NCsoft Corporation and Subsidiaries Consolidated Financial Statements
Index Page(s) Report of Independent Auditors... 1-2 Consolidated Financial Statements Consolidated Balance Sheets.... 3-4 Consolidated Statements of Income. 5 Statements of Changes in Shareholders Equity.. 6 Consolidated Statements of Cash Flows 7-8... 9-41
A member firm of www.samil.com Kukje Center Building 191 Hangangno 2-ga, Yongsan-gu Seoul 140-702, KOREA (Yongsan P.O. Box 266, 140-600) Report of Independent Auditors To the Shareholders and Board of Directors of NCsoft Corporation We have audited the accompanying consolidated balance sheets of NCsoft Corporation and its subsidiaries (collectively the "Company") as of, and the related consolidated statements of income, changes in shareholders equity and cash flows for the years then ended, expressed in Korean won. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of NC Interactive, Inc. and certain other consolidated subsidiaries of NCsoft Corporation, whose financial statements, prior to the elimination of intercompany transactions, reflect 15.0% and 16.5% of the Company s consolidated total assets as of, respectively, and 37.8% and 35.6% of the Company s consolidated total sales for the years then ended, respectively. These financial statements were audited by other auditors whose reports have been furnished us and our opinion, insofar as it relates to the amounts included for the subsidiaries, is based solely on the reports of the other auditors. We conducted our audits in accordance with auditing standards generally accepted in the Republic of Korea. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of NCsoft Corporation and its subsidiaries as of, and the results of their operations, the changes in their shareholders equity and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the Republic of Korea. Samil PricewaterhouseCoopers is the Korean member firm of PricewaterhouseCoopers. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.
Accounting principles and auditing standards and their application in practice vary among countries. The accompanying consolidated financial statements are not intended to present the financial position, results of operations and cash flows in conformity with accounting principles and practices generally accepted in countries and jurisdictions other than the Republic of Korea. In addition, the procedures and practices used in the Republic of Korea to audit such financial statements may differ from those generally accepted and applied in other countries. Accordingly, this report and the accompanying consolidated financial statements are for use by those who are informed about Korean accounting principles or auditing standards and their application in practice. Seoul, Korea April 2, 2007 This report is effective as of April 2, 2007, the audit report date. Certain subsequent events or circumstances, which may occur between the audit report date and the time of reading this report, could have a material impact on the accompanying consolidated financial statements and notes thereto. Accordingly, the readers of the audit report should understand that there is a possibility that the above audit report may have to be revised to reflect the impact of such subsequent events or circumstances, if any. 2
Consolidated Balance Sheets (in millions of Korean won) 2006 2005 Assets Current assets Cash and cash equivalents (Notes 3 and 5) 49,368 30,487 Short-term financial instruments (Notes 3 and 5) 250,849 231,727 Trade accounts receivable, net (Notes 5 and 17) 39,195 37,505 Inventories 4,433 2,973 Short-term loans receivable (Note 5) 2,311 838 Accrued income 3,516 2,128 Advance payment 12,594 11,294 Deferred income tax assets (Note 15) 2,257 248 Other current assets, net (Note 5) 8,882 7,092 Total current assets 373,405 324,292 Available-for-sale securities (Note 4) 516 639 Held-to-maturity securities (Note 4) 2,258 2,213 Equity-method investments (Note 6) 10,719 6,970 Property and equipment, net (Note 7) 84,599 84,972 Intangible assets, net (Note 8) 7,741 14,282 Refundable deposits (Note 5) 20,093 17,028 Long-term loans receivable (Note 5) 5,002 4,051 Deferred income tax assets (Note 15) 1,564 2,599 Long-term trade accounts receivable 468 - Long-term prepaid expenses 125 68 Total assets 506,490 457,114 3
Consolidated Balance Sheets (in millions of Korean won) 2006 2005 Liabilities and Shareholders' Equity Current liabilities Trade accounts payable (Notes 5 and 17) 4,415 3,885 Other accounts payable (Notes 5 and 17) 8,290 2,012 Accrued expenses (Note 5) 24,384 13,433 Income taxes payable (Note 5) 3,630 3,570 Advances received 33,843 25,872 Withholdings 984 2,829 Deferred income tax liabilities (Note 15) - 471 Other current liabilities (Note 5) 4,059 3,621 Total current liabilities 79,605 55,693 Provision for sales promotion - 2,323 Accrued severance benefits, net (Note 9) 5,311 3,418 Other long-term accounts payable 305 - Total liabilities 85,221 61,434 Commitments and contingencies (Note 10) Shareholders' equity Common stock (Note 11) 10,194 10,176 Additional paid-in capital (Note 11) 144,697 143,353 Retained earnings (Note 12) 291,091 253,039 Capital adjustments (Notes 13 and 14) (27,676) (13,211) Minority interest in consolidated subsidiaries 2,963 2,323 Total shareholders' equity 421,269 395,680 Total liabilities and shareholders' equity 506,490 457,114 The accompanying notes are an integral part of these consolidated financial statements. 4
Consolidated Statements of Income Years Ended (in millions of Korean won, except per share amounts) 2006 2005 Sales (Notes 17 and 20) 338,679 338,803 Cost of sales 82,695 78,456 Gross profit 255,984 260,347 Selling and administrative expenses 212,707 183,714 Operating income 43,277 76,633 Non-operating income Interest income 11,855 8,801 Equity in earnings of investees (Note 6) - 1,357 Miscellaneous income 1,200 2,747 Others 513 527 13,568 13,432 Non-operating expenses Interest expense 46 72 Equity in loss of affiliates (Note 6) 3,956 3,131 Donations 589 646 Others 2,239 1,649 6,830 5,498 Income before income tax expense 50,015 84,567 Income tax expense (Note 15) 11,069 14,581 Income before minority interest 38,946 69,986 Minority interest in income of consolidated subsidiaries 894 3,308 Net income 38,052 66,678 Earnings per share (in Korean won) (Note16) Basic earnings per share 1,890 3,324 Diluted earnings per share 1,838 3,205 The accompanying notes are an integral part of these consolidated financial statements. 5
