Accounting news 08 US GAAP. 02 Czech Accounting 04 IFRS. Winning is a state of mind

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1 Winning is a state of mind Accounting news Czech Accounting, IFRS and US GAAP July 2013, Deloitte Czech Republic 02 Czech Accounting What are the Possible Impacts of the Recodification on Czech Accounting? Invitation Seminar News in Czech Accounting 04 IFRS New IFRIC 21 Levies Amendments to IAS 36 - recoverable amount disclosures for non-financial assets IASB published new lease accounting proposals IFRS EU Endorsement Process Invitation Seminar IFRS News US GAAP Recognizing Revenue From Sales in a Virtual World

2 Czech Accounting What are the Possible Impacts of the Recodification on Czech Accounting? In this edition of the newsletter we would like to give consideration to some possible changes in Czech accounting to be introduced by the new Civil Code (hereinafter the NCC ) and the Business Corporation Act (hereinafter the BCA ) with effect from 1 January The changes discussed below have not been defined in Czech accounting legislation (predominantly in Accounting Act no. 563/1991 Coll. (hereinafter the AA ) and Regulation no. 500/2002 Coll.) to date but now is the right time to open a discussion in the accounting community, which has been slightly kept aside and is waiting with excitement for the changes resulting from amendments to standard legal documents in individual companies. Some areas discussed are outlined below. Report on Relations Although the Report on Relations (the full title of which is the Report on Relations between the Controlling Entity and the Controlled Entity and between the Controlled Entity and Entities Controlled by the Same Controlling Entity, hereinafter the related parties ) is prepared by the statutory body of the controlled entity; in practice, it is usually the Finance Department in a company that must prepare the Report. The Finance Department seeks to find the organisational structure of large holding companies, among other activities, to correctly identify individual relations. For this reason, we have included this issue in the accounting news as we assume that it is the best way to inform people practically responsible for the preparation of the Report on Relations. Had one of the draft versions of the BCA been approved, this section might have been shorter. One of the bills contained a paragraph that would allow the non-preparation of a Report on Relations for a fully-owned subsidiary under certain circumstances. However, this is not the case. Let us now take a closer look at the content of the Report on Relations, which was elaborated on in our Accounting news from February The content of the Report on Relations remains more or less the same as it used to be. In short, let us mention the issues that the Report must contain. They predominantly include: The structure of relations; The task of the controlled entity; The method of control; An overview of acts preformed at the initiative or in the interest of the controlling entity if such acts related to assets representing more than 10% of controlling entity s equity; An overview of mutual agreements; and Assessment of detriment. A precise list of issues is contained in Section 82 (2) of the BCA. If we are to emphasise one of the key changes in the content of the Report, we would mention the acts relating to assets exceeding more than 10% of equity. This clearly indicates that certain acts that have no substantial impact on a company will not have to be described and quantified in the Report. Important changes are defined in subsequent paragraphs of the BCA and relate to the review of the Report on Relations. The first significant change is that, contrarily to the current Commercial Code, the BCA does not stipulate the obligation to have the Report on Relations reviewed by an auditor. The review of the Report by an auditor may thus be agreed voluntarily. However, the Report on Relations continues to be part of the Annual Report. The auditor reviewing the compulsory financial statements of a company under Section 20 of the AA is obligated to review the Annual Report prepared under Section 21 of the AA. As the auditor reviews the Annual Report (in which the Report on Relations is included) for consistency with the financial statements, the auditor is also required to review the Report on Relations for consistency with the financial statements. This deduction results in the conclusion that most companies will not be able to avoid a certain review of the Report on Relations. In the previous paragraph, we intentionally used the phrase saying that the Report on Relations is part of the Annual Report. Section 84 (2) of the BCA stipulates that the Report on Relations is attached to the Annual Report under the accounting legal regulations. What exactly the attachment means is not obvious (at least to us) and for this reason, we would prefer if the Report on Relations continue to be part of the Annual Report, at least in circumstances in which the auditor reviews the Annual Report for consistency with the financial statements. Report on Business Activities A sometimes-neglected part of the Annual Report of joint-stock companies is, under the existing Commercial Code, the company s Report on Business Activities and the Balance of Its Assets as stipulated in Section 192 (2) of Commercial Code. We note that the Report is included in Section 436 (2) of the BCA and must be disclosed similar to the financial statements and always as part of the Annual Report. We discussed this Report in greater detail in our Accounting News from April Registered Capital of a Newly-Established Joint-Stock Company in Euros Now let us focus on an issue that is more accounting than legal. Nevertheless, at the beginning we will mention the relevant legal regulations. Section 246 (2) of the BCA stipulates that the amount of the registered capital of a joint-stock company is at least CZK 2 million or EUR 80,000. The previous section, ie Section 246 (1), stipulates that the registered capital is denominated in Czech crowns. If a joint-stock company maintains its accounting books and records in euros under a special law, it may denominate its registered capital in euros. This indicates that under the BCA, joint-stock companies may denominate their registered capital in euros and this amount will be recorded in the Register of Companies. However, Section 4 (12) of the AA stipulates that entities are obligated to maintain their accounting books and records in the currency units of Czech crowns. The question is whether the proposed amendment to the Accounting Act will adjust this or whether an approach as to when and how to translate the registered capital into Czech crowns will have to be identified in such situations.

