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SOHU COM INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) As used in this report, references to "us," "we," "our," "our company," "our group," "Sohu" and "Sohu.com" are to Sohu.com Inc. and, except where the context requires otherwise, our wholly-owned and majority-owned subsidiaries and variable interest entities ("VIEs"), Sohu.com Limited, Sohu.com (Hong Kong) Limited ("Sohu Hong Kong"), All Honest International Limited, Sohu.com (Game) Limited ("Sohu Game"),Go2Map Inc., Sohu.com (Search) Limited, Sogou Inc., Sogou (BVI) Limited, Sogou Hong Kong Limited, Vast Creation Advertising Media Services Limited ("Vast Creation"), Fox Video Investment Holding Limited ("Video Investment"), Fox Video Limited ("Sohu Video"), Fox Video (HK) Limited ("Video HK"), Beijing Sohu New Era Information Technology Co., Ltd. ("Sohu Era"), Beijing Sohu Software Technology Co., Ltd. ("New Software"), Beijing Fire Fox Digital Technology Co., Ltd. ("Beijing Fire Fox", also known as Beijing Huohu Digital Technology Co., Ltd., or "Huohu"), Beijing Sohu Interactive Software Co., Ltd. ("Sohu Software"), Go2Map Software (Beijing) Co., Ltd. ("Go2Map Software"), Beijing Sogou Technology Development Co., Ltd. ("Sogou Technology"), Beijing Sogou Network Technology Co., Ltd ("Sogou Network"), Fox Information Technology (Tianjin) Limited ("Video Tianjin"), Beijing Sohu New Media Information Technology Co., Ltd. ("Sohu Media"), Beijing Focus Time Advertising Media Co., Ltd. ("Focus Time"), Beijing Sohu New Momentum Information Technology Co., Ltd. ("Sohu New Momentum"), Beijing Century High Tech Investment Co., Ltd. ("High Century"), Beijing Sohu Entertainment Culture Media Co., Ltd. ("Sohu Entertainment", formerly known as Beijing Hengda Yitong Internet Technology Development Co., Ltd., or "Hengda"), Beijing Sohu Internet Information Service Co., Ltd. ("Sohu Internet"), Beijing GoodFeel Information Technology Co., Ltd. ("GoodFeel"), Beijing Tu Xing Tian Xia Information Consultancy Co., Ltd. ("Tu Xing Tian Xia"), Beijing Sogou Information Service Co., Ltd. ("Sogou Information"), Beijing 21 East Culture Development Co., Ltd. ("21 East Beijing"), Beijing Sohu Donglin Advertising Co., Ltd.("Donglin"), Beijing Pilot New Era Advertising Co., Ltd. ("Pilot New Era"), Beijing Focus Yiju Network Information Technology Co., Ltd. ("Focus Yiju"), Beijing Yi He Jia Xun Information Technology Co., Ltd. ("Yi He Jia Xun"), Beijing 17173 Network Technology Co., Ltd. ("17173 Network"), Tianjin Jinhu Culture Development Co., Ltd. ("Tianjin Jinhu") and our independently-listed majority-owned subsidiary Changyou.com Limited ("Changyou", formerly known as TL Age Limited) as well as the following direct and indirect subsidiaries and VIEs of Changyou: Changyou.com HK Limited ("Changyou HK", formerly known as TL Age Hong Kong Limited), Changyou.com Webgame (HK) Limited ("Changyou HK Webgame"), Changyou.com Gamepower (HK) Limited ("Changyou HK Gamepower"), ICE Entertainment (HK) Limited ("ICE HK"), Changyou.com (US) Inc. (formerly known as AmazGame Entertainment (US) Inc.), Changyou.com (UK) Company Limited ("Changyou UK"), ChangyouMy Sdn. Bhd ("Changyou Malaysia"), Changyou.com Korea Limited ("Changyou Korea"), Changyou.com India Private Limited ("Changyou India"), Changyou B L M H ZMETLER T CARET L M TED RKET ("Changyou Turkey"), Kylie Enterprises Limited, 7Road.com Limited ("7Road"), 7Road.com HK Limited ("7Road HK"), Beijing AmazGame Age Internet Technology Co., Ltd. ("AmazGame"), Beijing Changyou Gamespace Software Technology Co., Ltd. ("Gamespace"), ICE Information Technology (Shanghai) Co., Ltd. ("ICE Information"), Beijing Yang Fan Jing He Information Consulting Co., Ltd. ("Yang Fan Jing He"), Shanghai Jingmao Culture Communication Co., Ltd. ("Shanghai Jingmao"), Shanghai Hejin Data Consulting Co., Ltd. ("Shanghai Hejin"), Beijing Jingmao Film & Culture Communication Co., Ltd. ("Beijing Jingmao"), Beijing Gamease Age Digital Technology Co., Ltd. ("Gamease"), Beijing Guanyou Gamespace Digital Technology Co., Ltd. ("Guanyou Gamespace"), and Shanghai ICE Information Technology Co., Ltd.("Shanghai ICE"), Shenzhen 7Road Network Technologies Co., Ltd.("7Road Technology") , Shenzhen 7Road Technology Co., Ltd. ("Shenzhen 7Road"), and these references should be interpreted accordingly. Unless otherwise specified, references to "China" or "PRC" refer to the People's Republic of China and do not include the Hong Kong Special Administrative Region, the Macau Special Administrative Region or Taiwan. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or future strategies that are signified by the words "expect", "anticipate", "intend" ,"believe", or similar language. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our business and financial performance are subject to substantial risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. In evaluating our business, you should carefully consider the information set forth under the heading "Risk Factors" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission ("SEC") on February 28, 2012, as updated by Part II Item 1A of this report. Readers are cautioned not to place undue reliance on these forward-looking statements. OVERVIEW Sohu (NASDAQ: SOHU) is a leading Chinese online media, search, gaming, community and mobile service group. We operate one of the most comprehensive matrices of Chinese language Web properties, and we developed and operate one of the most popular massively multiplayer online games and two popular Web games in China. Substantially all of our operations are conducted through our indirect wholly-owned and majority-owned China-based subsidiaries and variable interest entities (collectively the "Sohu Group"). -42--------------------------------------------------------------------------------- Table of Contents Our businesses consist of the online advertising business, which consists of the brand advertising business as well as the search and others business, the online game business, the wireless business and the others business, among which online advertising and online games are our core businesses. Factors and Trends Affecting our Business The Internet and Internet-related markets in China continued to evolve rapidly during 2012. According to a semiannual report issued by the China Internet Network Information Center ("CNNIC"), the total number of Internet users in China had reached 538 million by the end of June 2012, an increase of 24.5 million from the end of 2011. The number of mobile Internet users in China had reached 388 million by the end of June 2012, an increase of 32.7 million from the end of 2011, and exceeding the 380 million desktop computer Internet users as of June 2012. Mobile Internet is becoming the top channel for Internet users to access Websites in China. We believe that this large and expanding user base will continue to provide significant opportunities for our company to expand our product offerings and to explore new revenue streams. However, China's economy has been experiencing decelerating growth recently, with the result that many large advertisers were cautious regarding their spending on advertising in the face of this economy uncertainty. At the same time, we have been facing fierce competition arising from existing and new Internet companies, which have been seizing advertising market share. We have noted that this macro-economic environment and increased competition has had some adverse impact on our brand advertising business. In China, online video is a popular Internet application, with over 350 million users as of June 30, 2012 according to the semiannual report issued by CNNIC. We expect that brand in the future will continue to allocate more advertising dollars to online video in order to exploit this growing market, but we are uncertain as to when such an increased allocation will occur, or how large it might be. The market prices of online video content are becoming relatively stable after a significant decline in prior months. During the third quarter of 2012, our strategic plan of building a dedicated sales team was well on track, and our video direct account sales team was in place. Also, we set up a video agency sales team during quarter. We are optimistic about the prospects of our online video business, and expect this business to resume on a growth track during the fourth quarter of 2012. In the third quarter, our search and others business continued to grow, which was attributable to the growth of pay-for-click services, as well as online marketing services on Sogou Web Directory. We expect our search and others business will sustain healthy revenue growth through the remainder of 2012. We continue to be pleased with, and optimistic regarding, the growth and profitability of our online games business. We believe that our strong performance in the third quarter reflects the resilience of the online games industry in China despite the weakening global macroeconomic environment and economic slowdown in China, and that it also reflects the ongoing strength of our online games content and our successful expansion into other fast-growing segments of the industry, such as web games. We believe, as discussed above, that there are significant opportunities to explore new revenue streams related to the mobile Internet market. Our wireless business faces a challenge in this regard, as we will need to catch up with our peer competitors with respect to penetration of new mobile applications and features. Summary of Our Business Online Advertising Business Brand Advertising Business Our brand advertising business offers various products and services (such as free of charge premier content including video content, interactive community, and other competitive Internet services) to our users, and provides advertising services to advertisers on our matrices of Chinese language Web properties consisting of: • sohu.com, a leading mass portal and online media destination; • focus.cn, a top real estate Website; and • 17173.com, a leading game information portal. Since December 15, 2011, 17173.com has been owned and operated by our majority-owned subsidiary Changyou.com Limited ("Changyou"). Our brand advertising business offers advertisements on our Web properties to companies seeking to increase their brand awareness online. -43--------------------------------------------------------------------------------- Table of Contents Search and Others Business Our search and others business, provided by our search subsidiary Sogou Inc. ("Sogou"), primarily offers customers pay-for-click services, as well as online marketing services on Sogou Web Directory. Online Game Business Our online game business is conducted via Changyou, which is a leading online game developer and operator in China. Changyou engages in the development, operation and licensing of online games, including massively multiplayer online games ("MMOGs") and Web games. Changyou developed and operates Tian Long Ba Bu ("TLBB"), which is one of the most popular MMOGs in China. Changyou's majority-owned subsidiary 7Road.com Limited ("7Road") jointly operates DDTank and Wartune (also known as "Shen Qu"), which are two popular Web games in China, primarily through an extensive network of third-party game platforms in China and overseas. For the third quarter of 2012, more than 71% of the revenues of our online game business were derived from TLBB. Changyou's online game revenues were $151.1 million, which represented 53% of our total revenues for the quarter. Net income contributed by Changyou for the quarter was $77.4 million, which represented 150% of our total net income. We depend on Changyou for a significant portion of our revenues, net income, and operating cash flow. Wireless Business Our wireless business offers mobile related services through different types of wireless products to mobile phone users. The mobile related services consist of the provision of content such as news, weather forecasts, chatting, entertainment information, mobile games, mobile phone ringtones, logo downloads and video content downloads. A majority of the content is purchased from third party content providers. The wireless products mainly consist of short messaging services ("SMS"), interactive voice response ("IVR"), mobile games and Ring Back Tone ("RBT"). Others Business Our others business primarily includes sub-licensing of licensed video content to third parties, offering cinema advertisement slots to be shown in theaters before the screening of movies, and offering Internet value-added services ("IVAS") with respect to Web games developed by third-party developers under revenue sharing arrangements with third-party developers. Business Restructuring Initial Public Offering of Changyou On April 7, 2009, Changyou completed its initial public offering on the NASDAQ Global Select Market, trading under the symbol "CYOU." After Changyou's offering, as we are Changyou's controlling shareholder, we continue to consolidate Changyou in our consolidated financial statements, but recognize noncontrolling interest reflecting shares held by shareholders other than us. For the third quarter of 2012, approximately 32% of the economic interest in Changyou was recognized as noncontrolling interest in our consolidated financial statements. On August 6, 2012, Changyou declared a special one-time cash dividend of $1.90 per Class A or Class B ordinary share, or $3.80 per American depositary share ("ADS") and a total of $201 million. On September 21, 2012, Changyou paid out this special cash dividend, of which $136 million was paid to and received by Sohu. We have entered into agreements with Changyou with respect to various interim and ongoing relationships between us, including a Master Transaction Agreement, a Revised Non-Competition Agreement, and an Amended and Restated Marketing Services Agreement. These agreements contain provisions which, among other things, relate to the transfer of assets and assumption of liabilities of the massively multiplayer online role-playing game ("MMORPG," which is a subset of the MMOG category) business, provide cross-indemnification between us and Changyou for liabilities arising from our respective businesses and mutually limit us and Changyou from competing in certain aspects of each other's businesses, and also include a number of ongoing commercial relationships. Sogou Transactions On October 22, 2010, Sogou sold 24.0 million, 14.4 million and 38.4 million, respectively, of its newly-issued Series A Preferred Shares to Alibaba Investment Limited ("Alibaba"), a private investment subsidiary of Alibaba Group Holding Limited, China Web Search (HK) Limited ("China Web"), an investment vehicle of Yunfeng Fund, LP, and Photon Group Limited ("Photon"), the investment fund of Sohu's Chairman and Chief Executive Officer Dr. Charles Zhang, for $15 million, $9 million, and $24 million, respectively. On June 29, 2012, Sohu purchased the 24.0 million Sogou Series A Preferred Shares held by Alibaba for fixed cash consideration of $25.8 million. After the purchase of these shares, we held 73% of the combined total of Sogou's outstanding ordinary shares and Series A Preferred Shares. As we are Sogou's controlling shareholder, we continue to consolidate Sogou in our consolidated financial statements, but recognize noncontrolling interest reflecting shares held by shareholders other than us. -44--------------------------------------------------------------------------------- Table of Contents 17173 Transaction On December 15, 2011, pursuant to an agreement entered into on November 29, 2011, we closed the sale to Changyou of certain assets associated with the business of 17173.com (the "17173 Business"), a leading game information portal in China, for fixed cash consideration of $162.5 million. In payment of part of the consideration, Changyou.com HK Limited delivered to Sohu.com Limited a promissory note in the amount of $16 million due on November 30, 2012. In connection with this transaction, we and Changyou revised the Non-Competition Agreement between us to provide our agreement not to compete with Changyou in the 17173 Business for a period of five years following the closing of Changyou's acquisition of the 17173 Business and to remove the prior prohibition on Changyou's competing with us in the 17173 Business. After the closing of the sale, we continued to consolidate the results of operations of the 17173 Business in our consolidated financial statements. On November 29, 2011, we and Changyou entered into a services agreement and an online links and advertising agreement pursuant to which we agreed to provide links and advertising space and technical support to Changyou, including the provision and maintenance of user log-in, information management and virtual currency payment systems for the 17173 Business. The agreements provide for a term of 25 years for the virtual currency payment system services, and an initial term of three years for all the other relevant services and links and advertising space, with aggregate fees payable by Changyou to us of approximately $30 million. Under the agreements, Changyou may renew certain rights for a subsequent term of 22 years, and may obtain a perpetual software license in respect of the information management system and the user log-in system following the expiration of the three-year term, subject to Changyou's payment to us of additional fees of up to approximately $5 million in the aggregate. 