CHEGG, INC 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion of our financial condition and results of operations in conjunction with our audited consolidated financial statements and the related notes included in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. We have omitted discussion of the earliest of the three years of financial condition and results of operations and this information can be found in Part I, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2023, filed with the SEC on February 20, 2024, which is available free of charge on the SEC's website at sec.gov and on our website at investor.chegg.com. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. See the section titled “Note about Forward-Looking Statements” for additional information. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in Part I, Item 1A, “Risk Factors.” Overview Chegg provides individualized learning support to students as they pursue their educational journeys. Available on demand 24/7 and powered by over a decade of learning insights, the Chegg platform offers students artificial intelligence (“AI”)-powered academic support thoughtfully designed for education coupled with access to a vast network of subject matter experts who help ensure quality and accuracy. No matter the goal, level, or style, Chegg helps millions of students around the world learn with confidence by helping them build essential academic, life, and job skills to achieve success. Our long-term strategy is centered upon our ability to utilize our Subscription Services to increase student engagement with our learning platform. We continue to invest in the expansion of our offerings and technology platform to provide a more compelling and personalized solution and deepen engagement with students. We continue to integrate artificial intelligence into our platform, and it is now conversational, more instructional, and interactive. We remain focused on providing a holistic and differentiated product offering that supports the whole student with 360 degrees of individualized academic and functional support, including the delivery of high-quality and accurate content. We believe the investments we are making will allow us to return to revenue growth over time. Our ability to achieve these long-term objectives is subject to numerous risks and uncertainties, which are described in greater detail below and in Part II, Item 1A, “Risk Factors.” Exploration of Strategic Alternatives On February 24, 2025, we announced that we are undertaking a strategic review process and exploring a range of alternatives to maximize shareholder value, including being acquired, undertaking a go-private transaction, or remaining as a standalone public company. This review will be ongoing with our continued investment, innovation, and execution. We have not set a timetable for the completion of this process, and there can be no assurance that it will result in any transaction or outcome. Business Updates and Developments Recent technological shifts, notably Google's roll out of AI Overviews (AIO) and continued increase in adoption of free and paid generative AI services by students, have created and are expected to continue to create headwinds for our industry and our business, most notably a reduction in traffic to our website and customers subscribing to our services. In mid-August, Google broadly rolled out its AIO search experience, or AIO, which displays AI-generated content at the top of its search results. This experience, which includes questions and solutions for education, keeps users on Google search results versus leading them onto our site. AIO’s prevalence has grown and will only continue to increase. While we continue to study the changes and adjust our SEO strategy, we expect Google to continue its shift from being a search origination point to the destination, which could materially adversely affect our business, operating results and financial condition. In addition, across our industry, there has been a continued increase in the adoption of free and paid generative AI products for academic support, and students are increasingly turning to generative AI for academic support, such as homework and exams, as well as assistance in other areas of daily life. This issue impacts education technology companies broadly, where students see generative AI products like Chat GPT and others as strong alternatives to vertically specialized solutions for education such as Chegg. These developments have negatively impacted our industry and our business and are expected to continue to impact our overall traffic and accelerate the decline in the number of new subscribers that sign up for our services, 42 Table of Contents resulting in continued negative impacts to our growth, business, operating results and financial condition. See Part II, Item 1A, “Risk Factors” for additional details. In June 2024, we undertook a strategic restructuring plan based on the environment in which we were operating to realign our expenses with the revenue trends at the time. The June 2024 restructuring plan included a reduction in workforce, the closure of two offices, and a change in our Chegg Skills offering such that we no longer offer Chegg Skills directly to customers. Since then, the factors described above have