Activision Blizzard, Inc.
Activision Blizzard, Inc. (Form: 10-Q, Received: 11/10/2008 17:29:00)

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark one)

 

 

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2008

 

OR

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

For the transition period from                      to                    

 

Commission File Number 1-15839

 

ACTIVISION BLIZZARD, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

95-4803544

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

3100 Ocean Park Boulevard, Santa Monica, CA

 

90405

(Address of principal executive offices)

 

(Zip Code)

 

(310) 255-2000
(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x  No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer  x       Accelerated Filer  o       Non-accelerated filer  o  (Do not check if a smaller reporting company)

Smaller reporting company  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  o No  x

 

The number of shares of the registrant’s Common Stock outstanding as of October 31, 2008 was 1,324,390,741.

 

 

 



Table of Contents

 

ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

 

INDEX

 

 

Explanatory Note

3

 

 

 

 

Cautionary Statement

3

 

 

 

PART I.

FINANCIAL INFORMATION

4

 

 

 

Item 1.

Financial Statements

4

 

 

 

 

Consolidated Balance Sheets as of September 30, 2008 (Unaudited) and December 31, 2007

4

 

 

 

 

Consolidated Statements of Operations for the three and nine months ended September 30, 2008 (Unaudited) and September 30, 2007 (Unaudited)

5

 

 

 

 

Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 (Unaudited) and September 30, 2007 (Unaudited)

6

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity for the nine months ended September 30, 2008 (Unaudited)

7

 

 

 

 

Notes to Consolidated Financial Statements

8

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results Of Operations

36

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

56

 

 

 

Item 4.

Controls and Procedures

57

 

 

 

PART II.

OTHER INFORMATION

59

 

 

 

Item 1.

Legal Proceedings

59

 

 

 

Item 1A.

Risk Factors

60

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

60

 

 

 

Item 6.

Exhibits

64

 

 

SIGNATURES

67

 

 

EXHIBIT INDEX

68

 

 

CERTIFICATIONS

 

 

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Table of Contents

 

EXPLANATORY NOTE

 

On July 9, 2008, a business combination by and among Activision, Inc., Sego Merger Corporation, a wholly-owned subsidiary of Activision, Inc., Vivendi S.A., (“Vivendi”) VGAC LLC, a wholly-owned subsidiary of Vivendi S.A., and Vivendi Games, Inc., a wholly-owned subsidiary of VGAC LLC, was consummated.  As a result of the consummation of the business combination, Activision, Inc. was renamed Activision Blizzard, Inc.  For accounting purposes, the business combination is treated as a “reverse acquisition,” with Vivendi Games, Inc. deemed to be the acquirer.  The historical financial statements of Activision Blizzard, Inc. prior to July 9, 2008 are those of Vivendi Games, Inc. (see Note 1 of consolidated financial statement for more details).

 

CAUTIONARY STATEMENT

 

This Quarterly Report on Form 10-Q contains, or incorporates by reference, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements consist of any statement other than a recitation of historical fact and include, but are not limited to, (1) projections of revenues, expenses, income or loss, earnings or loss per share, cash flow projections or other financial items; (2) statements of our plans and objectives, including those relating to product releases; (3) statements of future economic performance; and (4) statements of assumptions underlying such statements. We generally use words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “future,” “intend,” “may,” “outlook,” “plan,” “positioned,” “potential,” “project,” “remain,” “scheduled,” “set to,” “subject to,” “to be,” “upcoming,” “will,” and other similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk, reflect management’s current expectations, estimates and projections about our business, and are inherently uncertain and difficult to predict. Our actual results could differ materially. The forward-looking statements contained herein speak only as of the date on which they were made, and we disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of this Quarterly Report. Risks and uncertainties that may affect our future results include, but are not limited to the following: sales of Activision Blizzard’s titles, shifts in consumer spending trends, the impact of the current macroeconomic environment, the seasonal and cyclical nature of the interactive game market, Activision Blizzard’s ability to predict consumer preferences among competing hardware platforms, declines in software pricing, product returns and price protection, product delays, retail acceptance of Activision Blizzard’s products, adoption rate and availability of new hardware and related software, industry competition, rapid changes in technology and industry standards, protection of proprietary rights, litigation against Activision Blizzard, maintenance of relationships with key personnel, customers, vendors and third-party developers, domestic and international economic, financial and political conditions and policies, foreign exchange rates, integration of recent acquisitions and the identification of suitable future acquisition opportunities, Activision Blizzard’s success in integrating the operations of Activision and Vivendi Games in a timely manner, or at all, and the combined company’s ability to realize the anticipated benefits and synergies of the transaction to the extent, or in the timeframe, anticipated, as well as the other risk factors included in Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2008. Except as otherwise noted (including in connection with the review and presentation of results of operations for the quarter ended September 30, 2008), all references to “we,” “us,” “our,” “Activision Blizzard” or “the Company” in the following discussion and analysis mean Activision Blizzard, Inc. and its subsidiaries .

 

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Table of Contents

 

Part I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

 

ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Amounts in millions, except share data)

 

 

 

September 30,
2008

 

December 31,
2007

 

 

 

(Unaudited)

 

(As Adjusted)

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

2,842

 

$

62

 

Short-term investments

 

94

 

3

 

Accounts receivable, net of allowances of $96 million and $94 million at September 30, 2008 and December 31, 2007, respectively

 

316

 

104

 

Inventories

 

377

 

21

 

Software development

 

226

 

25

 

Intellectual property licenses

 

10

 

9

 

Deferred income taxes

 

228

 

143

 

Intangible assets, net

 

51

 

 

Other current assets

 

57

 

23

 

 

 

 

 

 

 

Total current assets

 

4,201

 

390

 

 

 

 

 

 

 

Long-term investments

 

86

 

 

Software development

 

20

 

51

 

Intellectual property licenses

 

 

8

 

Property and equipment, net

 

168

 

129

 

Deferred income taxes

 

80

 

24

 

Other assets

 

21

 

6

 

Intangible assets, net

 

1,462

 

7

 

Trade name

 

433

 

53

 

Goodwill

 

7,270

 

203

 

 

 

 

 

 

 

Total assets

 

$

13,741

 

$

871

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

338

 

$

49

 

Deferred revenues

 

206

 

197

 

Accrued expenses and other liabilities

 

557

 

274

 

 

 

 

 

 

 

Total current liabilities

 

1,101

 

520

 

 

 

 

 

 

 

Deferred income tax, net

 

696

 

 

Other liabilities

 

169

 

111

 

 

 

 

 

 

 

Total liabilities

 

1,966

 

631

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Common stock, $.000001 par value, 2,400,000,000 shares authorized, 1,323,628,497 shares issued and outstanding at September 30, 2008 and 590,618,180 shares issued and outstanding at December 31, 2007

 

 

 

Additional paid-in capital

 

12,165

 

490

 

Net payable to Vivendi and affiliated companies

 

 

77

 

Accumulated deficit

 

(403

)

(367

)

Accumulated other comprehensive income

 

13

 

40

 

 

 

 

 

 

 

Total shareholders’ equity

 

11,775

 

240

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

13,741

 

$

871

 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

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Table of Contents

 

ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Amounts in millions, except per share data)

 

 

 