Statements of Changes in Shareholders' Equity Years Ended (in millions of Korean won) Capital Capital Retained Capital Minority stock surplus earnings adjustments interests Total Balance at January 1, 2005 10,032 132,583 186,361 (9,963) - 319,013 Net income - - 66,678-3,308 69,986 Disposal of treasury stock - - - 62-62 Loss on disposal of treasury stock - - - (14) - (14) Equity in losses of investees - - - 221-221 Overseas operations translation adjustments - - - (2,208) - (2,208) Stock options 144 10,770 - (1,633) - 9,281 Loss on valuation of available-for-sale securities - - - 324-324 Others - - - - (985) (985) Balance at December 31, 2005 10,176 143,353 253,039 (13,211) 2,323 395,680 Balance at January 1, 2006 10,176 143,353 253,039 (13,211) 2,323 395,680 Net income - - 38,052-894 38,946 Acquisition of treasury stock (12,859) (12,859) Disposal of treasury stock - - - 28-28 Loss on disposal of treasury stock - - - (5) - (5) Equity in losses of investees - - - (306) - (306) Overseas operations translation adjustments - - - (2,303) (254) (2,557) Stock options 18 1,344-1,069-2,431 Loss on valuation of available-for-sale securities - - - (89) - (89) Balance at December 31, 2006 10,194 144,697 291,091 (27,676) 2,963 421,269 The accompanying notes are an integral part of these consolidated financial statements. 6
Consolidated Statements of Cash Flows Years Ended (in millions of Korean won) 2006 2005 Cash flows from operating activities Net income 38,052 66,678 Adjustments to reconcile net income to net cash provided by operating activities Bad debt expenses 3,609 4,224 Depreciation 17,983 16,591 Amortization of intangible assets 10,502 6,263 Equity in loss of investees 3,956 1,773 Provision for severance benefits 4,345 2,992 Provision for sales promotion - 1,150 Minority interest in income of consolidated subsidiaries 894 3,308 Stock compensation expenses 1,270 - Others, net 133 257 Changes in operating assets and liabilities Trade accounts receivable (5,064) (13,207) Inventories (1,595) (2,335) Accrued income (1,925) 248 Advance payment (1,977) (4,621) Other current assets (1,319) (3,080) Trade accounts payable 530 (388) Other accounts payable 6,280 (2,135) Long-term prepaid expenses (468) - Long-term account trade receivable (219) (10) Accrued expenses 11,029 5,632 Income taxes payable 60 (9,026) Advances received 7,972 10,758 Withholdings (1,710) (51) Other current liabilities (1,717) (1,029) Deferred tax assets and liabilities (1,412) (1,225) Payment for severance benefits (2,452) (1,516) Other long-term accounts payable 305 (10) Net cash provided by operating activities 87,062 81,241 7
Consolidated Statements of Cash Flows Years Ended (in millions of Korean won) 2006 2005 Cash flows from investing activities Acquisition of held-to-maturity securities (45) (2,144) Net decrease in short-term loans receivable 908 596 Net increase in short-term financial instruments (19,244) (9,293) Collection of long-term loans receivable 1,479 819 Granting of long-term loans (4,140) (2,991) Acquisition of equity-method investments (8,012) (1,990) Net increase in refundable deposits (3,265) (2,879) Proceeds from disposal of property and equipment 1,009 329 Acquisition in property and equipment (19,329) (76,383) Acquisition of intangible assets (4,187) (5,950) Others - (1) Net cash used in investing activities (54,826) (99,887) Cash flows from financing activities Issuance of common shares 1,159 9,282 Payment of short-term borrowings - (5,161) Proceeds from the disposal of treasury stock 22 42 Change in overseas operations translation adjustments (1,677) (1,791) Acquisition of treasury stock (12,859) - Net cash provided by (used in) investing activities (13,355) 2,372 Increase in cash due to changes in the consolidated entities - 3,838 Net increase (decrease) in cash and cash equivalents 18,881 (12,436) Cash and cash equivalents Beginning of year 30,487 42,923 End of year 49,368 30,487 The accompanying notes are an integral part of these consolidated financial statements. 8
1. The Consolidated Companies The accompanying consolidated financial statements include the accounts of NCsoft Corporation (the Controlling Company ) and its consolidated subsidiaries (collectively the Company ). The general information on the Controlling Company, its consolidated subsidiaries and equity method investees is described below. The Controlling Company NCsoft Corporation was incorporated in March 1997 under the Commercial Code of the Republic of Korea to provide entertainment services on the Internet such as online-game development and publishing. As of December 31, 2006, the Controlling Company s outstanding common stock amounted to 10,194 million (Note 11). The Controlling Company offered its shares to the public on June 14, 2000, by listing its common shares on the KOSDAQ Stock Market. Subsequently, the Controlling Company listed its shares on the Korea Stock Exchange on May 22, 2003, and revoked its registration with the KOSDAQ Stock Market. As of December 31, 2006, the Controlling Company s shareholders are as follows: Number of Shares Percentage of Shareholding (%) Remarks Kim Taek Jin 5,584,091 27.4 CEO Richard Garriott 472,300 2.3 Employee Robert Garriott 385,000 1.9 Director Others 13,580,483 66.6-20,021,874 98.2 Treasury stock 365,760 1.8 20,387,634 100.0 9