negatively impacted our business and our outlook. As a result, in November 2024, we announced an additional restructuring plan to further manage costs and align with the market. The November 2024 restructuring plan included a reduction in workforce and the closure of one office. During the year ended December 31, 2024, we recorded $24.6 million of restructuring charges and for fiscal year 2025, we expect to realize cost savings as a result of the restructuring plans. See Part I, Item 1A, “Risk Factors”, Note 6, “Property and Equipment, Net”, and Note 15, “Restructuring Charges” of our accompanying Notes to Consolidated Financial Statements included in Part II, Item 8, “Financial Statements” of this Annual Report on Form 10-K for additional information. In September 2024 and June 2024, in consideration of the sustained decline in our stock price, industry developments, and our financial performance, we determined that impairment tests for our goodwill, intangible assets and property and equipment were necessary. As a result, we recorded $677.2 million of impairment expense during the year ended December 31, 2024. See Note 6, “Property and Equipment, Net” and Note 7, “Goodwill and Intangible Assets” of our accompanying Notes to Consolidated Financial Statements included in Part II, Item 1, “Financial Statements” of this Annual Report on Form 10-K for additional information. During the years ended December 31, 2024, and 2023, we generated net revenues of $617.6 million and $716.3 million, respectively, and in the same periods had a net loss of $837.1 million and a net income of $18.2 million. We have presented revenues for our two product lines, Subscription Services and Skills and Other, based on how students view us and the utilization of our products by them. More detail on our two product lines is discussed in the next two sections titled “Subscription Services” and “Skills and Other.” Subscription Services Our Subscription Services can be accessed internationally through our websites and on mobile devices and include Chegg Study Pack, Chegg Study, Chegg Writing, Chegg Math, and Busuu. Students typically pay to access our Subscription Services on a monthly basis. Revenues from our Subscription Services are primarily recognized ratably over the monthly subscription period whereas the number of subscribers are determined as those who have paid to access our services at any time during the period. Changes in revenues are primarily related to changes in subscribers. Our Chegg Study subscription service provides access to personalized, step-by-step learning support powered by AI, computational engines, and subject matter experts. When students need writing help, including plagiarism detection scans and creating citations for their papers, they can use our Chegg Writing subscription service. Our Chegg Math subscription service helps students understand math by providing a step-by-step math solver and calculator. We also offer our Chegg Study Pack as a premium subscription bundle of our Chegg Study, Chegg Writing, and Chegg Math services. Subscribers to Busuu have access to a premium language learning platform that offers comprehensive support through self-paced lessons, live classes with expert tutors and a huge community of members to practice alongside. Skills and Other Our Skills and Other product line includes revenues from Chegg Skills, advertising services, print textbooks and eTextbooks. Our Chegg Skills learning platform offers professional courses focused on the latest technology skills. We work with leading brands and programmatic partners to deliver advertising across our platforms. We also provide a platform for students to rent or buy print textbooks and eTextbooks, which helps students save money compared to the cost of buying new. Seasonality of Our Business Revenues from Subscription Services are primarily recognized ratably over the subscription term, which has generally resulted in our highest revenues and profitability in the fourth quarter as it reflects more days of the academic year. Certain variable expenses, such as marketing expenses, remain highest in the first and third quarters such that our profitability may not provide meaningful insight on a sequential basis. As a result of these factors, the most concentrated periods for our revenues and expenses do not necessarily coincide, and comparisons of our historical quarterly results of operations on a sequential basis may not provide meaningful insight into our overall financial performance. 