INTRODUCTION

Smartphones and tablets have been a major transformative force in the on-line gaming industry. It is estimated that over 90 percent of smartphone and tablet owners play on-line games at least once a week, and 45 percent play daily. Apple's

App Store alone has more than 90,000 game apps (Baran 2014). The on-line gaming industry is a multi-billion dollar market segment, but includes far more than downloadable game apps; this industry segment includes multi-player video/ computer games, on-line gambling, and other lines of activity. The industry is volatile due to the rate of change in technology and consumer taste, and is a growing sector of the economy.

On-line games can be developed by hobbyists, or solo developers, who can rapidly find favor with consumers if an app game goes viral. There are many marginal and small games to be found on-line, and many short-lived games. However, a bigwin on-line game can generate hundreds of millions of dollars in annual revenues (Wall Street Journal 2014). The goal is to produce an engaging game with bold features to motivate players to play longer and, in turn, generate increased revenues for the developer. Complex games require significant development talent and technical expertise, and thus a substantial financial investment. The financial risk is that this investment will not provide returns unless the game reaches and maintains critical mass.

One example of a public company in this industry is King Digital Entertainment plc, which had an Initial Public Offering on the NYSE in March 2014 at US$22.50 per share, raising US$500 million in capital (Nayak 2014; Worstall 2014). The company had a market cap of approximately $US7 billion. King's major franchise is Candy Crush Saga, which has been downloaded more than 500 million times since its launch on mobile devices. However, 75 percent of King's revenue stream is from Candy Crush Saga, making King vulnerable if consumer attention shifts. Share price subsequently sunk to as low as $14, because of concerns over revenue trends and the strength of the product pipeline. Revenue trends are carefully monitored and reported in the financial press.

A company whose focus is on-line gaming faces many challenges when building a viable economic unit. The game must have an appealing and enduring game experience, and then this game experience must generate a revenue flow. Since many games allow a player to download an app for free, and play for free, the challenge of building revenue is not trivial.

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EXHIBIT 1

CGC Corporation

For the Years Ended August 31

Selected Financial Information

(in thousands of dollars)

2013 (Draft)2012 (Audited)

Revenueconsumables

Revenuedurables

Revenuetotal

Net loss

Current assets

$400

$450

Office and computer equipment

$446

$246

Deferred game costs

$825

$1,200

Goodwill

$164

$164

Unearned/deferred revenue

$120

$20

Other liabilities

$369

$290

Shareholders' equity

$1,346

$1,750

Advertising is one way to generate revenue, but offering paid elements within free games is another route. The continuing survival of an online gaming company rests with development of new and appealing features and/or new games. In a fast-paced market, companies must be able to adapt quickly.

CHESTER GAMES CORPORATION

Chester Games Corporation (CGC) was incorporated in 2011 when Mark Smith, Alice Chu, and Sam MacDonald united their three existing companies in a business combination. Chester is named after Smith's cat, with the cat's picture used as the company logo. CGC is involved in on-line gaming, and has a strategy to develop and maintain a stable of major games with staying power. CGC has had between eight and 12 games active at any time. CGC's games operate on-line and players are offered a free download of the game app. Playing is free. However, players can purchase ''virtual currency'' to buy ''virtual goods,'' which will enhance their game in some fashion. These in-app purchases are the source of CGC's revenue. Credit cards and PayPal have been used to collect money for this virtual currency.

CGC has obtained financing from venture capitalists, whose financing rate exceeds the 8 percent that CGC currently pays for medium-term financing with its other major lender, a financial institution. The venture capitalists also have an equity stake in the company, and have always viewed a public offering, or an amalgamation with another company enroute to an IPO, as an exit strategy that will allow them to profit on their investment. With poor operating results in fiscal year (FY) 2013, CGC's three major shareholders and the venture capitalists all anxiously await the FY 2013 financial statements. Revenue trends are critical, both in FY 2013, and going forward, in order to support the attractiveness of CGC as an IPO or amalgamation target. CGC has adopted IFRS, so that their financial statements provide a consistent base for this IPO or amalgamation.

Fiscal 2013 Results

It is now early October 2013, and the company is preparing its annual August 31 financial statements, which are prepared in accordance with IFRS and will, again, be audited. Selected financial information is included in Exhibit 1.

Fiscal year 2013 was disappointing for CGC, since revenue failed to meet expectations in the latter part of the year. The company failed to retain players in three of its major games, and two new games failed to ''take off.'' The result was continued operating losses. Management has embarked in cost-cutting, closing the two new games that did not meet expectations, and sacrificing plans for development of several future games, while preserving plans to develop two others.

