Rosetta Stone Inc
Annual Report 2012

Plain-text annual report

Use these links to rapidly review the documentTABLE OF CONTENTS INDEX TO CONSOLIDATED FINANCIAL STATEMENTSTable of ContentsUNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549Form 10-KANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2012Commission file number: 1-34283Rosetta Stone Inc.(Exact name of registrant as specified in its charter)Delaware(State of incorporation) 043837082(I.R.S. EmployerIdentification No.)1919 North Lynn St., 7th Fl.Arlington, Virginia(Address of principal executiveoffices) 22209(Zip Code)Registrant's telephone number, including area code:800-788-0822Securities Registered Pursuant to Section 12(b) of the Act:Title of Each Class Name of Each Exchange on Which RegisteredCommon Stock, par value $0.00005 pershare New York Stock ExchangeSecurities Registered Pursuant to Section 12(g) of the Act:None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No  Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o No  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 of1934 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 suchfiling requirements for the past 90 days. Yes  No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data Filerequired to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for suchshorter period that the registrant was required to submit and post such files). Yes  No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained,to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Checkone): Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No  The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $169.0 million as of June 30, 2012(based on the last sale price of such stock as quoted on the New York Stock Exchange). As of February 22, 2013, there were 21,345,526 shares of common stock outstanding. Documents incorporated by reference: Portions of the definitive Proxy Statement to be delivered to stockholders in connection with the 2013Annual Meeting of Stockholders to be held on May 23, 2013 are incorporated by reference into Part III. Large accelerated filer o Accelerated filer  Non-accelerated filer o(Do not check if a smaller reportingcompany) Smaller reporting company oTABLE OF CONTENTS 2 Page PART I Item 1. Business 4 Item 1A. Risk Factors 8 Item 1B. Unresolved Staff Comments 32 Item 2. Properties 32 Item 3. Legal Proceedings 33 Item 4 Mine Safety Disclosures 34 PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities 35 Item 6. Selected Financial Data 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 38 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 66 Item 8. Financial Statements and Supplementary Data 66 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 66 Item 9A. Controls and Procedures 66 Item 9B. Other Information 67 PART III Item 10. Directors, Executive Officers and Corporate Governance 68 Item 11. Executive Compensation 68 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related StockholderMatters 68 Item 13. Certain Relationships and Related Transactions, and Director Independence 68 Item 14. Principal Accounting Fees and Services 68 PART IV Item 15. Exhibits and Financial Statement Schedules 69 Table of ContentsCAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws. These forward-lookingstatements include, but are not limited to, statements regarding: our business strategies; information regarding our future financial performance; ourprojected plans and objectives; our development of new products including an English remediation solution; international expansion and ourdevelopment of a business model to drive growth; the sufficiency of our cash flows from operations and available sources of funds; the impact ofinflation on our financial position and results of operations; the effect of state tax law examination on our results of operations and financial position;our technology and product development initiatives; and our intellectual property strategy. These forward-looking statements are subject to risks anduncertainties that could cause actual results and events to differ. A detailed discussion of these and other risks and uncertainties that could causeactual results and events to differ materially from such forward-looking statements is included throughout this filing and particularly in Item 1A: "RiskFactors" section set forth in this Annual Report on Form 10-K. All forward-looking statements included in this document are based on informationavailable to us on the date hereof, and we assume no obligation to revise or publicly release any revision to any such forward-looking statement,except as may otherwise be required by law.3Table of ContentsPART I Item 1. Business Overview Rosetta Stone Inc. ("Rosetta Stone", "the Company", "we", or "us") is a leading provider of technology-based, language-learning solutions. Wedevelop, market, and sell language-learning solutions consisting of software, online services, mobile applications and audio practice tools primarilyunder our Rosetta Stone brand. Our teaching method, which we call Dynamic Immersion, is designed to leverage the innate, natural language-learningability that children use to learn their native language. Our courses are based on our proprietary interactive technologies and pedagogical content andutilize a sophisticated sequencing of images, text and sounds to teach a new language without translation or grammar explanation. We believe ouraward-winning solutions provide an effective, convenient and fun way to learn languages. We currently offer our self-study language-learning solutionsin over 30 languages. Rosetta Stone Inc. was incorporated in Delaware in 2005 and completed our initial public offering in April 2009. Our operations are headquarteredin Arlington, VA, and we have several operating locations in the U.S. as well as various international office locations in Asia and Europe. The strategic plan of the management team through 2015 includes three primary areas of focus:1.leveraging the brand; 2.innovating the platform; and 3.expanding distribution. In pursuing these priorities, we plan to balance margin with growth.Business Segments During 2012, we had a change in our chief operating decision maker ("CODM"), which led to a fourth quarter change in what our CODM uses tomeasure profitability and allocate resources. Accordingly, beginning with the fourth quarter of 2012, we have three operating segments, North AmericaConsumer, Rest of World ("ROW") Consumer and Institutional. From the first quarter of 2011 through the third quarter of 2012 we had two operatingsegments, Consumer and Institutional. Prior to 2011 we operated as a single segment. The North America Consumer and ROW Consumer segments derive revenues from individuals and sales to retail partners. The North AmericaConsumer segment includes sales made within the United States and Canada; the ROW Consumer segment includes sales made in countries other thanthe U.S. and Canada. The Institutional segment derives revenues from sales to educational institutions, government agencies and corporationsworldwide. For additional information regarding our segments, see Note 15 of Item 8, Financial Statements and Supplementary Data. Prior periods arepresented consistent with our current operating segments and definition of segment contribution.Products and ServicesCore Product Offering Our primary products include Rosetta Stone Version 4 TOTALe and Rosetta Stone TOTALe online. Version 4 TOTALe includes each of thecomponents described below and is available as either tangible packaged software or as an online download of perpetual software. Rosetta StoneTOTALe online combines dedicated conversational coaching and an online software subscription and is available4Table of Contentsin a selection of time-based offers (e.g. three, six and 12 months durations). ReFLEX, a solution designed specifically for English learners who want toimprove their listening and speaking skills, is sold as an online subscription in South Korea and Japan. The core Rosetta Stone language-learningsolution offered in TOTALe online and Version 4 TOTALe is offered in over 30 languages under the Rosetta Stone brand. Each language currently hasup to five levels and there are four different editions of our product: personal, enterprise, classroom and home school. Our solutions are available both in a perpetual format (CD-ROM or download) and by subscription online through our language-learning portal.For the year ended December 31, 2012, approximately 66% of our revenue was from CD-ROM or download sales while approximately 34% was fromonline subscriptions to both consumers and institutions. Our solutions include stand-alone sales and bundles of certain of the following components:•Rosetta Course is the self-study interactive language-learning curriculum that is the core component of the Rosetta Stone offering. Thecourse consists of sequences of listening, speaking, reading, and writing interactions designed to teach, reinforce and test learnersthrough our software program. •Rosetta Studio is a series of coach-led practice sessions that align with the curriculum in Rosetta Course. Studio sessions providelearners with the opportunity to practice what they have learned in Rosetta Course, by talking with a native-speaking coach and otherlearners. •Rosetta World is an interactive community of language learners. Rosetta World gives learners the opportunity to play games with otherlearners in a structured manner that reinforces what they have learned in Rosetta Course and Rosetta Studio. •Audio Companion is a series of digital audio files that contain lessons directly aligned to the Rosetta Stone curriculum, allowing users topractice and carry on their immersive experience when they are away from a computer. The lessons on the Audio Companion can betransferred to various audio platforms. •TOTALe Companion HD is a learning tool that provides access to Rosetta Course with the exception of the review and writing pathsteps, for use on tablet devices. TOTALe Companion HD includes our speech recognition technology. •TOTALe Companion includes a series of practice lessons which use images, audio and our speech recognition technology to help usersrefine their speaking skills while they are away from their computer.Product Developments Our product portfolio is a result of significant investment in product development over 20 years. Our product development focuses on bothsoftware and content development. Our development efforts include both creating new solutions and adding new languages to existing solutions. Ourdevelopment team has specific expertise in speech recognition, interface design, immersion learning and instructional design. Our research and development expenses were $23.5 million, $24.2 million, and $23.4 million for the years ended December 31, 2012, 2011 and2010, respectively. We are evaluating changes to our products to strengthen our brand and improve the relevance of our offerings. We are developing our first set ofproducts for children. In addition, we are enhancing our offering for educational organizations to expand our Institutional business. We intend to makeour products more modular, flexible and mobile.5Table of ContentsDistribution Channels Our global consumer distribution model comprises a mix of our call centers, websites, network of kiosks, select retail resellers, such asAmazon.com, Barnes & Noble, Best Buy, Books-a-Million, Costco, Groupon and Staples, home shopping networks such as GS Home Shopping inKorea and consignment distributors such as Navarre. We believe these channels complement each other, as consumers who have seen our direct-to-consumer advertising may purchase at our kiosks or retailers, and those who have seen our solutions demonstrated at our kiosks may purchasesolutions through our retailers, websites or call centers. Direct to consumer. Sales generated through either our websites or call centers. Retailers. Our retailers enable us to provide additional points of contact to educate consumers about our solutions, expand our presence beyondour own kiosks and websites, and further strengthen and enhance our brand image. Our retail relationships include Amazon.com, Barnes & Noble, BestBuy, Books-a-Million, Costco, Groupon, Staples, and others outside of the U.S. Home School. We promote interest in this market through advertising in publications focused on home schooling, attending local trade shows,seminars and direct mailings. Rosetta Stone Kiosks. As of December 31, 2012, we operated 87 retail kiosks, including 57 full service retail outlets, in airports, malls and otherstrategic high-traffic locations in 19 states. As of December 31, 2012, we operated one kiosk in the United Kingdom, three in Japan, and 26 in SouthKorea. Our institutional distribution model is focused on targeted sales activity primarily through a direct sales force in four markets: schools, colleges anduniversities; federal government agencies; corporations; and not-for-profit organizations. Regional sales managers are responsible for sales of oursolutions in their territories and supervise account managers who are responsible for maintaining our customer base. Educational Institutions. These customers include primary and secondary schools. Federal Government Agencies and Not-for-Profit. These customers include government agencies and organizations developing workforces toserve non-native speaking populations, offering literacy programs and preparing members for overseas missions. Corporations. We promote interest in this market with onsite visits, trade show and seminar attendance, speaking engagements and directmailings.Sourcing and Fulfillment Our strategy is to maintain a flexible, diversified and low-cost manufacturing base for our prepackaged products. We use third-party contractmanufacturers and suppliers to obtain substantially all our product and packaging components and to manufacture finished products. We believe that wehave good relationships with our manufacturers and suppliers and that there are alternative sources in the event that one or more of these manufacturersor suppliers is not available. We continually review our manufacturing and supply needs against the capacity of our contract manufacturers andsuppliers with a view to ensuring that we are able to meet our production goals, reduce costs and operate more efficiently. We package and distribute our products primarily from our fulfillment facility in Harrisonburg, Virginia. We also contract with third-partyfulfillment vendors in Munich, Germany, and Tokyo, Japan.6Table of ContentsCompetition The Rosetta Stone brand is recognized as a leading technology-based, language-learning solution. The language-learning market is highlyfragmented globally and consists of the following primary models: classroom instruction utilizing the traditional approach of memorization, grammarand translation; immersion-based classroom instruction; self-study books, audio recordings and software that relies primarily on grammar andtranslation; and free online and mobile offerings that provide content and opportunities to practice writing and speaking. Our competitors include Berlitz International Inc., Simon & Schuster, Inc. (Pimsleur), Random House Ventures LLC (Living Language), DisneyPublishing Worldwide and McGraw-Hill Education.Seasonality Our business is affected by variations in seasonal trends. These variations are primarily related to increased sales of our products and services toconsumers in