43 Table of Contents Components of Results of Operations Net Revenues We recognize revenues net of allowances for refunds or charge backs from our payment processors who process payments from credit cards, debit cards, and PayPal. Revenues from Chegg Study Pack, Chegg Study, Chegg Writing, Chegg Math, and Busuu are primarily recognized ratably over the monthly subscription period. Revenues from Chegg Skills are recognized over the delivery period, adjusted for an estimate of non-redemption. Revenues from advertising services are recognized upon fulfillment. Revenues from print textbooks and eTextbooks are recognized immediately. Cost of Revenues Our cost of revenues consists primarily of expenses associated with the delivery and distribution of our products and services. Cost of revenues primarily consists of content amortization expense related to content that we develop, license from publishers, or acquire through acquisitions, web hosting fees, customer support fees, payment processing costs, amortization of acquired intangible assets, employee-related expenses, which includes salaries, benefits and share-based compensation expense, and other direct costs related to providing content or services. In addition, cost of revenues includes allocated information technology and facilities costs. Operating Expenses We classify our operating expenses into three categories: research and development, sales and marketing, and general and administrative. One of the most significant components of our operating expenses is employee-related expenses, which include salaries, benefits, and share-based compensation expense. We allocate certain costs to each expense category, primarily based on the headcount in each group at the end of a period. As our business grows, our operating expenses may increase over time to expand capacity and sustain our workforce. Research and Development Research and development expenses consist of employee-related expenses, which includes salaries, benefits, and share-based compensation expense for employees on our product, engineering, and technical teams who are responsible for maintaining our website, developing new products, and improving existing products. Research and development expenses also include technology costs to support our research and development, and outside services. We expense substantially all of our research and development expenses as they are incurred. Our research and development expenses continue to support new products and services as well as expand our infrastructure capabilities to support back-end processes associated with our revenue transactions and internal systems. We intend to continue making significant investments in developing new products and services and enhancing the functionality of existing products and services. Sales and Marketing Sales and marketing expenses consist of user and advertiser-facing marketing and promotional expenditures through a number of targeted online marketing channels, sponsored search, display advertising, social media campaigns, and other initiatives. We incur employee-related expenses, which includes salaries, benefits and share-based compensation expenses for our employees engaged in marketing, business development and sales, sales support functions, and amortization of acquired intangible assets. Our marketing expenses are largely variable and to the extent there is increased or decreased competition for these traffic sources, or to the extent our mix of these channels' shifts, we could see a corresponding change in our sales and marketing expenses. General and Administrative General and administrative expenses consist of employee-related expenses, which includes salaries, benefits and share-based compensation expense for certain executives as well as our finance, legal, human resources and other administrative employees. In addition, general and administrative expenses include outside services, legal and accounting services, and facilities expense. 44 Table of Contents Impairment Expense Impairment expense consists of impairments of goodwill, intangible assets, and property and equipment, net. Interest Expense, Net and Other Income, Net Interest expense, net consists primarily of interest expense on the amortization of debt issuance costs related to the convertible senior notes. Other income, net consists primarily of interest income, gains on early extinguishment of the convertible senior notes, and realized gains/losses on the sale of our investments. Provision For Income Taxes Provision for income taxes consists primarily of federal and state income taxes in the United States and income taxes in certain non-US jurisdictions. Results of Operations The following table presents our historical consolidated statements of operations (in thousands, except percentage of total net revenues): Years Ended December 31, 2024 2023 Net revenues $ 617,574 100 % $ 716,295 100 % Cost of revenues (1) 180,927 29 225,941 32 Gross profit 436,647 71 490,354 68 Operating expenses: Research and development (1) 170,431 28 191,705 27 Sales and marketing (1) 108,329 18 126,591 18 General and administrative (1) 217,756 35 236,183 33 Impairment expense 677,239 n/m 3,600 — Total operating expenses 1,173,755 n/m 558,079 78 Loss from operations (737,108) n/m (67,725) (10) Total interest expense, net and other income, net 48,742 9 118,037 17 (Loss) income before provision for income taxes (688,366) n/m 50,312 7 Provision for income taxes (148,702) n/m (32,132) (4) Net (loss) income $ (837,068) n/m $ 18,180 3 % (1) Includes share-based compensation expense and restructuring charges as follows: Share-based compensation expense: Cost of revenues $ 1,786 $ 2,256 Research and development 28,044 44,103 Sales and marketing 7,466 9,524 General and administrative 47,318 77,619 Total share-based compensation expense $ 84,614 $ 133,502 Restructuring charges: Cost of revenues $ 762 $ 12 Research and development 11,387 1,692 Sales and marketing 2,630 1,228 General and administrative 9,824 2,772 Total restructuring charges $ 24,603 $ 5,704 _______________________________________ *n/m - not