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EX-10.2 - EXHIBIT 10.2 - ROSETTA STONE INChassleadership2018ltippsua.htm
EX-32 - EXHIBIT 32 - ROSETTA STONE INCa033118exhibit32.htm
EX-31.2 - EXHIBIT 31.2 - ROSETTA STONE INCa033118exhibit312.htm
EX-31.1 - EXHIBIT 31.1 - ROSETTA STONE INCa033118exhibit311.htm
EX-10.1 - EXHIBIT 10.1 - ROSETTA STONE INChass2018annualpsuagrmt1yrf.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 March 31, 2018
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 April 30, 2018, there were 22,610,814 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)
 
 
March 31,
2018
 
December 31,
2017
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
39,158

 
$
42,964

Restricted cash
 
57

 
72

Accounts receivable (net of allowance for doubtful accounts of $270 and $375, at March 31, 2018 and December 31, 2017, respectively)
 
13,703

 
24,517

Inventory
 
2,078

 
3,536

Deferred sales commissions
 
9,266

 
14,466

Prepaid expenses and other current assets
 
5,179

 
4,543

Total current assets
 
69,441

 
90,098

Deferred sales commissions
 
6,856

 
3,306

Property and equipment, net
 
32,243

 
30,649

Goodwill
 
50,225

 
49,857

Intangible assets, net
 
18,233

 
19,184

Other assets
 
1,827

 
1,661

Total assets
 
$
178,825

 
$
194,755

Liabilities and stockholders' (deficit) equity
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
8,949

 
$
8,984

Accrued compensation
 
12,568

 
10,948

Income tax payable
 
299

 
384

Obligations under capital lease
 
472

 
450

Other current liabilities
 
14,062

 
16,454

Deferred revenue
 
96,274

 
110,670

Total current liabilities
 
132,624

 
147,890

Deferred revenue
 
43,996

 
40,593

Deferred income taxes
 
2,002

 
1,968

Obligations under capital lease
 
1,801

 
1,850

Other long-term liabilities
 
31

 
31

Total liabilities
 
180,454

 
192,332

Commitments and contingencies (Note 15)
 

 

Stockholders' (deficit) equity:
 
 
 
 
Preferred stock, $0.001 par value; 10,000 and 10,000 shares authorized, zero and zero shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively
 

 

Non-designated common stock, $0.00005 par value, 190,000 and 190,000 shares authorized, 24,064 and 23,783 shares issued and 23,064 and 22,783 shares outstanding at March 31, 2018 and December 31, 2017, respectively
 
2

 
2

Additional paid-in capital
 
196,694

 
195,644

Accumulated loss
 
(184,521
)
 
(178,890
)
Accumulated other comprehensive loss
 
(2,369
)
 
(2,898
)
Treasury stock, at cost, 1,000 and 1,000 shares at March 31, 2018 and December 31, 2017, respectively
 
(11,435
)
 
(11,435
)
Total stockholders' (deficit) equity
 
(1,629
)
 
2,423

Total liabilities and stockholders' (deficit) equity
 
$
178,825

 
$
194,755

   
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 
 March 31,
 
 
2018
 
2017
Revenue:
 
 
 
 
Subscription and service
 
$
41,498

 
$
41,450

Product
 
1,310

 
6,243

Total revenue
 
42,808

 
47,693

Cost of revenue:
 
 
 
 
Cost of subscription and service revenue
 
7,374

 
6,534

Cost of product revenue
 
2,060

 
1,607

Total cost of revenue
 
9,434

 
8,141

Gross profit
 
33,374

 
39,552

Operating expenses:
 
 
 
 
Sales and marketing
 
24,191

 
24,168

Research and development
 
6,306

 
6,414

General and administrative
 
8,532

 
8,025

Total operating expenses
 
39,029

 
38,607

(Loss) income from operations
 
(5,655
)
 
945

Other income and (expense):
 
 
 
 
Interest income
 
25

 
13

Interest expense
 
(83
)
 
(115
)
Other income and (expense)
 
(228
)
 
311

Total other income and (expense)
 
(286
)
 
209

(Loss) income before income taxes
 
(5,941
)
 
1,154

Income tax expense
 
461

 
700

Net (loss) income
 
$
(6,402
)
 
$
454

(Loss) earnings per share:
 
 
 
 
Basic
 
$
(0.29
)
 
$
0.02

Diluted
 
$
(0.29
)
 
$
0.02

Common shares and equivalents outstanding:
 
 
 
 
Basic weighted average shares
 
22,425

 
22,125

Diluted weighted average shares
 
22,425

 
22,590

   
See accompanying notes to consolidated financial statements

4


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

 
 
Three Months Ended 
 March 31,
 
 
2018
 
2017
Net (loss) income
 
$
(6,402
)
 
$
454

Other comprehensive income (loss), net of tax:
 
 
 
 
Foreign currency translation gain (loss)
 
529

 
(43
)
Other comprehensive income (loss)
 
529

 
(43
)
Comprehensive (loss) income
 
$
(5,873
)
 
$
411

   See accompanying notes to consolidated financial statements

5


ROSETTA STONE INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
 
Three Months Ended March 31,
 
 
2018
 
2017
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net (loss) income
 
$
(6,402
)
 
$
454

Adjustments to reconcile net (loss) income to cash (used in) provided by operating activities:
 
 
 
 
Stock-based compensation expense
 
583

 
147

Loss (gain) on foreign currency transactions
 
245

 
(277
)
Bad debt recovery
 
(75
)
 
(364
)
Depreciation and amortization
 
3,610

 
3,075

Deferred income tax expense
 
36

 
300

Gain on disposal of equipment
 

 
(1
)
Amortization of deferred financing fees
 
34

 
71

Loss from equity method investments
 

 
(5
)
Net change in:
 
 
 
 
Accounts receivable
 
11,038

 
11,188

Inventory
 
1,467

 
361

Deferred sales commissions
 
1,655

 
1,588

Prepaid expenses and other current assets
 
(639
)
 
(807
)
Income tax receivable or payable
 
(91
)
 
(537
)
Other assets
 
(166
)
 
2

Accounts payable
 
(58
)
 
(1,680
)
Accrued compensation
 
1,597

 
1,731

Other current liabilities
 
(2,413
)
 
(2,989
)
Other long-term liabilities
 

 
8,762

Deferred revenue
 
(10,839
)
 
(15,263
)
Net cash (used in) provided by operating activities
 
(418
)
 
5,756

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Purchases of property and equipment
 
(3,948
)
 
(2,313
)
Proceeds from sale of fixed assets
 

 
2

Net cash used in investing activities
 
(3,948
)
 
(2,311
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Proceeds from the exercise of stock options
 
467

 
74

Payments under capital lease obligations
 
(115
)
 
