Netflix was founded by Reed Hastings and Marc Randolph in Scotts Valley, California in 1997. Netflix went public on March 12, 2003 when its shares began trading on the NASDAQ stock exchange. Initially, Netflix's business model was a subscription service that allowed subscribers to have a certain number of DVDs out at the same time with no due dates, late fees or shipping charges. For example, as of December 2003, the base subscription plan allowed subscribers to have three titles at a time for $19.95 per month. Subscribers chose titles at www.netflix.com and as soon as the subscriber returned a DVD, a new one was shipped from the subscriber's queue. DVDs were shipped via first-class mail and were returned by the customer through the mail in a prepaid mailer. Over time, and with the advent of new technology, Netflix's business model began to shift. In its 2009 annual report to shareholders, Netflix states that its core strategy "is to grow a large subscription business consisting of streaming and DVD-by-mail content." However, in its 2010 annual report, Netflix states that its core strategy is to "grow our streaming subscription business within the United States and globally". As co-founder Reed Hastings famously stated, "We named the company Netflix for a reason, we didn't name it DVDs-by-mail". The shift from a DVD-by-mail company to an online video streaming company created challenges for Netflix. One of these challenges related to the company's financial reporting. Under the DVD-by-mail business strategy, Netflix accounted for DVDs as long-term assets amortized over a one to three year period using the "sum-of-the-months" accelerated basis over the DVD's useful life. The company typically used a one-year useful life for new release DVDs and a three-year useful life for older, back-catalog DVDs. The estimated useful life took into account both the durability of the DVD as well as customer interest in the movie. Under the DVD model, approximately 40% of Netflix's DVD assets were amortized each quarter. Once Netflix began investing in streaming content, its content acquisition costs became much larger. The company typically acquired 3 to 5 year streaming contracts with high up-front costs which were amortized over the life of the streaming content. By 2011, Netflix's quarterly amortization had dropped to 24%. Analysts and investors questioned the company on its new amortization methods, concerned that Netflix was amortizing, in some cases, the same film over a longer time period based on it being in a streaming format rather than a physical DVD. Additionally, the asset recognition criteria at the time required that in order for Netflix to treat a content streaming agreement as an asset, the titles included in the streaming agreement must be known, the cost per title must be determinable, and the title must be available for streaming. While some of Netflix's content streaming agreements met these criteria, not all did. (See Appendix 4). Netflix's historical financial statements are included in Appendices 1 through 3. An example of straight-line amortization for a DVD collection is included in Appendix 5. Finally, Appendix 6 includes an example of DVD amortization using the "sum-of-the-months" accelerated basis.

1. What method of content amortization should Netflix use for the streaming agreements?

(Straight-line vs. accelerated)? Why?

2. Which method of amortization best matches the actual usage of the asset?

3. Should the streaming content acquired (but not created) by Netflix be listed as an asset, why or

why not?

4. Are you concerned with the lower rate of content amortization under the streaming strategy

versus the DVD-by-mail strategy?

5. What will be the impact on Netflix's net income of the lower content amortization under the

new streaming strategy?

5. Under the asset recognition criteria, some content agreements do not qualify as assets.

Therefore, the asset and associated liability would not appear on the balance sheet. Should this

be a concern for investors? Why?

Case Instructions:

Appendix 4: Content Acquisition Deals

Example 1:

Netflix gets 2-year content streaming deal with CBS; agreement includes 'Medium,'

'Frasier'

22 February 2011

Associated Press Newswires

(c) 2011. The Associated Press. All Rights Reserved.

SAN FRANCISO (AP) - Netflix Inc. and CBS Corp. said Tuesday that they struck a two-year

licensing agreement that will let users of Netflix's online streaming service watch certain shows

from the CBS library, including "Medium," "Frasier" and "Cheers."

Financial terms of the agreement were not released. CBS has the option to extend the deal for

two more years.

The companies said that starting in April dozens of CBS shows will join Netflix's instant

streaming collection, which currently contains more than 20,000 movies and TV shows.

Other shows included in the deal are "Family Ties," "Twin Peaks" and "Star Trek."

Example 2:

Netflix, Epix Deal to Stream Lionsgate, MGM, Paramount Films

10 August 2010

PCMag.com

Netflix on Tuesday announced a content deal with Epix that will add feature films from

Paramount, Lionsgate and MGM to the company's streaming lineup starting Sept. 1.

Epix, which launched in October 2009, is a subscription-based service that provides access to a

library of over 15,000 movies via its cable channel, video-on-demand service, and on its Web

site.

