UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended December 31, 2005

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from ___to___

Commission File No. 0-17948

209 Redwood Shores Parkway
Redwood City, California		94065
(Address of principal executive offices)		(Zip Code)

(650) 628-1500

(Registrant’s telephone number, including area code)

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 þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerate filer þ		Accelerated filer o		Non-accelerated filer 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 þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2005

Table of Contents

Page

Part I — FINANCIAL INFORMATION

Item 1.

Unaudited Condensed Consolidated Financial Statements

Condensed Consolidated Balance Sheets as of December 31, 2005 and March 31, 2005

3

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended December 31, 2005 and 2004

4

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended December 31, 2005 and 2004

5

Notes to Condensed Consolidated Financial Statements

6

Report of Independent Registered Public Accounting Firm

21

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

22

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

52

Item 4.

Controls and Procedures

54

Part II — OTHER INFORMATION

55

Item 1.

Legal Proceedings

55

Item 5.

Other Information

55

Item 6.

Exhibits

56

Signature

57

Exhibit Index

58

EXHIBIT 10.1

EXHIBIT 10.2

EXHIBIT 15.1

EXHIBIT 31.1

EXHIBIT 31.2

EXHIBIT 32.1

EXHIBIT 32.2

PART I — FINANCIAL INFORMATION

See accompanying Notes to Condensed Consolidated Financial Statements.

ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(1) DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

Electronic Arts Inc. develops, markets, publishes and distributes interactive software games that are playable by consumers on home video game consoles (such as the Sony PlayStation ^® 2, Microsoft Xbox ^® and Xbox 360 ^TM , and Nintendo GameCube ^TM ), personal computers, mobile platforms — including hand-held game players (such as the Game Boy ^® Advance, Nintendo DS ^TM and PlayStation ^® Portable “PSP ^TM ”) and cellular handsets — and online, over the Internet and other proprietary online networks. Some of our games are based on content that we license from others (e.g., Madden NFL Football, Harry Potter and FIFA Soccer), and some of our games are based on intellectual property that is wholly-owned by us (e.g., The Sims ^TM and Need for Speed ^TM ). Our goal is to develop titles that appeal to the mass markets, which often means translating and localizing them for sale in non-English speaking countries. In addition, we also attempt to create software game “franchises” that allow us to publish new titles on a recurring basis that are based on the same property. Examples of this include our annual iterations of our sports-based franchises (e.g., NCAA ^® Football and FIFA Soccer), titles based on long-lived movie properties (e.g., James Bond ^TM and Harry Potter) and wholly-owned properties that can be successfully sequeled (e.g., The Sims and Need for Speed).

The Condensed Consolidated Financial Statements are unaudited and reflect all adjustments (consisting only of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The preparation of these Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the amounts reported in these Condensed Consolidated Financial Statements and accompanying notes. Actual results could differ materially from those estimates. The results of operations for the current interim periods are not necessarily indicative of results to be expected for the current year or any other period.

These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2005, as filed with the Securities and Exchange Commission on June 7, 2005.

On October 18, 2004, our Board of Directors authorized a program to repurchase up to an aggregate of $750 million of our common stock. Pursuant to the authorization, we were able to repurchase shares of our common stock from time to time in the open market or through privately negotiated transactions over the course of a twelve-month period. Our common stock repurchase program was completed in September 2005. We repurchased and retired the following (in millions):

(2) FISCAL YEAR AND FISCAL QUARTER

Our fiscal year is reported on a 52/53-week period that, historically, has ended on the final Saturday of March in each year. Beginning with the current fiscal year ending March 31, 2006, we will end our fiscal year on the Saturday nearest March 31. Our results of operations for the fiscal years ended March 31, 2006 and 2005 contain the following number of weeks:

Our results of operations for the three and nine months ended December 31, 2005 and 2004 contain the following number of weeks:

For the three months ended June 30, 2005, there was one additional week included in our results of operations as compared to the three months ended June 30, 2004.

For simplicity of presentation, all fiscal periods are treated as ending on a calendar month end.

(3) EMPLOYEE STOCK-BASED COMPENSATION

We account for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” . We have adopted the disclosure-only provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” , as amended.

Had compensation cost for our stock-based compensation plans been measured based on the estimated fair value at the grant dates in accordance with the provisions of SFAS No. 123, as amended, we estimate that our reported net income and net income per share would have been the pro forma amounts indicated below. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The following weighted-average assumptions were used for grants made under our stock-based compensation plan during the three and nine months ended December 31, 2005 and 2004:

		Three Months Ended								Nine Months Ended
		December 31,								December 31,
		2005				2004				2005				2004
Risk-free interest rate			4.3	%			3.1	%			4.0	%			3.0	%
Expected volatility			32.4	%			35.5	%			33.7	%			37.0	%
Expected life of stock options (in years)			3.20				3.09				3.31				3.06
Expected life of employee stock purchase plans (in months)			6				6				6				6
Assumed dividends		None				None				None				None

Our calculations are based on a multiple option valuation approach and forfeitures are recognized when they occur.

At our Annual Meeting of Stockholders, held on July 28, 2005, our stockholders approved an amendment to our 2000 Equity Incentive Plan to (a) increase the number of shares authorized by 10 million, (b) authorize the issuance of awards of stock appreciation rights, (c) increase by 1 million shares the limit on the total number of shares underlying awards of restricted stock and restricted stock units that may be granted under the Equity Plan — from 3 million to 4 million shares, (d) modify the payment alternatives under the Equity Plan, (e) add flexibility to grant performance-based stock options and stock appreciation rights and modify the permissible performance factors currently contained in the Equity Plan, and (f) revise the share-counting methodology used in the Equity Plan. Our stockholders also approved an amendment the 2000 Employee Stock Purchase Plan (“the “ESPP”) to increase by 1,500,000 the number of shares of common stock reserved for issuance under the ESPP.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004) (“SFAS No. 123R”), “Share-Based Payment” . SFAS No. 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements using a fair-value-based method. The statement replaces SFAS No. 123, “Accounting for Stock-Based Compensation” , supersedes APB No. 25, “Accounting for Stock Issued to Employees” , and amends SFAS No. 95, “Statement of Cash Flows” . While the fair value method under SFAS No. 123R is similar to the fair value method under SFAS No. 123 with regards to measurement and recognition of stock-based compensation, we are currently evaluating the impact of several of the key differences between the two standards on our consolidated financial statements. For example, SFAS No. 123 permits us to recognize forfeitures as they occur while SFAS No. 123R will require us to estimate future forfeitures and adjust our estimate on a quarterly basis. SFAS No. 123R will also require a classification change in the statement of cash flows, whereby a portion of the income tax benefit from stock options will move from operating cash flow activities to financing cash flow activities (total cash flows will remain unchanged).

