UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)
x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
		EXCHANGE ACT OF 1934
		For the Quarterly Period Ended December 31, 2006
		OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
		EXCHANGE ACT OF 1934

 

For the transition period from                    to                   

Commission File Number 001-15839

ACTIVISION, INC.

(Exact name of registrant as specified in its charter)

 

(310) 255-2000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer x

Accelerated Filer o

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).   Yes o No x

The number of shares of the registrant’s Common Stock outstanding as of June 1, 2007 was 283,310,734.

ACTIVISION, INC. AND SUBSIDIARIES

INDEX

	Explanatory Note
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of December 31, 2006 (Unaudited) and March 31, 2006
	Consolidated Statements of Operations for the three and nine months ended December 31, 2006 (Unaudited) and December 31, 2005, as restated (Unaudited)
	Consolidated Statements of Cash Flows for the nine months ended December 31, 2006 (Unaudited) and December 31, 2005, as restated (Unaudited)
	Consolidated Statement of Changes in Shareholders’ Equity for the nine months ended December 31, 2006 (Unaudited)
	Notes to Consolidated Financial Statements for the three and nine months ended December 31, 2006 (Unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 1A.	Risk Factors
Item 6.	Exhibits
SIGNATURES
CERTIFICATION

 

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CAUTIONARY STATEMENT

This Quarterly Report on Form 10-Q contains, or incorporates by reference, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, but are not limited to, (1) projections of revenues, expenses, income or loss, earnings or loss per share, cash flow projections or other financial items; (2) statements of our plans and objectives, including those relating to product releases; (3) statements of future economic performance; and (4) statements of assumptions underlying such statements. We generally use words such as “anticipate”, “believe”, “could”, “estimate”, “expect”, “forecast”, “future”, “intend”, “may”, “plan”, “positioned”, “potential”, “project”, “scheduled”, “set to”, “subject to”, “upcoming” and other similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk, reflect management’s current expectations, estimates and projections about our business, and are inherently uncertain and difficult to predict. Our actual results could differ materially. The forward-looking statements contained herein speak only as of the date on which they were made, and we disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of this Quarterly Report. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed under the heading “Risk Factors”, included in Part II, Item 1A. All references to “we”, “us”, “our”, “Activision” or “the Company” in the following discussion and analysis mean Activision, Inc. and its subsidiaries.

EXPLANATORY NOTE

Restatement of Consolidated Financial Results

We recently completed a voluntary review of our historical stock option granting practices and a restatement of our consolidated financial statements as of and for the fiscal years ended March 31, 2006, 2005 and 2004 and related disclosures and a restatement of our selected consolidated financial data as of and for the fiscal years ended March 31, 2006, 2005, 2004, 2003 and 2002 and our unaudited quarterly financial data for each of the quarters in the fiscal years ended March 31, 2006 and 2005, and for the fiscal quarter ended June 30, 2006.  The impacts of the restatement adjustments extend to periods from the fiscal year ended March 31, 1994 through the fiscal quarter ended June 30, 2006.

The restatement reflected the findings of a special subcommittee of independent members of our Board of Directors, which was established in July 2006 to review our historical stock option granting practices (the “Special Subcommittee”).  The Special Subcommittee conducted its investigation with the assistance of Munger Tolles & Olson LLP as its independent counsel and Deloitte & Touche USA LLP (“Deloitte”) as forensic accounting experts retained by counsel.  The Special Subcommittee found that 3,450 of the option grants reviewed, covering 148,747,202 shares, required measurement date corrections.  As a result, we recorded approximately $66.7 million in additional pre-tax ($45.4 million after-tax) non-cash stock-based compensation expense over the thirteen year period from April 1, 1993 through March 31, 2006 in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and $0.6 million in additional pre-tax non-cash stock-based compensation expense during the quarter ended June 30, 2006 in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”.  More than 80% or $55.4 million of the $66.7 million relates to periods through March 31, 2003 and 4% or $2.6 million of the non-cash pre-tax expense relates to the fiscal year ended March 31, 2006.  Separately, the restatement reflects an additional $1.7 million pre-tax charge ($1.1 million after-tax) related to recently identified insufficient payroll tax withholdings in fiscal 2005.

This Quarterly Report on Form 10-Q should be read in conjunction with our Amended Annual Report on Form 10-K/A for the year ended March 31, 2006 filed with the SEC on May 25, 2007 and our Amended Quarterly Report on Form 10-Q/A for the three months ended June 30, 2006 filed with the SEC on June 7, 2007. Information regarding the effect of the restatement on our financial position and results of operations is provided in Note 2 of the Notes to Unaudited Consolidated Financial Statements included in Part I, Item 1 of this Report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I, Item 2 of this Report.

Financial information included in our previously filed reports on Form 10-K and Form 10-Q, the related opinions of our independent registered public accounting firm, and all earnings press releases and similar communications issued by us, for all periods ended on or before June 30, 2006 should not be relied upon and are superseded in their entirety by the information in our amended Annual Report on Form 10-K/A for the year ended March 31, 2006 filed with the SEC on May 25, 2007 and our Amended Quarterly Report on Form 10-Q/A for the three months ended June 30, 2006 and our Quarterly Reports on Form 10-Q for the three months ended September 30, 2006 and the three months ended December 31, 2006 filed with the SEC today.

