Mobile Madness Inc. (MMI) is relatively new company that designs video games and applications for mobile devices.

Question:

Mobile Madness Inc. (MMI) is relatively new company that designs video games and applications for mobile devices. Users are able to download a game or application onto a mobile device for a fee that normally ranges from 99 cents to $4.99. In addition, users can play the company’s games over the Internet.

The company was established by Thomas Waboose and Petra Bior, one year after they completed a degree in computer sciences. Thomas and Petra are excellent programmers, and have been playing video games since they were children. After designing a mobile device game for an undergraduate course assignment, the two friends decided to start up MMI. The company’s games have been well received by the market, and have been downloaded by over 5 million users across the globe. In addition, the company’s applications are also considered to be high quality.

The company experienced significant growth in its fi rst five years of operations, and decided to go public. Two analysts are currently following MMI’s shares, which are trading at $13, and are preparing their fi rst recommendation. MMI is scheduled to release its fi nancial results in two weeks during a conference call. Based on the results released by industry competitors, analysts are expecting the company to report revenue of $7 million and earnings of $1.5 million in the current year.

You are the senior manager with Singh and Islam, LLP, the auditors of MMI. Recently, you met with Thomas and Petra to discuss the following transactions that took place during the year:

MMI entered into an agreement with Eastern Sports Corp. (ESC). The terms of the agreement required MMI to provide in-game advertising to ESC in exchange for ESC providing MMI within-game advertising on its website. MMI normally does not sell advertising space in its games, and likely would not have been able to sell the advertising for cash. Since this is a new transaction for MMI, the fair value is difficult to estimate, but management believes the advertising is worth $200,000. ESC normally sells in-game advertising, and estimates the fair value of the advertising provided is $250,000. It is unlikely that MMI management would have paid cash for the advertising received. The transaction has been recorded as a credit to revenue and a debit to advertising expense for $200,000.

The company recently began selling the games of smaller companies on its website. The games are sold for $1 (credit card payments only), with 95 cents going to the game designing company and 5 cents being retained by MMI. The selling price of the game is established by the game designer. Th e game designer retains any continuing commitment to the customer after the game is purchased (e.g., game updates, modifications). During the year, 1 million games were downloaded, resulting in MMI recording $1 million in revenue and $950,000 in cost of goods sold.

MMI began selling two-year, non-refundable memberships. The memberships are sold for $75 and allow users to download any 100 games during the two-year period. During the year, 15,000 memberships were sold. Accordingly, members can download up to a maximum of 1.5 million games under the membership. On average, a member downloads 85 games. During the current year, a total of475,000 games were downloaded under the agreement. Management decided to record revenue of$1,125,000 during the current year as MMI has no further work required to service the memberships. Currently, MMI has over 200 games in its library available for download.

During the year, the company purchased the rights to develop a game based on a popular comic book hero. MMI paid $175,000 for this exclusive right, and incurred an additional $475,000 in programming costs to create the game, and $205,000 in promotional costs. MMI capitalized $855,000 as an intangible asset. The following are the expected downloads for the game, which will be sold for $1.99.

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MMI purchased 30-year bonds of another public company for $500,000. The bonds were purchased in the prior year, and classified as FV-NI as the fair value was increasing as rates decreased. During the current year, the bonds declined in value by $40,000 as central banks began to raise rates in order to combat inflation. At the beginning of the year, management reclassified the bonds to amortized cost as the company plans on holding the bonds until maturity, and the bond is a pure debt instrument.
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At the beginning of the year, MMI issued 100,000 redeemable preferred shares to the public for $5 each. The preferred shares have a dividend yield of 7%. The preferred shares must be redeemed if the common share price exceeds $20 per share. Dividends of $35,000 were declared and paid during the year.
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During the year, MMI was named in a patent infringement lawsuit in regards to the use of various trademarked logos. The company’s lawyers believe that there is a 50% chance that the case will be settled with no damages to be paid by MMI. However, there is a chance that the company may have to pay between $100,000 and $200,000 in damages. As of year end, both the $100,000 and $200,000 amounts are equally likely (50% each).
Draft financial statements reveal revenue and earnings of $7,478,000 and $2,257,000, respectively. Management displayed their excitement for their ability to meet analysts’ revenue and earnings expectation. Th e partner has asked you to prepare a memo for the audit file that discusses the appropriate accounting treatment of the above-noted transactions. The memo will be used as part of the audit planning process.
Required Prepare the memo.