rst-10q_20190630.htm

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2019

Commission file number: 1-34283

 

Rosetta Stone Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

(State of incorporation)

 

043837082

(I.R.S. Employer

Identification No.)

 

 

 

1621 North Kent Street, Suite 1200

Arlington, Virginia

(Address of principal executive offices)

 

22209

(Zip Code)

703-387-5800

(Registrant’s telephone number, including area code)

 

N/A

(Former name or former address, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes    No 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes    No 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer

 

Accelerated filer

 

Non-accelerated filer

 

Smaller reporting company 

 

Emerging growth company

 

 

 

 

 (Do not check if a smaller reporting company)

 

 

 

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.     

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes    No 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

Trading Symbol(s)

Name of each exchange on which registered

Common Stock, par value $0.00005 per share

RST

New York Stock Exchange

 

Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the latest practicable date.

As of July 29, 2019, there were 24,030,865 shares of the registrant’s Common Stock, $.00005 par value, outstanding.

 

 

 


 

ROSETTA STONE INC.

 

Table of Contents

 

 

 

Page

PART I. FINANCIAL INFORMATION

 

Item 1

Financial Statements (unaudited)

3

Item 2

Management's Discussion and Analysis of Financial Condition and Results of Operations

31

Item 3

Quantitative and Qualitative Disclosures About Market Risk

41

Item 4

Controls and Procedures

42

PART II. OTHER INFORMATION

 

Item 1

Legal Proceedings

43

Item 1A

Risk Factors

43

Item 2

Unregistered Sales of Equity Securities and Use of Proceeds

57

Item 3

Defaults Upon Senior Securities

57

Item 4

Mine Safety Disclosures

57

Item 5

Other Information

57

Item 6

Exhibits

58

Signatures

 

59

 

 

2


Table of Contents

 

PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements

ROSETTA STONE INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

(unaudited)

 

 

 

As of

 

 

 

June 30, 2019

 

 

December 31, 2018

 

Assets

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

20,773

 

 

$

38,092

 

Restricted cash

 

 

33

 

 

 

82

 

Accounts receivable (net of allowance for doubtful accounts of $398 and $372 at June 30, 2019 and December 31, 2018, respectively)

 

 

25,660

 

 

 

21,950

 

Inventory

 

 

1,652

 

 

 

933

 

Deferred sales commissions

 

 

10,103

 

 

 

11,597

 

Prepaid expenses and other current assets

 

 

4,773

 

 

 

4,041

 

Total current assets

 

 

62,994

 

 

 

76,695

 

Deferred sales commissions

 

 

6,096

 

 

 

6,933

 

Property and equipment, net

 

 

39,891

 

 

 

36,405

 

Operating lease right-of-use assets

 

 

6,373

 

 

 

 

Intangible assets, net

 

 

15,080

 

 

 

15,850

 

Goodwill

 

 

49,162

 

 

 

49,239

 

Other assets

 

 

1,870

 

 

 

2,136

 

Total assets

 

$

181,466

 

 

$

187,258

 

Liabilities and stockholders' deficit

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

Accounts payable

 

$

8,472

 

 

$

8,938

 

Accrued compensation

 

 

7,444

 

 

 

9,046

 

Income tax payable

 

 

283

 

 

 

328

 

Operating lease liabilities

 

 

1,611

 

 

 

 

Borrowings under credit facility

 

 

9,900

 

 

 

 

Other current liabilities

 

 

12,278

 

 

 

13,925

 

Deferred revenue

 

 

94,170

 

 

 

113,378

 

Total current liabilities

 

 

134,158

 

 

 

145,615

 

Deferred revenue

 

 

48,661

 

 

 

49,507

 

Deferred income taxes

 

 

2,261

 

 

 

2,776

 

Operating lease liabilities

 

 

4,657

 

 

 

 

Other long-term liabilities

 

 

1,099

 

 

 

1,368

 

Total liabilities

 

 

190,836

 

 

 

199,266

 

Commitments and contingencies (Note 11)

 

 

 

 

 

 

 

 

Stockholders' deficit:

 

 

 

 

 

 

 

 

