Above the Crowd

Virtual Goods, Accounting, and the Power of the “Rental” Model

February 8, 2010:

American journalists and corporate executives have been slow to appreciate the beauty, brilliance, and consumer allure of the virtual goods business model.It’s not that they did not have data points – China is chock full of multi-US$billion market capitalization companies that are based on this business model. That said, many luddites predicted it was an “Eastern” fascination that would never spread to the West. They never fully understood it.

As a result of this headstrong denial, I have often wondered what data point would finally convince me that the West had fully accepted the reality of the virtual goods business model. Last week I received my answer. Jeff Grabow from Ernst and Young asked my partner Mitch Lasky and I to sit down with Mick Bobroff, an audit partner developing an expertise in virtual item based revenue recognition. Now I wasn’t exactly waiting for a sign from God or anything – rather just a small signal that confirmed this new model was legit. Having an audit partner at a top three accounting firm become an expert certainly qualifies as a step in the right direction.

Mick had prepared a remarkably succinct and information rich presentation (here is a link to their PDF on the subject). I was fairly excited to go through it – at least as excited as anyone should get when discussing accounting principles. Here is a summary of what Mick had to say in his presentation titled “Revenue Recognition Considerations for the Sale of Virtual Goods”. [If you want to reach Mick, his contact info: 415-894-8205, michael.bobroff@ey.com]

  1. [Legal Point First] Michael made it clear that this document represented general observations and should not be used specifically as accounting advice. I understand and concur with regards to this post also. For your own books verify with your own accountant.
  2. There are already a ton of companies that trade on American stock exchanges (NYSE, NASDAQ) that use virtual goods models and adhere to GAAP. To the point above, they are all in China.  Examples: ChangYou (CYOU), Giant (GA), NetEase (NTES), Perfect World (PWRD), The 9 (NCTY), Shanda Games (GAME).  [For the record, TenCent is Hong Kong listed.] The current GAAP revenue recognition policies were honed with these companies.
  3. When a company sells virtual currency, this is not a revenue event (even though it may clearly be a cash event). When purchased but not yet used,  virtual currency sits on the balance sheet as a customer deposit or deferred revenue (i.e. a liability).
  4. Revenue recognition commences when virtual goods are bought with virtual currency by the consumer. Exactly how it “commences” depends on the following.
  5. There are two categories of virtual goods – (1) consumable items that are used once and gone, and (2) durable items that “work” over an extended period of time.
  6. For “consumable items” you can recognize revenue when it is consumed.
  7. For durable items (which many are), things are much trickier. You need to amortize the revenue (linearly) over the useful life of the good, or the average life of the actual user (i.e. – what is the average customer life of your customer?). This is a messy problem, especially when you understand how difficult it is to measure “customer life” when some customers never pay and others come and go in fairly random patterns. Also, your “average customer life” may change over time creating very complex accruals.
  8. The bottom line: getting this right requires quite a few database entries for tracking the sale and usage of every single virtual good sold in your digital world, in addition to the supply and usage of each virtual currency account, and the activity levels of each user (to estimate average life).

These policies were not particularly surprising. That said, when I was listening to the complications of the “durable item” revenue accounting, it reminded me of something I learned for the early leaders in the virtual items space — innovative Korean companies such as Nexon.

The “Rental” Model

About four to five years ago, the team at LindenLab (SecondLife) held a pizza night at their offices with the goal of learning more about the virtual item games that were wildly popular in Korea. We invited two bilingual gamers to install and play Audition, Kartrider, and FreeStyle. My big takeaway from that night was that not one of these titles actual allowed for the “sale” of virtual goods. Rather, each virtual item could only be “rented.” In each case, the user was given the option of one, seven, or thirty-day rental. I assumed this was Darwinian, and immediately began to wonder why “renting” might be better than outright ownership when it comes to virtual goods.