In March 2005, the Securities and Exchange Commission (“SEC”) released Staff Accounting Bulletin No. 107, “Share-Based Payment” , which provides the views of the staff regarding the interaction between SFAS No. 123R and certain SEC rules and regulations for public companies. In April 2005, the SEC adopted a rule that amends the compliance dates of SFAS No. 123R. Under the revised compliance dates, we will be required to adopt the provisions of SFAS No. 123R no later than our first quarter of fiscal 2007. While we continue to evaluate the impact of SFAS No. 123R on our consolidated financial statements, we currently believe that the expensing of stock-based compensation will have an impact on our Condensed Consolidated Statements of Operations similar to our pro forma disclosure under SFAS No. 123, as amended.

In October 2005, the FASB issued FASB Staff Position (“FSP”) Financial Accounting Standard (“FAS”) No. 123(R)-2, “Practical Accommodation to the Application of Grant Date As Defined in FASB Statement No. 123(R)” . The FASB provides companies with a “practical accommodation” when determining the grant date of an award subject to SFAS 123R. If (1) the award is a unilateral grant, that is, the recipient does not have the ability to negotiate the key terms and conditions of the award with the employer, (2) the key terms and conditions of the award are expected to be communicated to an individual recipient

within a relatively short time period, and (3) as long as all other criteria in the grant date definition have been met, then a mutual understanding of the key terms and conditions of an award is presumed to exist at the date the award is approved.

In November 2005, the FASB issued FSP FAS No. 123(R)-3, “ Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards ”. The FASB allows for a practical exception in calculating the additional paid-in capital pool of excess tax benefits upon adoption that is available to absorb tax deficiencies recognized subsequent to adoption SFAS No. 123R. Accordingly, we may adopt either the method prescribed under SFAS No. 123R or the one prescribed under FSP FAS No. 123(R)-3. We have not yet determined which method to adopt.

(4) GOODWILL AND OTHER INTANGIBLE ASSETS, NET

Goodwill information is as follows (in millions):

Finite-lived intangibles consist of the following (in millions):

Amortization of intangibles for the three and nine months ended December 31, 2005 was $3 million (of which $2 million was recognized as cost of goods sold) and $8 million (of which $5 million was recognized as cost of goods sold), respectively. Amortization of intangibles for the three and nine months ended December 31, 2004 was $2 million (of which $1 million was recognized as cost of goods sold) and $3 million (of which $1 million was recognized as cost of goods sold), respectively. Finite-lived intangible assets are amortized using the straight-line method over the lesser of their estimated useful lives or the agreement terms, typically from two to twelve years. As of December 31, 2005 and March 31, 2005, the weighted-average remaining useful life for finite-lived intangible assets was approximately 3.8 years and 4.3 years, respectively.

As of December 31, 2005, future amortization of finite-lived intangibles that will be recorded in cost of goods sold and operating expenses is estimated as follows (in millions):

(5) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES

The following table summarizes the restructuring activity related to our international publishing reorganization and our fiscal 2004, 2003 and 2002 restructurings:

International Publishing Reorganization

In connection with our intention to establish an international publishing headquarters in Geneva, Switzerland, during the next nine months, we expect to open a new facility in Geneva, relocate certain current employees to Geneva, hire new employees in Geneva, close certain facilities in the UK, and make other related changes in our international publishing business. We intend to treat certain costs that are directly associated with our international publishing reorganization as “restructuring costs” (as defined by SFAS No. 146, “ Accounting for Costs Associated with Exit or Disposal Activities ”). Other costs that are not properly categorized as restructuring costs will generally be treated as normal operating expenses in our Condensed Consolidated Statements of Operations. In accordance with SFAS No. 146, we will generally expense the restructuring costs as they are incurred and accrue costs associated with certain facility closures at the time we exit the facility.

We expect to incur between $55 million and $65 million in total restructuring costs, substantially all of which will result in cash expenditures. These restructuring costs will consist primarily of employee-related relocation assistance (approximately $43 million), facility exit costs (approximately $10 million), as well as other reorganization costs (approximately $8 million). While we may incur severance costs paid to terminating employees in connection with the reorganization, we do not expect these costs to be significant.

Approximately $15 million of these charges will be incurred during fiscal 2006, of which $7 million for the closure of certain UK facilities and $1 million in other costs in connection with our international publishing reorganization were incurred during the three months ended December 31, 2005 and included in restructuring charges in our Condensed Consolidated Statements of Operations. The restructuring accrual of $7 million as of December 31, 2005 is expected to be utilized by March 2017. This accrual is included in other accrued expenses presented in Note 7 of the Notes to Condensed Consolidated Financial Statements.

Fiscal 2004, 2003 and 2002 Restructurings

In fiscal 2004, 2003 and 2002, we entered into various restructurings based on management decisions. As of December 31, 2005, an aggregate of $27 million in cash had been paid out under the restructuring plans. In addition, we have made subsequent net adjustments of approximately $1 million during the three months ended December 31, 2005 relating to projected future cash outlays under the fiscal 2004, 2003 and 2002 restructuring plans. The remaining projected net cash outlay of $7 million is expected to be utilized by January 2009. The facilities-related accrued obligation shown above is net of $9 million of estimated future sub-lease income. The restructuring accrual is included in other accrued expenses presented in Note 7 of the Notes to Condensed Consolidated Financial Statements.

(6) ROYALTIES AND LICENSES

Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers and (3) co-publishing and/or distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademarks, copyrights, personal publicity rights, content and/or other intellectual property. Royalty payments to independent software developers are payments for the development of intellectual property related to our games. Co-publishing and distribution royalties are payments made to third parties for delivery of product.

Royalty-based obligations with content licensors and distribution affiliates are either paid in advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid. These royalty-based obligations are expensed to cost of goods sold at the greater of the contractual or effective royalty rate based on expected net product sales. Prepayments made to thinly capitalized independent software developers and co-publishing affiliates are generally made in connection with the development of a particular product and, therefore, we are generally subject to development risk prior to the general release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed as research and development as the services are incurred. Payments due after completion of the product (primarily royalty-based in nature) are generally expensed as cost of goods sold at the higher of the contractual or effective royalty rate based on expected net product sales.

