One of the first things I did when I started as CFO of 📝Second Life was to throw away the audit that the previous accountants had done.
The report had incorrectly recognized revenue. They were recognizing the revenue from the sale of the land over the life of a premium user. This is wrong because premium users would come and go, but land in Second Life accumulated. The premium user who originally bought the land could sell it to another premium user and so on. Certainly it would be correct to recognize the revenue from any transaction fees on the land transfer between premium users over the life of a premium user, but that would not work for the original proceeds from the first sale.
When 📝Linden Lab sold land in Second Life, Linden Lab would provision a dedicated server with the Second Life software on it and maintain that server in a data center on behalf of the resident. The price was about $1800 up front and then about $360 per month. It's easy to recognize the recurring monthly $360 charge each month. The setup fee is where the challenge is.
If there was a 12-month contract, then the $1800 would be recognized at $150 for 12 months. But there was no contract. A resident could buy the land one month and sell it to another resident at any time. In this way the land was an infinitely transferable digital good.
The Linden Dollar was the same. It is an infinitely transferable digital good as well.
With an eye toward the eventual filing of an S-1, we knew our revenue recognition methodology would receive a lot of scrutiny. We decided that we would seek "pre-clearance" from the SEC.
I explained the problem this way: we need to recognize this revenue in one of three ways:
- right away
- never, or
- somewhere in between.
Since right away would overstate revenue and never would understate revenue, the answer had to be "somewhere in between."
Working with our KPMG auditors led by Conor Moore was as dramatic and exciting as working with a much less beautiful Tom Cruise in The Firm...um, without all the crime. Recounting the day when we heard back from the IRS, Conor said:
I don't think I ever recall fist-pumping an accounting decision before.
The IRS "did not disagree" with our determination that we should recognize the sale of the digital goods over the expected life of the software. We referenced a previous ruling about Oracle software where the life of the software was based on how much of the code base changed over time. Over a three-year period, we determined, a user of Second Life could expect the experience to change materially.