(242
)
Net cash provided by (used in) financing activities
 
352

 
(168
)
Decrease in cash, cash equivalents, and restricted cash
 
(4,014
)
 
3,277

Effect of exchange rate changes in cash, cash equivalents, and restricted cash
 
193

 
233

Net (decrease) increase in cash, cash equivalents, and restricted cash
 
(3,821
)
 
3,510

Cash, cash equivalents, and restricted cash - beginning of period
 
43,036

 
36,597

Cash, cash equivalents, and restricted cash - end of period
 
$
39,215

 
$
40,107

SUPPLEMENTAL CASH FLOW DISCLOSURE:
 
 
 
 
Cash paid during the periods for:
 
 
 
 
Interest
 
$
49

 
$
44

Income taxes, net of refunds
 
$
437

 
$
893

Noncash financing and investing activities:
 
 
 
 
Accrued liability for purchase of property and equipment
 
$
1,121

 
$
608

Equipment acquired under capital lease
 
$
25

 
$

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 web-based software subscriptions, perpetual software products, online and professional services, audio practice products and mobile applications. The Company's offerings are sold on a direct basis and through select third party retailers and distributors. The Company provides its solutions to customers through the sale of web-based software subscriptions and packaged software, domestically and in certain international markets.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Rosetta Stone Inc. and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
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 March 31, 2018 consolidated balance sheet included herein includes account balances as of December 31, 2017 that were derived from the audited financial statements as of that date. The Consolidated Financial Statements and the Notes to the Consolidated Financial Statements do not include all disclosures required for annual financial statements and notes.
As discussed in this Note 2, the Company adopted certain recently issued accounting standards effective January 1, 2018. The new revenue recognition standard ("ASC 606") was adopted using the modified retrospective method. As such, the comparative information has not been restated under ASC 606 and continues to be reported under the accounting standards in effect for those prior comparative periods. See the Company’s Annual Report on Form 10-K filed with the SEC on March 14, 2017 for revenue recognition policies that were in effect in prior periods before adoption of ASC 606. Additionally, accounting standard update 2016-18 ("ASU 2016-18") related to the presentation of restricted cash in the statements of cash flow was adopted retrospectively for all comparative periods.
Except as noted above, the unaudited interim consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Company’s statements of financial position at March 31, 2018 and December 31, 2017, the Company’s results of operations for the three months ended March 31, 2018 and 2017 and its cash flows for the three months ended March 31, 2018 and 2017 have been made. The results for the three months ended March 31, 2018 are not necessarily indicative of the results to be expected for the year ending December 31, 2018. All references to March 31, 2018 or to the three months ended March 31, 2018 and 2017 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)

Recently Issued Accounting Standards
Accounting Standards Adopted During the Period: During 2018, the Company adopted the following recently issued Accounting Standard Updates ("ASU"):
In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230) Restricted Cash a consensus of the FASB Emerging Issues Task Force. 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 statements of cash flows. The Company retrospectively adopted ASU 2016-18 beginning January 1, 2018. The Company does not consider its restricted cash balances to be material for further disclosure or reconciliation. The adoption of this guidance did not impact the Company’s consolidated financial position, results of operations, or footnote disclosures.
In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income ("ASU 2018-02"). ASU 2018-02 provided financial statement preparers with an option to reclassify stranded tax effects within accumulated other comprehensive income to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act of 2017 (or portion thereof) was recorded. ASU 2018-02 is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted for any interim period for which financial statements have not been issued. The Company adopted ASU 2018-02 effective January 1, 2018. Due to the presence of a full valuation allowance, adoption did not have a material impact on the Company's consolidated financial statements and the disclosure requirements under ASU 2018-02 were not applicable.
In May 2014, the FASB issued ASC 606 which provided a new standard related to revenue recognition. Under ASC 606, revenue is recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.
The Company adopted ASC 606 effective January 1, 2018. As a result, the Company has changed its accounting for revenue. The Company adopted ASC 606 using the modified retrospective method applied using hindsight to those contracts that were not complete as of January 1, 2018. The cumulative effect of initially applying ASC 606 totaled $0.8 million and was recognized as an adjustment to reduce the opening balance of accumulated loss at January 1, 2018. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods.
The Company implemented or modified certain internal controls and key system functionality to enable the preparation of financial information under ASC 606.
The most significant impact of ASC 606 to the Company related to the accounting for offerings that contained perpetual software for which customers took possession, which occurs only in the Company's Consumer Language segment. Prior to the adoption of ASC 606, revenue was recognized at the time of delivery for these perpetual software products due to the fact that the Company had established vendor specific objective evidence of the fair value ("VSOE") for the undelivered services in the arrangement. To the extent that VSOE was not established for undelivered services bundled with perpetual software, all revenue was deferred and recognized as the services were provided. Under the new guidance in ASC 606, the requirement to establish VSOE of the undelivered services in order to recognize revenue at the time of delivery no longer exists and revenue is allocated to performance obligations by estimating the standalone selling price and using a relative value allocation method. Revenue recognition related to subscription services and professional services remained substantially unchanged. Adoption had no tax impact due to the presence of a full valuation allowance. The impact of adoption to the Company’s consolidated statement of operations for the three months ended March 31, 2018 was as follows (in thousands):

8

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

 
 
Three Months Ended March 31, 2018
Consolidated Statement of Operations Data:
 
As reported
 
Effect of change higher/(lower)
 
Balances without adoption of ASC 606
Revenue:
 
 
 
 
 
 
Subscription and service
 
$
41,498

 
$
(162
)
 
$
41,660

Product
 
1,310

 
931

 
379

Total revenue
 
42,808

 
769

 
42,039

Gross profit
 
33,374

 
769

 
32,605

Loss from operations
 
(5,655
)
 
769

 
(6,424
)
Loss before income taxes
 
(5,941
)
 
769

 
(6,710
)
Net loss
 
$
(6,402
)
 
$
769

 
$
(7,171
)
Adoption of ASC 606 had impacts to the consolidated balance sheet as well, primarily related to the presentation of deferred commissions and the reduction to deferred revenue. The Company's prior methodology was to bifurcate deferred commissions between current and non-current classifications. Under ASC 606, deferred commissions are classified as non-current unless the original amortization period is one year or less. Deferred revenue decreased on adoption of ASC 606 due to the changes in the timing of revenue recognition noted above. The impact of adoption to the Company’s consolidated balance sheet as of March 31, 2018 was as follows (in thousands):
 
 
As of March 31, 2018
Consolidated Balance Sheet Data:
 
As reported
 
Effect of change higher/(lower)
 
Balances without adoption of ASC 606
 
 
 
 
 
 
 
Deferred sales commissions current
 
9,266

 
(3,801
)
 
13,067

Total current assets
 
69,441

 
(3,801
)
 
73,242

Deferred sales commissions non-current
 
6,856

 
3,801

 
3,055

 
 
 
 