All share and per share information presented in this report has been adjusted to reflect splits and dividends of our common stock.

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PART I.  FINANCIAL INFORMATION.

Item 1.  Financial Statements.

ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

		December 31, 2006			March 31, 2006
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	367,910		$	354,331
Short-term investments		437,290			590,629
Accounts receivable, net of allowances of $107,124 and $98,253 at December 31, 2006 and March 31, 2006, respectively		456,589			28,782
Inventories		85,680			61,483
Software development		86,119			40,260
Intellectual property licenses		28,628			4,973
Deferred income taxes		4,266			9,664
Other current assets		17,896			25,933
Total current assets		1,484,378			1,116,055
Software development		15,688			20,359
Intellectual property licenses		64,800			82,073
Property and equipment, net		46,713			45,368
Deferred income taxes		85,552			52,545
Other assets		5,941			1,409
Goodwill		188,398			100,446
Total assets		$	1,891,470		$	1,418,255
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable		$	193,875		$	88,994
Accrued expenses		247,581			104,862
Total current liabilities		441,456			193,856
Other liabilities		41,128			1,776
Total liabilities		482,584			195,632
Commitments and contingencies (Note 14)
Shareholders’ equity:
Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at December 31, 2006 and March 31, 2006		—			—
Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at December 31, 2006 and March 31, 2006		—			—
Common stock, $.000001 par value, 450,000,000 shares authorized, 282,934,869 and 277,020,898 shares issued and outstanding at December 31, 2006 and March 31, 2006, respectively		—			—
Additional paid-in capital		948,028			867,297
Retained earnings		442,199			341,990
Accumulated other comprehensive income		18,659			16,369
Unearned compensation (Note 1)		—			(3,033		)
Total shareholders’ equity		1,408,886			1,222,623
Total liabilities and shareholders’ equity		$	1,891,470		$	1,418,255

 

The accompanying notes are an integral part of these consolidated financial statements.

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ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

		For the three months ended  December 31,						For the nine months ended  December 31,
		2006			2005			2006			2005
					As restated(1)						As restated(1)
Net revenues		$	824,259		$	816,242		$	1,200,500		$	1,279,875
Costs and expenses:
Cost of sales – product costs		382,165			367,685			618,162			617,021
Cost of sales – software royalties and amortization		77,449			104,264			106,058			139,267
Cost of sales – intellectual property licenses		23,566			26,376			37,838			55,765
Product development		37,162			53,254			88,395			99,698
Sales and marketing		87,410			156,013			156,139			259,110
General and administrative		43,387			24,757			91,647			67,228
Total costs and expenses		651,139			732,349			1,098,239			1,238,089
Operating income		173,120			83,893			102,261			41,786
Investment income, net		9,724			9,162			26,031			22,840
Income before income tax provision		182,844			93,055			128,292			64,626
Income tax provision		40,024			25,199			28,083			15,247
Net income		$	142,820		$	67,856		$	100,209		$	49,379
Basic earnings per share		$	0.51		$	0.25		$	0.36		$	0.18
Weighted average common shares outstanding		282,512			274,965			280,499			272,089
Diluted earning per share		$	0.46		$	0.23		$	0.33		$	0.17
Weighted average common shares outstanding assuming dilution		307,175			296,205			304,317			293,397

(1)             See Note 2 “Restatement of Unaudited Consolidated Financial Statements.”

The accompanying notes are an integral part of these consolidated financial statements.

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ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

		For the nine months ended December 31,
		2006			2005
					As restated(1)
Cash flows from operating activities:
Net income		$	100,209		$	49,379
Adjustments to reconcile net income to net cash used in operating activities:
Deferred income taxes		(33,254		)	(6,023		)
Realized gain on short-term investments		(1,823		)	(4,295		)
Depreciation and amortization		13,303			10,228
Amortization and write-offs of capitalized software development costs and intellectual property licenses		77,358			168,351
Stock-based compensation expense		18,433			2,506
Tax benefit of stock options and warrants exercised		11,377			21,269
Excess tax benefit from stock option exercises		(9,012		)	—
Changes in operating assets and liabilities:
Accounts receivable		(416,697		)	(305,305		)
Inventories		(20,573		)	(36,810		)
Software development and intellectual property licenses		(117,636		)	(162,793		)
Other assets		21,128			321
Accounts payable		98,473			104,895
Accrued expenses and other liabilities		133,297			74,345
Net cash used in operating activities		(125,417		)	(83,932		)
Cash flows from investing activities:
Capital expenditures		(13,106		)	(20,174		)
Cash payment to effect business combinations, net of cash acquired		(30,545		)	(7,081		)
Increase in restricted cash		—			(7,500		)
Purchases of short-term investments		(215,721		)	(143,162		)
Proceeds from sales and maturities of short-term investments		361,339			182,504
Net cash provided by investing activities		101,967			4,587
Cash flows from financing activities:
Proceeds from issuance of common stock to employees		18,956			37,850
Excess tax benefit from stock option exercises		9,012			—
Net cash provided by financing activities		27,968			37,850
Effect of exchange rate changes on cash		9,061			(5,044		)
Net increase (decrease) in cash and cash equivalents		13,579			(46,539		)
Cash and cash equivalents at beginning of period		354,331			313,608
Cash and cash equivalents at end of period		$	367,910		$	267,069

(1)             See Note 2 “Restatement of Unaudited Consolidated Financial Statements.”