  1. In world inventory gluts. As virtual worlds mature, they often suffer from game-wide inventory glut. Items that were once useful to newbies become throw-aways for the more advanced user, and can literally pollute the world and compromise the in-world economy. Allowing rental is like having free garbage collection.  Everything eventually goes away.
  2. User inventory clutter. More advanced users typically have a huge problem managing large inventories of items. Also, many items are trend-oriented and trends change. With the rental model, no user sits around thinking “wow, why did I really buy that two months ago and what do I do with it now?,” and “why am I buying all this stuff?” The rental model simplifies inventory management for the user.
  3. More marketing opportunities. When an item expires, it offers a unique time to re-market to the user for either an extension of the current good, to a trade to a newer, fresher, and perhaps more interesting item.
  4. Price segmentation. By offering 1, 7, and 30 day rentals, the merchant has basically price-segmented the market. This theoretically allows more users to experience the good than may have with a single, and arguably higher, price point.
  5. Good business. Why sell something that lasts forever if you can sell something that has to be naturally repurchased?
  6. Simpler accounting. I didn’t think of this sixth point until my meeting last week. The rental model does away with the notion of a “durable” virtual good, as they all expire. What’s more the time frame over which you recognize the revenue is now fixed at 1, 7, or 30 days. This dramatically reduces the accounting complexity.

Thanks again to Michael and Jeff at E&Y for reaching out and setting up the meeting. It’s great to recognize that virtual goods businesses are finally mainstream here in North America, and that they even have their own appropriate accounting policies. I also appreciate having one more reason to favor “rentals” vs “sales” when it comes to virtual items.

[I have received several comments that concern this post and how it relates to SecondLife. For those of you that don’t know, SecondLife doesn’t actually sell virtual items, its residents do. As such, this post does not relate to SecondLife at all.  It pertains to the 98% of virtual worlds where the hosting companies ALSO is in the digital goods business. Nothing would stop SL from offering rental as a choice to its developers, but the main message is that this post does not pertain to SL (which has a different business model altogether.)]

45 Comments

  1. pwb February 8, 2010

    If you sell virtual currency that can only be spent in-game and not withdrawn or otherwise monetized, I would count that as revenue. These are not deposits.

    Reply
    • CD February 9, 2010

      @pwb — It’s an accounting issue. It’s definitely income (esp if there is no way to get refunded), but for your bookkeeping you need to recognize it as revenue based on the principles that Bill lays out above. This is a common issue with a lot of businesses. Take Netflix for example, they don’t recognize 100% of your monthly payment as revenue when you pay, rather they spread it out and recognize your payment as revenue over the course of the month.

    • Marat February 10, 2010

      Really, does this currency bear any monetary liability to the issuer? Probably no. So it cannot be a deposit. Anyway it’s an interesting question.

    • bgurley February 10, 2010

      i am confident that the accountants view it that way.

  2. Jeremy February 8, 2010

    Nice to see advice for companies selling virtual goods & currency – this has been sorely missing for quite a while! Can’t wait to see the white paper with more definition.

    Reply
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  6. Chris Swan February 9, 2010

    Going back to the sale model I most confess some confusion at point 7. If I buy a durable item (let’s say a shovel) in the real world then the (hardware) store doesn’t have to amortise it for me – that’s my problem as the buyer (if I buy it for a company that keeps accounts). Why should the life of virtual goods become an issue for the seller?

    Reply
    • bgurley February 9, 2010

      Chris — in the example of the shovel, the hardware store has no further obligation to you as a user. In the example of virtual worlds, the obligation to store and render that object falls on the owner of the game.

  7. Eric von Coelln February 9, 2010

    I think the rental vs own model is also possibly driven by your user demographic. Older users are used to owning things whereas younger users are more open to rental models (much like people who want to buy CDs, to those that own MP3s, to those who are happy not owning anything and just streaming across Pandora). Over time renting may be more mainstream, but I think there is still the hurdle for virtual item newbies to get over the fact that they don’t own anything.

    Reply
    • Ordinal February 12, 2010

      Younger users know that if they stop paying for access to something, they can just torrent it anyway if they ever want it again.

  8. Diane February 9, 2010

    I agree with the above comment, why wait until currency is spentt to record the revenue if the currency can’t be taken out of the system anyway?