 
 
 
Other current liabilities
 
14,062

 
(172
)
 
14,234

Deferred revenue current
 
96,274

 
(1,368
)
 
97,642

Total current liabilities
 
132,624

 
(1,540
)
 
134,164

Total liabilities
 
180,454

 
(1,540
)
 
181,994

 
 
 
 
 
 
 
Accumulated loss
 
(184,521
)
 
1,540

 
(186,061
)
Total stockholders' deficit
 
(1,629
)
 
1,540

 
(3,169
)
The impact of adoption to the Company’s reportable segments for the three months ended March 31, 2018 was as follows (in thousands):
 
 
Three Months Ended March 31, 2018
Consolidated Segment Data:
 
As reported
 
Effect of change higher/(lower)
 
Balances without adoption of ASC 606
Revenue by Segment:
 
 
 
 
 
 
Literacy
 
$
12,384

 
$
35

 
$
12,349

Enterprise & Education ("E&E") Language
 
15,436

 
17

 
15,419

Consumer Language
 
14,988

 
717

 
14,271

Total revenue
 
$
42,808

 
$
769

 
$
42,039


9

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

Accounting Standards Not Yet Adopted: The following ASUs were recently issued but have not yet been adopted by the Company:
In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment ("ASU 2017-04"). ASU 2017-04 simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test. ASU 2017-04 is effective for annual and interim goodwill tests beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates on or after January 1, 2017. The Company is in the process of evaluating the guidance. Given the prospective adoption application, there is no impact on the Company's historical consolidated financial statements and disclosures.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). ASU 2016-13 changes the methodology for measuring credit losses of financial instruments and the timing of when such losses are recorded. ASU 2016-13 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019. Early adoption is permitted 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. However based on a preliminary assessment and as the Company does not hold significant financial instruments, the Company does not expect the adoption of this guidance to have a material impact on its consolidated financial statements.
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 record most leases on their balance sheets. A lessee would recognize a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. Lease expense recognition 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, however the Company does not expect to early adopt this guidance. ASU 2016-02 is required to be adopted using a modified retrospective approach. The Company expects its leases designated as operating leases in Note 15, "Commitments and Contingencies," will be reported on the consolidated balance sheets upon adoption. The Company is in the process of evaluating the other impacts of the new guidance on the Company's consolidated financial statements and disclosures.
Revenue Recognition
Nature of Revenue: The Company accounts for revenue contracts with customers by applying the requirements of ASC 606, which includes the following steps:
Identification of the contract, or contracts with a customer.
Identification of the performance obligations in the contract.
Determination of the transaction price.
Allocation of the transaction price to the performance obligations in the contract.
Recognition of the revenue when, or as, the Company satisfies a performance obligation.
The Company's primary sources of revenue are web-based software subscriptions, mobile application, 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 and professional services.
Revenue is recognized upon transfer of control of promised goods or services to customers in an amount that reflects the consideration expected to be received in exchange for those goods or services. Revenue is recognized net of allowances for returns. Revenue is also recognized net of any taxes collected from customers, which are subsequently remitted to governmental authorities.
Subscription and service revenue consists of fees associated with non-cancellable web-based software subscriptions, online services, professional services, and mobile applications. Subscription revenue is generated from contracts with customers that provide access to hosted software over a contract term without the customer taking possession of the software. Subscription revenue is recognized ratably over the contract period as the performance obligation is satisfied. Subscription revenue is generated by all three reportable segments and range from short-term to multi-year contracts. Online services are typically sold in short-term service periods and include dedicated online conversational coaching services and access to online communities of language learners. Professional services include implementation services. Online services revenue and professional services revenue are recognized as the services are provided. Expired services are forfeited and revenue is recognized upon expiry.

10

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

Product revenue primarily consists of revenue from perpetual language-learning software and audio practice products. Audio practice products are often combined with language-learning software and sold as a solution. Perpetual software revenue is recognized at the point in time when the software is made available to the customer. Audio practice products are recognized at the point in time that the audio practice products are delivered to the customer. As post-contract support (“PCS”) is provided to customers who purchase perpetual software at no charge, a portion of the transaction price is allocated to PCS service revenue and recognized as the PCS services are provided, which is typically up to three months from the date of purchase.
See Note 16 - “Segment Information” for further information on the disaggregation of revenue, including revenue by reportable segment, geographic area, and revenue type.
Performance Obligations: A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account in ASC 606. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. The Company’s performance obligations are satisfied at a point in time or over time as delivery occurs or as work progresses.
Significant Judgments: Some of the Company’s contracts with customers include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately, versus together, requires significant judgment. This includes determining whether distinct services are part of a series of distinct services that are substantially the same. When subscription services are sold with professional services, judgment is required to determine whether the professional services are distinct and can be accounted for separately. In the E&E Language segment, the Company has concluded that each promised service within the language-learning subscription is delivered concurrently with all other promised services over the contract term and, as such, concluded that these promises are a single performance obligation that includes a series of distinct services that have the same pattern of transfer to the customer. When there are multiple performance obligations, revenue is allocated to each performance obligation based on its relative standalone selling price (“SSP”). Judgment is required to determine the SSP for each distinct performance obligation where SSP is not directly observable, such as when the product or service is not sold separately, SSP is determined using internally published price lists which include suggested sales prices for each performance obligation based on the type of client and volume purchased. These price lists are derived from past experience and from the expectation of obtaining a reasonable margin based on the cost to fulfill each performance obligation.
Subscription revenue is recognized ratably over the contract period as the performance obligation is satisfied. Certain Consumer Language offerings have contracts with no fixed duration and are marketed as lifetime subscriptions. For these lifetime subscriptions, the Company estimates the expected contract period as the greater of the typical customer usage period or the longest fixed-period duration subscription that is currently marketed. The Company's current expected contract period for lifetime subscriptions is 24 months.
Certain Consumer Language offerings are sold with a right of return and the Company may provide other credits or incentives. These rights are accounted for as variable consideration when estimating the amount of revenue to recognize by utilizing the expected value method. Returns and credits are estimated at contract inception based on historical return rates, estimated channel inventory levels, the timing of new product introductions and other factors. Reserves for returns and credits are updated at the end of each reporting period as additional information becomes available.
The Company distributes its products and services both directly to the end customer and indirectly through resellers. Resellers earn commissions generally calculated as a fixed percentage of the gross sale amount to the end customer. The Company evaluates each of its reseller relationships to determine whether it is the principal (where revenue is recognized at the gross amount) or agent (where revenue is recognized net of the reseller commission). In making this determination the Company evaluates a variety of factors including the amount of control the Company is able to exercise over the transactions.
Contract Balances: The timing of revenue recognition, invoicing, and cash collection results in accounts receivable and deferred revenue in the consolidated balance sheets. Payment from customers is often received in advance of services being provided, resulting in deferred revenue. Accounts receivable is recorded when there is an executed customer contract and the right to the consideration becomes unconditional. Contract assets such as unbilled receivables are not material.
The allowance for doubtful accounts reflects the best estimate of probable losses inherent in the accounts receivable balance. The Company establishes an allowance for doubtful accounts based on specific risks identified, historical experience, and other currently available evidence.