3 Czech Accounting Elimination of the Reserve Fund Another area having an impact on accounting is the elimination of the obligation to create a reserve fund by companies with effect from 1 January Under the new law, companies will not be obligated to make compulsory contributions to their reserve funds unless their founding documents voluntarily stipulate otherwise. We have covered this change in our special New Codes Guide distributed by our associated advocate company Ambruz & Dark. This newsletter can be ordered here. The elimination of the reserve fund means that companies may eliminate their existing reserve funds from 1 January Accountants will immediately think of how such elimination of a reserve fund, which is historically created from a company s profit, will be accounted for and whether it may be paid out to the owners. We have already received comments on this issue from our clients. At this moment, the most prudent solution is the one approved by the supreme body of the company (ie the general meeting or owners). In our opinion, a decision on the elimination of the reserve fund should also contain information on whether the released reserve fund is, for example, transferred to other capital funds or retained earnings of prior years or whether it is paid out to shareholders or owners in full or in part. The interpretation of the BCA clearly shows that the supreme body of a company does not necessarily have to make the decision; in such situations, the decision may be made by the company s statutory body. We see no need in describing the additional thoughts of a prudent accountant, who would release a reserve fund. Conclusion The above-discussed issues definitely do not include all changes that will have to be stipulated in legislation in terms of accounting and you may now come across other issues in your companies. We welcome any of your questions or comments and will do our best to respond to them in future newsletters Invitation Seminar News in Czech Accounting Prague, Brno, Ostrava As in prior years, we are preparing a popular seminar on the news in Czech accounting, this year providing a summary in accounting legislation and the legal and tax news having an impact on companies financial statements. The seminar is predominantly intended for accountants, economists and financial managers preparing or involved in the preparation of financial statements under Czech accounting legislation and the related tax and legal regulations and for all of you who want to learn more about Czech accounting and the latest tax and legal developments. Seminars will be held in Czech before the year-end in Prague, Brno and Ostrava and will be delivered by our professionals. We will prepare a detailed programme in summer; this time, we would like to focus on the accounting and recognition of income, corrections of errors of prior years, the impacts of recodification on entities and the approach to recognising post-balance sheet events. Timing Prague: 14 November 2013 and 12 December 2013 Brno: 21 November 2013 Ostrava: 11 December 2013 More detailed information for the prepared seminar will be provided in the September issue of our dreport. 03

4 IFRS New IFRIC 21 Levies On 20 May 2013, the International Accounting Standards Board (IASB) released IFRIC 21 'Levies'. Background A levy is a payment to a government for which an entity receives no specific goods or services. An example of the levy is a bank levy in the United Kingdom and Hungary, fees paid to the Federal Government by pharmaceutical manufacturers in the United States or the railway tax in France. The final Interpretation covers a broad range of levies, rather than a focus on levies charged to participate in a market. The Interpretation has been developed to address concerns about how to account for levies that are based on financial data of a period that is different from that in which the activity that gives rise to the payment of the levy occurs. IFRIC 21 provides guidance on when to recognise a liability for a levy imposed by a government, both for levies that are accounted for in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets and those where the timing and amount of the levy is certain. Requirements of the Interpretation The Interpretation defines a levy as outflow of resources embodying future economic benefits that is imposed by governments on entities in accordance with legislation. Taxes within the scope of IAS 12 Income Taxes are excluded as fines and penalties. Levies cover other non-reciprocal payments to government. Entities are not required to apply the Interpretation to emission trading schemes, however, they may elect to apply it to such schemes as an accounting policy choice. Consistent with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a liability is recognised when an obligating event occurs. The obligating event is the activity that triggers the payment of the levy in accordance with the relevant legislation. The Interpretation does not address what to do with the corresponding debit from the recognition of a liability. In many cases, the corresponding entry will be to recognise an expense for the period unless an entity can demonstrate that there is an element of prepayment which can be carried forward as an asset. The Interpretation also considers a range of different levy arrangements. The table below summarises different types of levy arrangements dealt with by the Interpretation. Levy Arrangement Levy is triggered progressively as the entity generates revenue Levy is triggered in full as soon as the entity generates revenue in a given year Levy is triggered in full if the entity is operating on a specified date. Levy is triggered if the entity generates revenue above a specified minimum amount of revenue. The same recognition principles are applied in interim financial reports. Interaction with other pronouncements and effective date The Interpretation does not supersede IFRIC 6 Liabilities arising from Participating in a Specific Market Waste Electrical and Electronic Equipment, which remains in force and is consistent with IFRIC 21. IFRIC 21 is effective for annual periods beginning on or after 1 January 2014 and shall be applied on a retrospective basis. Recommendation Entities should review all the levies they currently pay to assess whether their existing accounting policy is consistent with the requirements of IFRIC 21. When would a