LeapFrog 2011 Annual Report Download - page 62

LEAPFROG ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except per share data)
considerable judgment in selecting comparable companies and estimating the multiples of revenue implied by
their market values. The discounted cash flow methodology requires management to exercise judgment in
selecting an appropriate discount rate and to make numerous assumptions in order to develop future business
and financial forecasts and the related estimates of future net cash flows. Future net cash flows depend
primarily on future sales of our products, which are inherently difficult to predict. This is especially true when
a significant portion of our future net sales is expected to be generated by both mature products as well as
products introduced in 2011 and planned to be introduced in 2012.
Research and Development Costs
Internal and external research and development costs incurred before a project reaches technological feasibility
are expensed as incurred. External costs incurred after a project reaches technological feasibility are
capitalized. Capitalized costs are amortized into cost of sales when the product is released to the market, over
two years using the straight-line method. Capitalized research and development costs are reviewed for future
recoverability periodically. Impairment losses are charged to cost of sales in the period in which they occur.
Advertising Expense
Production costs of commercials and programming are expensed when the production is first aired. The
Company’s direct costs of advertising, in-store displays and promotion programs are expensed as incurred.
Under arrangements with certain of its customers, the Company reduces the net selling price of its products as
an incentive (sales allowances) for the customers to independently promote LeapFrog products for resale. If
the benefits LeapFrog receives from the customer in these cooperative sales or advertising arrangements are
not specifically identifiable, the Company recognizes the costs as a direct reduction of revenue earned from
the customer during the period, with a corresponding reduction in accounts receivable. In those cases where
the benefits received from the customer are sufficiently separable and can be specifically identified, these costs
are included as advertising expense during the fiscal period in which the advertisements are run.
Royalty Expense
The Company licenses certain of its content from third parties under exclusive and nonexclusive agreements,
which permit the Company to utilize characters, stories, music, illustrations and trade names throughout
specified geographic territories. Royalty payments are typically calculated as a percentage of the unit product
selling price. Royalty expense is recorded when products are shipped to a customer or upon delivery of
content via the App Center, and is reported under cost of sales in the statements of operations.
Derivative Financial Instruments
The Company transacts business in various foreign currencies, primarily in the British Pound, Canadian
Dollar, Euro and Mexican Peso. As a safeguard against financial exposure from potential adverse changes in
currency exchange rates, the Company engages in a foreign exchange hedging program. The program utilizes
foreign exchange forward contracts that generally settle within 30 days to enter into fair value hedges of
foreign currency exposures of underlying non-functional currency assets and liabilities that are subject to
re-measurement. The exposures are generated primarily through inter-company sales in foreign currencies and
through U.S. Dollar-denominated sales by the Company’s foreign affiliates. The hedging program is designed
to reduce, but does not always eliminate, the impact of the re-measurement of balance sheet items due to
movements of currency exchange rates.
LeapFrog does not use forward exchange hedging contracts for speculative or trading purposes. All forward
contracts are carried on the balance sheet at fair value as assets or liabilities. The estimated fair values of
forward contracts are based on quoted market prices for similar assets and liabilities. The corresponding gains
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