Epix has the pay TV rights to new releases and movies from its partners, and will make these

films available to Netflix 90 days after they debut on premium TV channels and on-demand.

Netflix subscribers will have access to the movies via the company's "Watch Instantly"

streaming feature.

Terms of the deal were not released, but the Los Angeles Times said that the five-year deal could

be worth up to $1 billion.

1 1 1 1 1 Appendix 1 : Netflix Historical Income Statements FINDING WHERE Netflix Inc ( NNS : NELY WHAT illicit HANG IN HAWAI ! 2102 2003 2004 2005 20 06 2007 2008 2090 2010 201 1 Revenues 152 806 272 243 506 , 28 682 213 956 560 1 20 40 1 364 661 1 67 0,260 2 , 162,625 3 , 204 579 MOUNTAIN WILL A Cost of revenue Subscription 1 3 1! !' Fulfillment and sales expenses 77 044 147 736 273 401 393 788 532 : 621 6 64 407 761 133 909 461 1 154 .109 1 . 789 596 20.458 31 :898 59686 71987 94 364 121.761 149 101 169 810 203 . 246 250.305 Total cost of revenues 97 502 179 634 333 067 465 775 626 985 786 168 910 234 1 079 271 1 .357 355 2, 039 901 Gross profit I will Operating Expenses : 35 304 92 , 609 173 161 216 438 369 675 419 172 45 4 427 590 98 805 , 270 1 164 576 10 Technology & development expenses 1 1 1 1 HAHA ! Marketing 14 . 625 17 .8 84 22 .906 35 .388 48 379 70 979 89 873 1 14 542 163 329 259 033 General & administrative 35 , 783 49 949 98 027 144 , 562 225 524 218 212 189 713 237 744 293 839 402 , 638 1/ Stock - based compensation expense 6737 9585 16287 35 486 36 153 52 532 49 562 51 333 70.535 117 , 937 1/1! ! Gain on legal settlement 8 832 10:719 19587 . Gain on disposal of DVDS 1% Till 1950 700 6 6 187 4737 7:186 6327 4 560 6 094 9090 Total operating expense 65 977 88 137 153 807 213 449 305 261 327 527 332921 399 059 521 . 629 788.608 Operating income Other income ( expense ) - 10. 673 4 472 19 354 2 989 64 414 91 645 121 , 506 Interest expense on lease financing 1 1 4 White pill 191 939 283 641 376068 Obligations 1697 2457 2592 5,753 15 . 90 4 1 188 2 458 6 , 47 MAN 19 1 1972 417 -170 407 19629 - 20 025 Interest and other income ( expense ) 0 20 340 12,452 6. 728 3. 684 3 479 Income before income taxes -20 048 6 512 21 .276 8 35 80 .318 10.307 13150 192 102 267 606 35 52 Provision for ( benefit from) in income taxes 20 956 2 181 23802 31 236 19317 48414 78332 106843 13 .396 Net income ( loss ) - 20.948 6 512 21. 595 42 027 49 082 66 480 83 026 115 860 160 853 226 126 it! Net income per share HOUSE Till 1 1 1 - 50 . 74 50 .14 50 .42 50.29 50 .78 50.99 IN $1 .36 5205 5306 34 .28 Will Didred - 50 .74 50.10 50.33 5064 5071 50.97 5132 5198 8293 34 .161 that Appendix 2 : Netflix Historical Balance Sheets 41 / 141 Netflix Inc INMS : NFLX ) H PG 1 1 202 20 03 20 04 2005 20 06 20 07 2008 20 9 2010 2011 Assets the worth 1 1 9 1 1 Cash and cash equivalents Me In It ! ! Short -term investments 50 814 89 .894 174 461 212 ,236 400 430 17 439 139 881 134 224 194 49 9 50 8 053 Prepaid expenses 23 198 43 297 1 2125 4040 207 703 137 390 186018 153 868 289 758 2741 7:84 Prepaid revenue sharing experts 2753 231 303 905 4 695 3.232 1:742 6 1 16 8 122 12491 62 217 56 07 16.301 18691 37 329 181 06 919 709 WHY | Current content Forary , net 1 1/ WILL Other current assets 13 686 3:15 2 254 6 983 18 417 17:133 Deferred tax assets 0 / 1 1 1 1 1 1 5617 1/ 1 1 1 1 1 1 409 619 5,A49 4 669 10.635 15 627 13 , 329 23 , 818 43, 621 57 330 Total current assets hi 107 075 138 46 187 346 243 691 428 418 432 423 361 447 41 1 013 637 231 1 830 857 Camera Porary net Intangible assets , ne 972 22 238 42 158 37 032 104 908 12 070 98 , 547 108 810 180 973 1 046 934 1 1 1 6094 2 948 961 457 969 1/1 1 1 1 0 1 1 1 1 roperty and equipment net Deposestill in 1 1 620 972 18 728 40 213 59 50 3 13 , 175 124 . 