liability be recognised? The obligating event is the generation of revenue as specified in legislation. An entity accrues a liability to pay the levy as it generates revenue. The obligating event is initial revenue generated by the entity. In these arrangements a levy is typically payable based on the revenue of a previous period. Accordingly, earning revenue in the previous period is a necessary but not a sufficient condition to recognise a liability for the payment of the levy. The obligating event is being in operation on a specified date and until that date, the entity can avoid paying the levy. In this case, even though the amount of levy is calculated based on balances in a previous period, no obligation is accrued until the specified date has been reached. The obligating event is generating revenue above the trigger level. No liability is accrued until the trigger level is reached, irrespective of the likelihood of that event occurring. Accordingly, even if that minimum is always reached each period and it is reasonably certain that the threshold will be met in the current period, the liability is not booked until the obligating event has been reached. 04

5 IFRS Amendments to IAS 36 - recoverable amount disclosures for non-financial assets IASB published new lease accounting proposals In issuing IFRS 13 Fair Value Measurement in 2011, the International Accounting Standards Board (IASB) made some consequential amendments to the disclosure requirements in IAS 36 Impairment of Assets. Those changes had a broader impact than the IASB had intended. On 29 May 2013, the IASB rectified this through the issue of Recoverable Amount Disclosures for Non-Financial Assets (Amendments to IAS 36). These amendments to IAS 36: remove the requirement to disclose the recoverable amount of each cash- -generating unit (group of units) for which the carrying amount of goodwill or intangible assets with indefinite useful lives allocated to that unit (group of units) is significant when compared to the entity s total carrying amount of goodwill or intangible assets with indefinite useful lives; require an entity to disclose the recoverable amount of an individual asset (including goodwill) or a cash-generating unit for which the entity has recognised or reversed an impairment loss during the reporting period; require an entity to disclose additional information about the fair value less costs of disposal of an individual asset, including goodwill, or a cash-generating unit for which the entity has recognised or reversed an impairment loss during the reporting period, including: -- the level of the fair value hierarchy (from IFRS 13) within which the fair value measurement is categorised -- the valuation techniques used to measure fair value less costs of disposal -- key assumptions used in the measurement of fair value measurements categorised within 'Level 2' and 'Level 3' of the fair value hierarchy; require an entity to disclose the discount rate used, where an entity has recognised or reversed an impairment loss during the reporting period and recoverable amount is based on fair value less costs of disposal determined using a present value technique (this amendment originated in the cycle of annual improvements in the exposure draft published in May 2012). The overall effect of the amendments is: to reduce the circumstances in which the recoverable amount of assets or cash-generating units is required to be disclosed, to clarify the disclosures required, and to introduce an explicit requirement to disclose the discount rate used in determining impairment (or reversals) where the recoverable amount (based on fair value less costs of disposal) is determined using a present value technique. Effective date The amendments apply on a retrospective basis for annual periods beginning on or after 1 January An entity may apply the amendments earlier to any period in which it also applies IFRS 13. On 16 May 2013, the International Accounting Standards Board (IASB) re-exposed its proposed approach for the recognition and measurement of leases ( 2013 ED ). The 2013 ED is the latest step in a long-running project to improve the financial reporting of leases under IFRS and US GAAP. Background Lease accounting, particularly for lessees, was criticised in the financial crisis for not recognising contractual commitments under lease contracts in a way that was transparent and useful to users. As a result, lease accounting was revisited and at the same time lessor accounting was evaluated in an attempt to achieve symmetry between lessee and lessor accounting. A first Exposure Draft Leases ( 2010 ED ) was released in August 2010 and proposed uniform finance lease accounting approach for all lessees (all leases shall be recognised as financial lease) with an corresponding approach which reflected symmetry in the lessor model. You can find more information about the 2010 ED in our Accounting News from October Feedback on the 2010 ED indicated that the profit or loss impact of the lessee model did not reflect useful information as a result of so-called front-loading to profit or loss. Front-loading is caused by the combination of a decreasing interest charge over time as the lease liability is repaid and the straight line amortisation of the right-of-use asset. The re-exposed ED includes proposals to mitigate the front- -loading of profit or loss for specific types of leases. For lessors, feedback indicated that the current model does reflect decision useful information to users which has resulted in a reassessment of the symmetrical approach in the 2010 ED. 05

