NetFlix 2006 Annual Report Download - page 37

common stock. Our decision to incorporate implied volatility was based on our assessment that implied
volatility of publicly traded options in our common stock is expected to be more reflective of market
conditions and, therefore, can reasonably be expected to be a better indicator of expected volatility than
historical volatility of our common stock.
•Expected Life: We bifurcate our option grants into two employee groupings (executive and
non-executive) based on exercise behavior and consider several factors in determining the estimate of
expected life for each group, including the historical option exercise behavior and the terms and vesting
periods of the options granted. From the second quarter of 2006 through the fourth quarter of 2006, we
used an estimate of expected life of 4.5 years for one group and 3 years for the other group. We used an
estimate of expected life of 4 years for one group and 3 years for the other group from the second quarter
of 2005 through the first quarter of 2006.
We grant stock options to our employees on a monthly basis. Such stock options are designated as
non-qualified stock options and vest immediately. As a result of immediate vesting, stock-based compensation
expense determined under SFAS 123R is fully recognized upon the stock option grants and no estimate is
required for pre-vesting option forfeitures.
Income Taxes
We record a tax provision for the anticipated tax consequences of our reported results of operations. In
accordance with SFAS No. 109, Accounting for Income Taxes, the provision for income taxes is computed using
the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected
future tax consequences of temporary differences between the financial reporting and tax bases of assets and
liabilities, and for operating loss carryforwards. Deferred tax assets and liabilities are measured using the
currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are
expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount
that is believed more likely than not to be realized.
At December 31, 2004, our deferred tax assets, primarily the tax benefits of loss carryforwards, were offset
in full by a valuation allowance because of our history of losses through the first quarter of 2003, limited
profitable quarters to date and the competitive landscape of online DVD rentals. As a result of our analysis of
expected future income at December 31, 2005, it was considered more likely than not that a valuation allowance
for deferred tax assets was no longer required resulting in the release of a previously recorded allowance
generating a $34.9 million tax benefit. As of December 31, 2006, deferred tax assets do not include the tax
benefits attributable to approximately $56 million of excess tax deductions related to stock options. These
benefits will only be recorded when realized on tax returns and will be credited to equity at that time.
In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available
positive and negative evidence, including our past operating results, the existence of cumulative losses in the
most recent fiscal years and our forecast of future market growth, forecasted earnings, future taxable income, the
mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies. The
assumptions utilized in determining future taxable income require significant judgment and are consistent with
the plans and estimates we are using to manage the underlying businesses. We believe that the deferred tax assets
recorded on our balance sheet will ultimately be realized. In the event we were to determine that we would not be
able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets
would be charged to earnings in the period in which we make such determination.
Descriptions of Statement of Operations Components
Revenues:
Revenues include subscription revenues and revenues from the sale of advertising. We generate all our
revenues in the United States. We derive substantially all of our revenues from monthly subscription fees and
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