Question

Princely Entertainment Ltd. (PEL) is an interactive entertainment company for the mobile world. Frank Prince and his family members own the majority of the 4,000 shares, and have financed all growth through shareholder loans, equity investment, and retained earnings; lenders, historically, have been hesitant to become involved in this sector.
Currently, the company has three games it has developed and currently sells: Princely CRASH, Princely RATS, and Princely DOOM. Users access PEL games for free via their mobile devices and through social networks. PEL generates revenue primarily through sales of virtual items that can be used in the games, such as extra lives, boosters, and game content that enhance users’ entertainment experience. Princely CRASH has experienced viral growth in the past year, changing PEL from a marginal, home grown company into an entity with far more potential. Frank is coming to understand that his company might be a takeover target for one of the larger players in this business, or even have the potential to go public itself if growth continues. PEL would require far more volume and breadth of games for a public offering to be feasible, however. You, CPA, have just been hired as the first ever professional accounting member of PEL’s management team. You are VP Finance, but your position involves many different elements. The financial records have primarily been kept on a cash basis, but because of growth, Frank thinks it is time to revisit accounting policies and start getting audited statements that comply with ASPE or perhaps IFRS.
All revenue is received through direct deposit from Facebook© and PayPal©. Frank’s wife, Ethel, keeps the accounting records, and is known for her attention to detail. Payroll is handled by a third party service. Ethel prepares simple monthly financial statements for Frank based on cash received and paid. Unpaid bills are accrued at year end for the preparation of the annual financial statements.
Frank has reviewed the cash based revenue figures for 20X3 to date, per Exhibit 1. He explains that his expectations from hiring a professional accountant include having someone put the accounting policies in order and get the financial statements verified by external accountants. Frank is attentive to general business news, is involved with local business groups, and has some general awareness of specific accounting concepts. Frank asks that within the specific context of PEL, you explain the similarities and differences between Canadian Accounting Standards for Private Enterprises (ASPE) and International Financial Reporting Standards (IFRS). Then, you are to identify the reporting issues facing PEL, and draft a report that sets out reporting policy alternatives and your recommendations. Based on your recommendations, you will have to recalculate revenue and any related balance sheet accounts.

Exhibit 1

Princely DOOM is a game that Frank purchased in 20X3 from its developer, in exchange for 250 common shares of PEL. The developer was working independently and had developed a highly viable game, but lacked the ability to scale it up. PEL has provided upgrades, added functionality, and integrated DOOM with the Princely playing platform. The game developer now works for PEL on salary, but is entitled to a royalty stream of 20% of revenue from this game for five years beginning in 20X3. The common shares (and DOOM) have been recorded at $1 in the accounts; Frank is not sure how to value this transaction or even whether it has to be recorded at all.

Required:

Prepare the report requested.

Answer 1

1.      Basis of reporting; IFRS vs ASPE

PEL has been a very small company, with three on-line games that generate revenue through upgrades. Shareholders are the primary financial statement users along with, likely, CRA. There is no debt financing because of the risk of the industry. There is now a royalty to pay based on one particular revenue stream. This is new in 20X3. With one game showing major growth, the primary owner/manager is thinking about the prospect of being a takeover target, or a future public offering. This is likely premature because PEL is still very small. IFRS compliance would not likely be cost-effective at this point. ASPE should be used as a reporting basis, to provide some structure for reporting in general, and the royalty payment in particular.

 

2.      Financial reporting issues

 

a.     Revenue recognition, consumables versus durables (unearned revenue)

·         Revenue is recognized when performance is complete, measurement is possible, and collection is assured.  Performance would be regarded as being achieved when all of the following criteria have been met:

·         Seller’s performance is complete; Seller has transferred the significant risks and rewards of ownership to the buyer. 

·         The amount of revenue can be measured reliably. 

·         The benefit of the revenue will actually flow to the seller. 

·         The seller can reliably measure all costs relating to the transaction, past and future. 

·         The seller retains no continuing managerial involvement or control over the goods sold. 

 

Collection is not an issue because of the advance payment.  Advance payment establishes the presence of an arrangement. Performance criteria must be met for revenue to be recognized. These are contracts to provide services. The real question is when services have been rendered/performance has been achieved and how apportionment of delayed services rendered can be measured.

 

For items that are immediately consumed (e.g., rain or extra life), service is rendered immediately and all revenue is recognized up front, on collection.

 

For durables (e.g., stronger engines or tires), the service might be argued to be delivered up front, with PEL having no ongoing obligations to the customer. The game itself is provided for free and there is no service obligation present. However, the alternative point of view is that the revenue from durables can only be recognized when the durable is used over the playing life of the customer. PEL has an ongoing obligation to keep the game operational for these customers. A critical estimate is the playing life, which has been estimated at 5-8 months. This is used to measure the revenue to be recognized. The average used might be different for different games and must be substantiated. A final alternative is to defer all revenue until the player ceases playing. This seems excessively conservative.

 

If the playing life estimate is reliable, then deferred revenue recognition for durables seems appropriate. Revenue has been re-calculated as shown in Appendix 1. Revenue is lower than cash collected, and an unearned revenue account of $435,000 is reflected on the balance sheet as a liability. 