Minimum guaranteed royalty obligations are initially recorded as an asset and as a liability at the contractual amount when payment is not contingent upon performance by the licensor. When payment is contingent upon performance by the licensor, we record royalty payments as an asset when actually paid and as a liability when incurred rather than upon execution of the contract. Minimum royalty payment obligations are classified as current liabilities to the extent such royalty payments are contractually due within the next twelve months. As of December 31, 2005 and March 31, 2005, approximately $34 million and $51 million, respectively, of minimum guaranteed current and long-term royalty obligations had been recognized and are included in the royalty-related asset and accrual tables below.

Each quarter, we also evaluate the future realization of our royalty-based assets as well as any unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized through product sales. Any impairments determined before the launch of a product are charged to research and development expense. Impairments determined post-launch are charged to cost of goods sold. In either case, we rely on estimated revenue to evaluate the future realization of prepaid royalties and commitments. If actual sales or revised revenue estimates fall below the initial revenue estimates, then the actual charge taken may be greater in any given quarter than anticipated. We had no impairments during the three and nine months ended December 31, 2005. Impairments for the three and nine months ended December 31, 2004 were $1 million and $3 million, respectively.

The current and long-term portions of prepaid royalties and minimum guaranteed royalty-related assets, included in other current assets and other assets, consisted of (in millions):

At any given time, depending on the timing of our payments to our co-publishing and/or distribution affiliates, content licensors and/or independent software developers, we recognize unpaid royalty amounts due to these parties as either accounts payable or accrued liabilities. The current and long-term portions of accrued royalties, included in accrued and other liabilities as well as other liabilities, consisted of (in millions):

In addition, as of December 31, 2005, we had approximately $1,429 million that we were committed to pay co-publishing and/or distribution affiliates and content licensors but that were generally contingent upon performance by the counterparty (i.e., delivery of the product or content or other factors) and were therefore not recorded in our Condensed Consolidated Financial Statements. See Note 8 of the Notes to Condensed Consolidated Financial Statements.

(7) BALANCE SHEET DETAILS

Inventories
Inventories as of December 31, 2005 and March 31, 2005 consisted of (in millions):

Depreciation expense associated with property and equipment amounted to $20 million and $60 million for the three and nine months ended December 31, 2005, respectively. Depreciation expense associated with property and equipment amounted to $18 million and $50 million for the three and nine months ended December 31, 2004, respectively.

Income taxes

Change in Effective Income Tax Rate

During the three months ended December 31, 2005, we adjusted our projected annual effective income tax rate from our previous projection of 28 percent to 29 percent (in each case, excluding discrete adjustments). As a result, we recognized $4 million (or $0.01 per basic and diluted share) more income tax expense for both the three and nine months ended December 31, 2005 than we would have recognized had this projected annual effective income tax rate remained at 28 percent.

During the nine months ended December 31, 2005, our effective income tax rate was 27 percent. This rate included various adjustments recorded in the three months ended September 30, 2005 for the resolution of certain tax-related matters with foreign tax authorities, offset by additional income tax provisions resulting from certain intercompany transactions during the three months ended September 30, 2005. The net impact of these adjustments was that we recognized $9 million (or $0.03 per basic and diluted share) less income tax expense for the nine months ended December 31, 2005 than we would have recognized had our projected annual effective income tax rate remained at 29 percent.

During the three months ended December 31, 2004, our effective income tax rate was 31 percent. This differed from our previously projected annual effective income tax rate of 29 percent for fiscal 2005 due to an adjustment recorded in the three months ended December 31, 2004 related to certain tax audit developments and tax charges related to the Criterion acquisition. As a result, we recognized $10 million (or $0.03 per basic and diluted share) more income tax expense during the three months ended December 31, 2004 than we would have recognized had our projected effective income tax rate remained at 29 percent.

(8) COMMITMENTS AND CONTINGENCIES

      Lease Commitments and Residual Value Guarantees

We lease certain of our current facilities and equipment under non-cancelable operating lease agreements. We are required to pay property taxes, insurance and normal maintenance costs for certain of our facilities and will be required to pay any increases over the base year of these expenses on the remainder of our facilities.

In February 1995, we entered into a build-to-suit lease with a third party for our headquarters facility in Redwood City, California, which was refinanced with Keybank National Association in July 2001 and expires in July 2006. We accounted for this arrangement as an operating lease in accordance with SFAS No. 13, “ Accounting for Leases ”, as amended. Existing campus facilities developed in phase one comprise a total of 350,000 square feet and provide space for sales, marketing, administration and research and development functions. We have an option to purchase the property (land and facilities) for a maximum of $145 million or, at the end of the lease, to arrange for (i) an extension of the lease or (ii) sale of the property to a third party while we retain an obligation to the owner for approximately 90 percent of the difference between the sale price and the guaranteed residual value of up to $129 million if the sales price is less than this amount, subject to certain provisions of the lease.

In December 2000, we entered into a second build-to-suit lease with Keybank National Association for a five and one-half year term beginning December 2000 to expand our Redwood City, California headquarters facilities and develop adjacent property adding approximately 310,000 square feet to our campus. Construction was completed in June 2002. We accounted for this

arrangement as an operating lease in accordance with SFAS No. 13, as amended. The facilities provide space for sales, marketing, administration and research and development functions. We have an option to purchase the property for a maximum of $130 million or, at the end of the lease, to arrange for (i) an extension of the lease or (ii) sale of the property to a third party while we retain an obligation to the owner for approximately 90 percent of the difference between the sale price and the guaranteed residual value of up to $119 million if the sales price is less than this amount, subject to certain provisions of the lease.

We believe the estimated fair values of both properties under these operating leases are in excess of their respective guaranteed residual values as of December 31, 2005.

For the two lease agreements with Keybank National Association, as described above, the lease rates are based upon the LIBOR plus a margin and require us to maintain certain financial covenants as shown below, all of which we were in compliance with as of December 31, 2005.

      Letters of Credit

In July 2002, we provided an irrevocable standby letter of credit to Nintendo of Europe. The standby letter of credit guarantees performance of our obligations to pay Nintendo of Europe for trade payables. The original letter of credit guaranteed our trade payable obligations to Nintendo of Europe of up to € 18 million. In April 2005, we reduced the guarantee to € 8 million and in September 2005 we increased the guarantee to € 15 million. This standby letter of credit expired in July 2005 and was renewed through July 2006. As of December 31, 2005, we had € 2 million payable to Nintendo of Europe covered by this standby letter of credit.