11

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

Payment terms and conditions vary by contract type and customer. For the E&E Language and Literacy segments, payment terms generally range from 30 to 90 days. In the Consumer Language segment, resellers are generally granted payment terms of 45 days. Within Consumer Language, sales to end customers via the Rosetta Stone ecommerce website are done by credit card, which generally are settled within 7-10 days and may be made in installments. In instances where the timing of revenue recognition differs from the timing of invoicing, the Company has determined that contracts generally do not include a significant financing component. The primary purpose of invoicing terms is to provide customers with simplified and predictable ways of purchasing products and services and not to provide customers with financing.
Deferred revenue is comprised mainly of unearned revenue related to subscription services which is recognized ratably over the subscription period. Deferred revenue also includes payments for professional services and online services to be performed in the future which are earned as revenue when the service is provided. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, contract backlog is not material.
The opening and closing balances of the Company’s accounts receivable and deferred revenue are as follows:
 
 
Accounts Receivable
 
Deferred Revenue (current)
 
Deferred Revenue (non-current)
Opening balance as of January 1, 2018
 
$
24,517

 
$
110,670

 
$
40,593

Increase/(decrease), net
 
(10,814
)
 
(14,396
)
 
3,403

Ending balance as of March 31, 2018
 
$
13,703

 
$
96,274

 
$
43,996

The amount of revenue recognized in the three months ended March 31, 2018 that was included in the opening January 1, 2018 deferred revenue balance was $40.0 million. The vast majority of this revenue consists of deferred subscription revenue. The amount of revenue recognized from performance obligations satisfied in prior periods was not material.
The following table sets forth deferred revenue by reportable segment which represents the Company's unfulfilled performance obligations as of March 31, 2018 and the estimated revenue expected to be recognized in the future related to these performance obligations:
 
 
As of March 31, 2018
 
 
Total
 
Less than
1 Year
 
1-3 Years
 
3-5 Years
 
More than
5 Years
Literacy
 
$
33,735

 
$
25,483

 
$
7,694

 
$
508

 
$
50

E&E Language
 
51,803

 
39,991

 
10,466

 
1,014

 
332

Consumer Language
 
54,732

 
30,800

 
9,754

 
1,764

 
12,414

Total
 
$
140,270

 
$
96,274

 
$
27,914

 
$
3,286

 
$
12,796

The Company entered into a series of agreements with SOURCENEXT Corporation, (“SOURCENEXT”), comprising a single performance obligation associated with the perpetual license of certain intellectual property, software, and product code for exclusive development and sale of language and education-related products in Japan. The Company estimated a 20 year period to recognize the performance obligation. As of March 31, 2018, deferred revenue associated with SOURCENEXT totaled $16.8 million, which will be recognized ratably through April 2037 and comprised the majority of the Consumer Language non-current deferred revenue. As this customer relationship progresses, the Company may prospectively reassess the recognition period as needed.
Assets Recognized from Costs to Obtain a Contract with a Customer: The Company recognizes an asset for the incremental costs of obtaining a contract with a customer, which primarily represents sales commissions paid when a customer contract is either recorded as revenue or deferred revenue. Sales commissions paid to obtain non-cancellable subscription contracts are deferred and amortized in proportion to the period over which the revenue is recognized from the related contract. Deferred sales commissions are amortized to Sales and marketing expense on the consolidated statements of operations. Deferred sales commissions are classified as non-current unless the associated amortization period is one year or less. As of March 31, 2018, the total deferred sales commissions balance was $16.1 million. Amortization of deferred sales commissions recognized during the three months ended March 31, 2018 was $5.4 million.

12

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

Restructuring Costs
Restructuring plans have been initiated in 2015, 2016 and 2017 to reduce headcount and other costs in order to support the 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 within Cost of sales and Sales and marketing, Research and development, and General and administrative operating expense categories in the Company's consolidated 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 existed, 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.
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. See Note 10 "Income Taxes" for additional disclosures including the impact and additional disclosures associated with the recent Tax Cuts and Jobs Act of 2017 enacted on December 22, 2017.
Deferred Tax Valuation Allowance
The Company has recorded a valuation allowance offsetting certain of its deferred tax assets as of March 31, 2018. 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.

13

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

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.
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 statements of operations on a straight-line basis over the requisite service period, which is the vesting period. For equity awards granted with performance-based conditions, stock compensation expense is recognized in the statements of operations ratably for each vesting tranche based on the probability that operating performance conditions will be met and to what extent. Changes in the probability estimates associated with performance-based awards will be accounted for in the period of change using a cumulative catch-up adjustment to retroactively apply the new probability estimates. In any period in which the Company determines that achievement of the performance metrics is not probable, the Company ceases recording compensation expense and all previously recognized compensation expense for the performance-based award is reversed. For equity awards granted with market-based conditions, stock compensation expense is recognized in the statements of operations ratably for each vesting tranche regardless of meeting or not meeting the market conditions. See Note 11 "Stock-Based Compensation" for additional disclosures.
Basic and Diluted Net (Loss) Earnings Per Share
Net (loss) earnings per share is computed under the provisions of ASC topic 260, Earnings Per Share. Basic (loss) earnings per share is computed by dividing net (loss) earnings by the weighted average number of common shares outstanding during the period. Diluted (loss) earnings per share is computed by dividing net (loss) earnings by the weighted average number of common shares and potential common shares outstanding during the period. Potential common shares are included in the diluted computation when dilutive. Potentially dilutive shares are computed using the treasury stock method and primarily consist of shares issuable upon the exercise of stock options, restricted stock awards, restricted stock units and conversion of shares of preferred stock. Common stock equivalent shares are excluded from the diluted computation if their effect is anti-dilutive. When there is a net loss, there is a presumption that there are no dilutive shares as these would be anti-dilutive. See Note 3 "Basic and Diluted Net (Loss) Earnings Per Share" for additional disclosures.
Foreign Currency Translation and Transactions
The functional currency of the Company's foreign subsidiaries is their local currency. Accordingly, assets and liabilities of the foreign subsidiaries are translated into U.S. dollars at exchange rates in effect on the balance sheet date. Income and expense items are translated at average rates for the period. Translation adjustments are recorded as a component of accumulated other comprehensive loss in stockholders' deficit.
Cash flows of consolidated foreign subsidiaries, whose functional currency is their local currency, are translated to U.S. dollars using average exchange rates for the period. The Company reports the effect of exchange rate changes on cash balances