6 IFRS Summary of main proposals Objective The 2013 ED establishes the principles that lessees and lessors shall apply to report the amount, timing and uncertainty of cash flows arising from a lease. Scope The 2013 ED will not apply to leases of intangible assets, biological assets, exploration rights, and service concessions within the scope of IFRIC 12 Service Concession Arrangements. IFRIC 4 Determining Whether an Arrangement Contains a Lease contains guidance for the assessment of contracts that do not take the legal form of a lease but conveys a right to use an asset, for example take-or-pay arrangements. The 2013 ED has incorporated this guidance into the proposed standard, but has re-written the criteria which may lead to some changes in the application of the guidance in practice. Separating components of a contract The lessor will be required to split a contract into its respective components, for example a lease including a maintenance contract, using the principles for the allocation of transaction price to performance obligations outlined in the revenue recognition exposure draft ED/2011/6 Revenue from Contracts with Customers. Lease term The lease term is the non-cancellable lease term together with renewal option periods where there is a significant economic incentive to extend the lease. Classification of a lease At the commencement date the entity has to classify a lease as either Type A or Type B, where Type A leases normally mean that the underlying asset is not property while Type B leases normally mean the underlying asset is property. However, the entity will classify a lease other than a property lease as Type B if: the lease term is for an insignificant part of the total economic life of the underlying asset; or the present value of the lease payments is insignificant relative to the fair value of the underlying asset at the commencement date of the lease. Conversely, the entity will classify a property lease as Type A if: the lease term is for the major part of the remaining economic life of the underlying asset; or present value of the lease payments accounts for substantially all of the fair value of the underlying asset at the commencement date. Contract modifications A contract modification will result in a reassessment of lease assets and liabilities. The difference between the carrying amounts of assets and liabilities under the old lease and the new lease is recognised immediately in profit or loss. Lessee accounting At the commencement date of the lease, the lessee shall discount the lease payments using the rate the lessor charges the lessee, or if that rate is unavailable, the lessee s incremental borrowing rate. The lease payments include: fixed payments, less any lease incentives receivable from the lessor; variable lease payments that depend on an index or a rate are initially measured using the index or rate as at the commencement date; lease payments that are in-substance fixed payments; expected to be payable by the lessee under residual value guarantees; the exercise price of a purchase option if the lessee has a significant economic incentive to exercise that option; and payments for penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease. The lessee recognises the present value of lease payments as a liability. At the same time it recognises a right-of-use asset equal to the lease liability plus: any lease payments made to the lessor at or before the commencement date, less any lease incentives received from the lessor; and any initial direct costs incurred by the lessee. After the commencement date, the liability is increased by the unwinding of interest and reduced by lease payments made to the lessor. The lease liability is reassessed when there is a change in the expected amount of lease payments. If the remeasurement relates to the current period, the adjustment is reflected directly in profit or loss. Alternatively, the adjustment is recognised to the right-of- -use asset provided the adjustment does not result in the right-of-use asset being negative. The right-of-use asset will be subject to impairment. A lessee will recognise in profit or loss, unless the costs are included in the carrying amount of another asset: for Type A leases, the unwinding of the discount on the lease liability as interest and the amortisation of the right-of-use asset. for Type B leases, the lease payments will be recognised in profit or loss on a straight line basis over the lease term and reflected in profit or loss as a single lease cost. The single lease cost will be allocated to the actual unwinding of interest on the liability and any remaining lease cost is allocated to the amortisation of the right-of-use asset. However, the periodic lease cost shall not be less than the periodic unwinding of the discount on the lease liability. variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred. The ED proposes disclosure to enable the user to differentiate the financial impacts of owned and leased assets in the financial statements. 06

7 IFRS Lessor accounting The lessor model in the 2013 ED is similar to current lease accounting. For Type A leases: The lessor will discount the lease payments, as outlined for lessees, using the rate the lessor charges the lessee and recognise this amount as the lease receivable; Recognise a residual asset being the sum of the present value of any unguaranteed residual, variable lease payments not included in the lease receivable and an allocation of profit relating to the residual asset; Recognise the profit on the portion of the asset leased immediately in profit or loss; Recognise the unwinding of interest on the lease receivable and residual asset in profit or loss over the lease term. A reassessment in the expected lease payments, excluding the impact of credit risk, will be reflected immediately in profit or loss. The interest rate in the lease may be amended during the lease term if certain criteria are met. The lease receivable and residual asset will be subject to impairment. Income from Type B leases will be recognised in profit or loss on a straight line or other systematic basis over the lease term, similar to current operating lease accounting for lessors. The leased asset will not be derecognised or reclassified but will be depreciated using the principles for owned property, plant and equipment. The 2013 ED proposes disclosure to enable the user to determine the financial impacts of leases in the financial statements. Effective date The IASB will decide on the effective date only upon completion of its re-deliberations. As this is one of the convergence projects between IFRS and US GAAP, the FASB has issued a corresponding ED. Comments on both proposals will close on 13 September Summary The proposals would significantly affect the accounting for lease contracts by both lessees and lessors. Changes in recognition, measurement, and presentation of leases under ED 2013 may significantly impact financial statement metrics. For lessees: Operating lease/off-balance sheet treatment would be eliminated for virtually all leases except for short-term leases. The lease expense recognised each period could be significantly impacted depending on the nature of the underlying leased