the fourth quarter during the holiday selling season as well as higher sales to governmental and educational institutions in the second andthird quarters. We sell to a significant number of our retailers, distributors and institutional customers on a purchase order basis and we receive orderswhen these customers need products and services. As a result, their orders are typically not evenly distributed throughout the year.Intellectual Property Our ability to protect our core technology and intellectual property is critical to our success. We rely on a combination of measures to protect ourintellectual property, including patents, trade secrets, trademarks, trade dress, copyrights and non-disclosure and other contractual arrangements. We have five U.S. patents, two foreign patents and several U.S. and foreign patents pending. Many of these pending patents relate to our languageteaching methods. We hold a perpetual, irrevocable and worldwide license from the University of Colorado allowing us to use speech recognition technology forlanguage-learning solutions. We entered into the license agreement in December 2006, and paid the University of Colorado an up-front license fee. We have registered a variety of trademarks, including Rosetta Stone, Rosetta World, Rosetta, Rosetta Course, Rosetta Studio, Rosetta StoneLanguage-Learning Success & global design, Audio Companion, Dynamic Immersion, The Fastest Way to Learn a Language. Guaranteed., AdaptiveRecall, Contextual Formation, Simbio, the Rosetta Stone blue stone logo and design, the Rosetta Stone blue stone logo and design/Language-LearningSuccess, Rosettastone.com, Rosetta Stone TOTALe, rWorld, SharedTalk and TOTALe. All these trademarks are the subject of either registrations orpending applications in the United States, as well as numerous countries worldwide where we do business. We have applied to register our yellow coloras a trademark with the United States Patent and Trademark Office. We intend to continue to strategically register, both domestically and internationally,trademarks we use today and those we develop in the future. We are registering or have registered in the United States all editions of our Version 3 TOTALe languages and ReFLEX. We have a registeredcopyright for the refreshed Rosetta Stone blue stone logo design in the United States. We intend to continue to strategically register copyrights in ourvarious products. We believe that the distinctive marks that we use in connection with our solutions are important in building our brand image and distinguishing oursolutions from those of our competitors. These marks are among our most valuable assets. In addition to our distinctive marks, we own severalcopyrights and trade dress rights to our solutions, product packaging and user manuals. We also place significant value7Table of Contentson our trade dress, which is the overall image and appearance of our solutions, and we believe that our trade dress helps to distinguish our solutions inthe marketplace. Furthermore, our employees, contractors and other parties with access to our confidential information sign agreements that prohibit theunauthorized disclosure of our proprietary rights, information and technology.Employees As of December 31, 2012, we had 1,550 total employees, consisting of 879 full-time and 671 part-time employees. None of our employees arerepresented by a collective bargaining agreement. We believe our employee relations are good.Financial Information by Segment and Geographic Area For a discussion of financial information by segment and geographic area, see Note 15 to the consolidated financial statements contained in thisAnnual Report on Form 10-K.Available Information This Annual Report on Form 10-K, along with our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to thosereports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of chargethrough our website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and ExchangeCommission ("SEC"). Our website address is www.rosettastone.com. The SEC maintains a website that contains reports, proxy statements and otherinformation regarding issuers that file electronically with the SEC. These materials may be obtained electronically by accessing the SEC's website atwww.sec.gov.Item 1A. Risk Factors In addition to the other information set forth in this annual report on Form 10-K, you should carefully consider the risk factors discussed belowand in other documents we file with the Securities and Exchange Commission, which could materially affect our business, financial condition or futureresults. These are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financial condition and/or operating results.Our actual operating results may differ significantly from our guidance. From time to time, we may release guidance in our quarterly earnings releases, quarterly earnings conference call, or otherwise, regarding ourfuture performance that represents our management's estimates as of the date of release. This guidance, which includes forward-looking statements, isbased on projections prepared by our management. These projections are not prepared with a view toward compliance with published guidelines of theAmerican Institute of Certified Public Accountants, and neither our registered public accountants nor any other independent expert or outside partycompiles or examines the projections and, accordingly, no such person expresses any opinion or any other form of assurance with respect thereto. Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject tosignificant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and are based upon specificassumptions with respect to future business decisions, some of which will change. We generally state possible outcomes as high and low ranges, whichare intended to provide a sensitivity analysis as8Table of Contentsvariables are changed but are not intended to represent that actual results could not fall outside of the suggested ranges. The principal reason that werelease guidance is to provide a basis for our management to discuss our business outlook with analysts and investors. We do not accept anyresponsibility for any projections or reports published by any such persons. Guidance is necessarily speculative in nature, and it can be expected that some or all of the assumptions of the guidance furnished by us will notmaterialize or will vary significantly from actual results. Accordingly, our guidance is only an estimate of what management believes is realizable as ofthe date of release. Actual results will vary from our guidance and the variations may be material. In light of the foregoing, investors are urged not torely upon, or otherwise consider, our guidance in making an investment decision in respect of our common stock. Any failure to successfully implement our operating strategy or the occurrence of any of the events or circumstances set forth in our "Risk Factors"and in this annual report on Form 10-K could result in the actual operating results being different from our guidance, and such differences may beadverse and material.We may not be able to utilize all of our deferred tax assets. At December 31, 2012, we had net deferred tax assets of $30.1 million which was offset by a valuation allowance of $29.8 million for certainjurisdictions. We recorded the valuation allowance to reflect uncertainties about whether we will be able to realize some of our deferred tax assets beforethey expire. The valuation allowance is based on our estimates of taxable income for the jurisdictions in which we operate and the period over which ourdeferred tax assets will be realizable. We could in the future be required to increase the valuation allowance to take into account additional deferred taxassets that we may be unable to realize. An increase in the valuation allowance would have an adverse impact, which could be material, on our incometax provision and net income in the period in which we record the increase.Risks Related to Our BusinessOur introduction of Rosetta Stone Version 4 TOTALe and ReFLEX has increased our costs as a percentage of revenue, and these and futureproduct introductions may not succeed and may harm our business, financial results and reputation. We released Rosetta Stone Version 4 TOTALe and ReFLEX in various markets over the past few years. Rosetta Stone Version 4 TOTALeintegrates our existing language-learning software solutions with web-based services, which provide opportunities for practice with dedicated languageconversation coaches and other language learners to increase language socialization. ReFLEX integrates online language-learning software solutions toimprove the listening and speaking skills of English learners with web-based services, which provide opportunities for practice with dedicated languageconversation coaches and other language learners. These language coach services have a much higher cost as a percentage of revenue than our softwaresolutions and remain a risk factor due to the growth of these offerings as a percentage of our sales. We offer Rosetta Stone Version 4 TOTALeprimarily by bundling the web-based services of TOTALe with our software and audio offerings. At the same time, we expect to provide augmented,free peer-to-peer language practice. The services associated with Rosetta Stone Version 4 TOTALe and ReFLEX have decreased our margins. RosettaStone Version 4 TOTALe sells at a higher price per unit than our Version 3 software solutions and customers may not choose to engage withconversation coaches or be willing to pay higher prices to do so. Rosetta Stone Version 4 TOTALe and ReFLEX have also presented new managementand marketing challenges that differ from the challenges we faced in our previous business. In addition, we are now required to defer recognition of aportion of each sale of Version 4 TOTALe and ReFLEX in connection with the subscription terms of our online socialization services. We cannot assureyou that Rosetta Stone Version 4 TOTALe and9Table of ContentsReFLEX will be successful or profitable, or if it is profitable, that it will provide an adequate return on capital expended. If Rosetta Stone Version 4TOTALe and/or ReFLEX are not successful, our business, financial results and reputation may be harmed. We anticipate having to make investments innew products in the future, such as a children's product, and we may incur significant expenses without achieving the anticipated benefits of ourinvestment or preserving our brand and reputation. Investments in new products and technology are speculative, the development cycle for productsmay exceed planned estimates and commercial success depends on many factors, including innovativeness, developer support, and effective distributionand marketing. Customers may not perceive our latest offerings as providing significant new value and may reduce their purchases of our offerings,unfavorably impacting revenue. We may not achieve significant revenue from new product and service investments for a number of years, if at all.Our introduction of an English remediation solution targeting intermediate learners in Asia may not succeed and may harm our business,financial results and reputation. We introduced our English remediation solution, ReFLEX, in South Korea and Japan over the past two years. This solution targets more advancedEnglish learners in Asia, and provides learners with foundational phonetic skills needed to properly hear and produce distinctions that are present inEnglish, but absent in Asian languages. This online solution carries some lower price points than our full Rosetta Stone Version 4 TOTALe language-learning solution and may cannibalize sales of our Version 4 solution in Asia. We have devoted significant capital, personnel and management attentionto develop and launch the English remediation offering, including related research and development expenses, and incurring marketing expenses relatingto the launch. This product has presented new management and marketing challenges. Consumer demand for ReFLEX in South Korea and Japan has notbeen as high as we projected. We cannot assure you that the English remediation solution will be successful or profitable, or if it is profitable, that it willprovide an adequate return on capital expended.Because we generate all of our revenue from language-learning solutions, a decline in demand for our language-learning solutions or forlanguage-learning solutions in general could cause our revenue to decline. We generate substantially all of our revenue from our language-learning solutions, and we expect that we will continue to depend upon language-learning solutions for substantially all of our revenue in the foreseeable future. Because we are dependent on our language-learning solutions, factorssuch as changes in consumer preferences for these products may have a disproportionately greater impact on us than if we offered multiple productcategories. If consumer interest in our language-learning software products declines, or if consumer interest in learning foreign languages in generaldeclines, we would likely experience a significant loss of sales. Some of the potential developments that could negatively affect interest in and demandfor language-learning software products include:•a decline in international travel; and •changes in U.S. or international laws or policies making it more difficult for foreign persons to visit or take up residence in the UnitedStates.Because a substantial portion of our revenue is generated from our consumer business, if we fail to accurately forecast consumer demand andtrends in consumer preferences, our Rosetta Stone brand, sales and customer relationships may be harmed. Demand for our language-learning software products and related services, and for consumer products and services in general, is subject to rapidlychanging consumer demand and trends in consumer preferences. Therefore, our success depends upon our ability to:•identify, anticipate, understand and respond to these trends in a timely manner;10Table of Contents•introduce appealing new products and performance features on a timely basis; •provide appealing solutions that engage our customers; •anticipate and meet consumer demand for additional languages, learning levels and new platforms for delivery; •effectively position and market our products and services; •identify and secure cost-effective means of marketing our products to reach the appropriate consumers; •identify cost-effective sales distribution channels, kiosk locations and other sales outlets where interested consumers will buy ourproducts; •anticipate and respond to consumer price sensitivity and pricing changes of competitive products; and •identify and successfully implement ways of building brand loyalty and reputation. We may be unable to develop new solutions or solution enhancements in time to capture market opportunities or achieve sustainable acceptance innew or existing markets. In addition, our solutions may become less appealing to consumers due to changes in technologies or reduced life cycles of oursolutions. A decline in consumer demand for our solutions, or any failure on our part to satisfy such changing consumer preferences, could harm ourbusiness and profitability.We depend on discretionary consumer spending in the consumer segment of our business. Adverse trends in general economic conditions,including retail and online shopping patterns, airport traffic or consumer confidence, as well as numerous