NetFlix 2004 Annual Report Download - page 30

based upon information presently available. Actual results may differ significantly from these estimates under
different assumptions, judgments or conditions.
Amortization of DVD Library and Upfront Costs
We acquire DVDs from studios and distributors through either direct purchases or revenue sharing
agreements. The revenue sharing agreements enable us to obtain DVDs at a lower upfront cost than under
traditional direct purchase arrangements. Under the revenue sharing agreements, we share a percentage of the
actual net revenues generated by the use of each particular title with the studios over a fixed period of time, or the
Title Term, which is typically twelve months for each DVD title. At the end of the Title Term, we generally have
the option of returning the DVD title to the studio, destroying the title or purchasing the title.
In addition, we remit an upfront payment to acquire titles from the studios and distributors under revenue
sharing agreements. This payment includes a contractually specified initial fixed license fee that is capitalized
and amortized in accordance with our DVD library amortization policy. In some cases, this payment also
includes a contractually specified prepayment of future revenue sharing obligations that is classified as prepaid
revenue sharing expense and is charged to expense as future revenue sharing obligations are incurred. We
amortize our DVD library, less estimated salvage value, on a “sum-of-the-months” accelerated basis over its
estimated useful life. The useful life of the new-release DVDs and back-catalogue DVDs is estimated to be 1
year and 3 years, respectively. In estimating the useful life of our DVD library, we take into account library
utilization as well as an estimate for lost or damaged DVDs.
Prior to July 1, 2004, we amortized the cost of our entire DVD library, including the capitalized portion of
the initial fixed license fee, on a “sum-of-the-months” accelerated basis over one year. However, based on our
periodic evaluation of both new release and back-catalogue utilization for amortization purposes, we determined
that back-catalogue titles have a significantly longer life than previously estimated. As a result, we have revised
our estimate of useful life for the back-catalogue DVD library from a “sum of the months” accelerated method
using a one-year life to the same accelerated method of amortization using a three-year life. The purpose of this
change is to more accurately reflect the productive life of these assets. In accordance with APB 20, the change in
life has been accounted for as a change in accounting estimate on a prospective basis from July 1, 2004. New
releases will continue to be amortized over a one-year period. As a result of the change in the estimated life of
the back-catalogue library, total cost of revenues was $10.9 million lower, net income was $10.9 million higher
and net income per diluted share was $0.17 higher for the year ended December 31, 2004.
We believe the use of the accelerated method is appropriate for the amortization of our DVD library and the
initial fixed license fee because it approximates DVD utilization.
In addition, we have also determined that we are selling fewer previously rented DVDs than estimated but at
an average selling price higher than historically estimated. We have therefore revised our estimate of salvage
values, on direct purchase DVDs. For those direct purchase DVDs that we estimate we will sell at the end of their
useful lives, a salvage value of $3.00 per DVD has been provided effective July 1, 2004. For those DVDs that we
do not expect to sell, no salvage value is provided. Simultaneously with the change in estimate of expected
salvage value we recorded a write-off of approximately $1.9 million related to non-recoverable salvage value. As
a result of this write-off, total cost of revenues was $1.9 million higher, net income was $1.9 million lower and
net income per diluted share was $0.03 lower for the year ended December 31, 2004.
We will continue to periodically evaluate the useful lives and salvage values of our DVD library.
Stock-Based Compensation
We account for stock-based compensation expenses in accordance with the fair value recognition provisions
of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation,
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