When THQ signs a deal with a developer or licensor, THQ accounts for the minimum guaranteed royalty payments (due to developers and licensors) as BOTH an asset (prepaid and deferred royalties) and a liability (accrued royalties). It is perfectly normal GAAP to capitalize these costs and amortize them over the expected life of the title. As time passes, the asset side and the liability side are each reduced by the same amount, having no effect on shareholders' equity. The expensed portions are recognized in the income statement as Royalties. As the Royalties are recognized (as operating expenses), the corresponding amount is subtracted from both the asset and liability side. Notice how, in general, the Prepaid and deferred royalties + Software development costs (for both the current assets and the long-term assets) = Accrued royalties (current and long-term).
This method seems quite acceptable to me, as the company is matching revenue recognition with costs of the titles being produced. It is here where the operating cash flow is important to watch.
Important:
I mentioned earlier that over the past few years, THQ's cumulative net income is higher than its operating cash flow. One major reason for this is the upfront payment of royalties to developers and licensors. THQ pays the cash (or at least some of it) when the contract is signed (the rest is usually a milestone payment system). But until the product is marketed, THQ's income statement (and net income) doesn't reflect these costs as royalty expense. Therefore, since THQ is constantly signing new deals, they are spending cash, even though the net income won't reflect those payments for several quarters. But on the other side of the coin, if THQ's title is successful several quarters after securing the license (like WCW), THQ's cash flow begins to eclipse the reported earnings, because much of the cash has already been paid (many quarters ago), yet the royalties expense is still reflected in the operating expenses (reducing net income, even though much less money is being paid to the licensor or developer at this point).
This is a difficult concept to grasp, and I've grappled with it many times. But in times of increased investment in new licenses and development deals, THQ's cash flow lags the income, because of greater initial cash outflows. But as THQ's titles have long, successful lives, the cash flow catches up. I know I'm repeating myself a bit. It's late and I have to be up early to study the Q2 report.
A final thought: Aaron seemed to suggest that THQ's method (assuming he understood it) of accounting was aggressive to capitalize, rather than expense costs. This is quite normal across most businesses, especially public ones. This method of accounting is called the accrual method, wherein costs are matched with corresponding sales over time. The cleaner method, in which the income statement accurately reflects the cash flows of the company, is called the cash method. In this case, if Frost & Sullivan is working on a research report, they still need to pay their research analysts during the research period. In cash method, the company would recognize no sales until the product shipped, but it would still show the expenses for the labor hours that went into producing the report. Once the report is shipped, it could bring in money for many months. In cash method, the company would report operating income as nearly the same as gross profit (which would be extremely high--perhaps 95+%), because no more time is being spent composing the report and performing the research. This method, while reflecting the accurate picture of the business' cash flows, leads to lumpy and inconsistent operating results. For this reason, most companies match costs with sales (accrual method). I hope any accountants will correct me if I'm wrong.
Good luck to all.
Todd |
