Exhibit 99.2

 

REPORT OF INDEPENDENT AUDITORS

 

To the Shareholders and Board of Directors of Vivendi Games, Inc.:

 

We have audited the accompanying consolidated balance sheets of Vivendi Games, Inc. (“Vivendi Games,” as described in Note 1) as of December 31, 2007 and 2006, and the related consolidated statements of operations, owner’s equity and comprehensive income and cash flows for each of the three years in the period ended December 31, 2007.  These financial statements are the responsibility of Vivendi Games’ management.  Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of Vivendi Games’ internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of Vivendi Games’ internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Vivendi Games, Inc. as described in Note 1 as of December 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.

 

As more fully described in Note 2, beginning on January 1, 2006, Vivendi Games’ trade names were reclassified from finite to indefinite-lived assets and are no longer being amortized and in 2008, Vivendi Games retrospectively changed the manner in which it recognizes revenue associated with sales of The Burning Crusade expansion pack, which was released in January 2007.

 

/s/ Ernst & Young LLP

 

Los Angeles, California

 

February 29, 2008
except for the effects of the change in accounting
principle described in Note 2, as to which the date
is November 5, 2008

 

 

Vivendi Games, Inc.

 

Consolidated Balance Sheets

 

(in thousands, except share and per share amounts)

 

		As of March 31,			As of December 31,
		2008			2007			2006
		(unaudited) (as adjusted)			(as adjusted)
Assets
Current assets:
Cash and cash equivalents		$	47,354		$	62,241		$	67,969
Accounts receivable, net of bad debt allowance and other allowances		102,669			164,953			210,861
Inventories		20,075			21,359			27,914
Capitalized software development costs, net		3,174			845			5,841
Royalties and license agreements, net		35,970			33,550			30,383
Prepaid expenses and other current assets		7,068			12,476			9,925
Deferred taxes		141,814			142,376			75,141
Total current assets		358,124			437,800			428,034
Royalties and license agreements, net		51,359			58,761			9,208
Property and equipment, net		121,561			128,599			115,959
Other intangibles, net		58,803			60,043			62,309
Goodwill		207,262			203,417			202,094
Deferred taxes		26,768			24,165			—
Other assets		5,939			6,057			6,680
Total assets		$	829,816		$	918,842		$	824,284
Liabilities and owner’s equity
Current liabilities:
Accounts payable		$	30,805		$	48,835		$	60,862
Accrued expenses and other		326,535			362,200			261,652
Deferred revenues		185,807			189,640			116,696
Royalties payable		2,199			6,280			13,444
Total current liabilities		545,346			606,955			452,654
Deferred taxes		—			—			17,813
Other long-term liabilities		83,080			72,082			7,375
Total liabilities		628,426			679,037			477,842
Commitments and contingencies (Note 9)
Owner’s equity
Common stock: $0.01 par value; Authorized—100,000 shares, issued and outstanding—800 shares		—			—			—
Additional paid in capital		487,436			490,041			534,606
Net (receivable from) payable to Vivendi and affiliated companies		(4,255		)	77,254			372,061
Accumulated deficit		(324,494		)	(367,274		)	(594,290		)
Accumulated other comprehensive income		42,703			39,784			34,065
Owner’s equity		201,389			239,805			346,442
Total liabilities and owner’s equity		$	829,816		$	918,842		$	824,284

 

See accompanying notes.

 

1

 

Vivendi Games, Inc.

 

Consolidated Statements of Operations

 

(in thousands)

 

		Three Months Ended March 31,						Year Ended December 31,
		2008			2007			2007			2006			2005
		(unaudited) (as adjusted)						(as adjusted)
Product sales, net of returns and allowances		$	72,556		$	74,786		$	505,516		$	469,034		$	483,839
Subscription revenues		233,891			173,576			782,156			502,326			270,174
Licensing revenues		16,737			10,656			50,406			42,278			18,806
Other revenues		1,638			2,544			10,873			4,018			7,506
Net sales		324,822			261,562			1,348,571			1,017,656			780,325
Cost of sales (excluding depreciation and amortization)		93,595			75,311			382,021			321,349			304,028
Sales and marketing		27,278			30,584			175,582			149,865			140,745
Research and development		102,716			81,380			384,806			246,527			157,087
General and administrative		19,978			33,803			154,715			126,003			73,025
Amortization of capitalized software development costs		1,030			1,964			10,134			8,088			17,897
Depreciation expense and amortization of other intangibles		16,046			13,522			62,733			39,000			43,774
Restructuring costs		15			(1,619		)	(864		)	4,383			1,700
Total operating expenses		260,658			234,945			1,169,127			895,215			738,256
Operating income		64,164			26,617			179,624			122,441			42,069
Other expenses (income):
Interest, net (from) to Vivendi		(2,021		)	2,626			2,960			18,100			14,512
Interest, net		(507		)	(329		)	(1,008		)	(813		)	587
Foreign currency exchange loss (gain)		1,778			1,653			2,250			(1,751		)	(1,176		)
Other, net		(97		)	669			874			871			(5,230		)
Total other expenses (income)		(847		)	4,619			5,076			16,407			8,693
Income before income taxes		65,011			21,998			174,548			106,034			33,376
(Provision) benefit for income taxes on a stand-alone basis		(22,231		)	30,295			52,468			33,246			11,754
Net income		$	42,780		$	52,293		$	227,016		$	139,280		$	45,130

 

See accompanying notes.

 

2

 

Vivendi Games, Inc.

 

Consolidated Statements of Owner’s Equity and Comprehensive Income

 

(in thousands, except share amounts)

 

		Common Stock					Additional Paid In			Net Payable (Receivable)			Accumulated			Accumulated Other Comprehensive			Total Owner’s			Total Comprehensive
		Shares		Amount			Capital			with Vivendi			Deficit			Income			Equity			Income
Balance at January 1, 2005		800		$	—		$	618,127		$	435,094		$	(778,700	)	$	27,198		$	301,719
Net transfers to Vivendi		—		—			(15,606		)	(68,516		)	—			—			(84,122		)
Net income		—		—			—			—			45,130			—			45,130			45,130
Foreign currency translation adjustment		—		—			—			—			—			(1,964		)	(1,964		)	(1,964		)
Balance at December 31, 2005		800		—			602,521			366,578			(733,570		)	25,234			260,763			$	43,166
Net transfers to Vivendi		—		—			(63,921		)	5,483			—			—			(58,438		)
Reclassification of Vivendi stock options to liability awards		—		—			(3,994		)	—			—			—			(3,994		)
Net income		—		—			—			—			139,280			—			139,280			139,280
Foreign currency translation adjustment		—		—			—			—			—			8,831			8,831			8,831
Balance at December 31, 2006		800		—			534,606			372,061			(594,290		)	34,065			346,442			$	148,111
Net transfers to Vivendi		—		—			(44,565		)	(294,807		)	—			—			(339,372		)
Net income (as adjusted)		—		—			—			—			227,016			—			227,016			227,016
Foreign currency translation adjustment		—		—			—			—			—			5,719			5,719			5,719
Balance at December 31, 2007 (as adjusted)		800		—			490,041			77,254			(367,274		)	39,784			239,805			$	232,735
Net transfers to Vivendi (unaudited)		—		—			(2,605		)	(81,509		)	—			—			(84,114		)
Net income (unaudited, as adjusted)		—		—			—			—			42,780			—			42,780			42,780
Foreign currency translation adjustment (unaudited)		—		—			—			—			—			2,918			2,918			2,918
Balance at March 31, 2008 (unaudited, as adjusted)		800		$	—		$	487,436		$	(4,255	)	$	(324,494	)	$	42,703		$	201,389		$	45,699

 

See accompanying notes.