other external consumer dynamicsmay compromise our ability to generate revenue. The success of our business depends to a significant extent upon discretionary consumer spending, which is subject to a number of factors,including general economic conditions, consumer confidence, employment levels, business conditions, interest rates, availability of credit, inflation andtaxation. Adverse trends in any of these economic indicators may cause consumer spending to decline further, which could hurt our sales andprofitability. For our retail business, we depend on the continued popularity of physical stores and malls to generate customer traffic for retailers such asBarnes & Noble, Best Buy, Books-A-Million, Costco, and Staples which sell our products and our retail mall-based kiosks. We also depend oncontinued airline travel to generate traffic for our retail kiosks located in airports. Decreases in physical store, mall or airport retail traffic adversely affectour consumer sales and our profitability and financial condition. In addition, an increase in the taxation of online sales could result in reduced onlinepurchases or reduced margins on such sales. Furthermore, consumers may defer purchases of our solutions in anticipation of new products or newversions from us or our competitors.Because a significant portion of our sales are made to or through retailers and distributors, none of which have any obligation to sell ourproducts, the failure or inability of these parties to sell our products effectively could hurt our revenue and profitability. We rely on retailers and distributors, together with our direct sales force, to sell our products. Our sales to retailers and distributors are highlyconcentrated on a small group, including Amazon.com, Barnes & Noble, Best Buy, Books-A-Million, Costco, Groupon, Navarre, and Staples. Sales toor through our retailers and distributors accounted for approximately 17% of our revenue for the year ended December 31, 2012, compared to 14% forthe year ended December 31, 2011.11Table of Contents We have no control over the amount of products that these retailers and distributors purchase from us or sell on our behalf, we do not have long-term contracts with any of them, and they have no obligation to offer or sell our products or to give us any particular shelf space or product placementwithin their stores. Thus, there is no guarantee that this source of revenue will continue at the same level as it has in the past or that these retailers anddistributors will not promote competitors' products over our products or enter into exclusive relationships with competitors. Any material adversechange in the principal commercial terms, material decrease in the volume of sales generated by our larger retailers or distributors or major disruption ortermination of a relationship with these retailers and distributors could result in a potentially significant decline in our revenue and profitability.Furthermore, product display locations and promotional activities that retailers undertake can affect the sales of our products. The fact that we also sellour products directly could cause retailers or distributors to reduce their efforts to promote our products or stop selling our products altogether. Asevidenced by the bankruptcy and liquidation of Borders, book stores and other traditional physical retailers are experiencing diminished foot traffic andsales. Reduced customer foot traffic in these stores is likely to reduce their sales of our products. In addition, if one or more of these bookstores or otherretailers or distributors are unable to meet their obligations with respect to accounts payable to us, we could be forced to write off such accounts. Anybankruptcy, liquidation, insolvency or other failure of any of these retailers or distributors could result in significant financial loss and cause us to loserevenue in future periods.Product returns and pricing concessions could exceed our estimates, which would diminish our reported revenue. In the United States, we offer consumers who purchase our packaged software and audio practice products directly from us six-monthunconditional full money-back. We also permit some of our retailers and distributors to return packaged products, subject to certain limitations. Weestablish revenue reserves for packaged product returns based on historical experience, estimated channel inventory levels, the timing of new productintroductions and other factors. If packaged product returns exceed our reserve estimates, the excess would offset reported revenue, which could hurtour reported financial results. We continue to test changes to the pricing and delivery methods of our products. If we reduce our prices or our method of delivery as a result ofsuccessful tests in an effort to increase sales volume and overall market penetration, we may provide our retailers and distributors with price protectionon existing inventories, which would allow these retailers and distributors a credit against amounts owed with respect to unsold packaged product undercertain conditions. These price protection reserves could be material in future periods. It is uncertain whether these strategies will prove successful orwhether we will be able to develop the necessary infrastructure and business models. The intense competition we face in the sales of our language learning solutions and general economic and business conditions can put pressure onus to change our prices. If our competitors offer deep discounts on certain products or services or develop products that the marketplace considers morevaluable, we may need to lower prices or offer other favorable terms in order to compete successfully. Any such changes may reduce margins and couldadversely affect operating results. Any broad-based change to our prices and pricing policies could cause our revenues to decline or be delayed as oursales force implements and our customers adjust to the new pricing policies. If we do not adapt our pricing models to reflect changes in customer use ofour products or changes in customer demand, our revenues could decrease.12Table of ContentsIntense competition in our industry may hinder our ability to generate revenue and may diminish our margins. The market for foreign language-learning solutions is rapidly evolving, highly fragmented and intensely competitive, and we expect both productand pricing competition to persist and intensify. Increased competition could cause reduced revenue, price reductions, reduced gross margins and loss ofmarket share. Many of our current and potential competitors have longer operating histories and substantially greater financial, technical, sales,marketing and other resources than we do, as well as greater name recognition worldwide or in select local markets. The resources of these competitorsalso may enable them to respond more rapidly to new or emerging technologies and changes in customer requirements, reduce prices to win newcustomers and offer free language-learning software or online services. We may not be able to compete successfully against current or futurecompetitors. As the market for foreign language solutions continues to develop, a number of other companies with greater resources than ours could attempt toenter the market or increase their presence by acquiring or forming strategic alliances with our competitors or our distributors or by introducing theirown competing products. These companies and their products may be superior to any of our current competition. We have also seen increasedcompetition from imitation products which are lower priced, lower quality products that attempt to capitalize on the popularity of our products byutilizing similar packaging and marketing materials. In addition, we see increased competition from community practice providers which provide lowpriced entry points for consumers interested in learning languages. We may not have the financial resources, technical expertise, marketing, distributionor support capabilities to compete effectively with any of these new entrants to the market. We have seen an increase of language-learning applications on mobile platforms, such as iPhones and iPads, that are offered at extremely lowprices and, while they are currently limited in scope and ability to teach languages, they may present a threat as they develop. As we continue to expand into foreign markets, we expect that we will experience competition from local foreign language-learning companies thathave strong brand recognition and more experience in selling to local consumers and a better understanding of local marketing, sales channels andconsumer preferences. Our success will depend on our ability to adapt to these competitive forces, to adapt to technological advances, to develop more advanced productsmore rapidly and less expensively than our competitors, to continue to develop an international sales network, to adapt to changing consumerpreferences and to educate potential customers about the benefits of using our solutions rather than our competitors' products and services. Existing ornew competitors could introduce new products and services with superior features and functionality at lower prices. This could impair our ability to sellour products and services.Demand for paid language-learning solutions such as ours could decline if effective language-learning solutions become available for free. Presently there are a number of free online language applications and websites offering limited vocabulary lists, grammar explanations and tips,and crowd sourced text translations. In addition, there are some online services offering limited free lessons and learning tools, including one sponsoredby the U.S. Department of Education to help immigrants learn English. Many of these websites offer free language practice opportunities with otherlanguage learners. If these free products and applications become more sophisticated and competitive or gain widespread acceptance by the public,demand for our solutions could decline.13Table of ContentsOur future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing expenditures. Our future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing expenditures, including ourability to:•create greater awareness of our brands and our language-learning solutions; •select the right market, media and specific media vehicle in which to advertise; •identify the most effective and efficient level of spending in each market, media and specific media vehicle; •determine the appropriate creative message and media mix for advertising, marketing and promotional expenditures; •effectively manage marketing costs, including creative and media expenses, in order to maintain acceptable customer acquisition costs; •drive traffic to our websites, call centers, distribution channels and kiosks; and •convert customer inquiries into actual orders. Our planned marketing expenditures may not result in increased revenue or generate sufficient levels of product and brand name awareness, andwe may not be able to increase our net sales at the same rate as we increase our advertising expenditures. Some of our radio, television and print advertising has been through the purchase of "remnant" advertising segments. These segments are randomtime slots and publication dates that have remained unsold and are offered at discounts to advertisers who are willing to be flexible with respect to timeslots. There is a limited supply of this type of advertising and the availability of such advertising may decline or the cost of such advertising mayincrease. In addition, if we increase our marketing budget we cannot assure you that we can increase the amount of remnant advertising at thediscounted prices we have obtained in the past. If any of these events occur, we may be forced to purchase time slots and publication dates at higherprices, which will increase our costs. We also seek new customers through our online marketing efforts, including paid search listings, banner ads, text links and permission-based e-mails, as well as our affiliate and reseller programs and we engage in an active public relations program, including through social media sites such asFacebook and Twitter. We opportunistically adjust our mix of marketing programs to acquire new customers at a reasonable cost with the intention of achieving overallfinancial goals. If we are unable to maintain or replace our sources of customers with similarly effective sources, or if the cost of our existing sourcesincreases, our customer levels and marketing expenses may be adversely affected.Our business depends on our Rosetta Stone brand, and if we are not able to maintain and enhance our brand, our business and operatingresults may be harmed. We believe that market awareness of our Rosetta Stone brand in the United States has contributed significantly to the success of our business. Wealso believe that maintaining and enhancing the Rosetta Stone brand is critical to maintaining our competitive advantage. As we continue to grow ourbusiness, expand our products and services and extend our geographic reach, maintaining the quality and consistency of our language-learningsolutions, and thus the quality of our brand, may be more difficult. In addition, software piracy and trademark infringement may harm our Rosetta Stonebrand by undermining our reputation for quality software programs. We must continue to update our marketing communications in order to maintainand enhance our brand awareness and the value of our brand. Failure to do so may result in a decrease in brand value and related sales.14Table of ContentsWe depend on search engines and other online sources to attract visitors to our websites, and if we are unable to attract these visitors and convertthem into customers in a cost-effective manner, our business and financial results may be harmed. Our success depends on our ability to attract online consumers to our websites and convert them into customers in a cost-effective manner. Wedepend, in part, on search engines and other online sources for our website traffic. We are included in search results as a result of both paid searchlistings, where we purchase specific search terms that will result in the inclusion of our listing, and algorithmic searches that depend upon the searchablecontent on our sites. Search engines and other online sources revise their algorithms from time to time in an attempt to optimize their search results. If one or more of the search engines or other online sources on which we rely for website traffic were to modify its general methodology for howit displays our websites, resulting in fewer consumers clicking through to our websites, our sales could suffer. If any free search engine on which werely begins charging fees for listing or placement, or if one or more of the search engines or other online sources on which we rely for purchasedlistings, modifies or terminates its relationship with us, our expenses could rise, we could lose customers and traffic to our websites could decrease.Our expansion into international markets may not succeed and imposes special risks. Our business strategy contemplates stabilizing the losses we have experienced in international markets in order to prepare for future growth andexpansion into international markets. We are currently augmenting and optimizing certain of our website direct sales channels in Europe, Asia and LatinAmerica. In addition, we are continuing to selectively expand and