For the three months ended
September 30,

 

For the nine months ended 
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

(As Adjusted)

 

 

 

(As Adjusted)

 

Net revenues

 

 

 

 

 

 

 

 

 

Product sales

 

$

413

 

$

98

 

$

553

 

$

246

 

Subscription, licensing, and other revenues

 

298

 

228

 

834

 

650

 

Total net revenues

 

711

 

326

 

1,387

 

896

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses

 

 

 

 

 

 

 

 

 

Cost of sales – product costs

 

279

 

31

 

350

 

95

 

Cost of sales – software royalties and amortization

 

50

 

5

 

88

 

14

 

Cost of sales – intellectual property licenses

 

36

 

1

 

45

 

5

 

Cost of sales – massively, multiplayer, online game

 

43

 

40

 

123

 

146

 

Product development

 

200

 

117

 

414

 

327

 

Sales and marketing

 

142

 

46

 

220

 

105

 

Restructuring costs

 

61

 

 

61

 

(1

)

General and administrative

 

94

 

29

 

172

 

71

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

905

 

269

 

1,473

 

762

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

(194

)

57

 

(86

)

134

 

 

 

 

 

 

 

 

 

 

 

Investment income (loss), net

 

24

 

(2

)

28

 

(5

)

 

 

 

 

 

 

 

 

 

 

Income (loss) before income tax provision (benefit)

 

(170

)

55

 

(58

)

129

 

 

 

 

 

 

 

 

 

 

 

Income tax provision (benefit)

 

(62

)

7

 

(22

)

(12

)

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(108

)

$

48

 

$

(36

)

$

141

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share
Basic and diluted

 

$

(0.08

)

$

0.08

 

$

(0.04

)

$

0.24

 

 

 

 

 

 

 

 

 

 

 

Number of shares used in computation
Basic and diluted

 

1,271

 

591

 

816

 

591

 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)
(Amounts in millions)

 

 

 

For the nine months ended 
September 30,

 

 

 

2008

 

2007

 

 

 

 

 

(As Adjusted)

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

(36

)

$

141

 

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

 

 

 

 

 

Deferred income taxes

 

(109

)

(24

)

Depreciation and amortization

 

144

 

45

 

Impairment charges

 

24

 

 

Loss on disposal of property and equipment

 

 

1

 

Amortization and write-offs of capitalized software development costs and intellectual property licenses (1)

 

120

 

15

 

Stock-based compensation expense (2)

 

47

 

77

 

Tax benefit associated with employee stock options

 

2

 

 

Excess tax benefits from stock option exercises

 

(17

)

 

Changes in operating assets and liabilities, net of impact of acquisitions:

 

 

 

 

 

Accounts receivable

 

224

 

125

 

Inventories

 

(135

)

(3

)

Software development and intellectual property licenses

 

(119

)

(71

)

Other assets

 

(11

)

(3

)

Deferred revenues

 

10

 

88

 

Accounts payable

 

108

 

(10

)

Accrued expenses and other liabilities

 

(127

)

(73

)

 

 

 

 

 

 

Net cash provided by operating activities

 

125

 

308

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(24

)

(46

)

Cash acquired through the business combination, net of cash payments to effect acquisitions

 

1,137

 

 

Increase in restricted cash

 

(35

)

1

 

 

 

 

 

 

 

Net cash provided by (used in) investing activities

 

1,078

 

(45

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

19

 

 

Repurchase of stock through tender offer

 

(2

)

 

Return of capital to Vivendi

 

(79

)

 

Issuance of additional common stock related to the business combination

 

1,731

 

 

Net cash transfers to Vivendi and affiliated companies

 

(79

)

(294

)

Excess tax benefits from stock option exercises

 

17

 

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

1,607

 

(294

)

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

(30

)

3

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

2,780

 

(28

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

62

 

68

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

2,842

 

$

40

 

 


(1)

Excludes amortization of stock-based compensation expense.

(2)

Includes the net effects of capitalization and amortization of stock-based compensation expense.

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

For the Nine Months ended September 30, 2008

(Unaudited)

(Amounts in millions)

 

 

 

Common Stock

 

Additional
Paid-In 

 

Net Payable to

 

Accumulated

 

Accumulated
Other
Comprehensive

 

Total Shareholders’

 

 

 

Shares

 

Amount

 

Capital

 

Vivendi

 

Deficit

 

Income (Loss)

 

Equity

 

Balance at December 31, 2007 (As Adjusted)

 

591

 

$

 

$

490

 

$

77

 

$

(367

)

$

40

 

$

240

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Settlement of payable to Vivendi (see Note 18)

 

 

 

(2

)

(77

)

 

 

(79

)

Components of comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

(36

)

 

(36

)

Unrealized depreciation on short-term investments, net of taxes

 

 

 

 

 

 

(2

)

(2

)

Foreign currency translation adjustment

 

 

 

 

 

 

(25

)

(25

)

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

(63

)

Tender offer (see Note 1)

 

 

 

(2

)

 

 

 

(2

)

Issuance of additional common stock related to the business combination (see Note 1)

 

126

 

 

1,731

 

 

 

 

1,731

 

Issuance of common stock pursuant to employee stock options, restricted stock rights, employee stock purchase plans, and warrants

 

5

 

 

19

 

 

 

 

19

 

Stock-based compensation expense related to employee stock options, restricted stock rights, and employee stock purchase plans

 

 

 

42

 

 

 

 

42

 

Preliminary purchase consideration upon the business combination (see Note 4)

 

602

 

 

9,964

 

 

 

 

9,964

 

Tax benefit associated with employee stock options

 

 

 

2

 

 

 

 

2

 

Return of capital to Vivendi (see Note 18)

 

 

 

(79

)

 

 

 

(79

)

Balance at September 30, 2008

 

1,324

 

$

 

$

12,165

 

$

 

$

(403

)

$

13

 

$

11,775

 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

 

1.               Background and basis of presentation

 

Business Combination

 

We consummated our previously announced business combination (the “Business Combination”) pursuant to the Business Combination Agreement (the “Business Combination Agreement”), dated as of December 1, 2007, by and among Activision, Inc., Sego Merger Corporation, a wholly-owned subsidiary of Activision, Inc., Vivendi S.A. (“Vivendi”), VGAC LLC, a wholly-owned subsidiary of Vivendi (“VGAC”), and Vivendi Games, Inc., a wholly-owned subsidiary of VGAC (“Vivendi Games”). Up on the closing of the Business Combination, which occurred on July 9, 2008, Activision, Inc. was renamed Activision Blizzard, Inc. (“Activision Blizzard”). Activision Blizzard continues to operate as a public company traded on the NASDAQ under the ticker symbol ATVI. Activision Blizzard now conducts the combined business operations of Activision, Inc. and Vivendi Games including its subsidiary, Blizzard Entertainment, Inc. (“Blizzard”). In connection with the Business Combination, we issued approximately 717 million shares of common stock to VGAC including 126 million shares of common stock purchased by Vivendi for approximately $1.7 billion. Immediately following the consummation of the Business Combination, VGAC owned approximately 54% of Activision Blizzard’s issued and outstanding common stock. While Activision, Inc. was the surviving entity in this Business Combination, because the transaction is treated as a “reverse acquisition”, Vivendi Games is deemed to be the acquirer for accounting purposes. Accordingly, Activision Blizzard applied purchase accounting to the assets and liabilities of Activision, Inc. as of July 9, 2008. Also, for all Exchange Act filings following consummation of the Business Combination, the historical financial statements of Activision Blizzard for periods prior to the consummation of the Business Combination will be those of Vivendi Games. Activision, Inc.’s businesses were included in Activision Blizzard’s financial statements for all periods subsequent to the consummation of the Business Combination only.