In August 2003, we provided an irrevocable standby letter of credit to 300 California Associates II, LLC in replacement of our security deposit for office space. The standby letter of credit guarantees performance of our obligations to pay our lease commitment up to approximately $1 million. The standby letter of credit expires in December 2006. As of December 31, 2005, we did not have a payable balance covered by this standby letter of credit.

      Development, Celebrity, League and Content Licenses: Commitments

The products produced by our studios are designed and created by our employee designers, artists, software programmers and by non-employee software developers (“independent artists” or “third-party developers”). We typically advance development funds to the independent artists and third-party developers during development of our games, usually in installment payments made upon the completion of specified development milestones.

Contractually, these payments are considered advances against subsequent royalties on the sales of the products. These terms are set forth in written agreements entered into with the independent artists and third-party developers. In addition, we have certain celebrity, league and content license contracts that contain minimum guarantee payments and marketing commitments that are not dependent on any deliverables. Celebrities and organizations with whom we have contracts include: FIFA, FIFPRO Foundation and UEFA (professional soccer); NASCAR (stock car racing); National Basketball Association (professional basketball); PGA TOUR (professional golf); Tiger Woods (professional golf); National Hockey League and NHLPA (professional hockey); Warner Bros. (Harry Potter, Batman and Superman); MGM (James Bond); New Line Productions (The Lord of the Rings); Saul Zaentz Company (The Lord of the Rings); Marvel Enterprises (fighting); John Madden (professional football); National Football League Properties, Arena Football League and PLAYERS Inc. (professional football); Collegiate Licensing Company (collegiate football, basketball and baseball); ISC (stock car racing); Simcoh (Def Jam); Viacom Consumer

Products (The Godfather); Valve Corporation (Half-Life and Counter-Strike); ESPN (content in EA SPORTS ^TM games); and Twentieth Century Fox Licensing and Merchandising (The Simpsons). These developer and content license commitments represent the sum of (i) the cash payments due under non-royalty-bearing licenses and services agreements and (ii) the minimum payments and advances against royalties due under royalty-bearing licenses and services agreements, the majority of which are conditional upon performance by the counterparty. These minimum guarantee payments and any related marketing commitments are included in the table below.

The following table summarizes our minimum contractual obligations and commercial commitments as of December 31, 2005, and the effect we expect them to have on our liquidity and cash flow in future periods (in millions):

The lease commitments disclosed above include contractual rental commitments of $23 million under real estate leases for unutilized office space due to our restructuring activities. These amounts, net of estimated future sub-lease income, were expensed in the periods of the related restructuring and are included in our accrued and other liabilities reported on our Condensed Consolidated Balance Sheets as of December 31, 2005. See Note 5 in the Notes to Condensed Consolidated Financial Statements.

The commitments disclosed above do not include our JAMDAT acquisition commitment. See below.

      Acquisition of JAMDAT

In December 2005, we entered into a definitive merger agreement to acquire JAMDAT Mobile Inc., a global publisher of wireless games and other wireless entertainment applications. We will pay $27 per share in cash in exchange for each share of JAMDAT common stock and assume outstanding stock options for a total purchase price of approximately $680 million, plus transaction costs. This acquisition is subject to customary closing conditions, including approval by JAMDAT’s stockholders and regulatory approvals, and is expected to close during our fourth quarter of fiscal 2006.

      Litigation

On July 29, 2004, a class action lawsuit, Kirschenbaum v. Electronic Arts Inc. , was filed against us in Superior Court in San Mateo, California, alleging that we improperly classified “Image Production Employees” in California as exempt employees. On October 17, 2005, the court granted its preliminary approval of a settlement pursuant to which we agreed to make a lump sum payment of $15.6 million, which we paid to a third-party administrator during the three months ended December 31, 2005, to cover (a) all claims allegedly suffered by the class members, (b) plaintiffs’ attorneys’ fees, not to exceed 25% of the total settlement amount, (c) plaintiffs’ costs and expenses, (d) any incentive payments to the named plaintiffs that may be authorized by the court, and (e) all costs of administration of the settlement. On January 27, 2006, the court granted its final approval of the settlement.

On February 14, 2005, a second employment-related class action lawsuit, Hasty v. Electronic Arts Inc., was filed against us in Superior Court in San Mateo, California. The complaint alleges that we improperly classified “Engineers” in California as exempt employees and seeks injunctive relief, unspecified monetary damages, interest and attorneys’ fees. On or about March 16, 2005, we received a first amended complaint, which contains the same material allegations as the original complaint. We answered the first amended complaint on April 20, 2005.

On March 24, 2005, a class action lawsuit was filed against us and certain of our officers and directors. The complaint, which asserts claims under Section 10(b) and 20(a) of the Securities Exchange Act of 1934 based on allegedly false and misleading statements, was filed in the United States District Court, Northern District of California, by an individual purporting to represent a class of purchasers of EA common stock. Additional class action lawsuits were filed in the same court by other individuals asserting the same claims against us. On May 9, 2005, the court consolidated the complaints, and on January 26, 2006, the court dismissed the consolidated complaint with prejudice. Separately, there are two shareholder derivative actions pending in the Superior Court, San Mateo County, and one shareholder derivative action pending in the United States District Court, Northern District of California, all of which assert claims based on substantially the same factual allegations as set forth in the federal securities class action. We have not yet responded to any of the derivative action complaints.

In addition, we are subject to other claims and litigation arising in the ordinary course of business. Our management considers that any liability from any reasonably foreseeable disposition of such other claims and litigation, individually or in the aggregate, would not have a material adverse effect on our consolidated financial position or results of operations.

      Director Indemnity Agreements

We have entered into indemnification agreements with the members of our Board of Directors at the time they join the Board to indemnify them to the extent permitted by law against any and all liabilities, costs, expenses, amounts paid in settlement and damages incurred by the directors as a result of any lawsuit, or any judicial, administrative or investigative proceeding in which the directors are sued as a result of their service as members of our Board of Directors.

(9) COMPREHENSIVE INCOME

SFAS No. 130, “Reporting Comprehensive Income” , requires classifying items of other comprehensive income (loss) by their nature in a financial statement and displaying the accumulated balance of other comprehensive income (loss) separately from retained earnings and additional paid-in capital in the equity section of a balance sheet. Accumulated other comprehensive income primarily includes foreign currency translation adjustments, and the net-of-tax amounts for unrealized gains (losses) on investments and unrealized gains (losses) on derivatives designated as cash flow hedges.

The components of comprehensive income for the three and nine months ended December 31, 2005 and 2004 are summarized as follows (in millions):

The foreign currency translation adjustments are not adjusted for income taxes as they relate to indefinite investments in non-U.S. subsidiaries.

