Online Gaming Revenue Recognition : Strategies and Considerations

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The change in payment behaviour – from consumer to processor – has been a fast evolution since the birth of the internet. And, Duygu Tavan writes, the pace is accelerating. This evolution enables new payment technologies – but it also opens up new and various opportunities to recognise and report revenue.

The internet has opened up new ways to pay and make purchases and to even store funds electronically, often through prepaid or closed-loop systems such as Groupon.

Especially in the virtual social and gaming world, the opportunities are incredible – according to eMarketer, virtual goods will make up about two-thirds of total social gaming revenues in the US this year.

Subscription-based service providers – from TV programmes to online games – are recognising the revenue potential for ad hoc sales as a source of sales growth.

Many online gaming sites nowadays offer a free-to-play gaming model. In this case, the money comes in from purchases the player needs – or wants – to make in order to improve their avatar’s abilities, or to add extra ammunition and other game-specific items.

These virtual goods are usually bought with and in the gaming site’s virtual currency. And this is when a problem occurs: How do you recognise the revenue?

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According to Ernst & Young (E&Y) there are three main revenue recognition methods for virtual items in gaming:

  1. Game-based:  Revenue is recognised for the whole lifespan of the game. So if a player buys a good for a game that is estimated to last for another three years, the site can recognise the revenue “ratably over the remaining four years of expected life of the game”.
  2. User-based: This type of revenue recognition estimates the player’s presence in the virtual gaming world – which tends be shorter than the game’s expected lifespan. So revenue recognised in this instance will be in a shorter period. Estimating the player’s virtual life expectancy can be tricky and gaming sites need to be able to prove viable data to support this model of revenue recognition. In both these instances, the characteristics of the item bought do not matter.
  3. Item-based: According to E&Y, this model is the “most complex” one because it does consider the characteristics of the item. This is done because, as E&Y explains, the characteristics of the good sold determines, either as an implication or explicitely, “the period that the virtual good is made available to the user”. This period is the delivery obligation period and once that is  estimated, revenue gets recognised like in the game-based model. But as in user-based model, the gaming site must prove sufficient data about user behaviour and patterns for each individual item it sells.

No consistent way for revenue recognition

Sanjay Sarathy, senior vice president, marketing at Vindicia, a company that produces subscription billing solution for digital merchants, says the different ways of recognising revenue depends on how “conservative” a company is.

“It is the duty of the game company and their accountant to determine how they want to recognise revenue from the sale of virtual goods and their use,” he says.

“There is not a consistent way of doing it – and there may be differences in the GAAP revenue and cash earnings. But it has reached a point where large game companies have to disclose how they recognise revenue,” Sarathy says.

Case study: Zynga

One of these large companies is Zynga.

It has filed its S-1 form (which is used to register securities with the US SEC and contains information on the company’s business and financial status) at the beginning of July and explained that it recognises revenue from online gaming based on four principles:

o        there is persuasive evidence of an arrangement;

o        the service has been provided to the player;

o        the collection of our fees is reasonably assured; and

o        the amount of fees to be paid by the customer is fixed or determinable.

In its filing, Zynga detailed how it recognised revenue as such:

“For purposes of determining when the service has been provided to the player, we have determined that an implied obligation exists to the paying player to continue displaying the purchased virtual goods within the online game over their estimated life or until they are consumed.

“The proceeds from the sales of virtual goods are initially recorded in deferred revenue. We categorise our virtual goods as either consumable or durable. Consumable virtual goods, such as energy in CityVille, represent goods that can be consumed by a specific player action.

“For the sale of consumable virtual goods, we recognise revenue as the goods are consumed. Durable virtual goods, such as tractors in FarmVille, represent virtual goods that are accessible to the player over an extended period of time.

“We recognise revenue from the sale of durable virtual goods ratably over the estimated average playing period of paying players for the applicable game, which represents our best estimate of the average life of our durable virtual goods.

“If we do not have the ability to differentiate revenue attributable to durable virtual goods from consumable virtual goods for a specific game, we recognise revenue from the sale of durable and consumable virtual goods for that game ratably [rated, estimated or proportional] over the estimated average period that paying players typically play our games.

“We determine our estimated average playing period of paying players for each significant game beginning with the time a player first purchases a virtual good. For the three months ended March 31, 2011, the estimated average playing period of paying players for our games ranged from ten to 25 months. Future paying player usage patterns and behavior may differ from the historical usage patterns and therefore the estimated average playing periods may change in the future.”

Since this S-1 filing, Zynga’s revenues have soared: Revenues on a quarterly basis rose from $31.31m in the third quarter of 2009 to $170.67m year-on-year:

Q3 2009 – $31,311,000
Q4 2009 – $55,721,000
Q1 2010 – $100,927,000
Q2 2010 – $130,099,000
Q3 2010 – $170,674,000
Q4 2010 – $195,759,000
Q1 2011 – $235,421,000

Eric von Coelln, vice president at social-game focused free online multiplayer game site OMGPOP, and consultant for social gaming and e-commerce at EVCin, explains this phenomenal growth on his blog as such:

“Zynga was only able to discern consumables versus durables starting in October of 2009, and only in one game. By January 2010, they were able to reflect this split in all games, meaning they could escalate revenue recognition. Thus it is likely that this new ability helped improve the revenue in Q4 of 2009 and Q1 of 2010.”

Consumable items such as energy or fuel are recognised within a month. But durable items, such as tanks, are amortised throughout the lifetime of the user’s avatar. And Sarathy argues that revenue should be recognised when an item is purchased. “You buy the virtual currency and with that, you buy virtual items that you are going to use. So you can recognise the revenue when you buy it.”

Another level of complexity

But there is a level of complexity, as well, Sarathy says.

“If a user buys $30 worth of goods and a month later demands a charge back [for whatever valid reason] – how would you make a refund? If the goods are associated with a particular level, do you take the player’s level away? So in terms of revenue recognition, game publishers need to deal with not just the way they recognise the revenue but also with the charge back side.”

One smart way of dealing with this complexity is that the site could just refuse refunds and make all transactions final.

“As a game publisher, you have to be careful about how you deal with virtual currency, make sure that it cannot be redeemed outside of the gaming world.”

Most gaming sites, though, state that their virtual currency can only be used to purchase items for their games. And some gaming sites circumvent any regulatory issues by putting an expiry date to the value of items purchased.

But Sarathy argues that the lack of consitent standards has little to do with fraud issues. Rather, it is difficult to compare two gaming sites if both use different accounting methods for revenue recognition.

Zynga’s case therefore suggests that online gaming sites may focus revenue recognition on consumable instead of durable items. Revenue potential is tremendous, but companies need to be aware of the potential chaos that can erupt if the virtual currency makes its way out of the virtual gaming world.