NetFlix 2006 Annual Report Download - page 67

NETFLIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except share and per share data and percentages)
accounting for interim periods, disclosure and transition of uncertain tax positions. The interpretation is effective
for fiscal years beginning after December 15, 2006. The Company does not expect the adoption of this standard
to have a material effect on its financial position or results of operations.
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Instruments which
amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities and SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS No. 155
allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need
to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value
basis. SFAS No. 155 also clarifies and amends certain other provisions of SFAS No. 133 and SFAS No. 140.
This statement is effective for all financial instruments acquired or issued in fiscal years beginning after
September 15, 2006. The Company does not expect the adoption of this standard to have a material effect on its
financial position or results of operations.
2. DVD Library
The Company acquires DVDs from studios and distributors through either direct purchases or revenue
sharing agreements. The Company acquires DVDs for the purpose of renting them to its subscribers and earning
subscription rental revenues and as such, the Company considers its DVD library to be a productive asset.
Accordingly, the Company classifies its DVD Library as a non-current asset on its Consolidated Balance Sheet.
Additionally, in accordance with SFAS No. 95, Statement of Cash Flows, cash outflows for the acquisition of the
DVD Library, net of changes in Accounts payable, are classified as cash flows from investing activities on the
Company’s Consolidated Statements of Cash Flows. This is inclusive of any upfront non-refundable payments
required under revenue sharing agreements.
The Company amortizes its 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-catalog DVDs
is estimated to be 1 year and 3 years, respectively. In estimating the useful life of the DVD library, the Company
takes into account library utilization as well as an estimate for lost or damaged DVDs. Volume purchase
discounts received from studios on the purchase of titles are recorded as a reduction of DVD library inventory
when earned.
Prior to July 1, 2004, the Company amortized the cost of its 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 a periodic evaluation of both new release and back-catalog utilization for amortization purposes, the Company
determined that back-catalog titles have a significantly longer life than previously estimated. As a result, the
Company revised the estimate of useful life for the back-catalog 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 was to more accurately reflect the productive life of these assets. In accordance with
Accounting Principles Board Opinion No. 20, Accounting Changes (“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-
catalog 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.
In the third quarter of 2004, the Company determined that it was selling fewer previously rented DVDs than
estimated but at an average selling price higher than historically estimated. The Company therefore revised its
estimate of salvage values on direct purchase DVDs. For those direct purchase DVDs that the Company
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