Hey, Look, Zynga's Only Profitable Because Of A Sneaky Accounting Change

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When Zynga filed its financials for the quarter ended in June, it quickly became obvious why the company has delayed its IPO: The numbers were weak.

"Bookings" and "Daily Average Users," the company's two most meaningful performance metrics, both declined from the March quarter ("Bookings" is the light blue bars in the chart above).

Worse, over the past five quarters, the company's user base has begun to plateau (see chart below).

Image: Business Insider Research

And now Stephen Davidoff at the New York Times has also spotted another issue with Zynga's numbers:

If not for a recent accounting change, the apparently profitable company would be losing money.

Here's the story...

As BI Research analyst Pascal-Emmanuel Gobry explained in a recent note, Zynga discloses two types of revenue metrics:

Of these, "bookings" is actually a more meaningful measure of the company's performance in a given period.  This is because "Bookings" represents the dollar-amount of virtual goods sold to game players in the period, whereas "Revenue" is the amount bought in prior periods amortized over the expected life of the virtual goods.

Got that?

"Bookings" is what Zynga actually sells in the quarter or year. "Revenue" is what Zynga sold over the past 4-6 quarters and then spread over the next year or year-and-a-half.

Anytime a company uses "amortization" to calculate revenue, you need to pay close attention to the amortization schedule--the length of time that the sale is spread over. Because a change in this period will result in an increase or reduction in revenue in a given period, even though the company hasn't actually sold any more or less.

So, here's what happened with Zynga:

Last year, for the first six months of 2010, Zynga amortized revenue from virtual goods using an expected useful life of 14 months. In other words, $5 of fertilizer a Farmville player bought anytime over the past 14 months would be spread over the next 14 months, so that Zynga booked about $0.36 of revenue per month.

But for the first six months of this year, Zynga shortened its amortization schedule to 11 months instead of 14 months. This means that, for every $5 of Farmville fertilizer sold, the company will book $0.45 of revenue per month for 11 months.

And that, in turn, means that Zynga's reported revenue from these sales is considerably higher than it would have been had Zynga left its amortization schedule unchanged. (It also means that revenue in the 5th quarter will be lower, because all of the revenue from today's sale will already have been exhausted).

So, how much revenue has Zynga's accounting change contributed to the company this year?

$27 million!

Zynga has booked $522 million of revenue so far this year, so $27 million might not seem like a big change. But it's big enough to wipe out the company's $18 million of profit for the year.

In other words, had Zynga not changed its accounting, the company would have lost money for the first six months of 2011.

Here's the operative note from the latest SEC filing:

The estimated weighted-average life of durable and consumable virtual goods included in bookings during the six months ended June 30, 2010 was 14 months compared to 11 months for the six months ended June 30, 2011. In the six months ended June 30, 2011, online game revenue increased $27.3 million related to changes in our estimated average life of durable virtual goods.

And there's another point to make about these amortization schedules...

In 2010, Zynga's revenue also benefitted from the company reducing its amortization schedule, this time on a full-year basis. In 2010, the company shortened its amortization schedule to an average of 13 months (full year), from an average of 18 months in 2009. This had the impact of goosing Zynga's 2010 revenue as well.

It may also not be great news from a fundamental perspective that Zynga is shortening these amortization schedules.  Because what it means is that the company now thinks the useful life of the virtual goods it sells is only 11 months instead of 18 months two years ago.

This may be a result of the specific type of virtual goods the company is now selling, or that players consume virtual goods faster than it thought. But it also may mean that, after more history, the company has concluded that its game-players just don't stay as engaged in the games as long as it thought they would. And that, in turn, would force the company to continue to produce mega-hit games every few months just to stay even.

SEE ALSO:
ZYNGA'S Q2: The Numbers Were Even Worse Than They Looked

EXPLAINER: How Zynga Makes Money

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