1.  General

The Company

Digital Generation, Inc. and subsidiaries (the “Company,” “we,” “us” or “our”) is a provider of digital technology services that enable the electronic delivery of advertisements, syndicated programs, and video news releases to traditional broadcasters, online publishers and other media outlets. We also provide digital advertising campaign management solutions to media agencies and advertisers. We provide our customers with an integrated campaign management platform that helps advertisers and agencies simplify the complexities of managing their advertising budgets across multiple digital media channels and formats, including online, mobile, rich media, in-stream video, display and search. We provide our customers with the ability to plan, create, deliver, measure, track and optimize digital media campaigns. We also offer a variety of other ancillary products and services to the advertising industry. Our business has grown largely from acquisitions. See Note 4.

We market our services directly in the United States and through our subsidiaries in several countries, including Canada, Israel, the United Kingdom, France, Germany, Australia, Ireland, Spain, Japan, China, Mexico and Brazil. See Note 12.

Acquisitions

During 2012 and 2011 we completed the following acquisitions:

Each of the acquired businesses has been included in our results of operations since the date of closing.  Due to these acquisitions and related costs, our 2012 and 2011 operating results are not entirely comparable.  See Note 4.

Basis of Presentation

The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and include the accounts of our subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

These financial statements have been prepared by us without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations.  However, we believe the disclosures are adequate to make the information presented not misleading.  The unaudited consolidated financial statements reflect all adjustments, which are, in the opinion of management, of a normal and recurring nature and necessary for a fair presentation of our financial position as of the balance sheet dates, and the results of operations and cash flows for the periods presented.  These unaudited consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011 (“Annual Report”).

Seasonality and Political Advertising

Our business is seasonal, as a large portion of our revenues follow the advertising patterns of our customers.  Revenues tend to be lowest in the first and third quarters, build throughout the rest of the year and are generally the highest in the fourth quarter.  Further, our revenues are affected by political advertising, which peaks every other year consistent with the national, state and local election cycles in the United States.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates, including those related to the recoverability and useful lives of long-lived assets and the adequacy of the allowance for doubtful accounts and credit memo reserves, office closure exit costs, contingent consideration and income taxes. We base our estimates on historical experience, future expectations and on other relevant assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.

In March 2012, we reduced our estimated bonus for 2011 by approximately $1.1 million. The reduction was credited to general and administrative expense in the first quarter.  The revised estimate increased income from continuing operations, net income and diluted earnings per share by $0.6 million, $0.6 million and $0.02, respectively, during the six months ended June 30, 2012.

See Note 5 for a discussion of the risk of a future impairment of our goodwill.

Derivative Instruments

We enter into foreign currency forward contracts to hedge the exposure to the variability in expected future cash flows resulting from changes in related foreign currency exchange rates (principally the exchange rates between the New Israeli Shekel (“NIS”) and the U.S. Dollar). Portions of these transactions are designated as cash flow hedges, as defined by Accounting Standards Codification (“ASC”) Topic 815, “Derivatives and Hedging.”

ASC Topic 815 requires that we recognize derivative instruments as either assets or liabilities in the balance sheet at fair value. These contracts are Level 2 fair value measurements in accordance with ASC Topic 820, “Fair Value Measurements and Disclosures.” For derivative instruments that are designated and qualify as a cash flow hedge (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income (loss), net of taxes, and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings.

Our cash flow hedging strategy is to hedge against the risk of overall changes in cash flows resulting from certain forecasted foreign currency rent and salary payments during the next 12 months. We hedge portions of our forecasted expenses denominated in the NIS with foreign currency forward contracts.  At June 30, 2012, we had $16.4 million notional amount of foreign currency forward contracts outstanding that had a fair value liability balance of $0.6 million. The liability is included in “accrued liabilities” and is expected to be recognized in our results of operations in the next 12 months. It is our policy to offset fair value amounts recognized for derivative instruments executed with the same counterparty.  In connection with our foreign currency forward contracts we have agreed to maintain at least $1.5 million of cash in bank accounts with our counterparty.

Long-Term Investment

On March 29, 2012, we acquired a 17% equity interest in Adagoo Ltd. (“Adagoo”) for $1.0 million.  We also committed to purchase an additional 6% interest (bringing our total equity interest to 23%) for $0.5 million if certain conditions are satisfied.  Adagoo, founded in 2010 and based in Israel, is developing a web-based audience and content measurement platform for publishers.  The platform is being designed to help publishers analyze and classify Internet web sites as to demographics, content categories, and the absence of offensive content.  To date, Adagoo’s revenues have been nominal.  In the short term, we expect Adagoo to continue to report operating losses.  We are accounting for our investment using the equity method of accounting.

Acquisition and Integration Expenses

Acquisition and integration expenses reflect the expenses incurred in acquiring a business (e.g., investment banking fees, legal fees) and costs to integrate the acquired operation (e.g., severance pay, office closure costs) into the Company. A summary of our acquisition and integration expenses are as follows (in thousands):