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Should virtual goods, services and currency have special revenue recognition?

Premise: I've been troubled for some time over the application of physical-world premises to virtual-world interactions.  The E&Y article attached is a case in point; it is concise and informative as to the guidance, but does the guidance make sense?

I'd like to hear input (pros/cons/alternatives) on: should virtual currency and virtual goods be treated differently, and; could any virtual item be better treated as a term, subscription or perpetual software license instead of as a virtual good, and; allowing the speed of the evolution of the industry at this point in time and the degree of estimates required to follow the guidance, does following the guidance provide beneficial insights to external users of the financial statements?

Not included in this (but to me an interesting separate topic) is the importance of the insights provided by the above guidance to managerial accounting

Reference URL: http://www.ey.com/Publication/vwLUAssets/Revenue_recognition_on_the_sale_of_virtual_goods/$FILE/Hot%20Topic%202010-20_BB1929_Sale%20of%20virtual%20goods.pdf

Answers

Topic Expert
Joan Varrone
Title: CFO
Company: Cloud Cruiser
LinkedIn Profile
(CFO, Cloud Cruiser) |

I am troubled by the three different schema being offered in this article; recognize over the life of the game, life of the user or delivery/use of the item. There are serveral issues:\

1) The ability to estimate each of these for a new company as there is no data available which could mean that no revenue is recognized until you can establish a fact pattern. In addition, how much time is sufficient for establishing the pattern as the fall back is to use the life of the game if you cannot provide sufficient evidence for the other two tests.

2) Games are a fast moving and hits driven business which introduces volatility in establishin these metrics. For example you may initially estimate that a game's life is 2 years but competition may shorten that to 1 year or less.

3) These rules involve alot of estimation and can make the back end collection process more complicated than is necessary to run the business. This increases the cost to the company just to satisfy evidence for revenue recognition.

4) How do you handle the situation where free currency or goods are provided. You would have to have a system to determine if free currency was used. Do you then establish an inventory of currency and use LIFO and FIFO rules? Again this introduces back end complexities that are not needed by the business.

5) Given the above, revenue recognition would be choppy and not informative of the health of the business particularly in a fast moving business.

Topic Expert
Keith Perry
Title: Consulting CFO and Business Operations A..
Company: Growth Accelerator
(Consulting CFO and Business Operations Advisor, Growth Accelerator) |

Joan,

I agree on all points...there are paradoxes, perverse incentives, and a whole lot of blind dart throwing involved. What alternatives would you suggest?

BTW...#4 is hilarious!

Ok: new examples to help illustrate the absurdity.
1) Let's say I made buggy whips, and I use the above logic to recognize revenue. If I believe that buggies will be it forever, I'd have to amortize my sale over the life of the whip. If the automobile comes along and the market evaporates and the product life collapses, I end up with a windfall profit that disguises the underlying issues.
2) Let's say I'm a 21st century Mozart and I sell pre-recorded music (a true virtual good). If I believe that people will listen to my music forever, do I never get significant revenue even though my MP3s are flying off the virtual shelves?

Bryan Frey
Title: VP Finance/Corp Controller
Company:
(VP Finance/Corp Controller, ) |

This to me seems like rev rec for other fundamentally new products: you have to build a fact pattern and it will take time. Having done many startups there's nothing so frustrating. Warranty reserves are a great example. if you have a new product and no warranty history, how are you supposed to set a reserve? It can be anywhere from some negligible % of the cost of the item right on up to 100% of the COGS for that item. And you get to argue a position with your auditor and see what they let you get away with. Within the first year, especially with low volumes, you're just waiting and waiting for "proof" to arrive. It may take multiple years to suss it out with different degrees of "proof" each year as your experience builds.

I don't see how you avoid this with virtual goods. Everything needs to be broken down to the salable item level and experience built for each item. Until you have a sufficient fact pattern (which will naturally vary by lots of factors - not the least of which is how difficult your auditor wants to be) for any item you will need to create a hypothesis, pitch it to your auditor and defend it.

The reality of this is that you either a)explain to your investors that revenue doesn't matter - it's all about cash (they don't like that approach), or b)change how you productize your virtual goods. For example, you may take a special gun and change it from a "lifetime" bought good, to a "finite time" good. Thus you buy it for a week/month/year instead of forever. Interestingly No one likes uncertainty of revenue and this is a simple way to make it certain . Ratably recognized, but certain. this could effect the very game itself and how the company allows people to build credit over time, etc.. It's not too hard to see a company making it a bit easier to earn in-game credits if that $20 virtual gun needs to be re-purchased in 12 months rather than lasting forever.

And #4 above from Joan just gives me a headache.

Topic Expert
Joan Varrone
Title: CFO
Company: Cloud Cruiser
LinkedIn Profile
(CFO, Cloud Cruiser) |

Bryan

Thanks; I talked to a gaming CFO a few months ago and he said his investors just look at the cash..so great comment

Bryan Frey
Title: VP Finance/Corp Controller
Company:
(VP Finance/Corp Controller, ) |

That's a breath of fresh air, Joan. I have dealt with too many investors who say "it's all about cash", but their actions speak differently as they continually push for unnatural rev rec. However, that's not to disparage all investors. Many are completely with it and do genuinely get the cash angle and act to optimize operations for cash rather than GAAP.

Topic Expert
Keith Perry
Title: Consulting CFO and Business Operations A..
Company: Growth Accelerator
(Consulting CFO and Business Operations Advisor, Growth Accelerator) |

Bryan:

My last serious-revenue startup...yes, it was all about the cash until we started talking exit. In the exit, it was all about the rev-rec. So, eventually, this will bite us all in the posterior.

On the "proof" aspect, I get your point, but that argument usually comes up with regard to liabilities (warranties et al as you state). Since we're not talking liabilities in any sense here, why do they apply the same logic?

And back...what is the answer (or an answer)? I get the uncertainty...but the structure is (as all have pointed out here) driving the business decisions to a degree, and that seems fundamentally backward.

Bryan Frey
Title: VP Finance/Corp Controller
Company:
(VP Finance/Corp Controller, ) |

That's a fine counterpoint, Keith! So it's not always about cash, indeed.

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