(10) NET INCOME PER SHARE

The following table summarizes the computations of basic earnings per share (“Basic EPS”) and diluted earnings per share (“Diluted EPS”). Basic EPS is computed as net income divided by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock-based compensation plans including stock options, restricted stock unit awards, warrants and other convertible securities using the treasury stock method.

Excluded from the above computation of weighted-average common stock for Diluted EPS for the three and nine months ended December 31, 2005 were options to purchase 8 million and 7 million shares of common stock, respectively, as the options’

exercise price was greater than the average market price of the common shares. The weighted-average exercise price of these options was $62.88 and $63.68 per share, respectively.

Excluded from the above computation of weighted-average common stock for Diluted EPS for the three and nine months ended December 31, 2004 were options to purchase 1 million shares of common stock in each period, as the options’ exercise price was greater than the average market price of the common shares for each period. The weighted-average exercise price of these options was $51.05 and $52.18 per share, respectively.

(11) SEGMENT INFORMATION

SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information” , establishes standards for the reporting by public business enterprises of information about product lines, geographic areas and major customers. The method for determining what information to report is based on the way that management organizes our operating segments for making operational decisions and assessments of financial performance.

Our chief operating decision maker is considered to be our Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenue by geographic region and by product line for purposes of making operating decisions and assessing financial performance. Our view and reporting of business segments may change due to changes in the underlying business facts and circumstances and the evolution of our reporting to our CEO.

Information about our total net revenue by product line for the three and nine months ended December 31, 2005 and 2004 is presented below (in millions):

Information about our operations in North America, Europe and Asia as of and for the three and nine months ended December 31, 2005 and 2004 is presented below (in millions):

Our direct sales to Wal-Mart Stores, Inc. represented approximately 12 and 13 percent of total net revenue for the three and nine months ended December 31, 2005, respectively, and approximately 13 and 14 percent of total net revenue for the three and nine months ended December 31, 2004, respectively. Our direct sales to GameStop Corp. represented approximately 11 percent of total net revenue for the three months ended December 31, 2005.

(12) IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

In March 2004, the FASB ratified the measurement and recognition guidance and certain disclosure requirements for impaired securities as described in Emerging Issues Task Force (“EITF”) Issue No. 03-1, “ The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments ”. In June 2005, the FASB directed its staff to issue proposed FSP EITF 03-1-a, “ Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1 ,” as final. The FASB retitled this FSP as FSP FAS 115-1, “ The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments ”. The final FSP supersedes EITF Issue No. 03-1 and EITF Topic D-44, “ Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value ”. The final FSP replaces the guidance set forth in paragraphs 10 through 18 of EITF Issue No. 03-1 with references to existing other-than-temporary

impairment guidance. In September 2005, the FASB decided to retain the paragraph in the proposed FSP on how to account for debt securities subsequent to an other-than-temporary impairment. The FASB also decided to add a footnote to clarify that the proposed FSP does not address when a holder of a debt security would place a debt security on nonaccrual status or how to subsequently report income on a nonaccrual debt security. The FASB decided that transition would be applied prospectively and the effective date would be reporting periods beginning after December 15, 2005. In November 2005, the FASB issued FSP FAS 115-1. We believe the adoption of the measurement and recognition guidance in FSP FAS 115-1 will not have a material impact on our consolidated financial statements.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs — an amendment of ARB No. 43, Chapter 4 ”. SFAS No. 151 amends the guidance in Accounting Research Bulletin (“ARB”) No. 43, Chapter 4, “Inventory Pricing” , to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) and requires that those items be recognized as current-period charges. SFAS No. 151 also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We believe the adoption of SFAS No. 151 will not have a material impact on our consolidated financial statements.

In May 2005, the FASB issued SFAS No. 154, “ Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3 ”. SFAS No. 154 changes the requirements for the accounting and reporting of a change in accounting principle. Under previous guidance, changes in accounting principle were recognized as a cumulative affect in the net income of the period of the change. The new statement requires retrospective application of changes in accounting principle, limited to the direct effects of the change, to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Additionally, this Statement requires that a change in depreciation, amortization or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate affected by a change in accounting principle and that correction of errors in previously issued financial statements should be termed a “restatement”. SFAS No. 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. We do not believe that, upon adoption, SFAS No. 154 will have a material impact on our consolidated financial statements, however, after adoption, if a change in accounting principle is made, SFAS No. 154 could have a material impact on our consolidated financial statements.

In October 2005, the FASB issued FSP FAS No. 13-1, “ Accounting for Rental Costs Incurred during a Construction Period ”, which provides that rental costs associated with ground or building operating leases that are incurred during a construction period shall be recognized as rental expense. FSP FAS No. 13-1 is required to be applied to the first reporting period beginning after December 15, 2005. We do not believe the adoption of FSP FAS No. 13-1 will have a material impact on our consolidated financial statements.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders

Electronic Arts Inc.:

We have reviewed the accompanying condensed consolidated balance sheet of Electronic Arts Inc. and subsidiaries (the Company) as of December 31, 2005, the related condensed consolidated statements of operations for the three-month and nine-month periods ended December 31, 2005 and December 25, 2004, and the related condensed consolidated statement of cash flows for the nine-month periods ended December 31, 2005 and December 25, 2004. These condensed consolidated financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity U.S. generally accepted accounting principles.

We have previously audited in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Electronic Arts Inc. and subsidiaries as of March 26, 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for the year then ended (not presented herein); and in our report dated June 3, 2005, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of March 26, 2005, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

KPMG LLP
Mountain View, California
February 7, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. We use words such as “anticipate”, “believe”, “expect”, “intend” (and the negative of any of these terms), “future” and similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk and reflect management’s current expectations, and involve subjects that are inherently uncertain and difficult to predict. Our actual results could differ materially. We will not necessarily update information if any forward-looking statement later turns out to be inaccurate. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed in this report below under the heading “Risk Factors”, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2005 as filed with the Securities and Exchange Commission (“SEC”) on June 7, 2005 and in other documents we have filed with the SEC.

OVERVIEW

The following overview is a top-level discussion of our operating results as well as some of the trends and drivers that affect our business. Management believes that an understanding of these trends and drivers is important in order to understand our results for the three and nine months ended December 31, 2005, as well as our future prospects. This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Form 10-Q, including in the remainder of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Risk Factors” or the Condensed Consolidated Financial Statements and related notes. Additional information can be found within the “Business” section of our Annual Report on Form 10-K for the fiscal year ended March 31, 2005 as filed with the SEC on June 7, 2005 and in other documents we have filed with the SEC.

