Revenue Recognition Analysis Paper

Introduction
I chose to look at the financial filings of Electronic Arts (EA). The company is an American company traded on the NASDAQ exchange under the symbol ERTS. Electronic Arts develops, markets, and distributes interactive software games that are played on a variety of computer platforms in over 30 countries. I chose this company because I have an interest in the computer gaming industry, both from the viewpoint of someone that is interested in playing computer games and as an investor. The topic that I have chosen to address is the issue of revenue recognition.

Revenue Recognition Analysis
I started by looking at EAs annual report (Form 10-K) for the fiscal year ending March 31, 2007. Revenue recognition is discussed in some detail.
In particular, they state that revenue is recognized according to the criteria established by Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” and Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition”. Revenue is recognized when EA has estimated that all of the following criteria have been met: • Evidence of an arrangement.
Evidence of an agreement with the customer that reflects the terms and conditions to deliver products must be present. • Delivery. Delivery occurs when a product is shipped and the risk of loss and rewards of ownership have been transferred to the customer. • Fixed or determinable fee. Revenue is recognized as the arrangement fee becomes fixed or determinable. • Collection is deemed probable. Collection is deemed probable if the customer is expected to be able to pay amounts under the arrangement as those amounts become due.

Generally stated, these criteria are in place to ensure that the company follows the GAAP concepts that we have discussed in class, that revenues are recognized when they believe they have earned it and when the revenue is realized or
realizable.
EA further states that they must make a number of assumptions and judgments that can have a significant impact on the timing and amount of revenue reported.
One of particular importance is whether vendor-specific objective evidence of fair value (VSOE) exists for each element of a bundled package. This has significant impact to EA with regard to bundled sales of software that includes both software (or direct download) and essential server access for future on-line services. In several places in the annual report, EA engages in some forecasting to let investors know that changes are coming with regard to revenue recognition in FY2008. They state that through FY2007 they were able to determine VSOE and allocate revenue between the software and the on-line service independently. Beginning in FY2008 the required VSOE will not exist due to a change in pricing policy on these software bundles, thus forcing EA to defer revenue on the entire bundle over the expected service period. In FY2008, this revenue will be recognized on a straight-line basis over the six month period following product delivery.
Interestingly, EA states they intend to expense the cost of goods sold related to these certain transactions at the time the product is delivered. In the FY2007 annual report, deferred net revenue on packaged goods and digital content on the balance sheet was $23 million. They estimate that the same category deferred net revenue in FY2008 will likely be $400 to $500 million as a result
of this change to their revenue recognition policy. Obviously, this change will have a significant impact on the company’s financial ratios if this revenue is deferred into later periods.
I also looked at EA’s 1st and 2nd quarterly reports (Form 10-Q). For the 1st quarter FY2008, ending June 30, 2007, deferred net revenue was $68 million. In the 2nd quarter, deferred net revenue had risen to $364 million. Revenue for the second quarter fell 18% to $640 million from $784 million in the same quarter last year. However, if the $296 million 2nd quarter deferred revenue were included as it was in the previous year, revenue would have been $936 million, an increase of 19 percent from the year-ago period, according to EA.

Conclusion
Electronic Arts attempts to recognize revenue when they believe they have earned it and when the revenue is realizable. Because of a change in EA accounting practices for FY2008 related to vendor-specific objective evidence of fair value, EA will defer a significant portion of certain sales revenue over the six month period following product delivery while continuing to expense the cost of goods sold at the time of delivery. This change will result in a significant deferred revenue liability on the company’s financial statements. Based on our discussions in class, this deferral of revenue over a six month period while immediately recognizing the associated expenses seems to not be in keeping with the matching principle and in this case is resulting in a very large deferred revenue liability on the balance sheet when revenue is deferred into future periods.