 

In accordance with the terms of the Business Combination Agreement, on July 16, 2008, Activision Blizzard commenced a tender offer to purchase up to 293 million shares of its common stock at a price of $13.75 per share. The tender offer expired on August 13, 2008. We purchased 171,832 shares of our common stock as a result of the tender offer. These shares were accounted for using the treasury method and were retired and cancelled.

 

Upon consummation of the Business Combination, the senior unsecured credit agreement with Vivendi (as lender) became effective upon terms substantially similar to those previously disclosed in Note 21 of the consolidated financial statements included in Activision, Inc.’s Annual Report on Form 10-K for the fiscal year ended March 31, 2008. Under that credit agreement, we have access to funds for general corporate purposes as previously disclosed (see Note 16 for details).

 

Basis of Presentation

 

The accompanying unaudited Consolidated Financial Statements as of September 30, 2008 and for the three and nine month periods ended September 30, 2008 and 2007 include the accounts of Activision Blizzard, Inc. and its subsidiaries (“Activision Blizzard” or “we”).  The information furnished is unaudited and the adjustments included consist of only normal recurring adjustments that, in the opinion of management, are necessary to provide a fair statement of the results for the interim periods presented.

 

The accompanying unaudited Consolidated Financial Statements should be read in conjunction with Vivendi Games, Inc. and its subsidiaries (“Vivendi Games”) audited Consolidated Financial Statements for the year ended December 31, 2007 included in our Form 8-K as filed with the Securities and Exchange Commission (“SEC”) on November 5, 2008. The selection of footnote disclosures appearing in this Quarterly Report on Form 10-Q are those deemed necessary in order to update and make current the financial disclosures presented in the Vivendi Games’ audited financial statements for the year ended December 31, 2007.

 

Certain financial information that is normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles, (“US GAAP”), but is not required for interim reporting purposes, has been condensed or omitted.

 

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2.               Accounting changes

 

Comparative period – Following the consummation of the Business Combination, the historical financial statements of Activision Blizzard for periods prior to the consummation of the Business Combination are those of Vivendi Games. Activision, Inc.’s businesses were included in Activision Blizzard’s financial statements for all periods subsequent to the consummation of the Business Combination only.

 

Change in Segment Presentation– In conjunction with the Business Combination, we changed the manner in which senior management assesses the operating performance of, and allocates resources to, its operating segments. As a result, we operate four business segments: (i) Blizzard Entertainment, Inc. and its subsidiaries – publishing of traditional games and online subscription-based games in the massively multiplayer online game (“MMOG”) category (“Blizzard”), (ii) Activision Publishing - publishing interactive entertainment software and peripherals which includes certain studios, assets, and titles previously included in Vivendi Games’ Sierra Entertainment prior to the  Business Combination (“Activision”), (iii) Activision Blizzard Distribution - distribution of interactive entertainment software and hardware products (“Distribution”) (these three business segments form Activision Blizzard’s core operations) and (iv) Activision Blizzard’s non-core exit operations. Activision Blizzard’s non-core exit operations represent legacy Vivendi Games’ divisions or business units that the Company has begun to exit or wind down as part of our restructuring and integration efforts as a result of the Business Combination, but do not meet the criteria for separate reporting of discontinued operations. In accordance with the provisions of Statement of Financial Standards, No. 131, “Disclosures about Segments of an Enterprise and Related Information,” (“SFAS No. 131”), all prior period segment information has been restated, when practical, to conform to this new financial statement presentation (see Note 14 for details).

 

Change in Accounting Principles – In the current quarter, 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.

 

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 the 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.  We filed a Form 8-K with the SEC on November 5, 2008 which summarizes the effect of the changes to prior periods. The effects of these changes to the numbers in this Form 10-Q were as follows (amounts in millions):

 

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Three months ended September 30, 2007

 

 

 

As Reported

 

As Adjusted

 

Effect of
Change

 

As Adjusted
(Reclassified)

 

Consolidated Statement of Operations:

 

 

 

 

 

 

 

 

 

Product sales

 

$

73

 

$

106

 

$

33

 

$

98

 

Subscription, licensing and other revenues

 

221

 

220

 

(1

)

228

 

Cost of sales – product costs

 

70

 

72

 

2

 

31

 

Cost of sales – software royalties and amortization

 

1

 

3

 

2

 

5

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

29

 

57

 

28

 

57

 

Income (loss) before income tax provision (benefit)

 

27

 

55

 

28

 

55

 

Income tax provision (benefit)

 

(4

)

7

 

11

 

7

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

31

 

$

48

 

$

17

 

$

48

 

 

 

 

 

 

 

 

 

 

 

Net income per share
- Basic and diluted

 

$

0.05

 

$

0.08

 

$

0.03

 

$

0.08

 

 

 

 

Nine months ended September 30, 2007

 

 

 

As Reported

 

As Adjusted

 

Effect of 
Change

 

As Adjusted
(Reclassified)

 

Consolidated Statement of Operations:

 

 

 

 

 

 

 

 

 

Product sales

 

$

339

 

$

284

 

$

(55

)

$

246

 

Subscription, licensing and other revenues

 

624

 

613

 

(11

)

650

 

Cost of sales – product costs

 

239

 

234

 

(5

)

95

 

Cost of sales – software royalties and amortization

 

8

 

7

 

(1

)

14

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

193

 

133

 

(60

)

134

 

Income (loss) before income tax provision (benefit)

 

189

 

129

 

(60

)

129

 

Income tax provision (benefit)

 

12

 

(12

)

(24

)

(12

)

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

177

 

$

141

 

$

(36

)

$

141

 

 

 

 

 

 

 

 

 

 

 

Net income per share
- Basic and diluted

 

$

0.30

 

$

0.24

 

$

(0.06

)

$

0.24

 

 

 

 

December 31, 2007

 

 

 

As Reported

 

As Adjusted

 

Effect of
Change

 

As Adjusted
(Reclassified)

 

Consolidated Balance Sheets:

 

 

 

 

 

 

 

 

 

Software development

 

$

1

 

$

1

 

$

 

$

25

 

Deferred income taxes

 

127

 

143

 

16

 

143

 

Deferred revenues

 

137

 

190

 

53

 

197

 

Accrued expenses and other liabilities

 

374

 

362

 

(12

)

274

 

Accumulated deficit

 

(343

)

(367

)

(24

)

(367

)

 

 

 

Nine months ended September 30, 2007

 

 

 

As Reported

 

As Adjusted

 

Effect of
Change

 

As Adjusted
(Reclassified)

 

Consolidated Statement of Cash Flows:

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

177

 

$

141

 

$

(36

)

$

141

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

 

 

 

 

Deferred income taxes

 

 

(24

)

(24

)

(24

)

Amortization and write-offs of capitalized software development costs and intellectual property licenses

 

8

 

7

 

(1

)

15

 

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

 

 

Deferred revenues

 

8

 

83

 

75

 

88

 

Accrued expenses and other liabilities

 

44

 

30

 

(14

)

(73

)

 

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As adjusted (reclassified) reflects certain reclassification adjustments made to prior periods to be consistent with the current period presentation. There is no change on retained earnings as of January 1, 2007 as a result of the change in accounting principle.

