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EX-32 - EXHIBIT 32 - ROSETTA STONE INCa063017exhibit32.htm
EX-31.2 - EXHIBIT 31.2 - ROSETTA STONE INCa063017exhibit312.htm
EX-31.1 - EXHIBIT 31.1 - ROSETTA STONE INCa063017exhibit311.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2017
Commission file number: 1-34283
Rosetta Stone Inc.
(Exact name of registrant as specified in its charter)
Delaware
(State of incorporation)
 
043837082
(I.R.S. Employer
Identification No.)
1621 North Kent Street, Suite 1200
Arlington, Virginia
(Address of principal executive offices)
 
22209
(Zip Code)

703-387-5800
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý  No o
 Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ý  No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer
o
 
Accelerated filer
ý
 
Non-accelerated filer
o
 
Smaller reporting company 
o
 
Emerging growth company
o
 
 
 
 
 (Do not check if a smaller reporting company)
 
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  o  
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No ý
 Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the latest practicable date.
As of August 2, 2017, there were 22,285,515 shares of the registrant’s Common Stock, $.00005 par value, outstanding.



ROSETTA STONE INC.

Table of Contents



2


PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements
ROSETTA STONE INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
(unaudited)
 
 
June 30,
2017
 
December 31,
2016
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
26,367

 
$
36,195

Restricted cash
 
41

 
402

Accounts receivable (net of allowance for doubtful accounts of $547 and $1,072, at June 30, 2017 and December 31, 2016, respectively)
 
27,980

 
31,788

Inventory
 
5,851

 
6,767

Deferred sales commissions
 
12,631

 
14,085

Prepaid expenses and other current assets
 
4,626

 
3,813

Total current assets
 
77,496

 
93,050

Deferred sales commissions
 
3,488

 
4,143

Property and equipment, net
 
26,670

 
24,795

Goodwill
 
49,197

 
48,251

Intangible assets, net
 
21,037

 
22,753

Other assets
 
1,014

 
1,318

Total assets
 
$
178,902

 
$
194,310

Liabilities and stockholders' deficit
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
9,476

 
$
10,684

Accrued compensation
 
7,444

 
10,777

Income tax payable
 
564

 
785

Obligations under capital lease
 
422

 
532

Other current liabilities
 
16,943

 
22,150

Deferred revenue
 
98,582

 
113,821

Total current liabilities
 
133,431

 
158,749

Deferred revenue
 
35,965

 
27,636

Deferred income taxes
 
6,801

 
6,173

Obligations under capital lease
 
1,975

 
2,027

Other long-term liabilities
 
789

 
1,384

Total liabilities
 
178,961

 
195,969

Commitments and contingencies (Note 15)
 

 

Stockholders' deficit:
 
 
 
 
Preferred stock, $0.001 par value; 10,000 and 10,000 shares authorized, zero and zero shares issued and outstanding at June 30, 2017 and December 31, 2016, respectively
 

 

Non-designated common stock, $0.00005 par value, 190,000 and 190,000 shares authorized, 23,790 and 23,451 shares issued and 22,790 and 22,451 shares outstanding at June 30, 2017 and December 31, 2016, respectively
 
2

 
2

Additional paid-in capital
 
192,774

 
190,827

Accumulated loss
 
(178,025
)
 
(177,344
)
Accumulated other comprehensive loss
 
(3,375
)
 
(3,709
)
Treasury stock, at cost, 1,000 and 1,000 shares at June 30, 2017 and December 31, 2016, respectively
 
(11,435
)
 
(11,435
)
Total stockholders' deficit
 
(59
)
 
(1,659
)
Total liabilities and stockholders' deficit
 
$
178,902

 
$
194,310

   
See accompanying notes to consolidated financial statements

3


ROSETTA STONE INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
 
2017
 
2016
Revenue:
 
 
 
 
 
 
 
 
Subscription and service
 
$
41,985

 
$
37,757

 
$
83,435

 
$
75,728

Product
 
$
3,920

 
$
7,959

 
10,163

 
17,990

Total revenue
 
45,905

 
45,716

 
93,598

 
93,718

Cost of revenue:
 
 
 
 
 
 
 
 
Cost of subscription and service revenue
 
6,058

 
5,575

 
12,592

 
10,978

Cost of product revenue
 
1,533

 
2,389

 
3,140

 
5,034

Total cost of revenue
 
7,591

 
7,964

 
15,732

 
16,012

Gross profit
 
38,314

 
37,752

 
77,866

 
77,706

Operating expenses:
 
 
 
 
 
 
 
 
Sales and marketing
 
24,037

 
28,740

 
48,205

 
59,533

Research and development
 
6,348

 
6,748

 
12,762

 
13,319

General and administrative
 
8,594

 
10,118

 
16,619

 
20,895

Impairment
 

 
2,902

 

 
2,902

Lease abandonment and termination
 

 
30

 

 
30

Total operating expenses
 
38,979

 
48,538

 
77,586

 
96,679

Income (loss) from operations
 
(665
)
 
(10,786
)
 
280

 
(18,973
)
Other income and (expense):
 
 
 
 
 
 
 
 
Interest income
 
17

 
10

 
30

 
23

Interest expense
 
(130
)
 
(121
)
 
(245
)
 
(233
)
Other income and (expense)
 
425

 
927

 
736

 
2,155

Total other income and (expense)
 
312

 
816

 
521

 
1,945

Income (loss) before income taxes
 
(353
)
 
(9,970
)
 
801

 
(17,028
)
Income tax expense (benefit)
 
782

 
(992
)
 
1,482

 
(543
)
Net loss
 
$
(1,135
)
 
$
(8,978
)
 
$
(681
)
 
$
(16,485
)
Loss per share:
 
 
 
 
 
 
 
 
Basic
 
$
(0.05
)
 
$
(0.41
)
 
$
(0.03
)
 
$
(0.75
)
Diluted
 
$
(0.05
)
 
$
(0.41
)
 
$
(0.03
)
 
$
(0.75
)
Common shares and equivalents outstanding:
 
 
 
 
 
 
 
 
Basic weighted average shares
 
22,248

 
21,948

 
22,187

 
21,908

Diluted weighted average shares
 
22,248

 
21,948

 
22,187

 
21,908

   
See accompanying notes to consolidated financial statements

4


ROSETTA STONE INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
(unaudited)

 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
 
2017
 
2016
Net loss
 
$
(1,135
)
 
$
(8,978
)
 
$
(681
)
 
$
(16,485
)
Other comprehensive gain (loss), net of tax:
 
 
 
 
 
 
 
 
Foreign currency translation gain (loss)
 
377

 
(732
)
 
334

 
(1,209
)
Other comprehensive gain (loss)
 
377

 
(732
)
 
334

 
(1,209
)
Comprehensive loss
 
$
(758
)
 
$
(9,710
)
 
$
(347
)
 
$
(17,694
)
   See accompanying notes to consolidated financial statements




5


ROSETTA STONE INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
 
Six Months Ended June 30,
 
 
2017
 
2016
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net loss
 
$
(681
)
 
$
(16,485
)
Adjustments to reconcile net loss to cash used in operating activities:
 
 
 
 
Stock-based compensation expense
 
1,506

 
1,818

Gain on foreign currency transactions
 
(452
)
 
(2,343
)
Bad debt (recovery) expense
 
(300
)
 
280

Depreciation and amortization
 
6,062

 
6,586

Deferred income tax expense
 
630

 
508

Loss on disposal of equipment
 

 
36

Amortization of deferred financing fees
 
156

 
132

Loss on impairment
 

 
2,902

Loss from equity method investments
 
100

 
40

Gain on sale of subsidiary
 
(506
)
 

Net change in:
 
 
 
 
Restricted cash
 
372

 
(360
)
Accounts receivable
 
4,195

 
12,089

Inventory
 
932

 
(622
)
Deferred sales commissions
 
2,127

 
1,981

Prepaid expenses and other current assets
 
(671
)
 
(1,703
)
Income tax receivable or payable
 
(245
)
 
(1,190
)
Other assets
 
192

 
326

Accounts payable
 
(1,254
)
 
(1,630
)
Accrued compensation
 
(3,397
)
 
1,661

Other current liabilities
 
(5,652
)
 
(5,921
)
Other long-term liabilities
 
(485
)
 
(163
)
Deferred revenue
 
(7,257
)
 
(10,367
)
Net cash used in operating activities
 
(4,628
)
 
(12,425
)
CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Purchases of property and equipment
 
(5,393
)
 
(5,934
)
Proceeds from sale of fixed assets
 
2

 
38

Proceeds from the sale of subsidiary
 
110

 

Net cash used in investing activities
 
(5,281
)
 
(5,896
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Proceeds from the exercise of stock options
 
441

 
37

Payment of deferred financing costs
 
(143
)
 
(100
)
Payments under capital lease obligations
 
(344
)
 
(338
)
Net cash used in financing activities
 
(46
)
 
(401
)
Decrease in cash and cash equivalents
 
(9,955
)
 
(18,722
)
Effect of exchange rate changes in cash and cash equivalents
 
127

 
645

Net decrease in cash and cash equivalents
 
(9,828
)
 
(18,077
)
Cash and cash equivalents—beginning of period
 
36,195

 
47,782

Cash and cash equivalents—end of period
 
$
26,367

 
$
29,705

SUPPLEMENTAL CASH FLOW DISCLOSURE:
 
 
 
 
Cash paid during the periods for:
 
 
 
 
Interest
 
$
89

 
$
100

Income taxes, net of refunds
 
$
1,037

 
$
153

Noncash financing and investing activities:
 
 
 
