The Impact of the Focus on Services in Business and Financial Reporting

Over the past decade or more, the gaming industry has become increasingly focused on providing services to its customers rather than simply delivering products. This evolution has manifested itself in a number of ways, some of which are substantive, including online cooperative or competitive play, and others that are less substantive but still valuable, such as online leaderboards. Those tweaks to the service offerings are obvious. They are openly advertised, listed with product details, and discussed in reviews, articles, and forums. The less obvious but certainly impactful factor to consider is that a company cannot change what it does without making some changes to how it does it. This may take the form of a company having to review and estimate how long consumers use these services and deferring revenues throughout that time period, as Electronic Arts has done, developing and deploying new cloud service products to expand their overall product suite as Sony has done, or making significant capital investments in infrastructure as Microsoft has done. The industry‘s evolution into a more service-oriented one has resulted in creativity, new service offerings, and more options that have proven to be valuable to the consumer and, for those invested in companies that have adapted effectively, the investor.

To consider this further, I reviewed a few companies’ financial results and disclosures. I selected Electronics Arts, Inc. (EA), Sony Corporation, and Microsoft Corporation due to their having significant roles in the gaming industry. There are other companies that would be worthwhile to consider to add more color to the picture of what the environment is becoming, so there is no presumption that these three companies and their experiences are representative of what the impact has been. They likely aren’t. That shouldn’t preclude us from looking more closely, though, to see what we can find out.

Electronic Arts

It makes sense to start with Electronic Arts, as they are more strictly dedicated to the industry. The other two companies have significant operations in other industries, which makes what we can glean from their financials a little less clear as it relates to gaming. The bulk of my research was on their 10-Q Quarterly Reports for the quarters ended June and September 30, 2014. There are several technical takeaways that warrant discussion: revenue deferrals, the treatment of payments to thinly capitalized developers, and their recognition of revenues on a net basis.

Revenue deferral is a process that is put in place to ensure that a company doesn’t get to actually record what it has sold until it has earned it, and the inclusion of service elements has had a direct impact on EA’s financial statements. The earning and the recording generally must occur in the same period. When a game producer provides a continued service, such as an online environment used to interact with other players or online leaderboards, that revenue isn’t realized in the income statement as quickly since it isn’t recognized all at once as soon as the consumer buys the game. Additionally, in this case, EA still recognizes all of the expense up-front and does not apply the same type of deferral process to those. The negative impact on the income statement is even greater as a result. The requirement to delay the recognition of revenue must be considered even in instances where the online services are free. Years ago, it was common for a sale to be final and recognized as such when a consumer bought a cartridge or CD. Ultimately, the change in timing to the revenues is more directly related to financial statement presentation rather than actual business activity. Its impacts to the financial statements are largely cosmetic, though it does indeed impact the bottom line in a real way. At the end of the day, a $50 sale will still generally create $50 of revenue. Under revenue deferral, it may just get spread out over months or even years rather than get recognized all at once.

The impact to the timing of revenues on the income statement is relatively innocuous for investors, but the services being provided that necessitate this treatment is beneficial to consumers. Whether investors prefer revenues, which would be impacted by this, or cash, which would not, depends more on what type of organization and results the investor is looking for. Neither is better or worse—they are just positioned slightly differently. I think that this treatment of revenues provides a good incentive to the game maker to stay engaged in the product, which not only results in more ways for gamers to enjoy a game, but also potentially extends the value for a longer period of time. EA estimates the offering period—the period of time the service is expected to be offered to the consumer—to be approximately nine months for physical game sales and approximately six months for digitally distributed games sales.

The second point I noted above, which is another process of deferral and timing though this time regarding expenses rather than revenues, relates to how royalty-based payments are handled. Much like deferrals that affect revenues, some royalty payments have an extended period of time where they impact the income statement irrespective of the timing of the payment. Generally, royalty-based payments, whether they are paid in advance or accrued to be paid later, are capitalized and then expensed to costs of revenue at an appropriate rate while sales of the affected products are ultimately being made. That’s actually not different from how they would have been treated in a less service-oriented environment; however, EA does note that any prepayments made to thinly capitalized independent developers are handled differently due to the acceptance of the burden of risk on the part of EA in these cases. These expenses are written off immediately as research and development costs. If the product actually materializes and is sold, those latter royalty payments are expensed as costs of revenues. From an investor’s perspective, the deferral does still impact income, if only as it relates to timing. The key thing to note here is that expenses get accelerated when independent game projects are developed. That’s a mild deterrent to management to the extent that the risk itself wasn’t already a mild deterrent. In cases where management believes that consumers would be interested in a project, EA may take the calculated risk to go ahead and absorb the immediate write-off in the hopes that the project becomes profitable.

Nearly a fourth of EA’s total revenues, 22%, came from Microsoft and Sony alone. The supply chain has enlarged to include the company’s own competitors as participants in delivering their products to their ultimate customers. The sales to Microsoft and Sony represent more than twice the revenues they earned selling to their next largest customer, GameStop, which primarily sells physical games, both used and new, in brick-and-mortar storefronts.