The accompanying notes are an integral part of these consolidated financial statements.

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ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
For the Nine Months ended December 31, 2006
(Unaudited)
(In thousands)

		Common Stock					Additional Paid-In			Retained			Accumulated Other Comprehensive			Unearned			Shareholders’
		Shares		Amount			Capital			Earnings			Income			Compensation			Equity
Balance, March 31, 2006		277,021		$	—		$	867,297		$	341,990		$	16,369		$	(3,033	)	$	1,222,623
Components of comprehensive income:
Net income		—		—			—			100,209			—			—			100,209
Unrealized loss on short-term investments (net of tax benefit of $0.9 million)		—		—			—			—			(8,693		)	—			(8,693		)
Foreign currency translation adjustment		—		—			—			—			10,983			—			10,983
Total comprehensive income																			102,499
Issuance of common stock pursuant to employee stock option and stock purchase plans		3,532		—			18,956			—			—			—			18,956
Issuance of stock to effect business combination		2,382		—			30,000			—			—			—			30,000
Stock based compensation expense related to employee stock options, restricted stock, and employee stock purchases		—		—			23,431			—			—			—			23,431
Tax benefit associated with options and warrants		—		—			11,377												11,377
Reclassification of unearned compensation		—		—			(3,033		)	—			—			3,033			—
Balance, December 31, 2006		282,935		$	—		$	948,028		$	442,199		$	18,659		$	—		$	1,408,886

 

The accompanying notes are an integral part of these consolidated financial statements.

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

1.              Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements include the accounts of Activision, Inc. and its subsidiaries (“Activision,” the “Company,” or “we”).  The information furnished is unaudited and consists of only normal recurring adjustments that, in the opinion of management, are necessary to provide a fair statement of the results for the interim periods presented.  The Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements included in our Amended Annual Report on Form 10-K/A for the year ended March 31, 2006 as filed with the Securities and Exchange Commission (“SEC”) on May 25, 2007.

Software Development Costs and Intellectual Property Licenses

Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products.

We account for software development costs in accordance with Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.”  Software development costs are capitalized once the technological feasibility of a product is established and such costs are determined to be recoverable.  Technological feasibility of a product encompasses both technical design documentation and game design documentation.  For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis.  Prior to a product’s release, we expense, as part of “cost of sales — software royalties and amortization,” capitalized costs when we believe such amounts are not recoverable.  Capitalized costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Amounts related to software development which are not capitalized are charged immediately to product development expense.  We evaluate the future recoverability of capitalized amounts on a quarterly basis.  The recoverability of capitalized software development costs is evaluated based on the expected performance of the specific products for which the costs relate.  Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

Commencing upon product release, capitalized software development costs are amortized to “cost of sales — software royalties and amortization” based on the ratio of current revenues to total projected revenues, generally resulting in an amortization period of six months or less.  For products that have been released in prior periods, we evaluate the future recoverability of capitalized amounts on a quarterly basis.  The primary evaluation criterion is actual title performance.

Significant management judgments and estimates are utilized in the assessment of when technological feasibility is established, as well as in the ongoing assessment of the recoverability of capitalized costs.  In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred.  If revised forecasted or actual product sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge.

Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology, or other intellectual property or proprietary rights in the development of our products.  Depending upon the agreement with the rights holder, we may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product.

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

We evaluate the future recoverability of capitalized intellectual property licenses on a quarterly basis.  The recoverability of capitalized intellectual property license costs is evaluated based on the expected performance of the specific products in which the licensed trademark or copyright is to be used.  As many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors, such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property, and the rights holder’s continued promotion and exploitation of the intellectual property.  Prior to the related product’s release, we expense, as part of “cost of sales – intellectual property licenses,” capitalized intellectual property costs when we believe such amounts are not recoverable.  Capitalized intellectual property costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

Commencing upon the related product’s release, capitalized intellectual property license costs are amortized to “cost of sales – intellectual property licenses” based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed property will be utilized.  As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.  For intellectual property included in products that have been released, we evaluate the future recoverability of capitalized amounts on a quarterly basis.  The primary evaluation criterion is actual title performance.

Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized costs.  In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred.  If revised forecasted or actual product sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge.  Additionally, as noted above, as many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property.  Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.

Revenue Recognition

We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers.  Certain products are sold to customers with a street date (i.e., a date on which products are made widely available by retailers).  For these products we recognize revenue no earlier than the street date.  Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection.  With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of such copies. Per copy royalties on sales that exceed the guarantee are recognized as earned.  With respect to on-line transactions, such as electronic downloads of titles or product add-ons, revenue is recognized when the fee is paid by the on-line customer to purchase online content and we are notified by the online retailer that the product has been downloaded.  In addition, in order to recognize revenue for both product sales and licensing transactions, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable.  Revenue recognition also determines the timing of certain expenses, including “cost of sales – intellectual property licenses” and “cost of sales – software royalties and amortization.”