7Road Transactions On May 11, 2011, Changyou, through its VIE Gamease, acquired 68.258% of the equity interests of Shenzhen 7Road and began to consolidate Shenzhen 7Road's financial statements on June 1, 2011. Effective June 26, 2012, Shenzhen 7Road was reorganized into a Cayman Islands holding company structure where Changyou holds a direct ownership interest in 7Road through Changyou's subsidiary Changyou.com Webgame (HK) Limited, and Shenzhen 7Road is a VIE of 7Road. For purposes of clarity, as the reorganization did not result in any change in the ultimate beneficial ownership of Shenzhen 7Road's business, assets and results of operations, when we discuss 7Road and Shenzhen 7Road in this report, we treat the reorganization as if it had been effective upon Changyou's acquisition of 68.258% of the equity interests in Shenzhen 7Road. On June 21, 2012, 7Road's Chief Executive Officer surrendered to 7Road, without consideration, ordinary shares of 7Road representing 5.1% of the outstanding ordinary shares of 7Road, in order to increase the number of ordinary shares available for issuance as equity incentives to employees, directors and consultants of 7Road without dilution of the other shareholders of 7Road. As a result, the noncontrolling interest decreased to 28.074% of 7Road and Changyou's interest in 7Road increased to 71.926%. On September 26, 2012, 7Road submitted on a confidential basis to the SEC a draft registration statement for a possible initial public offering ("IPO") of ADSs representing ordinary shares of 7Road. CRITICAL ACCOUNTING POLICIES AND MANAGEMENT ESTIMATES Our discussion and analysis of our financial condition and results of operations relates to our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We have identified below the accounting policies that reflect our more significant estimates and judgments, and those that we believe are the most critical to fully understanding and evaluating our consolidated financial statements. Basis of Consolidation The consolidated financial statements include the accounts of Sohu and its wholly-owned and majority-owned subsidiaries and variable interest entities ("VIEs"). All intercompany transactions are eliminated. -45--------------------------------------------------------------------------------- Table of Contents We have adopted the guidance of accounting for VIEs, which requires VIEs to be consolidated by the primary beneficiary of the entity. Our management made evaluations of the relationships between us and its VIEs and the economic benefit flow of contractual arrangements with the VIEs. In connection with such evaluation, management also took into account the fact that, as a result of such contractual arrangements, the Sohu Group controls the shareholders' voting interests in the VIEs. As a result of such evaluation, management concluded that the Sohu Group is the primary beneficiary of its VIEs. As a result, we consolidate all of its VIEs in its consolidated financial statements. For majority-owned subsidiaries and VIEs, noncontrolling interest is recognized to reflect the portion of their equity which is not attributable, directly or indirectly, to the controlling shareholder. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. The recognition of revenues involves certain management judgments. The amount and timing of our revenues could be materially different for any period if management made different judgments or utilized different estimates. Online Advertising Revenues Online advertising revenues include revenues from brand advertising services as well as search and others services. For a barter transaction involving online advertising services, we recognize revenue and expense at fair value only if the fair value of the advertising services surrendered /received in the transaction is determinable. For our advertising-for-advertising barter transactions, the fair value of the advertising surrendered /received is not determinable, so no revenue from advertising-for-advertising barter transactions is recognized. Before September 1, 2012, our online advertising revenues were subject to PRC business tax ("Business Tax"). Our online advertising revenues were recognized after deducting agent rebates and applicable Business Tax and related surcharges. Business Tax is imposed primarily on revenues from the provision of taxable services and is calculated by multiplying the applicable tax rate by gross revenue. Effective September 1, 2012, the PRC Ministry of Finance and the State Administration of Taxation launched a Business Tax to Value Added Tax Transformation Pilot Program (the "Pilot Program") for certain industries in eight regions, including Beijing and Tianjin. Value Added Tax ("VAT") payable on goods sold or taxable labor services provided by a general VAT taxpayer for a taxable period is the net balance of the output VAT for the period after crediting the input VAT for the period. Hence, the amount of VAT payable does not result directly from output VAT generated from goods sold or taxable labor services provided. With the adoption of Pilot Program, our online advertising revenues are subject to VAT. Our online advertising revenues are now recognized after deducting agent rebates and net of VAT and related surcharges. Brand Advertising Revenues Business Model Currently the brand advertising business has two main types of pricing models, consisting of the Fixed Price Model and the Cost Per Impression ("CPM") pricing model. We apply the Fixed Price Model for a majority of our brand advertising revenues. Under the Fixed Price Model, a contract is signed to establish a fixed price for the advertising services to be provided. Under the CPM pricing model, the total contract amount for the advertising services is not fixed. Instead, a fixed price for each qualifying display is stated. Advertisers using the CPM pricing model pay us based on the number of qualifying displays of their advertisements appear on our Websites, and we recognize as revenue the fees charged to advertisers each time their advertisements are displayed on the Websites, on the condition that each display meets certain selected criteria imposed by advertisers. We provide advertisement placements to our advertisers on our different Website channels and in different formats, which can include, among other things, banners, links, logos, buttons, rich media, pre-roll and post-roll video screens, pause video screens and content integration, as specified in the contracts with the advertisers. Revenue recognition and basis of revenue presentation For brand advertising revenue recognition, prior to entering into contracts, we make a credit assessment of the customer to assess the collectability of the contract. For those contracts for which the collectability is determined to be reasonably assured, we recognize revenue when all revenue recognition criteria are met. For those contracts for which the collectability is determined not to be reasonably assured, we recognize revenue only when the cash was received and all other revenue recognition criteria are met. In accordance with ASU No.2009 -13, which we adopted commencing January 1, 2011, we treat advertising contracts with multiple deliverable elements as separate units of accounting for revenue recognition purposes and to recognize revenue on a periodic basis during the contract when each deliverable service is provided. Since the contract price is for all deliverables, we allocate the arrangement consideration to all deliverables at the inception of the arrangement on the basis of their relative selling prices. Since the number of advertising contracts that covered more than one quarter and the revenues from advertising contracts that covered more than one quarter were immaterial compared to the total advertising contracts, the impact of adoption of ASU 2009-13 to us is immaterial. -46- -------------------------------------------------------------------------------- Table of Contents We recognize gross revenue for the amount of fees we receive from our advertisers. Determining whether revenue should be reported gross or net is based on an assessment of various factors, the primary factor is whether we are acting as the principal in offering services to the customer or we are acting as an agent in the transaction. For the brand advertising business, we recognize net revenue for the transactions where we act as an agent. Whether we are serving as principal or agent in a transaction is judgmental in nature and is determined by evaluating the terms of the arrangement. Search and Others Revenues Search and others services mainly include pay-for-click services, as well as online marketing services on Sogou Web Directory. Pay-for-click services Pay-for-click services mainly consist of search query-based and contextual online marketing services. Search query-based online marketing services are keyword-based marketing services. Our auction-based system enables advertisers, on a real time basis, to bid on keywords that trigger the display of their Website links on Sogou search result pages. The display priority of advertiser Website links is based on both the price bid on the keyword and the quality factor of an advertiser's Website link for that search query. Revenue for pay-for-click services is recognized on a per click basis when the users click on the displayed links. Contextual online marketing services enable our advertisers' promotional links to be displayed on Sogou Website Alliance members' Websites where the links are relevant to the subject and content of such Web pages. Online marketing services on Sogou Web Directory Online marketing services on Sogou Web Directory mainly consist of displaying advertiser Website links on the Web pages of the Sogou Web Directory. The Sogou Web Directory is a Chinese Web directory navigation site which serves as a key access point to popular and preferred Websites and applications. Revenue for online marketing services on Sogou Web Directory is normally recognized on a straight-line basis over the contract period, provided our obligations under the contract have been met and all revenue recognition criteria have been met. Sogou Website Alliance Both pay-for-click services and online marketing services on Sogou Web Directory involve the Sogou Website Alliance. The Sogou Website Alliance is a program through which we expand distribution of our advertisers' Website links or advertisements by leveraging traffic on Sogou Website Alliance members' Websites. Payments made to Sogou Website Alliance members are included in cost of search and others revenues as traffic acquisition costs. We pay Sogou Website Alliance members either based on revenue-sharing arrangements, under which we pay a percentage of pay-for-click revenues generated from clicks by users of their properties, or based on a pre-agreed unit price. Basis of revenue presentation We recognize gross revenue for the amount of fees we receive from our advertisers. Determining whether revenue should be reported gross or net is based on an assessment of various factors, the primary factor is whether we are acting as the principal in offering services to the customer or we are acting as an agent in the transaction. For pay-for-click services, we recognize gross revenue, as we have the primary responsibility for fulfillment and acceptability. As there is no revenue sharing for online marketing services on Sogou Web Directory, there is no need to make a gross versus net judgment. Whether we are serving as principal or agent in a transaction is judgmental in nature and is determined by evaluating the terms of the arrangement. Online Game Revenues Our online game revenues are generated from MMOG operations revenues, Web game revenues and overseas licensing revenues. MMOG operations revenues Revenues are recorded net of applicable Business Tax, discounts and rebates to distributors. -47- -------------------------------------------------------------------------------- Table of Contents Online game revenues from Changyou's current MMOG operations are earned by providing online services to players pursuant to the item-based revenue model. Under the item-based revenue model, the basic game play functions are free of charge and players are charged for purchases of in-game virtual items. Online game revenues are recognized over the estimated lives of the virtual items purchased or as the virtual items are consumed. If different assumptions were used in deriving the estimated lives of the virtual items, the timing of our recording of the revenues would be impacted. Game operations revenues are collected by Changyou's VIEs through the sale of Changyou's prepaid cards, which it sells in both virtual and physical forms to third-party distributors and players. Proceeds received from sales of prepaid cards are initially recorded as receipts in advance from customers and, upon activation or charge of the prepaid cards, are transferred from receipts in advance from customers to deferred revenues. As Changyou does not have control of, and generally does not know, the ultimate selling price of the prepaid cards sold by distributors, net proceeds from distributors form the basis of revenue recognition. Prepaid cards will expire two years after the date of card production if they have never been activated. The proceeds from the expired game cards are recognized as revenue upon expiration of cards. Once the prepaid cards are activated and credited to a player's personal game account, they will not expire as long as the personal game account remains active. Changyou is entitled to suspend and close a player's personal game account if it has been inactive for a period of 180 consecutive days. The unused balances in an inactive player's personal game account are recognized as revenues when the account is suspended and closed. Web game revenue We generated Web game revenues for the first time in 2011, upon Changyou's acquisition of a majority interest in 7Road. 7Road's Web games are designed to be operated under the item-based revenue model. 