14

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

held in foreign currencies as a separate item in the reconciliation of the changes in cash, cash equivalents and restricted cash during the period.
The following table presents the effect of exchange rate changes on total comprehensive (loss) income (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2018
 
2017
Net (loss) income
 
$
(6,402
)
 
$
454

Foreign currency translation gain (loss)
 
529

 
(43
)
Comprehensive (loss) income
 
$
(5,873
)
 
$
411

Comprehensive (Loss) Income
Comprehensive (loss) income consists of net (loss) income and other comprehensive income (loss). Other comprehensive income (loss) refers to revenues, expenses, gains, and losses that are not included in net (loss) income, but rather are recorded directly in stockholders' (deficit) equity. For the three months ended March 31, 2018 and 2017, the Company's comprehensive (loss) income consisted of net (loss) and foreign currency translation gains and (losses).
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 months ended March 31, 2018 and 2017.
Advertising Costs
Costs for advertising are expensed as incurred. Advertising expense for the three months ended March 31, 2018 and March 31, 2017 was $6.0 million and $6.6 million, respectively.
Going Concern Assessment
As part of its internal control framework, the Company routinely performs a 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 below, management has concluded based on projections that the cash balance, funds available from the line of credit, and the cash flows from operations are sufficient to meet the liquidity needs through the one year period following the financial statement issuance date.
The consolidated 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 May 9, 2018
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 2018 cash flow forecast, 2018 operating budget, and long-term plan that extends beyond 2018. 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 May 9, 2018, 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.

15

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



3. BASIC AND DILUTED NET (LOSS) EARNINGS PER SHARE
 Net (loss) earnings per share is computed under the provisions of ASC topic 260, Earnings Per Share. Basic (loss) earnings per share is computed using net (loss) earnings and the weighted average number of shares of common stock outstanding. Diluted (loss) earnings per share reflects 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) earnings per common share (in thousands, except per share amounts):
 
 
Three Months Ended 
 March 31,
 
 
2018

2017
Numerator:
 
 

 
 

Net (loss) income
 
$
(6,402
)
 
$
454

Denominator:
 
 

 
 

Basic shares:
 
 
 
 
Weighted average number of common shares - basic
 
22,425

 
22,125

Diluted shares:
 
 
 
 
Weighted average number of common shares - basic
 
22,425

 
22,125

Number of dilutive common stock equivalent shares included in diluted shares calculation
 

 
465

Weighted average number of common shares - diluted
 
22,425

 
22,590

(Loss) earnings per common share:
 
 

 
 

Basic
 
$
(0.29
)
 
$
0.02

Diluted
 
$
(0.29
)
 
$
0.02

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):
 
 
Three Months Ended 
 March 31,
 
 
2018
 
2017
Stock options
 
543

 
116

Restricted stock units
 
230

 
183

Restricted stocks
 
558

 
166

Total common stock equivalent shares
 
1,331

 
465

Share-based awards to purchase approximately 0.3 million and 1.3 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 March 31, 2018 and 2017, respectively, were not included in the calculation of diluted earnings per share because they were anti-dilutive.

16

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



4. INVENTORY
Inventory consisted of the following (in thousands):
 
 
March 31,
2018
 
December 31,
2017
Raw materials
 
$
1,322

 
$
2,893

Finished goods
 
756

 
643

Total inventory
 
$
2,078

 
$
3,536

The total inventory balance as of March 31, 2018 reflected the Company's ongoing efforts to transition the Consumer Language segment to a software-as-a-service ("SaaS") model. The March 31, 2018 inventory balance also reflected a $1.3 million inventory obsolescence charge during the three months ended March 31, 2018 in the retail and direct-to-consumer channels of the Consumer Language business.
5. PROPERTY AND EQUIPMENT
For the three months ended March 31, 2018 and March 31, 2017 the Company capitalized $3.9 million and $2.6 million, respectively, of internal-use software development costs.
Depreciation and amortization expense related to property and equipment includes depreciation related to its physical assets and amortization expense related to amounts capitalized in the development of internal-use software. Depreciation and amortization expense associated with property and equipment consisted of the following (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2018
 
2017
Included in cost of revenue:
 
 
 
 
Cost of subscription and service revenue
 
$
1,454

 
$
994

Cost of product revenue
 
406

 
244

Total included in cost of revenue
 
1,860

 
1,238

Included in operating expenses:
 
 
 
 
Sales and marketing
 
181

 
143

Research and development
 
2

 
3

General and administrative
 
576

 
751

Total included in operating expenses
 
759

 
897

Total
 
$
2,619

 
$
2,135

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.

17

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 three months ended March 31, 2018 (in thousands):
 
 
Literacy
 
E&E Language
 
Consumer Language
 
Total
Balance as of January 1, 2018
 
 
 
 
 
 
 
 
Gross Goodwill
 
$
9,962

 
$
39,895

 
$
27,514

 
$
77,371

Accumulated Impairment
 

 

 
(27,514
)
 
(27,514
)
Goodwill as of January 1, 2018
 
$
9,962

 
$
39,895

 
$

 
$
49,857

 
 
 
 
 
 
 
 
 
Effect of change in foreign currency rate
 

 
368

 

 
368

 
 
 
 
 
 
 
 
 
Balance as of March 31, 2018
 
 
 
 
 
 
 
 
Gross Goodwill
 
$
9,962

 
$
40,263

 
$
27,514

 
$
77,739

Accumulated Impairment
 

 

 
(27,514
)
 
(27,514
)
Goodwill as of March 31, 2018
 
$
9,962

 
$
40,263

 
$

 
$
50,225

The Company routinely reviews goodwill at the reporting unit level for potential impairment as part of the Company's internal control framework. The Company's reporting units with goodwill balances were evaluated to determine if a triggering event has occurred. As of March 31, 2018, 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 2018 in connection with the interim impairment review.
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
 
$
12,505

 
$
15,636

 
$
26,656

 
$
312

 
$
55,109

Accumulated Amortization
 
(1,755
)
 
(12,222
)
 
(20,515
)
 
(278
)
 
(34,770
)
Accumulated Impairment
 
(26
)
 
(1,001
)
 
(128
)
 

 
(1,155
)
Balance as of January 1, 2018
 
$
10,724

 
$
2,413

 
$
6,013

 
$
34

 
$
19,184

 
 
 
 
 
 
 
 
 
 
 
Gross Carrying Amount
 
12,517

 
15,719

 
26,747

 
312

 
55,295

Accumulated Amortization
 
(1,817
)
 
(12,781
)
 
(21,015
)
 
(285
)
 
(35,898
)
Accumulated Impairment
 
(26
)
 
(1,009
)
 
(129
)
 

 
(1,164
)
Balance as of March 31, 2018
 
$
10,674

 
$
1,929

 
$
5,603

 
$
27

 
$
18,233

* Included in the tradename/trademark line above is the Rosetta Stone tradename, which is the Company's only indefinite-lived intangible asset. As of March 31, 2018, the carrying value of the tradename asset was $10.6 million.