asset as property or non-property. Detailed analysis of lease payments will be required for both classification and measurement. For lessors: The nature of the underlying leased asset will dictate whether the asset is derecognised and the pattern of income recognition. Some leases previously treated as 'operating leases' may require the underlying asset to be derecognised and be replaced with a lease receivable and a residual asset. IFRS EU Endorsement Process The European Financial Reporting Advisory Group (EFRAG) updated its report showing the status of endorsement of each IFRS, including standards, interpretations, and amendments, most recently on 21 June As of 25 June 2013, the following four IASB pronouncements are awaiting European Commission endorsement for use in the EU: Standards IFRS 9 Financial Instruments (issued in November 2009) and subsequent amendments (amendments to IFRS 9 and IFRS 7 issued in December 2011) Amendments Amendments to IFRS 10, IFRS 12 and IAS 27 Investment Entities (issued in October 2012) Amendments to IAS 36 Recoverable Amount Disclosures for Non-Financial Assets (issued in May 2013) Interpretation IFRIC 21 Levies (issued in May 2013) Click here for the Endorsement Status Report. The proposals would require management to exercise significant judgement in areas including identifying a lease, determining the lease term, and measuring lease assets and liabilities. 07

8 IFRS US GAAP Invitation Seminar IFRS News 2013 Prague, Brno, Ostrava Dear All, We would like to inform you that Deloitte is preparing a traditional autumn seminar on International Financial Reporting Standards (IFRS) for you. Once again, you will have an opportunity to learn IFRS news, get prepared for the 2013 financial statements and plan adjustments to be made in accounting policies in the following period. This year, we prepare a number of practical examples for your easier understanding of the news and their practical application. The seminar is predominantly intended for accountants, economists and financial managers of projects relating to IFRS and for all who want to know more about IFRS. Seminars will be held in Prague, Brno and Ostrava in Czech and will be delivered by our professionals. Timing Prague: 23 October 2013 and 27 November 2013 Brno: 12 November 2013 Ostrava: 13 November 2013 More-detailed information on the prepared seminar will be provided in the September issue of our dreport. 08 Recognizing Revenue From Sales in a Virtual World This article on the US GAAP topic highlights various considerations associated with revenue recognition in the online and mobile gaming industry (hereinafter referred to as the online gaming industry ), particularly the freemium gaming model. Putting in the picture The freemium gaming model is a rapidly expanding niche in the online and mobile gaming industry, providing gamers with free access to online games and the ability to purchase premium features such as virtual currency and virtual goods to progress more quickly in the games or enhance their gaming experience. The freemium gaming model is a rapidly expanding niche in the online and mobile gaming industry, providing gamers with free access to online games and the ability to purchase premium. Entities often apply the guidance in SAB Topic 13.A1 (codified in ASC S99-12) in developing accounting policies on this topic, since the freemium game software is generally hosted and often outside the scope of the software accounting guidance in ASC (although certain arrangements may still be within the scope of ASC , depending on the facts and circumstances). The SEC staff views the sale of virtual goods in a freemium environment as a service and not the sale of an actual good. Gaming entities typically recognize revenue from the sale of virtual goods over their best estimate of the life of the (1) virtual good, (2) gamer (i.e., the period during which the gamer is expected to play the game), or (3) game. An entity may have to invest in resources and technology to track the information it needs to support its revenue recognition accounting policy for virtual goods and currency. Because of the frequent involvement of third-party sellers of virtual goods and currency, an entity must carefully consider all relevant facts and circumstances when determining whether to recognize revenue on a net basis (as an agent) or a gross basis (as a principal). Background Online gaming is one of the most rapidly developing technologies in the market today, leading to the creation of various mediums through which more and more people can access online games and seamlessly interact with other gaming enthusiasts in real time. Online game developers and operators (collectively, gaming entities 1 ) are shifting away from a subscription- or fee-based business model to a freemium model, which is quickly becoming a lucrative and popular means of harnessing a substantial market share within the online gaming community. Accounting standards do not specifically address the recognition of revenue from microtransactions under the freemium model, largely because such transactions are a recent, rapidly evolving development in the industry. Under the freemium model, gamers are given access to a gaming entity s online game free of charge (or for a nominal fee) and revenue is largely generated through microtransactions involving the sale of virtual goods and services ( virtual goods ). Virtual goods are nonphysical objects that enhance the gamer s playing experience or ability to make progress in the game and may take various forms (e.g., items such as clothing, equipment, weapons, speed, power, or health). Some of these virtual goods are consumed by the gamer over a specified period or number of usages, while others offer a more lasting benefit. Virtual goods may be purchased by using real currency or the gaming entity s virtual currency. This virtual currency can be purchased directly from the gaming entity, earned by playing the game, or purchased or received from third parties (e.g., as marketing incentives or as gifts from social network friends). 1 Developers create and produce online freemium games as well as the virtual goods sold in these games. Developers generally distribute via their own Web site as well as on multiple third- -party online and mobile technology platforms, which typically charge the developers a payment processing fee for each microtransaction processed.