Cash flow projections are modest, and uncertain. Given the speed of change in the on-line gaming industry, revenue-based cash-flow projections are only meaningful for a limited time period. Even at that, management is not ready to predict that one of their games will experience hoped-for viral growth. Cash flow projections are presented in Exhibit 2, based on current expectations.

EXHIBIT 2

CGC Corporation

For the Years Ended August 31

Projections

(in thousands of dollars)

2014 2015 2016 2017

Net cash flowsconsumables $400 $450 $480 $480

Net cash flowsdurables $325 $375 $400 $350

Net cash flowsgame subscriptions $150 $250 $250 $200

Net cash flowtotal $875 $1,075 $1,130 $1,030

Of particular interest for FY 2014 is a math game to be made available free through schools, with a subscription-based advanced game marketed to parents for their children to continue to use at home. This will be the first venture into the education game market for CGC, but marketing data supports the need and industry trends in this segment are very positive. This will also be the first subscription-based game for CGC. Virtual currency is not used in this game and the subscription revenue for the advanced game is meant to support the advanced game and also make the free game viable. All of the deferred game costs at August 31, 2013 relate to the math game. This game will be heavily marketed in the upcoming weeks of October 2013, when the school year is in full swing.

Sale of Virtual Goods

The bulk of CGC's existing revenue is from the sale of virtual goods to players in games that CGC hosts on its servers. Most of this revenue was recognized immediately ''on cash receipt'' in fiscal year (FY) 2012. This policy is being revised in FY 2013 to conform to emerging industry norms.

Virtual goods are categorized as two types: consumables and durables. Consumable goods, like energy or life, are consumed by the player during a game. These goods last only a short period of time, often must be used immediately, and have no value to the player after being consumed. Durable goods, on the other hand, are accessible to a player over an extended period of time. An example of a durable good might be the purchase of an armored tank, which stays with the in-game character forever unless it is lost, destroyed, or abandoned.

The consumables and durables revenue streams are now (in FY 2013) being separated, game-by-game. Consumables revenue is recognized immediately. CGC's revenue from durables is to be recognized over the average life of the player. This policy is consistent with others in the industry.

Prior to FY 2013, CGC did not collect data that would accurately differentiate between revenue from consumable goods and revenue from durable goods. CGC recognized revenue up front, on cash receipt. The only exception to this was that the company did defer a nominal amount of revenue associated with sale of virtual durable goods in one of its newer games in FY 2012. This durables revenue was allocated over time, based on the estimated life of the player.

In FY 2013, data were compiled on the average life of a player for paying players in each of CGC's games. CGC considered recognizing the revenue from the durables over the length of time that the virtual durable goods would be used within the game, but these data could not easily be gathered.

The average life of a player can be difficult to estimate. Some play once, some play for years, and most fall into some middle ground. Upgrades and game modifications can affect character life, preferably extending playing life, but sometimes disenchanting players and, thus, ending the playing experience. CGC has established average life based on statistical data, game-by-game, gathered on monthly player character cohorts. These statistics track the ''churn rate'' of characters: the time between the first in-game payment and the time a character falls inactive. Players typically become inactive at a relatively consistent rate. For new games, statistics are used from other recently launched games with similar characteristics.

In FY 2014, CGC will migrate into an agreement with Facebook, where the existing stable of games reside. Facebook Credits will be the primary game payment method. Under the terms of the agreement, Facebook sets the price that players pay for Facebook Credits and collects the cash. CGC has the right to establish the price of virtual goods in Facebook Credits. Seventy percent of the cash collected is remitted to CGC, and Facebook retains the remaining 30 percent. There is debate within CGC as to whether the 2014 revenue should be recorded at the gross amount, or at the net amount. That is, if a player purchases virtual goods in exchange for $100 of Facebook Credit, should CGC record $70 of net revenue, or $100 of gross revenue with a $30 financing expense recorded? Transactions through credit cards and PayPal have been recorded as gross, although the financing expense averaged only about 3.5 percent of gross fees.

The Meeting

You are a recently qualified professional accountant who has been hired as CGC's first full-time controller. You and the company's three original shareholders recently met with CGC's external auditors, who explained that they will be relying primarily on substantive audit procedures for the FY 2013 audit.

1.Analyze the accounting treatment of deferred costs in the current year.

2.Evaluate the need for impairment testing in the current year, including calculations, if appropriate.

3.Identify the accounting policy that should be chosen to present revenue as either a gross number or net of financing costs, in the coming fiscal year when the Facebook Credit agreement becomes active.

4.Identify the accounting policy that should be chosen to recognize revenue from subscription arrangements in the coming fiscal year.