18

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 
 March 31,
 
 
2018
 
2017
Included in cost of revenue:
 
 
 
 
Cost of subscription and service revenue
 
$
114

 
$
117

Cost of product revenue
 
32

 
29

Total included in cost of revenue
 
146

 
146

Included in operating expenses:
 
 
 
 
Sales and marketing
 
481

 
455

Research and development
 
364

 
339

General and administrative
 

 

Total included in operating expenses
 
845

 
794

Total
 
$
991

 
$
940

The following table summarizes the estimated future amortization expense related to intangible assets for the remaining nine months of 2018 and years thereafter (in thousands):
 
 
As of March 31, 2018
2018 - remaining
 
$
2,384

2019
 
1,532

2020
 
1,282

2021
 
940

2022
 
940

Thereafter
 
548

Total
 
$
7,626

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 March 31, 2018 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.

19

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

8. OTHER CURRENT LIABILITIES
The following table summarizes other current liabilities (in thousands):
 
 
March 31, 2018
 
December 31, 2017
Accrued marketing expenses
 
$
3,122

 
$
5,316

Accrued professional and consulting fees
 
1,338

 
1,609

Sales return reserve
 
459

 
1,176

Sales, withholding and property taxes payable
 
3,391

 
3,616

Other
 
5,752

 
4,737

Total other current liabilities
 
$
14,062

 
$
16,454

9. FINANCING ARRANGEMENTS
Credit Facility
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 the 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 the 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 March 31, 2018, 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 March 31, 2018, there were no borrowings outstanding and the Company was eligible to borrow $9.4 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 $5.4 million. A quarterly commitment fee accrues on any unused portion of the credit facility at a nominal annual rate.

20

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 were located. The fair value of the lease liability at the date of acquisition was $4.0 million.
During the three months ended March 31, 2018, the Company acquired $25,000 in 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 March 31, 2018
2018-remaining
 
$
425

2019
 
564

2020
 
560

2021
 
557

2022
 
418

Thereafter
 
1

Total minimum lease payments
 
$
2,525

Less amount representing interest
 
252

Present value of net minimum lease payments
 
$
2,273

Less current portion
 
472

Obligations under capital lease, long-term
 
$
1,801

10. INCOME TAXES
New tax legislation, commonly referred to as the Tax Cuts and Jobs Act of 2017 (the "Tax Act"), was enacted on December 22, 2017. Given the significance of the Tax Act, the SEC staff issued Staff Accounting Bulletin No. 118 (SAB 118), which allowed registrants to record provisional amounts during a one year “measurement period” similar to that used when accounting for business combinations. However, the measurement period is deemed to have ended earlier when the registrant has obtained, prepared and analyzed the information necessary to finalize its accounting. During the measurement period, impacts of the Tax Act are expected to be recorded at the time a reasonable estimate for all or a portion of the effects can be made, and provisional amounts can be recognized and adjusted as information becomes available, prepared or analyzed.
SAB 118 summarizes the process to be applied at each reporting period to account for and qualitatively disclose: (1) the effects of the change in tax law for which accounting is complete; (2) provisional amounts (or adjustments to provisional amounts) for the effects of the tax law where accounting is not complete, but that a reasonable estimate has been determined; and (3) a reasonable estimate cannot yet be made and therefore taxes are reflected in accordance with law prior to the enactment of the Tax Act.
During the year of enactment, the Company recorded reasonable estimates of the effects of the Tax Act which principally related to a) the reduction in the U.S. corporate income tax rate from 35% to 21% and b) the change in the carryforward period of net operating losses. In the fourth quarter of 2017, the Company recorded an income tax benefit of $2.4 million to remeasure deferred tax liabilities associated with indefinite-lived intangible assets that will reverse at the new 21% rate. Absent this deferred tax liability, the Company was in a net deferred tax asset position that was offset by a full valuation allowance. Though the impact of the rate change has a net tax effect of zero, the accounting to determine the gross change in the deferred tax position and the offsetting valuation resulted in a $26.3 million reduction in both. Additionally, the Company recorded an income tax benefit of $3.1 million in the fourth quarter of 2017 related to the release of the valuation allowance associated with the post-2017 reversing deferred tax assets to offset 80% of the deferred tax liability associated with the Company's indefinite-lived intangible asset.
During the three months ended March 31, 2018, there were no updates to these estimates and the estimates made in the year of enactment represent the Company's best estimates. The Company continues to assess the impact of the Tax Act, however, the final impact of the Tax Act may differ from these estimates, due to, among other things, changes in interpretations,

21

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

additional guidance that may be issued by the Internal Revenue Service or state and local authorities, and any updates or changes to estimates the Company has utilized to calculate the transition impact. Therefore, as of March 31, 2018, the Company's accounting for the elements of the Tax Act is incomplete. The Company will complete the accounting for these items during 2018, after completion of the 2017 U.S. income tax return.
The Tax Act includes a one-time mandatory repatriation transition tax on the net accumulated earnings and profits of a U.S. taxpayer’s foreign subsidiaries.
Other significant Tax Act provisions that may impact income taxes include: an exemption from U.S. tax on dividends of future foreign earnings, a limitation of net operating losses generated after 2017 to 80% of taxable income, the inclusion of commissions and performance based compensation in determining the excess compensation limitation, and a minimum tax on certain foreign earnings in excess of 10% of the foreign subsidiaries tangible assets (i.e., global intangible low-taxed income or GILTI). The Company is still evaluating its policy election to treat the GILTI tax as a period expense or to provide U.S. deferred taxes on foreign temporary differences that are expected to generate GILTI income when they reverse in future years.
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 three months ended March 31, 2018 is based on the estimated annual effective tax rate for fiscal year 2018. 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 March 31, 2018, 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 March 31, 2018 results in a cumulative U.S. pre-tax loss;
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 or indefinite loss carryforward periods 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 March 31, 2018, a valuation allowance was provided for the U.S., Hong Kong, Mexico, Spain, France, and Brazil where the Company has determined the deferred tax assets will not more likely than not be realized.
Evaluation of the remaining jurisdictions as of March 31, 2018, 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

22

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

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 March 31, 2018, and December 31, 2017, the Company’s U.S. deferred tax liability was $1.9 million and $1.9 million, respectively, related to its goodwill and indefinite lived intangibles. As of March 31, 2018 the Company had foreign net deferred tax liabilities of $0.1 million compared to foreign net deferred tax liabilities of $0.1 million at December 31, 2017. As of March 31, 2018, and December 31, 2017, the Company had no unrecognized tax benefits.
For the three months ended March 31, 2018 the Company recorded an income tax expense of $0.5 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, Canada 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 provided the Company the ability 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. Performance units and restricted stock units do not have voting rights. 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. Since the establishment of the 2009 Plan, the Board of Directors authorized and the Company's shareholders' approved the allocation of additional shares of common stock to the 2009 Plan as follows:
Authorization Dates of 2009 Plan Additions
 
Number of Common Stock Shares Authorized to 2009 Plan
February 27, 2009
 
2,437,744

May 26, 2011
 
1,000,000

May 23, 2012
 
1,122,930

May 23, 2013
 
2,317,000

May 20, 2014
 
500,000

June 12, 2015
 
1,200,000

May 24, 2017
 
1,900,000

At March 31, 2018, there were 1,227,656 shares available for future grant under the 2009 Plan.