Preferred stock, $0.001 par value; 10,000 and 10,000 shares authorized, zero and zero shares issued and outstanding at June 30, 2019 and December 31, 2018, respectively)

 

 

 

 

 

 

Non-designated common stock, $0.00005 par value, 190,000 and 190,000 shares authorized, 25,017 and 24,426 shares issued, and 24,017 and 23,426 shares outstanding, at June 30, 2019 and December 31, 2018, respectively)

 

 

2

 

 

 

2

 

Additional paid-in capital

 

 

208,396

 

 

 

202,355

 

Treasury stock, at cost; 1,000 and 1,000 shares at June 30, 2019 and December 31, 2018, respectively)

 

 

(11,435

)

 

 

(11,435

)

Accumulated loss

 

 

(202,943

)

 

 

(199,592

)

Accumulated other comprehensive loss

 

 

(3,390

)

 

 

(3,338

)

Total stockholders' deficit

 

 

(9,370

)

 

 

(12,008

)

Total liabilities and stockholders' deficit

 

$

181,466

 

 

$

187,258

 

 

See accompanying notes to consolidated financial statements

3


Table of Contents

 

ROSETTA STONE INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

 

 

 

Three months ended June 30,

 

 

Six months ended June 30,

 

 

 

2019

 

 

2018

 

 

2019

 

 

2018

 

Revenue

 

$

45,942

 

 

$

43,502

 

 

$

90,553

 

 

$

86,310

 

Cost of revenue

 

 

8,861

 

 

 

7,930

 

 

 

17,287

 

 

 

17,364

 

Gross profit

 

 

37,081

 

 

 

35,572

 

 

 

73,266

 

 

 

68,946

 

Operating expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

25,800

 

 

 

24,874

 

 

 

49,038

 

 

 

49,065

 

Research and development

 

 

5,776

 

 

 

6,019

 

 

 

11,514

 

 

 

12,325

 

General and administrative

 

 

8,566

 

 

 

8,324

 

 

 

17,258

 

 

 

16,856

 

Total operating expenses

 

 

40,142

 

 

 

39,217

 

 

 

77,810

 

 

 

78,246

 

Loss from operations

 

 

(3,061

)

 

 

(3,645

)

 

 

(4,544

)

 

 

(9,300

)

Other income and (expense):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

9

 

 

 

23

 

 

 

42

 

 

 

48

 

Interest expense

 

 

(99

)

 

 

(81

)

 

 

(159

)

 

 

(164

)

Other income and (expense)

 

 

519

 

 

 

(1

)

 

 

1,315

 

 

 

(229

)

Total other income and (expense)

 

 

429

 

 

 

(59

)

 

 

1,198

 

 

 

(345

)

Loss before income taxes

 

 

(2,632

)

 

 

(3,704

)

 

 

(3,346

)

 

 

(9,645

)

Income tax expense

 

 

175

 

 

 

454

 

 

 

5

 

 

 

915

 

Net loss

 

$

(2,807

)

 

$

(4,158

)

 

$

(3,351

)

 

$

(10,560

)

Loss per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.12

)

 

$

(0.18

)

 

$

(0.14

)

 

$

(0.47

)

Diluted

 

$

(0.12

)

 

$

(0.18

)

 

$

(0.14

)

 

$

(0.47

)

Common shares and equivalents outstanding:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average shares

 

 

23,455

 

 

 

22,663

 

 

 

23,247

 

 

 

22,561

 

Diluted weighted average shares

 

 

23,455

 

 

 

22,663

 

 

 

23,247

 

 

 

22,561

 

 

See accompanying notes to consolidated financial statements

4


Table of Contents

 

ROSETTA STONE INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(unaudited)

 

 

 

Three months ended June 30,

 

 

Six months ended June 30,

 

 

 

2019

 

 

2018

 

 

2019

 

 

2018

 

Net loss

 

$

(2,807

)

 

$

(4,158

)

 

$

(3,351

)

 

$

(10,560

)

Other comprehensive loss, net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation loss

 

 

(265

)

 

 

(610

)

 

 

(52

)

 

 

(81

)

Other comprehensive loss

 

 

(265

)

 

 

(610

)

 