 
Accrued liability for purchase of property and equipment
 
$
690

 
$
579

Equipment acquired under capital lease
 
$

 
$
27

See accompanying notes to consolidated financial statements

6


ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. NATURE OF OPERATIONS
Rosetta Stone Inc. and its subsidiaries ("Rosetta Stone," or the "Company") develop, market and support a suite of language-learning and literacy solutions consisting of perpetual software products, web-based software subscriptions, online and professional services, audio practice products and mobile applications. The Company's offerings are sold on a direct basis and through select third party retailers and distributors. The Company provides its solutions to customers through the sale of packaged software and web-based software subscriptions, domestically and in certain international markets.
In March 2016, the Company announced the withdrawal of direct sales presence in almost all of its non-U.S. and non-northern European geographies related to the distribution of the Enterprise & Education Language offerings (the "2016 Restructuring Plan"). Where appropriate, the Company seeks to operate through partners in the geographies being exited. The Company has also initiated processes to close the software development operations in France and China. See Note 2 "Summary of Significant Accounting Policies," Note 13 "Restructuring," Note 16 "Segment Information" and Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations" within Part 1 for additional information about these strategic undertakings and the associated impact to the Company's financial statements and financial results.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Rosetta Stone Inc. and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
Basis of Presentation
The accompanying consolidated financial statements are unaudited. These unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP") and applicable rules and regulations of the Securities and Exchange Commission ("SEC") regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s most recent Annual Report on Form 10-K filed with the SEC on March 14, 2017. The June 30, 2017 consolidated balance sheet included herein includes account balances as of December 31, 2016 that were derived from the audited financial statements as of that date. The Consolidated Financial Statements and the Notes to the Consolidated Financial Statements do not include all disclosures required for annual financial statements and notes.
The unaudited interim consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Company’s statement of financial position at June 30, 2017 and December 31, 2016, the Company’s results of operations for the three and six months ended June 30, 2017 and 2016 and its cash flows for the six months ended June 30, 2017 and 2016 have been made. The results for the three and six months ended June 30, 2017 are not necessarily indicative of the results to be expected for the year ending December 31, 2017. All references to June 30, 2017 or to the three and six months ended June 30, 2017 and 2016 in the notes to the consolidated financial statements are unaudited.
Use of Estimates
The preparation of financial statements in accordance with GAAP requires management to make certain estimates and assumptions. The amounts reported in the consolidated financial statements include significant estimates and assumptions that have been made, including, but not limited to, those related to revenue recognition, allowance for doubtful accounts, estimated sales returns and reserves, stock-based compensation, restructuring costs, fair value of intangibles and goodwill, disclosure of contingent assets and liabilities, disclosure of contingent litigation, allowance for valuation of deferred tax assets, and the Company's quarterly going concern assessment. The Company bases its estimates and assumptions on historical experience and on various other judgments that are believed to be reasonable under the circumstances. The Company continuously evaluates its estimates and assumptions. Actual results may differ from these estimates and assumptions.

7

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Revenue Recognition
The Company's primary sources of revenue are web-based software subscriptions, online services, perpetual product software, and bundles of perpetual product software and online services. The Company also generates revenue from the sale of audio practice products, mobile applications, and professional services. Revenue is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered or services have been rendered; the fee is fixed or determinable; and collectability is reasonably assured. Revenue is recorded net of discounts and net of taxes.
The Company identifies the units of accounting contained within sales arrangements in accordance with Accounting Standards Codification ("ASC") subtopic 605-25, Revenue Recognition - Multiple Element Arrangements ("ASC 605-25"). In doing so, the Company evaluates a variety of factors including whether the undelivered element(s) have value to the customer on a stand-alone basis or if the undelivered element(s) could be sold by another vendor on a stand-alone basis.
For multiple element arrangements that contain perpetual software products and related online services, the Company allocates the total arrangement consideration to its deliverables based on the existence of vendor-specific objective evidence of fair value, or vendor-specific objective evidence ("VSOE"), in accordance with ASC subtopic 985-605-25, Software: Revenue Recognition-Multiple-Element Arrangements ("ASC 985-605-25"). The Company generates a portion of its Consumer revenue from the CD and digital download formats of the Rosetta Stone language-learning product which are typically multiple-element arrangements that contain two deliverables: perpetual software, delivered at the time of sale, and online service, which is considered an undelivered software-related element. The online service includes access to conversational coaching services. Because the Company only sells the perpetual language-learning software on a stand-alone basis in its homeschool version, the Company does not have a sufficient concentration of stand-alone sales to establish VSOE for the perpetual product. Where VSOE of the undelivered online services can be established, arrangement consideration is allocated using the residual method. The Company determines VSOE by reference to the range of comparable stand-alone renewal sales of the online service. The Company reviews these stand-alone sales on a quarterly basis. VSOE is established if at least 80% of the stand-alone sales are within a range of plus or minus 15% of a midpoint of the range of prices, consistent with generally accepted industry practice. Where VSOE of the undelivered online services cannot be established, revenue is deferred and recognized commensurate with the delivery of the online services.
For non-software multiple element arrangements the Company allocates revenue to all deliverables based on their relative selling prices. The Company's non-software multiple element arrangements primarily occur as sales to its Enterprise & Education Language and Literacy customers, and to a lesser extent its Consumer customers. These arrangements can include web-based subscription services, audio practice products and professional services or any combination thereof. The Company does not have a sufficient concentration of stand-alone sales of the various deliverables noted above to its customers, and therefore cannot establish VSOE for each deliverable. Third party evidence of fair value does not exist for the web-based subscription, audio practice products and professional services due to the lack of interchangeable language-learning products and services within the market. Accordingly, the Company determines the relative selling price of the web-based subscription, audio practice products and professional services deliverables included in its non-software multiple-element arrangements using the best estimated selling price. The Company determines the best estimated selling price based on its internally published price list which includes suggested sales prices for each deliverable based on the type of client and volume purchased. This price list is derived from past experience and from the expectation of obtaining a reasonable margin based on what each deliverable costs the Company.
In the U.S. and Canada, the Company offers consumers who purchase packaged software and audio practice products directly from the Company a 30-day, unconditional, full money-back refund. The Company also permits some of our retailers and distributors to return unsold packaged products, subject to certain limitations. In accordance with ASC subtopic 985-605, Software: Revenue Recognition ("ASC 985-605"), the Company estimates and establishes revenue reserves for packaged product returns at the time of sale based on historical return rates, estimated channel inventory levels, the timing of new product introductions and other factors.
The Company distributes its products and services both directly to the end customer and indirectly through resellers. Resellers earn commissions generally calculated as a fixed percentage of the gross sale to the end customer. The Company evaluates each of its reseller relationships in accordance with ASC subtopic 605-45, Revenue Recognition - Principal Agent Considerations (“ASC 605-45”) to determine whether the revenue recognized from indirect sales should be the gross amount of the contract with the end customer or reduced for the reseller commission. In making this determination the Company evaluates a variety of factors including whether it is the primary obligor to the end customer.

8

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Revenue for web-based subscriptions and online services is recognized ratably over the term of the subscription or service period, assuming all revenue recognition criteria have been met. The CD and digital download formats of Rosetta Stone language-learning products are bundled with an online service where customers are allowed to begin their online services at any point during a registration window, which is typically up to six months from the date of purchase from us or an authorized reseller. The online services that are not activated during this registration window are forfeited and revenue is recognized upon expiry. Revenue from non-refundable upfront fees that are not related to products already delivered or services already performed is deferred and recognized ratably over the term of the related arrangement because the period over which a customer is expected to benefit from the service that is included within our subscription arrangements does not extend beyond the contractual period. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding subscription agreement.
Software products are sold to end user customers and resellers. In many cases, revenue from sales to resellers is not contingent upon resale of the software to the end user and is recorded in the same manner as all other product sales. Revenue from sales of packaged software products and audio practice products is recognized as the products are shipped and title passes and risks of loss have been transferred. For many product sales, these criteria are met at the time the product is shipped. For some sales to resellers and certain other sales, the Company defers revenue until the customer receives the product because the Company legally retains a portion of the risk of loss on these sales during transit. In other cases where packaged software products are sold to resellers on a consignment basis, revenue is recognized for these consignment transactions once the end user sale has occurred, assuming the remaining revenue recognition criteria have been met. In accordance with ASC subtopic 605-50, Revenue Recognition: Customer Payments and Incentives (“ASC 605-50”), cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identified benefit is identified and the fair value is reasonably determinable. Price protection for changes in the manufacturer suggested retail value granted to resellers for the inventory that they have on hand at the date the price protection is offered is recorded as a reduction to revenue at the time of sale.
The Company offers customers the ability to make payments for packaged software purchases in installments over a period of time, which typically ranges between three and five months. Given that these installment payment plans are for periods less than 12 months, a successful collection history has been established and these fees are fixed and determinable, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met.
In connection with packaged software product sales and web-based software subscriptions, technical support is provided to customers, including customers of resellers, via telephone support at no additional cost for up to six months from the time of purchase. As the fee for technical support is included in the initial licensing fee, the technical support and services are generally provided within one year, the estimated cost of providing such support is deemed insignificant and no unspecified upgrades/enhancements are offered, technical support revenue is recognized together with the software product and web-based software subscription revenue. Costs associated with technical support are accrued at the time of sale.
Sales commissions from non-cancellable web-based software subscription contracts are deferred and amortized in proportion to the revenue recognized from the related contract.
Restructuring Costs
In recent periods, the Company has announced and initiated actions to reduce headcount and other costs in order to support its strategic shift in business focus. In connection with these plans, the Company incurred restructuring related costs, including employee severance and related benefit costs, contract termination costs, and other related costs. These costs are included in Cost of sales and the Sales and marketing, Research and development, and General and administrative operating expense categories in the Company's statements of operations.
Employee severance and related benefit costs primarily include cash payments, outplacement services, continuing health insurance coverage, and other benefits. Where no substantive involuntary termination plan previously exists, these severance costs are generally considered “one-time” benefits and recognized at fair value in the period in which a detailed plan has been approved by management and communicated to the terminated employees. Severance costs pursuant to ongoing benefit arrangements, including termination benefits provided for in existing employment contracts, are recognized when probable and reasonably estimable.
Contract termination costs include penalties to cancel certain service and license contracts and costs to terminate operating leases. Contract termination costs are recognized at fair value in the period in which the contract is terminated in accordance with the contract terms.