7Road primarily jointly operates its games with third-party operators who offer the game to users in China and other countries through their Websites or platforms. 7Road's joint operation arrangements with third parties provide for two revenue streams, an initial fixed license fee and monthly joint operation revenue sharing. Since 7Road is required to provide when-and-if-available upgrades to the joint operators over the joint operation period, the initial license fee is recognized ratably as revenue over the contract period. Since the third-party operator is the party that signs the user agreement with its users and is responsible for its users' experience on its Websites or platforms, 7Road does not have the primary responsibility for fulfillment and acceptability of the game services and is not considered a principal in the transactions with the users, and therefore recognizes revenues on a net basis. For arrangements where 7Road's games are hosted on third-party joint operator's servers, revenues are recognized upon the conversion of the virtual currency of the joint operator into 7Road's game coins or, if such operator does not have its own virtual currency, upon payment by the game players for the purchase of 7Road's game coins through such joint operator's Website and game platform. However, when 7Road also provides server hosting services to its joint operators for its games, revenues are allocated to two separate elements, including (i) the game and related service element and (ii) the hosting service element. Revenues allocated to the game and related service element are recognized upon conversion by game players of the joint operator's virtual currency into 7Road's game coins or payment by game players for 7Road's game coins through such operator's Website and game platform. Revenues allocated to the hosting service element are recognized over the implicit service period during which 7Road is obligated to provide access to the server for the game players to be able to consume their virtual items. Accordingly, for consumable virtual items, revenues are recognized when the virtual items are consumed or over the predetermined period of use, or benefit period, and for perpetual virtual items revenues are recognized over the estimated average period the game players play 7Road's games. Overseas licensing revenue Changyou enters into licensing arrangements with overseas licensees to operate its MMOGs in other countries or territories. These license agreements provide two revenue streams, consisting of an initial license fee and a monthly revenue-based royalty fee based on monthly revenue and sales from ancillary products of the games. The initial license fee is based on both a fixed amount and additional amounts receivable upon achieving certain sales targets. Since Changyou is obligated to provide post-sales services such as technical support and provision of updates and when-and-if-available upgrades to the licensees during the license period, the initial license fee from the licensing arrangement is recognized as revenue ratably over the license period. The fixed amount of the initial license fee is recognized ratably over the remaining license period from the launch of the game and the additional amount is recognized ratably over the remaining license period from the date when such additional amount is certain. The monthly revenue-based royalty fee is recognized when relevant services are delivered, provided that collectability is reasonably assured. -48- -------------------------------------------------------------------------------- Table of Contents Wireless Revenues Our wireless revenues are generated from the provision of mobile-related services through different types of wireless products to mobile phone users. The wireless products mainly consist of SMS, IVR, mobile games and RBT. In order to deliver our products to mobile phone users, we sign contracts with China Mobile Communications Corporation ("China Mobile"), China United Network Communication Group Company Limited ("China Unicom"), China Telecom Corporation ("China Telecom") and their subsidiaries, as well as other small mobile network operators. We refer to these mobile network operators, collectively, as the "China mobile network operators." The China mobile network operators charge their users wireless service fees on a monthly or per message /download basis, and pay us service fees after deducting the China mobile network operators' share of the fees. Wireless revenues are recognized in the month in which the service is performed, provided that no significant obligations remain. For the amount of revenues to be recognized, we rely on billing confirmations issued by the China mobile network operators. If at the end of each reporting period, an operator has not yet issued such billing confirmations, we estimate the amount of collectable wireless service fees and recognize revenue. When we later receive billing confirmations, we record a true-up accounting adjustment. For the three months ended September 30, 2012, 70% of our estimated wireless revenues were confirmed by billing confirmations received from the China mobile network operators. Generally, (i) within 15 to 120 days after the end of each month, we receive billing confirmations from the operators and (ii) within 30 to 180 days after delivering billing confirmations, each operator remits the wireless service fees, net of its service fees, to us. Currently, a majority of our wireless revenues are recorded on a gross basis, as we have the primary responsibility for fulfillment and acceptability of the wireless services. Others Revenues Other revenues are primarily generated from sub-licensing of licensed video content operated by Sohu, cinema advertisements operated by Changyou and IVAS provided by Sogou with respect to Web games developed by third-party developers. Revenue from sub-licensing of licensed video content For licensed video content purchased with payment in cash on an exclusive basis, we have rights to sub-license to other platforms. Revenue from sub-licensing of licensed video content is recognized when the following criteria are met: (1) Persuasive evidence of a sub-licensing arrangement exists; (2) The content has been delivered or is available for immediate and unconditional delivery; (3) The sub-license period as indicated in the arrangement has begun and the sub-licensee can begin its exploitation (exhibition); and (4) The sub-licensing fee is fixed or determinable and collection of the sub-licensing fee is reasonably assured. Revenue from cinema advertisements For cinema advertising revenues, a contract is signed with the advertiser to establish a fixed price and specify advertising services to be provided. Based on the contracts, we provide advertisement placements in advertising slots to be shown in theatres before the screening of movies. The rights to place advertisements in such advertising slots are granted under contracts with different theatres and film production companies. Revenue from cinema advertising is recognized when all the recognition criteria are met. Depending on the terms of a customer contract, fees for services performed can be recognized according to two principal methods, which are the proportional performance method and the straight-line method. Under the proportional performance method, fees are generally recognized based on a percentage of the advertising slots actually delivered where the fee is earned on a per-advertising slot placement basis. Under the straight-line method, fees are recognized on a straight-line basis over the contract period when the fee is not paid based on the number of advertising slots actually delivered. Revenue from IVAS We, through Sogou, offer Web games developed by third-party developers and generate revenue from the provision of Internet value-added services, including promotion, access maintenance and payment services to third-party developers. The online games can be accessed and played by end users free of charge but the end users may choose to purchase in-game merchandise to enhance their game playing experience. Under revenue sharing agreements signed with third-party developers, we collect payments from the end users for items sold, keep a pre-agreed percentage of the proceeds and remit the balance to the third-party developers. Revenue from IVAS is recognized when our obligations under the agreements and all other revenue recognition criteria have been met. -49--------------------------------------------------------------------------------- Table of Contents Share-based Compensation Expense Sohu, Changyou, Sogou, Sohu Video and 7Road all have incentive plans for the granting of share-based awards, including common stock /ordinary shares, share options, restricted shares and restricted share units, to their executive officers, management and employees. Share-based compensation expense is recognized as costs and /or expenses in the consolidated statements of comprehensive income based on the fair value of the related share-based awards on their grant dates. For Sohu share-based awards, in determining the fair value of share options granted, the Black-Scholes valuation model is applied; in determining the fair value of restricted share units granted, the public market price of the underlying shares on the grant dates is applied. For Changyou share-based awards, in determining the fair value of ordinary shares, restricted shares and restricted share units granted in 2008, the income approach /discounted cash flow method with a discount for lack of marketability was applied, given that the shares underlying the awards were not publicly traded at the time of grant. In determining the fair value of restricted share units granted in 2009 before Changyou's initial public offering, the fair value of the underlying shares was determined based on Changyou's offering price for its initial public offering. In determining the fair value of restricted share units granted after Changyou's initial public offering, the public market price of the underlying shares on the grant dates is applied. For Sogou share-based awards, in determining the fair value of share options granted, the income approach /discounted cash flow method with a discount for lack of marketability was applied, given that the shares underlying the awards were not publicly traded at the time of grant. On January 4, 2012, Sohu Video, the holding entity of Sohu's video division, adopted a 2011 Share Incentive Plan which provided for the issuance of up to 25,000,000 ordinary shares of Sohu Video (amounting to 10% of the outstanding Sohu Video shares on a fully-diluted basis) to management and key employees of the video division and to Sohu management. As of September 30, 2012, grants of options for the purchase of 15,352,200 of ordinary shares of Sohu Video had been made and were effective under the plan. However, as of September 30, 2012, the restructuring of Sohu's video division was still in process and certain significant factors remained uncertain. For purposes of ASC 718, no grant date is established until mutual understanding of the option awards' key terms and conditions between Sohu Video and the recipients can be reached, and such mutual understanding cannot be reached until the video division's restructuring plan has been substantially fixed, so that the enterprise value of Sohu Video and hence the fair value of the options is determinable and can be accounted for. As of September 30, 2012, on the basis that the broader terms and conditions of the option awards had neither been finalized nor mutually agreed with the recipients, no grant of options had occurred for purposes of ASC 718 and hence no share based compensation expense was recognized. On July 10, 2012, 7Road adopted a 2012 Share Incentive Plan (the "7Road 2012 Share Incentive Plan"), which initially provided for the issuance of up to 5,100,000 ordinary shares of 7Road (amounting to 5.1% of the outstanding 7Road shares on a fully-diluted basis) to selected directors, officers, employees, consultants and advisors of 7Road. On November 2, 2012, 7Road's Board of Directors and its shareholders approved an increase from 5,100,000 to 15,100,000 ordinary shares (amounting to 13.7% of the outstanding 7Road shares on a fully-diluted basis) in the number of ordinary shares available for issuance from time to time to selected directors, officers, employees, consultants and advisors of 7Road under its 2012 Share Incentive Plan. As of September 30, 2012, 2,546,250 restricted share units had been granted under the plan. Such restricted share units will not be vested until 7Road's completion of a firm commitment underwritten IPO of its shares resulting in a listing on an internationally recognized exchange and the expiration of all underwriters' lockup periods applicable to the IPO. The completion of a firm commitment IPO is considered to be a performance condition of the awards. An IPO event is not considered to be probable until it is completed. Under ASC718, compensation cost should be accrued if it is probable that the performance condition will be achieved and should not be accrued if it is not probable that the performance condition will be achieved. As a result, no compensation expense will be recognized relating to these restricted share units until the completion of an IPO, and hence no share-based compensation expense was recognized for the quarter ended September 30, 2012. Share-based compensation expense for the ordinary shares granted is fully recognized in the quarter during which these ordinary shares are granted. For share options, restricted shares and restricted share units granted with respect to Sohu shares and with respect to Changyou shares, compensation expense is recognized on an accelerated basis over the requisite service period. For share options granted with respect to Sogou shares, compensation expense is recognized on a straight-line basis over the estimated period during which the service period requirement and performance target will be met. The number of share-based awards for which the service is not expected to be rendered over the requisite period is estimated, and the related compensation expense is not recorded for that number of awards. The assumptions used in share-based compensation expense recognition represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. If factors change or different assumptions are used, our share-based compensation expense could be materially different for any period. Moreover, the estimates of fair value are not intended to predict actual future events or the value that ultimately will be realized by employees who receive equity awards, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by us for accounting purposes. -50- -------------------------------------------------------------------------------- Table of Contents Taxation Income Taxes Income taxes are accounted for using an asset and liability approach which requires the recognition of income taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our financial statements or tax returns. Deferred income taxes are determined based