meaningful 45 Table of Contents Years Ended December 31, 2024 and 2023 Net Revenues The following table presents our total net revenues for the periods shown for our Subscription Services and Skills and Other product lines (in thousands, except percentages): Years Ended December 31, Change in 2024 2024 2023 $ % Subscription Services $ 549,211 $ 640,520 $ (91,309) (14) % Skills and Other 68,363 75,775 (7,412) (10) Total net revenues $ 617,574 $ 716,295 $ (98,721) (14) Subscription Services revenues decreased by $91.3 million, or 14%, during the year ended December 31, 2024, compared to the same period in 2023. The decrease was primarily due to a 14% decrease in subscribers who have paid to access our services. Subscription Services revenues as a percentage of net revenues were 89% during each of the years ended December 31, 2024 and 2023. Skills and Other revenues decreased by $7.4 million, or 10%, during the year ended December 31, 2024 compared to the same period in 2023. The decrease was primarily due to lower revenues in Chegg Skills related to fewer enrollments. Skills and Other revenues as a percentage of net revenues were 11% during each of the years ended December 31, 2024 and 2023. Cost of Revenues The following table presents our cost of revenues for the periods shown (in thousands, except percentages): Years Ended December 31, Change in 2024 2024 2023 $ % Cost of revenues (1) $ 180,927 $ 225,941 $ (45,014) (20) % (1) Includes share-based compensation expense of: $ 1,786 $ 2,256 $ (470) (21) % (1) Includes restructuring charges of: $ 762 $ 12 $ 750 n/m _______________________________________ *n/m - not meaningful Cost of revenues decreased $45.0 million, or 20%, during the year ended December 31, 2024, compared to the same period in 2023. The decrease was primarily due to the absence of the $38.2 million content and related assets charge, lower contractor spend of $4.4 million, lower depreciation and amortization expense of $4.0 million, and lower payment processing fees of $2.9 million, which is primarily due to the decrease in subscribers who have paid to access our services, which was partially offset by higher web hosting fees of $2.5 million and the absence of the gain on disposition of textbooks of $1.2 million. Gross margins increased to 71% during the year ended December 31, 2024, from 68% during the same period in 2023. See Note 6, “Property and Equipment, Net” of our accompanying Notes to Consolidated Financial Statements included in Part II, Item 8, “Financial Statements” of this Annual Report on Form 10-K for additional information on the content and related assets charge. 46 Table of Contents Operating Expenses The following table presents our total operating expenses for the periods shown (in thousands, except percentages): Years Ended December 31, Change in 2024 2024 2023 $ % Research and development (1) $ 170,431 $ 191,705 $ (21,274) (11) % Sales and marketing (1) 108,329 126,591 (18,262) (14) General and administrative (1) 217,756 236,183 (18,427) (8) Impairment expense 677,239 3,600 673,639 n/m Total operating expenses $ 1,173,755 $ 558,079 $ 615,676 n/m (1) Includes share-based compensation expense of: Research and development $ 28,044 $ 44,103 $ (16,059) (36) % Sales and marketing 7,466 9,524 (2,058) (22) General and administrative 47,318 77,619 (30,301) (39) Total share-based compensation expense $ 82,828 $ 131,246 $ (48,418) (37) (1) Includes restructuring charges of: Research and development $ 11,387 $ 1,692 $ 9,695 n/m Sales and marketing 2,630 1,228 1,402 n/m General and administrative 9,824 2,772 7,052 n/m Total restructuring charges $ 23,841 $ 5,692 $ 18,149 n/m _______________________________________ *n/m - not meaningful Research and Development Research and development expenses decreased $21.3 million, or 11%, during the year ended December 31, 2024 compared to the same period in 2023. The decrease was primarily due to lower employee-related expenses of $28.8 million, which is primarily due to share-based compensation expense, partially offset by higher restructuring charges of $9.7 million. Research and development expenses as a percentage of net revenues were 28% during the year ended December 31, 2024 compared to 27% during the same period in 2023. Sales and Marketing Sales and marketing expenses decreased by $18.3 million, or 14%, during the year ended December 31, 2024, compared to the same period in 2023. The decrease was primarily attributable to lower depreciation and amortization expense of $12.0 million, which is primarily due to previously recognized impairment charges, lower employee-related expenses $4.3 million, which is primarily due to share-based compensation expense, and lower paid marketing expenses of $1.7 million. Sales and marketing expenses as a percentage of net revenues were 18% during each of the years ended December 31, 2024 and 2023. General and Administrative General and administrative expenses decreased $18.4 million, or 8%, during the year ended December 31, 2024 compared to the same period in 2023. The decrease was due to lower employee-related expenses of $38.6 million, which is primarily due to share-based compensation expense, partially offset by higher restructuring charges of $7.1 million, impairment of lease related assets of $5.6 million, and a higher loss contingency of $5.0 million. General and administrative expenses as a percentage of net revenues were 35% during the year ended December 31, 2024 compared to 33% during the same period in 2023. 