9

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Other related costs generally include external consulting and legal costs associated with the strategic shift in business focus. Such costs are recognized at fair value in the period in which the costs are incurred. See Note 13 "Restructuring" for additional disclosures.
Income Taxes
The Company accounts for income taxes in accordance with ASC topic 740, Income Taxes ("ASC 740"), which provides for an asset and liability approach to accounting for income taxes. Deferred tax assets and liabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilities versus the tax basis of assets and liabilities. Under this method, deferred tax assets are recognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred liabilities are recognized for taxable temporary differences. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The impact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted.
Deferred Tax Valuation Allowance
The Company has recorded a valuation allowance offsetting certain of its deferred tax assets as of June 30, 2017. When measuring the need for a valuation allowance on a jurisdiction by jurisdiction basis, the Company assesses both positive and negative evidence regarding whether these deferred tax assets are realizable. In determining deferred tax assets and valuation allowances, the Company is required to make judgments and estimates related to projections of profitability, the timing and extent of the utilization of temporary differences, net operating loss carryforwards, tax credits, applicable tax rates, transfer pricing methodologies and tax planning strategies. The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidence exists to support a reversal. Because evidence such as the Company’s operating results during the most recent three-year period is afforded more weight than forecasted results for future periods, the Company’s cumulative loss in certain jurisdictions represents significant negative evidence in the determination of whether deferred tax assets are more likely than not to be utilized in certain jurisdictions. This determination resulted in the need for a valuation allowance on the deferred tax assets of certain jurisdictions. The Company will release this valuation allowance when it is determined that it is more likely than not that its deferred tax assets will be realized. Any future release of valuation allowance may be recorded as a tax benefit increasing net income.
Fair Value of Financial Instruments
The Company values its assets and liabilities using the methods of fair value as described in ASC topic 820, Fair Value Measurements and Disclosures, ("ASC 820"). ASC 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The three levels of fair value hierarchy are described below:
Level 1: Quoted prices for identical instruments in active markets.
Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
Level 3: Significant inputs to the valuation model are unobservable.
The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, restricted cash, accounts receivable, accounts payable and other accrued expenses approximate fair value due to relatively short periods to maturity.
Divestitures
The Company deconsolidates divested subsidiaries when there is a loss of control or when appropriate when evaluated under the variable interest entity model. The Company recognizes a gain or loss at divestiture equal to the difference between the fair value of any consideration received and the carrying amount of the former subsidiary’s assets and liabilities. Any resulting gain or loss is reported in "Other income and (expense)" on the consolidated statement of operations.

10

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Stock-Based Compensation
The Company accounts for its stock-based compensation in accordance with ASC topic 718, Compensation—Stock Compensation ("ASC 718"). Under ASC 718, all stock-based awards, including employee stock option grants, are recorded at fair value as of the grant date. For options granted with service and/or performance conditions, the fair value of each grant is estimated on the date of grant using the Black-Scholes option pricing model. For options granted with market-based conditions, the fair value of each grant is estimated on the date of grant using the Monte-Carlo simulation model. These methods require the use of estimates, including future stock price volatility, expected term and forfeitures.
As the Company does not have sufficient historical option exercise experience that spans the full 10-year contractual term for determining the expected term of options granted, the Company estimates the expected term of options using a combination of historical information and the simplified method for estimating the expected term. The Company uses its own historical stock price data to estimate its forfeiture rate and expected volatility over the most recent period commensurate with the estimated expected term of the awards. For the risk-free interest rate, the Company uses a U.S. Treasury Bond rate consistent with the estimated expected term of the option award.
The Company’s restricted stock and restricted stock unit grants are accounted for as equity awards. Stock compensation expense associated with service-based equity awards is recognized in the statement of operations on a straight-line basis over the requisite service period, which is the vesting period. For equity awards granted with performance-based conditions, stock compensation expense is recognized in the statement of operations ratably for each vesting tranche based on the probability that operating performance conditions will be met and to what extent. Changes in the probability estimates associated with performance-based awards will be accounted for in the period of change using a cumulative catch-up adjustment to retroactively apply the new probability estimates. In any period in which the Company determines that achievement of the performance metrics is not probable, the Company ceases recording compensation expense and all previously recognized compensation expense for the performance-based award is reversed. For equity awards granted with market-based conditions, stock compensation expense is recognized in the statement of operations ratably for each vesting tranche regardless of meeting or not meeting the market conditions. See Note 11 "Stock-Based Compensation" for additional disclosures.
Foreign Currency Translation and Transactions
The functional currency of the Company's foreign subsidiaries is their local currency. Accordingly, assets and liabilities of the foreign subsidiaries are translated into U.S. dollars at exchange rates in effect on the balance sheet date. Income and expense items are translated at average rates for the period. Translation adjustments are recorded as a component of other comprehensive loss in stockholders' deficit.
Cash flows of consolidated foreign subsidiaries, whose functional currency is their local currency, are translated to U.S. dollars using average exchange rates for the period. The Company reports the effect of exchange rate changes on cash balances held in foreign currencies as a separate item in the reconciliation of the changes in cash and cash equivalents during the period.
The following table presents the effect of exchange rate changes on total comprehensive loss (in thousands):
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
 
2017
 
2016
Net loss
 
$
(1,135
)
 
$
(8,978
)
 
$
(681
)
 
$
(16,485
)
Foreign currency translation gain (loss)
 
377

 
(732
)
 
334

 
(1,209
)
Comprehensive loss
 
$
(758
)
 
$
(9,710
)
 
$
(347
)
 
$
(17,694
)
Comprehensive Loss
Comprehensive loss consists of net loss and other comprehensive income (loss). Other comprehensive income (loss) refers to revenues, expenses, gains, and losses that are not included in net loss, but rather are recorded directly in stockholders' deficit. For the three and six months ended June 30, 2017 and 2016, the Company's comprehensive loss consisted of net loss and foreign currency translation gains and (losses).
Upon sale of an investment in a foreign entity, the amount attributable to the accumulated translation adjustment component of that foreign entity is removed as a component of other comprehensive income (loss) and reported as part of the gain or loss on the sale of the investment. During the period ended June 30, 2017, a transfer of $0.1 million was made from

11

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

accumulated other comprehensive income (loss) and recognized as a loss within net loss related to the sale of a foreign subsidiary.
Components of accumulated other comprehensive loss as of June 30, 2017 are as follows (in thousands):
 
 
Foreign Currency
 
Total
Balance at beginning of period on January 1, 2017
 
$
(3,709
)
 
$
(3,709
)
Other comprehensive income before reclassifications
 
430

 
430

Amounts reclassified from accumulated other comprehensive income related to the sale of a foreign subsidiary
 
(96
)
 
(96
)
Net current period other comprehensive income
 
334

 
334

Accumulated other comprehensive loss at June 30, 2017
 
$
(3,375
)
 
$
(3,375
)
The other comprehensive income (loss) presented in the consolidated financial statements and the notes are presented net of tax. There has been no tax expense or benefit associated with the components of other comprehensive income (loss) due to the presence of a full valuation allowance for each of the three and six months ended June 30, 2017 and 2016.
Advertising Costs
Costs for advertising are expensed as incurred. Advertising expenses for the three months ended June 30, 2017 and June 30, 2016 was $6.2 million and $8.9 million, respectively. Advertising expense for the six months ended June 30, 2017 and June 30, 2016 was $12.8 million and $18.5 million, respectively.
Going Concern Assessment
The Company performs its quarterly going concern assessment in accordance with ASC sub-topic 205-40, Presentation of Financial Statements - Going Concern ("ASC 205-40"). Under ASC 205-40, management is required to assess the Company's ability to continue as a going concern. As further described in the discussion below, the Company has concluded, based on its projections, that its cash balance, funds available from its line of credit, and its cash flow from operations are sufficient to meet its liquidity needs through the one year period following the financial statement issuance date.
The financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Management has evaluated whether relevant conditions or events, considered in the aggregate, indicate that there is substantial doubt about the Company's ability to continue as a going concern. Substantial doubt exists when conditions and events, considered in the aggregate, indicate it is probable that the Company will be unable to meet its obligations as they become due within one year after the financial statement issuance date. The assessment is based on the relevant conditions that are known or reasonable knowable as of August 8, 2017
The assessment of the Company's ability to meet its future obligations is inherently judgmental, subjective and susceptible to change. The inputs that are considered important in the Company's going concern analysis, include, but are not limited to, the Company's 2017 cash flow forecast, 2017 operating budget, and long-term plan that extends beyond 2017. These inputs consider information including, but not limited to, the Company’s financial condition, liquidity sources, obligations due within one year after the financial statement issuance date, funds necessary to maintain operations, and financial conditions, including negative financial trends or other indicators of possible financial difficulty.
The Company has considered both quantitative and qualitative factors as part of the assessment that are known or reasonably knowable as of August 8, 2017, and concluded that conditions and events considered in the aggregate, do not indicate that it is probable that the Company will be unable to meet obligations as they become due through the one year period following the financial statement issuance date.
Recently Issued Accounting Standards
During 2017, the Company adopted the following recently issued Accounting Standard Updates ("ASU"):
In March 2016, the Financial Accounting Standards Board ("FASB") issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting ("ASU 2016-09"). Under ASU 2016-09, accounting for share-based payment award transactions was simplified related to the accounting for (a) income tax effects; (b) minimum statutory tax withholding requirements; (c) and forfeitures. ASU 2016-09 is effective for public entities