 

Stock Split - In July 2008, the Board of Directors approved a two-for-one split of our outstanding common shares effected in the form of a stock dividend (“the split”).  The split was paid September 5, 2008 to shareholders of record as of August 25, 2008.  The par value of our common stock was maintained at the pre-split amount of $.000001 per share.  The Consolidated Financial Statements and Notes thereto, including all share and per share data, have been restated as if the split had occurred as of the earliest period presented.

 

Reclassifications - Certain reclassifications have been made to prior year financial statements to conform to the current period presentation.

 

3.               Summary of significant accounting policies

 

Significant Accounting Assumptions and Estimates

 

The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of gain or loss contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions.

 

Principles of Consolidation

 

The Consolidated Financial Statements include the accounts of Activision Blizzard, Inc., a Delaware corporation, and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

 

Cash, Cash Equivalents, and Investments

 

Cash and cash equivalents include cash, money markets, and short-term investments with original maturities of not more than 90 days.

 

Short-term investments generally mature between three and thirty months. Investments with maturities beyond one year may be classified as short-term based on their liquid nature and because such securities represent the investment of cash that is available for current operations. All other investments that are not classified as short-term are classified as long-term investments. All of our investments are classified as available-for-sale and are carried at fair market value with unrealized appreciation (depreciation) reported, net of taxes, as a component of accumulated other comprehensive income (loss) in shareholders’ equity. The specific identification method is used to determine the cost of securities disposed with realized gains and losses reflected in investment income, net.

 

Restricted Cash – Compensating Balances

 

We have restricted cash of $87 million as of September 30, 2008 and $3 million as of December 31, 2007. Most of the restricted cash as of September 30, 2008 relates to the standby letter of credit required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases.  Under the terms of this arrangement, we are required to maintain with the issuing bank a compensating balance, restricted as to use, of not less than the sum of the available amount of the letter of credit plus the aggregate amount of any drawings under the letter of credit that have been honored thereunder but not reimbursed.  Restricted cash is included in short-term investments.

 

Financial Instruments

 

The estimated fair values of financial instruments have been determined using available market information and valuation methodologies described below. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts that we could realize in a current market exchange. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts.

 

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The carrying amount of cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses are a reasonable approximation of fair value due to their short-term nature. Short-term investments are carried at fair value with fair values estimated based on quoted market prices. Long-term investments are comprised of student loan backed taxable auction rate securities (see note 13 for details).

 

We account for derivative instruments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities , SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities , an amendment of SFAS No. 133 and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities . SFAS No. 133, 138, and 149 require that all derivatives, including foreign exchange contracts, be recognized in the balance sheet in other assets or liabilities at their fair value.

 

We utilize forward contracts in order to reduce financial market risks. These instruments are used to hedge foreign currency exposures of underlying assets, liabilities, or cash flows. Our accounting policies for these instruments are based on whether they meet the criteria for designation as hedging transactions. Changes in fair value of derivatives that are designated as cash flow hedges, are highly effective, and qualify as hedging instruments, are recorded in other comprehensive income, if any, until the underlying hedged item is recognized in earnings. Any ineffective portion of a derivative’s change in fair value is immediately recognized in earnings. Changes in fair value of derivatives that do not qualify as hedging instruments are recorded in earnings. The fair value of foreign currency contracts is estimated based on the prevailing exchange rate of the various hedged currencies as of the end of the period.

 

Software Development Costs and Intellectual Property Licenses

 

Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products.

 

We account for software development costs in accordance with Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed”,  (“SFAS No. 86”). Software development costs are capitalized once the technological feasibility of a product is established and such costs are determined to be recoverable. Technological feasibility of a product encompasses both technical design documentation and game design documentation. Significant management judgments and estimates are utilized in the assessment of when technological feasibility is established. For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis. Prior to a product’s release, we expense, as part of “cost of sales—software royalties and amortization”, capitalized costs when we believe such amounts are not recoverable. Capitalized costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation. Amounts related to software development which are not capitalized are charged immediately to product development expense.

 

Commencing upon product release, capitalized software development costs are amortized to “cost of sales—software royalties and amortization” based on the ratio of current revenues to total projected revenues for the specific product, generally resulting in an amortization period of six months or less.

 

Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology, music or other intellectual property or proprietary rights in the development of our products. Depending upon the agreement with the rights holder, we may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product. Prior to the related product’s release, we expense, as part of “cost of sales—intellectual property licenses,” capitalized intellectual property costs when we believe such amounts are not recoverable. Capitalized intellectual property costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.

 

Commencing upon the related product’s release, capitalized intellectual property license costs are amortized to “cost of sales—intellectual property licenses” based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed property will be utilized. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.

 

We evaluate the future recoverability of capitalized software development costs and intellectual property licenses on a quarterly basis. For products that have been released in prior periods, the primary evaluation criterion is actual title performance. For products that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific products to which the costs relate or in which the licensed trademark or copyright is

 

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to be used. Criteria used to evaluate expected product performance include: historical performance of comparable products developed with comparable technology; orders for the product prior to its release; and, for any sequel product, estimated performance based on the performance of the product on which the sequel is based. Further, as many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors, such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property, and the rights holder’s continued promotion and exploitation of the intellectual property.

 

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. Additionally, as noted above, as many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors .

 

Inventories

 

Inventories are valued at the lower of cost (first-in, first-out or weighted average) or market.

 

Long-Lived Assets

 

Property and Equipment.   Property and equipment are recorded at cost. Depreciation and amortization are provided using the straight-line method over the shorter of the estimated useful lives or the lease term: buildings, 25 to 33 years; computer equipment, office furniture and other equipment, 2 to 5 years; leasehold improvements, the shorter of 5 years or the life of the lease. When assets are retired or disposed of, the cost and accumulated depreciation thereon are removed and any resulting gains or losses are included in the accompanying consolidated statements of operations.

 

Goodwill and Other Indefinite-Lived Assets.   We account for goodwill using the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). Under SFAS No. 142, goodwill is considered to have an indefinite life, and is carried at cost. In addition acquired trade names were assessed as indefinite lived assets because there is no foreseeable limit on the period of time over which they are expected to contribute cash flows. Goodwill and acquired trade names are not amortized but are subject to an annual test for impairment and in between annual tests when events or circumstances indicate that the carrying value may not be recoverable.

 

Amortizable Intangible Assets.   Intangible assets subject to amortization are carried at cost less accumulated amortization. Amortizable intangible assets consist of internally developed franchises, acquired developed software, acquired game engines, favorable leases and distribution agreements, and other intangibles related primarily to licensing activities and retail customer relationships. Intangible assets subject to amortization are amortized over the estimated useful life in proportion to the pattern in which the economic benefits are consumed. Long-lived assets including amortizable intangible assets are reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets” (“SFAS No. 144”) whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of any impairment loss for long-lived assets and amortizable intangible assets is based on the amount by which the carrying value exceeds the fair value of the asset.