About Electronic Arts

We develop, market, publish and distribute interactive software games that are playable by consumers on home video game consoles (such as the Sony PlayStation ^® 2, Microsoft Xbox ^® and Xbox 360 ^TM , and Nintendo GameCube ^TM consoles), personal computers, mobile platforms — including hand-held game players (such as the Game Boy ^® Advance, Nintendo DS ^TM and PlayStation ^® Portable “PSP ^TM ”) and cellular handsets — and online, over the Internet and other proprietary online networks. Some of our games are based on content that we license from others (e.g., Madden NFL Football, Harry Potter and FIFA Soccer), and some of our games are based on our own wholly-owned intellectual property (e.g., The Sims ^TM and Need for Speed ^TM ). Our goal is to develop titles which appeal to the mass markets, which often means translating and localizing them for sale in non-English speaking countries. In addition, we also attempt to create software game “franchises” that allow us to publish new titles on a recurring basis that are based on the same property. Examples of this are the annual iterations of our sports-based franchises (e.g., NCAA ^® Football and FIFA Soccer), titles based on long-lived movie properties (e.g., James Bond ^TM and Harry Potter) and wholly-owned properties that can be successfully sequeled (e.g., The Sims and Need for Speed).

Overview of Financial Results

Total net revenue for the three months ended December 31, 2005 was $1,270 million, down 11 percent as compared to the three months ended December 31, 2004. Net revenue for the three months ended December 31, 2005 was driven by sales of Need for Speed™ Most Wanted, FIFA 06, Harry Potter and the Goblet of Fire™, the Sims™ 2 and Madden NFL 06 , each selling over two million copies in the quarter. NBA Live 06, SSX™ On Tour, Tiger PGA Tour® 06, From Russia with Love™ and Battlefield 2: Modern Combat™ also had strong sales, each selling over one million copies in the quarter.

Net income for the three months ended December 31, 2005 was $259 million as compared to $375 million for the three months ended December 31, 2004. Diluted net income per share for the three months ended December 31, 2005 was $0.83 as compared to $1.18 for the three months ended December 31, 2004.

We generated $259 million in cash from operating activities during the nine months ended December 31, 2005 as compared to generating $160 million for the nine months ended December 31, 2004. The increase in cash generated from operating activities was primarily due to a higher percentage of net revenue recognized in the first two months of our third quarter of fiscal 2006 as compared to the third quarter of fiscal 2005, which allowed us to collect a higher percentage of our net revenue during the quarter.

Management’s Overview of Historical and Prospective Business Trends

Transition to Next-Generation Consoles. Our industry is cyclical and has entered into a transition stage heading into the next cycle. In November 2005, Microsoft launched the Xbox 360, and over the course of the next twelve months, we expect Sony and Nintendo to introduce new video game consoles, as well. During this transition, we intend to continue developing new titles for the current generation of video game consoles while we also continue to make significant investments in the development of products that operate on the next-generation consoles. We have incurred, and expect to continue to incur, higher costs during this transition to next-generation consoles. Moreover, we expect development costs for next-generation video games to be greater on a per-title basis than development costs for current-generation video games. We also expect that, as the current generation of consoles reach the end of their cycle and next-generation consoles are introduced into the market, sales of video games for current-generation consoles will continue to decline as consumers replace their current-generation consoles with next-generation consoles, or defer game software purchases until they are able to purchase a next-generation platform. We also expect our operating expenses to increase for the fiscal year ending March 31, 2006 as compared to prior fiscal years, primarily as a result of the transition. In addition, we expect our net revenue, gross profit and net income to decrease in our fiscal year ending March 31, 2006 as compared to the prior fiscal year. Throughout the remainder of this transition, we expect our operating results to continue to be volatile and difficult to predict, which could cause our stock price to fluctuate significantly.

Expansion of Mobile Platforms . The introduction of the PSP and Nintendo DS has resulted in increased sales of titles for mobile platforms. During the three months ended December 31, 2005, our net revenue from sales of our titles for mobile platforms increased to $192 million from $55 million for the three months ended December 31, 2004. Similarly, during the nine months ended December 31, 2005, our net revenue from sales of our titles for mobile platforms increased to $305 million from $83 million for the nine months ended December 31, 2004. As the mobile platform installed base continues to grow, we expect that sales of our titles for these platforms may become an increasingly important part of our business, particularly during the transition from current-generation to next-generation consoles.

Increasing Cost of Titles. Titles have become increasingly expensive to produce and market as the platforms on which they are played continue to advance technologically and consumers demand continual improvements in the overall gameplay experience. We expect this trend to continue throughout the transition from current-generation to next-generation consoles as (1) we become more familiar with, and gain expertise in, developing titles for next-generation consoles, (2) we require larger production teams to create our titles, (3) the technology needed to develop titles becomes more complex, (4) the number and nature of the platforms for which we develop titles increases and becomes more diverse, (5) the cost of licensing the third-party intellectual property we use in many of our titles increases, and (6) we develop new methods to distribute our content via the Internet and on hand-held and wireless devices.

Software Prices. We expect the average prices of our titles for current-generation consoles to continue to decline as (1) more value-oriented consumers purchase current-generation consoles, (2) a greater number of competitive titles are published, and (3) consumers defer purchases in anticipation of next-generation consoles. As a result, we expect our gross margins to be negatively impacted.

Sales of “Hit” Titles. Sales of “hit” titles, several of which were top sellers across a number of international markets, contributed significantly to our net revenue. Our top-selling titles across all platforms worldwide during the three months ended December 31, 2005 were Need for Speed Most Wanted , FIFA 06 , Harry Potter and the Goblet of Fire , The Sims 2 and Madden NFL 06. Hit titles are important to our financial performance because they benefit from overall economies of scale. We have developed, and it is our objective to continue to develop, many of our hit titles to become franchise titles that can be regularly iterated.