 

(52

)

 

 

(81

)

Comprehensive loss

 

$

(3,072

)

 

$

(4,768

)

 

$

(3,403

)

 

$

(10,641

)

 

See accompanying notes to consolidated financial statements

5


Table of Contents

 

ROSETTA STONE INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

 

Six months ended June 30,

 

 

 

2019

 

 

2018

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

 

 

 

Net loss

 

$

(3,351

)

 

$

(10,560

)

Non-cash adjustments to reconcile net loss to cash used in operating activities:

 

 

 

 

 

 

 

 

Stock-based compensation expense

 

 

2,576

 

 

 

1,936

 

Loss on foreign currency transactions

 

 

191

 

 

 

120

 

Bad debt expense

 

 

123

 

 

 

61

 

Depreciation and amortization

 

 

6,986

 

 

 

7,089

 

Operating lease costs

 

 

1,059

 

 

 

 

Deferred income tax (benefit) expense

 

 

(515

)

 

 

117

 

Gain on disposal or sale of assets

 

 

(1,394

)

 

 

(17

)

Amortization of deferred financing costs

 

 

33

 

 

 

68

 

Net change in:

 

 

 

 

 

 

 

 

Accounts receivable

 

 

(3,826

)

 

 

1,131

 

Inventory

 

 

(718

)

 

 

1,423

 

Deferred sales commissions

 

 

2,332

 

 

 

1,648

 

Prepaid expenses and other current assets

 

 

(819

)

 

 

90

 

Income tax receivable or payable

 

 

(49

)

 

 

(347

)

Other assets

 

 

(89

)

 

 

(401

)

Accounts payable

 

 

(466

)

 

 

1,609

 

Accrued compensation

 

 

(1,027

)

 

 

(4,588

)

Other current liabilities

 

 

(1,324

)

 

 

(3,548

)

Operating lease liabilities

 

 

(1,060

)

 

 

 

Other long-term liabilities

 

 

(31

)

 

 

 

Deferred revenue

 

 

(20,045

)

 

 

(10,565

)

Net cash used in operating activities

 

 

(21,414

)

 

 

(14,734

)

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

 

 

 

Purchases of property and equipment

 

 

(9,709

)

 

 

(8,136

)

Proceeds from sale of assets

 

 

1,396

 

 

 

17

 

Net cash used in investing activities

 

 

(8,313

)

 

 

(8,119

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

 

 

 

Proceeds from the exercise of stock options

 

 

2,887

 

 

 

1,316

 

Proceeds from borrowings under credit facility

 

 

10,500

 

 

 

 

Repayments of borrowings under credit facility

 

 

(600

)

 

 

 

Payment of deferred financing costs

 

 

(47

)

 

 

 

Payments under financing lease liabilities

 

 

(222

)

 

 

(225

)

Net cash provided by financing activities

 

 

12,518

 

 

 

1,091

 

Decrease in cash, cash equivalents, and restricted cash

 

 

(17,209

)

 

 

(21,762

)

Effect of exchange rate changes in cash, cash equivalents, and restricted cash

 

 

(159

)

 

 

(276

)

Net decrease in cash, cash equivalents, and restricted cash

 

 

(17,368

)

 

 

(22,038

)

Cash, cash equivalents, and restricted cash—beginning of period

 

 

38,174

 

 

 

43,036

 

Cash, cash equivalents, and restricted cash—end of period

 

$

20,806

 

 

$

20,998

 

SUPPLEMENTAL CASH FLOW DISCLOSURE:

 

 

 

 

 

 

 

 

Cash paid during the periods for:

 

 

 

 

 

 

 

 

Interest

 

$

126

 

 

$

97

 

Income taxes, net of refund

 

$

575

 

 

$

1,028

 

Noncash operating, investing and financing activities:

 

 

 

 

 

 

 

 

Accrued liability for purchase of property and equipment

 

$

1,341

 

 

$

1,068

 

 

See accompanying notes to consolidated financial statements

6


Table of Contents

 

ROSETTA STONE INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Non-Designated

 

 

Additional

 

 

 

 

 

 

 

 

 

 

Other

 

 

Total

 

 