23

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


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 is 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. There have been no market based awards or options granted in the periods presented.
For the three months ended March 31, 2017, there were no stock options granted. For the three months ended March 31, 2018, the fair value of stock options granted was calculated using the following assumptions in the Black-Scholes model:  
 
 
Three Months Ended 
 March 31,
 
 
2018
 
2017
Expected stock price volatility
 
39.8%
 
none
Expected term of options
 
6 years
 
none
Expected dividend yield
 
 
none
Risk-free interest rate
 
2.73%
 
none
Stock-Based Compensation Expense
Stock compensation expense associated with service-based equity awards is recognized in the statements of operations on a straight-line basis over the requisite service period, which is the vesting period. For equity awards granted with performance-based conditions, stock compensation expense is recognized in the statements of operations ratably for each vesting tranche based on the probability that operating performance conditions will be met and to what extent. Changes in the probability estimates associated with performance-based awards are 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 statements of operations ratably for each vesting tranche regardless of meeting or not meeting the market conditions.

24

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


The following table presents stock-based compensation expense included in the related financial statement line items (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2018
 
2017
Included in cost of revenue:
 
 
 
 
Cost of subscription and service revenue
 
$
(39
)
 
$
(15
)
Cost of product revenue
 
(13
)
 
27

Total included in cost of revenue
 
(52
)
 
12

Included in operating expenses:
 
 
 
 
Sales and marketing
 
(101
)
 
(228
)
Research and development
 
(16
)
 
(151
)
General and administrative
 
752

 
514

Total included in operating expenses
 
635

 
135

Total
 
$
583

 
$
147

Service-Based Restricted Stock Awards
The following table summarizes the Company's service-based restricted stock award activity from January 1, 2018 to March 31, 2018:
 
 
Service Based Awards
 
Weighted
Average
Grant Date
Fair Value
 
Aggregate
Intrinsic
Value
Non-vested Service-based Awards, January 1, 2018
 
431,118

 
$
8.07

 
$
3,477,484

Service-based awards granted
 
209,862

 
13.81

 
 

Service-based awards vested
 
(111,232
)
 
8.42

 
 

Service-based awards canceled
 
(10,105
)
 
7.91

 
 

Non-vested Service-Based Awards, March 31, 2018
 
519,643

 
$
10.31

 
$
5,359,286

As of March 31, 2018, 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 $3.7 million and is expected to be recognized over a weighted average period of 2.67 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.
Performance-Based Restricted Stock Units
Beginning in the first quarter of 2017, the Company began granting annual performance-based restricted stock units ("PSUs") to certain employees which will become earned or eligible to vest based on the Company's achievement of certain pre-defined key operating performance goals during a one to three-year period. The number of PSUs earned or eligible to vest following the performance period is subject to approval by the Compensation Committee of the Board of Directors. Once earned, certain PSUs are then subject to additional service and vesting requirements, while certain PSUs vest shortly after being earned. 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.

25

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


The following table summarizes the Company's PSU activity from January 1, 2018 to March 31, 2018:
 
 
PSUs
 
Weighted
Average
Grant Date
Fair Value
 
Aggregate
Intrinsic
Value
Non-vested PSUs, January 1, 2018
 
433,588

 
$
9.43

 
$
5,406,842

PSUs granted
 
318,833

 
13.82

 
 
PSUs vested
 
(28,051
)
 
9.43

 
 
PSUs canceled
 
(21,335
)
 
9.43

 
 
Non-vested PSUs, March 31, 2018
 
703,035

 
$
11.42

 
$
9,244,910

As of March 31, 2018, 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 $3.6 million and is expected to be recognized over a weighted average period of 1.81 years.
Service-Based Stock Options
The following table summarizes the Company's service-based stock option activity from January 1, 2018 to March 31, 2018:
 
 
Service-based Options
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Contractual
Life (years)
 
Aggregate
Intrinsic
Value
Service-based Options Outstanding, January 1, 2018
 
1,628,711

 
$
9.81

 
6.79
 
$
5,203,196

Service-based options granted
 
1,692

 
13.72

 
 
 
 
Service-based options exercised
 
(53,710
)
 
8.69

 
 
 
 
Service-based options canceled
 
(37,101
)
 
14.88

 
 
 
 
Service-based Options Outstanding, March 31, 2018
 
1,539,592

 
9.74

 
6.65
 
5,878,052

Vested and expected to vest March 31, 2018
 
1,521,668

 
9.76

 
6.63
 
5,780,367

Exercisable at March 31, 2018
 
1,317,006

 
$
9.99

 
6.46
 
$
4,782,483

As of March 31, 2018, 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 $1.0 million and is expected to be recognized over a weighted average period of 1.52 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.

26

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, 2018 to March 31, 2018:
 
 
Units Outstanding
 
Weighted
Average
Grant Date Fair Value
 
Aggregate
Intrinsic
Value
Units Outstanding, January 1, 2018
 
234,658

 
$
10.19

 
$
2,926,185

Units granted
 
1,222

 
13.72

 
16,766

Units released
 

 

 
 
Units cancelled
 

 

 
 
Units Outstanding, March 31, 2018
 
235,880

 
10.21

 
3,101,822

Vested and expected to vest at March 31, 2018
 
235,639

 
11.19

 
3,098,649

Vested and deferred at March 31, 2018
 
220,063

 
$
10.14

 
$
2,893,828

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.
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 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.
On February 20, 2017, the Compensation Committee approved 64,719 PRSAs and 144,497 PSOs as eligible for further service vesting requirements. The non-eligible 5,704 and 169,968 PRSAs and PSOs, respectively, were cancelled as of February 20, 2017. PRSAs and PSOs vest 50%, 25%, and 25% on April 4, 2017, 2018 and 2019, respectively. As of March 31, 2018, 32,359 PRSAs were 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 $0.1 million and is expected to be recognized over a weighted average period of 1.00 years.
On February 22, 2018, the Compensation Committee approved the maximum quantity of 140,846 MRSAs and 314,465 MSOs as eligible for further service vesting requirements. MRSAs and MSOs vest annually on a pro-rata basis over three years beginning April 4, 2018. As of March 31, 2018, future compensation cost related to the non-vested portion of the MRSAs and MSOs not yet recognized in the consolidated statement of operations was $0.2 million and is expected to be recognized over a weighted average period of 1.67 years.
12. STOCKHOLDERS' (DEFICIT) EQUITY
At March 31, 2018, 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 March 31, 2018, the Company had shares of common stock issued of 24,064,291 and shares of common stock outstanding of 23,064,291.
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