International Operations and Sales and Foreign Exchange Impact. Net revenue from international sales accounted for approximately 46 percent of our total net revenue during the first nine months of fiscal 2006 and approximately 47 percent of our total net revenue during the first nine months of fiscal 2005. Our international net revenue was primarily driven by sales in Europe and, to a lesser extent, in Asia. Foreign exchange rates had an unfavorable impact on our net revenue of $12 million, or less than 1 percent, for the nine months ended December 31, 2005 as compared to the nine months ended December 31, 2004. Foreign exchange rates had an unfavorable impact on our net revenue of $21 million, or 1 percent, for the three months ended December 31, 2005 as compared to the three months ended December 31, 2004. We expect foreign currency movements to negatively impact our revenue for the remaining three months of fiscal 2006. We anticipate that international net revenue will increase as a percentage of net revenue during the remainder of fiscal 2006 as the console installed base continues to expand

outside of North America. In particular, we believe that in order to succeed in Asia, it is important to develop content locally. As such, we expect to continue to devote resources to hiring local development talent and expanding our infrastructure outside of North America, most notably, through the expansion and creation of local studio facilities in Asia. In addition, we anticipate establishing online game marketing, publishing and distribution functions in China. As part of this strategy, we may seek to partner with established local companies through acquisitions, joint ventures or other similar arrangements. Our international business has also grown through acquisitions and investments such as our acquisition of Criterion Software Group Ltd. and our tender offer for Digital Illusions C.E. (“DICE”) in fiscal 2005.

Expansion of Studio Resources and Technology. In fiscal 2005, we devoted significant resources to the overall expansion of our studio facilities in North America and Europe. As we move through the life cycle of current-generation consoles, we will continue to devote significant resources to the development of current-generation titles while at the same time continuing to invest heavily in tools, technologies and titles for the next-generation of platforms and technology.

Increasing Licensing Costs. We generate a significant portion of our net revenue and operating income from games based on licensed content such as Madden NFL Football, FIFA, James Bond and Harry Potter. We have recently entered into new licenses and renewed older licenses, some of which contain higher royalty rates than similar license agreements we have entered into in the past. As a result, we expect our gross margins to continue to be negatively impacted.

Acquisition of JAMDAT . In December 2005, we entered into a definitive merger agreement to acquire JAMDAT Mobile Inc., a global publisher of wireless games and other wireless entertainment applications. We will pay $27 per share in cash in exchange for each share of JAMDAT common stock and assume outstanding stock options for a total purchase price of approximately $680 million, plus transaction costs. This acquisition is subject to customary closing conditions, including approval by JAMDAT’s stockholders and regulatory approvals, and is expected to close during our fourth quarter of fiscal 2006.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, contingent assets and liabilities, and revenue and expenses during the reporting periods. The policies discussed below are considered by management to be critical because they are not only important to the portrayal of our financial condition and results of operations but also because application and interpretation of these policies requires both judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.

Revenue Recognition, Sales Returns, Allowances and Bad Debt Reserves

We principally derive revenue from sales of packaged interactive software games designed for play on video game consoles (such as the PlayStation 2, Xbox, Xbox 360 and Nintendo GameCube), PCs and mobile platforms including hand-held game players (such as the Nintendo Game Boy Advance, Nintendo DS and Sony PSP) and cellular handsets. We evaluate the recognition of revenue based on the criteria set forth in Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” , as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” and Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements” , as revised by SAB No. 104, “Revenue Recognition” . We evaluate revenue recognition using the following basic criteria and recognize revenue when all four of the following criteria are met:

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Evidence of an arrangement: Evidence of an agreement with the customer that reflects the terms and conditions to deliver products must be present in order to recognize revenue.

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Delivery: Delivery is considered to occur when the products are shipped and risk of loss and reward have been transferred to the customer. For online games and services, revenue is recognized as the service is provided.

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Fixed or determinable fee: If a portion of the arrangement fee is not fixed or determinable, we recognize that amount as revenue when the amount becomes fixed or determinable.

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Collection is deemed probable: At the time of the transaction, we conduct a credit review of each customer involved in a significant transaction to determine the creditworthiness of the customer. Collection is deemed probable if we expect the customer to be able to pay amounts under the arrangement as those amounts become due. If we determine that collection is not probable, we recognize revenue when collection becomes probable (generally upon cash collection).

Determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report. For example, for multiple element arrangements, we must make assumptions and judgments in order to: (1) determine whether and when each element has been delivered; (2) determine whether undelivered products or services are essential to the functionality of the delivered products and services; (3) determine whether vendor-specific objective evidence of fair value (“VSOE”) exists for each undelivered element; and (4) allocate the total price among the various elements we must deliver. Changes to any of these assumptions or judgments, or changes to the elements in a software arrangement, could cause a material increase or decrease in the amount of revenue that we report in a particular period.

Product revenue, including sales to resellers and distributors (“channel partners”), is recognized when the above criteria are met. We reduce product revenue for estimated future returns, price protection, and other offerings, which may occur with our customers and channel partners. In certain countries, we have stock-balancing programs for our PC products, which allow for the exchange of PC products by resellers under certain circumstances. It is our general practice to exchange products or give credits, rather than give cash refunds.

In certain countries, from time to time, we decide to provide price protection for both our PC and video game system products. In our decision, we analyze historical returns, current sell-through of distributor and retailer inventory of our products, current trends in the video game market and the overall economy, changes in consumer demand and acceptance of our products and other related factors when evaluating the adequacy of the sales returns and price protection allowances. In addition, we monitor the volume of our sales to our channel partners and their inventories, as substantial overstocking in the distribution channel could result in high returns or higher price protection costs in subsequent periods.

In the future, actual returns and price protections may materially exceed our estimates as unsold products in the distribution channels are exposed to rapid changes in consumer preferences, market conditions or technological obsolescence due to new platforms, product updates or competing products. For example, the risk of product returns and/or price protection for our products may continue to increase as the PlayStation 2, Xbox and Nintendo GameCube consoles move through their lifecycles and an increasing number and aggregate amount of competitive products heighten pricing and competitive pressures. While management believes it can make reliable estimates regarding these matters, these estimates are inherently subjective. Accordingly, if our estimates changed, our returns and price protection reserves would change, which would impact the total net revenue we report. For example, if actual returns and/or price protection were significantly greater than the reserves we have established, our actual results would decrease our reported total net revenue. Conversely, if actual returns and/or price protection were significantly less than our reserves, this would increase our reported total net revenue.

Significant judgment is required to estimate our allowance for doubtful accounts in any accounting period. We determine our allowance for doubtful accounts by evaluating customer creditworthiness in the context of current economic trends and historical experience. Depending upon the overall economic climate and the financial condition of our customers, the amount and timing of our bad debt expense and cash collection could change significantly.

Royalties and Licenses

Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers and (3) co-publishing and/or distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademark, copyright, personal publicity rights, content and/or other intellectual property. Royalty payments to independent software developers are payments for the development of intellectual property related to our games. Co-publishing and distribution royalties are payments made to third parties for delivery of product.