Consolidated Subsidiaries and Equity-Method Investees Consolidated subsidiaries and equity-method investees as of December 31, 2006, are as follows: Company Overseas Subsidiaries Total issued and outstanding shares Shares owned by the controlling Company Percentage of ownership (%) NC Interactive Inc. 339,000,000 339,000,000 100.00 ArenaNet Inc. 73,442,962 73,442,962 100.00 NC Japan KK 7,500 4,500 60.00 NC Europe, Ltd. 3,723,470 3,723,470 100.00 Domestic equity-method investees OraionSoft Co., Ltd. 1 I-Scream Entertainment, Inc. 2 200,000 200,000 100.00 200,000 39,166 19.58 Overseas equity-method investees NCsoft China Co., Ltd. (formerly Shanghai NC-SINA Information Technology Co., Ltd.) 3 - - 49.00 NC Taiwan Co., Ltd. 14,000,000 6,860,000 49.00 NC True Co., Ltd. 4 14,284,460 8,570,676 60.00 NCsoft Research & Development Center 3 - - 100.00 NCsoft Japan KK 1 2,000 2,000 100.00 J-Interactive Co., Ltd. 1 40,000 40,000 100.00 1 During the year ended December 31, 2006, the Company acquired 51% ownership in NCsoft China Co., Ltd at 3,144 million and made additional investments of 500 million in OraionSoft Co., Ltd. by acquiring additional 100 thousand shares of newly issued common stock. The Company established NCsoft Japan KK by making an investment of 818 million and purchased all of the stocks of J-Interactive Co., Ltd. for 3,550 million. 2 The Company exerts significant control over I-Scream Entertainment Inc. although the Company s ownership in the investee is less than 20%. 3 There are no issued and outstanding shares since these are not corporations. 4 Although the Company owns only 49% of the total number of common shares of NC True Co., Ltd., the 60% ownership is used in applying the equity method of accounting since it owns 60% of the voting rights as well as sharing of the profits. The consolidated subsidiaries and equity method investees are classified in accordance with the Enforcement Decree on External Audit for Corporations and the financial accounting standards for consolidated financial statements. 10
The primary business activities of the consolidated subsidiaries are as follows: (1) NC Interactive Inc. NC Interactive Inc. was incorporated in Texas, U.S.A., in 2000, to provide entertainment services on the Internet in the U.S.A. such as online-games development and publishing. As of December 31, 2006, its capital stock amounted to US$ 34 million and is wholly owned by the Controlling Company. (2) ArenaNet Inc. ArenaNet Inc. was incorporated in Washington, U.S.A., in 2000, to provide entertainment services on the Internet such as online-game development and its whole shares were acquired by the Controlling Company in December 2002. As of December 31, 2006, its capital stock amounted to US$ 22 million and is wholly owned by the Controlling Company. (3) NC Europe, Ltd. NC Europe, Ltd. was incorporated in London, United Kingdom, in 2004, to provide entertainment services on the Internet such as online-game publishing in Europe. As of December 31, 2006, its capital stock increased to GBP 4 million through additional issuance of common stock during year ended December 31, 2006, and is wholly owned by the Controlling Company. (4) NC Japan KK NC Japan KK was incorporated in Tokyo, Japan in 2001, to provide entertainment services on the Internet such as online-game publishing in Japan. As of December 31, 2006, its capital stock amounted to JPY 375 million and the Controlling Company holds 60% of its outstanding shares. 11
A summary of financial data of the consolidated subsidiaries, prior to the elimination of intercompany transactions, is as follows: Condensed Balance Sheets As of December 31, 2006 (In millions of Korean won) NC Interactive Inc. ArenaNet Inc. NC Japan KK NC Europe, Ltd. Current assets 32,369 6,486 13,309 18,093 Non-current assets 5,976 706 2,717 2,406 Total assets 38,345 7,192 16,026 20,499 Current liabilities 26,049 1,654 8,617 14,940 Non-current liabilities 158 - - - Total liabilities 26,207 1,654 8,617 14,940 Capital stock 41,910 25,603 4,021 7,889 Capital surplus 101 70 4,021 185 Retained earnings (Accumulated deficit) (24,051) (17,901) 638 (1,761) Capital adjustments (5,822) (2,234) (1,271) (754) Total shareholders equity 12,138 5,538 7,409 5,559 Total liabilities and shareholders equity 38,345 7,192 16,026 20,499 Condensed Income Statement For the year ended December 31, 2006 (In millions of Korean won) NC Interactive Inc. ArenaNet Inc. NC Europe, Ltd. NC Japan KK Sales 62,071 13,400 32,585 30,065 Cost of sales 38,812-14,447 19,880 Gross profit 23,259 13,400 18,138 10,185 Selling and administrative expenses 30,131 15,580 14,276 9,550 Operating income (loss) (6,872) (2,180) 3,862 635 Non-operating income 373 158 43 97 Non-operating expenses 829-11 118 Ordinary income (loss) (7,328) (2,022) 3,894 614 Income tax expense 197-1,658 - Net income (loss) (7,525) (2,022) 2,236 614 12
Changes in goodwill of consolidated subsidiaries for the year ended December 31, 2006, are as follows: (In millions of Korean won) Acquisition Cost Amortization before January 1, 2006 Amortization for the year ended December 31, 2006 Balance as of December 31, 2006 ArenaNet Inc. 19,159 11,495 3,832 3,832 NC Japan KK 1,126 676 225 225 20,285 12,171 4,057 4,057 2. Summary of Significant Accounting Policies The significant accounting policies followed by the Company in the preparation of the accompanying consolidated financial statements, are summarized below. Basis of Consolidated Financial Statement Presentation The Company maintains its accounting records in Korean won and prepares statutory consolidated financial statements in the Korean language in conformity with the accounting principles generally accepted in the Republic of Korea. Certain accounting principles applied by the Company that conform with financial accounting standards and accounting principles in the Republic of Korea may not conform with generally accepted accounting principles in other countries. Accordingly, these consolidated financial statements are intended for use by those who are informed about Korean accounting principles and practices. The accompanying consolidated financial statements have been condensed, restructured and translated into English from the Korean language consolidated financial statements. Certain information attached to the Korean language financial statements, but not required for a fair presentation of the Company s financial position, results of operations or cash flows, is not presented in the accompanying consolidated financial statements. Accounting Estimates The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect amounts reported therein. Although these estimates are based on management s best knowledge of current events and actions that the Company may undertake in the future, actual results may differ from those estimates. 13