 

3

 

Vivendi Games, Inc.

 

Consolidated Statements of Cash Flows

 

(in thousands)

 

		Three Months Ended March 31,						Year Ended December 31,
		2008			2007			2007			2006			2005
		(unaudited) (as adjusted)						(as adjusted)
Operating activities
Net income		$	42,780		$	52,293		$	227,016		$	139,280		$	45,130
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation expense and amortization of other intangibles		16,046			13,522			62,733			39,000			43,774
Amortization of capitalized software development costs		1,030			1,631			10,134			8,088			17,897
(Gain) loss on disposal of fixed assets		(73		)	859			1,071			961			(10		)
Gain from sale of businesses		—			—			—			—			(4,448		)
Income taxes		20,457			(28,390		)	(77,467		)	(38,115		)	(20,197		)
Changes in operating assets and liabilities:
Accounts receivable		66,672			73,572			46,831			(43,847		)	132,564
Inventories		1,917			9,028			7,396			(12,380		)	6,648
Capitalized software development costs		(3,360		)	(1,417		)	(5,767		)	(11,571		)	(6,692		)
Royalties and license agreements, net		4,981			(18,305		)	(52,297		)	(994		)	8,425
Prepaid expenses and other assets		5,562			2,863			(929		)	(278		)	4,186
Accounts payable, accrued expenses and other		(54,456		)	(39,034		)	147,714			124,744			(45,952		)
Deferred revenue		326			126,406			72,930			26,226			57,835
Royalties payable		(4,081		)	(6,109		)	(7,165		)	(1,185		)	(38,089		)
Net cash provided by operating activities		97,801			186,919			432,200			229,929			201,071
Investing activities
Purchase of property and equipment, net		(5,414		)	(23,616		)	(68,330		)	(96,474		)	(36,600		)
Acquisitions, net of cash acquired		(4,059		)	—			—			(25,390		)	(67,560		)
Proceeds from sale of businesses		—			—			—			—			5,100
Net cash used in investing activities		(9,473		)	(23,616		)	(68,330		)	(121,864		)	(99,060		)
Financing activities
Payment of capital leases		—			—			—			(78		)	(719		)
Net cash transfers to Vivendi and affiliated companies		(106,814		)	(225,856		)	(371,126		)	(76,622		)	(115,994		)
Net cash used in financing activities		(106,814		)	(225,856		)	(371,126		)	(76,700		)	(116,713		)
Effect of foreign exchange rate changes on cash and cash equivalents		3,599			(8,069		)	1,528			4,165			(3,208		)
Net (decrease) increase in cash and cash equivalents		(14,887		)	(70,622		)	(5,728		)	35,530			(17,910		)
Cash and cash equivalents:
Beginning of period		62,241			67,969			67,969			32,439			50,349
End of period		$	47,354		$	(2,653	)	$	62,241		$	67,969		$	32,439
Supplemental disclosure of cash flow information
Cash paid, net of refunds, to taxing authorities during the period		$	2,081		$	4,069		$	21,809		$	7,707		$	4,502
Net cash (received from) paid to third parties for interest during the period		$	(438	)	$	(249	)	$	(630	)	$	(654	)	$	189

 

See accompanying notes.

 

4

 

Vivendi Games, Inc.

 

Notes to Consolidated Financial Statements

 

(Information subsequent to December 31, 2007 and pertaining to March 31, 2008 and the three months ended March 31, 2008 and 2007 is unaudited)

 

1. Business Organization and Basis of Presentation

 

These consolidated financial statements represent the accounts of Vivendi Games, Inc. and its subsidiaries (“Vivendi Games”) and Universal Interactive, Inc. (“UI”), which has historically been under the common control of Vivendi S.A. (“Vivendi”). During 2006, Vivendi transferred UI to Vivendi Games, at which time UI became a wholly owned subsidiary of Vivendi Games. The consolidated entity is known as “Vivendi Games,” and is a wholly owned indirect subsidiary of Vivendi. Vivendi, a leader in entertainment with activities in music, TV, cinema, telecom, Internet and games, is listed on the compartiment A of Eurolist, Euronext Paris S.A.

 

Vivendi Games is a global developer, publisher and distributor of multi-platform interactive entertainment. Through its division Blizzard Entertainment, Inc., Vivendi Games is the leader in terms of subscriber base and revenues generated in the subscription-based MMORPG category, and through Sierra Entertainment, it develops and distributes games for the personal computer (“PC”), console and handheld markets. Vivendi Games has recently entered the casual online and mobile gaming markets by establishing new divisions: Sierra Online and Vivendi Games Mobile.

 

Vivendi Games has development teams around the world and a pipeline of its own original and copyrighted material. Vivendi Games maintains relationships with strategic partners such as Universal Music Group, NBC Universal and 20^th Century Fox.

 

Headquartered in Los Angeles, California, Vivendi Games is structured around two main divisions: Blizzard Entertainment and Sierra Entertainment (along with the separate divisions Sierra Online and Vivendi Games Mobile). Vivendi Games also provides, through Sierra Entertainment, functional support services, such as global wholesale sales and operations and corporate support services, such as executive management, finance, legal and human resources, to all divisions in order to leverage economics of scale.

 

Although Vivendi Games is a wholly owned subsidiary of Vivendi, it operates its activities independently, through its various offices and locations, with limited operational reliance on Vivendi or Vivendi’s affiliates. Vivendi Games shares certain corporate support services rendered at the Vivendi level, mainly cash and tax management. Vivendi maintains a centralized cash management pool from which Vivendi Games borrows and lends cash on a daily basis. Vivendi charges Vivendi Games interest on the cumulative net cash transfers. Likewise, Vivendi manages its global tax situation for the benefit of the entire portfolio of its businesses. Vivendi Games is part of tax sharing agreements and consolidated returns in certain jurisdictions.

 

Blizzard Entertainment, Inc. (“Blizzard”)

 

Blizzard is headquartered in Irvine, California and is a development studio and publisher best known as the creator of World of Warcraft and the Diablo, StarCraft and Warcraft franchises. Blizzard distributes its products and generates revenues worldwide through various means: subscription revenues (which consist of fees from individuals playing World of Warcraft, Blizzard’s massively multi-player online game and other ancillary online revenues); licensing revenues from third-party companies who distribute World of Warcraft in China and Taiwan; electronic download sales of PC products; and retail sales of physical “boxed” product.