47 Table of Contents Impairment Expense Impairment expense was $677.2 million during the year ended December 31, 2024, consisting of impairments of goodwill, intangible assets, and other related property and equipment. Impairment expense was $3.6 million during the year ended December 31, 2023 consisting of an impairment of intangible assets. See Note 6, “Property and Equipment, Net” and Note 7, “Goodwill and Intangible Assets” of our accompanying Notes to Consolidated Financial Statements included in Part II, Item 1, “Financial Statements” of this Annual Report on Form 10-K for additional information. Interest Expense, Net and Other Income, Net The following table presents our interest expense, net, and other income, net, for the periods shown (in thousands, except percentages): Years Ended December 31, Change in 2024 2024 2023 $ % Interest expense, net $ (2,590) $ (3,773) $ 1,183 (31) % Other income, net 51,332 121,810 (70,478) (58) Total interest expense, net and other income, net $ 48,742 $ 118,037 $ (69,295) (59) Interest expense, net decreased by $1.2 million, or 31%, during the year ended December 31, 2024, compared to the same period in 2023. The decrease was primarily due to the early extinguishment of a portion of the 2026 notes. Other income, net decreased $70.5 million, or 58%, during the year ended December 31, 2024 compared to the same period in 2023, primarily due to a decrease in gain on early extinguishment of a portion of convertible senior notes of $66.4 million and a decrease in interest income of $9.4 million partially offset by the gain on the sale of equity investment of $3.8 million. See Note 8, “Convertible Senior Notes,” of our accompanying Notes to Consolidated Financial Statements included in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on the gain on early extinguishment of a portion of the 2026 notes and 2025 notes. Provision for income taxes The following table presents our provision for income taxes for the periods shown (in thousands, except percentages): Years Ended December 31, Change in 2024 2024 2023 $ % Provision for income taxes $ (148,702) $ (32,132) $ (116,570) n/m _______________________________________ *n/m - not meaningful The $116.6 million change in provision for income taxes during the year ended December 31, 2024 compared to the same period in 2023, was primarily due to the establishment of a valuation allowance against our U.S. federal and state deferred tax assets. 48 Table of Contents Liquidity and Capital Resources The following table presents our cash, cash equivalents and investments and convertible senior notes as of the periods shown (in thousands, except percentages): As of December 31, Change in 2024 2024 2023 $ % Cash, cash equivalents, investments $ 528,374 $ 579,561 $ (51,187) (9) % Convertible senior notes, net (1) 485,949 599,837 (113,888) (19) _____________________________________________________ (1) Consists of the current and long-term portion of convertible senior notes, net. Cash, cash equivalents, and investments decreased $51.2 million, or 9%, during the year ended December 31, 2024 primarily due to the early extinguishment of a portion of the 2026 notes of $96.5 million and purchases of property and equipment of $75.0 million, partially offset by the net cash provided by operating activities of $125.2 million. Convertible senior notes, net decreased $113.9 million, or 19%, during the year ended December 31, 2024 primarily due to the early extinguishment of a portion of the 2026 notes. The 2026 notes and 2025 notes mature on September 1, 2026 and March 15, 2025, respectively, unless converted, redeemed, or repurchased in accordance with their terms prior to such dates. Holders of the 2026 notes and 2025 notes may convert their notes at any time on or after June 1, 2026 and December 15, 2024, respectively, until the close of business on the second scheduled trading day immediately preceding the respective maturity dates. See Note 8, “Convertible Senior Notes” of our accompanying Notes to Consolidated Financial Statements included in Part I, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on our notes. As of December 31, 2024, our principal sources of liquidity were cash, cash equivalents, and investments totaling $528.4 million, which were held for working capital purposes. The substantial majority of our net revenues are from e-commerce transactions with students, which are settled within a few days through payment processors, as opposed to our accounts payable, which are settled based on contractual payment terms with our suppliers. We believe that our existing sources of liquidity will be sufficient to fund our operations and debt service obligations for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, our investments in research and development activities, our acquisition of new products and services and our sales and marketing activities. To the extent that existing sources of liquidity are insufficient to fund our future operations, we may need to raise additional funds through public or private equity or debt financing. Additional funds may not be available on terms