optimize our indirect sales channels in Europe, Asia and Latin America throughretailer and distributor arrangements with third parties. If we are unable to stabilize losses in our international operations successfully and in a timelymanner, our ability to subsequently pursue our growth strategy will be impaired. Such stabilization and expansion may be more difficult or take longerthan we anticipate, and we may not be able to successfully market, sell, deliver and support our products and services internationally to the extent weexpect. Our international operations and our efforts to increase sales in international markets are subject to a number of risks that are in addition to ordifferent than those affecting our U.S. operations, including:•difficulty in staffing and managing geographically dispersed operations and culturally diverse work forces and increased travel,infrastructure and legal compliance costs associated with multiple international locations; •difficulty in establishing and maintaining financial and other internal controls over geographically dispersed operations; •competition from local foreign language software providers and preferences for local products in some regions; •expenses associated with customizing products, support services and websites for foreign countries; •inability to identify an effective and efficient level of advertising, marketing and promotional expenditures in order to maintain acceptablecustomer acquisition costs; •inability to drive traffic to our websites, call centers, kiosks and distribution channels; •inability to register domain names for "Rosetta Stone" in Country Code Top Level Domains in order to operate country specific websitesto permit consumers to easily locate our products in other countries due in large part to cybersquatting;15Table of Contents•difficulties with providing appropriate and appealing products to suit consumer preferences and capabilities in these markets, such as thepotential need to customize English language software solutions for local markets; •difficulties with establishing successful sales channels; •inability to successfully develop relationships with significant retailers and distributors; •potential political and economic instability in some regions; •potential unpredictable changes in foreign government regulations; •legal and cultural differences in the conduct of business; •import and export license requirements, tariffs, taxes and other trade barriers; •inflation and fluctuations in currency exchange rates; •potentially adverse tax consequences; •difficulties in enforcing contracts and collecting accounts receivable, and longer payment cycles, especially in emerging markets; •the burden and difficulties of complying with a wide variety of U.S. and foreign laws, regulations, trade standards, treaties and technicalstandards, including the Foreign Corrupt Practices Act; •difficulty in protecting our intellectual property and the high incidence of software piracy in some regions; •costs and delays in downsizing foreign work forces as a result of differing employment and other laws; •protectionist laws and business practices that favor local competitors; and •uncertainty regarding liability for information retrieved and replicated in foreign countries. The effects of any of the risks described above could reduce our future revenue from our international operations and could harm our overallbusiness, revenue and financial results.If the recognition by schools and other institutions of the value of technology-based education does not continue to grow, our ability to generaterevenue from institutions could be impaired. Our success depends in part upon the continued adoption by institutions and potential customers of technology-based education initiatives. Someacademics and educators oppose online education in principle and have expressed concerns regarding the perceived loss of control over the educationprocess that can result from offering courses online. If the acceptance of technology-based education does not continue to grow, our ability to continueto grow our institutional business could be impaired.If there are changes in the spending policies or budget priorities for government funding of colleges, universities, schools, other educationproviders, or government agencies, we could lose revenue. Many of our institutional customers are colleges, universities, primary and secondary schools, other education providers, armed forces andgovernment agencies that depend substantially on government funding. Accordingly, any general decrease, delay or change in federal, state or localfunding for colleges, universities, primary and secondary schools, or other education providers or government agencies that use our products andservices could cause our current and potential customers to reduce their purchases of our products and services, to exercise their right to terminatelicenses, or to decide not to renew licenses, any of which could cause us to lose revenue. In addition, a specific reduction in16Table of Contentsgovernmental funding support for products such as ours would also cause us to lose revenue and could hurt our overall gross margins.Some of our institutional business faces a lengthy and unpredictable sales cycle for our solutions, which could delay new sales. We face a lengthy sales cycle between our initial contact with some potential institutional customers and the signing of license agreements withthese customers. As a result of this lengthy sales cycle, we have only a limited ability to forecast the timing of such institutional sales. A delay in orfailure to complete license transactions could cause us to lose revenue, and could cause our financial results to vary significantly from quarter to quarter.Our sales cycle varies widely, reflecting differences in our potential institutional customers' decision-making processes, procurement requirements andbudget cycles, and is subject to significant risks over which we have little or no control, including:•customers' budgetary constraints and priorities; •the timing of our customers' budget cycles; •the need by some customers for lengthy evaluations that often include both their administrators and faculties; and •the length and timing of customers' approval processes.If we are unable to continually enhance our products and services and adapt them to technological changes and customer needs, including theemergence of new computing devices and more sophisticated online services, we may lose market share and revenue and our business couldsuffer. We need to anticipate, develop and introduce new products, services and applications on a timely and cost-effective basis that keeps pace withtechnological developments and changing customer needs. The process of developing new high technology products, services and applications andenhancing existing products, services and applications is complex, costly and uncertain, and any failure by us to anticipate customers' changing needsand emerging technological trends accurately could significantly harm our market share and results of operations. For example, the number ofindividuals who access the internet through devices other than a personal computer, such as tablet computers, mobile devices, televisions and set-topbox devices, has increased dramatically and this trend is likely to continue. Our products and services may not work or be viewable on these devicesbecause each manufacturer or distributor may establish unique technical standards for such devices. With the exception of TOTALe Companion, wehave no experience to date in operating versions of our products and services developed or optimized for users of alternative devices, and new devicesand new platforms are continually being released. Accordingly, we may need to devote significant resources to the creation, support and maintenance ofsuch versions. If we fail to develop or sell products and services that respond to these or other technological developments and changing customerneeds, such as the demand for products designed for children, cost effectively, we may lose market share and revenue and our business could suffer. We offer our software products and services primarily on Windows and Macintosh platforms. To the extent that there is a slowdown of customerpurchases of personal computers on either the Windows or Macintosh platform or in general, to the extent that we have difficulty transitioning productor version releases to new Windows and Macintosh operating systems, or to the extent that significant demand arises for our products or competitiveproducts on other platforms before we choose and are able to offer our products on these platforms, our business could be harmed. To the extent newreleases of operating systems, including for mobile and non-PC devices, or other third-party products, platforms or devices make it more difficult forour products to perform, and our customers are persuaded to use alternative technologies, our business could be harmed.17Table of ContentsIf we fail to manage our expansion effectively, we may experience difficulty in filling purchase orders, declines in product and service quality andcustomer satisfaction, increased costs or disruption in our operations. We are currently involved in efforts to stabilize losses in our international business and aim to ultimately expand our operations internationally,grow our institutional business, and move our business more online, which has strained our managerial, operational, financial and other resources. We anticipate that continued expansion of our operations will be required to satisfy consumer and institutional demand and to avail ourselves ofnew market opportunities. The expanding scope of our business will continue to place a significant strain on our management team, informationtechnology systems and other resources. To properly manage our growth, we need to hire and retain personnel, upgrade our existing operational,management and financial and reporting systems, including warehouse management and inventory control, improve our business processes and controlsand identify and develop relationships with additional retailers and distributors. We may also be required to expand our distribution facilities and ouroperational facilities or add new facilities, which could require significant capital expenditures. Failure to effectively manage our expansion and moveour business more online in a cost-effective manner could result in difficulty in filling purchase orders, declines in product and service quality andcustomer satisfaction, increased costs or disruption of our operations. Our growth also makes it difficult for us to adequately predict the expenditures we will need to make in the future. If we do not make the necessaryoverhead expenditures to accommodate our future growth, we may not be successful in executing our growth strategy.If we move our consumer business substantially online and sell our solutions pursuant to a monthly, quarterly or other subscription fee, ratherthan an upfront fee, our revenue, results of operations and cash flow will be negatively impacted in the short term. Historically, we have predominantly sold our packaged software programs for a single upfront fee and recorded 65-90% of the revenue at the timeof sale. We are delivering more of our solutions online pursuant to different duration subscription fees. Selling in this manner will result in substantiallyless cash and revenue from the initial sale to the customer and could have a substantially negative impact on our revenue, results of operations and cashflow in the short term.A transition to more online offerings may not be successful, if we are not able to attract and retain customers, which could adversely affect ourbusiness and financial performance. Our ability to attract customers to online offerings will depend in part on our ability to consistently provide our customers with a valuable andquality experience for learning languages. If consumers do not perceive our service offering to be of value, or if we introduce new or adjust existingfeatures or change the mix of content in a manner that is not favorably received by them, we may not be able to attract and retain customers. Customersmay cancel their subscription to our service for many reasons, including a perception that they do not use the service sufficiently, the need to cuthousehold expenses, competitive services providing a better value or experience, or customer service issues not being satisfactorily resolved. If toomany of our customers cancel our service, or if we are unable to attract new customers in numbers sufficient to grow our business, our operating resultswill be adversely affected. If too many customers cancel our service, we may be required to incur significantly higher marketing and advertisingexpenditures than we currently anticipate to replace these customers. We expect to derive an increasing portion of our revenues in the future fromsubscriptions to our cloud-based offerings. This subscription model prices and delivers our products in a way that differs from the historical pricing anddelivery methods of our language learning solutions. These changes reflect a shift from perpetual license sales and distribution of our software in favorof providing our customers the right to access certain of our software in a hosted environment or use downloaded software for a specified subscriptionperiod. This cloud strategy requires continued investment in product development18Table of Contentsand cloud operations, and may give rise to a number of risks, including a lag in sales, dissatisfaction from perpetual license customers, difficulty settingoptimal pricing that could negatively affect sales and/or earnings, revenues that decline over the short or long term, confusion among our customers,resellers and investors and higher than forecasted costs.Our revenue is subject to seasonal and quarterly variations, which could cause our financial results to fluctuate significantly. We have experienced, and we believe we will continue to experience, substantial seasonal and quarterly variations in our revenue and net income.These variations are primarily related to increased sales of our products and services to consumers in the fourth quarter during the holiday selling seasonas well as higher sales to governmental and educational institutions in the second and third quarters. We sell to a significant number of our retailers,distributors and institutional customers on a purchase order basis and we receive orders when these customers need products and services. As a result,their orders are typically not evenly distributed throughout the year. Our quarterly results of operations also may fluctuate significantly as a result of avariety of other factors, including the timing of holidays and advertising initiatives, changes in our products, services and advertising initiatives andchanges in those of our competitors. Budgetary constraints of our institutional customers may also cause our quarterly results to fluctuate. As a result of these seasonal and quarterly fluctuations, we believe that comparisons of our results of operations between different quarters are notnecessarily meaningful and that these comparisons are not reliable as indicators of our future performance. In addition, these fluctuations could result involatility and adversely affect our cash flows. As our business grows, these seasonal fluctuations may become more pronounced. Any