 

In addition to the Irvine (California) head offices, Blizzard maintains offices in or around Austin (Texas), Paris (France), Cork (Ireland), Seoul (South Korea), Shanghai (China) and Taipei (Taiwan) to provide support to World of Warcraft players in their native language, to enhance online community management and to tailor marketing initiatives to specific regions.

 

5

 

Sierra Entertainment (“Sierra”)

 

Sierra, headquartered in Los Angeles, California, is focused on the traditional PC, console and handheld game markets. Games are developed by internal and external studios. Sierra is focused on launching new original franchises, continuing to rejuvenate existing franchises, and improving its internal development capabilities to meet the standards for current and next generation technologies.

 

Sierra operates four integrated internal studios which provide development capabilities across numerous genres for gamers worldwide: High Moon Studios (San Diego, California), specializing in the development of third person action titles; Massive Entertainment (Malmö, Sweden), a developer in the real time strategy genre and creator of the World in Conflict PC title; Radical Entertainment (Vancouver, B.C.), specializing in the creation of open world games, including Scarface: The World is Yours; and Swordfish Studios (Birmingham and Manchester, England), which focuses on developing first person action titles.

 

Sierra also provides services to the other operating divisions by handling global wholesale sales and operations. In North America, products are sold on a direct-to-retail basis to mass-market retailers, consumer electronic stores, discount warehouses, and game specialty stores. International activities are conducted through offices in the United Kingdom (“U.K.”), Germany, France, Italy, Spain, the Netherlands, Sweden and Australia. Products are sold internationally on a direct-to-retail basis, through Sierra’s wholly-owned subsidiaries and through third-party distributors.

 

Sierra Online and Vivendi Games Mobile

 

During 2006 Vivendi Games launched two divisions to capture the opportunities arising from the growing casual game market. These divisions established their product portfolios either by: (a) leveraging existing intellectual properties from the Sierra controlled portfolio, (b) licensing properties from third parties or (c) creating new original intellectual properties. Games are mainly developed internally and, to a lesser extent, by third-party developers.

 

Sierra Online (“SOL”), headquartered in Los Angeles, California, is focused on short and mid-session casual games, mainly playable on dedicated console Internet networks such as Xbox Live Arcade (“XBLA”) from Microsoft or on the Internet. Games are developed by internal studios and external developers.

 

Vivendi Games Mobile (“VGM”), headquartered close to Paris, France, is focused on developing and distributing games playable on mobile phone handsets. Games are distributed by mobile phone carriers to the handsets of their respective mobile phone network subscribers on a pay-per-download or subscription basis, with VGM receiving a share of revenues from the carriers. Games are primarily distributed in North America, Europe and Australia.

 

Business Combination Agreement with Activision, Inc. (“Activision”)

 

On December 1, 2007, Vivendi signed a definitive business combination agreement (“BCA”) with Activision to combine Vivendi Games with Activision. Under the terms of the agreement, a wholly owned subsidiary of Activision will be merged with and into Vivendi Games. In the merger, shares of Vivendi Games will be converted into 295.3 million new shares of Activision common stock. Concurrent with the merger, Vivendi will purchase 62.9 million newly issued shares of Activision common stock at a price of $27.50 per share for a total of $1.7 billion in cash. As a result of these transactions, Vivendi will own approximately 52% of the new combined entity, Activision Blizzard, on a fully diluted basis. This transaction is subject to the approval of Activision’s stockholders and the satisfaction of customary closing conditions, as well as the receipt of regulatory approvals under the Hart-Scott-Rodino Antitrust Improvements Act and the European Union merger control regulations (both of which have already occurred). Upon closing, all pre-existing arrangements, other than licenses entered into in the ordinary course of business with Vivendi or Vivendi’s affiliates, will be terminated. Such impacts are further described in Note 15 Subsequent Events.

 

6

 

Interim Financial Information

 

The interim consolidated financial statements for the three months ended March 31, 2008 and 2007 are unaudited and have been prepared on the same basis as the audited consolidated financial statements and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) necessary to state fairly the financial information set forth therein, in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). Accordingly, these interim consolidated financial statements do not include all the information and footnotes required by U.S. GAAP for annual financial statements. The results of operations for the interim periods are not necessarily indicative of the results for a full year. All references to interim consolidated financial statements amounts are unaudited.

 

Basis of Presentation

 

The accompanying consolidated financial statements and related notes reflect the historical results of the operations and financial position of certain entities under the common control of Vivendi that design, develop, publish, market, and distribute interactive entertainment software for personal computers and game console platforms. Vivendi Games’ owner’s equity represents the difference between the identifiable assets and liabilities of these entities under Vivendi Games’ control and includes the net transfers between Vivendi Games and Vivendi and Vivendi’s affiliated companies, under the cash management pool agreement. The consolidated statements of operations and consolidated statements of owner’s equity and comprehensive income include certain expenses for corporate services and overhead that are allocated from or to Vivendi and its affiliated companies (see Note 11). These expenses have been allocated based on the specific nature of the expense and/or a formula, which management believes reasonably allocates expenses to or from Vivendi Games; however, such amounts may have been different had Vivendi Games operated as a separate stand-alone entity during the periods presented.

 

All information included in the accompanying consolidated financial statements and notes to consolidated financial statements reflects only Vivendi Games’ results, and does not reflect any impact of the proposed merger as described above.

 

Certain prior year balances have been reclassified to conform to the current year’s presentation.

 

2. Summary of Significant Accounting Policies

 

Change in Accounting Principle

 

In the third quarter of 2008, the Company changed the manner in which it recognizes revenue associated with sales of The Burning Crusade expansion pack, released in January 2007 for its massively, multi-player, online game, World of Warcraft.  Prior to the Business Combination, Vivendi Games determined that the sale of an expansion pack was a separate deliverable with standalone value apart from the World of Warcraft license and the subscription to the online game. Pursuant to Emerging Issues Task Force No. 00-21 Revenue Arrangements with Multiple Deliverables (“EITF No. 00-21”), Vivendi Games recognized revenue from the sale of an expansion pack upon delivery because it had standalone value and there was objective and reliable evidence of fair value for the subscription service.  As a result of the consummation of the Business Combination the Company changed its weighting of the factors considered in determining if sales of The Burning Crusade expansion pack have standalone value.  After considering the intended functionality of the expansion pack and the necessity of the World of Warcraft license and subscription service to the functionality of the expansion pack, the Company determined that it is preferable to conclude that the expansion packs do not have standalone value and to account for fees from sales of expansion packs over the remaining estimated useful life of the customer.  This method recognizes revenue over the period during which the customer is expected to utilize the intended full functionality of the expansion pack. The Company believes that it is preferable to recognize revenue from sales of expansion packs over the estimated remaining useful life of the customer, because this is consistent with the accounting for the World of Warcraft license and the evolution of accounting for on-line enabled video games in the console industry. In accordance with Statement of Financial Accounting Standards (SFAS) No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”), this change has been applied retrospectively to our consolidated financial statements for all prior periods. 