Application of the Statements of Korean Financial Accounting Standards The Korean Accounting Standards Board has published a series of Statements of Korean Financial Accounting Standards (SKFAS), which will gradually replace the existing financial accounting standards established by the Korean Financial Supervisory Commission. As SKFAS Nos. 15 through 17 became applicable to the Company on January 1, 2005, the Company adopted these Standards in its financial statements covering periods beginning January 1, 2005. And as SKFAS Nos. 18 through 20 became effective for the Company on January 1, 2006, the Company adopted these Standards in its financial statements for the year ended December 31, 2006. In accordance with SKFAS No. 20, Related Party Disclosures, the Company discloses key management personnel compensation by category, the nature of the related party relationship and information about the transactions and outstanding balances necessary for an understanding of the potential effect of the relationship on the financial statements. However, the disclosures of December 31, 2005 financial statements presented herein for comparative purposes have not been provided in accordance with the addendum of SKFAS No. 20. Principles of Consolidation The fiscal year end of the consolidated subsidiaries is the same as that of the Controlling Company. Differences in accounting policy between the Company and its consolidated subsidiaries are adjusted during consolidation. The accompanying consolidated financial statements include the accounts of the Controlling Company and its subsidiaries. All significant intercompany transactions and balances with consolidated subsidiaries have been eliminated during consolidation. To eliminate the investment account of the Controlling Company and corresponding capital accounts of subsidiaries, the purchase method is applied. The Controlling Company records the differences between the initial investment accounts and corresponding capital accounts of subsidiaries as goodwill or negative goodwill, which is amortized over five years, using the straight-line method. 14
Unrealized gains or losses included in inventories and other assets as a result of intercompany transactions are eliminated based on the average gross profit ratio of the corresponding company. Unrealized gains or losses, arising from sales by the Controlling Company to the consolidated subsidiaries, is fully eliminated and charged to the equity of the Controlling Company. Unrealized gains or losses, arising from sales by the consolidated subsidiaries to the Controlling Company, or sales between consolidated subsidiaries, are fully eliminated, and charged to the equity of the Controlling Company and the minority interests, based on the percentage of ownership. The Company records the equity of the consolidated subsidiaries, which is not included in the equity of the Controlling Company, as a minority interest in consolidated subsidiaries. In addition, if losses of the consolidated subsidiaries, included in minority interest, are in excess of minority interest, the deficit in excess of minority interest is charged to the equity of the Controlling Company. Until losses charged to the equity of the Controlling Company are recovered, all gains on related consolidated subsidiaries are recognized in equity of the Controlling Company. Revenue Recognition Revenue related to entertainment services on the Internet and royalty is recognized when services are provided. Cash and Cash Equivalents The Company considers cash on hand, bank deposits and highly liquid marketable securities with original maturities of three months or less to be cash and cash equivalents. Marketable Securities, and Investments in Debt and Equity Securities The Company accounts for equity and debt securities under the provisions of SKFAS No. 8, Investments in Securities. This statement requires investments in equity and debt securities to be classified into three categories: trading, available-for-sale and held-to-maturity. Securities are initially carried at cost, including incidental expenses, with cost being determined using the weighted-average method. Debt securities, which the Company has the intent and ability to hold to maturity, are generally carried at cost, adjusted for the amortization of discounts or premiums. Premiums and discounts on debt securities are amortized over the term of the debt using the effective interest method. Trading and available-for-sale securities are carried at fair value, except for non-marketable securities, classified as available-for-sale securities, which are carried at cost. Non-marketable debt securities are carried at a value using the present value of future cash flows, discounted at a reasonable interest rate determined considering the credit ratings provided by independent credit rating agencies. 15
Unrealized valuation gains or losses on trading securities are charged to operations and those resulting from available-for-sale securities are charged to capital adjustment, the accumulated amount of which shall be charged to operations when the related securities are sold, or when an impairment loss on the securities is recognized. Impairment losses are recognized in the statement of income when the recoverable amounts are less than the acquisition cost of securities or adjusted cost of debt securities for the amortization of discounts or premiums. Equity-Method Investments Investments in equity securities of companies, over which the Company exercises a significant control or influence, are recorded using the equity method of accounting. Under the equity method, the Company records changes in its proportionate ownership in the book value of the investee in current operations, as capital adjustments or as adjustments to retained earnings, depending on the nature of the underlying change in the book