favorable to us or at all. If adequate funds are not available on acceptable terms, or at all, we may be unable to adequately fund our business plans and it could have a negative effect on our business, operating cash flows and financial condition. As of December 31, 2024, we have incurred cumulative losses of $889.4 million from our operations and we may incur additional losses in the future. Most of our cash, cash equivalents, and investments are held in the United States. As we planned to repatriate a portion of the earnings from our subsidiary in India, we accrued a total tax liability of $5.2 million. In November 2024, our subsidiary in India distributed $23.0 million to the United States, resulting in a remittance of $3.5 million in withholding tax. As of December 31, 2024, the net cumulative tax expense related to future distributions amounts to $1.7 million. As a result of the Tax Cuts and Jobs Act, we anticipate the U.S. federal impact for the remaining foreign jurisdictions to be minimal if these funds are repatriated. In addition, based on our current and future needs, we believe our current funding and capital resources for our international operations are adequate. The following table presents our contractual obligations and other commitments as of December 31, 2024 (in thousands): Total Next 12 Months Beyond 12 Months Convertible senior notes (1) $ 487,044 $ 359,138 $ 127,906 Purchase obligations (2) 172,827 61,170 111,657 Operating lease obligations (3) 29,165 6,822 22,343 Total contractual obligations $ 689,036 $ 427,130 $ 261,906 _____________________________________________________ (1) Consists of the remaining principal amount due upon maturity and cash interest payments. Our convertible senior notes are recorded on our consolidated balance sheets at their carrying amounts. As of December 31, 2024, the carrying amount of the 2026 notes and 2025 notes was $127.3 million and $358.6 million, respectively. 49 Table of Contents (2) Represents contractual obligations primarily related to information technology services. (3) Our corporate offices are leased under operating leases, which expire at various dates through 2033. In addition, we are also subject to certain legal proceedings and claims in the ordinary course of business and record a liability when we believe that a loss is probable and reasonably estimable. As of December 31, 2024, we've recognized an estimated loss contingency accrual of $7.0 million related to one of our legal proceedings. The timing of such payment is uncertain and we are unable to reliably estimate the timing and therefore have not included in the above table. See Note 10, “Commitments and Contingencies” of our accompanying Notes to Consolidated Financial Statements included in Part I, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. The following table presents our consolidated statements of cash flows data for the periods shown (in thousands, except percentages): Years Ended December 31, Change in 2024 2024 2023 $ % Net cash provided by operating activities $ 125,205 $ 246,198 $ (120,993) (49) % Net cash provided by investing activities 11,345 268,673 (257,328) (96) Net cash used in financing activities (109,142) (852,770) 743,628 (87) Net cash provided by operating activities decreased $121.0 million, or 49%, during the year ended December 31, 2024, compared to the same period in 2023 and was primarily driven by lower bookings as well as timing of bill payments. Net cash provided by investing activities decreased $257.3 million, or 96%, during the year ended December 31, 2024, compared to the same period in 2023 and was primarily driven by lower cash from investment maturities of $425.5 million and lower cash proceeds from the sale of investments of $324.5 million partially offset by an increase in cash used for the purchases of investments of $467.0 million. Net cash used in financing activities decreased $743.6 million, or 87%, during the year ended December 31, 2024, compared to the same period in 2023 and was primarily related to lower repurchases of our convertible senior notes of $409.5 million and lower repurchases of our common stock of $332.2 million. Critical Accounting Policies, Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (U.S. GAAP). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. These estimates form the basis for judgments we make about the carrying values of our assets and liabilities, which are not readily apparent from other sources. We base our estimates and judgments on historical experience and on various other assumptions that we believe are reasonable under the circumstances. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. We believe that assumptions and estimates of the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations. For further information on all of our significant accounting policies, see Note 2, “Significant Accounting Policies”, of our accompanying Notes to Consolidated Financial Statements included in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Revenue Recognition and Deferred Revenue For sales of third-party products, we evaluate whether we are acting as a principal or an agent. Where our role in a transaction is that of principal, revenues are recognized on a gross basis. This requires revenue to comprise the gross value of the transaction billed to the customer, after trade discounts, with any related expenditure charged as a cost of revenues. Where our role in a transaction is that of an agent, revenues are recognized on a net basis with revenues representing the margin earned. Our determination is based on our evaluation of whether we control the specified goods or services prior to transferring them to the customer. There are significant judgments involved in determining whether we control the specified goods or 50 Table of Contents services prior to transferring them to the customer including whether we have the ability to direct the use of the good or service and obtain substantially all of the remaining benefits from the good or service. We have concluded that we control our Subscription Services and therefore we recognize revenues and cost of revenues on a gross basis. For print textbooks and eTextbooks, we have concluded that we do not control the service and therefore we recognize revenues on a net basis based on our role in the transaction as an agent. Some of our customer arrangements include multiple performance obligations. We have determined these performance obligations qualify as distinct performance obligations, as the customer can benefit from the service on its own or together with other resources that are readily available to the customer, and our promise to transfer the service is separately identifiable from other promises in the contract. For these arrangements that contain multiple performance obligations, we allocate the transaction price based on the relative standalone selling price (SSP) method by comparing the SSP of each distinct performance obligation to the total value of the contract. We determine the SSP based on our historical pricing and discounting practices for the distinct performance obligation when sold separately. If the SSP is not directly observable, we estimate the SSP by considering information such as market conditions, and information about the customer. Some of our customer arrangements may include an amount of variable consideration in addition to a fixed revenue share that we earn. This variable consideration can either increase or decrease the total transaction price depending on the nature of the variable consideration. We estimate the amount of variable consideration that we will earn at the inception of the contract, adjusted during each period, and include an estimated amount each period. In determining this estimate, we consider the single most likely amount in a range of possible amounts. This estimated amount of variable consideration requires management to make a judgment based on the forecasted amount of consideration that we expect we will earn as well as the time period in which we can reasonably rely on the accuracy of the forecast. Our estimate of variable consideration is constrained to only include the amount of variable consideration for which it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur, as the amounts that we could potentially earn in outer years can change significantly based on factors that are out of our control. If our forecasts are inaccurate, the estimated amount of variable consideration could be inaccurate, which could impact our revenue recognition in a given period. Impairment of Intangible Assets and Long-Lived Assets Intangible assets and long-lived assets are tested for impairment, at the asset group level, at least annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Factors that we consider include the recognition of goodwill impairment charges or planned changes in the use of the asset group. When measuring the recoverability, we make assumptions regarding our estimated future undiscounted cash flows expected to be generated by the asset group. If the asset group is not recoverable, we proceed to estimating the fair value of the asset group, which includes assumptions regarding future growth rates and the amount and timing of expected future cash flow. If our estimates or related assumptions are inaccurate, our conclusion on whether these assets are recoverable or impaired could be incorrect, which could whether we recognize an impairment in a given period. Goodwill Goodwill is tested for impairment at least annually or whenever events or changes in circumstances indicate that their carrying values may not be recoverable. We first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. In our qualitative assessment, we consider factors including economic conditions, industry and market conditions and developments, overall financial performance and other relevant entity-specific events in determining whether it is more likely than not that the fair value of our reporting unit is less than the carrying amount. Our qualitative assessment requires management to make judgments based on the factors listed above in our determination of whether events or changes in circumstances indicate that the carrying values may not be recoverable. If our qualitative assessment concludes that it is more likely than not that the fair value is less than the carrying amount, a quantitative assessment of impairment is performed. Performing a quantitative impairment test includes the determination of fair value and involves significant estimates and assumptions including, among others, forecasted