 

Common Stock

 

 

Paid-in

 

 

Treasury

 

 

Accumulated

 

 

Comprehensive

 

 

Stockholders'

 

 

 

Shares

 

 

Amount

 

 

Capital

 

 

Stock

 

 

Loss

 

 

Loss

 

 

Deficit

 

Balance—January 1, 2019

 

 

22,912

 

 

$

2

 

 

$

202,355

 

 

$

(11,435

)

 

$

(199,592

)

 

$

(3,338

)

 

$

(12,008

)

Stock issued upon the exercise of stock options

 

 

67

 

 

 

 

 

 

744

 

 

 

 

 

 

 

 

 

 

 

 

744

 

Restricted stock award and performance stock unit vesting

 

 

270

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrestricted common stock issued in lieu of cash bonus

 

 

37

 

 

 

 

 

 

576

 

 

 

 

 

 

 

 

 

 

 

 

576

 

Stock-based compensation expense

 

 

 

 

 

 

 

 

1,220

 

 

 

 

 

 

 

 

 

 

 

 

1,220

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(544

)

 

 

 

 

 

(544

)

Other comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

213

 

 

 

213

 

Balance—March 31, 2019

 

 

23,286

 

 

$

2

 

 

$

204,895

 

 

$

(11,435

)

 

$

(200,136

)

 

$

(3,125

)

 

$

(9,799

)

Stock issued upon the exercise of stock options

 

 

206

 

 

 

 

 

 

2,145

 

 

 

 

 

 

 

 

 

 

 

 

2,145

 

Restricted stock award and performance stock unit vesting

 

 

70

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation expense

 

 

 

 

 

 

 

 

1,356

 

 

 

 

 

 

 

 

 

 

 

 

1,356

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(2,807

)

 

 

 

 

 

(2,807

)

Other comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(265

)

 

 

(265

)

Balance—June 30, 2019

 

 

23,562

 

 

$

2

 

 

$

208,396

 

 

$

(11,435

)

 

$

(202,943

)

 

$

(3,390

)

 

$

(9,370

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Non-Designated

 

 

Additional

 

 

 

 

 

 

 

 

 

 

Other

 

 

Total

 

 

 

Common Stock

 

 

Paid-in

 

 

Treasury

 

 

Accumulated

 

 

Comprehensive

 

 

Stockholders'

 

 

 

Shares

 

 

Amount

 

 

Capital

 

 

Stock

 

 

Loss

 

 

Loss

 

 

Equity / (Deficit)

 

Balance—January 1, 2018

 

 

22,316

 

 

$

2

 

 

$

195,644

 

 

$

(11,435

)

 

$

(178,890

)

 

$

(2,898

)

 

$

2,423

 

Stock issued upon the exercise of stock options

 

 

54

 

 

 

 

 

 

467

 

 

 

 

 

 

 

 

 

 

 

 

467

 

Restricted stock award and performance stock unit vesting

 

 

167

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation expense

 

 

 

 

 

 

 

 

583

 

 

 

 

 

 

 

 

 

 

 

 

583

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(6,402

)

 

 

 

 

 

(6,402

)

Cumulative effect adjustment - adoption of ASC 606

 

 

 

 

 

 

 

 

 

 

 

 

 

 

771

 

 

 

 

 

 

771

 

Other comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

529

 

 

 

529

 

Balance—March 31, 2018

 

 

22,537

 

 

$

2

 

 

$

196,694

 

 

$

(11,435

)

 

$

(184,521

)

 

$

(2,369

)

 

$

(1,629

)

Stock issued upon the exercise of stock options

 

 

85

 

 

 

 

 

 

850

 

 

 

 

 

 

 

 

 

 

 

 

850

 

Restricted stock award and performance stock unit vesting

 

 

147

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation expense

 

 

 

 

 

 

 

 

1,352

 

 

 

 

 

 

 

 

 

 

 

 

1,352

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(4,158

)

 

 

 

 

 

(4,158

)

Other comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(610

)

 

 

(610

)

Balance—June 30, 2018

 

 

22,769

 

 

$

2

 

 

$

198,896

 

 

$

(11,435

)

 