value of the investee. Differences between the initial purchase price and the Company s initial proportionate ownership in the net book value of the investee are amortized over five years using the straight-line method and the amortization is charged to current operations. The Company s proportionate unrealized profit arising from sales by the equity-method investees to the Company or sales between equity-method investees is eliminated to the extent of the Company s ownership. Unrealized profit arising from sales between the Company and its subsidiaries is fully eliminated. Foreign currency denominated financial statements of equity-method investees are translated into Korean won using the exchange rates in effect as of the balance sheet date for assets and liabilities, and annual average exchange rates for income and expenses. Any resulting translation gain or loss is included in the capital adjustment account, a component of shareholders' equity. Allowance for Doubtful Accounts The Company provides an allowance for doubtful accounts based on management s estimate of the collectibility of receivables or loans. Inventories Inventories are stated at the lower of cost or market, with cost being determined using the weighted-average method. If the net realizable value of inventory is less than its cost, a contra inventory account representing the valuation loss, is created to reduce the inventory to its net realizable value. The said valuation loss is recorded as cost of sales. If, however, the circumstances which caused the valuation loss cease to exist, causing the market value to rise above the carrying amount, the valuation loss is reversed limited to the original carrying amount before valuation. The said reversal is a deduction from cost of sales. 16
Property and Equipment Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed by the declining-balance method over estimated useful lives of years as follows: Estimated useful life Fixtures Machinery Office Equipment Vehicle 4~18 years 3~4 years 3~15 years 4~6 years Routine maintenance and repairs are charged to current operations as incurred. Betterments and renewals, which enhance the value or extend the useful life of the related assets, are capitalized. The Company assesses the potential impairment of property and equipment when there is evidence that events or changes in circumstances have made the recovery of an asset s carrying value unlikely. The carrying value of the assets is reduced to the estimated realizable value, and an impairment loss is recorded as a reduction in the carrying value of the related assets and charged to current operations. However, the recovery of the impaired assets is recorded in current operations up to the cost of the assets, net of accumulated depreciation before impairment, when the estimated value of the assets exceeds the carrying value after impairment. Intangible Assets Intangible assets, consisting of industrial property rights and intellectual rights, are stated at cost, net of accumulated amortization. Amortization is computed using the straight-line method over the estimated useful lives of five years. The Company assesses the potential impairment of intangible assets when there is evidence that events or changes in circumstances have made the recovery of an asset s carrying value unlikely. The carrying value of the assets is reduced to the estimated realizable value and an impairment loss is recorded as a reduction in the carrying value of the related asset and charged to current operations. However, the recovery of the impaired assets is recorded in current operations up to the cost of the asset, net of amortization before impairment, when the estimated value of the assets exceeds the carrying value after impairment. Allowance for Sales Promotion The Company provides an allowance for estimated future sales promotion expenses based upon management s estimate of the level of future expenses. 17
Accrued Severance Benefits Employees and directors with at least one year of service are entitled to receive a lump-sum severance payment upon termination of their employment with the Company, based on their length of service and rate of pay at the time of termination. Accrued severance benefits represent the amount which would be payable assuming all eligible employees and directors were to terminate their employment as of the balance sheet date. Treasury Stock Treasury stock are stated at cost and recorded as a capital adjustment in shareholders equity. Gain on disposal of treasury stock is recorded as capital surplus. Any loss on disposal of treasury stock is offset against prior gains on disposal of treasury stock included in capital surplus. The remaining loss is offset against retained earnings. Foreign Currency Translation Monetary assets and liabilities denominated in foreign currencies are translated into Korean won at the exchange rates in effect at the balance sheet date, and resulting translation gains and losses are recognized in the current operations. The exchange rate used to translate U.S. dollar denominated monetary assets and liabilities at December 31, 2006, is 929.6 : US$ 1 (2005 : 1,013 : US$ 1). Income Taxes The Company recognizes deferred income taxes for anticipated future tax consequences resulting from temporary differences between amounts reported for financial reporting and income tax purposes. Deferred income tax assets and liabilities are computed on such temporary differences by applying enacted statutory tax rates applicable to the years when such differences are expected to be reversed. Deferred income tax assets are recognized to the extent that it is almost certain that such deferred income tax assets will be realized. The total income tax provision includes current tax expenses under applicable tax regulations and the change in the balance of deferred income tax assets and liabilities during the year. Stock Based Compensation Compensation costs for stock options granted to employees and executives are recognized on the basis of fair value. Under the fair value basis method, compensation costs for stock option plans are determined using an option-pricing model in which the Company assumes that there is no volatility in the underlying stock prices at grant dates and recognizes an equal amount of compensation expense over the vesting period. Lease Transactions The Company accounts for lease transactions as either operating leases or capital leases, depending on the terms of the lease agreement. Machinery and equipment, acquired under capital lease agreements, are recorded at cost as property and equipment, and depreciated using the declining-balance method over their estimated useful lives. 18