 

7

 

In addition to the above, the Company also identified certain ancillary fees charged to World of Warcraft subscribers that had been recognized immediately rather than deferred over the estimated remaining subscription life.  Accordingly, the Company has also retrospectively adjusted subscription revenues for the year ended December 31, 2007, and such adjustments are immaterial to all periods presented.

 

As a result of these changes, cost of sales and amortization of capitalized software costs were also impacted, as cost of sales and software amortization are recognized in relation to the related revenues.  Additionally, Vivendi Games provides for estimated sales returns and price protection deductions to be taken by customers as a reduction to product sales, which is included within accrued liabilities. The effects of these changes were as follows: (amounts in thousands)

 

		As of March 31, 2008			As of March 31, 2008			As of December 31, 2007			As of December 31, 2007
		(unaudited) (as reported)			(unaudited) (as adjusted)			(as reported)			(as adjusted)
Consolidated Balance Sheet
Capitalized software development costs, net		$	3,174		$	3,174		$	740		$	845
Deferred taxes		126,243			141,814			126,621			142,376
Accrued expenses and other		330,754			326,535			374,133			362,200
Deferred revenues		141,867			185,807			136,805			189,640
Accumulated deficit		(300,344		)	(324,495		)	(342,592		)	(367,274		)

 

		Three Months ended March, 31												Year ended December 31,
		2008			2008			2007			2007			2007			2007
		(unaudited, as reported)			(unaudited, as adjusted)			(unaudited, as reported)			(unaudited, as adjusted)			(as reported)			(as adjusted)
Consolidated Statement of Operations:
Product sales, net of returns and allowances		$	67,682		$	72,556		$	190,272		74,786			538,518			505,316
Subscription revenues		236,997			233,891			181,276			173,576			795,621			782,156
Cost of sales (excluding depreciation and amortization)		92,811			93,595			84,647			75,311			387,786			382,021
Amortization of capitalized software development costs		925			1,030			5,662			1,964			10,239			10,134
Operating income		63,285			64,164			136,769			26,617			220,421			179,624
Income before income taxes		64,132			65,011			132,150			21,998			215,345			174,548
Benefit (provision) for income taxes on a stand-alone basis		(21,884		)	(22,231		)	(13,215		)	30,295			36,353			52,468
Net income		$	42,248		$	42,780		$	118,935		$	52,293		$	251,698		$	227,016

 

8

 

Consolidated Statement of Cash Flows:
Net income		$	42,248		$	42,780		$	118,935		$	52,293		$	251,698		$	227,016
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of capitalized software development costs		925			1,030			5,662			1,631			10,239			10,134
Deferred income taxes		20,110			20,457			15,120			(28,390		)	(61,352		)	(77,467		)
Changes in operating assets and liabilities:
Accounts payable, accrued expenses and other		(62,170		)	(54,456		)	(22,680		)	(39,034		)	159,647			147,714
Deferred revenue		9,024			326			(4,131		)	126,406			20,095			72,930

 

Use of Estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the reporting period, including but not limited to sales returns and price protection, the collectability of accounts receivable, the realizability of third party and internal capitalized software costs, valuation of deferred tax assets and the fair value of stock-based compensation. Actual results could differ from those estimates.

 

Fair Value of Financial Instruments

 

The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities are a reasonable approximation of fair value due to the short maturities of these instruments.

 

Principles of Consolidation

 

The accompanying consolidated financial statements include the accounts and transactions of Vivendi Games as more fully described in Note 1. All material intercompany balances and transactions between the consolidated companies have been eliminated.

 

Cash and Cash Equivalents

 

Cash and cash equivalents include short-term highly liquid investments purchased with original maturities of three months or less. Significant amounts of cash balances are subsequently swept by Vivendi via the cash pooling agreement (see Note 11).

 

Accounts Receivable, Sales Returns, Price Protection and Other Reserves

 

Accounts receivable consist principally of amounts owed by distributors, retail and mass marketing chains, software specialty retail chains and computer superstores.

 

Vivendi Games may permit product returns from, or grant price protection to, Vivendi Games’ customers under certain conditions. In general, price protection refers to the circumstances when Vivendi Games elects to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allows customers a credit against amounts owed by such customers with respect to open and/or future invoices. Vivendi Games has provided for the estimated amounts of returns and price-protection deductions to be taken by customers as a reduction to product sales and is included within accrued liabilities.

 

The conditions Vivendi Games’ customers must meet to be granted the right to return products or price protection are, among other things, compliance with applicable payment terms, and consistent delivery of inventory and sell-through reports. Vivendi Games may also consider other factors, including the facilitation of slow-moving

 

9

 

inventory and other market factors. Management must make estimates of potential future product returns and price protection related to current period product revenue. Vivendi Games estimates the amount of future returns and price protection for current period product revenue utilizing historical experience and information regarding inventory levels and the demand and acceptance of its products by the end consumer.

 

The following factors are used to estimate the amount of future returns and price protection for a particular title: historical performance of titles in similar genres; historical performance of the hardware platform; historical performance of the brand; console hardware life cycle; Vivendi Games’ sales force and retail customer feedback; industry pricing; weeks of on-hand retail channel inventory; absolute quantity of on-hand retail channel inventory; warehouse on-hand inventory levels; the title’s recent sell-through history (if available); marketing trade programs; and competing titles. The relative importance of these factors varies among titles depending upon, among other items, genre, platform, seasonality, and sales strategy. Significant management judgments and estimates must be made and used in connection with establishing the accrual for sales returns and price protection in any accounting period.

 

Based upon historical experience, Vivendi Games believes the estimates are reasonable. However, actual returns and price protection could vary materially from accrual estimates due to a number of reasons including, among others, a lack of consumer acceptance of a title, the release in the same period of a similarly themed title by a competitor, or technological obsolescence due to the emergence of new hardware platforms. Material differences may result in the amount and timing of revenue for any period if factors or market conditions change or if management makes different judgments or utilizes different estimates in determining the accruals for sales returns and price protection. For example, a 1% increase in the March 31, 2008 and the December 31, 2007 accruals for sales returns and price protection would reduce net sales for the three and twelve month periods by $0.5 million and $0.5 million (as adjusted), respectively.

 

In addition, Vivendi Games also provides co-operative advertising concessions, marketing development funds, volume discounts and front-end rebates to certain customers. These reserves are presented as a reduction to accounts receivable and were determined based on historical experience, budgeted customer allowances and existing commitments to customers. The ultimate amount of these deductions taken by customers could differ from Vivendi Games’ estimates, and the difference could be material. As of March 31, 2008, December 31, 2007 and 2006, other allowances amounted to $11.4 million, $28.4 million and $31.0 million, respectively.