 

For DOOM, the developer who gets royalties would prefer earlier revenue recognition (revenue when collected) to maximize his royalties. PEL might prefer later revenue recognition to preserve cash flow. This is more than just a timing issue: there would be unearned revenue from durables at the end of the royalty agreement, not subject to royalties, and this is a permanent reduction in the royalty the developer would receive.

 

b.     Revenue recognition, virtual currency (also unearned revenue, but with a separate analysis)

 

Revenue for the virtual currency could be recognized:

a. When received – (possibility for unused 10-30%)

b. When used / enters another revenue stream.

 

Performance criteria must be met for revenue to be recognized. Measurability is straight-forward, and this payment establishes the presence of an arrangement. Virtual currency is akin to a gift card that does not expire.

 

PEL has the obligation to keep the game “alive” for a reasonable period to allow consumers to use their virtual currency.  Since PEL has the obligation to provide services (either consumables or durables) when the virtual currency is used, revenue should be recognized at that point, based on the revenue stream that the virtual currency joins. (i.e., immediately on transfer for consumables, over the average playing life for durables; consistent with the conclusions in a).

 

If 10-30% of the amount collected for virtual currency will never be used, it could be recognized as revenue immediately. If the estimate is reliable, then some revenue recognition up front seems appropriate. That is, the liability unearned revenue might be measured at 70-90% of the gross amount. 

 

However, the 10-30% figures are on-line industry averages, and PEL presently has no historical information about its own experience. The virtual currency never expires, so there is no legal cut off point. Virtual currency is new in 20X3, and a past history of sufficient length may not be present. Without historical data, there should be no revenue recognition for virtual currency that may not be used until after a few years, at which point historical data would become available.

 

Accordingly, revenue has been re-calculated as in Appendix 1. A liability of 141,000 for unused virtual currency would be shown on the balance sheet. Revenue is lower by this amount because PEL has not yet earned the revenue.

 

c.     Gross versus net revenue

 

The question is whether revenue should be reported net, at $7 and $9.65, or gross, at $10, with a $3 or $0.65 financing fee. The presentation will affect the perceived size of the revenue streams, which are possibly important in looking at PEL as an acquisition target or an IPO candidate. Separate recognition will encourage the financial statement users to understand that financing fees are a significant expense (Facebook© is more expensive than Paypal©). For the DOOM revenue stream, the outcome may affect the royalty payment, because higher gross revenues may result in higher royalties. As with the issue in a, this contract should be re-examined with the developer for unintended consequences.

 

PEL appears to be the principal in these transactions as the other parties in the channel of distribution, Facebook© and Paypal© do not take on the significant risks and rewards of providing the service. PEL sets the price and provides the product. Accordingly, PEL should use the gross method to report revenues. It is not possible to quantify the impact of this recommendation, because the split of cash flow between Paypal© and Facebook© is not known. Presentation will be affected, but not bottom line net income except if there are changes to the royalty payable for DOOM.

 

d.     DOOM investment

The cost of the investment in the tangible asset – DOOM asset, and the related share equity issued, are currently recorded at $1. This is a non-monetary transaction that should be recorded at either fair value if there is commercial substance or at carrying value if there is no commercial value. (Note that this is not a related party transaction so none of the guidance for related parties is relevant.) 

 

There is commercial substance in this transaction since the cash flows related to shares given up would be very different from the timing, risk and amount of cashflows related to the game received. 

 

Under ASPE, if the non-monetary transaction has commercial substance, the transaction is reported at the fair value of either the asset given up or the asset received, depending on which value is more reliably measurable.

 

For PEL’s transaction, an equity element is given up.

 

In general the Board of Directors is responsible to existing shareholders, under legislation, for the obligation to issue common share at fair value. This prevents any disadvantage to existing shareholders from dilution. Accordingly, valuation of issued shares at fair value is prudent.

 

The recommendation is that PEL should value the acquisition at fair value. 

 

As a result, the fair value must be established. PEL must have had some idea as to the value of the game when it was acquired, as the basis for the number of shares being issued. It is unlikely that the PEL shares could be valued as a reference point because the shares are closely held by family members. However, the basis of negotiations between PEL and the developer is the logical starting point to ascertain an estimate of fair value.

 

Objective evidence to support the value of the transaction must be gathered and assessed. The value as of the transaction date must be set, not the value of the modified game at the end of the year. The transaction value can be informed by the first year of revenue from the product.

 

Appendix 1 – Revised revenue

Prince Entertainment Limited, nine months ended September 30, 20X3

(in 000’s)

		Princely	Princely	Princely	Total
		CRASH	RATS	DOOM
Revenue - Consumables	No change	$ 2,245	$ 110	$ 260	$ 2,615
Revenue - Durables		680	95	170	945
	Less: adj Unearned revenue	315	10	110	(435)
		365	85	60	510
Revenue – Virtual currency		180	5	30	215
	Less: adj Liability for  Virtual Currency	120	1	20	141
		60	4	10	74
					$3,199