Revenue recognition on the sale of virtual goods

Zynga: Revenue Recognition

Review the excerpts from the 2011 Zynga annual report and the Morgan Stanley exhibit and briefly answer the following questions. This assignment should not exceed 1 page.

Zynga Inc. (ZNGA) is the world’s leading provider of social game services with 240 million monthly users in over 175 countries. Zynga’s leading games include CityVille, Zynga Poker, FarmVille, CastleVille, FrontierVille, Mafia Wars, Words with Friends and Draw Something. Facebook is the primary distributor, marketer and payment platform for the company’s games, although the games are available on other social networks and through mobile applications. Zynga went public in December 2011 and is headquartered in San Francisco, CA. 1) Does Zynga charge its customers to play the company’s games? How does Zynga earn

revenue? 2) In your own words, explain how Zynga records revenue from the sale of virtual goods? 3a) Do you think Zynga’s method for accounting for virtual goods is appropriate? Why or why

not? 3b) What other information would you like Zynga to provide in order to better assess whether

the accounting treatment for virtual goods is appropriate 4a) Zynga notes that a change in the estimated average playing period resulted in an increase in

revenue of $53.9 million in 2011 and an offsetting reduction in revenue in 2012. What must have happened to the average playing period (i.e., did it increase or decrease)? What does that imply about the nature of Zynga’s business?

4b) What net income would Zynga have reported in 2011 had the company not made this

change?

Zynga Inc. Consolidated Statements of Operations

(in thousands) Year Ended December 31, 2011 2010 2009 Revenue $ 1,140,100 $ 597,459 $ 121,467

Costs and expenses: Cost of revenue 330,043 176,052 56,707 Research and development 727,018 149,519 51,029 Sales and marketing 234,199 114,165 42,266 General and administrative 254,456 32,251 24,243

Total costs and expenses 1,545,716 471,987 174,245

Income (loss) from operations (405,616) 125,472 (52,778)

Interest income 1,680 1,222 177 Other income (expense), net (2,206) 365 (209) (Provision for) / benefit from income taxes 1,826 (36,464 (12)

Net income (loss) $ (404,316) $ 90,595 $ (52,822)

Zynga Inc. Notes to Consolidated Financial Statements

Revenue Recognition We derive revenue from the sale of virtual goods associated with our online games and the

sale of advertising within our games.

Online Game We operate our games as live services that allow players to play for free. Within these

games, players can purchase virtual currency to obtain virtual goods to enhance their game- playing experience.

We recognize revenue when the service has been provided to the player and the collection of our fees is reasonably assured. For purposes of determining when the service has been provided to the player, we have determined that an implied obligation exists to the paying player to continue displaying the purchased virtual goods within the online game over their estimated life or until they are consumed. The proceeds from the sale of virtual goods are initially recorded in deferred revenue. We categorize our virtual goods as either consumable or durable:

Consumable virtual goods, such as energy in CityVille, represent goods that can be consumed by a specific player action. Common characteristics of consumable goods include virtual goods that are no longer displayed on the player’s game board after a short period of time, do not provide the player any continuing benefit following consumption, or enable a player to perform in-game action immediately. For the sale of consumable virtual goods, we recognize revenue as the goods are consumed, which approximates one month.

Durable virtual goods, such as tractors in Farmville, represent virtual goods that are accessible to the player over an extended period of time. We recognize revenue from the sale of durable virtual goods ratably over the estimated average playing period of paying players for the applicable game, which represents our best estimate of the estimated average life of durable virtual goods.

Future usage patterns may differ from historical usage patterns and therefore the estimated average playing periods may change in the future. We assess the estimated average playing period for paying players and the estimated average life of our virtual goods quarterly. Cumulative changes in estimated average playing period for paying players in 2011 resulted in an increase in revenue of $53.9 million and will result in an offsetting reduction of 2012 revenue in the same amount.

Advertising We have contractual relationships with agencies, advertising brokers and certain advertisers

for advertisements within our games. We recognize advertising revenue for branded virtual goods and sponsorships, engagement advertisements and offers, mobile advertisements and other advertisements as advertisements are delivered to customers.

Zynga Inc. Notes to Consolidated Financial Statements

We report our advertising revenue net of amounts due to advertising agencies and brokers because we are not the primary obligor in our arrangements, we do not set the pricing, and we do not establish or maintain the relationship with the advertiser.

Revenue by type The following table presents the components of revenue (in thousands):

Year Ended December 31, 2011 2010 2009 Online game $ 1,065,648 $ 574,632 $ 85,748 Advertising 74,452 22,827 35,719

Total revenue $ 1,140,100 $ 597,459 $ 121,467

Source: Investext. Reprinted for educational purposes.

M O R G A N S T A N L E Y R E S E A R C H

January 25, 2012 Zynga Inc.

M O R G A N S T A N L E Y R E S E A R C H

Zynga Inc. January 25, 2012

Consumable Goods – One-time use items, revenue recognized within current period

Zynga: Company Overview – Virtual Goods

Source: Company filing, Company website

Durable Goods – Revenue recognized over expected life of game

(Energy in Empires & Allies) (Resources in CastleVille) (Power-ups in Indiana Jones Adv. World)

(Tractors in FarmVille) (Fountain of Youth in CityVille) (Weapons in Mafia Wars 2)