9 Accounting standards do not specifically address the recognition of revenue from microtransactions under the freemium model, largely because such transactions are a recent, rapidly evolving development in the industry. In determining their accounting policies for the sale of virtual goods, gaming entities take into account the nature of the virtual good and overall game, industry practices, regulator views, and other general accounting guidance. Key Accounting Issues The sections below discuss certain transactions under the freemium and other similar gaming models, the accounting guidance applicable to those transactions, and the various approaches industry participants are applying when recognizing revenue. They also address emerging challenges that entities in the industry are confronting when determining an accounting policy to apply to these transactions. Entities are encouraged to review all sources of guidance identified in this document and, when necessary, involve their accounting advisers in the application of the appropriate guidance. Existing Guidance In the past, many gaming entities applied the guidance in ASC when recognizing revenue from the development and sale of computer games, which historically involved the sale of game software on some form of removable media such as a compact disc. However, with the advent of online gaming and, specifically, the freemium gaming model, ASC may not be applicable in certain instances because gamers are generally given access to a hosted software environment but not a contractual right to take possession of the software during the hosting period. As a result, gaming entities look to the guidance in ASC 605 and SAB Topic 13.A (codified in ASC S99-1) when developing accounting policies on this topic. SAB Topic 13.A states that revenue should not be recognized until: Persuasive evidence of an arrangement exists. Delivery has occurred or services have been rendered. The seller s price to the buyer is fixed or determinable. Collectibility is reasonably assured. 09 Given the lack of specific guidance on these transactions and the unique nature of each virtual good sold, similar entities risk developing diverse accounting policies for recognizing revenue under such circumstances, which may also be inconsistent with the SEC s views. For many microtransactions, three of the four criteria in SAB Topic 13.A are usually met at the time of sale. That is, the terms and conditions gamers must accept generally serve as evidence of the existence of an arrangement, the price of the virtual goods is typically fixed when purchases are made, and collectibility is usually reasonably assured since up-front payments are often required at the time of purchase. However, it can often be difficult to determine when delivery has occurred or services have been rendered for virtual goods, particularly because the structure, life, and use of virtual goods can vary significantly from game to game. Regarding the assessment of delivery, the SEC staff views the sale of a virtual good as representing a service rather than the sale of an actual good. Because many virtual goods have an enduring benefit, entities have adopted accounting policies for recognizing revenue as these benefits are consumed over time (as a service) rather than at a single point in time (as a sale of a good). Given the lack of specific guidance on these transactions and the unique nature of each virtual good sold, similar entities risk developing diverse accounting policies for recognizing revenue under such circumstances, which may also be inconsistent with the SEC s views. Although this article focuses on the challenges associated with developing accounting policies for arrangements that are outside the scope of the software revenue recognition guidance in ASC , certain arrangements may still be within the scope of ASC and thus could be subject to different accounting treatment. Recently, gaming entities have focused on the mobile market by developing game applications for use on mobile devices, such as smartphones. To play many of these games, gamers must download a base version of the application for free or a nominal fee. Thereafter, they can connect to a store within the game and purchase virtual goods such as premium versions of the game or items that enhance their gaming experience (e.g., additional powers or weaponry). Some of these game applications enable gamers to play the games offline on their mobile devices. In such circumstances, an entity may need to consider whether the software application provided to a gamer is within the scope of the software revenue recognition guidance in ASC , since the gamer may have a contractual right to take possession of the software. An entity would need to evaluate all facts and circumstances associated with the arrangement when deciding which GAAP to apply to it. Developing an Accounting Policy In developing an appropriate accounting policy for the sale of virtual goods, gaming entities generally apply one of three methods (discussed below) for recognizing revenue, depending on the facts and circumstances associated with the arrangement with the gamer and the nature of the virtual goods being sold. The decision of which method to use should be based on how the virtual good is consumed by the gamer and how the deliverables are defined; however, entities may also need to consider the availability of information about how virtual goods are consumed to assess their ability to apply each of these methods. Although it may be helpful to use mass data storage devices and query tools, additional investment in resources to track and maintain the necessary information could be required. This challenge can affect the determination of an appropriate accounting policy and is considered below in the discussion of each of the methods. Methods for Recognizing Revenue for the Sale of Virtual Goods The three methods below for recognizing revenue associated with the sale of virtual goods are commonly used by entities operating in the freemium gaming industry. 1. Life of the Virtual Good Under this method, revenue from the sale of virtual goods is recognized over the period during which the gamer is expected to be able to access and consume the benefits inherent in a purchased virtual good (i.e., the deliverable is deemed to be the virtual good, in which case revenue recognition mirrors the consumption of the virtual good by the gamer). This method is used when the virtual good is deemed a separate deliverable in the arrangement, since it provides the gamer with a specific benefit that can be consumed at a certain time or over a specified period or number of usages (other than the life of the gamer or of the game itself). Under this method, revenue is recognized over the estimated life of the virtual good (generally The deliverable is deemed to be the virtual good, in which case revenue recognition mirrors the consumption of the virtual good by the gamer. on a straight-line basis unless another systematic and rational basis better reflects the consumption of the virtual good), provided that the entity can reasonably estimate the virtual good s life.

