 1,204 1,268 1,269 1,413 1,710 1,751 General and administrative 591 648 676 809 757 942 1,020 1,126 Charge related to the resolution of Department of Justice investigation 500 0 0 0 0 0 0 0 Total costs and expenses 6,279 6,145 6,662 7,077 7,256 8,570 10,564 11,025 Income from operations 2,296 2,881 3,058 3,507 3,389 3,237 2,740 3,394 Interest and other income (expense), net 96 204 302 (18 ) 156 253 65 152 Income from continuing operations before income taxes 2,392 3,085 3,360 3,489 3,545 3,490 2,805 3,546 Provision for income taxes 594 580 631 784 655 657 647 639 Net income from continuing operations $ 1,798 $ 2,505 $ 2,729 $ 2,705 $ 2,890 $ 2,833 $ 2,158 $ 2,907 Net income (loss) from discontinued operations 0 0 0 0 0 (48 ) 18 (21 ) Net income $ 1,798 $ 2,505 $ 2,729 $ 2,705 $ 2,890 $ 2,785 $ 2,176 $ 2,886 Net income (loss) per share-basic: Continuing operations $ 5.59 $ 7.77 $ 8.44 $ 8.34 $ 8.88 $ 8.68 $ 6.59 $ 8.83 Discontinued operations 0 0 0 0 0 (0.14 ) 0.05 $ (0.06 ) Net income per share-basic $ 5.59 $ 7.77 $ 8.44 $ 8.34 $ 8.88 $ 8.54 $ 6.64 $ 8.77 Net income (loss) per share-diluted: Continuing operations $ 5.51 $ 7.68 $ 8.33 $ 8.22 $ 8.75 $ 8.56 $ 6.48 $ 8.68 Discontinued operations 0 0 0 0 0 (0.14 ) 0.05 (0.06 ) Net income per share-diluted $ 5.51 $ 7.68 $ 8.33 $ 8.22 $ 8.75 $ 8.42 $ 6.53 $ 8.62 42 -------------------------------------------------------------------------------- Table of Contents The following table presents our unaudited quarterly results of operations as a percentage of revenues for the eight quarters ended December 31, 2012: Quarter Ended Mar 31, Jun 30, Sep 30, Dec 31, Mar 31, Jun 30, Sep 30, Dec 31, 2011 2011 2011 2011 2012 2012 2012 2012Revenues: Google (advertising and other) 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 92.9 % 86.6 % 89.5 % Motorola Mobile (hardware and other) 0 0 0 0 0 7.1 13.4 10.5 Total revenues 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Costs and expenses: Cost of revenues-Google (advertising and other) 34.2 35.1 34.8 35.0 35.6 33.7 33.4 34.4 Cost of revenues-Motorola Mobile (hardware and other) 0 0 0 0 0 5.9 11.3 8.7 Research and development 14.3 13.7 14.4 12.3 13.5 13.0 14.1 13.4 Sales and marketing 12.0 12.1 12.4 12.0 11.9 12.0 12.9 12.2 General and administrative 6.9 7.2 6.9 7.6 7.2 8.0 7.7 7.8 Charge related to the resolution of Department of Justice investigation 5.8 0 0 0 0 0 0 0 Total costs and expenses 73.2 68.1 68.5 66.9 68.2 72.6 79.4 76.5 Income from operations 26.8 31.9 31.5 33.1 31.8 27.4 20.6 23.5 Interest and other income (expense), net 1.1 2.3 3.1 (0.1 ) 1.5 2.1 0.5 1.1 Income from continuing operations before income taxes 27.9 34.2 34.6 33.0 33.3 29.5 21.1 24.6 Provision for income taxes 6.9 6.4 6.5 7.4 6.2 5.5 4.9 4.4 Net income from continuing operations 21.0 % 27.8 % 28.1 % 25.6 % 27.1 % 24.0 % 16.2 % 20.2 % Net income (loss) from discontinued operations 0 % 0 % 0 % 0 % 0 % (0.4 %) 0.1 % (0.2 %) Net income 21.0 % 27.8 % 28.1 % 25.6 % 27.1 % 23.6 % 16.3 % 20.0 % Liquidity and Capital Resources In summary, our cash flows are as follows (in millions): Year Ended December 31, 2010 2011 2012 Net cash provided by operating activities $ 11,081 $ 14,565 $ 16,619 Net cash used in investing activities (10,680 ) (19,041 ) (13,056 ) Net cash provided by financing activities 3,050 807 1,229 At December 31, 2012, we had $48.1 billion of cash, cash equivalents, and marketable securities. Cash equivalents and marketable securities are comprised of time deposits, money market and other funds, including cash collateral received related to our securities lending program, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, and municipalities in the U.S., corporate securities, mortgage-backed securities and asset-backed securities. As of December 31, 2012, $31.4 billion of the $48.1 billion of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we would be required to 43 -------------------------------------------------------------------------------- Table of Contents accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. At December 31, 2012, we had unused letters of credit for approximately $89 million. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months. Our liquidity could be negatively affected by a decrease in demand for our products and services. In addition, we may make acquisitions or license products and technologies complementary to our business and may need to raise additional capital through future debt or equity financing to provide for greater flexibility to fund any such acquisitions and licensing activities. Additional financing may not be available at all or on terms favorable to us. We have a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. As of December 31, 2012, we had $2.5 billion of commercial paper outstanding recorded as short-term debt, with a weighted-average interest rate of 0.2% that mature at various dates through 2013. Average commercial paper borrowings during the year were $2.2 billion and the maximum amount outstanding during the year was $2.7 billion. In conjunction with this program, we have a $3.0 billion revolving credit facility expiring in July 2016. The interest rate for the credit facility is determined based on a formula using certain market rates. As of December 