$

(188,679

)

 

$

(2,979

)

 

$

(4,195

)

 

See accompanying notes to consolidated financial statements

 

 

7


Table of Contents

 

ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

1. NATURE OF OPERATIONS

Rosetta Stone Inc. and its subsidiaries ("Rosetta Stone," or the "Company") develop, market and support a suite of language-learning and literacy solutions consisting of web-based software subscriptions, perpetual software products, online and professional services, audio practice products and mobile applications. The Company's offerings are sold on a direct basis and through select third party retailers and distributors. The Company provides its solutions to customers through the sale of web-based software subscriptions, mobile applications, and packaged software, domestically and in certain international markets.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Rosetta Stone Inc. and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Certain numbers in the prior period consolidated financial statements have been reclassified to conform to the current period presentation.

Basis of Presentation

The accompanying consolidated financial statements are unaudited. These unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP") and applicable rules and regulations of the Securities and Exchange Commission ("SEC") regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s most recent Annual Report on Form 10-K filed with the SEC on March 6, 2019. The June 30, 2019 consolidated balance sheet included herein includes account balances as of December 31, 2018 that were derived from the audited financial statements as of that date. The Consolidated Financial Statements and the Notes to the Consolidated Financial Statements do not include all disclosures required for annual financial statements and notes.

As discussed in this Note 2 and Note 7, the Company adopted the new lease standard (“ASC 842”) effective January 1, 2019 using the modified retrospective approach. The Company elected the comparatives under 840 option, and as such, the comparative information has not been restated under ASC 842 and continues to be reported under the accounting standards in effect for those prior comparative periods. See the Company’s Annual Report on Form 10-K filed with the SEC on March 6, 2019 for lease policies that were in effect in prior periods before adoption of ASC 842.

Except as noted above, the unaudited interim consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Company’s statements of financial position at June 30, 2019 and December 31, 2018, the Company’s results of operations and stockholders’ equity activity for the three and six months ended June 30, 2019 and 2018, and its cash flows for the six months ended June 30, 2019 and June 30, 2018 have been made. The results for the three and six months ended June 30, 2019 are not necessarily indicative of the results to be expected for the year ending December 31, 2019. All references to June 30, 2019 or to the three and six months ended June 30, 2019 and 2018 in the notes to the consolidated financial statements are unaudited.

Use of Estimates

The preparation of financial statements in accordance with GAAP requires management to make certain estimates and assumptions. The amounts reported in the consolidated financial statements include significant estimates and assumptions that have been made, including, but not limited to, those related to revenue recognition, allowance for doubtful accounts, estimated sales returns and reserves, stock-based compensation, fair value of intangibles and goodwill, disclosure of contingent assets and liabilities, disclosure of contingent litigation, allowance for valuation of deferred tax assets, and the Company's quarterly going concern assessment. The Company bases its estimates and assumptions on historical experience and on various other judgments that are believed to be reasonable under the circumstances. The Company continuously evaluates its estimates and assumptions. Actual results may differ from these estimates and assumptions.

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ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

Recently Issued Accounting Standards

Accounting Standards Adopted During the Period: During 2019, the Company adopted the following recently issued Accounting Standard Updates ("ASU"):

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), which was further amended by additional ASUs that collectively created ASC 842. Under ASC 842, entities are required to record most leases on their balance sheets. A lessee would recognize a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. Lease expense recognition guidance was largely unchanged. ASC 842 was effective for the Company on January 1, 2019 and was adopted on that date using the modified retrospective approach and the Company elected the comparatives under 840 option. In accordance with the standard, the comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. ASC 842 provided a package of practical expedients that allow an entity to not reassess (1) whether any expired or existing contracts contain a lease, (2) the lease classification of any expired or existing lease, and (3) initial direct costs for any existing leases. The Company elected to apply the package of practical expedients and adoption of ASC 842 did not result in the recognition of a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The most significant impacts of ASC 842 adoption as of January 1, 2019 related to (1) the recognition of $5.3 million in operating right-of-use assets and a corresponding total of $5.2 million in total operating lease liabilities on the Company’s balance sheet, and (2) the additional presentation and disclosure requirements that are further discussed in Note 7 “Leases”. Prior to the adoption of ASC 842, operating leases were not included on the balance sheets.