12

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

in annual periods beginning after December 15, 2016, including interim periods within those annual periods. Early adoption is permitted. The Company adopted this ASU as of January 1, 2017. Due to the historical cumulative shortfall position, the adoption of ASU 2016-09 did not result in a cumulative-effect adjustment to retained earnings. ASU 2016-09 allows for an entity-wide accounting policy election, which would be applied prospectively, to either account for forfeitures when they occur or continue to estimate the number of awards that are expected to vest. The Company has elected to continue to estimate the number of awards that are expected to vest. Other aspects of adoption ASU 2016-09 did not have a material impact to the Company’s consolidated financial statements.
In January 2017, the FASB issued ASU No. 2017-01, Business Combination (Topic 805) Clarifying the Definition of a Business ("ASU 2017-01"). ASU 2017-01 clarifies the definition of a business and requires that an entity apply certain criteria in order to determine when a set of assets and activities qualifies as a business. ASU 2017-01 is effective for public entities for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years, and should be applied on a prospective basis. Early adoption is permitted. The Company has adopted this guidance as of January 1, 2017. Due to the prospective application of this ASU, there was no impact to historical financial statements and no additional disclosures are required.
The following ASUs were recently issued but have not yet been adopted by the Company:
In February 2017, the FASB issued ASU No. 2017-05, Other Income—Gains and Losses from the Derecognition of Nonfinancial Assets (Subtopic 610-20): Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets ("ASU 2017-05"). ASU 2017-05 clarifies the scope and accounting of a financial asset that meets the definition of an “in-substance nonfinancial asset” and defines the term, “in-substance nonfinancial asset.” ASU 2017-05 also adds guidance for partial sales of nonfinancial assets. ASU 2017-05 is effective at the same time Topic 606, Revenue from Contracts with Customers is effective. ASU 2017-05 may be applied retrospectively for all periods presented or retrospectively with a cumulative-effect adjustment at the date of adoption. The Company is in the process of evaluating the impact of the new guidance on the Company's financial statements and disclosures and the adoption method.
In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment ("ASU 2017-04"). ASU 2017-04 simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test. ASU 2017-04 is effective for annual and interim goodwill tests beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates on or after January 1, 2017. The Company is in the process of evaluating the guidance. Given the prospective adoption application, there is no impact on the Company's historical consolidated financial statements and disclosures.
In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows (Topic 230) Restricted Cash a consensus of the FASB Emerging Issues Task Force ("ASU 2016-18"). Under ASU 2016-18, amounts generally described as restricted cash should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. ASU 2016-18 is effective for public entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the timing of adoption of this guidance. The new guidance only impacts presentation of the Company's consolidated statement of cash flows.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). ASU 2016-13 changes the methodology for measuring credit losses of financial instruments and the timing of when such losses are recorded. ASU 2016-13 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019. Early adoption is permitted for fiscal years, and interim periods within those years, beginning after December 15, 2018. The Company is in the process of evaluating the impact of the new guidance on the Company's consolidated financial statements and disclosures.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) ("ASU 2016-02"). Under ASU 2016-02, entities will be required to recognize a lease liability and a right-of-use asset for all leases. Lessor accounting is largely unchanged. ASU 2016-02 is effective for public entities in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. The Company is in the process of evaluating the impact of the new guidance on the Company's consolidated financial statements and disclosures.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities ("ASU 2016-01"). ASU 2016-01 changes how entities measure certain equity investments and present changes in the fair value of financial liabilities measured under the fair value option that

13

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

are attributable to their own credit. Under the new guidance, entities will be required to measure equity investments that do not result in consolidation and are not accounted for under the equity method at fair value and recognize any changes in fair value in net income unless the investments qualify for the new practicability exception. The accounting for other financial instruments, such as loans and investments in debt securities is largely unchanged. ASU 2016-01 is effective for public entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not believe that the adoption of this guidance will have a material impact on the Company's consolidated financial statements and disclosures.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which replaces the current revenue accounting guidance. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date which defers the effective date of the updated guidance on revenue recognition by one year. In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which clarifies and improves the operability and understandability of the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, which clarifies and improves the operability and understanding of the implementation guidance on identifying performance obligations and licensing. Collectively these ASUs comprise the new revenue standard ("New Revenue Standard"). The core principle of the New Revenue Standard is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply a five step model to 1) identify the contract(s) with a customer, 2) identify the performance obligations in the contract, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract and 5) recognize revenue when (or as) the entity satisfies a performance obligation. The New Revenue Standard is effective for annual periods beginning after December 15, 2017.
The Company expects that it will adopt the New Revenue Standard beginning in the first quarter of 2018. The New Revenue Standard provides the option between two different methods of adoption. The full retrospective method calls for the Company to present each prior reported period shown in the financial statements under the new guidance. The modified retrospective method requires the Company to calculate the cumulative effect of applying the new guidance as of the date of adoption via adjustment to retained earnings. The Company is currently considering adopting the New Revenue Standard using the modified retrospective method.
The Company is currently evaluating the impact the New Revenue Standard will have on its financial statements, disclosures, policies, processes, and system requirements. Internal resources have been assigned to assist in the evaluation and the Company will continue to make investments in systems to enable timely and accurate reporting under the New Revenue Standard. As part of its initial evaluations, the Company believes the impact of the change in the New Revenue Standard on the Enterprise & Education and Literacy segments will be minimal as the accounting outcome of the vast majority of transactions remains unchanged. Due to the elimination of software specific accounting guidance, the Company anticipates more significant changes to the accounting for the packaged perpetual software product line within the Consumer segment. While the Company continues to assess all potential impacts under the New Revenue Standard, including the areas described above, we do not know or cannot reasonably estimate quantitative information related to the impact of the New Revenue Standard on the Company's consolidated financial statements and disclosures at this time.
3. DIVESTITURE
On March 13, 2017, the Company entered into a Product and Intellectual Property Agreement, (the “PIPA”) with SOURCENEXT Corporation, (“SOURCENEXT”), a leading software distributor and developer in Japan. Under the PIPA, the Company provided a perpetual, exclusive license of certain brands and trademarks, including the primary Rosetta Stone brand, and product code for exclusive development and sale of language and education-related products in Japan. In conjunction with the PIPA, the Company received approximately $9.0 million on March 13, 2017 and another $2.0 million on June 19, 2017. If certain additional brand licensing actions are successfully completed, SOURCENEXT will pay the Company an additional $2.0 million, net of adjustments. In addition, the Company is guaranteed to receive minimum payments totaling an additional $6.0 million over the next ten years. Finally, as part of the Agreement, the Company will have the first right to license and sell any products developed by SOURCENEXT under the Rosetta Stone trademark in territories outside of Japan.

14

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
3. DIVESTITURE (Continued)

On April 25, 2017, the Company and SOURCENEXT signed a Stock Purchase Agreement ("SPA") for the sale of the Company's Japanese subsidiary ("RST Japan") and certain other assets related to the language market in Japan. The Company received $0.5 million associated with the SPA closure on June 29, 2017 when 100% of the Company's capital stock of RST Japan and the other assets related to the language market in Japan were transferred to SOURCENEXT.
The SPA and the PIPA were considered related and viewed as a multiple element arrangement. Of the nearly $11.5 million that was received to date under the terms of the PIPA and SPA, approximately $11.4 million was allocated to deferred revenue to be recognized over an estimated 20-year period. As this customer relationship progresses, the Company may prospectively reassess the 20-year recognition period as needed. Approximately $0.1 million was allocated to RST Japan and the other assets related to the language market in Japan to be included in the gain/loss calculation. At the time of closing, RST Japan was in a net liability position. The sale under the terms of the SPA resulted in a pre-tax gain of $0.4 million, reported in “Other income and (expense)” on the consolidated statement of operations. This gain was comprised of a gain of $0.5 million related to the sale of RST Japan and the other assets related to the language market in Japan, partially offset by a $0.1 million loss on the transfer of the foreign subsidiary's cumulative translation adjustment on the date of sale.
4. NET LOSS PER SHARE
 Net loss per share is computed under the provisions of ASC topic 260, Earnings Per Share. Basic loss per share is computed using net loss and the weighted average number of shares of common stock outstanding. Diluted earnings per share reflect the weighted average number of shares of common stock outstanding plus any dilutive shares outstanding during the period. Potentially dilutive shares consist of shares issuable upon the exercise of stock options, restricted stock awards, and restricted stock units.
The following table sets forth the computation of basic and diluted net loss per common share (in thousands, except per share amounts):
 
 
Three Months Ended 
 June 30,

Six Months Ended 
 June 30,
 
 
2017

2016

2017

2016
Numerator:
 
 
 
 
 
 

 
 

Net loss
 
$
(1,135
)
 
$
(8,978
)
 
$
(681
)
 
$
(16,485
)
Denominator:
 
 
 
 
 
 

 
 

Basic shares:
 
 
 
 
 
 
 
 
Weighted average number of common shares - basic
 
22,248

 
21,948

 
22,187

 
21,908

Diluted shares:
 
 
 
 
 
 
 
 
Weighted average number of common shares - diluted
 
22,248

 
21,948

 
22,187

 
21,908

Loss per common share:
 
 
 
 
 
 

 
 

Basic
 
$
(0.05
)
 
$
(0.41
)
 
$
(0.03
)
 
$
(0.75
)
Diluted
 
$
(0.05
)
 
$
(0.41
)
 
$
(0.03
)
 
$
(0.75
)
 The Company calculates dilutive common stock equivalent shares using the treasury stock method. In periods where the Company has a net loss, no dilutive common stock equivalent shares are included in the calculation for diluted shares as they are considered anti-dilutive. The following table sets forth dilutive common stock equivalent shares calculated using the treasury stock method (in thousands):

15

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
4. NET LOSS PER SHARE (Continued)

 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
 
2017
 
2016
Stock options
 
301

 
17

 
207

 
22

Restricted stock units
 
154

 
169

 
192

 
165

Restricted stocks
 
262

 
70

 
216

 
83

Total common stock equivalent shares
 
717

 
256

 
615

 
270

Share-based awards to purchase approximately 0.5 million and 2.2 million shares of common stock that had an exercise price in excess of the average market price of the common stock during the three months ended June 30, 2017 and 2016, respectively, were not included in the calculation of diluted earnings per share because they were anti-dilutive. Share-based awards to purchase approximately 0.7 million and 2.0 million shares of common stock that had an exercise price in excess of the average market price of the common stock during the six months ended June 30, 2017 and 2016, respectively, were not included in the calculation of diluted earnings per share because they were anti-dilutive.
5. INVENTORY
Inventory consisted of the following (in thousands):
 
 
June 30,
2017
 
December 31,
2016
Raw materials
 
$
3,591

 
$
4,384

Finished goods
 
2,260

 
2,383

Total inventory
 
$
5,851

 
$
6,767

6. GOODWILL
The value of goodwill is primarily derived from the acquisition of Rosetta Stone Ltd. (formerly known as Fairfield & Sons, Ltd.) in January 2006, the acquisition of certain assets of SGLC International Co. Ltd ("SGLC") in November 2009, the acquisition of Livemocha, Inc. ("Livemocha") in April 2013, the acquisition of Lexia Learning Systems, Inc. ("Lexia") in August 2013, and the acquisition of Tell Me More S.A. ("Tell Me More") in January 2014.
The Company tests goodwill for impairment annually on June 30 of each year at the reporting unit level using a fair value approach, in accordance with the provisions of ASC topic 350, Intangibles - Goodwill and other ("ASC 350"), or more frequently, if impairment indicators arise.

