SEC Probe May Involve Game Industry Gray Area

Like hard-core gamers poring over a strategy guide, investors and analysts are scrutinizing obscure entries in the financial reports of video game publishers.

Two items in particular -- reserves and expense capitalization -- are getting attention in the search for clues as to why the Securities and Exchange Commission issued sweeping requests in July for information from the industry’s leading companies: Activision Inc., THQ Inc., Midway Games Inc. and Acclaim Entertainment Inc.

Publicly, the companies have said little more than that the SEC seemed to be focusing on accounting practices in general and, more specifically, “revenue recognition.”

Privately, though, executives speculate that the SEC may be probing two areas of accounting that could be vulnerable to abuse -- reserves set aside for unsold goods and capitalization of development expenses. And because all four companies received the same request for information, the probe appears to be aimed at detecting industry-wide patterns, executives and analysts say.

An SEC spokesman declined to comment. But current and former SEC officials said part of the agency’s core mission is scrutinizing the financial reporting practices of companies to see if industry-specific rules need to be tightened.

If patterns are what the SEC is after in video-game industry accounting, the agency may be hard pressed to find many.

Both reserves and capitalization of expenses depend on a host of factors that generally depend on management’s best guesses.

Take reserves. Video game publishers -- along with record companies and software makers -- traditionally set aside a portion of revenue to account for products that, ultimately, won’t sell or will have to be discounted in stores, and the size of this reserve represents the company’s best estimate of what customers won’t like.

For unproven titles, publishers reserve more to be on the safe side. For highly anticipated titles, they tend to sock away less.

“It would be hard for anyone to be justified in telling a company what a proper reserve level is,” Michael Wallace, managing director with UBS Securities in New York, wrote in a recent report. “Only the company can make a proper judgment on this, since there is no ‘rule of thumb’ to gauge reserves.”

Reserves can vary considerably from company to company, and from quarter to quarter. In the quarter ended last December, for example, THQ’s reserves amounted to 19% of its revenue for the previous 12 months. Midway’s reserves were 6% of sales for the same period.

“There’s no hard-and-fast rule,” said Phil Ames, a music industry accountant and royalty auditor, “because every artist is different. And every genre has different return patterns. It’s easy to find justification for any amount you want.”

That’s what makes reserves vulnerable to abuse, analysts say. One tactic is to “stuff the channel” by shipping lots of games toward the end of one quarter -- knowing that much of the product will be returned in the next quarter.

Another is the “cookie jar” approach, where companies build up reserves in good times in order to dip into the fund during a weak quarter to hit financial goals.

Such stratagems are “standard revenue recognition issues” that have come under increasing regulatory scrutiny at companies in a wide range of industries, said Clifford Hyatt, a former SEC official in Los Angeles who handles securities cases for the law firm Chadbourne & Parke.

For example, as a result of an SEC probe of practices in the software industry, Microsoft Corp. last year settled allegations that it misstated earnings from 1994 to 1999. The company had moved $900 million to reserve accounts for anticipated expenses, sometimes over- reporting earnings and at other times underreporting them.

Microsoft settled by saying it would cease using the accounting method.

Other notable companies that have faced government charges involving over-inflated reserve funds range from copier maker Xerox Corp. to small-appliance manufacturer Sunbeam Corp. In June, the giant mortgage buyer Freddie Mac acknowledged that it had engaged in earnings “smoothing” by underreporting earnings from 2000 to 2002 by $1.5 billion to $4.5 billion.

In the game industry, Take-Two Interactive Software Inc. last year restated seven quarters of revenue through July 2001 because it improperly booked sales of games that were returned. The New York company, which confirmed that it is still under SEC investigation, declined to comment.

“My sense is that all this is emanating from the Take-Two investigation,” Wallace of UBS said.

With capitalization of expenses, software companies are required by federal regulations to capitalize costs when a product is “technologically feasible.” Just what that means is highly subject to interpretation, according to game industry executives.

Because games are partly the product of creative development, it’s not always clear when they become “feasible” commercial products, one former company president said.

As a result, some companies capitalize expenses toward the end of the development process, while other companies, such as Electronic Arts Inc., don’t capitalize at all, preferring instead to record expenses as they occur.

“With some games, you need to see 90% of the work before you can tell whether it’s a viable product, much less say when you’re going to be able to ship it,” said the executive, who asked not to be identified. “Nobody’s really established a uniform standard around this.”

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Game companies taketh away

Game publishers typically take a charge against revenue to account for products that are returned by retailers or must be discounted. Those ‘reserves’ averaged 9% of game sales industrywide, but the actual numbers vary considerably.

Reserves as a percentage of trailing 12-month revenue:

*--* Dec March June Sept Dec March Company 2001 2002 2002 2002 2002 2003 Activision 9% 7% 7% 6% 8% 7% Electronic Arts 6% 4% 5% 6% 6% 5% Midway 11% 9% 7% 9% 19% 14% THQ 10% 8% 9% 8% 12% 9% Take-Two* 10% 6% 6% 5% 7% 6%

*--*

*Take-Two Interactive fiscal year ends Oct. 31.

Sources: UBS Securities, company reports