 

Vivendi Games extends credit to various companies in the retail and mass merchandising industry, and management has provided for the estimated accounts receivable that will remain uncollected. These estimates were based on an analysis of historical bad debts, customer concentrations, customer creditworthiness, current economic trends and customers’ payment terms and their economic condition. Collection of trade receivables may be affected by changes in any of these criteria as well as economic or other industry conditions and may, accordingly, impact Vivendi Games’ overall credit risk. As of March 31, 2008, December 31, 2007 and 2006, bad debt allowances amounted to $10.6 million, $10.3 million and $5.2 million, respectively.

 

Vivendi Games’ top ten customers accounted for approximately 21% and 18% of net accounts receivable at March 31, 2008 and 2007, respectively, and 10% and 23% of net sales for the three months ended March 31, 2008 and 2007, respectively. Of these top ten customers, no sales made to one customer accounted for more than 10% of Vivendi Games’ total net sales for both periods presented. World of Warcraft, which was launched by Blizzard at the end of November 2004, accounted for approximately 85% (as adjusted) of total net sales during the three months ended March 31, 2008 compared to 87% (as adjusted) of total net sales during the three months ended March 31, 2007.

 

Vivendi Games’ top ten customers accounted for approximately 30% (as adjusted) and 38% of net accounts receivable at December 31, 2007 and 2006, respectively, and 17% (as adjusted), 24% and 29% of net sales for the years ended December 31, 2007, 2006 and 2005, respectively. Of these top ten customers, no sales made to one customer accounted for more than 10% of Vivendi Games’ total net sales for all years presented. One customer had amounts outstanding, after allowances, at December 31, 2006, in excess of 10% of Vivendi Games’ net accounts receivable (13%), and no customer had amounts outstanding, after allowances, at December 31, 2007, in excess of 10%. World of Warcraft accounted for approximately 76% (as adjusted), 62%, and 48% of total net sales during the years ended December 31, 2007, 2006, and 2005, respectively.

 

10

 

Inventories

 

Inventories are valued at the lower of cost (average cost) or market value. Costs include materials, capitalized production labor and all capitalizable operations’ overhead costs.

 

Property and Equipment

 

Property and equipment are stated at cost. Property and equipment acquired as part of a business acquisition are stated at estimated fair market value at the date of purchase. Assets financed by leasing contracts that meet the requirements of a capital lease are capitalized at the present value of future minimum lease payments and amortized over the shorter of the lease term or the estimated useful lives of the assets. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets and includes the amortization of assets acquired through leasing contracts.

 

The major categories and related estimated useful lives are as follows:

 

Computer equipment and software		3 years
Equipment		5 years
Furniture and fixtures		5 years
Leasehold improvements		Shorter of 7 years or life of lease

 

Major renewals and improvements are capitalized. Maintenance, repairs and minor renewals are charged to expense as incurred. When property is sold or otherwise disposed of, the cost and related accumulated depreciation is removed from the accounts, and any resulting gain or loss is included in the accompanying consolidated statements of operations.

 

Capitalized Software Development Costs

 

Capitalized software development costs represent costs incurred in connection with the internal development of products. Vivendi Games accounts for capitalized software development costs in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. Software development costs are capitalized once the technological feasibility of a product is established and such costs are determined to be recoverable. Technological feasibility is evaluated on a product-by-product basis. Prior to a product’s release, Vivendi Games expenses capitalized costs when it believes such amounts are not recoverable. Capitalized costs for those products that are cancelled or abandoned are charged to research and development expense in the period of cancellation. Amounts related to software development which are not capitalized are charged immediately to research and development expense. For many of the Vivendi Games’ internal development projects, technological feasibility has been determined to be achieved late in the development cycle. As a result, most software development costs are expensed as research and development costs, and not capitalized.

 

Capitalized software development costs are classified as current based upon the expected future release dates of the associated software titles. Capitalized software development costs are amortized on a product-by-product basis generally over a four-month period which commences in the month that the product is released, with a majority of the expense being recognized in the first month. Capitalized software costs related to the initial development of World of Warcraft were amortized straight-line over a ten-month period commencing on its first launch in November 2004.

 

During the three months ended March 31, 2008 and 2007, amortization expense of capitalized software development costs was $1.03 million (as adjusted), and $1.96 million (as adjusted), respectively. During the years ended December 31, 2007, 2006 and 2005, amortization expense of capitalized software development costs was $10.1  million (as adjusted), $8.1 million, and $17.9 million, respectively.

 

Royalties and License Agreements

 

Royalties and license agreements consist primarily of prepayments made to independent software developers under development arrangements that have alternative future uses or are based on existing, proven game engine

 

11

 

technology, and prepaid royalties and license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, or other intellectual property or proprietary rights in the development of Vivendi Games’ products. Depending upon the agreement with the rights holder, Vivendi Games may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product. Royalties and license agreements are generally expensed to cost of sales based on contractual rates applied to actual net product sales. Royalties and license agreements are classified as current and non-current assets based upon expected release date of the associated software titles.

 

Capitalized royalties and license costs are reviewed by Vivendi Games quarterly for recoverability. The recoverability of capitalized royalties and license costs is evaluated based on the expected performance of the specific products to which the costs relate. Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

 

Any capitalized royalties and license costs not considered recoverable are either written off or impaired to net realizable value. Such costs are written off, as a component of research and development costs, if titles are canceled prior to completion due to failure to meet Vivendi Games’ desired quality specifications. Impairments are taken on capitalized royalties and license costs for games to be released in future periods which are not considered recoverable. Such impairments are recorded either as a component of research and development costs in the period of the change in estimate for titles to be released in future years, or as a component of cost of sales for titles to be released later within the current year. Certain license agreements deemed to be “at risk” for full recoverability are amortized on a straight line basis over the term of the license.

 

Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual product sales are less than and/or revised forecasted or actual costs are greater than the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge.

 

Write-offs for canceled titles and pre-release impairments of $8.0 million and $1.2 million were recorded during the three months ended March 31, 2008 and March 31, 2007, respectively. Canceled title write-offs and pre-release impairments of $6.9 million, $19.2 million and $17.7 million were recorded for the years ended December 31, 2007, 2006 and 2005, respectively.

 

Long-Lived Assets

 

Vivendi Games reviews long-lived assets, such as fixed assets and certain identifiable intangibles with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Factors that could indicate the occurrence of such events or circumstances include current period operating or cash flow losses combined with a history of operating or cash flow losses, a projection or forecast that demonstrates continuing operating or cash flow losses, or incurring costs in excess of amounts originally expected to acquire or construct an asset. If the asset is not recoverable, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value, as defined in SFAS No. 144, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of (“SFAS No. 144”). No impairment was recorded during any period presented, as no specific triggering event occurred.