16

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
6. GOODWILL (Continued)

The following table shows the balance and changes in goodwill for the Company's operating segments for the six months ended June 30, 2017 (in thousands):
 
 
Literacy Segment
 
Enterprise & Education Language Segment
 
Consumer Segment
 
Total
Balance as of January 1, 2017
 
 
 
 
 
 
 
 
Gross Goodwill
 
$
9,962

 
$
38,289

 
$
27,514

 
$
75,765

Accumulated Impairment
 

 

 
(27,514
)
 
(27,514
)
Goodwill as of January 1, 2017
 
$
9,962

 
$
38,289

 
$

 
$
48,251

 
 
 
 
 
 
 
 
 
Effect of change in foreign currency rate
 

 
946

 

 
946

 
 
 
 
 
 
 
 
 
Balance as of June 30, 2017
 
 
 
 
 
 
 
 
Gross Goodwill
 
$
9,962

 
$
39,235

 
$
27,514

 
$
76,711

Accumulated Impairment
 

 

 
(27,514
)
 
(27,514
)
Goodwill as of June 30, 2017
 
$
9,962

 
$
39,235

 
$

 
$
49,197

In connection with the annual goodwill impairment test performed as of June 30, 2017, the Company performed a qualitative goodwill impairment test for its reporting units with remaining goodwill. As of June 30, 2017, the Company concluded that there were no indicators of impairment that would cause us to believe that it is more likely than not that the fair value of our reporting units with goodwill is less than the carrying value. Accordingly, a quantitative impairment test has not been performed and no goodwill impairment charges were recorded in 2017 in connection with the annual goodwill impairment test.
In connection with the annual goodwill impairment test performed as of June 30, 2016, the Consumer Fit Brains reporting unit was evaluated, which resulted in $1.7 million impairment loss for the remaining Consumer Fit Brains reporting unit's goodwill. The impairment charge was recorded in the "Impairment" line on the statement of operations.
7. INTANGIBLE ASSETS
Intangible assets consisted of the following items as of the dates indicated (in thousands):
 
 
Trademark / tradename *
 
Core technology
 
Customer relationships
 
Patents and Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
Gross Carrying Amount
 
$
12,431

 
$
15,092

 
$
26,149

 
$
312

 
$
53,984

Accumulated Amortization
 
(1,481
)
 
(9,859
)
 
(18,485
)
 
(251
)
 
(30,076
)
Accumulated Impairment
 
(26
)
 
(1,001
)
 
(128
)
 

 
(1,155
)
Balance as of January 1, 2017
 
$
10,924

 
$
4,232

 
$
7,536

 
$
61

 
$
22,753

 
 
 
 
 
 
 
 
 
 
 
Gross Carrying Amount
 
12,474

 
15,415

 
26,444

 
312

 
54,645

Accumulated Amortization
 
(1,624
)
 
(11,058
)
 
(19,506
)
 
(265
)
 
(32,453
)
Accumulated Impairment
 
(26
)
 
(1,001
)
 
(128
)
 

 
(1,155
)
Balance as of June 30, 2017
 
$
10,824

 
$
3,356

 
$
6,810

 
$
47

 
$
21,037

* Included in the tradename/trademark line above is the Rosetta Stone tradename, which is the Company's only indefinite-lived intangible asset. As of June 30, 2017, the carrying value of the tradename asset was $10.6 million.

17

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
7. INTANGIBLE ASSETS (Continued)

Amortization Expense for the Long-lived Intangible Assets
The following table presents amortization of intangible assets included in the related financial statement line items during the respective periods (in thousands):
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
 
2017
 
2016
Included in cost of revenue:
 
 
 
 
 
 
 
 
Cost of subscription and service revenue
 
$
117

 
$
103

 
$
234

 
$
201

Cost of product revenue
 
30

 
44

 
59

 
92

Total included in cost of revenue
 
147

 
147

 
293

 
293

Included in operating expenses:
 
 
 
 
 
 
 
 
Sales and marketing
 
460

 
542

 
915

 
1,257

Research and development
 
343

 
452

 
682

 
894

General and administrative
 

 

 

 

Total included in operating expenses
 
803

 
994

 
1,597

 
2,151

Total
 
$
950

 
$
1,141

 
$
1,890

 
$
2,444

The following table summarizes the estimated future amortization expense related to intangible assets for the remaining six months of 2017 and years thereafter (in thousands):
 
 
As of June 30, 2017
2017 - remaining
 
$
1,928

2018
 
3,260

2019
 
1,532

2020
 
1,282

2021
 
940

Thereafter
 
1,488

Total
 
$
10,430

Impairment Reviews of Intangible Assets
The Company also routinely reviews indefinite-lived intangible assets and long-lived assets for potential impairment as part of the Company’s internal control framework.
As an indefinite-lived intangible asset, the Rosetta Stone tradename was evaluated as of June 30, 2017 to determine if indicators of impairment exist. The Company concluded that there were no potential indicators of impairment related to this indefinite-lived intangible asset. Additionally all other long-lived intangible assets were evaluated to determine if indicators of impairment exist and the Company concluded that there are no potential indicators of impairment.
During the second quarter of 2016, the Company recorded an impairment loss of $1.2 million associated with the impairment of the remaining carrying value of the Consumer Fit Brains long-lived intangible assets as of June 30, 2016. The impairment charge is recorded in the "Impairment" line on the statement of operations.

18

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

8. OTHER CURRENT LIABILITIES
The following table summarizes other current liabilities (in thousands):
 
 
June 30, 2017
 
December 31, 2016
Accrued marketing expenses
 
$
5,256

 
$
8,460

Accrued professional and consulting fees
 
1,000

 
2,050

Sales return reserve
 
1,495

 
1,338

Sales, withholding and property taxes payable
 
3,436

 
3,772

Other
 
5,756

 
6,530

Total other current liabilities
 
$
16,943

 
$
22,150

9. FINANCING ARRANGEMENTS
Revolving Line of Credit
On October 28, 2014, Rosetta Stone Ltd. (“RSL”), a wholly owned subsidiary of parent company Rosetta Stone Inc., executed a Loan and Security Agreement with Silicon Valley Bank (“Bank”) to obtain a $25.0 million revolving credit facility (the “credit facility”). Since the original date of execution, the Company and the Bank have executed several amendments to the credit facility to reflect updates to the Company's financial outlook and extend the credit facility.
Under the amended agreement, the Company may borrow up to $25.0 million, including a sub-facility, which reduces available borrowings, for letters of credit in an aggregate availability amount of $4.0 million. Borrowings by RSL under the credit facility are guaranteed by the Company as the ultimate parent. The credit facility has a term that expires on April 1, 2020, during which time RSL may borrow and re-pay loan amounts and re-borrow the loan amounts subject to customary borrowing conditions.
The total obligations under the credit facility cannot exceed the lesser of (i) the total revolving commitment of $25.0 million or (ii) the borrowing base, which is calculated as 80% of eligible accounts receivable. As a result, the borrowing base will fluctuate and the Company expects it will follow the general seasonality of cash and accounts receivable (lower in the first half of the year and higher in the second half of the year). If the borrowing base less any outstanding amounts, plus the cash held at the Bank ("Availability") is greater than $25.0 million, then the Company may borrow up to an additional $5.0 million, but in no case can borrowings exceed $25.0 million. Interest on borrowings accrues at the Prime Rate provided that the Company maintains a minimum cash and Availability balance of $17.5 million. If cash and Availability is below $17.5 million, interest will accrue at the Prime Rate plus 1%.
Proceeds of loans made under the credit facility may be used as working capital or to fund general business requirements. All obligations under the credit facility, including letters of credit, are secured by a security interest on substantially all of the Company’s assets including intellectual property rights and by a stock pledge by the Company of 100% of its ownership interests in U.S. subsidiaries and 66% of its ownership interests in certain foreign subsidiaries.
The credit facility contains customary affirmative and negative covenants, including covenants that limit or restrict our ability to, among other things, incur additional indebtedness, dispose of assets, execute a material change in business, acquire or dispose of an entity, grant liens, make share repurchases, and make distributions, including payment of dividends. The Company is required to maintain compliance with a minimum liquidity amount and minimum financial performance requirements, as defined in the credit facility. As of June 30, 2017, the Company was in compliance with all covenants.
The credit facility contains customary events of default, including among others, non-payment defaults, covenant defaults, bankruptcy and insolvency defaults, and a change of control default, in each case, subject to customary exceptions. The occurrence of a default event could result in the Bank’s acceleration of repayment obligations of any loan amounts then outstanding.
As of June 30, 2017, there were no borrowings outstanding and the Company was eligible to borrow $20.4 million of available credit, less $4.0 million in letters of credit that have been issued by the Bank on the Company's behalf, resulting in a net borrowing availability of $16.4 million. A quarterly commitment fee accrues on any unused portion of the credit facility at a nominal annual rate.