on the differences between the accounting basis and the tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws. Deferred tax assets are reduced by a valuation allowance, if based on available evidence, it is considered that it is more likely than not that some portion of or all of the deferred tax assets will not be realized. In making such determination, we consider factors including future reversals of existing taxable temporary differences, future profitability, and tax planning strategies. If events were to occur in the future that would allow us to realize more of our deferred tax assets than the presently recorded net amount, an adjustment would be made to the deferred tax assets that would increase income for the period when those events occurred. If events were to occur in the future that would require us to realize less of our deferred tax assets than the presently recorded net amount, an adjustment would be made to the valuation allowance against deferred tax assets that would decrease income for the period when those events occurred. Significant management judgment is required in determining income tax expense and deferred tax assets and liabilities. Our deferred tax assets are related to net operating losses and temporary differences between accounting basis and tax basis for our China-based subsidiaries and VIEs that are subject to corporate income tax in the PRC under the PRC Corporate Income Tax Law. Withholding tax The PRC Corporate Income Tax Law (the "CIT Law") imposes a 10% withholding income tax for dividends distributed by foreign invested enterprises to their immediate holding companies outside mainland China. A lower withholding tax rate will be applied if there is a tax treaty between mainland China and the jurisdiction of the foreign holding company. A holding company in Hong Kong, for example, will be subject to a 5% withholding tax rate under the Arrangement Between the PRC and the Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital (the "China-HK Tax Arrangement") if such holding company is considered a non-PRC resident enterprise and holds at least 25% of the equity interests in the PRC foreign invested enterprise distributing the dividends, subject to approval of the PRC local tax authority. However, if the Hong Kong holding company is not considered to be the beneficial owner of such dividends under applicable PRC tax regulations, such dividend may remain subject to a withholding tax rate of 10%. In 2012, Changyou's Board of Directors determined to cause one of Changyou's PRC subsidiaries to distribute all of its 2012 earnings to its overseas parent company, Changyou.com HK Limited ("Changyou HK"). Based on an assessment performed pursuant to requirements specified by PRC tax authorities, Changyou concluded that it was more likely than not that such distribution would be subject to 5% withholding tax. For the nine months ended September 30, 2012, Changyou accrued deferred tax liabilities in the amount of $8.7 million for withholding taxes associated with this distribution plan. Uncertain Tax Positions In order to assess uncertain tax positions, we apply a more likely than not threshold and a two-step approach for tax position measurement and financial statement recognition. For the two-step approach, the first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon settlement. Transition from PRC Business Tax to PRC Value Added Tax Effective September 1, 2012, a pilot program for transition from the imposition of Business Tax to the imposition of VAT for revenues from certain industries was expanded from Shanghai to eight other cities and provinces in China, including Beijing and Tianjin. Our brand advertising and search revenues are subject to this program. Business Tax had been imposed primarily on revenues from the provision of taxable services, assignments of intangible assets and transfers of real estate. Prior to the implementation of the pilot program, our Business Tax rate, which varies depending upon the nature of the revenues being taxed, generally ranged from 3% to 5%. -51- -------------------------------------------------------------------------------- Table of Contents VAT payable on goods sold or taxable labor services provided by a general VAT taxpayer for a taxable period is the net balance of the output VAT for the period after crediting the input VAT for the period. Before the implementation of the pilot program, we were mainly subject to a small amount of VAT for revenues of Changyou's subsidiary 7Road that are deemed for PRC tax purposes to be derived from the sale of software. VAT has been imposed on those 7Road revenues at a rate of 17%, with a 14% immediate tax refund, resulting in a net rate of 3%. With the implementation of the pilot program, in addition to the revenues currently subject to VAT, our brand advertising and search revenues are in the scope of the pilot program and are now subject to VAT at a rate of 6%. Under ASC 605-45, the presentation of taxes on either a gross basis (included in revenues and costs) or a net basis (excluded from revenues) is an accounting policy decision determined by management. As VAT imposed on brand adverting and search revenues and VAT imposed on 7Road's revenues from the sale of software are considered as substantially different in nature, we determined that it is reasonable to apply the guidance separately for these two types of VAT. The basis for this determination is that VAT payable on brand advertising and search revenues is the difference between the output VAT (at a rate of 6%) and available input VAT amount (at the rate applicable to the supplier), which is a component of our costs for providing the brand advertising and search services. On the other hand, VAT payable by 7Road is in effect at 3% of the applicable revenues from the sale of software, irrespective of the availability of any input VAT, under preferential VAT treatment provided to 7Road by the local tax bureau. In this regard, we believe the VAT payable by 7Road is more akin to a sales tax than typical VAT. As a result, we adopted the net presentation method for our brand advertising and search businesses both before and after the implementation of the pilot program, and for the revenues of 7Road deemed to be derived from the sale of software, we adopted the gross presentation method before and after the implementation of the pilot program. The implementation of the pilot program has not had a significant impact on our consolidated statements of comprehensive income for the three and nine months ended September 30, 2012. Noncontrolling Interest Noncontrolling interest is the portion of economic interest in Sohu's majority-owned subsidiaries and VIEs which is not attributable, directly or indirectly, to Sohu. Currently, the noncontrolling interest in our consolidated financial statements mainly consists of noncontrolling interest for Changyou and Sogou. Noncontrolling Interest for Changyou To reflect the economic interest in Changyou held by shareholders other than Sohu ("noncontrolling shareholders"), Changyou's net income attributable to these noncontrolling shareholders is recorded as noncontrolling interest in Sohu's consolidated statements of comprehensive income, based on their share of the economic interests in Changyou. Changyou's cumulative results of operations attributable to these noncontrolling shareholders, along with changes in shareholders' equity, adjustment for share-based compensation expense in relation to those share-based awards which are unvested and vested but not yet settled and adjustment for changes in Sohu's ownership in Changyou from Sohu's purchase of Changyou ADSs representing Class A ordinary shares, are recorded as noncontrolling interest in Sohu's consolidated balance sheets. Noncontrolling Interest for Sogou To reflect the economic interest in Sogou held by shareholders other than Sohu ("noncontrolling shareholders"), Sogou's net income /loss attributable to these noncontrolling shareholders is recorded as noncontrolling interest in Sohu's consolidated statements of comprehensive income. Sogou's cumulative results of operations attributable to these noncontrolling shareholders, along with changes in shareholders' equity /(deficit) and adjustment for share-based compensation expense in relation to those share-based awards which are unvested and vested but not yet settled and noncontrolling shareholders' investments in Series A Preferred Shares are accounted for as a noncontrolling interest classified as permanent equity in Sohu's consolidated balance sheets, as redemption of the noncontrolling interest is solely within the control of Sohu. These treatments are based on the terms governing investment by the noncontrolling shareholders in the Series A Preferred Shares of Sogou (the "Sogou Series A Terms"), the terms of Sogou's restructuring, and Sohu's purchase of Sogou Series A Preferred Shares from Alibaba. By virtue of these terms, as Sogou has been losing money after its restructuring, the net losses have been and will be allocated in the following order: (i) net losses were allocated to ordinary shareholders until their basis in Sogou decreased to zero; (ii) additional net losses will be allocated to holders of Sogou Series A Preferred Shares until their basis in Sogou decreases to zero; and (iii) further net losses will be allocated between ordinary shareholders and holders of Sogou Series A Preferred Shares based on their shareholding percentage in Sogou. -52- -------------------------------------------------------------------------------- Table of Contents Any subsequent net income from Sogou will be allocated in the following order: (i) net income will be allocated between ordinary shareholders and holders of Sogou Series A Preferred Shares based on their shareholding percentage in Sogou until their basis in Sogou increases to zero; (ii) additional net income will be allocated to holders of Sogou Series A Preferred Shares to bring their basis back; (iii) further net income will be allocated to ordinary shareholders to bring their basis back; and (iv) further net income will be allocated between ordinary shareholders and holders of Sogou Series A Preferred Shares based on their shareholding percentage in Sogou. Net Income per Share Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common shares and, if dilutive, potential common shares outstanding during the period. Potential common shares comprise shares issuable upon the exercise or settlement of share-based awards using the treasury stock method. The dilutive effect of share-based awards with performance requirements is not considered before the performance targets are actually met. The computation of diluted net income per share does not assume conversion, exercise, or contingent issuance of securities that would have an anti-dilutive effect (i.e., an increase in earnings per share amounts or a decrease in loss per share amounts) on net income per share. Additionally, for purposes of calculating the numerator of diluted net income per share, the net income attributable to Sohu is adjusted as follows: (1) Changyou's net income attributable to Sohu is determined using the percentage that the weighted average number of Changyou shares held by Sohu represents of the weighted average number of Changyou ordinary shares and shares issuable upon the exercise or settlement of share-based awards under the treasury stock method, instead of by the percentage held by Sohu of the total economic interest in Changyou, which is used for the calculation of basic net income per share. (2) Sogou's net income /(loss) attributable to Sohu is determined using the percentage that the weighted average number of Sogou shares held by Sohu represents of the weighted average number of Sogou ordinary shares and Series A Preferred Shares, shares issuable upon the conversion of convertible preferred shares under the if-converted method, and shares issuable upon the exercise or settlement of share-based awards under the treasury stock method, instead of by Sogou's net income /(loss) allocated to Sohu by virtue of the Sogou Series A Terms, the terms of the restructuring and Sohu's purchase of Sogou Series A Preferred Shares from Alibaba, which is used for the calculation of basic net income per share. Fair Value of Financial Instruments Our financial instruments include cash equivalents, restricted time deposits, short-term investments, accounts receivable, investments in debt securities, prepaid and other current assets, accounts payable, short-term bank loans, accrued liabilities, receipts in advance and deferred revenue, other short-term liabilities and long-term bank loans. The carrying amount of accounts receivable, prepaid and other current assets, accounts payable, receipts in advance and deferred revenue, accrued liabilities and other short-term liabilities approximates their fair value. Other financial instruments are measured at their respective fair values. For fair value measurements, U.S. GAAP establishes a three-tier hierarchy which prioritizes the inputs used in the valuation methodologies in measuring fair value: Level 1 - observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - include other inputs that are directly or indirectly observable in the market place. Level 3 - unobservable inputs which are supported by little or no market activity. The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Cash Equivalents Our cash equivalents mainly consist of time deposits placed with banks with an original maturity of three months or less. Restricted time deposits - Changyou offshore bridge loans from banks, secured by time deposits In the third quarter of 2012, Changyou drew down offshore bridge loans from branches of certain banks for the purposes of expediting the payment of the special one-time cash dividend to its shareholders and providing working capital to support its overseas operations. All of these bridge loans were secured by an equivalent or greater amount in RMB deposits by Changyou in the onshore branches of such banks. The offshore bridge loans from the branches of the lending banks are classified as short-term bank loans or long-term bank loans based on their payment terms. The RMB onshore deposits securing the offshore loans are treated as restricted time deposits on our consolidated balance sheets. Restricted time deposits are valued based on the prevailing interest rates in the market. The rates of interest under the loan agreements with the lending banks were also determined based on the prevailing interest rates in the market. We classify the valuation techniques that use these inputs as Level 2 of fair value measurements of offshore bridge loans from banks. -53--------------------------------------------------------------------------------- Table of Contents Short-term Investments For investments in financial instruments with a variable interest rate indexed to the performance of underlying assets, we elected the fair value method at the date of initial recognition and carried these investments subsequently at fair value. Changes in the fair value are reflected in the consolidated statements of comprehensive income. Accounts Receivable, Net The carrying value of accounts receivable is reduced by an allowance that reflects our best estimate of the amounts that will not be collected. We make estimations of the collectability of accounts receivable. Many factors are considered in estimating the general allowance, including but not limited to reviewing delinquent accounts receivable, performing an aging analysis and a customer credit analysis, and analyzing historical bad debt records and current economic trends. Additional allowance for specific doubtful accounts might be made if the financial conditions of our customers or the China mobile network operators deteriorate or the China mobile network operators are unable to collect fees from their end customers, resulting in their inability to make payments due to us. Investments in Debt Securities We invest our excess cash in certain debt securities of high-quality corporate issuers. We elected the fair value option to account for our investments in debt securities at their initial recognition. Changes in the fair value are reflected in the consolidated statements of comprehensive income as other income /(expense). The fair value election was made to mitigate accounting mismatches and to achieve operational simplifications. Equity Investments Investments in entities over which we do not have significant influence are recorded as equity investments and are accounted for by the cost method. Investments in entities over which we have significant influence but do not control are also recorded as equity investments and are accounted for by the equity method. Under the equity method, our share of the post-acquisition profits or losses of the equity investment is recognized in our consolidated statements of comprehensive income; and our share of post-acquisition movements in equity investments is recognized in equity in our consolidated balance sheets. Unrealized gains on transactions between us and our equity investees are eliminated to the extent of the interest in the equity investments. Unrealized losses are also eliminated unless the transaction provides evidence of an impairment of the asset transferred. When our share of losses in an equity investment equals or exceeds our interest in the equity investment, we do not recognize further losses, unless we have incurred obligations or made payments on behalf of the equity investee. Long-Lived Assets Long-lived assets include fixed assets, intangible assets and prepaid non-current assets. Fixed Assets Fixed assets mainly comprise computer equipment and hardware, office building, leasehold improvements, office furniture and vehicles. Fixed assets are recorded at cost less accumulated depreciation with no residual value. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Intangible Assets Intangible assets mainly comprise customer lists, video content and license, developed technologies, computer software purchased from unrelated third parties, domain names and trademarks, marketing rights and others, as well as operating rights for licensed games. Intangible assets are recorded at cost less accumulated amortization with no residual value. Amortization of intangible assets other than licensed video content is computed using the straight-line method over their estimated useful lives. We amortize licensed video content over the shorter of the term of the estimated period over which the benefits of the license agreement will be enjoyed based on the trend of accumulation of viewership or the applicable license period. Beginning in the third quarter of 2011, licensed video content is amortized on an accelerated basis based on the viewership accumulation trend over the shorter of the term of the estimated period over which the benefits of the license agreement will be enjoyed or the applicable license period. -54- -------------------------------------------------------------------------------- Table of Contents For exclusively licensed video content which we sub-licensed to similar platforms in return for payment in cash, we allocate a portion of the video content cost from cost of brand advertising revenues to sub-licensing cost. The allocation is based on the revenues to be generated through sub-licensing. We amortize sub-licensing cost using the individual-film-forecast-computation method, which amortizes such costs in the same ratio that actual sub-licensing revenue bears as of the current period end to the total of the actual revenue earned and the estimated remaining unrecognized ultimate revenue. Prepaid non-current Assets Prepaid non-current assets primarily include prepayments for the office buildings to be built as our and Changyou's headquarters before they are recognized as fixed assets, prepayments for the technological infrastructure and fitting-out of our office building before they are recognized as fixed assets, and prepaid PRC income tax arising from the sale of the 17173 Business by us to Changyou. Since the sale of the 17173 Business was between entities that are included in our consolidated financial statements, it was considered an "intra-entity transaction" and, under ASC 810-10, income taxes paid should be deferred. Accordingly, we recorded income tax related to the sale of the 17173 Business as prepaid PRC income tax. The prepaid PRC income tax will be amortized over the period of the weighted average remaining life of the 17173 Business-related assets sold to Changyou. Impairment of Long-lived Assets In accordance with ASC 360-10-35, we review the carrying values of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Based on the existence of one or more indicators of impairment, we measure any impairment of long-lived assets using the projected discounted cash flow method at the asset group level. The estimation of future cash flows requires significant management judgment based on our historical results and anticipated results and is subject to many factors. The discount rate that is commensurate with the risk inherent in our business model is determined by our management. An impairment loss would be recorded if we determined that the carrying value of long-lived assets may not be recoverable. The impairment to be recognized is measured by the amount by which the carrying values of the assets exceed the fair value of the assets. We noted that prices for purchased video content decreased significantly in the second quarter of 2012. We considered this is an indicator of impairment, and accordingly we performed an impairment test for our purchased video content at the asset group level. We divided purchased video content into seven asset groups, consisting of TV series, Pay Channel, Overseas Content, Movies, Animations, Variety shows, and Documentary films. We tested the recoverability of the carrying values of these asset groups by comparing their carrying amounts to the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset groups. If the carrying amount of an asset group was determined to not be recoverable, an impairment loss was recognized, measured by comparing the carrying value of the asset group to the asset group's fair value. The fair values of the purchased video content were estimated using the discounted cash flow method. The impairment losses were allocated only to the purchased video content within the asset group, since the carrying amount of other long-lived assets within the asset group was considered to be already below their fair value. Goodwill Goodwill represents the excess of the purchase price over the fair value of the identifiable assets and liabilities acquired as a result of our acquisitions of interests in our subsidiaries and VIEs. We test goodwill for impairment at the reporting unit level on an annual basis as of October 1, and between annual tests when an event occurs or circumstances change that could indicate that the asset might be impaired. Commencing in September 2011, we adopted the Financial Accounting Standards Board ("FASB") revised guidance on "Testing of Goodwill for Impairment." Under this guidance, we have the option to choose whether we will apply the qualitative assessment first and then the quantitative assessment, if necessary, or to apply the quantitative assessment directly. For reporting units applying qualitative assessment first, we start the goodwill impairment test by assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we determine that it is more-likely-than-not the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is mandatory. Otherwise, no further testing is required. The quantitative impairment test consists of a comparison of the fair value of goodwill with its carrying value. For reporting units directly applying quantitative assessment, we perform the goodwill impairment test by quantitatively comparing the fair values of those reporting units to their carrying amounts. Application of a goodwill impairment test requires significant management judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. The judgment in estimating the fair value of reporting units includes estimating future cash flows, determining appropriate discount rates and making other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit. -55--------------------------------------------------------------------------------- Table of Contents Contingent Consideration Our contingent consideration primarily consisted of contingent payments generated from the acquisition of 7Road. The acquisition of 7Road includes a contingent consideration arrangement that requires additional consideration to be paid by Changyou based on the future financial performance of 7Road through December 31, 2012. The fair value of the contingent consideration recognized on the acquisition date was estimated using the income approach. As of September 30, 2012, certain specified performance milestones in 2012 had been achieved by 7Road based on its nine months' financial performance, and we recorded consideration payable of $19.7 million in other accrued liabilities. Changes in fair value of the contingent consideration were recognized in other income /(expense). There are no indemnification assets involved. Mezzanine Equity On May 11, 2011, Changyou, through its VIE Gamease, acquired 68.258% of the equity interests of Shenzhen 7Road and began to consolidate Shenzhen 7Road's financial statements on June 1, 2011. Effective from June 26, 2012, Shenzhen 7Road was reorganized into a Cayman Islands holding company structure where Changyou holds a direct ownership interest in 7Road through Changyou's subsidiary Changyou.com Webgame (HK) Limited, and Shenzhen 7Road is a VIE of 7Road. For purposes of clarity, as the reorganization did not result in any change in the ultimate beneficial ownership of Shenzhen 7Road's business, assets and results of operations, when we discuss 7Road and Shenzhen 7Road in this report, we treat the reorganization as if it had been effective upon Changyou's acquisition of 68.258% of the equity interests in Shenzhen 7Road. Mezzanine Equity consists of noncontrolling interest in 7Road and a put option pursuant to which the noncontrolling shareholders will have the right to put their equity interests in 7Road to Changyou at a pre-determined price if 7Road achieves specified performance milestones in the coming three years and certain circumstances occur. The put option will expire in 2014. Since the occurrence of the sale is not solely within the control of Changyou, we classify the noncontrolling interest as mezzanine equity instead of permanent equity in our and Changyou's consolidated financial statements. Under ASC subtopic 480-10, we calculate, on an accumulative basis from the acquisition date, (i) the amount of accretion that would increase the balance of noncontrolling interest to its estimated redemption value over the period from the date of the Shenzhen 7Road acquisition to the earliest redemption date of the noncontrolling interest in 7Road and (ii) the amount of net profit attributable to noncontrolling shareholders of 7Road based on their ownership percentage. The carrying value of the noncontrolling interest as mezzanine equity will be adjusted by an accumulative amount equal to the higher of (i) and (ii). On June 21, 2012, 7Road's Chief Executive Officer surrendered to 7Road, without consideration, ordinary shares of 7Road representing 5.1% of the outstanding ordinary shares of 7Road, in order to increase the availability of ordinary shares available for issuance as equity incentives to employees, directors and consultants of 7Road without dilution of the other shareholders of 7Road. As a result, the noncontrolling interest decreased to 28.074% of 7Road and Changyou's interest in 7Road increased to 71.926%. Under ASC subtopic 480-10, changes in a parent's ownership interest while the parent retains control of its subsidiary are accounted for as equity transactions, and do not impact net income or comprehensive income in the consolidated financial statements. The variance of $6.8 million caused by 7Road's Chief Executive Officer's surrender of shares was recorded as a credit to additional paid-in capital. In the third quarter of 2012, Changyou's management estimated that, based on 7Road's performance in the nine months of 2012, 7Road will likely to exceed the specified performance milestones set forth in the acquisition agreement, and accordingly increased the estimated redemption value of the noncontrolling interests in 7Road. The increase in the redemption value was recognized over the period from the date of the 7Road acquisition to the earliest exercise date of the put right as net income attributable to mezzanine-classified noncontrolling interests. Comprehensive Income Comprehensive income is defined as the change in equity of a company during a period from transactions and other events and circumstances excluding transactions resulting from investments from owners and distributions to owners. Accumulated other comprehensive income, as presented on our consolidated balance sheets, includes a cumulative foreign currency translation adjustment. Segment Reporting Our segments are business units that offer different services and are reviewed separately by the chief operating decision maker ("CODM"), or the decision making group, in deciding how to allocate resources and in assessing performance. Our CODM is the Chief Executive Officer. There are five segments in the Sohu Group, consisting of brand advertising, Sogou (which mainly consists of the search and related business), Changyou (which mainly consists of the online game business), wireless and others. -56--------------------------------------------------------------------------------- Table of Contents Functional Currency and Foreign Currency Translation Functional Currency An entity's functional currency is the currency of the primary economic environment in which it operates, normally that is the currency of the environment in which the entity primarily generates and expends cash. Management's judgment is essential to determine the functional currency by assessing various indicators, such as cash flows, sales price and market, expenses, financing and inter-company transactions and arrangements. The functional currency of Sohu.com Inc. is the U.S. dollar. The functional currency of our subsidiaries in the U.S., the Cayman Islands, the British Virgin Islands and Hong Kong is the U.S. dollar. The functional currencies of our subsidiaries and VIEs in the PRC, the United Kingdom, Malaysia and Korea are the national currencies of those counties. Foreign Currency Translation Assets and liabilities of our China-based subsidiaries and VIEs, the United Kingdom, Malaysia and Korea are translated into U.S. dollars, our reporting currency, at the exchange rate in effect at the balance sheets date and revenues and expenses are translated at the average exchange rates in effect during the reporting period. Foreign currency translation adjustments are not included in determining net income for the