seasonal orquarterly fluctuations that we report in the future may differ from the expectations of market analysts and investors. This could cause the price of ourcommon stock to fluctuate significantly.Substantially all of our inventory is located in one warehouse facility. Any damage or disruption at this facility could cause significant financialloss, including loss of revenue and harm to our reputation. Substantially all of our inventory is located in one warehouse facility. We could experience significant interruption in the operation of this facilityor damage or destruction of our inventory due to natural disasters, accidents, failures of the inventory locator or automated packing and shippingsystems or other events. If a material portion of our inventory were to be damaged or destroyed, we might be unable to meet our contractual obligationswhich could cause us significant financial loss, including loss of revenue and harm to our reputation.The loss of key personnel or the failure to attract and retain highly qualified personnel could compromise our ability to effectively manage ourbusiness and pursue our growth strategy. Our future performance depends on the continued service of our key technical, development, sales, services and management personnel. We relyon our executive officers and senior management to execute our existing business plans and to identify and pursue new opportunities. We rely on ourtechnical and development personnel for product innovation. We generally do not have employment agreements with our non-executive personnel and,therefore, they could terminate their employment with us at any time. The loss of key employees could result in significant disruptions to our business,and the integration of replacement personnel could be costly and time consuming, could cause additional disruptions to our business, and could beunsuccessful. We do not carry key person life insurance covering any of our employees. Our future success also depends on our continued ability to attract and retain highly qualified technical, development, sales, services andmanagement personnel. Competition for such personnel is19Table of Contentsintense, and we may fail to retain our key employees or attract or retain other highly qualified personnel in the future. Many of our employees arelocated in Harrisonburg, Virginia, a city that does not have a large pool of qualified replacement personnel. The lack of qualified local replacementpersonnel may make it more difficult to quickly find replacement personnel and may increase the costs of identifying and relocating replacementpersonnel to Harrisonburg, Virginia or increase costs due to hiring replacements in other higher cost of living cities such as Arlington, Virginia orBoulder, Colorado. In addition, wage inflation and the cost of retaining our key personnel in the face of competition for such personnel may increase our costs fasterthan we can offset these costs with increased prices or increased sales volume.Our kiosk business generates significant revenues, and if we are unable to successfully reposition our kiosk business, or hire, train, motivate andretain sales personnel to staff our kiosks, or to identify suitable locations and negotiate site licenses on acceptable terms, we could lose revenue,our costs could increase and our profitability could decline. The number of worldwide kiosks decreased 50% from 174 as of December 31, 2011 to 87 as of December 31, 2012. In 2012, based on ourevaluation of historical and forecasted kiosk sales performance and profitability, we significantly reduced the size of our worldwide kiosk program, inaddition to continually reviewing the performance of remaining kiosk locations. In order to successfully generate revenues from our kiosk program we must be able to hire, train, motivate and retain sales personnel to staff thesekiosks. Our kiosks are small and widely dispersed, and, as such, are operated without substantial hands-on management or oversight by us. As a result,we depend on our kiosk sales personnel to effectively manage sales, customer issues and reporting of financial transactions from these kiosks. Thesuccess of our kiosks will depend upon various additional factors, including our ability to negotiate site licenses on acceptable terms and on negotiatingacceptable labor costs. We must identify and negotiate cost-effective site licenses for kiosk locations that will generate sufficient consumer demand.Many of these site licenses contain terms and conditions that are highly favorable to licensors including allowing licensors to cancel them on shortnotice, sometimes as little as thirty days, and broad indemnification terms in favor of licensors. If competition for kiosk space increases, license feesmay increase and other terms may become even less favorable to us, resulting in lower profitability. Our failure to properly manage the repositioning ofthis sales channel could cause us to lose revenue and increase our expenses.Failure to maintain the availability of the systems, networks, databases and software required to operate and deliver our internet-based productsand services could damage our reputation and cause us to lose revenue. We rely on internal systems and external systems, networks and databases maintained by us and third-party providers to process customer orders,handle customer service requests, and host and deliver our internet-based language- learning solutions, including our online language courses andRosetta Stone TOTALe, and our SharedTalk online peer-to-peer collaborative and interactive community. Any damage, interruption or failure of oursystems, networks and databases could prevent us from processing customer orders and result in degradation or interruptions in delivery of ourproducts and services. Notwithstanding our efforts to protect against interruptions in the availability of our e-commerce websites and internet-basedproducts and services, we do occasionally experience unplanned outages or technical difficulties. In addition, we do not have complete redundancy forall of our systems. We do not maintain real-time back-up of all of our data, and in the event of system disruptions, we could experience loss of datawhich could cause us to lose customers and could harm our reputation and cause us to face unexpected liabilities and expenses. If we continue toexpand our business, we will put additional strains on these systems. If we move additional product features to online systems or more of our businessonline, all of these considerations will become more significant.20Table of ContentsWe may also need to grow, reconfigure or relocate our data centers in response to changing business needs, which may be costly and lead to unplanneddisruptions of service.We are subject to U.S. and foreign government regulation of online services which could subject us to claims, judgments, and remedies, includingmonetary liabilities and limitations on our business practices. We are subject to regulations and laws directly applicable to providers of online services. The application of existing domestic and internationallaws and regulations to us relating to issues such as user privacy and data protection, data security, defamation, promotions, billing, consumerprotection, accessibility, content regulation, quality of services, and intellectual property ownership and infringement in many instances is unclear orunsettled. In addition, we will also be subject to any new laws and regulations directly applicable to our domestic and international activities.Internationally, we may also be subject to laws regulating our activities in foreign countries and to foreign laws and regulations that are inconsistentfrom country to country. We may incur substantial liabilities for expenses necessary to defend litigation in connection with such regulations and laws orto comply with these laws and regulations, as well as potential substantial penalties for any failure to comply.We may be subject to legal liability for Cloud-based online services and for data security breaches which could compromise our informationtechnology network security, trade secrets and customer data. Rosetta Stone TOTALe enables individuals to exchange information and engage in various online activities on a domestic and an internationalbasis. The law relating to the liability of providers of online services for activities of their users is currently unsettled both within the United States andinternationally. Claims may be brought against us for defamation, negligence, copyright or trademark infringement, unlawful activity, tort, includingpersonal injury, fraud, or other theories based on the nature and content of information that may be posted online or generated by our users. Defense ofany such actions could be costly and involve significant time and attention of our management and other resources and may require us to change ourbusiness in an adverse manner. In addition, the amount of data we store for our users on our servers (including personal information) will increase as we increase our Cloud basedofferings. Any systems failure or compromise of our security that results in the release of our users' data could seriously limit the adoption of ourproducts and services as well as harm our reputation and brand and, therefore, our business. We may also need to expend significant resources toprotect against security breaches. The risk that these types of events could seriously harm our business is likely to increase as we expand the number ofweb based products and services we offer as well as increase the number of countries where we operate. Further, failure or perceived failure by us to comply with our policies, applicable requirements, or industry self-regulatory principles related to thecollection, use, sharing or security of personal information, or other privacy, data-retention or data-protection matters could result in a loss of userconfidence in us, damage to our brands, and ultimately in a loss of users, advertising partners, or affiliates, which could adversely affect our business. Hackers develop and deploy viruses, worms, and other malicious software programs that attack our products and services and gain access to ournetworks and data centers. Groups of hackers may also act in a coordinated manner to launch distributed denial of service attacks, or other coordinatedattacks. Sophisticated organizations or individuals may launch targeted attacks using novel methods to gain access to computers running our software.These threats may result in breaches of our network or data security, disruptions of our internal systems and business applications, impairment of ourability to provide services to our customers, product development delays, harm to our competitive position from the compromise of confidentialbusiness information, or other negative impacts on our business.21Table of ContentsOur possession and use of personal information presents risks and expenses that could harm our business. Unauthorized disclosure ormanipulation of such data, whether through breach of our network security or otherwise, could expose us to costly litigation and damage ourreputation. Maintaining our network security is of critical importance because our online e-commerce systems and our online administration tools for ourinstitutional business store proprietary and confidential customer, employee and other sensitive data, such as names, addresses, other personalinformation and credit card numbers. Our call centers also process confidential customer data, which is provided to employees in the call centers. Weand our vendors use commercially available encryption technology to transmit personal information when taking orders. We use security and businesscontrols to limit access and use of personal information. However, third parties may be able to circumvent these security and business measures bydeveloping and deploying viruses, worms and other malicious software programs that are designed to attack or attempt to infiltrate our systems andnetworks. In addition, employee error, malfeasance or other errors in the storage, use or transmission of personal information could result in a breach ofcustomer or employee privacy. We employ contractors and temporary and part-time employees who may have access to the personal information ofcustomers and employees. It is possible such individuals could circumvent our controls, which could result in a breach of customer or employeeprivacy. Possession and use of personal information in conducting our business subjects us to legislative and regulatory burdens that could requirenotification of data breaches, restrict our use of personal information and hinder our ability to acquire new customers or market to existing customers.As our business evolves and as we expand internationally, we may become subject to additional and/or more stringent legal obligations concerning ourtreatment of customer information. We have incurred, and will continue to incur, expenses to comply with privacy and security standards and protocolsimposed by law, regulation, industry standards or contractual obligations. If third parties improperly obtain and use the personal information of our customers or employees, we may be required to expend significantresources to resolve these problems. A major breach of our network security and systems could have serious negative consequences for our businesses,including possible fines, penalties and damages, reduced customer demand for our products and services, harm to our reputation and brand and loss ofour ability to accept and process customer credit card orders.We are exposed to risks associated with credit card and payment fraud, and with credit card processing and alternative payment methods, whichcould cause us to lose revenue. Many of our customers use credit cards or automated payment systems to pay for our products and services. We have suffered losses, and maycontinue to suffer losses, as a result of orders placed with fraudulent credit cards or other fraudulent payment data. For example, under current creditcard practices, we may be liable for fraudulent credit card transactions if we do not obtain a cardholder's signature, a frequent practice in internet sales.We employ technology solutions to help us detect fraudulent transactions. However, the failure to detect or control payment fraud could cause us to losesales and revenue. From time to time, credit card processing fees may increase as a result of rate changes by the payment processing companies or changes in ourbusiness practices which increase the fees on a cost-per-transaction basis. Such increases may adversely affect our results of operations. We are subject to rules, regulations and practices governing our accepted payment methods which could change or be reinterpreted to make itdifficult or impossible for us to comply. A failure to comply with these rules or requirements could make us subject to fines and higher transaction feesand we could lose our ability to accept these payment methods. Our business and results of operations could be adversely affected if these changes wereto occur.22Table of Contents We accept payment methods other than payment cards, particularly in some areas of the world. As our service continues to evolve and expandinternationally, we will likely continue to explore accepting various forms of payment, which may have higher fees and costs than our currently acceptedpayment methods. If more consumers use higher cost