Accounting Standards Not Yet Adopted: The following ASUs were recently issued but have not yet been adopted by the Company:

In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement ("ASU 2018-13"). ASU 2018-13 modifies the disclosure requirements for fair value measurements by removing, modifying, or adding certain disclosures. ASU 2018-13 is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years, with early adoption permitted for any eliminated or modified disclosures. The Company is in the process of evaluating the effect of adopting this new accounting guidance to determine the impact it may have on the Company’s consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment ("ASU 2017-04"). ASU 2017-04 simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test. ASU 2017-04 is effective for annual and interim goodwill tests beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates on or after January 1, 2017. The Company is in the process of evaluating the guidance. Given the prospective adoption application, there is no impact on the Company's historical consolidated financial statements and disclosures.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). ASU 2016-13 changes the methodology for measuring credit losses of financial instruments and the timing of when such losses are recorded. ASU 2016-13 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019. Early adoption is permitted, however the Company anticipates adopting ASU 2016-13 effective January 1, 2020. The Company is in the process of evaluating the impact of the new guidance on the Company's consolidated financial statements and disclosures. However based on a preliminary assessment and as the Company does not hold significant financial instruments, the Company does not expect the adoption of this guidance to have a material impact on its consolidated financial statements.

Revenue Recognition

Nature of Revenue: The Company accounts for revenue contracts with customers by applying the requirements of ASC topic 606, Revenue from Contracts with Customers, ("ASC 606"), which includes the following steps:

 

Identification of the contract, or contracts with a customer.

 

Identification of the performance obligations in the contract.

 

Determination of the transaction price.

 

Allocation of the transaction price to the performance obligations in the contract.

 

Recognition of the revenue when, or as, the Company satisfies a performance obligation.

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ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

The Company's primary sources of revenue are web-based software subscriptions, mobile applications, online services, and professional services.

Revenue is recognized upon transfer of control of promised goods or services to customers in an amount that reflects the consideration expected to be received in exchange for those goods or services. Revenue is recognized net of allowances for returns. Revenue is also recognized net of any taxes collected from customers, which are subsequently remitted to governmental authorities.

The majority of our revenue is recognized from non-cancellable web-based software subscriptions, online services, professional services, and mobile applications. Subscription revenue is generated from contracts with customers that provide access to hosted software over a contract term without the customer taking possession of the software. Subscription revenue is recognized ratably over the contract period as the performance obligation is satisfied. Subscription revenue is generated by all three reportable segments and range from short-term to multi-year contracts. Online services are typically sold in short-term service periods and include dedicated online conversational coaching services and access to online communities of language learners. Professional services include implementation services. Online services revenue and professional services revenue are recognized as the services are provided. Expired services are forfeited and revenue is recognized upon expiry.

Performance Obligations: A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account in ASC 606. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. The Company’s performance obligations are satisfied at a point in time or over time as delivery occurs or as work progresses.

Significant Judgments: Some of the Company’s contracts with customers include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately, versus together, requires significant judgment. This includes determining whether distinct services are part of a series of distinct services that are substantially the same. When subscription services are sold with professional services, judgment is required to determine whether the professional services are distinct and can be accounted for separately. In the E&E Language segment, the Company has concluded that each promised service within the language-learning subscription is delivered concurrently with all other promised services over the contract term and, as such, concluded that these promises are a single performance obligation that includes a series of distinct services that have the same pattern of transfer to the customer. When there are multiple performance obligations, revenue is allocated to each performance obligation based on its relative standalone selling price (“SSP”). Judgment is required to determine the SSP for each distinct performance obligation where SSP is not directly observable, such as when the product or service is not sold separately, SSP is determined using internally published price lists which include suggested sales prices for each performance obligation based on the type of client and volume purchased. These price lists are derived from past experience and from the expectation of obtaining a reasonable margin based on the cost to fulfill each performance obligation.