19

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
9. FINANCING ARRANGEMENTS (Continued)


Capital Leases
The Company enters into capital leases under non-committed arrangements for equipment and software. In addition, as a result of the Tell Me More acquisition, the Company assumed a capital lease for a building near Versailles, France, where Tell Me More’s headquarters are located. The fair value of the lease liability at the date of acquisition was $4.0 million.
During the six months ended June 30, 2017, the Company acquired no equipment or software through the issuance of capital leases. During the six months ended June 30, 2016, the Company acquired $27,000 of equipment or software through the issuance of capital leases.
Future minimum payments under capital leases with initial terms of one year or more are as follows (in thousands):
 
 
As of June 30, 2017
2017-remaining
 
$
263

2018
 
521

2019
 
518

2020
 
514

2021
 
511

Thereafter
 
382

Total minimum lease payments
 
$
2,709

Less amount representing interest
 
312

Present value of net minimum lease payments
 
$
2,397

Less current portion
 
422

Obligations under capital lease, long-term
 
$
1,975

10. INCOME TAXES
In accordance with ASC topic 740, Income Taxes (“ASC 740”), and ASC subtopic 740-270, Income Taxes: Interim Reporting, the income tax provision for the six months ended June 30, 2017 is based on the estimated annual effective tax rate for fiscal year 2017. The estimated effective tax rate may be subject to adjustment in subsequent quarterly periods as the estimates of pretax income for the year, along with other items that may affect the rate, may change and may create a different relationship between domestic and foreign income and loss.
The Company accounts for uncertainty in income taxes under ASC subtopic 740-10-25, Income Taxes: Overall: Background (“ASC 740-10-25”). ASC 740-10-25 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.
Valuation Allowance Recorded for Deferred Tax Assets
The Company evaluates the recoverability of its deferred tax assets at each reporting period for each tax jurisdiction and establishes a valuation allowance, if necessary, to reduce the deferred tax asset to an amount that is more likely than not to be recovered. As of June 30, 2017, the analysis of the need for a valuation allowance on U.S. deferred tax assets considered that the U.S. entity has incurred a three-year cumulative loss. As previously disclosed, if the Company does not have sufficient objective positive evidence to overcome a three-year cumulative loss, a valuation allowance may be necessary. In evaluating whether to record a valuation allowance, the guidance in ASC 740 deems that the existence of cumulative losses in recent years is a significant piece of objectively verifiable negative evidence that is difficult to overcome. An enterprise that has cumulative losses is generally prohibited from using an estimate of future earnings to support a conclusion that realization of an existing deferred tax asset is more likely than not.
Consideration has been given to the following positive and negative evidence:
Three-year cumulative evaluation period ended June 30, 2017 results in a cumulative U.S. pre-tax loss;

20

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
10. INCOME TAXES (Continued)

from 2006, when the U.S. entity began filing as a C-corporation for income tax purposes, through 2010, the U.S. entity generated taxable income each year;
the Company has a history of utilizing all operating tax loss carryforwards and has not had any tax loss carryforwards or credits expire unused;
lengthy loss carryforward periods of 20 years for U.S. federal and most state jurisdictions apply; and
the Company incurred a U.S. federal jurisdiction net operating loss for the most recently completed calendar year and has additional net operating loss carryforwards subject to limitation pursuant to IRC Section 382.
As of June 30, 2017, a valuation allowance was provided for the U.S., Hong Kong, Mexico, Spain, France, Brazil, and Canada where the Company has determined the deferred tax assets will not more likely than not be realized.
Evaluation of the remaining jurisdictions as of June 30, 2017, resulted in the determination that no additional valuation allowances were necessary at this time. However, the Company will continue to assess the need for a valuation allowance against its deferred tax assets in the future and the valuation will be adjusted accordingly, which could materially affect the Company’s financial position and results of operations.
As of June 30, 2017, and December 31, 2016, the Company’s U.S. deferred tax liability was $6.8 million and $6.1 million, respectively, related to its goodwill and indefinite lived intangibles. As of June 30, 2017 the Company had foreign net deferred tax liabilities of $45,000 compared to foreign net deferred tax liabilities of $0.1 million at December 31, 2016. As of June 30, 2017, and December 31, 2016, the Company had no unrecognized tax benefits.
For the six months ended June 30, 2017 the Company recorded an income tax expense of $1.5 million for deferred tax expense related to the tax impact of amortization of indefinite lived intangible assets and current tax expense related to our operations in U.K., Germany, and China.
11. STOCK-BASED COMPENSATION
2006 Stock Incentive Plan
On January 4, 2006, the Company established the Rosetta Stone Inc. 2006 Stock Incentive Plan (the "2006 Plan") under which the Company's Board of Directors, at its discretion, could grant stock options to employees and certain directors of the Company and affiliated entities. The 2006 Plan initially authorized the grant of stock options for up to 1,942,200 shares of common stock. On May 28, 2008, the Board of Directors authorized the grant of additional stock options for up to 195,000 shares of common stock under the plan, resulting in total stock options available for grant under the 2006 Plan of 2,137,200 as of December 31, 2008. The stock options granted under the 2006 Plan generally expire at the earlier of a specified period after termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from such grant date. Stock issued as a result of exercises of stock options will be issued from the Company's authorized available stock. All unissued stock associated with the 2006 Stock Incentive Plan expired in 2016 at the end of the ten year contractual term.
2009 Omnibus Incentive Plan
On February 27, 2009, the Company's Board of Directors approved the 2009 Omnibus Incentive Plan (the "2009 Plan") that provides for the ability of the Company to grant up to 2,437,744 of new stock incentive awards or options including Incentive and Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock, Restricted Stock Units, Performance Units, Performance Shares, Performance based Restricted Stock, Share Awards, Phantom Stock and Cash Incentive Awards. Service, performance and market-based restricted stock awards are considered outstanding at the time of grant as the stockholder is entitled to voting rights and to receive any dividends declared subject to the loss of the right to receive accumulated dividends if the award is forfeited prior to vesting. The stock incentive awards and options granted under the 2009 Plan generally expire at the earlier of a specified period after termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from such grant date. Concurrent with the approval of the 2009 Plan, the 2006 Plan was terminated for purposes of future grants.
On May 26, 2011 the Board of Directors authorized and the Company's stockholders' approved the allocation of an additional 1,000,000 shares of common stock to the 2009 Plan. On May 23, 2012, the Board of Directors authorized and the

21

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
11. STOCK-BASED COMPENSATION (Continued)


Company's stockholders approved the allocation of 1,122,930 additional shares of common stock to the 2009 Plan. On May 23, 2013, the Board of Directors authorized and the Company's stockholders approved the allocation of 2,317,000 additional shares of common stock to the 2009 Plan. On May 20, 2014, the Board of Directors authorized and the Company's stockholders approved the allocation of 500,000 additional shares of common stock to the 2009 Plan. On June 12, 2015, the Board of Directors authorized and the Company's stockholders approved the allocation of 1,200,000 additional shares of common stock to the 2009 Plan. On May 24, 2017, the Board of Directors authorized and the Company's stockholders approved the allocation of 1,900,000 additional shares of common stock to the 2009 Plan. At June 30, 2017, there were 2,165,448 shares available for future grant under the 2009 Plan.
Valuation Assumptions
The determination of fair value of our stock-based awards is affected by assumptions regarding subjective and complex variables. Generally, our assumptions are based on historical information and judgment is required to determine if historical trends may be indicators of future outcomes. In accordance with ASC 718, the fair value of stock-based awards to employees is calculated as of the date of grant. Compensation expense is then recognized over the requisite service period of the award. Stock-based compensation expense recognized is based on the estimated portion of the awards that are expected to vest. Estimated forfeiture rates are applied in the expense calculation. The Company determines the fair values of stock-based awards as follows:
Service-Based Restricted Stock Awards, Restricted Stock Units, Performance-Based Restricted Stock Awards, and Performance Share Units: Fair value is determined based on the quoted market price of our common stock on the date of grant.
Service-Based Stock Options and Performance-Based Stock Options: Fair value is determined using the Black-Scholes pricing model, which requires the use of estimates, including the risk-free interest rate, expected volatility, expected dividends, and expected term.
Market-Based Restricted Stock Awards and Market-Based Stock Options: The fair value of the market-based awards is determined using a Monte-Carlo simulation model. The Monte Carlo valuation also estimates the number of market-based awards that would be awarded which is reflected in the fair value on the grant date.
For the six months ended June 30, 2017, there were 48,830 stock options granted. For the six months ended June 30, 2016, the fair value of stock options granted was calculated using the following assumptions in the Black-Scholes model:  
 
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
Expected stock price volatility
 
44.6%
 
46.1% - 47.0%
Expected term of options
 
6 years
 
5.5 - 6.5 years
Expected dividend yield
 
 
Risk-free interest rate
 
1.92%
 
1.24% - 1.50%

22

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
11. STOCK-BASED COMPENSATION (Continued)


For the six months ended June 30, 2017 and 2016, the fair value of market-based stock options and market-based restricted stock awards granted was calculated using the following assumptions in the Monte-Carlo simulation model:
 
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
Expected stock price volatility
 
none
 
44.9%-49.1%
Expected term of options
 
none
 
1.7 years-7 years
Expected dividend yield
 
none
 
Risk-free interest rate
 
none
 
.71%-1.53%
Stock-Based Compensation Expense
Stock compensation expense associated with service-based equity awards is recognized in the statement of operations on a straight-line basis over the requisite service period, which is the vesting period. For equity awards granted with performance-based conditions, stock compensation expense is recognized in the statement of operations ratably for each vesting tranche based on the probability that operating performance conditions will be met and to what extent. Changes in the probability estimates associated with performance-based awards will be accounted for in the period of change using a cumulative catch-up adjustment to retroactively apply the new probability estimates. In any period in which the Company determines that achievement of the performance metrics is not probable, the Company ceases recording compensation expense and all previously recognized compensation expense for the performance-based award is reversed. For equity awards granted with market-based conditions, stock compensation is recognized in the statement of operations ratably for each vesting tranche regardless of meeting or not meeting the market conditions.
The following table presents stock-based compensation expense included in the related financial statement line items (in thousands):
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
 
2017
 
2016
Included in cost of revenue:
 
 
 
 
 
 
 
 
Cost of subscription and service revenue
 
$
4

 
$
15

 
$
(11
)
 
$
(2
)
Cost of product revenue
 
(3
)
 
6

 
24

 
7

Total included in cost of revenue
 
1

 
21

 
13

 
5

Included in operating expenses:
 
 
 
 
 
 
 
 
Sales and marketing
 
245

 
240

 
17

 
319

Research and development
 
181

 
289

 
30

 
170

General and administrative
 
932

 
847

 
1,446

 
1,324

Total included in operating expenses
 
1,358

 
1,376

 
1,493

 
1,813

Total
 
$
1,359

 
$
1,397

 
$
1,506

 
$
1,818


23

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
11. STOCK-BASED COMPENSATION (Continued)


Service-Based Stock Options
The following table summarizes the Company's service-based stock option activity from January 1, 2017 to June 30, 2017:
 
 
Service-based Options
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Contractual
Life (years)
 
Aggregate
Intrinsic
Value
Service-based Options Outstanding, January 1, 2017
 
1,793,930

 
$
9.81

 
7.58
 
$
1,154,498

Service-based options granted
 
48,830

 
11.42

 
 
 
 
Service-based options exercised
 
(55,875
)
 
7.94

 
 
 
 
Service-based options canceled
 
(53,496
)
 
9.54

 
 
 
 