948 131 653 128 570 136 , 353 1 249 1 316 0 it likely 1 1 1 Deferred tax asset Other assets 1690 1272 1600 21 239 15 50 16:865 22 409 15:958 17 467 28.30 0 79 836 10 800 2065 4 465 10595 12300 17 .826 26732 With Total assets 130.530 176012 251 793 364 681 608 779 678 . 998 617 9 46 679 734 982 . (167 3 069 196 Liabilities and Stockholders Equity Current Inbilling HEALTH Accounts payable Child /1 1 WAITING 20 350 32 654 Day at 49.775 63 491 93.864 99.951 100 , 344 Accrued expenses 1 1/ 102 1:525 1313 28503 23:308 38 86 103 4 47 2820 101256 Current portion of leave financing obligation 1231 16 68 33 387 36 489 61 / 374 Deferred revenue 1 152 210 2043 2369 9743 18 .324 31 936 48 533 69 .678 71 6 65 83 ,127 100 097 127 , 183 148 796 Total current Public 905 216017 226 369 38 Long-termdebi BER 40 426 63 019 94910 137 587 193 447 208 248 241 60 388 579 1 225 055 160 Long term debut due to related party Least funding obligations , excluding current portion 460 10 so we all ! ' ' 1 1 0 1 1 1 the liabilities 5 20 209 00 209090 20606 200. 90 242 1 ,121 35 , 652 37 98 8 36 372 34 : 123 31 80 10 10 4029 16786 17650 69.201 769 53 Total Fibillies Stockbroker & CONey on time 591 691 903 2 426.386 Common stock WALL 1 174 63 04 95 510 138420 1941568 249 186 270 791 480301 60103 2 4203 in washington the boy As 65 2602 270 256 2928 83 315 868 454 71 102 710 23857 31 6 2 2 210 . 175 $ 2 5 Additional paid in capital Deferred stock - based compensation | Treasury stock at com 10 102 BAND 109 9 Accumulated other comprehensive come 274 396 27 I gott I williguet / I like " Retained earnings THE -159805- 153.293 -131 698 189 671 1 0 - 10 1 1 1 1 1 1 18 /1 1 1 40 SBY 25 426 108 452 1 8 1 1 1 198 817 237 729 422930 Total stockholders equi 89 356 12.908 156 283 206 252 41421 429812 347 155 109 143 290 164 642810 176012 251 793 364 58 1 608 779 678 .948 617. 346 679 , 734 482 0 67 3069 106opendix 3 : Netflix Historical Statement of Cash Flows Netflix inc (DIS MALLY Cash Cows from operating activities Net income ( boss 1595 42027 49 082 6 6 608 83026 115860 160 853 236126 Adjustments to reconcile net income to net cash provided by Acquisition of streaming contend Weary 0 34821 -18240 -61 217 -206 210 - 2 320 712 Change in streaming content babies COIN 167 836 1 460.40 Amortuation of content Wary 20558 46271 82333 96 8 83 141 160 203 415 204 757 219 430 304 596 795 872 Depreciation amortuation of property and equipment and the marbles 9.134 16.618 22 219 32458 3ROH 38064 43.747 Stock - based compensation expense 10719 1658 1976 12.264 12618 27.946 61 .58 2 Excess fat benefits from stock - based compensation 13217 26248 5270 - 12683 43714 Other for each for 4.750 1501 2434 579 9296 - 15. 158 - 13.754 894 9 128 4050 Deferred Moves 34. 905 15.948 42 - 18 547 Charges in operating assets and babies Prepaid expenses and other current assets 240 9130 28 7064 3 843 $358 - 18027 Prepaid concert ON3 35 876 621 1 Accounts payable 12308 17 , 121 3208 16535 1537 12: 095 2431 Accrued experts 1306 12.432 17 5 54 182 13160 67209 08 902 Deferred revenue 8 581 13.61 16597 21 .145 1483 11 .462 16970 27.085 21 .61 Other assets and fabrics 2168 1654 Net cash flows from $1 14 84 742 147 571 156 214 191 271 424 2140137 175043 276 401 317 712 Cash Bone from in eating actis the Acquisition of corners brary 24070 - 35620 102471 181 416 164528 -208 647 - 162 849 - 19304 - 123.901 85.150 Purchases of short term investments 0 -105310 - 256 959 - 278000 -107367 -273 750 Proceeds from sak of them -terms investments 4 45 013 6 209 1 32 307313 164706 120857 5094 Proceeds from maturities of short term treatment s 35 673 19 818 38105 Purchases of property & equipment 8 872 14.963 -27 653 - 27333 41256 83790 -45932 33837 49582 Acquestion of bearable asset Proceeds from sake of DVD S. 781 12409 1. 