 

Revenue Recognition

 

Product sales

 

We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers, and once any performance obligations have been completed.  Certain products are sold to customers with a street date (the earliest date these products may be sold by retailers).  For these products we recognize revenue on the later of the street date or the

 

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sale date.  Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection.

 

Some of our software products provide limited online features at no additional cost to the consumer. Generally, we consider such features to be incidental to the overall product offering and an inconsequential deliverable. Accordingly, we recognize revenue related to products containing these limited online features upon the transfer of title and risk of loss to our customer.  In instances where online features or additional functionality is considered a substantive deliverable in addition to the software product, we take this into account when applying our revenue recognition policy.   This evaluation is performed for each software product together with any online transactions, such as electronic downloads of titles of product add-ons when it is released.  When we determine that a software title contains online functionality that constitutes a more-than-inconsequential separate service deliverable in addition to the product, principally because of its importance to game play, we consider that our performance obligations for this title extend beyond the sale of the game. Vendor-specific objective evidence of fair value (“VSOE”) does not exist for the online functionality, as we do not separately charge for this component of the title. As a result, we recognize all of the revenue from the sale of the title ratably over an estimated service period. In addition, we defer the costs of sales for this title to match revenues. Cost of sales includes: manufacturing costs, software royalties and amortization, and intellectual property licenses.

 

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 No. 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, licensing and other revenues.

 

With respect to online transactions, such as electronic downloads of titles or product add-ons that do not include a more-than-inconsequential separate service deliverable, revenue is recognized when the fee is paid by the online customer to purchase online content and we are notified by the online retailer that the product has been downloaded. In addition, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable.

 

Sales incentives or other consideration given by us to our customers are accounted for in accordance with EITF Issue 01-09, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).”  In accordance with EITF Issue 01-09, sales incentives and other consideration that are considered adjustments of the selling price of our products, such as rebates and product placement fees, are reflected as reductions to revenue.  Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer’s national circular ad, are reflected as sales and marketing expenses.

 

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 license agreements 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, we defer their recognition and recognize 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, we recognize these additional royalties as revenues based on activation of the underlying prepaid time by the end users.

 

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With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of a master copy. Per copy royalties on sales that exceed the guarantee are recognized as earned.  In addition, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable.

 

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.

 

Allowances for Returns, Price Protection, Doubtful Accounts, and Inventory Obsolescence

 

We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers, and the anticipated timing of other releases in order to assess future demands of current and upcoming titles. Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets, but at the same time are controlled to prevent excess inventory in the channel. We benchmark units to be shipped to our customers using historical and industry data.

 

We may permit product returns from, or grant price protection to, our customers under certain conditions. In general, price protection refers to the circumstances when we elect 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 to us with respect to open and/or future invoices. The conditions our customers must meet to be granted the right to return products or price protection include, among other things, compliance with applicable payment terms, and consistent delivery to us of inventory and sell-through reports. We may also consider other factors, including the facilitation of slow-moving inventory and other market factors. Management must make estimates of potential future product returns and price protection related to current period product revenue. We estimate 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 our 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 franchise; console hardware life cycle; sales force and retail customer feedback; industry pricing; weeks of on-hand retail channel inventory; absolute quantity of on-hand retail channel inventory; our 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 allowance for returns and price protection in any accounting period. Based upon historical experience we believe our estimates are reasonable. However, actual returns and price protection could vary materially from our allowance 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 our revenue for any period if factors or market conditions change or if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection. For example, a 1% change in our September 30, 2008 allowance for returns and price protection would impact net revenues by $2 million.

 

Similarly, management must make estimates of the uncollectibility of our accounts receivable. In estimating the allowance for doubtful accounts, we analyze the age of current outstanding account balances, historical bad debts, customer concentrations, customer creditworthiness, current economic trends, and changes in our customers’ payment terms and their economic condition, as well as whether we can obtain sufficient credit insurance. Any significant changes in any of these criteria would affect management’s estimates in establishing our allowance for doubtful accounts.

 

We value inventory at the lower of cost or market. We regularly review inventory quantities on hand and in the retail channel and record a provision for excess or obsolete inventory based on the future expected demand for our products. Significant changes in demand for our products would impact management’s estimates in establishing our inventory provision.

 

Shipping and Handling

 

Shipping and handling costs, which consist primarily of packaging and transportation charges incurred to move finished goods to customers, are included in “cost of sales—product costs.”

 

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Income Taxes

 

We account for income taxes using Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). Under SFAS No. 109, income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

 

Foreign Currency Translation

 

The functional currencies of our foreign subsidiaries are their local currencies. All assets and liabilities of our foreign subsidiaries are translated into U.S. dollars at the exchange rate in effect at the end of the period, and revenue and expenses are translated at average exchange rates during the period. The resulting translation adjustments are reflected as a component of accumulated other comprehensive income (loss) in shareholders’ equity.

 

Earnings (Loss) Per Common Share

 

Basic earnings (loss) per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for all periods. Diluted earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding, increased by common stock equivalents. Common stock equivalents are calculated using the treasury stock method and represent incremental shares issuable upon exercise of our outstanding options and warrants. However, potential common shares are not included in the denominator of the diluted earnings per share calculation when inclusion of such shares would be anti-dilutive, such as in a period in which a net loss is recorded. Earnings (loss) per share for periods prior to the Business Combination are retrospectively adjusted to reflect the number of split adjusted shares received by Vivendi, former parent company of Vivendi Games.

 

Stock-Based Compensation

 

We account for stock-based compensation in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R requires companies to estimate the fair value of share-based payment awards on the measurement date 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 our Consolidated Statement of Operations.

 

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in our Consolidated Statement of Operations for the three and nine months ended September 30, 2008 included compensation expense for share-based payment awards granted by Activision, Inc. prior to, but not yet vested as of July 9, 2008, based on the revalued fair value estimated as of July 9, 2008 (see note 17), and compensation expense for the share-based payment awards granted subsequent to July 9, 2008 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. Stock-based compensation expense recognized in the Consolidated Statement of Operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

We estimate the value of employee stock options on the date of grant using a binomial-lattice model (see Note 17). Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.

 

Prior to the Business Combination, Vivendi Games had equity incentive plans that are equity-settled and cash-settled. Equity-settled award includes stock options and restricted shares plans from Vivendi, and the cash-settled award includes stock appreciation rights and restricted stock units from Vivendi, and the Blizzard Equity Plan (“BEP”). In accordance with SFAS No. 123R, for cash-settled awards, the Company recorded a liability and recognized changes in fair value of the liability that occur during the period as compensation cost over the requisite service period. Changes in the fair value of the liability that occur after the end of the requisite service period are compensation cost of the period in which the changes occur. Any differences between the amount for which the liability is settled and its fair value at the settlement date as estimated in accordance with SFAS No. 123R is an adjustment of compensation cost in the period of settlement.

 

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4.               Acquisitions

 

Reverse acquisition

 

The Business Combination (see Note 1) is accounted for as a reverse acquisition under the purchase method of accounting. For this purpose, Vivendi Games was deemed to be the accounting acquirer and Activision, Inc. was deemed to be the accounting acquiree.