10 In certain circumstances, the virtual good may be consumed immediately upon (or shortly after) its delivery to the gamer (i.e., it may be used immediately by a gamer and provide no further enhancements), potentially resulting in recognition of the related revenue upon or shortly after delivery. However, an entity would need to consider the specific facts and circumstances carefully before making such a determination. One of the challenges in applying this method is gathering and maintaining the data necessary to determine or reasonably estimate 2 the life of the virtual good (i.e., the period over which the virtual good is consumed by each individual gamer). Given the sheer volume and continually evolving characteristics of virtual goods, it may be difficult to track the differing behaviors of a broad spectrum of gamers (not to mention that there is a potential for certain virtual goods to be traded in secondary markets). To track information at this level of detail, an entity may need sophisticated systems and significant time to store, process, and analyze the related data. Consequently, some gaming entities have concluded that even though they may be able to apply an accounting policy to recognize revenue over the life of the virtual good, this method is not appropriate because they do not have enough information to determine or reasonably estimate the virtual good s life. Therefore, some gaming entities may consider recognizing revenue over the period during which the gamer is expected to play the game or over the life of the game because this would at least result in the deferral of revenue over a period greater than the life of the virtual good. The existence of sufficient reliable historical information may influence an entity s determination of the appropriate accounting policy because the entity may be required to recognize revenue over a gamer s or game s life when the life of the virtual good cannot be determined or reasonably estimated. However, an entity s lack of systems and processes to track readily available information should not, in and of itself, dictate its accounting policy. If an entity determines that the most appropriate method for recognizing revenue is over the life of a virtual good, the entity would need to make a reasonable effort to establish systems and processes for tracking the necessary information to support such a policy. The entity should only use another method when the available information does not enable it to determine or reasonably estimate the life of the virtual good. Example Entity A introduces a hosted freemium action tennis game into the market. To improve the playing experience of gamers, A develops two super- -nutrients that can be purchased to enhance the performance of a gamer s avatar. The first nutrient, Lobpro, gives a gamer s avatar additional strength and speed for one match in which the gamer participates. The second nutrient, Ace, endows the avatar with increased strength and speed for the duration of a tournament, which potentially consists of several matches. The prices of the two nutrients differ considerably given the disparity in the benefits provided. Both super-nutrients are available for one-time use. On the basis of historical evidence, gamers typically complete a match in less than a day, while tournaments may take several days to complete. Under these circumstances, A could recognize revenue associated with Lobpro over the period it takes the gamer to complete the match. Because the evidence has indicated that a match typically lasts less than a day, A would recognize revenue over that period and commence revenue recognition when the match involving the use of Lobpro begins. Similarly, revenue associated with the purchase of Ace could be recognized over the period of the gamer s participation in a tournament. Because the periods in which gamers participate in a tournament may differ, it may be difficult to determine an appropriate period in which to recognize the related revenue. Entity A would need to have sufficient historical information regarding the typical tournament period (potentially by type of gamer) to estimate the manner in which the virtual good is consumed and hence the manner in which revenue would be recognized. Further, such estimates would need to be evaluated periodically to ensure that the pattern of consumption is still appropriate. 2. Life of the Gamer Under this method, revenue is recognized on a systematic and rational basis over the period during which the gamer is expected to continue to play the game. This method is typically used when the gaming entity considers the gamer s overall gaming experience to be the ultimate deliverable in the arrangement and delivery of the benefits inherent in any virtual currency or good therefore takes place over the period in which the gamer continues to play the game. This method would also be appropriate when a virtual good is deemed to be the deliverable and provides a gamer with an enduring benefit that is consumed over the gamer s life or the life of the virtual good cannot be reasonably estimated. As with revenue recognition over the life of the virtual good, it may be challenging for entities to gather and maintain the data they need to reasonably estimate the life of each gamer. Some gaming entities may be able to determine an estimated life for all gamers provided that the pool of gamers is relatively homogeneous (i.e., each gamer behaves similarly to others). Other entities may need to stratify the population of gamers on the basis of similar characteristics (such as gamers that purchase virtual goods versus those that do not) or group gamers by their activity level within the game so that they can estimate a life for each different pool of gamer. The appropriate level of disaggregation and the basis of recognizing revenue (straight-line or some other more representative systematic and rational basis) will depend on the degree of similarity between gamers behaviors. As previously mentioned, entities may need to track detailed gamer-level information when using this method. Consequently, some gaming entities have concluded that even though they may be able to recognize revenue over the life of the gamer, this method would not be appropriate because they do not have enough information to determine or reasonably estimate this life. Therefore, entities may consider recognizing revenue over the life of the game since this would at least result in the deferral of revenue over a period greater than the life of the gamer. 2 Entities may also have to consider whether, as evidence of a reasonable estimate of usage life, there is a sufficient history of the consumption pattern of newly introduced virtual goods. 10