    Reply
    • bgurley February 9, 2010

      because you have a future obligation. Talk to your accountant. This is only for GAAP rev rec. If you are running a private business….

    • Marat February 10, 2010

      @bgurley What kind of future obligation? To accept the currency back and redeem with real money or other assets? Then yes, it’s a liability. But it’s impossible to classify some virtual goods as future obligations. These currencies have no monetary obligations to the issuer at all, they are goods in themselves.

    • bgurley February 10, 2010

      Bullshit. Accountants can decide that if they want to.

    • tweber February 16, 2010

      Virtual currency is typically legally developed as a licensed software product, with no right return. While it is used to “Buy” a virtual good, legally it is traded for a different licensed software product (a virtual good). The purchase is accounted for as a liability that is not recognized until the completion of both parts of that transaction (the initial purchase and the trade for the virtual good) occurs.

      I thinking we are missing the point that BG is driving towards however: the fact that accountants are catching up or being forced to provide the correct rules, which get complex when you include pricing changes, promotions or changes in the lifetime of a use, it underscores the legitimacy and depth of the model. Whether purchased or rental (probably depends on the good as both seem like rational transaction methods to me) or ad supported etc, this is going to be an interesting space. Next up are the lawyers, and the governments relative to escheat laws.

      One point I will disagree with slightly: regardless of public or not, still need to report in US GAAP to investors, although some cash focused pro forma might make sense too. It means that the headaches and expenses everyone incurred relative to hiring software revenue recognition people is now expanded to include those accountants with virtual goods experience. Bummer.

  9. Iggy February 9, 2010

    I never thought of “planned obsolescence” in the virtual world… very creative

    Reply
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  11. Dan Wyeth February 10, 2010

    Nothing new here….you can read all of this in the Public filings of Chinese companies on http://www.sec.gov. The real question is how are you determing the useful life. Not sure anyone can answer that!

    Reply
  12. Lindal Kidd February 11, 2010

    Given two virtual worlds, one with a rental mode4l and the other with an ownership model, as a consumer I will choose the ownership model every time.

    Virtual goods are ephemeral enough without giving them an expiration date.

    Reply
  13. Imnotgoing Sideways February 11, 2010

    What I read here is the concept of getting something that is intrinsically permanent and copyable and artificially injecting a “death” in order to sell further copies. While economically sound for real world items which face wear&tear, it appears to be nothing more than a sucker punch to the consumer of virtual items in order to artificially bolster profits without any extra effort on the part of the creator. (=_=)

    Maintenance fees for real work, a premium for quality and rarity, and/or simple product:demand… Yes. Fake death to garner wage for wage’s sake… No. (>_<)

    Reply
    • bgurley February 12, 2010

      At TenCent, the clothes actual deteriorate.

    • Imnotgoing Sideways February 12, 2010

      The fatal flaw in you arguement here is that they don’t “actually deteriorate”. There is an artificial algorythim used to determine the “life” of the product until it’s arbitrarily deleted by the system. All of which is quite frankly a sham to garner artificial profits on the backs of the consumers.

  14. hypatiaa February 11, 2010

    “When a company sells virtual currency, this is not a revenue event (even though it may clearly be a cash event). When purchased but not yet used, virtual currency sits on the balance sheet as a customer deposit or deferred revenue (i.e. a liability).”

    I’m glad you said this. It’s true, and I agree. I don’t agree that sales/rentals of virtual goods are the only way to diminish this problem, but problem in Second Life this certainly is. People are holding L$ and not spending enough of them on virtual goods in SL, I totally agree. Rather leaving it on the LindeX and other currency exchanges for resale, they are not buying land like they were (which is a recurring subscription fee – real revenue for LL) nor are they spending it in the wider virtual economy. They could even be putting it into US dollar reserves but most of them just go back and buy more L$ and try to milk the spread with viewer market buy sales again. It needs fixing, and badly.

    I’m not quite sure that virtual goods rentals will go over well with the general user base, but as an option for content creators it may not be a bad idea, but I don’t think its a silver bullet. Items for land generally are kept a while, and land sales/rentals are another one of those revenue making events, as the money ends up as tier paid to you. Content sales and land tier are another one of those interdependent things.