 

The preliminary purchase price of Activision, Inc. consists of the following items (amounts in millions):

 

Fair market value of Activision, Inc.’s outstanding common stock immediately prior to the Business Combination at the closing price

 

$

9,102

 

Fair value of Activision, Inc.’s existing vested and unvested stock awards at the closing price*

 

861

 

Transaction expenses

 

1

 

Total consideration

 

$

9,964

 

 


* The fair value of the existing vested and unvested stock award is comprised of the following (amounts in millions):

 

Fair value of Activision, Inc. existing vested stock awards

 

$

713

 

Fair value of Activision, Inc. unvested stock awards

 

296

 

Less: Unearned stock-based compensation

 

(148

)

 

 

$

861

 

 

The fair value of Activision, Inc.’s stock awards was determined using fair value of Activision, Inc.’s common stock of $15.04 per share, which is the closing price as of July 9, 2008 a binomial-lattice model and the following assumptions: (a) varying volatility ranging from 42.38% to 51.50%, (b) a risk free interest rate of 3.97%, (c) an expected life ranging from approximately 3.22 years to 4.71 years, (d) risk adjusted stock return of 8.89%, and (e) an expected dividend yield of 0.0%.

 

The Company’s allocation of the preliminary purchase price of Activision, Inc. is as follows (amounts in millions):

 

 

 

 

 

Amount

 

Working capital, excluding inventories

 

 

 

$

1,194

 

Inventories

 

 

 

221

 

Property and equipment

 

 

 

64

 

Deferred tax asset

 

 

 

62

 

Other long term assets

 

 

 

128

 

 

 

 

 

 

 

 

 

Estimated useful
life

 

 

 

Intangible assets:

 

 

 

 

 

License agreements

 

3 - 10 years

 

207

 

Developed software

 

Less than 1 year

 

68

 

Game engines

 

2 - 5 years

 

128

 

Internally developed franchises

 

5 - 12 years

 

1,124

 

Retail customer relationships

 

Less than 1 year

 

40

 

Favorable leases

 

1 – 2 years

 

5

 

Distribution agreements

 

4 years

 

17

 

Activision trade name

 

Indefinite

 

386

 

Goodwill

 

Indefinite

 

7,085

 

Long term liabilities

 

 

 

(24

)

Deferred tax liability

 

 

 

(741

)

Total consideration

 

 

 

$

9,964

 

 

Goodwill arises from the Business Combination due to the acquired work force of Activision, Inc., and the expected synergies from the Business Combination. The following table presents the gross and net balances, and accumulated amortization of the components of our purchased amortizable intangible assets acquired in the Business Combination as of September 30, 2008 (amounts in millions):

 

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Table of Contents

 

 

 

 

 

Accumulated

 

 

 

 

 

Gross

 

Amortization

 

Net

 

License agreements

 

$

207

 

$

(8

)

$

199

 

Developed software

 

68

 

(21

)

47

 

Game engines

 

128

 

(6

)

122

 

Internally developed franchises

 

1,124

 

(16

)

1,108

 

Retail customer relationships

 

40

 

(36

)

4

 

Favorable leases

 

5

 

(1

)

4

 

Distribution agreements

 

17

 

(1

)

16

 

 

 

 

 

 

 

 

 

Total

 

$

1,589

 

$

(89

)

$

1,500

 

 

Intangibles and goodwill are not tax deductible. The estimated future after-tax decreases to net income from the amortization of the finite-lived intangible assets are the following amounts (amounts in millions):

 

Year ending December 31,

 

Amount

 

2008 (remaining three months)

 

$

222

 

2009

 

284

 

2010

 

198

 

2011

 

141

 

2012

 

119

 

Thereafter

 

536

 

 

The following table summarizes unaudited pro forma financial information assuming the Business Combination (see Note 1) had occurred at the beginning of the periods presented. This pro forma financial information is for informational purposes only and does not reflect any operating efficiencies or inefficiencies which may result from the Business Combination and therefore is not necessarily indicative of results that would have been achieved had the businesses been combined during the periods presented (amounts in millions, except per share data).

 

 

 

For the three months ended
September 30,

 

For the nine months ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Pro forma net revenues

 

$

764

 

$

644

 

$

2,698

 

$

2,022

 

 

 

 

 

 

 

 

 

 

 

Pro forma net loss

 

(121

)

(9

)

(166

)

(103

)

 

 

 

 

 

 

 

 

 

 

Pro forma net loss per share

 

 

 

 

 

 

 

 

 

- basic and diluted

 

(0.09

)

(0.01

)

(0.13

)

(0.08

)

 

Freestyle Games, Ltd.

 

On September 11, 2008, we completed an acquisition of Freestyle Games, Ltd., a premier United Kingdom based video game developer specializing in music based games. The acquisition is expected to be immaterial to current year earnings (loss) per share and cash flow. Additionally, pro forma Consolidated Statements of Operations for this acquisition are not shown, as they would not differ materially from reported results.

 

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5.               Inventories

 

We value inventories at the lower of cost (first-in, first-out or weighted average) or market. Our inventories consist of the following (amounts in millions):

 

 

 

September 30, 2008

 

December 31, 2007

 

Finished goods

 

$

353

 

$

19

 

Purchased parts and components

 

24

 

2

 

 

 

 

 

 

 

 

 

$

377

 

$

21

 

 

6.               Goodwill

 

The changes in the carrying amount of goodwill by reportable segments, (see Notes 2 and 14 for details) for the nine months ended September 30, 2008 are as follows (amounts in millions):

 

 

 

Blizzard

 

Activision

 

Distribution

 

Activision
Blizzard’s
Core
Operations

 

Activision
Blizzard’s
Non-core
Exit
Operations

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2007

 

$

178

 

$

 

$

 

$

178

 

$

25

 

$

203

 

Goodwill acquired during the period

 

 

7,080

 

12

 

7,092

 

 

7,092

 

Re-assigned goodwill

 

 

7

 

 

7

 

(7

)

 

Issuance of contingent consideration

 

 

 

 

 

6

 

6

 

Impairment charge (see Note 10)

 

 

 

 

 

(16

)

(16

)

Tax benefit credited to goodwill

 

 

(15

)

 

(15

)

 

(15

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of September 30, 2008

 

$

178

 

$

7,072

 

$

12

 

$

7,262

 

$

8

 

$

7,270

 

 

Goodwill acquired during the period represents goodwill of $7.1 billion related to the acquisition of Activision, Inc. (see Note 4). As a result of the Business Combination, goodwill affected by the reorganization/integration was reassigned to the reporting units affected using a relative fair value approach. The tax benefit credited to goodwill represents the tax deduction resulting from the exercise of stock options that were outstanding and vested at the consummation of the Business Combination and included in the purchase price of Activision, Inc. to the extent that the tax deduction does not exceed the fair value of those options.

