Digital River 2006 Annual Report Download - page 79

gross amount of product sales and related costs or the net amount earned as net revenue. We act as the
merchant of record on most of the transactions processed and have contractual relationships with our clients,
which obligate us to pay to the client a specified percentage of each sale. We derive our revenue primarily
from transaction fees based on a percentage of the products sale price and fees from services rendered
associated with the e-commerce and other services provided to our clients and end customers. Our revenue is
recorded at net as generally our clients are subject to inventory risks and control customers’ product choices.
Clients do not have the right to take possession of the software applications used in the delivery of services.
We also provide customers with various proprietary software backup services. We recognize revenue for
these back up services upon delivery or based upon historical usage within the contract period of the digital
backup services when this information is available. Digital backup services are recognized straight-line over
the life of the backup service when historical usage information is unavailable. Shipping revenues are recorded
net of any associated costs.
We also, to a lesser extent, provide fee-based client services, which include website design, custom
development and integration, analytical marketing and email marketing services. If we receive payments for
fee-based services in advance of delivery, these amounts are deferred and recognized over the service period.
Provisions for doubtful accounts and transaction losses and authorized credits are made at the time of
revenue recognition based upon our historical experience. The provision for doubtful accounts and transaction
losses are recorded as charges to operating expense, while the provision for authorized credits is recognized as
a reduction of net revenues.
Deferred Revenue
Deferred revenue is recorded when service payment is received in advance of performing our service
obligation. Revenue is recognized over either the estimated usage period when usage information is available,
or ratably over the service period when usage information is not available.
Advertising Costs
The costs of advertising are charged to sales and marketing expense as incurred. We incurred advertising
expense of $1.5 million, $0.1 million and $1.0 million in 2006, 2005 and 2004, respectively.
Income Taxes
Deferred income taxes reflect the tax effects of temporary differences between the carrying amounts of
assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We record
deferred tax assets for favorable tax attributes, including tax loss carryforwards. We currently have significant
U.S. tax loss carryforwards resulting from the tax deduction for exercise of stock options and acquired
operating tax loss carryforwards. The benefit of the loss carryforwards from exercise of stock options was
recognized as additional paid in capital when the deferred tax asset valuation allowance was reversed in the
fourth quarter of 2005. The benefit of the acquired tax loss carryforwards has been reserved by a valuation
allowance pursuant to United States generally accepted accounting principles. These valuation reserves of the
deferred tax asset will be reversed if and when it is more likely than not that the deferred tax asset will be
realized. We evaluate the need for a valuation allowance of the deferred tax asset on a quarterly basis.
Other Income, Net
Our other income, net line item is the total of interest income on our cash, cash equivalents, and short-
term investments, interest expense on our debt and foreign currency transaction gains and losses. Interest
income was $22.8 million, $9.7 million and $3.2 million in 2006, 2005 and 2004, respectively. Interest
expense was $2.5 million in 2006 compared with $2.5 million in 2005 and $1.5 million in 2004. Gains related
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DIGITAL RIVER, INC.
Notes to Consolidated Financial Statements — (Continued)