Zynga is back in the news with disappointing results. The Company’s second quarter results were announced on July 25 with a loss and slowing revenue growth. Several law firms responded in our great American tradition by announcing class-action suits.
Clearly, there are some strategic and organizational issues in play. For example, what is Facebook’s long-term relationship with Zynga? Also, can the Company’s management team meet the challenges facing the Company, particularly those from competitors, and its own staff?
However, we shall stick to the accounting issues, our forte. And again we dredge up Zynga’s revenue recognition policy, which we have discussed before (“Zippy Zynga” and “Zynga’s First 10-K: Zestful Zephyrs”). Recall the revenue recognition enunciated in the firm’s 10-K:
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 sales 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 may 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 often times enable a player to perform an in-game action immediately. For the sale of consumable virtual goods, we recognize revenue as the goods are consumed (emphasis added). 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 average life of our durable virtual goods (emphasis added). If we do not have the ability to differentiate revenue attributable to durable virtual goods from consumable virtual goods for a specific game, we recognize revenue from the sale of durable and consumable virtual goods for that game ratably over the estimated average period that paying players typically play our games (as further discussed below), which ranged from eight to 25 months in 2011 (emphasis added). Future paying player usage patterns and behavior may differ from the historical usage patterns and therefore the estimated average playing periods may change in the future.
We stated in previous columns, and we still maintain, that this method is too arbitrary as it depends on virtual tractors and such. We would prefer that Zynga record revenue as cash streams are received, and forgo all of the subjective deferral manipulations. And we continue to laugh at the so-called non-GAAP metric “bookings” which adjusts revenues for the change in deferred revenue. We are amused because bookings look more like GAAP revenue than the method actually employed.
Cory Johnson at Bloomberg also explored this revenue recognition issue recently (“The Ins and Outs of Zynga’s Nifty Accounting Tricks”). He notes that Zynga has changed the estimates of customer usage for these virtual gaming assets in five of the last six quarters. By changing these estimates, Zynga has been able to convert some quarterly losses into quarterly profits. A marvelous tool for injecting extra revenues when necessary—and without any additional expenses!
We also note that Zynga’s revenue recognition practices allow it to claim higher quarterly growth rates than it would if it quit deferring any revenues. The average growth rate of quarterly revenues over previous adjacent quarters is 15 percent, and the average growth rate of quarterly revenues over the previous year’s quarter is 74 percent.
If one adjusts revenues by eliminating the deferred revenues, as we advocate, the growth rates become more realistic. The average growth rate of quarterly revenues over previous adjacent quarters is only 6 percent, and the average growth rate of quarterly revenues over the previous year’s quarter is 30 percent.
Apparently, Zynga recognizes revenue the way it does and also discloses bookings so it can have the best of both worlds. It more than doubles revenue growth rates by applying its revenue recognition method of choice, but also shows higher revenues via the bookings metric. Ah, what magic!
POSTSCRIPT. Writing about Groupon last week and now Zynga reminds us of McKenna’s interesting article in Forbes “How Zynga, Facebook and Groupon’s Go-To Auditor Rewrites Accounting Rules” (April 23, 2012). Particularly interesting are her comments about “Revenue Recognition on the Sale of Virtual Goods” by Ernst & Young. She claims that E&Y asserts that revenue recognition is essentially up to the discretion of management for these firms; in other words, anything goes.
We shall leave it to our readers to peruse this column by Francine and E&Y’s brochure. We shall simply comment that if one had shorted Groupon and Zynga at that time, one would have earned returns (before transactions costs) of 67% and 62% respectively.
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.