 

7.               Intangible assets

 

Intangible assets consist of the following (amounts in millions):

 

 

 

September 30, 2008

 

 

 

Estimated
Useful
Lives

 

Gross
carrying
amount

 

Accumulated

amortization

 

Impairment
charge
(See Note
10)

 

Net

 

Acquired definite-lived intangible assets:

 

 

 

 

 

 

 

 

 

 

 

License agreements

 

3-10 years

 

$

207

 

$

(8

)

$

 

$

199

 

Developed software

 

1-2 years

 

283

 

(233

)

 

50

 

Game engines

 

2-5 years

 

136

 

(6

)

 

130

 

Internally developed franchises

 

11-12 years

 

1,124

 

(16

)

 

1,108

 

Retail customer relationships

 

Less than 1 year

 

40

 

(36

)

 

4

 

Favorable leases

 

1-4 years

 

5

 

(1

)

 

4

 

Distribution agreements

 

4 years

 

17

 

(1

)

 

16

 

Other intangibles

 

0-2 years

 

14

 

(12

)

 

2

 

 

 

 

 

 

 

 

 

 

 

 

 

Acquired indefinite-lived intangible assets:

 

 

 

 

 

 

 

 

 

 

 

Activision trademark

 

Indefinite

 

386

 

 

 

386

 

Acquired trade names

 

Indefinite

 

52

 

 

(5

)

47

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

2,264

 

$

(313

)

$

(5

)

$

1,946

 

 

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Table of Contents

 

 

 

December 31, 2007

 

 

 

Estimated
Useful
Lives

 

Gross
carrying
amount

 

Accumulated
amortization

 

Impairment
charge

 

Net

 

Acquired definite-lived intangible assets:

 

 

 

 

 

 

 

 

 

 

 

Developed software

 

2 yrs

 

$

215

 

$

(210

)

$

 

$

5

 

Other intangibles

 

0-2 yrs

 

14

 

(11

)

 

3

 

 

 

 

 

 

 

 

 

 

 

 

 

Acquired indefinite-lived intangible assets:

 

 

 

 

 

 

 

 

 

 

 

Acquired trade names

 

Indefinite

 

52

 

 

 

52

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

281

 

$

(221

)

$

 

$

60

 

 

Amortization expense of intangible assets for the three and nine months ended September 30, 2008 was $90 million and $92 million, respectively. Amortization expense of intangible assets for the three and nine months ended September 30, 2007 was $1 million and $3 million, respectively.

 

8.               Income Taxes

 

The income tax benefit of $62 million for the three months ended September 30, 2008 reflects our effective income tax rate benefit for the quarter of 36.5%. The significant items that generate the variance between our effective rate for the three-months ended September 30, 2008 and our statutory rate of 35% were the result of the state income taxes provided, net of federal benefit, foreign income taxes, goodwill impairment and California research and development tax credits.

 

For the nine months ended September 30, 2008 our effective tax rate benefit of 37.9% differs from the effective tax rate benefit of 9.3% for the nine months ended September 30, 2007.  The difference is due to the recognition of the California Research and Development tax credit and IRC 199 Domestic Production Deduction in the third quarter of 2008 and tax benefits from net operating losses surrendered at September 30, 2007.

 

The income tax benefit of $12 million for the nine months ended September  30, 2007 reflects our effective income tax rate benefit of 9.3%, which differs from our effective tax rate benefit of 30% for the year ended December 31, 2007 due to the recognition of research and development tax credits in the fourth quarter of 2007 and the release of additional valuation allowance on deferred tax assets and net operating losses surrendered when compared to those estimated at September 30, 2007, as a result of meeting the more likely than not recognition criteria in the fourth quarter of 2007.

 

We adopted the provisions of Financial Accounting Standards Board Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”) an interpretation of SFAS No. 109 on January 1, 2007. At December 31, 2007, we had $14 million of unrecognized tax benefits. As a result of the Business Combination, an additional $74 million of unrecognized tax benefits was added, resulting in a balance of $88 million at September 30, 2008. It is reasonably possible there will be an $11 million decrease of our unrecognized tax benefits within the next twelve months due to the completion of certain income tax audits.

 

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Table of Contents

 

We recognize interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2008, we had approximately $1 million of accrued interest related to uncertain tax positions. For the nine months ended September 30, 2008, we recorded approximately $1 million of interest expense related to uncertain tax positions.

 

On July 9, 2008, Activision Blizzard entered into a Tax Sharing Agreement (the “Tax Sharing Agreement”) with Vivendi. The Tax Sharing Agreement generally governs Activision Blizzard’s and Vivendi’s respective rights, responsibilities and obligations with respect to the ordinary course of business taxes. Under the Tax Sharing Agreement, with certain exceptions, Activision Blizzard generally is responsible for the payment of U.S. and certain non-U.S. income taxes that are required to be paid to tax authorities on a stand-alone Activision Blizzard basis. In the event that Activision Blizzard joins Vivendi in the filing of a group tax return, Activision Blizzard will pay its share of the tax liability for such group tax return to Vivendi, and Vivendi will pay the tax liability for the entire group to the appropriate tax authority. Vivendi will indemnify Activision Blizzard for any tax liability imposed upon it due to Vivendi’s failure to pay any group tax liability. Activision Blizzard will indemnify Vivendi for any tax liability imposed on Vivendi (or any of its subsidiaries) due to Activision Blizzard’s failure to pay any taxes it owes under the Tax Sharing Agreement.

 

9.               Software Development Costs and Intellectual Property Licenses

 

As of September 30, 2008, capitalized software development costs included $180 million of internally developed software costs and $66 million of payments made to third-party software developers. As of December 31, 2007, capitalized software development costs included $1 million of internally developed software costs and $75 million of payments made to third-party software developers. Capitalized intellectual property licenses were $10 million and $17 million as of September 30, 2008 and December 31, 2007, respectively. Amortization and write-offs of capitalized software development costs and intellectual property licenses for the three and nine months ended September 30, 2008 and 2007 was $81 million and $1 million, $120 million and $15 million, respectively.

 

10.        Restructuring

 

The Company has implemented an organizational restructuring as a result of the Business Combination described in Note 1. This organizational restructuring is to integrate different operations to create the streamlined organization of Activision Blizzard.

 

The primary goals of the organizational restructuring were to rationalize the title portfolio and consolidate certain corporate functions so as to realize the synergies of the Business Combination.

 

Since the consummation of the Business Combination, the Company has commenced the organizational restructuring activities, focusing first on North American staff, redundant premises and related redundant equipment assets.  We have communicated to the North America, Canada, and Australia redundant employees and ceased use of certain offices under operating lease contracts. Impairment of goodwill and other intangibles and write-offs of prepaid royalties and intellectual licenses were also recorded as a result. The following table details the amount of restructuring reserves included in accrued expenses and other liabilities in the Consolidated Balance Sheets at September 30, 2008 (amounts in millions):

 

 

 

 

 

 

 

Asset

 

Contract

 

 

 

 

 

 

 

Facilities

 

write-

 

termination

 

 

 

 

 

Severance(1)

 

costs(1)

 

downs(2)

 

costs(1)

 

Total

 

Balance as of December 31, 2007

 

$

 

$

 

$

 

$

 

$

 

Original restructuring charges (charges to expenses)

 

32

 

2

 

24

 

3

 

61

 

Utilization (cash paid or otherwise settled)

 

(9

)

 

(24

)

(2

)

(35

)

 

 

 

 

 

 

 

 

 

 

 

 

Balance at September 30, 2008

 

$

23

 

$

2

 

$

 

$

1

 

$

26

 

 


(1)           Accounted for in accordance with Statement of Financial Accounting Standards 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”).