Service-based Options Outstanding, June 30, 2017
 
1,733,389

 
9.93

 
7.14
 
3,132,268

Vested and expected to vest June 30, 2017
 
1,676,078

 
9.99

 
7.10
 
2,976,064

Exercisable at June 30, 2017
 
1,285,695

 
$
10.26

 
6.74
 
$
2,177,981

As of June 30, 2017, future compensation cost, net of estimated forfeitures, related to the non-vested portion of the service-based stock option awards not yet recognized in the consolidated statement of operations was $1.4 million and is expected to be recognized over a weighted average period of 1.98 years.
Service-based stock options are granted at the discretion of the Board of Directors or the Compensation Committee (or its authorized member(s)) and expire 10 years from the date of the grant. Service-based stock options generally vest over a four-year period based upon required service conditions and do not have performance or market conditions.
Service-Based Restricted Stock Awards
The following table summarizes the Company's service-based restricted stock award activity from January 1, 2017 to June 30, 2017:
 
 
Service Based Awards
 
Weighted
Average
Grant Date
Fair Value
 
Aggregate
Intrinsic
Value
Non-vested Service-based Awards, January 1, 2017
 
374,380

 
$
8.94

 
$
3,348,080

Service-based awards granted
 
278,906

 
7.85

 
 

Service-based awards vested
 
(106,451
)
 
9.65

 
 

Service-based awards canceled
 
(28,079
)
 
8.02

 
 

Non-vested Service-Based Awards, June 30, 2017
 
518,756

 
$
8.26

 
$
4,285,755

As of June 30, 2017, future compensation cost, net of estimated forfeitures, related to the non-vested portion of the service-based restricted stock awards not yet recognized in the consolidated statement of operations was $3.1 million and is expected to be recognized over a weighted average period of 2.50 years.
Service-based restricted stock awards are granted at the discretion of the Board of Directors or Compensation Committee (or its authorized member(s)). Restricted stock awards generally vest over a four-year period based upon required service conditions.

24

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
11. STOCK-BASED COMPENSATION (Continued)


Restricted Stock Units
The following table summarizes the Company's restricted stock unit activity from January 1, 2017 to June 30, 2017:
 
 
Units Outstanding
 
Weighted
Average
Grant Date Fair Value
 
Aggregate
Intrinsic
Value
Units Outstanding, January 1, 2017
 
188,057

 
$
9.93

 
$
1,675,588

Units granted
 
40,718

 
11.42

 
465,000

Units released
 

 

 
 
Units cancelled
 

 

 
 
Units Outstanding, June 30, 2017
 
228,775

 
10.20

 
2,466,195

Vested and expected to vest at June 30, 2017
 
119,525

 
11.42

 
1,288,478

Vested and deferred at June 30, 2017
 
82,157

 
$
12.44

 
$
885,652

For the six months ended June 30, 2017, there were 40,718 restricted stock units granted. Restricted stock units are granted to members of the Board of Directors as part of their compensation packages. Restricted stock units convert to common stock following the separation of service with the Company. Restricted stock unit awards vest quarterly over a one year period from the date of grant, with expense recognized straight-line over the vesting period. The Company's restricted stock units are accounted for as equity awards. The grant date fair value is based on the market price of the Company's common stock at the date of grant. The Company did not grant any restricted stock units prior to April 2009.
Performance-Based Restricted Stock Units
On March 17, 2017, the Company granted performance-based restricted stock units ("PSUs") to certain employees which will become eligible to vest based on the Company's achievement of certain pre-defined key operating performance goals during the cumulative period from January 1, 2017 to December 31, 2018, which will be certified by the Compensation Committee in February 2019. Any PSUs that become eligible to vest are subject to additional service requirements where the eligible PSUs will vest annually on a pro-rata basis over the two year period beginning March 17, 2019. The PSUs were granted at "target" (at 100% of target). Based upon actual attainment of the operating performance results relative to target, actual issuance of PSUs can be eligible for vest anywhere between a maximum of 200% and 0% of the target number of PSUs originally granted.
The following table summarizes the Company's PSU activity from January 1, 2017 to June 30, 2017:
 
 
PSUs
 
Weighted
Average
Grant Date
Fair Value
 
Aggregate
Intrinsic
Value
Non-vested PSUs, January 1, 2017
 

 
$

 
$

PSUs granted
 
450,370

 
9.43

 
 
PSUs vested
 

 

 
 
PSUs canceled
 
(16,241
)
 
9.43

 
 
Non-vested PSUs, June 30, 2017
 
434,129

 
$
9.43

 
$
4,679,911

As of June 30, 2017, future compensation cost, net of estimated forfeitures, related to the non-vested portion of the PSUs not yet recognized in the consolidated statement of operations was $2.5 million and is expected to be recognized over a weighted average period of 2.00 years.
CEO 2016 Performance and Market Conditioned Restricted Stock Awards and Stock Options Grants
On April 4, 2016, the Company named Mr. John Hass as President, CEO and Chairman of the Board. In conjunction with his appointment, the Compensation Committee approved a stock-based compensation package for Mr. Hass aimed to provide significant reward potential for achieving outstanding Company operating performance results and building stockholder value. The package was comprised of 70,423 performance-based restricted stock awards (PRSAs), 314,465 performance-based stock

25

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
11. STOCK-BASED COMPENSATION (Continued)


options (PSOs), 70,423 market-based restricted stock awards (MRSAs), and 314,465 market-based stock options (MSOs). The April 4, 2016 grant date fair values associated with these grants were $7.10, $3.24, $6.17 and $0.94, respectively.
PRSAs and PSOs were eligible to vest based on the achievement of certain operating performance targets during the 2016 calendar year, related to defined measures of revenue, bookings, adjusted free cash flow, and adjusted EBITDA, certified by the Compensation Committee in the first quarter of 2017. The PRSAs and PSOs are subject to additional service requirements where the eligible PRSAs and PSOs will vest 50%, 25%, and 25% on April 4, 2017, 2018 and 2019, respectively. Awards also vest if a majority change in control of the Company occurs during the performance or vesting period.
On February 20, 2017, the Compensation Committee approved 64,719 PRSAs and 144,497 PSOs as eligible under this plan, subject to the aforementioned service vesting requirements. The non-eligible 5,704 and 169,968 PRSAs and PSOs, respectively, were cancelled as of February 20, 2017. As of June 30, 2017, 32,359 PRSAs vested and 72,248 PSOs were vested. Future compensation cost related to the non-vested portion of the PRSAs and PSOs not yet recognized in the consolidated statement of operations was $0.2 million and is expected to be recognized over a weighted average period of 1.85 years.
In addition to the market condition, the MRSAs and MSOs also have a service condition. Vesting of these MRSAs and MSOs are dependent upon whether the Company achieves predetermined growth rates of total stockholder return for the two-year measurement period beginning on January 4, 2016 and ending on December 29, 2017. Following the end of the market performance measurement period on December 29, 2017, the Compensation Committee will certify the eligible quantity of MRSAs and MSOs which will vest annually on a pro-rata basis over three years beginning April 4, 2018. The Company records compensation expense ratably for each vesting tranche of the MRSAs and MSOs based on the Monte Carlo fair value estimated on the grant date, regardless of meeting or not meeting the market conditions.
The MRSAs were granted at "target" (at 100% of target). Based upon actual attainment of total stockholder return growth rate results through December 29, 2017 relative to target, actual issuance of MRSAs can fall anywhere between a maximum of 200% and 0% of the target number of MRSAs originally granted. The MSOs were granted at "maximum" (at 200% of target). Based on actual attainment of total stockholder return growth rate results through December 29, 2017 relative to maximum, actual issuance of stock options can fall anywhere between 100% and 0% of the maximum number of MSOs originally granted.
As of June 30, 2017, future compensation cost related to the non-vested portion of the MRSAs and MSOs not yet recognized in the consolidated statement of operations was $0.4 million and is expected to be recognized over a weighted average period of 2.14 years.
12. STOCKHOLDERS' DEFICIT
At June 30, 2017, the Company's Board of Directors had the authority to issue 200,000,000 shares of stock, of which 190,000,000 were designated as Common Stock, with a par value of $0.00005 per share, and 10,000,000 were designated as Preferred Stock, with a par value of $0.001 per share. At June 30, 2017, the Company had shares of common stock issued of 23,790,345 and shares of common stock outstanding of 22,790,345.
On August 22, 2013, the Company’s Board of Directors approved a share repurchase program under which the Company is authorized to repurchase up to $25 million of its outstanding common stock from time to time in the open market or in privately negotiated transactions depending on market conditions, other corporate considerations, debt facility covenants and other contractual limitations, and applicable legal requirements. For the year ended December 31, 2013, the Company paid $11.4 million to repurchase 1,000,000 shares at a weighted average price of $11.44 per share as part of this program. No shares were repurchased during 2014, 2015, or the six months ended June 30, 2017. Shares repurchased under the program were recorded as treasury stock on the Company’s consolidated balance sheet. The shares repurchased under this program during the year ended December 31, 2013 were not the result of an accelerated share repurchase agreement. Management has not made a decision on whether shares purchased under this program will be retired or reissued.

26

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



13. RESTRUCTURING
2016 Restructuring Plan
In the first quarter of 2016, the Company announced and initiated actions to withdraw the direct sales presence in almost all of its non-U.S. and non-northern European geographies related to the distribution of Enterprise & Education Language offerings. The Company has also initiated processes to close its software development operations in France and China. The Company does not expect to incur any additional material restructuring costs in connection with the 2016 Restructuring Plan. The 2016 Restructuring Plan remaining balance is expected to be paid during 2017.
Restructuring charges included in the Company’s unaudited consolidated statement of operations related to the 2016 Restructuring Plan include the following:
Employee severance and related benefits costs incurred in connection with headcount reductions involving employees primarily in France, China, Brazil, Canada, Spain, Mexico, U.S. and the U.K.;
Contract termination costs associated with operating lease terminations from office closures; and
Other related costs.
The following table summarizes activity with respect to the restructuring charges for the 2016 Restructuring Plan during the six months ended June 30, 2017 (in thousands):
 
 
Balance at January 1, 2017
 
Cost Incurred
 
Cash Payments
 
Other Adjustments (1)
 
Balance at June 30, 2017
Severance costs
 
$
500

 
$
(12
)
 
$
(281
)
 
$

 
$
207

Contract termination costs
 
22

 

 
(18
)
 

 
4

Other costs
 
70

 
(7
)
 
(34
)
 

 
29

Total
 
$
592

 
$
(19
)
 
$
(333
)
 
$

 
$
240

(1) Other Adjustments includes non-cash period changes in the liability balance, which may include non-cash lease closure expense and foreign currency translation adjustments.
2015 Restructuring Plan
In 2015, the Company announced and initiated actions to reduce headcount and other costs in order to support its strategic shift in business focus. During 2016, the final costs were incurred and final payments were made against the 2015 Restructuring Plan accruals. The Company does not expect to incur any additional restructuring costs in connection with the 2015 Plan.
Other Employee Severance Actions
In the first quarter of 2017, the Company initiated actions to reduce headcount in its U.S. consumer product operations and its China locations. Primarily comprised of severance costs associated with these actions, the Company recorded expense of $0.8 million in the first quarter of 2017. The Company recorded an additional $0.2 million in the second quarter of 2017 related to the reduction of headcount in the Fit Brains business and other terminations in consumer product operations. Of these amounts, $0.7 million has been paid and the remaining $0.3 million is expected to be paid before the end of 2017.