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

Sales incentives or other consideration given by us to our customers is accounted for in accordance with the Financial Accounting Standards Board’s Emerging Issues Task Force (“EITF”) Issue 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).”  In accordance with EITF Issue 01-9, sales incentives and other consideration that are considered adjustments of the selling price of our products, such as rebates and product placement fees, are reflected as reductions of revenue.  Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer’s national circular ad, are reflected as sales and marketing expenses.

Allowances for Returns, Price Protection, Doubtful Accounts, and Inventory Obsolescence

In determining the appropriate unit shipments to our customers, we benchmark our titles using historical and industry data.  We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers, and the anticipated timing of other releases in order to assess future demands of current and upcoming titles.  Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets, but at the same time are controlled to prevent excess inventory in the channel.

We may permit product returns from, or grant price protection to, our customers under certain conditions.  In general, price protection refers to the circumstances when we elect to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allows customers a credit against amounts owed by such customers to us with respect to open and/or future invoices.  The conditions our customers must meet to be granted the right to return products or price protection are, among other things, compliance with applicable payment terms, and consistent delivery to us of inventory and sell-through reports.  We may also consider other factors, including the facilitation of slow-moving inventory and other market factors.  Management must make estimates of potential future product returns and price protection related to current period product revenue.  We estimate the amount of future returns and price protection for current period product revenue utilizing historical experience and information regarding inventory levels and the demand and acceptance of our products by the end consumer.  The following factors are used to estimate the amount of future returns and price protection for a particular title:  historical performance of titles in similar genres; historical performance of the hardware platform; historical performance of the brand; console hardware life cycle; Activision sales force and retail customer feedback; industry pricing; weeks of on-hand retail channel inventory; absolute quantity of on-hand retail channel inventory; our warehouse on-hand inventory levels; the title’s recent sell-through history (if available); marketing trade programs; and competing titles.  The relative importance of these factors varies among titles depending upon, among other items, genre, platform, seasonality, and sales strategy.  Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period.  Based upon historical experience we believe our estimates are reasonable.  However, actual returns and price protection could vary materially from our allowance estimates due to a number of reasons including, among others, a lack of consumer acceptance of a title, the release in the same period of a similarly themed title by a competitor, or technological obsolescence due to the emergence of new hardware platforms.  Material differences may result in the amount and timing of our revenue for any period if factors or market conditions change or if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection.  For example, a 1% change in our December 31, 2006 allowance for returns and price protection would impact net revenues by $1.1 million.

Similarly, management must make estimates of the uncollectibility of our accounts receivable.  In estimating the allowance for doubtful accounts, we analyze the age of current outstanding account balances, historical bad debts, customer concentrations, customer creditworthiness, current economic trends, and changes in our customers’ payment terms and their economic condition, as well as whether we can obtain sufficient credit insurance.  Any significant changes in any of these criteria would affect management’s estimates in establishing our allowance for doubtful accounts.

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

We value inventory at the lower of cost or market.  We regularly review inventory quantities on hand and in the retail channel and record a provision for excess or obsolete inventory based on the future expected demand for our products. Significant changes in demand for our products would impact management’s estimates in establishing our inventory provision.

Stock-Based Compensation

On April 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan (“employee stock purchases”), based on estimated fair values. SFAS 123R supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”).  In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123R. We have applied the provisions of SAB 107 in our adoption of SFAS 123R.

We adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of April 1, 2006, the first day of our fiscal year 2007. The Company’s Consolidated Financial Statements as of and for the three and nine months ended December 31, 2006 reflect the impact of SFAS 123R. In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R.  Stock-based compensation expense recognized under SFAS 123R for the three and nine months ended December 31, 2006 was $7.7 million and $18.4 million, respectively.  See Note 15 for additional information.

SFAS 123R requires companies to estimate the fair value of share-based payment awards on the measurement date using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statement of Operations. Prior to the adoption of SFAS 123R, the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under APB 25, compensation expense was recorded for the issuance of stock options and other stock-based compensation based on the intrinsic value of the stock options and other stock-based compensation on the date of grant or measurement date.  Under the intrinsic value method, compensation expense was recorded on the measurement date only if the current market price of the underlying stock exceeded the stock option or other stock-based award’s exercise price.  For the three and nine months ended December 31, 2005, we recognized $322,000 and $2.5 million, respectively, in stock-based compensation expense related to employee stock options and restricted stock, under APB 25.  See Notes 2 and 15 for additional information.

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in our Consolidated Statements of Operations for the three and nine months ended December 31, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of, April 1, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, and compensation expense for the share-based payment awards granted subsequent to April 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. As stock-based compensation expense recognized in the Consolidated Statements of Operations for the three and nine months ended December 31, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

As of April 1, 2005, we changed our method of valuation for share-based awards to a binomial-lattice model from the Black-Scholes option-pricing model (“Black-Scholes model”) which was used for options granted prior to April 1, 2005.  For additional information, see Note 15.  Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.