610 12 368 11 .164 12919 customers to hummers 0 6000 Other assets 67301 98072 08 381 123 24X X5 REY 836028-184 960 -286070 -16081 265RX Cash Cows from financing activites : Principal payments of leave branching obligations Proceeds from instance of common stock 88020 6209 6035 13.393 12984 604 18872 49 716 19014 Excess the benches from stock - based competition 0 13217 26218 3220 12683 62 214 25 748 Burton Tips to be of grade , net andmake costs and payments Net proceeds from public offering of common soc 0 194 04 needs from balance of debt net of instance costs 193017 0 198 060 Repurchases of common sthe PUSSY -104NON - 324.135 - 210.254 04 6BE Net cash provided In lived in tranche actress 13 314 125 453 -1301 17 6535 WHAT JEALOUS ANDASK I Most of exchange rate changes on cash and cash equivalents Net increase ( decrease in cash and cash equivalents 42 683 30 080 84 567 37 783 184 174 232 49 1 60 275 313 954 Cash and cash equalslords , beginning of year 16 131 59 814 89894 174 461 212 256 100 430 171 419 434 134 XX 134.224 104 460 THAT 139 XXX1 1 Appendix 5 : Straight- line Amortization Example Entry Debit Credit At time of purchase : " Content Library 1 1 1 1 100 Cash 1 1 41 100 Year 1 : IN Content Amortization 1 4 Content Library Year 2 : 1 1 1 30 what will Content Amortization Content Library 1 1 1 1 Year 3 1 1 My Content Amortization Content Library 30 . I 1 1 1 If Netflix's estimate is accurate and the DVD's sell for $10 1 1 1 1 1 1 1 at the end of the three - year life : Cash 1 1 / Content Library If Netflix's estimate is wrong and the DVDS sell for less 1 1 1 / 1 1 1 I'll put than $10 at the end of its three - year life ( it sells for $5 ) : Cast 1 0 1/ 1 1 1 191/ 1 1 / / ass on Sale of DVDS Content Library 10 WAR 1 1 1 1 4 1 1 1 The content library ( for example one season of Modern Family ) is purchased for $100 Netflix 1 1 1 1 1 estimates that the DVDs can be sold for SIO after three years of use INTEREST 1 1 1 1Appendix 6 : " Sum- of the - Months " Amortization Schedule Month of the Months left in mortimation the amortization Sum of the Amortization cost of the Salvage Value Amortization period period months Top Amount 361656 5100 $4. 86 656 35/ GGG 5190 $4.73 EGG 34/646 $1 50 32 $109 $4.46 21656 5100 30/ 656 5100 8 $4.05 29/ 565 SLOW 8 16 66 $10 53. 92 5100 11 2 1 1 261656 $100 12 25 / 606 24 1 6 65 SION $10 $3.38 14 231 GGG 656 21656 5100 52.97 656 1 16 66 2016 6 6 52.70 $2.43 17 100 $10 52.30 $100 52. 16 1 1516 66 5190 52 03 141656 $100 $189 25 12 GGG 5176 37 100 $10 26 5100 $1. 49 28 656 5100 1 1 SIEGE $10 $1 35 65 SIR 30 656 71606 5100 $10 6560 656 SIGNS 5100 190 510 50.68 10 SIO 50 54 1 1806 510 510 5041 DO 50.14 When We $ 1 The content library ( for example one season of Modern Family ) is purchased for $100 Netflix With estimates that the DVDs can be sold for $10 after three years of use . Why HE 1 1 1 1 1/ Using the " Sum of the - Months " amortization schedule , $49 46 is amortized in Year 1 . $30 00 1 1 amortized in Year 2 and $10 54 is amortized in Year TAMIL 1 1