period but are accumulated in a separate component of equity in our consolidated balance sheets. Foreign currency transactions denominated in currencies other than the functional currency are translated into the functional currency using the exchange rates prevailing at the dates of the transactions. Monetary assets and liabilities denominated in foreign currencies at the balance sheet date are re-measured at the applicable rates of exchange in effect at that date. Gains and losses resulting from foreign currency re-measurement are included in the consolidated statements of comprehensive income. RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011 In 2011, we adjusted our business groupings from brand advertising business, online game business, sponsored search business, and wireless and others business to online advertising business (consists of the brand advertising business as well as the search and others business), online game business, wireless business and others business. To conform to current period presentations, the relevant amounts for prior periods have been reclassified. Commencing January 1, 2012, with the development of our business, we reclassified certain expenses for our Search business and our video division. Change in Presentation to Properly Reflect the Classification of Expenses of Video Business Prior to 2012, the video division was a relatively small operation in the Sohu Group. It did not have clearly defined business departments because it was highly dependent on the Sohu Group's resources to sustain its operation. The video division's compensation and benefits expenses were recorded under cost of revenues and were not allocated to individual operating expense categories, in view of the fact that most of the employees in the video division provided services related to the maintenance of content and resources that directly contributed to video-related brand advertising revenues. Commencing January 1, 2012, as the video division has grown significantly and business departments have been defined through the restructuring process to become more self-sustainable, compensation and benefits expenses have been allocated to the respective business departments to properly reflect the operating results of the video division. The video division's compensation and benefits expenses were classified as cost of revenues, product development, sales and marketing and general and administrative expenses, respectively, based on the nature of the related employees' roles and responsibilities. To conform to current period presentations, the relevant amounts for prior periods have been changed accordingly. The change from cost of revenues to operating expenses was not material to historical periods, and amounted to $1.4 million and $2.9 million for the three and the nine months ended September 30, 2011. Reclassification of Expenses of Search and Others Business To expand distribution of customers' sponsored links or advertisements, the search and others business acquires traffic from third-party Websites. Most traffic acquisition payments are made to Sogou's Website Alliance members. Payments to Sogou's Website Alliance members are based on a portion of pay-for-click revenues generated from clicks by users of their properties, and are included in cost of revenues. A relatively small portion of traffic acquisition payments to third-party Websites are based on pre-agreed unit prices and the actual traffic volume they direct to our search and others business. Prior to 2012, traffic acquisition payments based on pre-agreed unit price and the actual traffic volume were recorded in sales and marketing expenses. -57--------------------------------------------------------------------------------- Table of Contents Commencing January 1, 2012, in order to enhance comparability with industry peers, all traffic acquisition costs were recorded in cost of revenues. To conform to current period presentations, the relevant amounts for prior periods have been reclassified accordingly. Such reclassifications amounted to $2.0 million and $5.9 million for the three and the nine months ended September 30, 2011. Revenues The following table presents our revenues by revenue source and by proportion for the periods indicated (in thousands, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2012 vs 2012 vs 2012 2011 2011 2012 2011 2011 Revenues Online advertising: Brand advertising $ 77,874 27 % $ 76,572 33 % $ 1,302 $ 208,154 27 % $ 201,453 33 % $ 6,701 Search and others 35,284 12 % 18,410 8 % 16,874 85,684 11 % 40,002 7 % 45,682 Subtotal of online advertising revenues 113,158 39 % 94,982 41 % 18,176 293,838 38 % 241,455 40 % 52,383 Online game 151,093 54 % 115,798 50 % 35,295 415,711 54 % 312,259 52 % 103,452 Wireless 14,312 5 % 14,210 6 % 102 43,261 6 % 37,559 6 % 5,702 Others 6,815 2 % 7,870 3 % (1,055 ) 14,899 2 % 14,661 2 % 238 Total revenues $ 285,378 100 % $ 232,860 100 % $ 52,518 $ 767,709 100 % $ 605,934 100 % $ 161,775 Total revenues were $285.4 million and $767.7 million, respectively, for the three and nine months ended September 30, 2012, compared to $232.9 million and $605.9 million, respectively, for the corresponding periods in 2011. The increase in total revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $52.5 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $161.8 million. The increases were mainly attributable to increases in online game revenues and search and others revenues. Online Advertising Revenues Online advertising revenues were $113.2 million and $293.8 million, respectively, for the three and nine months ended September 30, 2012, compared to $95.0 million and $241.5 million, respectively, for the corresponding periods in 2011. The increase in online advertising revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $18.2 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $52.3 million. The increases were mainly attributable to increases in search and others revenues. Brand Advertising Revenues Brand advertising revenues were $77.9 million and $208.2 million, respectively, for the three and nine months ended September 30, 2012, compared to $76.6 million and $201.5 million, respectively, for the corresponding periods in 2011. The increase in brand advertising revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $1.3 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $6.7 million. The increases were mainly attributable to increases in revenues from the sectors of fast-moving consumer goods, online game and transportation. We expect brand advertising revenues to increase modestly in the fourth quarter of 2012, compared to the third quarter of 2012. Search and Others Revenues Search and others revenues were $35.3 million and $85.7 million, respectively, for the three and nine months ended September 30, 2012, compared to $18.4 million and $40.0 million, respectively, for the corresponding periods in 2011. The increase in search and others revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $16.9 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $45.7 million. The increases were mainly due to increased traffic and improved monetization of traffic. -58--------------------------------------------------------------------------------- Table of Contents We expect search and others revenues to increase modestly in the fourth quarter of 2012, compared to the third quarter of 2012. Online Game Revenues Online game revenues were $151.1 million and $415.7 million, respectively, for the three and nine months ended September 30, 2012, compared to $115.8 million and $312.3 million, respectively, for the corresponding periods in 2011. The increase in online game revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $35.3 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $103.4 million. The increases were mainly due to the ongoing popularity of Changyou's flagship game TLBB, the increase in average revenue per active paying account for Changyou's MMOGs, and the growth of Wartune in China. For the three months ended September 30, 2012, average revenue per active paying account of Changyou's MMOGs in China increased by 46% to RMB319, from RMB218 for the three months ended September 30, 2011. We expect online game revenues to increase in the fourth quarter of 2012, compared to the third quarter of 2012. Wireless Revenues Wireless revenues were $14.3 million and $43.3 million, respectively, for the three and nine months ended September 30, 2012, compared to $14.2 million and $37.6 million, respectively, for the corresponding periods in 2011. The increase in wireless revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $0.1 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $5.7 million. The latter was mainly due to enhanced product distribution programs. We expect wireless revenues to decrease slightly for the fourth quarter of 2012, compared to the third quarter of 2012. Others Revenues Revenues for other services were $6.8 million and $14.9 million, respectively, for the three and nine months ended September 30, 2012, compared to $7.9 million and $14.7 million, respectively, for the corresponding periods in 2011. The decrease in other revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $1.1 million. The decrease was mainly due to decreased revenues from sub-licensing of licensed video content and cinema advertisement business. Costs and Expenses Cost of Revenues The following table presents our cost of revenues by source and by proportion for the periods indicated (in thousands, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2012 vs 2012 vs 2012 2011 2011 2012 2011 2011 Cost of revenues: Online advertising: Brand advertising $ 37,476 39 % $ 30,221 44 % $ 7,255 $ 125,331 45 % $ 76,942 46 % $ 48,389 Search and others 19,736 20 % 9,478 14 % 10,258 49,056 18 % 24,365 14 % 24,691 Subtotal of cost of online advertising revenues 57,212 59 % 39,699 58 % 17,513 174,387 63 % 101,307 60 % 73,080 Online game 21,026 22 % 14,578 22 % 6,448 55,735 20 % 33,496 20 % 22,239 Wireless 9,474 10 % 8,727 13 % 747 28,535 10 % 22,728 13 % 5,807 Others 9,037 9 % 4,469 7 % 4,568 17,458 7 % 11,359 7 % 6,099 Total cost of revenues $ 96,749 100 % $ 67,473 100 % $ 29,276 $ 276,115 100 % $ 168,890 100 % $ 107,225 -59- -------------------------------------------------------------------------------- Table of Contents Total cost of revenues was $96.7 million and $276.1 million, respectively, for the three and nine months ended September 30, 2012, compared to $67.5million and $168.9 million, respectively, for the corresponding periods in 2011. The increase in cost of revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $29.2 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $107.2 million. The increases were mainly attributable to increases in cost of brand advertising revenues and cost of search and others revenues. Cost of Online Advertising Revenues Cost of online advertising revenues was $57.2 million and $174.4 million, respectively, for the three and nine months ended September 30, 2012, compared to $39.7 million and $101.3 million, respectively, for the corresponding periods in 2011. The increase in cost of online advertising revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $17.5 million, and the increase was mainly attributable to increase in cost of search and others revenues. The increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $73.1 million, and the increase was mainly attributable to increase in cost of brand advertising revenues. Cost of Brand Advertising Revenues Cost of brand advertising revenues mainly consists of content and license costs (including amortization of licensed video content and impairment of purchased video content), bandwidth leasing costs, salary and benefits expenses, depreciation expenses and revenue sharing payments. Cost of brand advertising revenues was $37.5 million and $125.3 million, respectively, for the three and nine months ended September 30, 2012, compared to $30.2 million and $76.9 million, respectively, for the corresponding periods in 2011. The increase in cost of brand advertising revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $7.3 million. The increase mainly consisted of a 2.2 million increase in amortization of licensed video content, a $2.0 million increase in bandwidth leasing costs, and a $1.1 million increase in salary and benefits expenses. The increase in cost of brand advertising revenues from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $48.4 million. The increase mainly consisted of a $15.6 million increase in amortization of licensed video content, a $15.1 million increase in impairment of purchased video content, an $8.8 million increase in bandwidth leasing costs, and a $2.8 million increase in salary and benefits expenses. Our brand advertising gross margin was 52% and 40%, respectively, for the three and nine months ended September 30, 2012, as compared to 61% and 62%, respectively, for the corresponding periods in 2011. The decrease in our brand advertising gross margin for the three months ended September 30, 2012 was mainly due to increase in content and bandwidth costs. The decrease for the nine months ended September 30, 2012 was mainly due to increases in content and bandwidth costs and the impairment of purchased video content. Cost of Search and Others Revenues Cost of search and others revenues mainly consists of traffic acquisition costs, depreciation expenses, bandwidth leasing costs, as well as salary and benefits expenses. Cost of search and others revenues was $19.7 million and $49.1 million, respectively, for the three and nine months ended September 30, 2012, compared to $9.5 million and $24.4 million, respectively, for the corresponding periods in 2011. The increase in cost of search and others revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $10.2 million. The increase mainly consisted of a $7.9 million increase in traffic acquisition costs, a $1.3 million increase in depreciation expenses, a $0.6 million increase in salary and benefits expenses and a $0.4 million increase in bandwidth leasing costs, along with increased traffic volume. The increase in cost of search and others revenues from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $24.7 million. The increase mainly consisted of an $18.8 million increase in traffic acquisition costs, a $3.1 million increase in depreciation expenses, a $1.5 million increase in salary and benefits expenses and a $1.2 million increase in bandwidth leasing costs, along with increased traffic volume. Our search and others gross margin was 44% and 43%, respectively, for the three and nine months ended September 30, 2012, as compared to 49% and 39%, respectively, for the corresponding periods in 2011. The decrease in our search and others gross margin for the three months ended September 30, 2012 was mainly due to higher traffic acquisition costs. The increase for the nine months ended September 30, 2012 was mainly due to higher revenues from online marketing services on Sogou Web Directory. -60--------------------------------------------------------------------------------- Table of Contents Cost of Online Game Revenues Cost of online game revenues mainly consists of salary and benefits expenses, bandwidth leasing costs, depreciation expenses, revenue-based royalty payments to game developers, Business Tax and VAT arising from transactions between Changyou's subsidiaries and its VIEs, and amortization of licensing fees. Cost of online game revenues was $21.0 million and $55.7 million, respectively, for the three and