27

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
12. STOCKHOLDERS' EQUITY (DEFICIT) (Continued)


were repurchased during 2014, 2015, 2016, 2017 or the three months ended March 31, 2018. Shares repurchased under the program were recorded as treasury stock on the Company’s consolidated balance sheets. 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.
13. RESTRUCTURING AND OTHER EMPLOYEE SEVERANCE
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 E&E Language offerings. There was approximately $0.1 million of remaining accrued severance costs as of December 31, 2017 and March 31, 2018, with only minor changes in activity during the three months ended March 31, 2018. The remaining amount is expected to be settled by the end of 2018.
Other Employee Severance Actions
In 2017, the Company initiated actions to reduce headcount in its Fit Brains business and in the U.S. and China locations within consumer product operations, primarily comprised of severance costs. There was approximately $0.1 million of remaining accrued severance costs as of December 31, 2017 and March 31, 2018, with only minor changes in activity during the three months ended March 31, 2018. The remaining amount is expected to be settled by the end of 2018.
Restructuring Cost
The following table summarizes the major types of costs associated with the restructuring actions for the three months ended March 31, 2018 and 2017 (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2018
 
2017
Severance costs
 
$
10

 
$
754

Contract termination costs
 

 

Other costs
 
21

 
26

Total
 
$
31

 
$
780

The following table presents total restructuring costs associated with the restructuring actions included in the related line items of our statements of operations (in thousands):
 
 
Three Months Ended 
 March 31,
 
 
2018
 
2017
Cost of revenue
 
$
35

 
$
165

Sales and marketing
 
2

 
331

Research and development
 

 
218

General and administrative
 
(6
)
 
66

Total
 
$
31

 
$
780

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.

28

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



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.
A summary of the Company’s lease abandonment activity for the three months ended March 31, 2018 and 2017 is as follows (in thousands):
 
 
As of March 31,
 
 
2018
 
2017
Accrued lease abandonment costs, beginning of period
 
$
1,081

 
$
2,123

Costs incurred and charged to expense
 

 

Principal reductions
 
(262
)
 
(252
)
Accrued lease abandonment costs, end of period
 
$
819

 
$
1,871

Accrued lease abandonment costs liability:
 
 
 
 

Short-term - included in "Other current liabilities"
 
$
819

 
$
1,057

Long-term
 

 
814

Total
 
$
819

 
$
1,871

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 nine months of 2018 and the years thereafter (in thousands):
 
 
As of March 31, 2018
Periods Ending December 31,
 
 
2018-remaining
 
$
3,349

2019
 
1,742

2020
 
1,004

2021
 
590

Thereafter
 

Total
 
$
6,685

Total expenses under operating leases are $0.6 million and $0.7 million for the three months ended March 31, 2018 and 2017, respectively. 

29

ROSETTA STONE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
15. COMMITMENTS AND CONTINGENCIES (Continued)


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.
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 E&E Language segment derives revenue from sales of language-learning solutions to educational institutions, corporations, and government agencies worldwide. The Consumer Language 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. Effective January 1, 2018 the Company adopted ASC 606 using the modified retrospective approach. Segment revenue in prior comparative periods reflects amounts previously reported and has not been restated. See Note 2 "Summary of Significant Accounting Policies" for additional disclosures regarding revenue recognition and the impact of adoption of ASC 606.
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 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 E&E 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.
The E&E Language segment and Consumer Language segment are 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 development expenses are included as shared Language costs. 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 March 31, 2018 were as follows (in thousands):
 
 
 
 
Language
 
 
 
 
Literacy Segment
 
E&E Language Segment
 
Consumer Language Segment
 
Shared Services
 
Combined Language
 
Total Company
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenue
 
$
12,384

 
$
15,436

 
$
14,988

 
$

 
$
30,424

 
$
42,808

 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
2,008

 
1,612

 
3,805

 
19

 
5,436

 
7,444

Sales and marketing
 
6,228

 
7,989

 
9,107

 
229

 
17,325

 
23,553

Research and development
 
1,815

 

 

 
3,908

 
3,908

 
5,723

General and administrative
 
461

 
(55
)
 
(9
)
 

 
(64
)
 
397

Segment contribution
 
$
1,872

 
$
5,890

 
$
2,085

 
$
(4,156
)
 
$
3,819

 
$
5,691

Segment contribution margin %
 
15.1
%
 
38.2
%
 
13.9
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unallocated depreciation and amortization, stock compensation, restructuring and other expenses (net) included in:
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
1,990

Sales and marketing
 
 
 
 
 
 
 
 
 
 
 
638

Research and development
 
 
 
 
 
 
 
 
 
 
 
583

General and administrative
 
 
 
 
 
 
 
 
 
 
 
1,332

Subtotal
 
 
 
 
 
 
 
 
 
 
 
4,543

 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate unallocated expenses, net:
 
 
 
 
 
 
 
 
 
 
 
 
Unallocated general and administrative
 
 
 
 
 
 
 
 
 
 
 
6,803

Unallocated non-operating expense
 
 
 
 
 
 
 
 
 
 
 
286

Subtotal
 
 
 
 
 
 
 
 
 
 
 
7,089

 
 
 
 
 
 
 
 
 
 
 
 
 
Loss before income taxes
 
 
 
 
 
 
 
 
 
 
 
$
(5,941
)

31

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

Operating results by segment for the three months ended March 31, 2017 were as follows (in thousands):
 
 
 
 
Language
 
 
 
 
Literacy Segment
 
E&E Language Segment
 
Consumer Language Segment
 
Shared Services
 
Combined Language
 
Total Company
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenue (1)
 
$
10,170

 
$
16,500

 
$
21,023

 
$

 
$
37,523

 
$
47,693

 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
1,828

 
1,844

 
2,911

 
(3
)
 
4,752

 
$
6,580

Sales and marketing
 
5,514

 
7,635

 
9,825

 
492

 
17,952

 
$
23,466

Research and development
 
1,504

 

 

 
4,501

 
4,501

 
$
6,005

General and administrative
 
363

 
(98
)
 
(70
)
 

 
(168
)
 
$
195

Segment contribution
 
$
961

 
$
7,119

 
$
8,357

 
$
(4,990
)
 
$
10,486

 
$
11,447

Segment contribution margin %
 
9.4
%
 
43.1
%
 
39.8
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unallocated depreciation and amortization, stock compensation, restructuring and other expenses (net) included in:
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
1,561

Sales and marketing