 

Other Intangibles

 

Other intangibles consist of acquired trade names, acquired developed software, and other intangibles related primarily to licensing activities. As of January 1, 2006, trade names were assessed as indefinite-lived assets (see goodwill and indefinite-lived assets below). Other intangibles consist of the following:

 

12

 

		As of March 31,			As of December 31,
		2008			2007			2006
		(unaudited)			(in thousands)
Trade names		$	52,917		$	52,888		$	52,530
Acquired developed software		214,562			214,848			213,240
Other intangibles		13,094			13,097			12,100
		280,573			280,833			277,870
Less accumulated amortization		(221,770		)	(220,790		)	(215,561		)
		$	58,803		$	60,043		$	62,309

 

Acquired developed software and other intangibles are deemed to have finite lives and are amortized on a straight-line basis over the periods expected to be benefited (approximately three to five years). During the three months ended March 31, 2008 and 2007, Vivendi Games recorded amortization expense of $1.1 million and $1.0 million, respectively. During the years ended December 31, 2007, 2006 and 2005, Vivendi Games recorded amortization expense of $4.2 million, $2.2 million and $4.0 million, respectively. Amounts are included in depreciation expense and amortization of other intangibles within the accompanying consolidated statements of operations. Vivendi Games assesses impairment of other intangibles, other than trade names, in accordance with SFAS No. 144 and recognized no impairment loss during any period presented, as no specific triggering event occurred.

 

As of March 31, 2008, the estimated aggregate amortization expense to be recognized during the remainder of 2008 and in 2009 is approximately $2.8 million and $3.4 million, respectively, after which all other definite-lived intangibles will be principally amortized in full. The net balances at March 31, 2008 for trade names, acquired developed software and other intangibles were $52.6 million, $4.1 million and $2.1 million, respectively. The net balances at December 31, 2007 for trade names, acquired developed software and other intangibles were $52.6 million, $4.8 million and $2.6 million, respectively.

 

Goodwill and Other Indefinite-Lived Assets

 

Vivendi Games accounts for its goodwill in accordance with SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”). SFAS No. 142 addresses financial accounting and reporting requirements for acquired goodwill and other intangible assets with indefinite lives. Other than Vivendi Games’ trade names, which are included in other intangible assets above, management believes that all acquired identified intangible assets included in the accompanying consolidated balance sheet have finite lives and are assessed for impairment under SFAS No. 144.

 

Under SFAS No. 142, goodwill is deemed to have an indefinite useful life. Further, goodwill and other indefinite lived assets (trade names) should not be amortized but rather tested at least annually for impairment. An impairment loss is recognized if the carrying amount of goodwill at each reporting unit, as defined by SFAS No. 142, exceeds its implied fair value. Other indefinite lived assets are assessed for impairment by comparing the fair value of the asset to its carrying amount, and to the extent the carrying amount exceeds the fair value, an impairment loss is recognized.

 

In accordance with SFAS No. 142, Vivendi Games does not amortize goodwill. Vivendi Games reviewed goodwill for impairment as of December 31, 2007, 2006 and 2005 and concluded that goodwill was not impaired. To review goodwill for impairment, goodwill is first allocated to its reporting unit in accordance with SFAS No. 142, which corresponds to Vivendi Games’ operating divisions. Beginning on January 1, 2006, Vivendi Games’ chief operating decision makers began reviewing financial information separately for Vivendi Games’ operating divisions as described in Note 1. Accordingly, goodwill was re-allocated on January 1, 2006, to those operating divisions based on their relative fair value. At both March 31, 2008 and December 31, 2007, approximately 90% of Vivendi Games’ goodwill is allocated to Blizzard.

 

Prior to 2006, Vivendi Games amortized its trade names. Effective January 1, 2006, Vivendi Games determined that they had an indefinite life because there is no foreseeable limit on the period of time over which they are expected to contribute cash flows and ceased amortization. Trade names were assessed for impairment during the years ended December 31, 2007 and 2006, and no impairment was recorded.

 

13

 

Vivendi Games has not recognized any impairment for goodwill or trade names for any period presented. During 2005, Vivendi Games recognized amortization expense of $17.2 million related to trade names, which was included in depreciation expense and amortization of other intangibles within the accompanying consolidated statements of operations.

 

Income Taxes

 

Vivendi Games’ income taxes are presented as if Vivendi Games were a stand-alone taxpayer even though Vivendi Games’ operating results are included in the consolidated federal, and certain foreign, and state and local income tax returns of Vivendi or Vivendi’s subsidiaries. Vivendi manages its tax position for the benefit of the entire portfolio of its businesses, and as such, the calculation of Vivendi Games’ tax provision and related tax accounts herein may differ from those of Vivendi, and in addition, are not necessarily reflective of tax strategies Vivendi Games may have utilized if on a stand-alone basis.

 

Income taxes are accounted in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS No. 109”). Deferred tax assets and liabilities are recognized with respect to the tax consequences attributable to differences between the financial statement carrying values and tax basis of existing assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled.

 

Further, the effect on deferred tax assets and liabilities of changes in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established, when necessary, to reduce deferred tax assets if it is more likely than not that some portion or all of the deferred tax assets will not be realized.

 

In accordance with Accounting Principles Board Opinions (“APB”) No. 23, Accounting for Income Taxes—Special Areas, Vivendi Games has not provided for U.S. income taxes on undistributed earnings of its foreign subsidiaries since it is management’s intention that undistributed earnings will be indefinitely reinvested in the foreign operations. Amounts at any period-end presented were not significant.

 

On January 1, 2007, Vivendi Games adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, (“FIN 48”). FIN 48 clarifies the accounting for the uncertainty in recognizing income taxes in an organization in accordance with SFAS No. 109 by providing detailed guidance for financial statement recognition, measurement and disclosure involving uncertain tax positions. FIN 48 requires an uncertain tax position to meet a more-likely-than-not recognition threshold at the effective date to be recognized both upon the adoption of FIN 48 and in subsequent periods. The adoption did not have a material effect on the consolidated financial statements.

 

Vivendi Games recognizes penalties related to income tax matters as part of the provision for income taxes and interest is included within interest expense. Amounts recorded in periods presented are immaterial.

 

Derivatives

 

Other than share-based awards (see Note 8), Vivendi Games accounts for its derivative and hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”). The assets or liabilities associated with its derivative instruments and hedging activities are recorded at fair value in other current assets or other current liabilities, respectively, in the consolidated balance sheets presented herein. The accounting for gains and losses resulting from changes in fair value depends on the use of the derivative and whether it is designated and qualifies for hedge accounting.

 

Vivendi Games transacts business in various foreign currencies and has significant international sales and expenses denominated in foreign currencies, subjecting Vivendi Games to foreign currency risk. Vivendi Games utilizes foreign exchange forward contracts to mitigate foreign currency exchange rate risk associated with foreign-currency-denominated assets and liabilities, primarily intercompany receivables and payables. The forward contracts generally have a contractual term of approximately one month; therefore, the fair value of the forward contracts is not significant at each month end. Vivendi Games does not use foreign exchange forward contracts for

 

14

 

speculative or trading purposes. None of Vivendi Games’ foreign exchange forward contracts were designated as hedging instruments under SFAS No. 133. Accordingly, gains or losses resulting from changes in the fair value of the forward contracts are reported as a component of foreign currency exchange gain (loss) within the accompanying consolidated statements of operations. As of March 31, 2008, December 31, 2007 and 2006, outstanding foreign exchange forward contracts, principally hedge firm obligations, related to third-party development contracts, and forecasted operating cash flows in currencies other than Vivendi Games’ functional currency. The fair values of outstanding positions under these contracts are considered immaterial for all periods presented.