3. Cash and Cash Equivalents, and Short-Term Financial Instruments Cash and cash equivalents, and short-term financial instruments as of December 31, 2006 and 2005, consist of the following: Annual interest rate (%) (in millions of Korean won) at December 31, 2006 2006 2005 Cash and cash equivalents Cash on hand - 745 7 Passbook accounts 0.1 ~ 3.4 13,610 4,913 Deposits in foreign currencies 0 ~ 5.1 35,013 25,567 49,368 30,487 Short-term financial instruments Repurchase agreement 4.7 ~ 4.9 140,000 105,000 Certificate of deposit (registered) 4.7 ~ 4.9 55,000 - Time deposits 4.8 ~ 5.1 55,000 125,000 Deposits in foreign currencies - 849 1,727 250,849 231,727 As of December 31, 2006, short-term financial instruments of 849 million are restricted in connection with the lease transactions. 19
4. Available -For-Sale and Held-To-Maturity Securities Available-for-sale securities as of, consist of the following: (in millions of Korean won) Percentage of Ownership (%) Acquisition cost 2006 2005 Market value Carrying Acquisition value cost Market value Carrying value The Ilgan Sports Inc. 1 1.9 1,000 516 516 1,000 639 639 Artifact Entertainment 5.5 2,980 - - 2,980 - - 3,980 516 516 3,980 639 639 1 The difference between the acquisition cost and carrying value amounting to 484 million is recorded as deferred tax asset of 133 million and capital adjustment of 351 million. The changes in accumulated unrealized loss on valuation of available-for-sale securities for the years ended, are as follows: (in millions of Korean won) January 1, 2006 Gain (Loss) Disposal December 31, 2006 The Ilgan Sports Inc. (261) (90) - (351) (in millions of Korean won) January 1, 2005 Gain (Loss) Disposal December 31, 2005 The Ilgan Sports Inc. (807) 546 - (261) All held-to-maturity securities as of, consist of government and municipal bonds. The Company recognized 67 million in interest income related to the held-to-maturity securities during the year ended December 31, 2006. The annual maturities of held-to-maturity securities outstanding as of December 31, 2006 and 2005, are as follows: (in millions of Korean won) 2006 2005 Over one year to five years 2,258 2,213 20
5. Monetary Assets and Liabilities Denominated in Foreign Currencies Monetary assets and liabilities denominated in foreign currencies as of December 31, 2006 and 2005, are as follows: 2006 2005 Foreign Korean won Foreign Korean won Currency (in thousands) Equivalent (in millions) Currency (in thousands) Equivalent (in millions) Monetary assets Cash and cash equivalents US$ 18,692 17,376 US$ 15,624 15,827 JP 986,612 7,714 JP 746,769 6,421 GBP 3,738 6,818 GBP 1,903 3,325 Short-term financial instruments US$ 914 849 US$ 1,705 1,727 Trade accounts receivable US$ 16,519 15,356 US$ 23,325 23,629 JP 511,229 3,997 JP 667,893 5,743 GBP 3,192 5,822 GBP 2,831 4,945 Other current assets US$ 1,801 1,674 US$ 3,928 3,979 JP 5,202 41 JP - - GBP 541 987 GBP 448 783 Short-term loans receivable US$ 20 19 US$ 63 63 JP 94,500 739 JP - - Long-term loans receivable US$ - US$ 50 51 Refundable deposits US$ 1,002 931 US$ 757 767 JP 147,773 1,155 JP 136,375 1,173 Monetary liabilities Trade accounts payable US$ 1,553 1,444 US$ 3,101 3,141 JP 311,192 2,433 JP 196,948 1,694 GBP 295 538 GBP 534 932 Other accounts payable US$ 147 137 US$ 542 549 JP 19,491 152 JP 239,965 2,063 GBP 3,058 5,579 GBP 2.,004 3,501 Accrued expenses US$ 9,270 8,617 US$ 11,914 12,401 JP 244,499 1,912 JP 11,395 98 GBP 512 934 GBP 371 647 Income taxes payable US$ 94 87 US$ 333 337 JP 241,506 1,888 JP 10,350 89 GBP 94 173 GBP 56 97 Other current liabilities US$ 828 770 US$ - - JP 2,926 23 JP 6,800 58 21
6. Equity-Method Investments Equity-method investments as of, are as follows: 2006 Acquisition Cost (in millions of Korean won) Percentage of Ownership (%) Net Asset Value Carrying Value NCsoft China Co., Ltd. (formerly Shanghai NC-SINA Information Technology Co., Ltd.) 1 49.00 6,915 1,574 3,245 NC Taiwan Co., Ltd. 49.00 2,353 2,262 2,262 NC True Co., Ltd. 2 60.00 3,734 240 240 OraionSoft Co., Ltd 1 100.00 1,100 812 614 I-Scream Entertainment, Inc. 3 19.60 196 - - NCsoft Research & Development Center 100.00 2,156 737 737 NCsoft Japan KK 1 100.00 818 259 259 J-Interactive Co., Ltd. 1 100.00 3,550 (116) 3,362 20,822 5,768 10,719 2005 Acquisition Cost (in millions of Korean won) Percentage of Ownership (%) Net Asset Value Carrying Value NCsoft China Co., Ltd. (formerly Shanghai NC-SINA Information Technology Co., Ltd.) 49.0 3,771 1,420 1,420 NC Taiwan Co., Ltd. 49.0 2,353 3,298 3,298 NC True Co., Ltd. 1, 3 60.0 3,734 1,151 1,151 OraionSoft Co., Ltd. 100.0 600 425 231 I-Scream Entertainment, Inc. 2 19.58 196 - - NCsoft Research & Development Center 1 100.0 2,156 870 870 12,810 7,164 6,970 1 During the year ended December 31, 2006, the Company acquired 51% ownership in NCsoft China Co., Ltd. at 3,144 million and made additional investments of 500 million in OraionSoft Co., Ltd. by acquiring additional 100 thousand shares of newly issued common stock. The Company established NCsoft Japan KK by making an investment of 818 million and purchased all of the stocks of J-Interactive Co., Ltd. for 3,550 million. 22
