Adobe 2006 Annual Report Download - page 44

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We have to estimate provisions for returns which are recorded against our revenues. In determining our
estimate for returns, and in accordance with our internal policy regarding global channel inventory which is used
to determine the level of product held by our distributors on which we have recognized revenue, we rely upon
historical data, the estimated amount of product inventory in our distribution channel, the rate at which our
product sells through to the end user, product plans and other factors. Our estimated provisions for returns can
vary from what actually occurs. More or less product may be returned from what was estimated. The amount of
inventory in the channel could be different than what is estimated. Our estimate of the rate of sell through for
product in the channel could be different than what actually occurs. There could be a delay in the release of our
products. These factors and unanticipated changes in the economic and industry environment could make our
return estimates differ from actual returns, thus materially impacting our financial position and results of
operations.
Stock-based Compensation
We adopted the provisions of, and account for stock-based compensation in accordance with, Statement of
Financial Accounting Standard (“SFAS”) 123R during the first quarter of fiscal 2006. We elected the modified-
prospective method, under which prior periods are not revised for comparative purposes. Under the fair value
recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the
fair value of the award and is recognized as expense on a straight-line basis over the requisite service period,
which is the vesting period.
We currently use the Black-Scholes option pricing model to determine the fair value of stock options and
employee stock purchase plan shares. The determination of the fair value of stock-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 complex and subjective variables. These variables include our expected stock price volatility over the
term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and
expected dividends.
We estimate the expected term of options granted by calculating the average term from our historical stock
option exercise experience. As permitted by Staff Accounting Bulletin (“SAB”) 107, we estimate the volatility of
our common stock by using implied volatility in market traded options. Our decision to use implied volatility was
based upon the availability of actively traded options on our common stock and our assessment that implied
volatility is more representative of future stock price trends than historical volatility. We base the risk-free interest
rate that we use in the option pricing model on zero-coupon yields implied from U.S. Treasury issues with
remaining terms similar to the expected term on the options. We do not anticipate paying any cash dividends in
the foreseeable future and therefore use an expected dividend yield of zero in the option pricing model. We are
required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual
forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record
stock-based compensation expense only for those awards that are expected to vest. All share based payment
awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally
the vesting periods.
If factors change and we employ different assumptions for estimating stock-based compensation expense in
future periods or if we decide to use a different valuation model, the future periods may differ significantly from
what we have recorded in the current period and could materially affect our operating income, net income and net
income per share.
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options
that have no vesting restrictions and are fully transferable, characteristics not present in our option grants and
employee stock purchase plan shares. Existing valuation models, including the Black-Scholes and lattice binomial
models, may not provide reliable measures of the fair values of our stock-based compensation. Consequently,
there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may
bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of
those stock-based payments in the future. Certain stock-based payments, such as employee stock options, may
expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on
the grant date and reported in our financial statements. Alternatively, value may be realized from these