revenue growth rates, operating margins and capital expenditures, and discount rates used to calculate projected future cash flows. If the carrying value exceeds the fair value, an impairment loss is recognized in an amount equal to the excess. If estimates or related assumptions change, this could have a significant impact on either the fair value of our reporting unit, the amount of any goodwill impairment, or both. 51 Table of Contents Share-based Compensation Expense We measure and recognize share-based compensation expense for all awards made to employees, directors and consultants, including restricted stock units (RSUs), performance-based RSUs (PSUs) with either a market-based condition or financial and strategic performance target and our employee stock purchase plan (ESPP) based on estimated fair values. We estimate a forfeiture rate to calculate the share-based compensation expense related to our awards. Estimated forfeitures are determined based on historical data and we continue to evaluate the appropriateness of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover and other factors. Quarterly changes in the estimated forfeiture rate can have a significant impact on our share-based compensation expense as the cumulative effect of adjusting the rate is recognized in the period the forfeiture estimate is changed. If a revised forfeiture rate is higher than the previously estimated forfeiture rate, an adjustment is made that will result in a decrease to the share-based compensation expense recognized in the financial statements. If a revised forfeiture rate is lower than the previously estimated forfeiture rate, an adjustment is made that will result in an increase to the share-based compensation expense recognized in the financial statements. Share-based compensation expense for PSUs with a market-based condition is recognized regardless of whether the market condition is satisfied subject to continuing service over the requisite service period. Share-based compensation expense recognized related to PSUs with a financial and strategic performance target is subject to the achievement of performance objectives and requires significant judgment by management in determining the current level of attainment of such performance objectives. Management may consider factors such as the latest financial forecasts and general business trends in the assessment of PSU award attainment. Subsequent changes to these considerations may have a material impact on the amount of share-based compensation expense recognized in the period, which may lead to volatility of share-based compensation expense period-to-period. If the performance objectives are not met or service is no longer provided, no share-based compensation expense will be recognized, and any previously recognized share-based compensation expense will be reversed. We will continue to use judgment in evaluating the assumptions related to our share-based compensation expense on a prospective basis. As we continue to accumulate additional data related to our common stock, we may refine our estimates, which could materially impact our future share-based compensation expense. Provision for Income Taxes We account for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our consolidated financial statements or tax returns. In estimating future tax consequences, we generally consider all expected future events other than enactments or changes in the tax law or rates. In assessing the realization of deferred tax assets, we consider whether it is more likely than not that all or some portion of deferred tax assets will not be realized. The ultimate realization of the deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Valuation allowances are provided to reduce deferred tax assets to the amount that is more likely than not to be realized. In assessing the need for a valuation allowance, we consider all available evidence including future reversals of existing taxable temporary differences, projected future taxable income, taxable income in prior carryback years if permitted under the tax law, and tax-planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made. We record uncertain tax positions on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the tax benefit as the largest amount that is cumulative more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. The calculation of tax expense and liabilities involves dealing with uncertainties in the application of complex global tax regulations. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. Significant judgment is required in determining our provision for income taxes and evaluating our uncertain tax positions. To the extent that the final tax outcome of these matters may differ from the amounts that were initially recorded, such differences will impact the income tax provision in the period in which such determination is made. As a result, significant changes to these estimates may result in an increase or decrease to our tax provision in a subsequent period. 52 Table of Contents Recent Accounting Pronouncements For relevant recent accounting pronouncements, see Note 2, “Significant Accounting Policies”, of our accompanying Notes to Consolidated Financial Statements included in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K.