Subscription revenue is recognized ratably over the contract period as the performance obligation is satisfied. Certain Consumer Language offerings have contracts with no fixed duration and are marketed as lifetime subscriptions. For these lifetime subscriptions, the Company estimates the expected contract period as the greater of the typical customer usage period or the longest fixed-period duration subscription that is currently marketed. The Company's current expected contract period for lifetime subscriptions is 24 months.

Certain Consumer Language offerings are sold with a right of return and the Company may provide other credits or incentives. These rights are accounted for as variable consideration when estimating the amount of revenue to recognize by utilizing the expected value method. Returns and credits are estimated at contract inception based on historical return rates, estimated channel inventory levels, the timing of new product introductions and other factors. Reserves for returns and credits are updated at the end of each reporting period as additional information becomes available.

The Company distributes its products and services both directly to the end customer and indirectly through resellers. Resellers earn commissions generally calculated as a fixed percentage of the gross sale amount to the end customer. The Company evaluates each of its reseller relationships to determine whether it is the principal (where revenue is recognized at the gross amount) or agent (where revenue is recognized net of the reseller commission). In making this determination the Company evaluates a variety of factors including the amount of control the Company is able to exercise over the transactions.

Contract Balances: The timing of revenue recognition, invoicing, and cash collection results in accounts receivable and deferred revenue in the consolidated balance sheets. Payment from customers is often received in advance of services being provided, resulting in deferred revenue. Accounts receivable is recorded when there is an executed customer contract and the right to the consideration becomes unconditional. Contract assets such as unbilled receivables are not material.

The allowance for doubtful accounts reflects the best estimate of probable losses inherent in the accounts receivable balance. The Company establishes an allowance for doubtful accounts based on specific risks identified, historical experience, and other currently available evidence.

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ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

Payment terms and conditions vary by contract type and customer. For the E&E Language and Literacy segments, payment terms generally range from 30 to 90 days. In the Consumer Language segment, resellers and mobile app stores are generally granted payment terms between 30 to 45 days. Within Consumer Language, sales to end customers via the Rosetta Stone ecommerce website are done by credit card, which generally are settled within 7-10 days and may be made in installments. In instances where the timing of revenue recognition differs from the timing of invoicing, the Company has determined that contracts generally do not include a significant financing component. The primary purpose of invoicing terms is to provide customers with simplified and predictable ways of purchasing products and services and not to provide customers with financing.

Deferred revenue is comprised mainly of unearned revenue related to subscription services which is recognized ratably over the subscription period. Deferred revenue also includes payments for professional services and online services to be performed in the future which are earned as revenue when the service is provided. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, contract backlog is not material. See Note 10 "Revenue and Deferred Revenue" for additional disclosures.

Assets Recognized from Costs to Obtain a Contract with a Customer: The Company recognizes an asset for the incremental costs of obtaining a contract with a customer, which primarily represents sales commissions paid when a customer contract is either recorded as revenue or deferred revenue. Sales commissions paid to obtain non-cancellable subscription contracts are deferred and amortized in proportion to the period over which the revenue is recognized from the related contract. Deferred sales commissions are amortized to sales and marketing expense on the consolidated statements of operations. Deferred sales commissions are classified as non-current unless the associated amortization period is one year or less.

Income Taxes

The Company accounts for income taxes in accordance with ASC topic 740, Income Taxes ("ASC 740"), which provides for an asset and liability approach to accounting for income taxes. Deferred tax assets and liabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilities versus the tax basis of assets and liabilities. Under this method, deferred tax assets are recognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred liabilities are recognized for taxable temporary differences. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The impact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted. See Note 15 "Income Taxes" for additional disclosures.

Deferred Tax Valuation Allowance

The Company has recorded a valuation allowance offsetting certain of its deferred tax assets as of June 30, 2019. When measuring the need for a valuation allowance on a jurisdiction by jurisdiction basis, the Company assesses both positive and negative evidence regarding whether these deferred tax assets are realizable. In determining deferred tax assets and valuation allowances, the Company is required to make judgments and estimates related to projections of profitability, the timing and extent of the utilization of temporary differences, net operating loss carryforwards, tax credits, applicable tax rates, transfer pricing methodologies and tax planning strategies. The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidence exists to support a reversal. Because evidence such as the Company’s operating results during the most recent three-year period is afforded more weight than forecasted results for future periods, the Company’s cumulative loss in certain jurisdictions represents significant negative evidence in the determination of whether deferred tax assets are more likely than not to be utilized in certain jurisdictions. The Company will release this valuation allowance when it is determined that it is more likely than not that its deferred tax assets will be realized. Any future release of valuation allowance may be recorded as a tax benefit increasing net income.