31, 2012, we were in compliance with the financial covenant in the credit facility and no amounts were outstanding. In May 2011, we issued $3.0 billion of unsecured senior notes in three equal tranches, due in 2014, 2016, and 2021, with stated interest rates of 1.25%, 2.125%, and 3.625%. The net proceeds from the sale of the notes were used to repay a portion of our outstanding commercial paper and for general corporate purposes. As of December 31, 2012, the total carrying value and estimated fair value of these notes were $3.0 billion and $3.2 billion. The estimated fair value was based on quoted prices for our publicly-traded debt as of December 31, 2012. We are not subject to any financial covenants under the notes. Cash Provided by Operating Activities Cash provided by operating activities consist of net income adjusted for certain non-cash items, including amortization, depreciation, deferred income taxes, excess tax benefits from stock-based award activities, stock-based compensation expense, as well as the effect of changes in working capital and other activities. Cash provided by operating activities in 2012 was $16,619 million and consisted of net income of $10,737 million, adjustments for non-cash items of $5,172 million, a gain on divestiture of business of $188 million and increase in cash from changes in working capital and other activities of $898 million. Adjustments for non-cash items primarily consisted of $2,692 million of stock-based compensation expense, $1,988 million of depreciation and amortization expense on property and equipment, $974 million of amortization of intangible and other assets, and $188 million of excess tax benefits from stock-based award activities, partially offset by $266 million of deferred income taxes. In addition, the increase in cash from changes in working capital activities primarily consisted of an increase in income taxes, net, of $1,492 million including additional tax obligations accrued, partially offset by an increase in the amount of estimated income taxes we paid during the year, an increase in accrued expenses and other liabilities of $762 million, a decrease in inventories of $301 million, an increase accrued revenue share of $299 million, and an increase in deferred revenue of $163 million. These changes were partially offset by an increase in prepaid revenue share, expenses, and other assets of $833 million including prepayments for certain content arrangements, an increase of accounts receivable of $787 million due to growth in fees billed to our customers, and a decrease in accounts payable of $499 million due to the timing of invoice processing and payments. Cash provided by operating activities in 2011 was $14,565 million and consisted of net income of $9,737 million, adjustments for non-cash items of $4,198 million, and increase in cash from changes in working capital and other activities of $630 million. Adjustments for non-cash items primarily consisted of $1,974 million of stock- 44 -------------------------------------------------------------------------------- Table of Contents based compensation expense, $1,396 million of depreciation and amortization expense of property and equipment, $455 million of amortization of intangible and other assets, $343 million of deferred income taxes, and $110 million related to impairment of equity investments. In addition, the increase in cash from changes in working capital activities primarily consisted of an increase in accrued expenses and other liabilities of $795 million, a net increase in income taxes payable and deferred income taxes of $731 million, an increase in accrued revenue share of $259 million, an increase of $162 million in deferred revenue, and an increase of $101 million in accounts payable. These increases were partially offset by an increase in accounts receivable of $1,156 million due to the growth in fees billed to our advertisers, and an increase in prepaid revenue share, expenses and other assets of $262 million. The increase in income taxes payable and deferred income taxes reflected primarily additional tax obligations accrued, partially offset by estimated income taxes paid during 2011. In addition, we paid $500 million related to the resolution of a Department of Justice investigation during the year. Cash provided by operating activities in 2010 was $11,081 million, and consisted of net income of $8,505 million, adjustments for non-cash items of $2,675 million, and decrease in cash from changes in working capital and other activities of $99 million. Adjustments for non-cash items primarily consisted of $1,376 million of stock-based compensation expense, $1,067 million of depreciation and amortization expense on property and equipment, and $329 million of amortization of intangible and other assets, partially offset by $94 million of excess tax benefits from stock-based award activities. In addition, the decrease in cash from changes in working capital activities primarily consisted of an increase of $1,129 million in accounts receivable due to the growth in fees billed to our advertisers and an increase of $414 million in prepaid revenue share, expenses and other assets. These increases were partially offset by an increase in accrued expenses and other