 

Foreign Currency Translation

 

The assets and liabilities of Vivendi Games’ foreign operations are translated into U.S. dollars at exchange rates as of the balance sheet date, revenues and expenses are translated at average exchange rates for the period, and equity balances are translated at the historical rate. Resulting translation adjustments are included in other comprehensive income, a component of owner’s equity.

 

15

 

Vivendi Games, Inc.

 

Notes to Consolidated Financial Statements

 

2. Summary of Significant Accounting Policies

 

Translation gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the consolidated statements of operations as incurred. Foreign currency exchange gain (loss) includes the effect of gains and losses recognized on foreign exchange forward contracts.

 

Other Comprehensive Income

 

Vivendi Games computes other comprehensive income, which is reported on the accompanying consolidated statements of owner’s equity and comprehensive income, pursuant to SFAS No. 130, Reporting Comprehensive Income. Total comprehensive income for Vivendi Games includes net income and foreign currency translation adjustments. For all periods presented, other comprehensive income is comprised only of foreign currency translation adjustments.

 

Revenue Recognition

 

We recognize revenues for the massively, multiplayer, online game World of Warcraft, its expansion packs and other ancillary services in accordance with Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements, (“SAB No. 101”), as amended by Staff Accounting Bulletin No. 104, “Revenue Recognition” (“SAB 104”).

 

We consider the World of Warcraft boxed product including expansion packs and other ancillary revenues as a single deliverable with the total arrangement consideration combined and recognized ratably as revenue over the estimated customer life beginning upon activation of the software and delivery of the services. Revenues attributed to the sale of World of Warcraft boxed software and related expansion packs are classified as Product Sales and revenues attributable to subscription and other ancillary services are classified as Subscription Revenues.

 

Product Sales

 

Vivendi Games recognizes revenue from the sale of its products upon the transfer of title and risk of loss to customers, net of estimated returns, price protection and other allowances. In addition, in order to recognize revenue for product sales, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable. Revenue recognition also determines the timing of recognition of certain expenses. Where uncertainty about collectibility exists, Vivendi Games defers revenue recognition until collectibility of amounts owed is reasonably assured.  The element of revenues and related costs that relate to the World of Warcraft boxed software, including the sale of an expansion pack, is deferred and recognized ratably over the estimated customer life beginning upon activation of the software and delivery of the services. The interactive entertainment software industry is highly seasonal, with the highest levels of consumer demand and therefore product sales occurring during the calendar year-end holiday buying season. As a result, Vivendi Games’ net sales and operating income have historically been higher during the second half of the calendar year. Vivendi Games’ receivables and credit risks are likewise higher during the second half of the calendar year. The revenues from pay-per-downloads or subscriptions operated by third-party distributors for SOL and VGM are recognized upon receiving appropriate revenue statements from each distributor. These revenues are included in product sales. With the exception of World of Warcraft, some of Vivendi Games’ software products provide limited online features at no additional cost to the consumer. Generally, such features are considered to be incidental to the overall product offering and an inconsequential deliverable. Accordingly, Vivendi Games does not defer any revenue related to products containing these limited online features.

 

16

 

Subscription Revenues

 

Subscription revenues are recognized in accordance with SAB No. 101, as amended by SAB No. 104. Subscription revenues are derived from World of Warcraft, a game that is playable through Blizzard’s servers on a subscription-only basis. After the first month of free usage that is included with the boxed software, the World of Warcraft end user may enter into a subscription agreement for additional access. Subscription revenues received are deferred and recognized as subscription revenues ratably over the subscription period. Revenue from the sale of prepaid cards, sold through retail outlets and other stores, is deferred and recognized as subscription revenue ratably beginning when the cards are first activated. Revenue from internet gaming rooms in Asia is recognized upon usage of the time packages sold. Ancillary revenues associated with subscriptions are recognized ratably over the estimated customer life.

 

Licensing Revenues

 

Third-party licensees in China and Taiwan distribute and host Blizzard’s World of Warcraft game in their respective countries under a license agreement with Blizzard. The licensees paid certain minimum, non-refundable, generally recoupable guaranteed royalties when entering into the licensing agreements. Upon receipt of the recoupable advances, Vivendi Games defers their recognition and recognizes the revenues in subsequent periods as these advances are recouped by the licensees. As the licensees pay additional royalties above and beyond those initially advanced, Vivendi Games recognizes these additional royalties as revenues based on activation of the underlying prepaid time by the end users.

 

Other Revenues

 

Other revenues primarily include ancillary sales of non-software related products. It includes licensing activity of intellectual property other than software (such as characters) to third-parties. Revenue is recorded upon receipt of licensee statements, or upon the receipt of cash, provided the license period has begun.

 

Taxes Assessed by Governmental Authorities

 

Vivendi Games accounts for taxes that are externally imposed on revenue producing transactions on a net basis, as a reduction to revenue.

 

Cost of Sales

 

Cost of sales includes direct operating costs associated with supporting and servicing World of Warcraft players, royalties to external developers and licensors and the traditional manufacturing costs of “retail box” PC and console products.

 

Advertising Costs

 

Vivendi Games expenses advertising costs as incurred and has recorded approximately $73.3 million, $73.4 million and $63.2 million, of advertising costs as a component of sales and marketing expense within the accompanying consolidated statements of operations for the years ended December 31, 2007, 2006 and 2005, respectively. The classification of sales incentives offered such as cooperative advertising, marketing development fund claims, slotting fees and product placement between a reduction in net sales and marketing expenses is determined by Vivendi Games based on the criteria in EITF No. 01-09, Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).

 

During the years ended December 31, 2007, 2006 and 2005, Vivendi Games has classified approximately $13.3 million, $12.1 million and $8.1 million, respectively, of cooperative advertising and product placement sales incentives as a reduction of net sales.

 

17

 

Shipping and Handling Costs

 

Amounts billed to customers for shipping and handling costs are included in net sales. Shipping and handling costs that are incurred by Vivendi Games consist primarily of packaging and transportation charges for the movement of finished goods to customers. During the years ended December 31, 2007, 2006 and 2005, Vivendi Games included $5.3 million, $5.4 million and $5.3 million, respectively, of shipping and handling costs as a component of sales and marketing expense within the accompanying consolidated statements of operations.

 

Stock-Based Compensation

 

Prior to 2005, Vivendi Games accounted for stock-based employee compensation arrangements in accordance with APB No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and related interpretations, and complied with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”), as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. Under APB No. 25, compensation expense is calculated as the difference between the fair value of the underlying Vivendi stock at the date of grant and the strike price.