The online channels for digital distribution will also have a meaningful impact on the financials for companies that sell through those channels. EA has taken a position of recognizing revenue on a net basis rather than a gross basis. They have done this to comply with the related guidance, and from an investors’ perspective it is cosmetic. It affects how the lines in the income statement get presented but doesn’t affect the bottom line or even timing. They have taken this position due to the fact that EA’s role in digital storefronts is more that of an agent rather than the primary obligor. To put it simply, many of their games are sold through other companies’ storefronts, such as Xbox Live Marketplace, Sony PlayStation Network, Apple App Store, and the Google Play store. In these cases they have to carve out the fees for participating in the storefront from revenues rather than recognizing them as a cost of revenues, which emphasizes two points about EA and their role in the marketplace. First, they have a significant relationship with these storefront companies. Nearly a fourth of their total revenues, 22%, came from Microsoft and Sony alone during the quarter ended June 30, 2014 (29, Note 16). Second, the role of the digital marketplace is becoming significant, and the supply chain has enlarged to include the company’s own competitors as participants in delivering their products to their ultimate customers. The sales to Microsoft and Sony represent more than twice the revenues they earned selling to their next largest customer, GameStop, which primarily sells physical games, both used and new, in brick-and-mortar storefronts.

Sony

Sony is an enormous entertainment conglomerate that participates in the gaming industry as well as in the music, film, related hardware, and other industries as well. Sony’s strategic positioning as it relates to the gaming industry is currently focused on building and reinforcing the PS4 customer base, the PS Now platform which has yet to be fully deployed, and PlayStation Vue, a cloud television service that has also yet to be deployed. Management believes these initiatives will provide Sony’s customers the intrinsic additional value that they are seeking, encouraging them to buy their products and services. A few of the key things I noticed upon review of their most recent 20-F for their fiscal year ended March 31, 2014 were their treatment of research and development, their Gaikai acquisition, and their accounting for online services’ deferral to contrast with EA.

Sony PlayStation 4

Sony’s treatment of research and development, which is consistent with standard treatment, still merits discussion if only to illustrate the timing of when expenses are capitalized and when they are not. The introduction of complexities related to online services results in management having to write off more research and development expenses immediately. The level of complexity, as a result, must be managed at a level that is palatable to investors’ expectations in terms of its impact to the income statement. Additionally, and even more interesting, is the timeframe that Sony applies to capitalize these expenses, in instances where they can, for products that go to market. Sony expenses all costs immediately as they are incurred while the feasibility of a contemplated software project is being examined. This is obviously a soft line, as it should be, since there is a lot of judgment of management and of the technical development teams in determining where that tipping point should be. This is yet another somewhat cosmetic accounting technicality that affects timing more than the ultimate bottom line. The line that gets drawn would inevitably be impacted by the complexity of the project. The introduction of online interaction would add to that complexity and delay the period of time when they would be able to capitalize an expense, which management often prefers to do. It’s another subtle pressure that acts as a disincentive to adding online interactivity, since it forces them to reduce net income sooner. Management would favor a “sweet spot” of how much to offer that would improve sales without providing too much of a negative impact on short-term performance. I sincerely doubt they consider this too closely—it ultimately depends on how successful the product is overall and not these timing issues. Still, these pressures are not ignored by management and, subtle though they may be, they reinforce the incentive to do more to meet the expectations of today’s consumers.

Aside from financial presentation, the increase in service offerings in gaming has also brought companies to redesign their structure through acquisitions in an effort to evolve along with the industry quickly. Sony acquired Gaikai during the fiscal year ended March 31, 2013 for 28,167 million yen (F-90, Note 4). This company has developed a high-quality, fast interactive cloud-streaming platform that enables streaming of a broad array of content, ranging from immersive core games with rich graphics to casual content, to a wide variety of devices via the Internet. This deal illustrates Sony’s firm commitment to developing this service-oriented environment and investing in their capacity to participate in it in the future.

The reporting of games that have service offerings included can also increase the complexity of financial statement comparisons. While EA adopted a deferral mechanism for most, if not all, of their games that offer online services, even if they are not substantial in nature, Sony only does these deferrals in instances where these online services provide a “substantive deliverable in addition to the software product” (F-23). In these cases they defer for an estimated six months. It is interesting to me as it is a slightly more aggressive stance than what EA has taken but still completely reasonable within the accounting requirements under US Generally Accepted Accounting Principles (GAAP) for treatment of these revenues. From an investor perspective, looking only at this segment’s numbers, it would make the timing of Sony’s delivery to customers to be shorter than EA to a small degree, as they are not applying the same standard of measurement, though both are reasonable and allowable. That’s what disclosures are for, though. The level of detail in these filings can seem daunting, but the information included must be considered and interpreted in full prior to making specific conclusions. When portions of the financials are skipped or disregarded, investors bear the risk of not understanding the business they are reviewing. All of the facts and information that are disclosed in a filing must be evaluated to truly understand the reporting company.