nine months ended September 30, 2012, compared to $14.6 million and $33.5 million, respectively, for the corresponding periods in 2011. The increase in cost of online game revenues from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $6.4 million. The increase mainly consisted of a $3.0 million increase in salary and benefits expenses, which was mainly attributable to increased headcount, a $1.7 million increase in depreciation and amortization expenses and a $0.6 million increase in bandwidth leasing costs. The increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $22.2 million. The increase mainly consisted of a $7.4 million increase in salary and benefits expenses, which was mainly attributable to increased headcount, a $5.9 million increase in depreciation and amortization expenses and a $4.1 million increase in bandwidth leasing costs. Our online game gross margin was 86% and 87%, respectively, for the three and nine months ended September 30, 2012, as compared to 87% and 89%, respectively, for the corresponding periods in 2011. The decreases in our online game gross margin were mainly due to an increase in headcount and related salaries and benefits expenses, as well as higher bandwidth and server costs as Changyou operated a larger portfolio of online games. Cost of Wireless Revenues Cost of wireless revenues mainly consists of revenue sharing with partners, collection charges and transmission fees paid to China mobile network operators, bandwidth leasing costs and depreciation expenses. Cost of wireless revenues was $9.5 million and $28.5 million, respectively, for the three and nine months ended September 30, 2012, compared to $8.7 million and $22.7 million, respectively, for the corresponding periods in 2011. The increase in cost of wireless revenues from the three and nine months ended September 30, 2011 to the three and nine months ended September 30, 2012 was $0.8 million and $5.8 million, respectively. The increases were mainly due to increased revenue sharing with partners. The collection charges and transmission fees vary between China mobile network operators. The collection charges and transmission fees mainly included (i) a gateway fee of $0.008 to $0.032 per message in the third quarter of 2012, and $0.005 to $0.031 per message, depending on the volume of the monthly total wireless messages, in the third quarter of 2011 and (ii) a collection fee of 15% to 87% of total fees collected by China mobile network operators from mobile phone users (with the residual paid to us) in both the third quarter of 2012 and 2011. Our wireless gross margin was both 34% for the three and nine months ended September 30, 2012, as compared to 39% for both of the corresponding periods in 2011. The decreases in our wireless gross margin were mainly due to increased revenue sharing with partners. Cost of Revenues for Other Services Cost of revenues for other services mainly consists of payments to theatres and film production companies for pre-film screening advertisement slots. Cost of revenues for other services was $9.0 million and $17.5 million, respectively, for the three and nine months ended September 30, 2012, compared to $4.5 million and $11.4 million, respectively, for the corresponding periods in 2011. The increase in cost of revenues for other services from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $4.5 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $6.1 million. The increases were mainly due to long-lived assets impairment costs for our cinema advertisement business. -61- -------------------------------------------------------------------------------- Table of Contents Operating Expenses The following table presents our operating expenses by nature and by proportion for the periods indicated (in thousands, except percentages): Three Months Ended September 30, Nine Months Ended September 30, 2012 vs 2012 vs 2012 2011 2011 2012 2011 2011 Operating expenses: Product development $ 46,994 38 % $ 28,943 32 % $ 18,051 $ 128,927 39 % $ 78,005 34 % $ 50,922 Sales and marketing 58,250 47 % 47,150 51 % 11,100 145,903 43 % 112,275 48 % 33,628 General and administrative 19,666 15 % 15,686 17 % 3,980 54,968 17 % 41,000 18 % 13,968 Impairment of intangible assets via acquisition of businesses 0 0 % 0 0 % 0 2,906 1 % 0 0 % 2,906 Total operating expenses $ 124,910 100 % $ 91,779 100 % $ 33,131 $ 332,704 100 % $ 231,280 100 % $ 101,424 Total operating expenses were $124.9 million and $332.7 million, respectively, for the three and nine months ended September 30, 2012, compared to $91.8 million and $231.3 million, respectively, for the corresponding periods in 2011. The increase in operating expenses from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $33.1 million, and the increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $101.4 million. The increases were mainly attributable to increases in product development expenses and sales and marketing expenses. Product Development Expenses Product development expenses mainly consist of personnel-related expenses incurred for enhancement and maintenance of our Websites, and costs associated with new product development and enhancement of existing products and services, which mainly include the development costs of online games prior to the establishment of technological feasibility and maintenance costs after the online games are available for marketing. Product development expenses were $47.0 million and $128.9 million, respectively, for the three and nine months ended September 30, 2012, compared to $28.9 million and $78.0 million, respectively, for the corresponding periods in 2011. The increase in product development expenses from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $18.1 million. The increase mainly consisted of a $14.7 million increase in salary and benefits expenses, which was mainly attributable to increased headcount, and a $1.0 million increase in travel expenses. The increase in product development expenses from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $50.9 million. The increase mainly consisted of a $39.6 million increase in salary and benefits expenses, which was mainly attributable to increased headcount, a $2.4 million increase in travel expenses, and a $2.2 million increase in professional fees. Sales and Marketing Expenses Sales and marketing expenses mainly consist of advertising and promotional expenditures, salary and benefits expenses, travel expenses, and facility expenses. Sales and marketing expenses were $58.3 million and $145.9 million, respectively, for the three and nine months ended September 30, 2012, compared to $47.2 million and $112.3 million, respectively, for the corresponding periods in 2011. The increase in sales and marketing expenses from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $11.1 million. The increase mainly consisted of a $7.9 million increase in salary and benefits expenses, which was mainly attributable to increased headcount, a $1.4 million increase in travel expenses, and a $0.6 million increase in advertising and promotional expenditures as a result of increased marketing and promotion activities. The increase in sales and marketing expenses from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $33.6 million. The increase mainly consisted of an $18.6 million increase in salary and benefits expenses, which was mainly attributable to increased headcount, a $7.6 million increase in advertising and promotional expenditures as a result of increased marketing and promotion activities, and a $3.7 million increase in travel expenses. General and Administrative Expenses General and administrative expenses mainly consist of salary and benefits expenses, professional service fees, travel expenses, and facility expenses. -62- -------------------------------------------------------------------------------- Table of Contents General and administrative expenses were $19.7 million and $55.0 million, respectively, for the three and nine months ended September 30, 2012, compared to $15.7 million and $41.0 million, respectively, for the corresponding periods in 2011. The increase in general and administrative expenses from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $4.0 million. The increase mainly consisted of a $1.7 million increase in salary and benefits expenses, which was mainly attributable to increased headcount, a $1.1 million increase in professional service fees, and a $1.0 million increase in travel expenses. The increase in general and administrative expenses from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $14.0 million. The increase mainly consisted of a $6.0 million increase in salary and benefits expenses, which was mainly attributable to increased headcount, a $3.6 million increase in bad debt expenses and a $2.2 million increase in professional service fees. Share-based Compensation Expense Sohu, Changyou, Sogou, Sohu Video and 7Road all have incentive plans for the granting of share-based awards, including common stock /ordinary shares, share options, restricted shares and restricted share units, to their employees and directors. Share-based compensation expense was recognized in costs and/or expenses for the three and nine months ended September 30, 2012 and September 30, 2011, respectively, as follows (in thousands): Three Months Ended Nine Months Ended September 30, September 30, Share-based compensation expense 2012 2011 2012 2011 Cost of revenues $ 232 $ 253 $ 426 $ 1,543 Product development expenses 1,316 1,633 4,019 4,826 Sales and marketing expenses 582 874 1,613 2,835 General and administrative expenses 1,713 1,617 4,144 4,857 $ 3,843 $ 4,377 $ 10,202 $ 14,061 Share-based compensation expense recognized for share awards of Sohu, Changyou, Sogou, Sohu Video and 7Road, respectively, was as follows (in thousands): Three Months Ended Nine Months Ended September 30, September 30, Share-based compensation expense 2012 2011 2012 2011 For Sohu share-based awards $ 1,440 $ 2,607 $ 4,621 $ 8,735 For Changyou share-based awards 750 1,172 2,769 4,210 For Sogou share-based awards 1,653 598 2,812 1,116 For Sohu Video share-based awards 0 - 0 - For 7Road share-based awards 0 - 0 - $ 3,843 $ 4,377 $ 10,202 $ 14,061 For Sohu share options, as of September 30, 2012 there was no unrecognized compensation expense because the requisite service periods for the remaining share options had ended by the end of 2009. For Sohu restricted share units, as of September 30, 2012 there was $4.0 million of related unrecognized compensation expense. For Changyou share-based awards, as of September 30, 2012, there was $2.5 million of unrecognized compensation expense. For Sogou share-based awards, as of September 30, 2012, there was $1.7 million of unrecognized compensation expense. For Sohu Video, no share-based compensation expense was recognized for the three and the nine months ended September 30, 2012 with respect to Sohu Video share option grants made during those nine months. This is because, under U.S. GAAP, no grant of options had occurred, as no grant date had been established at this stage. -63- -------------------------------------------------------------------------------- Table of Contents For 7Road, no share-based compensation expense was recognized for the three and the nine months ended September 30, 2012, as performance targets had not been met. Operating Profit As a result of the foregoing, our operating profit was $63.7 million and $158.9 million, respectively, for the three and nine months ended September 30, 2012, compared to $73.6 million and $205.8 million, respectively, for the corresponding periods in 2011. Other Income /(expense) Other income was a negative $0.1 million and $3.3 million, respectively, for the three and nine months ended September 30, 2012, compared to other income of $3.2 million and $5.2 million, respectively, for the corresponding periods in 2011. The decreases were mainly due to changes in the fair value of consideration payable to 7Road. Interest Income Interest income was $6.0 million and $19.7 million, respectively, for the three and nine months ended September 30, 2012, compared to $4.3 million and $10.3 million, respectively, for the corresponding periods in 2011. The increases were mainly due to increased cash balance and higher return on cash. Income Tax Expense Income tax expense was $18.7 million and $55.9 million, respectively, for the three and nine months ended September 30, 2012, compared to $14.4 million and $35.7 million, respectively, for the corresponding periods in 2011. The increase in income tax expense from the three months ended September 30, 2011 to the three months ended September 30, 2012 was $4.3 million. The increase from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 was $20.2 million. The increases were mainly due to an increase in withholding tax and net income of Changyou, and an increase in the applicable tax rates for the Sohu Group. Net Income For the three and nine months ended September 30, 2012, we had net income of $51.5 million and $126.1 million, respectively, compared to $64.3 million and $181.1 million, respectively, for the corresponding periods of 2011. Net Income Attributable to Noncontrolling Interest Net income attributable to noncontrolling interest was $21.1 million and $57.6 million, respectively, for the three and nine months ended September 30, 2012, compared to $16.4 million and $43.7 million, respectively, for the corresponding periods in 2011. The increases in net income attributable to noncontrolling interest were mainly due to increased net income of Changyou. We expect the noncontrolling interest recognized for Changyou to increase in the fourth quarter of 2012, compared to the third quarter of 2012, due to vesting of share-based awards, as well as an increase in Changyou's net income. We expect the noncontrolling interest recognized for Sogou to remain at a low level. Net Income attributable to Sohu.com Inc. As a result of the foregoing, we had net income attributable to Sohu of $25.9 million and $61.8 million, respectively, for the three and nine months ended September 30, 2012, compared to $46.8 million and $135.9 million, respectively, for the corresponding periods in 2011. LIQUIDITY AND CAPITAL RESOURCES Our principal sources of liquidity are cash and cash equivalents, short-term investments, investments in debt securities, as well as the cash flows generated from our operations. As of September 30, 2012, we had cash and cash equivalents, short-term investments and investments in debt securities of approximately $894.3 million. As of September 30, 2011, we had cash and cash equivalents, short-term investments and investments in debt securities of approximately $808.4 million. Cash equivalents primarily comprise time deposits. -64--------------------------------------------------------------------------------- Table of Contents In November 2009, we entered into an agreement to purchase a Beijing office building to serve as our headquarters. The purchase price is approximately $127 million, of which $107 million had been paid as of September 30, 2012. In December 2011, we also entered into an agreement for technological infrastructure and fitting-out work for this office building. The contractual amount is approximately $28 million, of which $16 million had been paid as of September 30, 2012. These $107 million and $16 million payments have been recognized as prepaid non-current assets in our consolidated balance sheets. The remaining $20 million for the office building and $12 million for the technological infrastructure