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UT CPAs 2B, LLP

Memorandum

To: All Staff Accountants

From: Robert Goodwin

Date: 13 April 2018

RE: New client revenue testing

We have recently been hired to consult for SmartApps, Inc., a local startup that produces gamification-based math

training apps that teach basic math concepts to elementary students. We are preparing to meet with them to discuss

their audit needs as they are planning to go public in the near future and do not have any experience with being audited.

We have been tasked with helping SmartApps implement the needed internal controls and ensure that they are

prepared for the audit process. For the majority of their business, our standard controls worksheets will be sufficient.

However, their revenue recognition process is very different than our other clients.

What follows is a discussion recently published in the IAE journal regarding similar issues in their revenue recognition

(exhibit 1). Please review this material, and then answer the questions below.

Questions:

1. Revenue Recognition Models:

a. Rank the three different methods proposed by EY for Zynga’s in-game revenue recognition from most

to least aggressive and explain the rankings.

b. Determine whether any of the three methods are invalid under the FASB’s new revenue recognition

rules.

c. Finally, develop and justify your opinion about which of the three methods is the best method for

recognizing this type of revenue.

2. AIS Needs for In-Game Revenue Documentation:

a. Develop a list of database fields our client would need to capture in its accounting information system

in order to effectively capture and document the evidence needed to justify revenue recognition

journal entries.

3. Audit Planning and Testing Procedures:

a. Assuming that our client will be in a similar position as Zynga, indicate what internal controls would be

key to the revenue recognition process.

b. What substantive testing procedures would an auditor need for an organization that recognizes

revenues from in-game currency activities?

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Exhibit 1:

Facebook provides a social networking platform used by more than 1 billion people, and Zynga Inc. is a video game

developer with many products (e.g., FarmVille, Words with Friends) that interface with social technology sites like

Facebook and Google. FarmVille players can use Facebook to purchase in-game currency they can use to acquire

resources, such as hay and livestock, in pursuit of a more productive virtual farm. Revenue recognition in firms that

earn money through socially based use of virtual items is challenging. For example, how does Zynga recognize revenue

received when customers convert real dollars into FarmVille currency in order to purchase virtual goods? Revenue from

conversion of real dollars into in-game currency is big business: Zynga estimates that such sales, from FarmVille hay to

Mafia Wars assault rifles, accounted for nearly all of Zynga’s $1.1 billion in 2011 revenues and 12 percent of revenue

for Zynga’s distributor, Facebook (McKenna 2012).

While neither the FASB nor the SEC have issued rules to account for sales of virtual goods, Ernst & Young (EY), auditor

for Zynga and Facebook, recently proposed three revenue recognition models it believes are consistent with generally

accepted accounting principles:

(1) Game-based, where firms recognize revenue when players spend their purchased credits,

(2) User-based, a faster scheme that recognizes revenue over the estimated average time a typical user plays the

game, and

(3) Speedy item-based, rooted in the properties of specific virtual goods (Ernst & Young 2010).

Under the game-based method, Facebook treats the purchase of credits (real-world currency converted into credits to

buy virtual goods) as deferred revenue—the same way a retailer would book the sale of a gift card—until the player

spends the credits (McKenna 2012). When a player uses credits to purchase, for instance, a $10.00 FarmVille tractor,

Facebook credits or charges $10.00 (which, unseen to the player, buys 100 Facebook credits that convert to 55 Farm

Cash dollars). Facebook sends $7.00 to Zynga and keeps $3.00 (30 percent) as a processing fee. Only after the tractor

purchase will Facebook move its processing fee from deferred revenue into current revenue, and only then will Zynga

recognize revenue.

For the user-based method, Zynga must wait until the revenue is both realized and earned. Stated differently, even

when Zynga has the cash in hand, it does not recognize any current revenue until it delivers the product or service,

which Zynga can define under multiple structures. This revenue recognition method depends on management

estimates of the life of a game, a customer, or a virtual item. Tweaking estimates can materially affect the bottom line.

For example, in its fourth amended registration statement, Zynga noted that during the first half of 2011, it estimated

the blended average paying player life for a game as 15 months, down from 19 months a year earlier. The shorter player

life increased GAAP revenue for the six months by $27.3 million, turning a loss for the six months ended June 30, 2011

into a net profit of $18.1 million. Interestingly, this change came just before Zynga went public in mid-December at

$10.00 a share.

For speedy item-based recognition, Zynga may recognize revenues from ‘‘consumable’’ virtual items (e.g., energy)

immediately, and revenues from ‘‘durable’’ goods (e.g., tractors) over the estimated time a player is projected to play

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a game. EY’s revenue recognition methods may be problematic for two reasons. First, EY consulted for Zynga before

becoming its auditor when Zynga went public. While designed to address such conflicts, the Sarbanes-Oxley Act allows

an accounting firm to first consult on technical and internal accounting issues for a startup and later, when that

emerging organization is preparing to go public, segue into a role as independent auditor, potentially auditing its own

work (McKenna 2012).

Second, newly enacted changes to revenue recognition standards may further complicate the issue for firms like Zynga.

The new rules will divide revenue recognition into five steps:

1. Identify the contract with the customer.

2. Identify the performance obligations in the contract.

3. Determine the transaction price.

4. Allocate the transaction price to the performance obligations in the contract.

5. Recognize revenue when (or as) the entity satisfies a performance obligation.

Determining whether separately purchased items represent distinct performance obligations and identifying the

criteria for completion of each individual obligation may further complicate revenue recognition for online game

companies. For example, if a FarmVille player purchases a large amount of Farm Cash, and that cash can be spent

separately on virtually infinite permutations of different products, then how should Zynga determine its obligation and

the related revenue allocation?