payment methods, our payment costs could increase and our financial results could suffer.Any significant interruptions in the operations of our call center or third-party call centers could cause us to lose sales and disrupt our ability toprocess orders and deliver our solutions in a timely manner. We rely on both an in-house call center and third-party call centers to sell our solutions, respond to customer service and technical support requestsand process orders. Any significant interruption in the operation of these facilities, including an interruption caused by our failure to successfullyexpand or upgrade our systems or to manage these expansions or upgrades, could reduce our ability to receive and process orders and provide productsand services, which could result in lost and cancelled sales and damage to our brand and reputation. As we grow, we will need more capacity from those existing call centers or we will need to identify and contract with new call centers. We maynot be able to continue to locate and contract for call center capacity on favorable terms, or at all. Additionally, the rates those call centers charge us mayincrease or those call centers may not continue to provide service at the current levels. We structure our marketing and advertising to drive potential customers to our call centers and websites to purchase our solutions. If our call centeroperators do not convert inquiries into sales at expected rates, our ability to generate revenue could be impaired. Training and retaining qualified callcenter operators is challenging due to the expansion of our product and service offerings and the seasonality of our business. If we do not adequatelytrain our call center operators, they will not convert inquiries into sales at an acceptable rate. Our call center employs a large number of personnel and historically has been subject to a high turnover rate among employees. We may have toterminate employees from time to time as our business changes and labor demands shift among our facilities. Any significant increase in labor costs,deterioration of employee relations, slowdowns or work stoppages at any of our locations, due to employee turnover or otherwise, could harm ourbusiness and profitability. In addition, high employee turnover could increase our exposure to employee-related litigation. Likewise, the third-party callcenters we utilize face similar issues.If any of our products contain defects or errors or if new product releases or services are delayed, our reputation could be harmed, resulting insignificant costs to us and impairing our ability to sell our solutions. If our products contain defects, errors or security vulnerabilities, our reputation could be harmed, which could result in significant costs to us andimpair our ability to sell our products in the future. In the past, we have encountered product development delays due to errors or defects. We wouldexpect that, despite our testing, errors will be found in new products and product enhancements in the future. Significant errors in our products orservices could lead to, among other things:•delays in or loss of market acceptance of our products and services; •diversion of our resources; •a lower rate of license renewals or upgrades for consumer and institutional customers; •injury to our reputation; or •increased service expenses or payment of damages.23Table of Contents In addition, we could face claims for product liability, tort or breach of warranty. Our contracts with customers contain provisions relating towarranty disclaimers and liability limitations, which may not be upheld. Defending a lawsuit, regardless of its merit, is costly and may divertmanagement's attention and adversely affect the market's perception of us and our products and services. In addition, if our business liability insurancecoverage proves inadequate or future coverage is unavailable on acceptable terms, or at all, we could face significant financial losses.Our sales to U.S. government agencies subject us to special risks that could adversely affect our business. Government sales entail a variety of risks as evidenced by the non-renewal of our contracts with the U.S. Army and the U.S. Marine Corps in2011. These risks include the following:•government contracts are subject to the approval of appropriations by the United States Congress to fund the expenditures by theagencies under these contracts. Congress often appropriates funds for government agencies on a yearly basis, even though their contractsmay call for performance over a number of years; •our products and services are included on a General Services Administration, or GSA, schedule. The loss of the GSA schedule coveringour software products and related services could cause us to lose our ability to sell our products and services to U.S. governmentcustomers; •we must comply with complex federal procurement laws and regulations in connection with government contracts, which may imposeadded costs on our business; and •federal government contracts contain provisions and are subject to laws and regulations that provide government customers with rightsand remedies not typically found in commercial contracts. These rights and remedies allow government clients, among other things, toterminate existing contracts, with short notice, for convenience, without cause, reduce or modify contracts or subcontracts, and claimrights in products, systems, and technology produced by us.If we fail to effectively upgrade our information technology systems, we may not be able to accurately report our financial results or prevent fraud. As part of our efforts to continue improving our internal control over financial reporting, we plan to continue to upgrade our existing financialinformation technology systems in order to automate several controls that are currently performed manually. We may experience difficulties intransitioning to these upgraded systems, including loss of data and decreases in productivity, as personnel become familiar with these new systems. Inaddition, our management information systems will require modification and refinement as we grow and as our business needs change, which couldprolong difficulties we experience with systems transitions, and we may not always employ the most effective systems for our purposes. If weexperience difficulties in implementing new or upgraded information systems or experience significant system failures, or if we are unable tosuccessfully modify our management information systems or respond to changes in our business needs, we may not be able to effectively manage ourbusiness and we may fail to meet our reporting obligations. In addition, as a result of the automation of these manual processes, the data produced maycause us to question the accuracy of previously reported financial results.Our software products must interoperate with computer operating systems of our customers. If we are unable to ensure that our productsinteroperate properly with customer systems, our business could be harmed. Our products must interoperate with our customers' computer systems, including student learning management systems of our institutionalcustomers. As a result, we must continually ensure that our products interoperate properly with these systems. Changes in operating systems, thetechnologies we incorporate into our products or the computer systems our customers use may damage our business.24Table of ContentsAs our product and service offerings become more complex, our reported revenue may become less predictable. Our planned expansion of products and services will generate more varied sources of revenue than our existing business. In the fourth quarter of2011, we made announcements regarding our business, including evolving from a CD-ROM based desktop software model to digital services,combining self-study with live online conversational coaching in a multi-device platform. In 2012, we transitioned our distribution to more online in theconsumer business. The accounting policies that apply to these sources of revenue may be more complex than those that apply to our traditionalproducts and services. In addition, we may change the manner in which we sell our software licenses, and such change could cause delays in revenuerecognition in accordance with accounting standards. Under these accounting standards, even if we deliver products and services to, and collect cashfrom, a customer in a given fiscal period, we may be required to defer recognizing revenue from the sale of such product or service until a future periodwhen all the conditions necessary for revenue recognition have been satisfied. If we move more of our consumer business online we will also collectless cash from our initial transactions with consumers which could substantially decrease our revenues in the short term. Conditions that can causedelays in revenue recognition include software arrangements that have undelivered elements for which we have not yet established vendor specificobjective evidence of fair value, requirements that we deliver services for significant enhancements or modifications to customize our software for aparticular customer or material customer acceptance criteria.Many of our expenses are fixed and many are based, in significant part, on our expectations of our future revenue and are incurred prior to thesale of our products and services. Therefore, any significant decline in revenue for any period could have an immediate negative impact on ourmargins, net income and financial results for the period. Our expense levels are based, in significant part, on our estimates of future revenue and many of these expenses are fixed in the short term. As aresult, we may be unable to adjust our spending in a timely manner if our revenue falls short of our expectations. Accordingly, any significant shortfallof revenue in relation to our estimates could have an immediate negative effect on our profitability. In addition, as our business evolves, we anticipateincreasing our operating expenses to expand our product development, technical support, sales and marketing and administrative organizations. Anysuch expansion could cause material losses to the extent we do not generate additional revenue sufficient to cover the additional expenses.We may incur losses associated with currency fluctuations and may not be able to effectively hedge our exposure, which could impair ourfinancial performance. Our operating results are subject to fluctuations in foreign currency exchange rates. We currently do not attempt to mitigate a portion of these risksthrough foreign currency hedging, based on our judgment of the appropriate trade-offs among risk, opportunity and expense. In the future, we mightchoose to engage in foreign currency hedging transactions. If the foreign currency hedging markets are negatively affected by clearing and tradeexecution regulations imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the cost of hedging our foreign exchangeexposure could increase.We may need to raise additional funds to pursue our growth strategy or continue our operations, and we may be unable to raise capital whenneeded. From time to time, we may seek additional equity or debt financing to provide for the capital expenditures required to finance working capitalrequirements, continue our expansion, develop new products and services or make acquisitions or other investments. In addition, if our business planschange, general economic, financial or political conditions in our markets change, or other circumstances arise that have a material effect on our cashflow, the anticipated cash needs of our25Table of Contentsbusiness as well as our conclusions as to the adequacy of our available sources of capital could change significantly. Any of these events orcircumstances could result in significant additional funding needs, requiring us to raise additional capital. We cannot predict the timing or amount of anysuch capital requirements at this time. If financing is not available on satisfactory terms, or at all, we may be unable to expand our business or to developnew business at the rate desired and our results of operations may suffer.Acquisitions, joint ventures and strategic alliances may have an adverse effect on our business. We may make acquisitions or enter into joint ventures and strategic alliances as part of our long-term business strategy. Such transactions involvesignificant challenges and risks including that the transaction does not advance our business strategy, that we do not realize a satisfactory return on ourinvestment, that we experience difficulty integrating new employees, business systems, and technology, diversion of management's attention from ourother businesses or that we acquire undiscovered liabilities such as patent infringement claims or violations of the U.S. Foreign Corrupt Practices Actand similar worldwide anti-bribery laws. It may take longer than expected to realize the full benefits, such as increased revenue, enhanced efficiencies,or market share, or those benefits may ultimately be smaller than anticipated, or may not be realized. These events could harm our operating results orfinancial condition.Changes in applicable accounting principles could negatively affect our financial performance. Our financial statements are prepared in accordance with generally accepted accounting principles adopted in the United States ("GAAP") and aresubject to interpretation by the SEC and the Financial Accounting Standards Board ("FASB"). A change in GAAP or interpretations of GAAP canhave a negative effect on our reported financial results and even retroactively affect previously reported results. The FASB is currently working togetherwith the International Accounting Standards Board ("IASB") on several projects to align accounting principles internationally. These efforts by theFASB and IASB could change the accounting principles applicable to us and result in materially worse financial results for us in areas including, butnot limited to, principles for recognizing revenue.If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. Under GAAP, we review our goodwill and indefinite lived intangible assets for impairment at least annually and when there are changes incircumstances. Factors that may be considered a change in circumstances include a decline in stock price and market capitalization, future cash flows andslower growth rates in our industry. We may therefore be required to record a significant charge to earnings in our financial statements during the periodin which any impairment of our goodwill or indefinite lived intangible assets is determined, resulting in a negative effect on our results of operations.Changes in, or interpretations of, tax rules and regulations may adversely affect our effective tax rates. We are subject to tax in multiple U.S. and foreign tax jurisdictions. If certain foreign earnings previously treated as permanently reinvested arerepatriated, the related U.S. tax liability may be reduced by any foreign income taxes paid on these earnings. Unanticipated changes in our tax ratescould affect our future results of operations. Our future effective tax rates could be unfavorably affected by changes in the tax rates in jurisdictionswhere our income is earned or by changes in the valuation of our deferred tax assets and liabilities.26Table of ContentsOur investment portfolio may become impaired by deterioration of the capital markets. We follow an established