Restricted Stock

In June 2005, we issued the rights to 155,763 shares of restricted stock to an employee.  Additionally, in October 2005 we issued the rights to 96,712 shares of restricted stock to an employee.  These shares all vest over a five-year period and remain subject to forfeiture if vesting conditions are not met.  In accordance with APB 25, we recognized unearned compensation in connection with the grant of restricted shares equal to the fair value of our common stock on the date of grant.  The fair value of these shares when issued was approximately $12.84 and $15.51 per share, respectively, and resulted in a total increase in “Additional paid-in capital” and “Unearned compensation” of $2.0 million and $1.5 million on the respective balance sheets at the times of grant.  Prior to the adoption of SFAS 123R, we reduced unearned compensation and recognized compensation expense over the vesting periods.  Upon adoption of SFAS 123R, unearned compensation was reclassified against additional paid in capital and we will increase additional paid in capital and recognize compensation expense over the respective remaining vesting periods.  Additionally, in the third quarter of fiscal 2007 we issued the rights to an aggregate of 81,000 shares of restricted stock to various employees.  These shares vest over two and three year periods (with some subject to vesting acceleration clauses if the holder achieves certain performance objectives) and remain subject to forfeiture if vesting conditions are not met.  In accordance with SFAS 123R we will recognize compensation expense and increase additional paid in capital related to these restricted stock shares over the requisite service period.  For the three and nine months ended December 31, 2006, we recorded expenses related to these shares of approximately $292,000 and $642,000, respectively, which was included as a component of stock-based compensation expense within “General and administrative” on the accompanying Consolidated Statements of Operations.  Since the issuance dates, we have recognized $1.1 million of the $4.8 million total fair value, with the remainder to be recognized over a weighted-average period of 3.12 years.

2.     Restatement of Unaudited Consolidated Financial Statements

We recently completed a voluntary review of our historical stock option granting practices and a restatement of our consolidated financial statements as of and for the fiscal years ended March 31, 2006, 2005 and 2004 and related disclosures and a restatement of our selected consolidated financial data as of and for the fiscal years ended March 31, 2006, 2005, 2004, 2003 and 2002 and our unaudited quarterly financial data for each of the quarters in the fiscal years ended March 31, 2006 and 2005, and the fiscal quarter ended June 30, 2006.  The impacts of the restatement adjustments extend to periods from the fiscal year ended March 31, 1994 through the fiscal quarter ended June 30, 2006.

The restatement reflects the findings of a special subcommittee of independent members of our Board of Directors, which was established in July 2006 to review our historical stock option granting practices (the “Special Subcommittee”).  The Special Subcommittee conducted its investigation with the assistance of Munger Tolles & Olson LLP as its independent counsel and Deloitte & Touche USA LLP (“Deloitte”) as forensic accounting experts retained by counsel.  The Special Subcommittee found that 3,450 of the option grants reviewed, covering 148,747,202 shares, required measurement date corrections.  As a result, we recorded approximately $66.7 million in additional pre-tax ($45.4 million after-tax) non-cash stock-based compensation expense over the thirteen year period from April 1, 1993 through March 31, 2006 in accordance with APB 25, and $0.6 million in additional pre-tax non-cash stock-based compensation expense during the quarter ended June 30, 2006 in accordance with SFAS 123R.  More than 80% or $55.4 million of the $66.7 million relates to periods through March 31, 2003 and 4% or $2.6 million of the non-

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

cash pre-tax expense relates to the fiscal year ended March 31, 2006. Separately, the restatement reflected an additional $1.7 million pre-tax charge ($1.1 million after-tax) related to recently identified insufficient payroll tax withholdings in fiscal 2005. Additional information regarding the restatement is available with the Company’s Amended Annual Report on Form 10-K/A for the period ending March 31, 2006.

The following table summarizes additional pre-tax stock-based compensation expense and related tax adjustments resulting from the review of our equity award practices for the three and nine months ended December 31, 2005 (in thousands):

 

(1) Also includes an immaterial amount of interest expense related to our $1.7 million charge for insufficient payroll tax withholdings in fiscal 2005.

The following tables reflect the impact of the additional non-cash charges for stock-based compensation expense and related tax effects on:

Certain Tax Consequences:  Certain stock options were granted with an exercise price lower than the fair market value on the actual measurement dates, with vesting occurring after December 31, 2004, which resulted in nonqualified deferred compensation for purposes of Section 409A of the Internal Revenue Code.  Section 409A subjects the option holders to additional income tax, penalties and interest on the value of the options deferred and, in certain cases, exercised each year.  We do not have any tax liability associated with Section 409A. For options that have already been exercised by non-executive officer employees, that are subject to Section 409A consequences, the Company has elected to  participate in the Internal Revenue Service program described in IRS Announcement 2007-18 pursuant to which the Company was able to pay the Section 409A taxes on behalf of its non-executive officer employees, and has incurred $7.3 million in additional pre-tax compensation expense in the fiscal quarter ended March 31, 2007, in absorbing these related costs on behalf of these employees. With respect to unexercised options subject to Section 409A held by such current and former non-executive officer employees, the Company on or about June 7, 2007 is commencing an offer to amend the exercise price of these options to eliminate their Section 409A tax liability consistent with Internal Revenue Service guidance.  Pursuant to the offer, the Company will also make a cash payment in January 2008 to employees who accept the offer, in an amount equal to the difference between the original exercise price of each amended option and the amended exercise price of each amended option. This will likely result in additional future compensation expense to the Company once these actions occur.