2 Although the Company owns only 49% of the total number of common shares of NC True Co., Ltd., the 60% ownership is used in applying the equity method of accounting since it owns 60% of the voting rights as well as sharing of the profits. 3 The Company exerts significant control over I-Scream Entertainment Inc., although the Company s ownership in the investee is less than 20%. The changes in the difference between the initial purchase price and the Company s initial proportionate ownership in the net book value of the investee for the year ended December 31, 2006, were as follows: (in millions of Korean won) Beginning Balance Increase Amortization or Impairment Ending Balance NCsoft China Co., Ltd. (formerly Shanghai NC-SINA Information Technology Co., Ltd.) - 1,892 221 1,671 J-Interactive Co., Ltd. - 3,726 248 3,478-5,618 469 5,149 The changes in unrealized profit arising from transactions with this affiliates for the year ended December 31, 2006, are as follows: (in millions of Korean won) Beginning Balance Increase Decrease Ending Balance OraionSoft Co., Ltd. 194 121 117 198 23
The changes in the book and carrying values of equity-method investment securities for the years ended, are as follows: 2006 (in millions of Korean won) Beginning balance Acquisition Change in Equity in gain (loss) capital of affiliates adjustments 1 Carrying value NCsoft China Co., Ltd. (formerly Shanghai NC-SINA Information Technology Co., Ltd.) 1,420 3,144 (1263) (56) 3,245 NC Taiwan Co., Ltd. 3,298 - (809) (227) 2,262 NC True Co., Ltd. 1,151 - (945) 34 240 OraionSoft Co., Ltd. 230 500 (113) (3) 614 NCsoft Research & Development Center 871 - (89) (45) 737 NCsoft Japan KK - 818 (549) (9) 259 J-Interactive Co., Ltd. - 3,550 (188) - 3,362 6,970 8,012 (3,956) (306) 10,719 2005 (in millions of Korean won) Beginning balance Acquisition Change in Equity in gain (loss) capital of affiliates adjustments 1 Carrying value NCsoft China Co., Ltd. (formerly Shanghai NC-SINA Information Technology Co., Ltd.) 1,388-38 (7) 1,419 NC Taiwan Co., Ltd. 2,160-1,304 (166) 3,298 NC True Co., Ltd. 2,369 984 (2,027) (175) 1,151 OraionSoft Co., Ltd. 215-16 - 231 NCsoft Research & Development Center 939 1,006 (1,104) 30 871 7,071 1,990 (1,773) (318) 6,970 1 Capital adjustments reflect the translation adjustments resulting from the translation of the foreign currency denominated financial statements of overseas subsidiaries. 24
The equity method of accounting was applied based on the most recent unaudited financial statements of the following equity-method investee since the effect of its valuation on the Company s financial statements is immaterial: (in millions of Korean won) Closing date Net asset value OraionSoft Co., Ltd. December 31, 2006 812 NCsoft Japan KK December 31, 2006 259 J-Interactive Co., Ltd. December 31, 2006 (116) 7. Property and Equipment The changes in property and equipment for the years ended, are as follows: 2006 (in millions of Korean won) Beginning balance Ending Increase Decrease Others 1 balance Accumulated depreciation Book value Land 54,641-4 - 54,637-54,637 Fixtures 5,893 1,026 1,209 (251) 5,459 3,905 1,554 Main frame and servers 54,619 5,653 4,189 (685) 55,398 42,520 12,878 Tools, furniture and office equipment 18,804 3,003 633 (1,420) 19,754 14,546 5,208 Vehicles 215 74 74 (30) 185 121 64 Construction-in-progress 685 9,573 - - 10,258-10,258 134,857 19,329 6,109 (2,386) 145,691 61,092 84,599 2005 (in millions of Korean won) Beginning balance Increase Decrease Changes in consolidated entities Others 1 Ending balance Accumulated depreciation Book value Land - 54,641 - - - 54,641-54,641 Fixtures 4,214 1,370-380 (71) 5,893 4,026 1,867 Main frame and servers 39,754 15,435 1,694 2,252 (1,128) 54,619 33,509 21,110 Tools, furniture and office equipment 12,339 4,159 3 2,228 81 18,804 12,259 6,545 Vehicles 97 93 28 61 (8) 215 91 124 Construction-in-progress - 685 - - - 685-685 56,404 76,383 1,725 4,921 (1,126) 134,857 49,885 84,972 25
The changes in accumulated depreciation for years ended, are as follows: (in millions of Korean won) Beginning balance 2006 Disposal Depreciation Others 1 Ending balance Fixtures 4,026 1,115 1,145 (151) 3,905 Main frame and servers 33,509 3,264 12,703 (428) 42,520 Tools, furniture and office equipment 12,259 618 4,059 (1,154) 14,546 Vehicles 91 18 76 (28) 121 49,885 5,015 17,983 (1,761) 61,092 2005 (in millions of Korean won) Beginning balance Disposal Depreciation Changes in consolidated entities Others 1 Ending balance Fixtures 2,813-1,190 34 (11) 4,026 Main frame and servers 23,710 1,191 11,197 106 (313) 33,509 Tools, furniture and office equipment 7,724 2 4,146 385 6 12,259 Vehicles 59 26 58 2 (2) 91 34,306 1,219 16,591 527 (320) 49,885 1 This includes changes resulting from translation of foreign currency financial statements. As of December 31, 2006, the value of the Company s land, as determined by the local government in Korea for property tax assessment purposes, approximates 56,947 million. As of December 31, 2006, property and equipment are insured against losses which may arise from fire and other casualties of up to 97,201 million. 26
8. Intangible Assets The changes in intangible assets for the years ended, are as follows: 2006 (in millions of Korean won) Beginning balance Increase Amortization or impairment Others 1 Ending balance Industrial property rights 527 3,132 3,237 133 555 Intellectual property rights 3,428 1,055 2,724 (359) 1,400 Goodwill 10,327-4,541-5,786 14,282 4,187 10,502 (226) 7,741 2005 (in millions of Korean won) Beginning balance Increase Amortization or impairment Changes in consolidated entities Others 1 Ending balance Industrial property rights 603 230 306 - - 527 Intellectual property rights 1,287 3,297 1,690 672 (138) 3,428 Goodwill 11,495 2,423 4,267 676-10,327 13,385 5,950 6,263 1,348 (138) 14,282 1 This includes changes resulting from translation of foreign currency financial statements. Amortization costs of intangible assets amounting to 4,991 million and 5,511 million were classified as selling and administrative expenses, and cost of sales, respectively. Research and development costs incurred for the years ended, were accounted for as follows: (in millions of Korean won) 2006 2005 Cost of sales - 15,549 Selling and administrative expenses 60,226 29,956 60,226 45,505 27