 

On January 1, 2005, Vivendi Games adopted SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123(R)”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS No. 123(R) supersedes Vivendi Games’ previous accounting under APB No. 25. Vivendi Games elected to adopt SFAS No. 123(R), as of January 1, 2005, using the modified prospective method. As a result, Vivendi Games’ consolidated financial statements as of and for all periods presented reflect the impact of SFAS No. 123(R).

 

SFAS No. 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant, and re-measure the fair value of liability awards at each reporting period, using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in Vivendi Games’ consolidated statements of operations.

 

Stock-based compensation expense recognized is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Prior to 2007, Vivendi Games generally attributed the value of stock-based compensation to expense using the accelerated multi-tranche method (see Note 8). Beginning in 2007, Vivendi Games’ employees have been granted awards which cliff vest at the end of a three-year vesting period. Stock-based compensation expense relating to these stock options is recognized on a straight-line basis over the vesting period.

 

Restricted stock grants from Vivendi (including restricted stock units) are generally attributed to expense using the straight-line single option method. However, awards granted under the Blizzard 2006 Equity Incentive Plan (the “Blizzard Equity Plan”) (see Note 8) are attributed to expense using the accelerated multi-tranche method, as they are subject to graded vesting.

 

Employee Benefit Plans

 

In accordance with the laws and practices of each country in which it operates, Vivendi Games (via Vivendi) and its employees (including those employees of Vivendi who are fully dedicated to Vivendi Games) participate in, or maintain employee benefit plans providing retirement pensions, postretirement health care, life insurance and post employment benefits (principally severances) to eligible employees, retirees and their beneficiaries. Retirement pensions are provided for substantially all employees through defined contribution plans, which are integrated with local Social Security and multi-employer plans. Vivendi’s funding policy is consistent with applicable government funding requirements and regulations of each country in which Vivendi maintains a pension plan.

 

3. Acquisitions

 

There were no acquisitions of development studios during the three months ended March 31, 2008 or during the year 2007.

 

18

 

2006 Acquisitions

 

During 2006, Vivendi Games acquired the net assets or all of the common stock of several development studios located in Seattle, Washington; San Mateo, California; Santiago, Chile; and, Shanghai, People’s Republic of China. These studios develop interactive entertainment software products (games) and related technologies. The acquisitions were accounted for as purchases under SFAS No. 141, Business Combinations (“SFAS No. 141”). Results from operations are included in the consolidated statements of operations from the date of acquisition.

 

Total purchase consideration was approximately $25.4 million, all of which was paid in cash. The following net assets were recognized resulting from these acquisitions (amounts in thousands):

 

Goodwill		$	23,680
Acquired developed software		2,070
Property and equipment		700
Other non-current assets		30
Current net assets		1,200
Non-current deferred tax liabilities and other non-current liabilities		(2,290		)
Total Net Assets Recognized		$	25,390

 

Acquired developed software is being amortized over three years. Of the acquired goodwill, $9.2 million is tax deductible. Prior to the studio acquisitions, Vivendi Games had entered into certain development and licensing agreements with certain of the studios. These agreements were terminated in connection with these acquisitions.

 

Additional consideration of up to $2.0 million may be payable to former owners of the development studios acquired in 2006 based on future performance, as defined in each applicable acquisition agreement, through December 2008. Amounts will be paid if certain financial targets are achieved. During the three months ended March 31, 2008, $0.2 million of the $2.0 million had been accrued as additional consideration and recorded as compensation expense. During the year ended December 31, 2007, $0.9 million of the $2.0 million had been accrued as additional consideration and recorded as compensation expense. The $0.9 million was paid during the first quarter of 2008. As of December 31, 2007, approximately $0.1 million of the $2.0 million had been forfeited. As of March 31, 2008, the remaining $1.0 million of additional purchase consideration not yet paid remains subject to the achievement of future financial targets contingencies.

 

2005 Acquisitions

 

During 2005, Vivendi Games acquired the net assets or all of the common stock of several development studios located in Canada, the U.S., and the U.K. These studios develop interactive entertainment software products (games) and related technologies. The acquisitions were accounted for as purchases under SFAS No. 141. Results from operations are included in the consolidated statements of operations from the date of acquisition.

 

Total purchase consideration was approximately $71.6 million, all of which was paid in cash. This amount includes additional consideration earned since the acquisition date. The following net assets were recognized resulting from these acquisitions (amounts in thousands):

 

Goodwill		$	50,069
Acquired developed software		9,560
Property and equipment		4,100
Other non-current assets		70
Contract termination (immediately charged to earnings)		1,000
Current net assets		9,350
Non-current deferred tax liabilities and other non-current liabilities		(2,520		)
Total Net Assets Recognized		$	71,629

 

Acquired developed software is being amortized over five years. Of the acquired goodwill, approximately $6.5 million is tax deductible. Prior to the studio acquisitions, Vivendi Games had entered into certain development

 

19

 

and licensing agreements with certain of the studios. These agreements were terminated in connection with the respective acquisitions.

 

As originally defined in each applicable acquisition agreement, additional consideration of up to $21.2 million may be payable to the former owners of the development studios acquired in 2005 based on future performance through March 2010. Amounts will be paid if and when certain financial targets are achieved or upon satisfaction of certain service commitments. Based on the studios’ current performance, management believes that most of the $21.2 million will be earned. As of December 31, 2007, Vivendi Games has expensed as compensation and paid a total of $4.6 million of the maximum contingent consideration of $21.2 million. During the three months ended March 31, 2008, Vivendi Games paid an additional $4.1 million, which was recorded as goodwill. In the three months ended March 31, 2008 and the year ended December 31, 2007, $0.5 million and $0.6 million of the $21.2 million were forfeited, respectively. As of March 31, 2008, the remaining balance of $11.4 million remains subject to future earnings targets, as defined. If earned, future payments will be recorded as additional goodwill.

 

Pro forma consolidated statements of operations for these acquisitions are not shown, as they would not differ materially from reported results.

 

4. Inventories

 

Inventories consist of the following:

 

		As of March 31,			As of December 31,
		2008			2007			2006
		(in thousands)
		(unaudited)
Finished goods		$	16,123		$	18,953		$	22,820
Purchased parts and components		3,952			2,406			5,094
		$	20,075		$	21,359		$	27,914

 

5. Property and Equipment

 

Property and equipment consist of the following:

 

		As of March 31,			As of December 31,
		2008			2007			2006
		(in thousands)
		(unaudited)
Computer equipment and software		$	275,159		$	266,359		$	216,780
Furniture and fixtures		15,481			14,941			18,396
Leasehold improvements		37,525			36,316			15,760
		328,165			317,616			250,936
Less accumulated depreciation and amortization		(206,604		)	(189,017		)	(134,977		)
		$	121,561		$	128,599		$	115,959

 

6. Accrued Expenses and Other Liabilities

 

Accrued expenses and other liabilities consist of the following:

 

20