liabilities of $745 million, an increase in accounts payable of $272 million, an increase in accrued revenue share of $214 million, an increase in deferred revenue of $111 million, and a net increase in income tax payable and deferred income taxes of $102 million, which includes the same $94 million of excess tax benefits from stock-based award activities included under adjustments for non-cash items. The increase in accrued expense and other liabilities, accounts payable, accrued revenue share, and deferred revenues are primarily a result of the growth in our business and headcount. The increase in net income taxes payable and deferred income taxes was primarily a result of additional tax obligations accrued, partially offset by the release of certain tax reserves as a result of the settlement of our tax audits for our 2005 and 2006 tax years. As we expand our business internationally, we have offered payment terms to certain advertisers that are standard in their locales but longer than terms we would generally offer to our domestic advertisers. In addition, we continue to evaluate our Motorola restructuring plan, and may incur additional charges, some of which may be significant. This may increase our working capital requirements and may have a negative effect on cash provided by our operating activities. Cash Used In Investing Activities Cash used in investing activities in 2012 of $13,056 million was primarily attributable to cash used in acquisitions and other investments of $11,264 million, including $9,518 million net cash paid in connection with the acquisition of Motorola, and capital expenditures of $3,273 million related primarily to our facilities, data centers, and related equipment. These decreases were partially offset by net maturities and sales of marketable securities of $1,770 million. Also, in connection with our securities lending program, we returned cash collateral of $334 million. See Note 3 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information about our securities lending program. Cash used in investing activities in 2011 of $19,041 million was primarily attributable to net purchases of marketable securities of $12,926 million, capital expenditures of $3,438 million related principally to our facilities, data centers, and related equipment, and cash used in acquisitions and other investments of $2,328 million, including $676 million paid in connection with the acquisition of ITA Software, Inc. Also, in connection with our securities lending program, we returned $354 million of cash collateral. Cash used in investing activities in 2010 of $10,680 million was primarily attributable to net purchases of marketable securities of $6,886 million, capital expenditures of $4,018 million of which $1.8 billion was for the 45-------------------------------------------------------------------------------- Table of Contents purchase of an office building in New York City in December 2010, and remaining amounts related principally to our data centers and related equipment, and cash consideration used in acquisitions and other investments of $1,067 million. Also, in connection with our securities lending program, we received $2,361 million of cash collateral which was invested in reverse repurchase agreements. In order to manage expected increases in internet traffic, advertising transactions, and new products and services, and to support our overall global business expansion, we expect to make significant investments in our systems, data centers, corporate facilities, information technology infrastructure, and employees in 2013 and thereafter. However, the amount of our capital expenditures has fluctuated and may continue to fluctuate on a quarterly basis. In addition, we expect to spend a significant amount of cash on acquisitions and other investments from time to time. These acquisitions generally enhance the breadth and depth of our expertise in engineering and other functional areas, our technologies, and our product offerings. In December 2012, we signed an agreement for the disposition of Motorola Home business for total consideration of approximately $2.35 billion in cash and stock subject to certain adjustments. We expect the transaction to close in 2013. Cash Provided by Financing Activities Cash provided by financing activities in 2012 of $1,229 million was primarily driven by net proceeds of $1,328 million from short-term debt issued under our commercial paper program and excess tax benefits from stock-based award activities of $188 million. This was partially offset by net payments for stock-based award activities of $287 million. Cash provided by financing activities in 2011 of $807 million was primarily driven by net proceeds of $726 million of debt issued and excess tax benefits from stock-based award activities of $86 million. Cash provided by financing activities in 2010 of $3,050 million was primarily driven by $3,463 million of net cash proceeds from the issuance of commercial paper and a promissory note. This was partially offset by $801 million in stock repurchases in connection with our acquisitions of AdMob, Inc. and On2 Technologies, Inc., as well as net proceeds from stock-based award activities of $294 million, and excess tax benefits from stock-based award activities of $94 million. Contractual Obligations as of December 31, 2012 Payments due by period Less than 1-3 3-5 More than Total 1 year years years 5 years (in millions) Operating lease obligations, net of sublease income amounts $ 3,619 $ 466 $ 870 $ 688 $ 1,595 Purchase obligations 2,123 942 943 119 119 Long-term debt obligations 3,401 70 1,121 1,083 1,127 Other long-term liabilities reflected on our balance sheet 236 41 119 40 36 Total contractual obligations $ 9,379 $ 1,519 $ 3,053 $ 1,930 $ 2,877 The above table does not include future rental income of $649 million related to the leases that we assumed in connection with our building purchases. 