and fitting-out work will be settled in installments as various stages of the development plan are completed. This office building and related technological infrastructure and fitting-out work are in progress and are expected to be completed in 2013. In August 2010, Changyou entered into an agreement to purchase a Beijing office building to serve as its headquarters. The purchase price is approximately $157 million, of which $125 million had been paid as of September 30, 2012 and was recognized as prepaid non-current assets in our consolidated balance sheets. The remaining $32 million will be settled by early of 2013, when the office building development is expected to be completed. In the third quarter of 2012, Changyou drew down offshore bridge loans from banks of $222 million, which were secured by the equivalent or greater amount of RMB deposits in onshore branches of those banks, totaling RMB1.43 billion ($226 million). As of September 30, 2012, the Sohu Group also had commitments for bandwidth purchases in the amount of $25 million, commitments for video content purchases in the amount of $19 million, commitments for operating leases in the amount of $12 million and commitments for other content and service purchases in the amount of $12 million. We believe our current liquidity and capital resources are sufficient to meet anticipated working capital needs (net cash used in operating activities), commitments and capital expenditures over the next twelve months. We may, however, require additional cash resources due to changes in business conditions and other future developments, or changes in general economic conditions. Cash Generating Ability We believe we will continue to generate strong cash flow from our online brand advertising business and online game business, which, along with our available cash, will provide sufficient liquidity and financial flexibility. Our cash flows were summarized below (in thousands): Nine Months Ended September 30, 2012 2011 Net cash provided by operating activities $ 279,781 $ 256,491 Net cash used in investing activities (346,743 ) (209,936 ) Net cash provided by /(used in) financing activities 110,433 (39,209 ) Effect of exchange rate change on cash and cash equivalents (2,609 ) 21,688 Net increase in cash and cash equivalents 40,862 29,034 Cash and cash equivalents at beginning of period 732,607 678,389 Cash and cash equivalents at end of period $ 773,469 $ 707,423 Net Cash Provided by Operating Activities For the nine months ended September 30, 2012, $279.8 million net cash provided by operating activities was primarily attributable to our net income of $126.1 million, adjusted by non-cash items of depreciation and amortization of $76.7 million, impairment of purchased video content of $15.1 million, share-based compensation expense of $10.2 million, impairment of intangible assets of $7.5 million, other miscellaneous non-cash expenses of $3.6 million, and an increase in cash from working capital items of $48.2 million, and adjust out the investment income from investments in debt securities of $4.1 million and excess tax benefits of $3.5 million. For the nine months ended September 30, 2011, $256.5 million net cash provided by operating activities was primarily attributable to our net income of $181.1 million, adjusted by non-cash items of depreciation and amortization of $45.5 million, share-based compensation expense of $14.1 million, and an increase in cash from working capital items of $19.4 million, offset by a decrease in cash from change in the fair value of debt securities of $2.2 million and excess tax benefits of $1.4 million. In accordance with U.S. GAAP, the above excess tax benefits were presented as a reduction in cash flows from operating activities and a cash inflow from financing activities. Realizing these benefits reduces the amount of taxes payable and does not otherwise affect cash flows. -65--------------------------------------------------------------------------------- Table of Contents Net Cash Used in Investing Activities For the nine months ended September 30, 2012, $346.7 million net cash used in investing activities was primarily attributable to $225.8 million restricted time deposits used as collateral for offshore bridge loans from banks, $94.9 million used in acquiring fixed assets and intangible assets, $20.3 million used in short-term investments, investment income from investments in debt securities of $4.1 million described above under the heading "Net Cash Provided by Operating Activities", and $1.6 million used in business acquisition and other investment activities. For the nine months ended September 30, 2011, $209.9 million net cash used in investing activities was primarily attributable to $130.1 million used in acquiring fixed assets and intangible assets including a $37 million payment for Sohu's office building, and $79.8 million used in business acquisitions and investing activities. Net Cash Provided by /Used in Financing Activities For the nine months ended September 30, 2012, $110.4 million net cash provided by financing activities was primarily attributable to $222.4 million of offshore bridge loans from banks, $3.5 million excess tax benefits described above under the heading "Net Cash Provided by Operating Activities," and $1.3 million from the exercise of share-based awards in a subsidiary, offset by $64.6 million used for the portion of the Changyou dividend distributed to noncontrolling interest shareholders, $25.8 million used for the purchase of Sogou Series A Preferred Shares from Alibaba, $13.8 million used for the payment of contingent consideration, and $12.6 million used for the repurchase of our common stock. For the nine months ended September 30, 2011, $39.2 million net cash used in financing activities was primarily attributable to $25.7 million used for the purchase of 750,000 Changyou ADSs, and $16.6 million used for the repurchase of our common stock, offset by $1.5 million from the issuance of common stock upon the exercise of share options granted under our stock incentive plan, $1.4 million excess tax benefits mentioned above under the heading "Net Cash Provided by Operating Activities," and $0.2 million in proceeds from noncontrolling shareholders. Restrictions on Cash Transfers to Sohu.com Inc. To fund any cash requirements it may have, Sohu may need to rely on dividends and other distributions on equity paid by Sohu.com Limited and Changyou, our wholly-owned subsidiary and majority-owned subsidiary. Since substantially all of our operations are conducted through our indirect wholly-owned and majority-owned China-based subsidiaries and VIEs, Sohu.com Limited and Changyou may need to rely on dividends, loans or advances made by our PRC subsidiaries. For Sohu apart from Changyou, although the VIEs generate revenue and cash, due to significant costs involved in these VIEs' operations, they generally have minimal profit and cash balances, and their operating cash flow was negative for the three and nine months ended September 30, 2012. However, substantially all of Changyou's operations have conducted through Changyou's VIEs Gamease, Guanyou Gamespace, Shanghai ICE and Shenzhen 7Road, which have generated all of our online game revenues. Although Changyou's subsidiaries received a majority of the VIEs' profits pursuant to the various contractual agreements between the VIEs and the subsidiaries, significant cash balances remained in Changyou's VIEs as of September 30, 2012. As Changyou's VIEs are not owned by Changyou's subsidiaries, they are not able to make dividend payments to Changyou's subsidiaries. Instead, each of AmazGame, Gamespace, ICE Information and 7Road Technology, which are Changyou's subsidiaries in China, has entered into a number of contracts with its corresponding VIE to provide services to such VIE in return for cash payments. In order for us to receive any dividends, loans or advances from Changyou's PRC subsidiaries, or to distribute any dividends to our shareholders and ADS holders, we will need to rely on these payments made from these VIEs to Changyou's PRC subsidiaries. Depending on the nature of services provided by Changyou's PRC subsidiaries to their corresponding VIEs, certain of these payments are subject to PRC taxes, including Business Tax and VAT, which effectively reduce the amount that a PRC subsidiary receives from its corresponding VIE. In addition, the PRC government could impose restrictions on such payments or change the tax rates applicable to such payments. In addition, regulations in the PRC currently permit payment of dividends of a PRC company only out of accumulated profits as determined in accordance with accounting standards and regulations in China. Our China-based subsidiaries, which are wholly foreign-owned enterprises ("WFOEs"), are also required to set aside at least 10% of their after-tax profit based on PRC accounting standards each year to their general reserves until the cumulative amount reaches 50% of their paid-in capital. These reserves are not distributable as cash dividends, or as loans or advances. These WFOEs may also allocate a portion of their after-tax profits, at the discretion of their Boards of Directors, to their staff welfare and bonus funds. Any amounts so allocated may not be distributed to Changyou and /or to Sohu.com Limited and, accordingly, would not be available for distribution to Sohu. Also, under regulations of the State Administration of Foreign Exchange, ("SAFE"), the RMB is not convertible into foreign currencies for capital account items, such as loans, repatriation of investments and investments outside of China, unless prior approval of the SAFE is obtained and prior registration with the SAFE is made. -66- -------------------------------------------------------------------------------- Table of Contents With respect to PRC tax, certain dividends paid by WFOEs to their immediate Hong Kong holding companies that meet tax authorities' requirements would be subject to a withholding tax at the rate of 5%, which would reduce the amount of cash available for distribution to Sohu. Any such dividends paid to Hong Kong holding companies that did not meet the tax authorities' requirements would be subject to a withholding tax at the rate of 10%, which would further reduce the amount of cash available for distribution to Sohu. With respect to U.S. tax, as Sohu Group has two listed companies, Sohu.com Inc. and Changyou.com Limited, which are regarded as separate legal entities for U.S. tax purposes, certain transactions between these two companies as well as between their subsidiaries and VIEs might expose Sohu.com Inc. to 34% U.S. Corporate Income Tax. In addition, certain transactions of Changyou and its subsidiaries and VIEs (for example, investing in U.S. properties) might also expose Sohu.com Inc. to the risk that these transactions will be treated as taxable for U.S. tax purposes. Moreover, if Changyou pays dividends, Sohu.com Inc., as one of the shareholders of Changyou, might be subject to U.S. tax at 34% for the dividends received or, under certain circumstances, when Sohu sells Changyou ADSs originally held by Sohu at a price higher than its U.S. tax basis, a portion of the proceeds will be subject to U.S. tax at 34%. Furthermore, any dividends or any deemed dividends received by Sohu.com Inc. would be subject to U.S. Tax at 34%. We do not expect any of such restrictions or taxes to have a material impact on our ability to meet our cash obligations. Dividend Policy On August 6, 2012, Changyou declared a special one-time cash dividend of $1.90 per Class A or Class B ordinary share, or $3.80 per ADS and a total of $201 million. On September 21, 2012, Changyou paid out this special cash dividend, of which $136 million was paid to and received by Sohu. Sohu does not expect to pay any of such dividend to its shareholders in the foreseeable future. We do not expect Changyou to declare any additional dividends in the foreseeable future. The Sohu Group intends to retain all available funds and any future earnings for use in the operation and expansion of its own business, and does not anticipate paying any cash dividends on Sohu.com Inc.'s common stock or causing Changyou to pay any dividends, on Changyou.com Limited's ordinary shares, including ordinary shares represented by Changyou.com Limited's ADSs, for the foreseeable future. Future cash dividends distributed by Sohu.com Inc. and Changyou.com Limited, if any, will be declared at the discretion of their respective Boards of Directors and will depend upon their future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and such other factors as their respective Boards of Directors may deem relevant. Holders of ADSs of Changyou.com Limited will be entitled to receive dividends, subject to the terms of the deposit agreement, to the same extent as the holders of Changyou.com Limited's ordinary shares, less the fees and expenses payable under the deposit agreement. Cash dividends will be paid by the depositary to holders of ADSs in U.S. dollars, subject to the terms of the deposit agreement. Other distributions, if any, will be paid by the depositary to holders of ADSs in any manner that the depositary deems equitable and practicable. OFF-BALANCE SHEET COMMITMENTS AND ARRANGEMENTS We have not entered into any financial guarantees or other commitments to guarantee the payment obligations of third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder's equity, or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or that engages in leasing, hedging or product development services with us. -67- -------------------------------------------------------------------------------- Table of Contents IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS In July 2012, the FASB issued revised guidance on "Testing Indefinite-Lived Intangible Assets for Impairment." The revised guidance applies to all entities, both public and nonpublic, that have indefinite-lived intangible assets, other than goodwill, reported in their financial statements. Under the revised guidance, an entity has the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. However, if an entity concludes otherwise, then it is required to determine the fair value of the indefinite-lived intangible asset and perform a quantitative impairment test by comparing the fair value with the carrying amount in accordance with Subtopic 350-30. An entity also has the option to bypass a qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test. An entity will be able to resume performing the qualitative assessment in any subsequent period. In conducting a qualitative assessment, an entity should consider the extent to which relevant events and circumstances, both individually and in the aggregate, could have affected the significant inputs used to determine the fair value of the indefinite-lived intangible asset since the last assessment. An entity also should consider whether there have been changes to the carrying amount of the indefinite-lived intangible asset when evaluating whether it is more likely than not that the indefinite-lived intangible asset is impaired. An entity should consider positive and mitigating events and circumstances that could affect its determination of whether it is more likely than not that the indefinite-lived intangible asset is impaired. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity's financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. We are currently evaluating the impact on our consolidated financial statements of adopting this guidance. |