 

(2)           Accounted for in accordance with SFAS No. 144 and SFAS No. 142.

 

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Utilization represents the amount of cash paid to settle restructuring liabilities incurred ($9 million of severance and $2 million of contract termination costs) and non-cash asset write-down charges of which $3 million relates to fixed assets disposal, $5 million relates to impairment of acquired trade name, and $16 million relates to impairment of goodwill.

 

The total restructuring reserve balance as of September 30, 2008 and the net restructuring charges for the three and nine months periods then ended are presented below by reporting segments (amounts in millions):

 

 

 

Restructuring charges

 

 

 

Ending balance

 

Three months ended

 

Nine months ended

 

 

 

September 30, 2008

 

September 30, 2008

 

September 30, 2008

 

 

 

 

 

 

 

 

 

Activision

 

$

 

$

1

 

$

1

 

Blizzard

 

 

 

 

Distribution

 

 

 

 

Activision Blizzard’s core operations

 

 

1

 

1

 

Activision Blizzard’s non- core exit operations

 

26

 

60

 

60

 

Total

 

$

26

 

$

61

 

$

61

 

 

For the next nine months, we anticipate incurring between $75 million and $100 million of additional before tax restructuring charges, and after tax cash restructuring charges between $45 million and $60 million relating to the Business Combination. Overall, including charges incurred through September 30, 2008, we expect to incur cash and non-cash before tax restructuring charges between $135 million and $160 million by June 30, 2009 with an after tax cash impact between $70 million and $90 million. The after tax cash charges are expected to consist primarily of employee-related severance cash costs (approximately $55 million), facility exit cash costs (approximately $25 million) and cash contract terminations (approximately $10 million). Separately, these restructuring charges are expected to be partially offset by approximately between $30 million and $50 million of cash proceeds from asset disposals and cash after tax benefits related to the streamlining of the Vivendi Games title portfolio.

 

11.        Comprehensive Income (Loss) and Accumulated Other Comprehensive Income (Loss)

 

Comprehensive Income (loss)

 

The components of comprehensive income (loss) for the three and nine months ended September 30, 2008 and 2007 were as follows (amounts in millions):

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(108

)

$

48

 

$

(36

)

$

141

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

 

(26

)

7

 

(25

)

2

 

Unrealized depreciation on short-term investments, net of taxes

 

(2

)

 

(2

)

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss)

 

(28

)

7

 

(27

)

2

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

(136

)

$

55

 

$

(63

)

$

143

 

 

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Table of Contents

 

Accumulated Other Comprehensive Income (Loss)

 

For the nine months ended September 30, 2008 the components of accumulated other comprehensive income (loss) were as follows (amounts in millions):

 

 

 

 

 

Unrealized

 

Accumulated

 

 

 

 

 

appreciation

 

other

 

 

 

Foreign

 

(depreciation)

 

comprehensive

 

 

 

currency

 

on investments

 

income

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2007

 

$

40

 

$

 

$

40

 

Other comprehensive loss

 

(25

)

(2

)

(27

)

 

 

 

 

 

 

 

 

Balance as of September 30, 2008

 

$

15

 

$

(2

)

$

13

 

 

Other comprehensive income (loss) is presented net of tax benefits related to unrealized depreciation on our investments for the nine months ended September 30, 2008.  Income taxes were not provided for foreign currency translation items as these are considered indefinite investments in non-U.S. subsidiaries.

 

12.        Investment Income (Loss), Net

 

Investment income (loss), net is comprised of the following (amounts in millions):

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Interest income (expense), net

 

$

17

 

$

(2

)

$

22

 

$

(3

)

Net realized gain on investments

 

4

 

 

4

 

 

Net unrealized gain (loss) on foreign exchange contracts

 

3

 

 

2

 

(2

)

 

 

 

 

 

 

 

 

 

 

Investment income (loss), net

 

$

24

 

$

(2

)

$

28

 

$

(5

)

 

In 2007, Vivendi provided Vivendi Games access to centralized cash management pool from which Vivendi Games was able to borrow or lend on a daily basis at market rates.  From the consummation of the Business Combination, we managed our own investment portfolio.

 

13.        Fair Value Measurements

 

As of January 1, 2008, we adopted Statement of Financial Accounting Standards No. 157 “Fair Value Measurements” (“SFAS No. 157”) for financial assets and liabilities. SFAS No. 157 establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of “observable inputs” and minimize the use of “unobservable inputs.” The three levels of inputs used to measure fair value are as follows:

 

·                  Level 1 – Quoted prices in active markets for identical assets or liabilities.

 

·                  Level 2 – Observable inputs other than quoted prices included in Level 1, such as quoted prices for markets that are not active or other inputs that are observable or can be corroborated by observable market data.

 

·                  Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

 

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Table of Contents

 

The table below segregates all financial assets and liabilities that are measured at fair value on a recurring basis (which, for purposes of SFAS No. 157, means they are so measured at least annually) into the most appropriate level within the fair value hierarchy based on the inputs used to determine the fair value at the measurement date. Financial Statement Position FAS 157-2 delayed the effective date for the application of SFAS No. 157 for all nonfinancial assets and liabilities until January 1, 2009, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (amounts in millions):

 

 

 

September 30,
2008

 

Quoted prices
in active
markets for
identical assets
(level 1)

 

Significant
other
observable
inputs
(level 2)

 

Significant
unobservable
inputs
(level 3)

 

 

 

 

 

 

 

 

 

 

 

Money market funds

 

$

2,673

 

$

2,673

 

$

 

$

 

Asset-backed securities

 

7

 

 

7

 

 

Auction rate securities

 

86

 

 

 

86

 

Total financial assets at fair value

 

$

2,766

 

$

2,673

 

$

7

 

$

86

 

 

The following table provides a reconciliation of the beginning and ending balances for our investment in auction rate securities, as these assets are measured at fair value using significant unobservable inputs (Level 3) (amounts in millions):

 

 

 

Level 3

 

 

 

 

 

Balance as of January 1, 2008

 

$

 

Transfers in and/or (out) of Level 3

 

 

Purchases via the business combination

 

88

 

Total losses realized/unrealized included in earnings

 

 

Total losses included in other comprehensive income (a)

 

(2

)

Purchases, sales, issuances, and settlements, net

 

 

Interest received

 

 

Balance as of September 30, 2008

 

$

86

 

 


(a)  Due to uncertainties surrounding the timing of liquidation of our auction rate securities, we classify these instruments as long-term investments in our consolidated balance sheets as of September 30, 2008. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every 7 to 35 days. On an industry-wide basis, many auctions have failed, and there is, as yet, no meaningful secondary market for these instruments. Each of the auction rate securities in our investment portfolio as of September 30, 2008 has experienced a failed auction and there is no assurance that future auctions for these securities will succeed. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. In the event that there is a failed auction, the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar instruments. The securities for which auctions have failed will continue to earn interest at the contractual rate and be auctioned every 7 to 35 days until the auction succeeds, the issuer calls the securities or they mature. As a result, our ability to liquidate and fully recover the carrying value of our auction rate securities in the near term may be limited or not exist.