9. Accrued Severance Benefits Changes in accrued severance benefits for the years ended, are as follows: (in millions of Korean won) 2006 2005 Beginning balance 3,418 1,942 Provisions 4,345 2,992 Severance payments (2,452) (1,516) Ending balance 5,311 3,418 10. Commitment and Contingencies As of December 31, 2006, the Controlling Company has a license agreements with Gamania Digital Entertainment Co., Ltd., a Taiwanese company, and several overseas subsidiaries and affiliates, wherein the Controlling Company, in return for granting the license to use its online game, Lineage, receives royalties from its licenses. As of December 31, 2006, the Controlling Company has a license agreement with THE 9 Limited and several overseas subsidiaries and affiliates to export its online game, Guild Wars. The initial royalties were recognized as sales during the term of the agreement based on sales. As of December 31, 2006, the Controlling Company has a license agreement with ArenaNet Inc. to have the rights to distribute the online game developed by ArenaNet Inc., Guild Wars in the Asian market and pay royalties based on sales. As of December 31, 2006, the Controlling Company has a license agreement with GalaxGate Co., Ltd. to have the authority to distribute exclusively the online game developed by GalaxGate Co., Ltd., ATrix. As of December 31, 2006, the Controlling Company has investment contracts with Space Time Studios and Digital Legends Entertainment S.L, to develope certain games. The Controlling Company will pay royalties based on sales. In 2006, the Controlling Company entered into a contract in Gyeonggi Province to purchase the land located in Pangyo amounting to 35,302 million. The Controlling Company should use this land for the specific purpose described in the contract for 20 years and not sell the land for 10 years after the registration of a proprietary right. 28
As of December 31, Seoul Guarantee Insurance Co., Ltd. has provided guarantees in connection with execution of a contract amounting to 8 million. As of December 31, 2006, NC Interactive Inc. an affiliate, has provided guarantees for execution of the operating lease of the Company amounting to approximately 534 million. As of December 31, 2006, short-term financial instruments of 849 million is restricted in connection with the lease transactions. The details of the Company s liabilities according to capital lease agreements as of December 31, 2006, are as follows: (in millions of Korean won) Year Lease expense Unearned interest Lease liabilities 2007 186 14 172 2008 195 6 189 2009 62-62 2010 49-49 Thereafter 4-4 496 20 476 The Company has entered into various lease agreements for the rental of certain building and computer equipment. The Company accounts for these leases as operating leases under which lease payments are charged to expense as incurred. Accordingly, the Company made a payment of 6,467 million in 2006 for the corresponding lease expenses. As of December 31, 2006, future lease payments under operating lease agreements are as follows: (in millions of Korean won) Year Lease payment 2007 5,110 2008 2,963 2009 2,895 2010 2,137 Thereafter 533 13,638 29
As of December 31, 2006, the Company is a defendant in eight pending lawsuits in connection with violating certain intellectual property rights including IHQ, Inc. On January 19, 2007, the lawsuit filed by IHQ, Inc. was settled as the Company paid compensation for damages amounting to 100 million and the Company recognized the corresponding amounts as other accounts payable. Other lawsuits filed, excluding the one just mentioned, seek for compensation for damages totaling 11,513 million. As of report date, however, no estimate can be made as to the time of settlement, or the amount of obligations which could arise, if any, upon such settlement. 11. Common Stock and Capital Surplus The Company is authorized to issue 100 million common shares with par value per share of 500. As of December 31, 2006, the Company has 20,387,634 shares issued. The details of issuances of common stock for the year ended December 31, 2006, are as follows: (in millions of Korean won, except par value) Number of Shares Par Value Common Stock Capital Surplus Balance, January 1, 2006 20,353,110 500 10,176 143,353 Issuance of common shares on January 31, 2006 1 15,792 500 9 652 Issuance of common shares on April 30, 2006 1 17,381 500 9 647 Issuance of common shares on July 31, 2006 1 85 500-2 Issuance of common shares on August 31, 2006 1 400 500-10 Issuance of common shares on October 31, 2006 1 666 500-28 Issuance of common shares on December 31, 2006 1 200 500-5 Balance, December 31, 2006 20,387,634 10,194 144,697 1 Common shares were issued due to exercise of stock options. Paid-in capital in excess of par value is not available for the payment of cash dividends, but may be transferred to capital stock through an appropriate resolution of the Company s Board of Directors or may be used to reduce accumulated deficit, if any, with the ratification of the Company s majority shareholders. 30
12. Retained Earnings Retained earnings as of, consist of : (in millions of Korean won) 2006 2005 Legal reserve 169 169 Reserve for business rationalization 3,135 3,135 Reserve for research and manpower development 2,079 4,158 Reserve for investment of small and medium-sized companies 393 786 Reserve for business operation loss 6,386 16,234 12,162 24,482 Unappropriated retained earnings carried forward to subsequent year 278,929 228,557 291,091 253,039 Legal reserve The Commercial Code of Korea requires the Company to appropriate, as a legal reserve, an amount equal to a minimum of 10% of cash dividends paid until such reserve equals 50% of its issued capital stock. The reserve is not available for the payment of cash dividends, but may be transferred to capital stock by an appropriate resolution of the Company s Board of Directors or used to reduce accumulated deficit, if any, with the ratification of the Company s majority shareholders. Other reserves Pursuant to the Corporate Income Tax Law, the Company is allowed to appropriate retained earnings as a reserve for research and manpower development, investment in small and medium-sized companies and business operations loss. These reserves are not available for dividends until used for the specified purposes or reversed. 31