·                  the Consolidated Statements of Operations for the three and nine months ended December 31, 2005 (Unaudited).

·                  the Consolidated Statement of Cash Flows for the nine months ended December 31, 2005 (Unaudited).

·                  the pro forma information required by SFAS No. 123 for the three and nine months ended December 31, 2005 (Unaudited).

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

Consolidated Statement of Operations (Unaudited)

		For the three months ended December 31, 2005
(in thousands, except per share data)		As previously  reported			Adjustments			As restated
Net revenues		$	816,242		$	—		$	816,242
Costs and expenses:
Cost of sales – product costs		367,685			—			367,685
Cost of sales – software royalties and amortization		104,264			—			104,264
Cost of sales – intellectual property licenses		26,376			—			26,376
Product development		53,139			115			53,254
Sales and marketing		155,999			14			156,013
General and administrative		24,712			45			24,757
Total costs and expenses		732,175			174			732,349
Operating income		84,067			(174		)	83,893
Investment income, net		9,162			—			9,162
Income before income tax provision		93,229			(174		)	93,055
Income tax provision		25,284			(85		)	25,199
Net income		$	67,945		$	(89	)	$	67,856
Basic earnings per share		$	0.25		$	—		$	0.25
Weighted average common shares outstanding		274,965			—			274,965
Diluted earnings per share		$	0.23		$	—		$	0.23
Weighted average common shares outstanding assuming dilution		298,752			(2,547		)	296,205

 

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

Consolidated Statement of Operations (Unaudited)

		For the nine months ended December 31, 2005
(in thousands, except per share data)		As previously  reported			Adjustments			As restated
Net revenues		$	1,279,875		$	—		$	1,279,875
Costs and expenses:
Cost of sales – product costs		617,021			—			617,021
Cost of sales – software royalties and amortization		139,267			—			139,267
Cost of sales – intellectual property licenses		55,765			—			55,765
Product development		99,013			685			99,698
Sales and marketing		258,957			153			259,110
General and administrative		65,780			1,448			67,228
Total costs and expenses		1,235,803			2,286			1,238,089
Operating income		44,072			(2,286		)	41,786
Investment income, net		22,840			—			22,840
Income before income tax provision		66,912			(2,286		)	64,626
Income tax provision		15,794			(547		)	15,247
Net income		$	51,118		$	(1,739	)	$	49,379
Basic earnings per share		$	0.19		$	(0.01	)	$	0.18
Weighted average common shares outstanding		272,089			—			272,089
Diluted earnings per share		$	0.17		$	—		$	0.17
Weighted average common shares outstanding assuming dilution		295,963			(2,566		)	293,397

 

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

Consolidated Statement of Cash Flows (Unaudited)

		For the nine months ended December 31, 2005
(in thousands)		As previously  reported			Adjustments			As restated
Cash flows from operating activities:
Net income		$	51,118		$	(1,739	)	$	49,379
Adjustments to reconcile net loss to net cash used in operating activities:
Deferred income taxes		(10,819		)	4,796			(6,023		)
Realized gain on sale of short term investments		(4,295		)	—			(4,295		)
Depreciation and amortization		10,228			—			10,228
Amortization of capitalized software development costs and intellectual property licenses		168,351			—			168,351
Stock-based compensation expense		292			2,214			2,506
Tax benefit of stock options and warrants exercised		26,612			(5,343		)	21,269
Changes in operating assets and liabilities (net of effects of acquisitions):
Accounts receivable		(305,305		)	—			(305,305		)
Inventories		(36,810		)	—			(36,810		)
Software development and intellectual property licenses		(162,793		)	—			(162,793		)
Other assets		321			—			321
Accounts payable		104,895			—			104,895
Accrued expenses and other liabilities		74,273			72			74,345
Net cash used in operating activities		(83,932		)	—			(83,932		)
Cash flows from investing activities:
Capital expenditures		(20,174		)	—			(20,174		)
Cash payments to effect business combinations, net of cash acquired		(7,081		)	—			(7,081		)
Increase in restricted cash		(7,500		)	—			(7,500		)
Purchases of short-term investments		(143,162		)	—			(143,162		)
Proceeds from sales and maturities of short-term investments		182,504			—			182,504
Net cash provided by investing activities		4,587			—			4,587
Cash flows from financing activities:
Proceeds from issuance of common stock to employees		37,850			—			37,850
Net cash provided by financing activities		37,850			—			37,850
Effect of exchange rate changes on cash		(5,044		)	—			(5,044		)
Net decrease in cash and cash equivalents		(46,539		)	—			(46,539		)
Cash and cash equivalents at beginning of period		313,608			—			313,608
Cash and cash equivalents at end of period		$	267,069		$	—		$	267,069

 

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

Pro forma information regarding net income and net income per share is required by SFAS No. 123 and has been determined as if the Company had accounted for its employee stock purchase plan and employee stock option plans under the fair value method of SFAS No. 123.  The impact of the restatements on the pro forma information is as follows (in thousands, except per share data):