46-------------------------------------------------------------------------------- Table of Contents Operating Leases We have entered into various non-cancelable operating lease agreements for certain of our offices, land, and data centers throughout the world with original lease periods expiring primarily between 2013 and 2063. We are committed to pay a portion of the related operating expenses under certain of these lease agreements. These operating expenses are not included in the above table. Certain of these leases have free or escalating rent payment provisions. We recognize rent expense under such leases on a straight-line basis over the term of the lease. Certain leases have adjustments for market provisions. Purchase Obligations Purchase obligations represent non-cancelable contractual obligations at December 31, 2012. These contracts are primarily related to distribution arrangements, video and other content licensing revenue sharing arrangements, data center operations and facility build-outs, as well as purchase of inventory. Long-term Debt Obligations Long-term debt obligations represent principal and interest payments to be made over the life of our unsecured senior notes issued in May 2011. Please see Note 4 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further details. Other Long-Term Liabilities Other long-term liabilities consist of cash obligations, primarily the legal settlement with the Authors Guild and the Association of American Publishers (AAP), asset retirement obligations, and milestone and royalty payments owed in connection with certain acquisitions and licensing agreements. In addition to the amounts above, we had long-term taxes payable of $2.1 billion as of December 31, 2012 related to tax positions for which the timing of the ultimate resolution is uncertain. At this time, we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. As a result, this amount is not included in the above table. Off-Balance Sheet Entities At December 31, 2012, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the U.S. (U.S. GAAP). In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our board of directors. 47 -------------------------------------------------------------------------------- Table of Contents Income Taxes We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest. Our effective tax rates have differed from the statutory rate primarily due to the tax impact of foreign operations, state taxes, certain benefits realized related to stock-based award activities, and research and experimentation tax credits. The effective tax rates were 21.2%, 21.0%, and 19.4% for 2010, 2011, and 2012. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust, intellectual property, privacy, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is both probable that a loss has been incurred, and the amount can be reasonably estimated. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material impact on our business, consolidated financial position, results of operations, or cash flows. See Note 11 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information regarding contingencies. Business Combinations We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair values of assets acquired and liabilities assumed, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing certain intangible assets include but are not limited to future expected cash flows from customer relationships and acquired patents and developed technology; and discount rates. Management's estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. 48 -------------------------------------------------------------------------------- Table of Contents Other estimates associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed, as more fully discussed in Note 6 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Impairment of Marketable and Non-Marketable Securities We periodically review our marketable and non-marketable securities for impairment. If we conclude that any of these investments are impaired, we determine whether such impairment is other-than-temporary. Factors we consider to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period and our intent to sell. For marketable debt securities, we also consider whether (1) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, and (2) the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and record the corresponding charge as interest and other income, net. Prior period reclassification Prior period balance related to inventories has been reclassified to conform to the current year presentation. |