Royalty-based obligations with content licensors and distribution affiliates are either paid in advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid. These royalty-based obligations are expensed to cost of goods sold at the greater of the contractual or effective royalty rate based on expected net product sales. Significant judgment is required to estimate the effective royalty rate for a particular contract. Because the computation of effective royalty rates requires us to

project future revenue, it is inherently subjective as our future revenue projections must anticipate (1) the total number of titles subject to the contract, (2) the timing of the release of these titles, (3) the number of software units we expect to sell, and (4) future pricing. Determining the effective royalty rate for hit-based titles is particularly difficult due to the inherent risk of such titles. Accordingly, if our future revenue projections change, our effective royalty rates would change, which could impact the royalty expense we recognize. Prepayments made to thinly capitalized independent software developers and co-publishing affiliates are generally in connection with the development of a particular product and, therefore, we are generally subject to development risk prior to the general release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed as research and development as the services are incurred. Payments due after completion of the product (primarily royalty-based in nature) are generally expensed as cost of goods sold at the higher of the contractual or effective royalty rate based on expected net product sales.

Minimum guaranteed royalty obligations are initially recorded as an asset and as a liability at the contractual amount when no significant performance remains with the licensor. When significant performance remains with the licensor, we record royalty payments as an asset when actually paid rather than upon execution of the contract. Minimum royalty payment obligations are classified as current liabilities to the extent such royalty payments are contractually due within the next twelve months. As of December 31, 2005 and March 31, 2005, approximately $34 million and $51 million, respectively, of minimum guaranteed current and long-term royalty obligations had been recognized.

Each quarter, we also evaluate the future realization of our royalty-based assets as well as any unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized through product sales. Any impairments determined before the launch of a product are charged to research and development expense. Impairments determined post-launch are charged to cost of goods sold. In either case, we rely on estimated revenue to evaluate the future realization of prepaid royalties and commitments. If actual sales or revised revenue estimates fall below the initial revenue estimate, then the actual charge taken may be greater in any given quarter than anticipated. We had no impairments during the three and nine months ended December 31, 2005. Impairments for the three and nine months ended December 31, 2004 were $1 million and $3 million, respectively.

Valuation of Long-Lived Assets

We evaluate both purchased intangible assets and other long-lived assets in order to determine if events or changes in circumstances indicate a potential impairment in value exists. This evaluation requires us to estimate, among other things, the remaining useful lives of the assets and future cash flows of the business. These evaluations and estimates require the use of judgment. Our actual results could differ materially from our current estimates.

Under current accounting standards, we make judgments about the recoverability of purchased intangible assets and other long-lived assets whenever events or changes in circumstances indicate a potential impairment in the remaining value of the assets recorded on our condensed consolidated balance sheets. In order to determine if a potential impairment has occurred, management makes various assumptions about the future value of the asset by evaluating future business prospects and estimated cash flows. Our future net cash flows are primarily dependent on the sale of products for play on proprietary video game consoles, hand-held game players and PCs (collectively referred to as “platforms”). The success of our products is affected by our ability to accurately predict which platforms and which products we develop will be successful. Also, our revenue and earnings are dependent on our ability to meet our product release schedules. Due to product sales shortfalls, we may not realize the future net cash flows necessary to recover our long-lived assets, which may result in an impairment charge being recorded in the future. There were no impairment charges recorded in the three and nine months ended December 31, 2005 and 2004.

Income Taxes

In the ordinary course of our business, there are many transactions and calculations where the tax law and ultimate tax determination is uncertain. As part of the process of preparing our Condensed Consolidated Financial Statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate prior to the completion and filing of tax returns for such periods. This process requires estimating both our geographic mix of income and our current tax exposures in each jurisdiction where we operate. These estimates involve complex issues, require extended periods of time to resolve, and require us to make judgments, such as anticipating the positions that we will take on tax returns prior to our actually preparing the returns and the outcomes of disputes with tax authorities. We are also required to make determinations of the need to record deferred tax liabilities and the recoverability of deferred tax assets. A valuation allowance is established to the extent recovery of deferred tax assets is not likely based on our estimation of future taxable income in each jurisdiction.

In addition, changes in our business, including acquisitions, changes in our international structure, changes in the geographic location of business functions, changes in the geographic mix and amount of income, as well as changes in our agreements with tax authorities, valuation allowances, applicable accounting rules, applicable tax laws and regulations, rulings and interpretations thereof, developments in tax audit and other matters, and variations in the estimated and actual level of annual pre-tax income can affect the overall effective income tax rate and result in a variance between the projected effective tax rate for any quarter and the final effective tax rate for the fiscal year. For example, during the three months ended September 30, 2005, we resolved various tax-related matters with foreign tax authorities which decreased our tax expense and engaged in certain intercompany transactions which increased our income tax expense. Collectively, these items resulted in a net decrease in tax expense for the quarter of approximately $9 million. Conversely, we expect our acquisition of JAMDAT Mobile Inc. to adversely impact our effective tax rate.

With respect to our projected effective income tax rate each quarter prior to the end of a fiscal year, we are required to make a projection of several items, including our projected mix of full-year income in each jurisdiction in which we operate and the related income tax expense in each jurisdiction. The projected annual effective income tax rate is also adjusted for taxes related to certain anticipated changes in how we do business. Significant non-recurring charges are taken in the quarter incurred. The actual results could vary from those projected, and as such, the overall effective income tax rate for a fiscal year could be different from that previously projected for the full year.

Our results of operations for the three and nine months ended December 31, 2005 and 2004 contain the following number of weeks:

For the three months ended June 30, 2005, there was one additional week included in our results of operations as compared to the three months ended June 30, 2004.

For simplicity of presentation, all fiscal periods are treated as ending on a calendar month end.

Net Revenue

We principally derive net revenue from sales of packaged interactive software games designed for play on video game consoles (such as the PlayStation 2, Xbox, Xbox 360 and Nintendo GameCube), PCs and mobile platforms which include hand-held game players (such as the Nintendo Game Boy Advance, Nintendo DS and Sony PSP) and cellular handsets. Additionally, in Europe and Asia, we generate a significant portion of net revenue by marketing and selling third-party interactive software games through our established distribution network. We also derive net revenue from selling subscriptions to some of our online games, programming third-party web sites with our game content, allowing other companies to manufacture and sell our products in conjunction with other products, and selling advertisements on our online web pages.

From a geographical perspective, our total net revenue for the three and nine months ended December 31, 2005 and 2004 was as follows (in millions):