		For the three months ended December 31, 2005
(in thousands, except per share data)		As previously reported			Adjustments			As restated
Net income, as reported		$	67,945		$	(89	)	$	67,856
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		—			72			72
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(4,841		)	619			(4,222		)
Pro forma net income		$	63,104		$	602		$	63,706
Earnings per share
Basic – as reported		$	0.25		$	—		$	0.25
Basic – pro forma		$	0.23		$	—		$	0.23
Diluted – as reported		$	0.23		$	—		$	0.23
Diluted – pro forma		$	0.21		$	0.01		$	0.22

 

		For the nine months ended December 31, 2005
(in thousands, except per share data)		As previously reported			Adjustments			As restated
Net income, as reported		$	51,118		$	(1,739	)	$	49,379
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		—			1,695			1,695
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(11,517		)	(671		)	(12,188		)
Pro forma net income		$	39,601		$	(715	)	$	38,886
Earnings per share
Basic – as reported		$	0.19		$	(0.01	)	$	0.18
Basic – pro forma		$	0.15		$	(0.01	)	$	0.14
Diluted – as reported		$	0.17		$	—		$	0.17
Diluted – pro forma		$	0.13		$	—		$	0.13

 

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

3.              Acquisitions

RedOctane, Inc.

On June 6, 2006, we completed our acquisition of 100% of RedOctane, Inc. (“RedOctane”) for an aggregate accounting purchase price of $99.9 million, including transaction costs, consisting of: $30.9 million in cash; 2,382,077 shares of Activision common stock valued at approximately $30.0 million based upon prevailing market prices which was issued on the closing date; and $39.0 million payable in Activision common stock within two years of the closing date, which is recorded in other liabilities. In addition, in the event the adjusted net income of the business over a certain period of time exceeds specified target levels by certain amounts, certain former shareholders of RedOctane will be entitled to an additional amount of up to $51.0 million payable in shares of Activision common stock. The contingent consideration will be recorded as an additional element of the purchase price if those contingencies are achieved. Based in Sunnyvale, California, RedOctane is a publisher, developer, and distributor of interactive entertainment software, hardware and accessories. RedOctane offers its interactive entertainment products in versions that operate on the Sony PlayStation 2 (“PS2”), the Microsoft Xbox (“Xbox”), and the personal computer (“PC”), and its leading product offering is Guitar Hero for the PS2. RedOctane also designs, manufactures, and markets high quality video game peripherals and accessories. This acquisition provides Activision with an early leadership position in music-based gaming, which we expect will be one of the fastest growing genres in the coming years.

The results of operations of RedOctane and the estimated fair market values of the acquired assets and liabilities have been included in the Consolidated Financial Statements since the date of acquisition. Pro forma Consolidated Statements of Operations for this acquisition are not shown, as they would not differ materially from reported results. The acquired, finite-lived intangible assets are being amortized over estimated lives ranging from 0.6 to 1.6 years. Goodwill has been included in the publishing segment of our business and is non-deductible for tax purposes.

Purchase Price Allocation

We accounted for this acquisition in accordance with SFAS No. 141, “Business Combinations.” SFAS No. 141 addresses financial accounting and reporting for business combinations, requiring that the purchase method be used to account and report for all business combinations. The purchase price for the RedOctane transaction was allocated to assets acquired and liabilities assumed as set forth below (in thousands):

Current assets		$	17,530
Property and equipment, net		207
Other assets		1,033
Goodwill		87,004
Trademark and other intangibles		16,700
Deferred tax liability		(6,496		)
Other liabilities		(16,033		)
Total consideration		$	99,945

 

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

Purchased Intangible Assets

The following table presents details of the purchased finite-lived intangible assets acquired in the RedOctane acquisition (in thousands):

		Estimated Useful
		Life
		(in years)		Amount
Finite-lived intangibles:
Trademark		1.3		$	1,000
Other intangibles		0.6-1.6		15,700
Total finite-lived intangibles				$	16,700

 

The following tables present details of our total purchased finite-lived intangible assets as of December 31, 2006 (in thousands):

		Gross			Accumulated Amortization			Net
Trademark		$	1,000		$	520		$	480
Other intangibles		15,700			9,121			6,579
Total		$	16,700		$	9,641		$	7,059

 

The estimated future amortization expense of purchased, finite-lived intangible assets as of December 31, 2006 is as follows (in thousands):

Fiscal year ending March 31,		Amount
2007 (remaining three months)		$	2,061
2008		4,998
2009		—
2010		—
2011		—
Thereafter		—
Total		$	7,059

 

4.              Cash, Cash Equivalents, and Short-Term Investments

Short-term investments generally consist of investments with maturities between three and thirty months. Investments with maturities beyond one year may be classified as short-term if they are liquid and represent the investment of cash that is available for current operations. All of our short-term investments are classified as available-for-sale and are carried at fair market value with unrealized appreciation (depreciation) reported as a separate component of accumulated other comprehensive income (loss) in shareholders’ equity. The specific identification method is used to determine the cost of securities disposed with realized gains and losses reflected in investment income, net.