27

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
13. RESTRUCTURING (Continued)


Restructuring Cost
The following table summarizes the major types of costs associated with the restructuring actions for the three and six months ended June 30, 2017 and 2016, and total costs incurred through June 30, 2017 (in thousands):
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
Incurred through
 
 
2017
 
2016
 
2017
 
2016
 
June 30, 2017
Severance costs
 
$
178

 
$
2,233

 
$
932

 
$
4,486

 
$
12,610

Contract termination costs
 
36

 
94

 
36

 
94

 
1,335

Other costs
 
(9
)
 
185

 
17

 
441

 
1,024

Total
 
$
205

 
$
2,512

 
$
985

 
$
5,021

 
$
14,969

As of June 30, 2017, the entire restructuring liability of $0.5 million was classified as a current liability within accrued compensation and other current liabilities on the consolidated balance sheets.
The following table presents total restructuring costs associated with the restructuring actions included in the related line items of our Statement of Operations (in thousands):
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
 
2017
 
2016
 
2017
 
2016
Cost of revenue
 
$
40

 
$
477

 
$
205

 
$
572

Sales and marketing
 
4

 
734

 
335

 
2,219

Research and development
 
127

 
579

 
345

 
928

General and administrative
 
34

 
722

 
100

 
1,302

Total
 
$
205

 
$
2,512

 
$
985

 
$
5,021

These restructuring expenses are not allocated to any reportable segment under our definition of segment contribution as defined in Note 16 "Segment Information."
At each reporting date, the Company will evaluate its accrued restructuring costs to ensure the liabilities reported are still appropriate. Any changes to the estimated costs of executing approved restructuring plans will be reflected in the Company’s consolidated statements of operations.
14. LEASE ABANDONMENT AND TERMINATION
As part of the Company’s effort to reduce general and administrative expenses through a planned space consolidation at its Arlington, Virginia headquarters location, the Company incurred lease abandonment charges of $3.2 million in the first quarter of 2014. Prior to January 31, 2014, the Company occupied the 6th and 7th floors at its Arlington, Virginia headquarters. The Company estimated the liability under operating lease agreements and accrued lease abandonment costs in accordance with ASC 420, Exit or Disposal Cost Obligation ("ASC 420"), as the Company has no future economic benefit from the abandoned space and the lease does not terminate until December 31, 2018. All leased space related to the 6th floor was abandoned and ceased to be used by the Company on January 31, 2014.
In a further effort to reduce general and administrative expenses through a planned space consolidation, the Company relocated its headquarters location to 1621 North Kent Street, Suite 1200, Arlington, Virginia 22209. The previously leased space at the 7th floor of 1919 North Lynn Street was abandoned and ceased to be used by the Company on October 10, 2016 and resulted in $1.6 million in lease abandonment expense in the fourth quarter of 2016.

28

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
14. LEASE ABANDONMENT AND TERMINATION (Continued)

A summary of the Company’s lease abandonment activity for the six months ended June 30, 2017 and 2016 is as follows (in thousands):
 
 
As of June 30,
 
 
2017
 
2016
Accrued lease abandonment costs, beginning of period
 
$
2,123

 
$
1,281

Costs incurred and charged to expense
 

 
30

Principal reductions
 
(505
)
 
(217
)
Accrued lease abandonment costs, end of period
 
$
1,618

 
$
1,094

Accrued lease abandonment costs liability:
 
 
 
 

Short-term
 
$
1,067

 
$
434

Long-term
 
551

 
660

Total
 
$
1,618

 
$
1,094

15. COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company leases copiers, parking spaces, buildings, a warehouse and office space under operating lease and site license arrangements, some of which contain renewal options.
The following table summarizes future minimum operating lease payments for the remaining six months of 2017 and the years thereafter (in thousands):
 
 
As of June 30, 2017
Periods Ending December 31,
 
 
2017-remaining
 
$
2,200

2018
 
4,456

2019
 
1,742

2020
 
1,004

2021
 
590

Thereafter
 

Total
 
$
9,992

Total expenses under operating leases are $0.6 million and $1.0 million for the three months ended June 30, 2017 and 2016, respectively.  Total expenses under operating leases are $1.3 million and $2.1 million for the six months ended June 30, 2017 and 2016, respectively. 
The Company accounts for its leases under the provisions of ASC topic 840, Accounting for Leases ("ASC 840"), and subsequent amendments, which require that leases be evaluated and classified as operating leases or capital leases for financial reporting purposes. Certain operating leases contain rent escalation clauses, which are recorded on a straight-line basis over the initial term of the lease with the difference between the rent paid and the straight-line rent recorded as either a deferred rent asset or liability depending on the calculation. Lease incentives received from landlords are recorded as deferred rent liabilities and are amortized on a straight-line basis over the lease term as a reduction to rent expense.
Litigation    
From time to time, the Company has been subject to various claims and legal actions in the ordinary course of its business. The Company is not currently involved in any legal proceeding the ultimate outcome of which, in its judgment based on information currently available, would have a material impact on its business, financial condition or results of operations.

29

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

16. SEGMENT INFORMATION
The Literacy segment derives the majority of its revenue from the sales of literacy solutions to educational institutions serving grades K through 12. The Enterprise & Education ("E&E") Language segment derives revenue from sales of language-learning solutions to educational institutions, corporations, and government agencies worldwide. The Consumer segment derives the majority of its revenue from sales of language-learning solutions to individuals and retail partners. Revenue from transactions between the Company's operating segments is not material. The Company's current operating segments also represent the Company's reportable segments.
The Company and its Chief Operating Decision Maker ("CODM") assess profitability and performance of each of its current operating segments in terms of segment contribution. Segment contribution is calculated as segment revenue less expenses directly incurred by or allocated to the segment. Direct segment expenses include costs and expenses that are directly incurred by or allocated to the segment and include materials costs, service costs, customer care and coaching costs, sales and marketing expenses, and bad debt expense. In addition to the previously referenced expenses, the Literacy segment includes direct research and development expenses and Combined Language includes shared research and development expenses, cost of revenue, and sales and marketing expenses applicable to the Consumer Language and Enterprise & Education Language segments. Segment contribution excludes depreciation, amortization, stock compensation, restructuring and other related expenses. The Company does not allocate expenses beneficial to all segments, which include certain general and administrative expenses such as legal fees, payroll processing fees, accounting related expenses, lease abandonment, impairment, and non-operating income and expense. These expenses are included below the segment contribution line in the unallocated expenses section of the tables presented below.
Beginning on January 1, 2017, the Company modified its definition and presentation of segment contribution. E&E Language segment and Consumer segment are now characterized as "Language" since both of these segments primarily address the language-learning market and share many of the same costs. These shared language costs are included in the "Shared Services" column of the tables presented below. General and administrative expenses directly incurred by the Language segments consist only of bad debt expense, net of recoveries. Additionally, research and developments expenses are now included in segment contribution. Further, the depreciation, amortization, stock compensation, restructuring and other related expenses which are included in cost of revenue, sales and marketing, research and development, and general and administrative are presented in total as unallocated costs. Prior periods have been reclassified to reflect our current segment presentation and definition of segment contribution. The Company will continue to evaluate its management reporting and will update its operating and reportable segments as appropriate.
With the exception of goodwill, the Company does not identify or allocate its assets by operating segment. Consequently, the Company does not present assets or liabilities by operating segment.

30

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
16. SEGMENT INFORMATION (Continued)

Operating results by segment for the three months ended June 30, 2017 were as follows (in thousands):
 
 
 
 
Language
 
 
 
 
Literacy Segment
 
E&E Segment
 
Consumer Segment
 
Shared Services
 
Combined Language
 
Total Company
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenue
 
$
10,370

 
$
17,260

 
$
18,275

 
$

 
$
35,535

 
$
45,905

 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
1,329

 
1,855

 
3,001

 
(3
)
 
4,853

 
6,182

Sales and marketing
 
5,626

 
8,020

 
9,132

 
414

 
17,566

 
23,192

Research and development
 
1,431

 

 

 
4,261

 
4,261

 
5,692

General and administrative
 
393

 
28

 
82

 

 
110

 
503

Segment contribution
 
$
1,591

 
$
7,357

 
$
6,060

 
$
(4,672
)
 
$
8,745

 
$
10,336

Segment contribution margin %
 
15.3
%
 
42.6
%
 
33.2
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unallocated depreciation and amortization, stock compensation, restructuring and other expenses (net) included in:
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
1,409

Sales and marketing
 
 
 
 
 
 
 
 
 
 
 
845

Research and development
 
 
 
 
 
 
 
 
 
 
 
656

General and administrative
 
 
 
 
 
 
 
 
 
 
 
1,656

Subtotal
 
 
 
 
 
 
 
 
 
 
 
4,566

 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate unallocated expenses, net:
 
 
 
 
 
 
 
 
 
 
 
 
Unallocated general and administrative
 
 
 
 
 
 
 
 
 
 
 
6,435

Unallocated lease abandonment expense
 
 
 
 
 
 
 
 
 
 
 

Unallocated impairment
 
 
 
 
 
 
 
 
 
 
 

Unallocated non-operating income
 
 
 
 
 
 
 
 
 
 
 
(312