Fair Value of Financial Instruments

The Company values its assets and liabilities using the methods of fair value as described in ASC topic 820, Fair Value Measurements, ("ASC 820"). ASC 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The three levels of fair value hierarchy are described below:

Level 1: Quoted prices for identical instruments in active markets.

Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

Level 3: Significant inputs to the valuation model are unobservable.

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, restricted cash, accounts receivable, accounts payable and other accrued expenses approximate fair value due to relatively short periods to maturity.

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ROSETTA STONE INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

Stock-Based Compensation

The Company accounts for its stock-based compensation in accordance with ASC topic 718, Compensation—Stock Compensation ("ASC 718"). Under ASC 718, all stock-based awards, including employee stock option grants, are recorded at fair value as of the grant date. For options granted with service and/or performance conditions, the fair value of each grant is estimated on the date of grant using the Black-Scholes option pricing model which require the use of estimates, including future stock price volatility, expected term and forfeitures.

Stock options are granted to directors with a 10 -year contractual term. The Company estimates the expected term of stock options using historical grant and exercise information. The Company uses its own historical stock price data to estimate its forfeiture rate and expected volatility over the most recent period commensurate with the estimated expected term of the awards. For the risk-free interest rate, the Company uses a U.S. Treasury Bond rate consistent with the estimated expected term of the option award.

The Company’s restricted stock and restricted stock unit grants are accounted for as equity awards. Stock compensation expense associated with service-based equity awards is recognized in the statements of operations on a straight-line basis over the requisite service period, which is the vesting period. For equity awards granted with performance-based conditions, stock compensation expense is recognized in the statements of operations ratably for each vesting tranche based on the probability that operating performance conditions will be met and to what extent. Changes in the probability estimates associated with performance-based awards will be accounted for in the period of change using a cumulative catch-up adjustment to retroactively apply the new probability estimates. In any period in which the Company determines that achievement of the performance metrics is not probable, the Company ceases recording compensation expense and all previously recognized compensation expense for the performance-based award is reversed. For equity awards granted with market-based conditions, stock compensation expense is recognized in the statements of operations ratably for each vesting tranche regardless of meeting or not meeting the market conditions. See Note 12 "Stock-Based Compensation" for additional disclosures.

Basic and Diluted Net Loss Per Share

Net loss per share is computed under the provisions of ASC topic 260, Earnings Per Share. Basic loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted loss per share is computed by dividing net loss by the weighted average number of common shares and potential common shares outstanding during the period. Potential common shares are included in the diluted computation when dilutive. Potentially dilutive shares are computed using the treasury stock method and primarily consist of shares issuable upon the exercise of stock options, restricted stock awards, restricted stock units and conversion of shares of preferred stock. Common stock equivalent shares are excluded from the diluted computation if their effect is anti-dilutive. When there is a net loss, there is a presumption that there are no dilutive shares as these would be anti-dilutive. See Note 14 "Basic and Diluted Net Loss Per Share" for additional disclosures.

Foreign Currency Translation and Transactions

The functional currency of the Company's foreign subsidiaries is their local currency. Accordingly, assets and liabilities of the foreign subsidiaries are translated into U.S. dollars at exchange rates in effect on the balance sheet date. Income and expense items are translated at average rates for the period. Translation adjustments are recorded as a component of accumulated other comprehensive loss in stockholders' deficit.

Cash flows of consolidated foreign subsidiaries, whose functional currency is their local currency, are translated to U.S. dollars using average exchange rates for the period. The Company reports the effect of exchange rate changes on cash balances held in foreign currencies as a separate item in the reconciliation of the changes in cash, cash equivalents and restricted cash during the period.

The following table presents the effect of exchange rate changes on total comprehensive loss (in thousands):