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

The following table summarizes our investments in securities as of December 31, 2006 (amounts in thousands):

 

The following table summarizes the contractual maturities of our investments in debt securities as of December 31, 2006 (amounts in thousands):

		Amortized Cost			Fair Value
Due in one year or less		$	308,320		$	307,005
Due after one year through two years		56,875			56,731
Due after two years through three years		4,022			4,014
Due in three years or more		12,906			12,531
		382,123			380,281
Asset and mortgage-backed securities		54,078			53,739
Certificate of deposit		9,997			9,991
Total		$	446,198		$	444,011

 

For the three and nine months ended December 31, 2006, there were no gross realized losses and gross realized gains of $1.8 million on the sale of short-term investments. For the three months ended December 31, 2005, there were no gross realized gains and $2,000 of gross realized losses on the sale or maturity of short-term investments. For the nine months ended December 31, 2005, there were $1.3 million of gross realized gains and $2,000 of gross realized losses on the sale or maturity of short-term investments.

In accordance with EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” the fair value of investments in an unrealized loss position for which an other-than-

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

temporary impairment has not been recognized was $430.7 million and $672.4 million at December 31, 2006 and March 31, 2006, respectively, with related gross unrealized losses of $2.2 million and $5.5 million, respectively. At December 31, 2006, the gross unrealized losses were comprised mostly of unrealized losses on U.S. agency issues, corporate bonds, and mortgage-backed securities, with $1.8 million of unrealized loss being in a continuous unrealized loss position for twelve months or greater. At March 31, 2006, the gross unrealized losses were comprised mostly of unrealized losses on U.S. agency issues, corporate bonds, and mortgage-backed securities with $3.9 million of unrealized loss being in a continuous unrealized loss position for twelve months or greater.

Our investment portfolio consists of government and corporate securities with effective maturities of less than 30 months. The longer the term or holding period of the securities, the more susceptible they are to changes in market rates of interest, yields on bonds, and market price volatility.  Investments are reviewed periodically to identify possible impairment.  When evaluating the investments, we review factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and our ability and intent to hold the investment for a period of time which may be sufficient for anticipated recovery in market value.  We have the intent and ability to hold these securities for a reasonable period of time sufficient for a forecasted recovery of fair value up to (or beyond) the initial cost of the investment.  We expect to realize the full value of all of these investments upon maturity or sale.

5.              Inventories

Inventories are valued at the lower of cost (first-in, first-out) or market. Our inventories consist of the following (amounts in thousands):

		December 31, 2006			March 31, 2006
Finished goods		$	81,652		$	58,876
Purchased parts and components		4,028			2,607
		$	85,680		$	61,483

 

6.              Goodwill and Other Intangible Assets

The changes in the carrying amount of goodwill for the nine months ended December 31, 2006 are as follows (amounts in thousands):

		Publishing			Distribution			Total
Balance as of March 31, 2006		$	95,094		$	5,352		$	100,446
Goodwill acquired during the period		87,257			—			87,257
Adjustment to prior period purchase allocation		51			—			51
Effect of foreign currency exchange rates		(5		)	649			644
Balance as of December 31, 2006		$	182,397		$	6,001		$	188,398

 

Goodwill acquired during the period represents goodwill related to the acquisition of RedOctane of $87.0 million and goodwill related to the acquisition of a recently acquired South Korean publishing company of $253,000.

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

For the Three and Nine Months ended December 31, 2006

(Unaudited)

7.              Income Taxes

The income tax provision of $40.0 million and $28.1 million for the three months and nine months ended December 31, 2006 reflects our effective income tax rate of 21.9%. This is lower than prior year as a result of improved profitability leading to utilization of net operating loss carry forwards and in turn a reduction in valuation allowances related to federal and state research and development tax credits, partially offset by the establishment of tax reserves. The significant items that generated the variance between our effective rate and our statutory rate of 35% were federal and state research and development tax credits and the impact of foreign tax rate differentials, offset by state taxes. The realization of deferred tax assets depends primarily on the generation of future taxable income. We believe that it is more likely than not that we will generate taxable income sufficient to realize the benefit of net deferred tax assets recognized.

The income tax expense of $25.2 million for the three months ended December 31, 2005 reflects our effective income tax rate for the quarter of 27.1%, which differs from our effective tax rate of 12.2% for the year ended March 31, 2006 primarily due to an increase in federal and state research and development credits for the full year ended March 31, 2006 over the amounts originally anticipated for the year.  The significant items that generated the variance between our effective rate and our federal statutory rate of 35% were research and development tax credits and the impact of foreign tax rate differentials, partially offset by state taxes.

8.              Software Development Costs and Intellectual Property Licenses

As of December 31, 2006, capitalized software development costs included $77.7 million of internally developed software costs and $24.1 million of payments made to third-party software developers. As of March 31, 2006, capitalized software development costs included $45.0 million of internally developed software costs and $15.6 million of payments made to third-party software developers. Capitalized intellectual property licenses were $93.4 million and $87.0 million as of December 31, 2006 and March 31, 2006, respectively. Amortization and write-offs of capitalized software development costs and intellectual property licenses were $79.2 million and $168.4 million for the nine months ended December 31, 2006 and 2005, respectively.

9.              Comprehensive Income (Loss) and Accumulated Other Comprehensive Income (Loss)

Comprehensive Income (Loss)

The components of comprehensive income (loss) for the three and nine months ended December 31, 2006 and 2005 were as follows (amounts in thousands):

 

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