11 3. Life of the Game Under this method, revenue is recognized over the estimated life of the game itself, which is generally the longest period over which recognition could take place. This method would be appropriate when an entity is unable to determine or reasonably estimate the gamer s life and the gamer s overall gaming experience is considered to be the ultimate deliverable in the arrangement. Similarly, it may also be appropriate to use this method when the virtual good is deemed to be the deliverable but the life of the virtual good or gamer cannot be reasonably estimated. This method may be particularly relevant when gamers are permitted to trade and transfer virtual goods or currency between one another, which could make the virtual good s and gamer s life indeterminable. The life of a game may be linked to a variety of factors, such as the degree to which a game s underlying source code has changed or the number of gamers who still participate in the game. An entity using such data points in estimating a game s life should track changes in such data and update its game-life estimate as of each reporting period. 11 Example Gaming entities need to determine whether the virtual good or the gamer s overall gaming experience is the deliverable in the arrangement. Gamer B plays a game developed by Company D. As part of the game, B is able to purchase an array of virtual goods such as clothing and weapons. Gamer B can also sell or trade such goods on a secondary market facilitated by a third party. Company D initially determines that it will recognize revenue over the life of the virtual good; however, D subsequently concludes that it cannot reliably estimate the life of each virtual good because each good is consumed by multiple gamers with dissimilar behaviors. In addition, D is unable to reliably estimate a gamer s life. Company D therefore concludes that it would be most appropriate to recognize revenue associated with the purchase of each virtual good over the estimated life of the game. Challenges and Other Considerations Determining the Deliverable and Commencement of Revenue Recognition As mentioned above, gaming entities need to determine whether the virtual good or the gamer s overall gaming experience is the deliverable in the arrangement. Because this decision will affect the determination of the appropriate accounting policy, it should include careful consideration of the nature of all the virtual goods sold as well as any other pertinent facts and circumstances. If the virtual good is deemed the deliverable in the arrangement, revenue recognition would commence when the gamer begins consuming the virtual good. However, if the overall gaming experience is deemed the deliverable, revenue recognition could begin as soon as the gamer purchases virtual currency (or directly purchases a virtual good). This is consistent with the view that when gamers purchase virtual currency (or directly purchase a virtual good), they have access to the virtual goods that may enhance their gaming experience. Once an entity determines that the ultimate deliverable in an arrangement is the overall gaming experience and commences revenue recognition on this basis, the entity would generally not be permitted to change its policy to another method unless there is a change in the facts and circumstances leading to the conclusion that the overall gaming experience is the deliverable. Availability of Secondary Markets Some gaming entities permit virtual goods or currency to be resold or otherwise transferred between gamers (although this practice is prohibited by many gaming entities). These sales may be facilitated by the gaming entities themselves or by thirdparty resellers. When revenue is recognized over the life of a virtual good, the existence of secondary markets may affect a gaming entity s ability to determine or estimate the period over which the benefits of a virtual good are consumed because the benefits may last longer than those consumed by the original purchaser. Similarly, the determination of a gamer s life may be influenced by the gamer s ability to trade virtual goods and currency on an open market, since this may alter the period during which a gamer continues to play a game. In developing appropriate revenue recognition policies, gaming entities should consider the possibility that the benefits of virtual currency and virtual goods may be consumed by multiple gamers. This factor adds another layer of complexity to a gaming entity s ability to obtain sufficient historical information to support its accounting policy; gaming entities will need to factor this into existing data accumulation practices. Virtual Currency and Breakage Gamers often use a gaming entity s own virtual currency to purchase virtual goods. This virtual currency is generally in proportion to the cash amount used to purchase it. For example, $1 may buy 10 virtual-currency credits, which can then be used to purchase various virtual goods (entities also sometimes offer volume discounts to gamers, such as $5 for 60 currency credits). As discussed above, when the virtual good (and not the gaming experience) is deemed to be the deliverable, it would not be appropriate to recognize revenue upon the sale of virtual-currency credits since the entity is still obliged to deliver the virtual goods that are ultimately purchased by a gamer. However, sometimes gamers do not ultimately redeem all available virtual-currency credits (often referred to as breakage ). Entities generally use one of the following two approaches to recognize breakage: 1. Breakage is determined on each gamer s available virtual currency and recognized when the gaming entity is legally released from its obligation to the gamer (e.g., the currency units expire or redemption of the virtual currency becomes remote). 2. Breakage is recognized on an entire population of virtual currency to the extent that the currency is considered homogeneous. Such breakage is recognized in proportion to the recognition pattern of amounts redeemed for virtual goods if redemption of a certain amount of virtual currency is considered remote. Under this approach, the estimated value of virtual currency expected to go unused in a large homogeneous virtual-currency pool sold over a certain period would be recognized in proportion to actual redemptions for virtual goods (i.e., as the related revenue for the virtual good is recognized). To appropriately recognize revenue from breakage under this method, entities need to be able to reasonably and objectively determine the amount of breakage and the period over which, and policy under which, revenue is recognized. In either scenario, the estimation of the amount of breakage and the period over which it should be recognized need to be supported by sufficient historical evidence that is representative of future outcomes and is not materially different from actual results.