Microsoft

Microsoft is also a large company that participates in markets in addition to gaming. Their financials similarly include data that doesn’t directly relate to gaming, but there are still a couple things worth noting for the purposes of this article, particularly their position on free or open-source business models and their position on what makes a console successful. Microsoft’s strategic vision is designed to facilitate growth through effective competition. This strategy, announced in July 2014, is described by them as suited for performing in a mobile-first and cloud-first world. It represents the most recent iteration of Microsoft’s continuous effort to adapt to changes in pricing and delivery structures as well as to the prevalence of cloud-based services for consumers and businesses. Microsoft is devoting significant resources to develop and deploy their cloud-based services as well as to ensuring that the Windows products evolve with these changes so it can retain and reinforce, if not advance, its place in the market. Their taking this initiative is a clear and direct acknowledgement of what Microsoft and its competitors and customers are seeing as changes to this marketplace.

Microsoft Xbox 360

Microsoft is a strong advocate of investing in themselves and in their products. This is a key characteristic of their strategy that they are relying on to build and maintain an environment that they can use to deliver online services to gamers. Consistent with this self-advocacy, they have taken a position that free games and open-source games, both of which are generally funded by advertising, leverage other parties for research and development costs rather than absorbing them themselves. Per their 10-K for the year ended June 30, 2014, they have consistently invested in research and development in amounts equal to 13% of their revenues, or over $11 billion in their fiscal year 2014 (36, Part II, Item 7). They are on pace to reach the same percentage of revenues for the current year per their 10-Q for the quarter ended September 30, 2014, having already spent over $3 billion. Microsoft remarked on this due to a competitive challenge that it presents them with, since the price difference between a free game as compared with one that costs up to sixty dollars can be a difficult case to make to a consumer. I thought it was worth pointing out since these types of games have become extremely common and also have developed their own space in the gaming services field. For my part, I privately don’t feel that those types of products are necessarily good for gamers, but I may be biased as I haven’t played them much (only with my children). Since there is an appetite for them and they are resulting in funding for those parties putting them out, it may be worth watching. The common practice of leveraging advertising and the fruits of other companies’ development through the use of open code does create a bit of a complicated playing field for companies that have to fund their own research and development. I’m not sure how many of the companies that are doing that are also available to investors publically. Microsoft believes that their capital-intensive approach to developing this gaming space to deliver these services will be more effective for their investors and for their customers than these alternative approaches.

Microsoft believes that the success factors for consoles include services and digital access as key components. Their Annual Report states their belief that “the success of gaming and entertainment consoles is determined by the availability of games for the console, providing exclusive game content that gamers seek, the computational power and reliability of console, and the ability to create new experiences via online services, downloadable content, and peripherals” (5, Part I, Item 1). I hadn’t seen these success factors for this industry expressed so clearly and consistently with my beliefs, and I also feel that its breadth is voicing the commitment to this overall environment change. Although I have mixed feelings about them as a company, I can’t disagree that they are generally really good at what they do and that they have been enormously successful. The company hasn’t even existed for forty years yet and they have a market cap in excess of $385 billion. That’s astounding.

The market is continuing to adapt to the changing needs and wants of consumers as well as to the changing abilities and offerings of game producers. I have enjoyed partticipating in it as a consumer as the changes really have been dramatic, not to mention occurring rapidly from a historical perspective. Years ago, I was initially resistant to online interaction or the introduction of additional services. As they evolved and as I had more opportunities, I found instances where both became appealing. The expectation of service from the customer is widespread in this market and is clearly being observed and addressed by the producers. This compulsion to adapt so that they may retain and attract consumers’ interest is beneficial to the consumer in the long run. These types of interactions—this pushing and pulling between consumers and producers—are catalysts for creativity. The risk for investors is only that they may select a company whose business model doesn’t materialize into expected returns; that’s a natural risk that isn’t unique to this environment, even as dynamic as it has proven to be. The risk for the gamer is inconsequential. We have plenty to gain from changes to the product and delivery and little to lose as it’s a completely discretionary product, which allows us to exercise significant control over our purchase decisions.

A notepad, adding machine, and clipboard

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Disclosure

At the time of this writing, Brian Johnson does not have direct investments in Electronic Arts, Inc., Sony Corporation, or Microsoft Corporation. None of the content of this article should be construed or used as investment advice.

Works Cited

Electronic Arts, Inc. 2014 Quarterly Report. Electronic Arts, Inc., 2014. Web. 5 August, 2014.
—. 2014 Quarterly Report. Electronic Arts, Inc., 2014. Web. 4 November, 2014.
Microsoft Corporation. 2014 Annual Report. Microsoft Corporation, 2014. Web. 31 July, 2014.
—. 2014 Quarterly Report. Microsoft Corporation, 2014. Web. 23 October, 2014.
Sony Corporation. 2014 Annual Report. Sony Corporation, 2014. Web. 26 June, 2014.