Amazon.com 2005 Annual Report Download - page 37

SFAS 109, Accounting for Income Taxes, requires that deferred tax assets be evaluated for future realization
and reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many
factors when assessing the likelihood of future realization of our deferred tax assets including our recent
cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carry-forward
periods available to us for tax reporting purposes, and other relevant factors. In accordance with the provisions of
SFAS 109, we allocate our valuation allowance to current and long-term deferred tax assets on a pro-rata basis.
We recorded a tax benefit in 2005 of $90 million, representing $0.22 and $0.21 of basic and diluted earnings
per share, as we determined at year end that certain of our deferred tax assets were more likely than not
realizable. The range of possible judgments relating to valuation of our deferred tax assets is very wide. For
example, had we determined that the weight of available evidence did not support a decision that these deferred
tax assets are realizable; the “Provision (benefit) for income taxes” would have been an expense of $185 million
for 2005 rather than an expense of $95 million for the same period. At December 31, 2005 we continue to have a
valuation allowance of $213 million, which relates primarily to deferred tax assets that would only be realizable
upon the occurrence of future capital gains.
Stock-Based Compensation
As of January 1, 2005, we early adopted SFAS 123(R), which requires us to measure compensation cost for
stock awards at fair value and recognize compensation over the service period for awards expected to vest. The
estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated
estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the
period estimates are revised. We consider many factors when estimating expected forfeitures, including types of
awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ
substantially from our current estimates.
Liquidity and Capital Resources
Our financial focus is on long-term, sustainable growth in free cash flow1. Free cash flow was $529 million
for 2005, which includes the effect of a $40 million patent litigation settlement, compared to $477 million and
$347 million for 2004 and 2003. Operating cash flows and free cash flows can be volatile and are sensitive to
many factors, including changes in working capital and timing of capital expenditures. Working capital at any
specific point in time is subject to many variables, including seasonality, the timing of expense payments,
discounts offered by vendors, vendor payment terms, and fluctuations in foreign exchange rates.
Our principal sources of liquidity are cash flows generated from operations and our cash, cash equivalents,
and marketable securities balances, which, at fair value, were $2.0 billion and $1.8 billion at the end of 2005 and
2004. Amounts held in foreign currencies were $905 million and $970 million at the end of 2005 and 2004, and
were primarily Euros, British Pounds, and Yen.
Prior to the adoption of SFAS 123(R), cash retained as a result of tax deductions relating to stock-based
compensation was presented in operating cash flows, along with other tax cash flows. SFAS 123(R)
supersedes prior guidance and requires tax benefits relating to excess stock-based compensation deductions to be
prospectively presented in the statement of cash flows as financing cash inflows, which is effectively a
reclassification between operating cash flows and financing cash flows versus prior presentation. Tax benefits
resulting from stock-based compensation deductions in excess of amounts reported for financial reporting
purposes were $7 million, $8 million, and $4 million for December 31, 2005, 2004, and 2003, with the amount
for 2005 treated as financing cash flows to the detriment of operating cash flow. We expect the corresponding
amount for 2006 to increase substantially and possibly be in excess of $100 million, although the actual amount
1Free cash flow is defined as net cash provided by operating activities less purchases of fixed assets,
including capitalized internal-use software and website development, both of which are presented on our
consolidated statements of cash flows.
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