    I would seriously ask you to consider a demurrage charge on the L$, negatively charging the currency so that people feel compelled to spend it, or to store it in more secure hard US$ currency that LL can easily invest ala a bank. Think of it as “the rental model” applied to the virtual currency itself.

    It may help encourage more people to keep a US$ reserve for tier payments as well, rather than leaving it volatile on the currency exchange, ready to snap at a moments notice into the “liability” in which you rightfully call it.

    I would also ask to consider caps on inventory and charging for having a larger one.

    Lots of options and choices are good.

    Reply
  15. wrath Constantine February 11, 2010

    So if I purchase, say, holiday decorations in a virtual environment. I rez them once a year. But oops! They got deleted because of planned obsolescence. Currency that I paid good real-world money for, used to purchase goods in game, no longer mine to enjoy? Projects that I spent months on for special events, destroyed because someone else decided I didn’t need it anymore? Who the HELL are they to decide what I can and cannot keep when I purchased it? Any virtual world that adopts this policy will kill itself. Any startup virtual environment that started with this policy would die on the ground. Keep your mitts out of my inventory.

    Reply
    • Imnotgoing Sideways February 12, 2010

      This is exactly as I see it. And, Second Life already contains the capacity. We can’t pretend it’s not there. (>__<)

      If I had to pay for it, THAT would have been plenty of reason for me to NEVER go back to that store again. (=_=)

    • Greho March 29, 2011

      As a Second Life user, I concur. However, I like the idea of expiring goods as it would apply to trial uses or short-term commitments.

      I’ve purchased many things for one-time events, which I would have gladly rented for the event and allowed to return. I have over USD $100 of inventory items which I’ve used maybe a dozen times in the last three years.

      Had I been given the ability to rent these things for 24 or 48 hours, maybe including set-up help, I’d have jumped at the chance.

  16. Jumpman Lane February 12, 2010

    sion chicken!

    Reply
  17. David February 13, 2010
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  22. Andrew Parker February 18, 2010

    Fascinating post Bill. I like your assumption that the rental model is likely better than a sale model due to Darwinism.

    It’s odd to think how this accounting model will be applied to cases where the same class of virtual currency or virtual items can be both earned an purchased. It appears to me based on your description that if I buy the “red flaming sword” in a game the company needs to amortize the revenue during the duration of the durable. But, if I find the red flaming sword organically in the game, this is not an accounting event. Feels inconsistent…

    Reply
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  24. Lance February 24, 2010

    More marketing opportunities. When an item expires, it offers a unique time to re-market to the user for either an extension of the current good, to a trade to a newer, fresher, and perhaps more interesting item. – I agree with this third point.

    Reply
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  27. Sebastian April 19, 2010

    Just from a user experience perspective, “renting” somehow feels weird, but if all items come with a (pseudo)natural decay, that would feel in-world, avoid currency/inventory glut, and allow for new revenue models. You could buy, rent or find them, epic items might be more durable (hence part of their value), but all of them: perishable virtual goods.

    Reply
  28. JS Mackie December 15, 2010

    The use of virtual goods, or at least the valuation of these actually makes for an interesting case study and could arguably be used as a market research tool to analyze specific trends, preferences and consumer purchasing decisions with respect to specific demographics that are engaging within these virtual worlds. Accountants Motherwell

    Reply
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  30. musicdesdotcom July 13, 2011

    I would ask to consider caps on inventory and charging for having a larger one. Lots of options and choices are good. thanks

    Reply
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  32. Ralvis March 20, 2013

    I know this story is on durable goods, but I have to ask how companies are tracking the consumption of consumable virtual goods to enable rev rec? The accounting for consumable virtual goods may be simple but the reporting requirements are not (at least not in my world – I work for a company that bill/collects for in app virtual good sales on our online gaming platform; the third party develops the apps and virtual goods and we pay them their share). Are companies using aggregated consumption data/trends or are they strictly applying the tracking requirements outlined in the EY article (http://www.vindicia.com/blog/2010/02/09/virtual-goods-accounting)?

    Reply

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