investment policy and set of guidelines to monitor and help mitigate our exposure to interest rate and credit risk. Thepolicy sets forth credit quality standards and limits our exposure to any one issuer, as well as our maximum exposure to various asset classes. As ofDecember 31, 2012, our cash consisted of highly liquid, investments with a original maturities of three months or less and demand deposits withfinancial institutions. If financial market conditions worsen in the future, investments in some financial instruments may suffer from market liquidity andcredit problems. We cannot predict future market conditions or market liquidity, or credit availability, and can provide no assurance that our investmentportfolio will remain materially unimpaired.Catastrophic events may disrupt our business and may not be manageable under our Crisis Management Policy. We rely on our network infrastructure and enterprise applications, internal technology systems and our website for our development, marketing,operational, support, hosted services and sales activities. A disruption, infiltration or failure of these systems or third-party hosted services that we relyon for some of our business systems could, in the event of a major earthquake, fire, flood, power loss, telecommunications failure, software orhardware malfunctions, cyber-attack, war, terrorist attack or other catastrophic event, cause system interruptions, reputational harm, loss of intellectualproperty, delays in our product development, lengthy interruptions in our services, breaches of data security and loss of critical data and could preventus from fulfilling our customers' orders. We have developed certain disaster recovery plans and backup systems to reduce the potentially adverse effectof such events, but a catastrophic event that results in the destruction or disruption of any of our data centers or our critical business or informationtechnology systems could severely affect our ability to conduct normal business operations and, as a result, our future operating results could beadversely affected.If government regulations relating to the Internet or other areas of our business change, we may need to alter the manner in which we conductour business, or incur greater operating expenses. The adoption or modification of laws or regulations relating to the Internet or other areas of our business could limit or otherwise adversely affectthe manner in which we currently conduct our business. In addition, the growth and development of the market for online commerce may lead to morestringent consumer protection laws, which may impose additional burdens on us. If we are required to comply with new regulations or legislation ornew interpretations of existing regulations or legislation, this compliance could cause us to incur additional expenses or alter our business model.Changes in how network operators handle and charge for access to data that travel across their networks could adversely impact our business. We rely upon the ability of consumers to access certain of our language learning solutions through the Internet. To the extent that networkoperators implement usage based pricing, including meaningful bandwidth caps, or otherwise try to monetize access to their networks by data providers,we could incur greater operating expenses and our subscriber acquisition and retention could be negatively impacted. Furthermore, to the extent networkoperators were to create tiers of Internet access service and either charge us for or prohibit us from being available through these tiers, our businesscould be negatively impacted.27Table of ContentsRisks Related to Intellectual Property RightsProtection of our intellectual property is limited, and any misuse of our intellectual property by others, including software piracy, could harm ourbusiness, reputation and competitive position. Our intellectual property is important to our success. We believe our trademarks, copyrights, trade secrets, pending patents, trade dress and designsare valuable and integral to our success and competitive position. To protect our proprietary rights, we rely on a combination of patents, copyrights,trademarks, trade secret laws, confidentiality procedures, contractual provisions and technical measures. We have five issued patents in the United States and two foreign patents. We have several patent applications on file in the United States and othercountries. However, we do not know whether any of our pending patent applications will result in the issuance of patents or whether the examinationprocess will require us to narrow our claims. Even if patents are issued from our patent applications, which are not certain, they may be contested,circumvented or invalidated in the future. Moreover, the rights granted under any issued patents may not provide us with proprietary protection orcompetitive advantages, and, as with any technology, competitors may be able to develop similar or superior technologies now or in the future. Inaddition, we have not emphasized patents as a source of significant competitive advantage and have instead sought to primarily protect our proprietaryrights under laws affording protection for trade secrets, copyright and trademark protection of our products, brands, trademarks and other intellectualproperty where available and appropriate. However, all of these measures afford only limited protection and may be challenged, invalidated orcircumvented by third parties. In addition, these protections may not be adequate to prevent our competitors or customers from copying or reverse-engineering our products. Third parties could copy all or portions of our products or otherwise obtain, use, distribute and sell our proprietaryinformation without authorization. Third parties may also develop similar or superior technology independently by designing around our intellectualproperty, which would decrease demand for our products. In addition, our patents may not provide us with any competitive advantages and the patentsof others may seriously impede our ability to conduct our business. We protect our products, trade secrets and proprietary information, in part, by requiring all of our employees to enter into agreements providing forthe maintenance of confidentiality and the assignment of rights to inventions made by them while employed by us. We also enter into non-disclosureagreements with our technical consultants, customers, vendors and resellers to protect our confidential and proprietary information. We cannot assureyou that our confidentiality agreements with our employees, consultants and other third parties will not be breached, that we will be able to effectivelyenforce these agreements, that we will have adequate remedies for any breach, or that our trade secrets and other proprietary information will not bedisclosed or will otherwise be protected. We rely on contractual and license agreements with third parties in connection with their use of our products and technology. There is no guaranteethat such parties will abide by the terms of such agreements or that we will be able to adequately enforce our rights, in part because we rely, in manyinstances, on "click-wrap" and "shrink-wrap" licenses, which are not negotiated or signed by individual licensees. Accordingly, some provisions of ourlicenses, including provisions protecting against unauthorized use, copying, transfer, resale and disclosure of the licensed software program, may beunenforceable under the laws of several jurisdictions. Protection of trade secret and other intellectual property rights in the markets in which we operate and compete is highly uncertain and may involvecomplex legal questions. The laws of countries in which we operate may afford little or no protection to our trade secrets and other intellectual propertyrights. Although we defend our intellectual property rights and combat unlicensed copying and use of software and intellectual property rights through avariety of techniques, preventing unauthorized use or infringement of our intellectual property rights is inherently difficult. Despite our enforcement28Table of Contentsefforts against software piracy, we lose significant revenue due to illegal use of our software and from counterfeit copies of our software. If piracyactivities increase, it may further harm our business. We also expect that the more successful we are, the more likely that competitors will try to illegally use our proprietary information and developproducts that are similar to ours, which may infringe on our proprietary rights. In addition, we could potentially lose future trade secret protection forour source code if any unauthorized disclosure of such code occurs. The loss of future trade secret protection could make it easier for third parties tocompete with our products by copying functionality. In addition, any changes in, or unexpected interpretations of, the trade secret and other intellectualproperty laws in any country in which we operate may compromise our ability to enforce our trade secret and intellectual property rights. Costly andtime-consuming litigation could be necessary to enforce and determine the scope of our confidential information and trade secret protection. If we areunable to protect our proprietary rights or if third parties independently develop or gain access to our or similar technologies, our business, revenue,reputation and competitive position could be harmed.Third-party use of our trademarks as keywords in internet search engine advertising programs may direct potential customers to competitors'websites, which could harm our reputation and cause us to lose sales. Competitors and other third parties, including counterfeiters, purchase our trademarks and confusingly similar terms as keywords in internet searchengine advertising programs and in the header and text of the resulting sponsored link advertisements in order to divert potential customers to theirwebsites. Preventing such unauthorized use is inherently difficult. If we are unable to protect our trademarks and confusingly similar terms from suchunauthorized use, competitors and other third parties may continue to drive potential online customers away from our websites to competing andunauthorized websites, which could harm our reputation and cause us to lose sales.Our trademarks are limited in scope and geographic coverage and may not significantly distinguish us from our competition. We own several federal trademark registrations, including registrations of the Rosetta Stone mark, hold common law trademark rights and havetrademark applications pending in the U.S. and abroad for additional trademarks. Even if federal registrations and registrations in other countries aregranted to us, our trademark rights may be challenged. It is also possible that our competitors will adopt trademarks similar to ours, thus impeding ourability to build brand identity and possibly leading to customer confusion. In fact, various third parties have registered trademarks that are similar to oursin the United States and overseas. We could incur substantial costs in prosecuting or defending trademark infringement suits. If we fail to effectivelyenforce our trademark rights, our competitive position and brand recognition may be diminished.We have not registered copyrights for all our products, which may limit our ability to enforce them. We have not registered our copyrights in all of our software, written materials, website information, designs or other copyrightable works. TheUnited States Copyright Act automatically protects all of our copyrightable works, but without a registration we cannot enforce those copyrights againstinfringers or seek certain statutory remedies for any such infringement. Preventing others from copying our products, written materials and othercopyrightable works is important to our overall success in the marketplace. In the event we decide to enforce any of our copyrights against infringers,we will first be required to register the relevant copyrights, and we cannot be sure that all of the material for which we seek copyright registration wouldbe registrable in whole or in part, or that once registered, we would be successful in bringing a copyright claim against any such infringers.29Table of ContentsWe must monitor and protect our internet domain names to preserve their value. We may be unable to prevent third parties from acquiringdomain names that are similar to, infringe on or otherwise decrease the value of our trademarks. We own several domain names that include the terms Rosetta Stone and Rosetta World. Third parties may acquire substantially similar domainnames that decrease the value of our domain names and trademarks and other proprietary rights which may hurt our business. Third parties also mayacquire country specific domain names in the form of Country Code Top Level Domains which include our trademarks and which prevent us fromoperating country specific websites from which customers can view our products and engage in transactions with us. Moreover, the regulation ofdomain names in the United States and foreign countries is subject to change. Governing bodies could appoint additional domain name registrars ormodify the requirements for holding domain names. Recently, ICANN (the Internet Corporation for Assigned Names and Numbers), the internationalauthority over top-level domain names, expanded the number of generic Top Level Domains ("TLDs") which allow companies and organizations tocreate additional Web addresses that appear to the right of the "dot," such as the long-standing TLDs, ".com," ".gov" and ".org." ICANN may also addadditional TLDs in the future. As a result, we may not maintain exclusive rights to all potentially relevant domain names in the United States or in othercountries in which we conduct business, which could harm our business or reputation. Moreover, attempts may be made to register our trademarks asnew TLDs or as domain names within the selected new TLDs and we will have to make efforts to enforce our rights against such registration attempts.Claims that we misuse the intellectual property of others could subject us to significant liability and disrupt our business. We may become subject to material claims of infringement by competitors and other third parties with respect to current or future products, e-commerce and other web-related technologies, online business methods, trademarks or other proprietary rights. Our competitors, some of which mayhave substantially greater resources than we have and they have made significant investments in competing products and technologies, may have, orseek to apply for and obtain, patents, copyrights or trademarks that will prevent, limit or interfere with our ability to make, use and sell our current andfuture products and technologies, and we may not be successful in defending allegations of infringement of these patents, copyrights or trademarks.Further, we may not be aware of all of the patents and other intellectual property rights owned by third parties that may be potentially adverse to ourinterests. We may need to resort to litigation to enforce our proprietary rights or to determine the scope and validity of a third-party's patents or otherproprietary rights, including whether any of our products, technologies or processes infringe the patents or other proprietary rights of third parties. Wemay incur substantial expenses in defending against third-party infringement claims regardless of the merit of such claims. The outcome of any suchproceedings is uncertain and, if unfavorable, could force us to discontinue sales of the affected products or impose significant penalties or restrictions onour business. We do not conduct comprehensive patent searches to determine whether the technologies used in our products infringe upon patents heldby others. In addition, product development is inherently uncertain in a rapidly evolving technological environment in which there may be numerouspatent applications pending, many of which are confidential when filed, with regard to similar technologies.We do not own all of the software, other technologies and content used in our products and services. Some of our products and services include intellectual property owned by third parties, including software that is integrated with internallydeveloped software and a portion of our voice recognition software, which we license from the University of Colorado. From time to time we may berequired to renegotiate with these third parties or negotiate with new third parties to include their technology or content in our existing products, in newversions of our existing products or in wholly new products. We30Table of Contentsmay not be able to negotiate or renegotiate licenses on commercially reasonable terms, or at all, and the third-party software may not be appropriatelysupported, maintained or enhanced by the licensors. If we are unable to obtain the rights necessary to use or continue to use third-party technology orcontent in our products and services, the inability to support, maintain and enhance any software could result in increased costs, or in delays orreductions in product shipments until equivalent software could be developed, identified, licensed and integrated.Our use of open source software could impose limitations on our ability to commercialize our products. We incorporate open source software into our products and may use more open source software in the future. The use of open source software isgoverned by license agreements. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that these licensescould be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. In such event,we could be required to seek licenses from third parties in order to continue offering our products, make generally available, in source code form,proprietary code that links to certain open source modules, re-engineer our products, discontinue the sale of our products if re-engineering could not beaccomplished on a cost-effective and timely basis, or become subject to other consequences. In addition, open source licenses generally do not providewarranties or other contractual protections regarding infringement claims or the quality of the code. Thus, we may have little or no recourse if webecome subject to infringement claims relating to the open source software or if the open source software is defective in any manner.Risks Related to Owning Our Common StockSome of our stockholders could together exert significant influence over our company. As of December 31, 2012, funds affiliated with ABS Capital Partners beneficially owned in the aggregate shares representing approximately 23%of our outstanding voting power. Two managing members of the general partner of ABS Capital Partners currently serve on our board of directors.Additionally, as of December 31, 2012, Norwest Equity Partners VIII, LP, or Norwest, beneficially owned in the aggregate shares representingapproximately 15% of our outstanding voting power. One managing member of the general partner of Norwest currently serves on our board ofdirectors. As a result, these stockholders could together potentially have significant influence over all matters presented to our stockholders for approval,including election and removal of our directors and change of control transactions. The interests of these stockholders may not always coincide with theinterests of the other holders of our common stock.If securities analysts do not publish research or reports about our business or if they publish negative evaluations of our stock, the price of ourstock could decline. The trading market for our common stock depends in part on the research and reports that industry or financial analysts publish about us or ourbusiness. If one or more of the analysts covering our business downgrade their evaluations of or recommendations regarding our stock, or if one ormore of the analysts cease providing research coverage on our stock, the price of our stock could decline. If one or more of these analysts ceaseproviding research coverage on our stock, we could lose visibility in the market for our stock, which in turn could cause our stock price to decline.Our stock price is volatile, and changes in net revenue, margin or earnings shortfalls or the volatility of the market generally could cause themarket price of our stock to decline. The market price for our common stock has experienced significant fluctuations and may continue to fluctuate significantly. Our quarterly financialresults have fluctuated in the past and are likely to vary significantly in the future due to a number of factors, many of which are outside of our control31Table of Contentsand which could adversely affect our operations and operating results. A number of factors may affect the market price for our common stock,including: shortfalls in revenue, margins, earnings or key performance metrics, confusion on the part of industry analysts and investors about the impactof our subscription offerings, shortfalls in the number of subscribers, changes in analyst estimates or recommendations, new product announcements bycompetitors, seasonal variations in demand, loss of a large customer, variations in competitors' financial performance and regulatory or macro-economiceffects.Provisions in our organizational documents and in the Delaware General Corporation Law may prevent takeover attempts that could be beneficialto our stockholders. Provisions in our second amended and restated certificate of incorporation and second amended and restated bylaws, and in the Delaware GeneralCorporation Law, may make it difficult and expensive for a third party to pursue a takeover attempt we oppose even if a change in control of ourcompany would be beneficial to the interests of our stockholders. Any provision of our second amended and restated certificate of incorporation orsecond amended and restated bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for ourstockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for ourcommon stock. Our board of directors has the authority to issue up to 10,000,000 shares of preferred stock in one or more series and to fix the powers,preferences and rights of each series without stockholder approval. The ability to issue preferred stock could discourage unsolicited acquisitionproposals or make it more difficult for a third party to gain control of our company, or otherwise could adversely affect the market price of our commonstock. Further, as a Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law. This section generally prohibits usfrom engaging in mergers and other business combinations with stockholders that beneficially own 15% or more of our voting stock, or with theiraffiliates, unless our directors or stockholders approve the business combination in the prescribed manner. However, because funds affiliated with ABSCapital Partners and Norwest acquired their shares prior to our initial public offering, Section 203 is currently inapplicable to any business combinationor transaction with them or their affiliates. In addition, our second amended and restated certificate of incorporation includes a classified board ofdirectors and requires that any action to be taken by stockholders must be taken at a duly called meeting of stockholders and may not be taken by writtenconsent. Our second amended and restated bylaws require that any stockholder proposals or nominations for election to our board of directors mustmeet specific advance notice requirements and procedures, which make it more difficult for our stockholders to make proposals or director nominations.Item 1B. Unresolved Staff Comments None.Item 2. Properties Our corporate headquarters are located in Arlington, Virginia, where we sublease approximately 31,281 square feet of space. The term of thissublease was amended in the fourth quarter of 2012 and runs through December 31, 2018. We continue to lease approximately 8,038 square feet of additional space in Arlington, Virginia, with lease terms ending August 31, 2013. Weintend to occupy this space until the end of the lease term. We currently own two facilities with approximately 62,000 and 14,500 square feet of usable space in Harrisonburg, Virginia, that serve as ouroperations offices. In addition, we lease two facilities with32Table of Contentsapproximately 56,000 and 6,000 square feet in Harrisonburg, Virginia for use as a packing and distribution center for all of our U.S. and some of ourinternational fulfillment, in addition to sales operations. We also lease space for our one full service retail outlet in Virginia, and small offices in Boulder, Colorado, Tokyo, Japan, San Paulo, Brazil,Seoul, South Korea, and London, United Kingdom. Our Boulder office serves as a research and development location while our Tokyo, San Paulo,Seoul and London offices serve as regional sales offices. As of December 31, 2012, we also had site licenses for 87 kiosks. Most of our kiosk site licenses have terms of one to 89 months and provide fora minimum rent plus a percentage rent based upon sales after certain minimum thresholds have been achieved. These site licenses generally require thatwe pay insurance, utilities, real estate taxes and repair and maintenance expenses. Some of the site licenses also contain early termination options, whichcan be exercised by us or the licensor under certain conditions.Item 3. Legal Proceedings In July 2009, we filed a lawsuit in the United States District Court for the Eastern District of Virginia against Google Inc., seeking, among otherthings, to prevent Google from infringing upon our trademarks. In August 2010, the U.S. District Court for the Eastern District of Virginia issued itsfinal order dismissing our trademark infringement lawsuit against Google. We appealed the District Court's decision to the U.S. Court of Appeals forthe Fourth Circuit. In April 2012, the appellate court reversed the District Court's grant of summary judgment in Google's favor and remanded the caseto the District Court for further consideration. The case was settled pursuant to the terms of a confidential settlement agreement and dismissed withprejudice in October 2012. In April 2010, a purported class action lawsuit was filed against us in the Superior Court of the State of California, County of Alameda fordamages, injunctive relief and restitution in the matter of Michael Pierce, Patrick Gould, individually and on behalf of all others similarly situated v.Rosetta Stone Ltd. and DOES 1 to 50. The complaint alleges that plaintiffs and other persons similarly situated who are or were employed as salariedmanagers by us in our retail locations in California are due unpaid wages and other relief for our violations of state wage and hour laws. Plaintiffsmoved to amend their complaint to include a nationwide class in January 2011. In March 2011, the case was removed to the United States District Courtfor the Northern District of California. In November 2011, the parties agreed to a mediator's proposed settlement terms, and as a result, as ofSeptember 30, 2011, we reserved $0.6 million for the proposed settlement amount. We dispute the plaintiffs' claims and have not admitted anywrongdoing with respect to the case. In June 2011, Rosetta Stone GmbH was served with a writ filed by Langenscheidt KG ("Langenscheidt") in the District Court of Cologne,Germany alleging trademark infringement due to Rosetta Stone GmbH's use of the color yellow on its packaging of its language-learning software andthe advertising thereof in Germany. In January 2012, the District Court of Cologne ordered an injunction of Rosetta Stone GmbH's use of the coloryellow in packaging, on its website and in television commercials and declared Rosetta Stone liable for damages, attorneys' fees and costs toLangenscheidt. No dollar amounts have been specified yet for the award of damages by the District Court of Cologne. In its decision, the District Courtof Cologne also ordered the destruction of Rosetta Stone GmbH's product and packaging which utilized the color yellow and which was deemed tohave infringed Langenscheidt's trademark. Langenscheidt has not posted the necessary bond to immediately enforce that decision. We have continued tovigorously defend this matter through an appeal to the Court of Appeals in Cologne. The Court of Appeals in Cologne affirmed the decision inNovember 2012 and we have moved to have a further appeal heard before the German Federal Supreme Court. We also commenced a separateproceeding for the cancellation of Langenscheidt's German trademark33Table of Contentsregistration of yellow as an abstract color mark. In June 2012, the German Patent and Trademark Office rendered a decision in the cancellationproceeding denying our request to cancel Langenscheidt's German trademark registration. We have appealed that decision and a hearing on the appeal isscheduled to be held in April 2013 before the German Federal Patent Court. We cannot predict the timing and ultimate outcome of this matter, howeverwe believe the range of possible loss is immaterial to our financial statements. Even if the plaintiff is unsuccessful in its claims against us, we will incurlegal fees and other costs in the defense of these claims and appeals. From time to time, we have been subject to various claims and legal actions in the ordinary course of our business. We are not currently involvedin any legal proceeding the ultimate outcome of which, in our judgment based on information currently available, would have a material impact on ourbusiness, financial condition or results of operations.Item 4. Mine Safety Disclosures Not applicable.34Table of ContentsPART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Market for Common Stock Our common stock is listed on the New York Stock Exchange, or NYSE, under the symbol "RST." The following table sets forth, for each of theperiods indicated, the high and low reported sales price of our common stock on the NYSE. On February 22, 2013, the last reported sales price of our common stock on the NYSE was $12.53 per share. As of that date, there wereapproximately 233 holders of record of our common stock.Dividends We have not paid any cash dividends on our common stock and do not intend to do so in the foreseeable future. We currently intend to retain allavailable funds and any future earnings to support the operation of and to finance the growth and development of our business.Securities Authorized For Issuance Under Equity Compensation Plans For information regarding securities authorized for issuance under equity compensation plans, see Part III "Item 12—Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters."Stockholder Return Performance Presentation The following graph compares the change in the cumulative total stockholder return on our common stock during the period from April 16, 2009(the first day our stock began trading on the NYSE) through December 31, 2012, with the cumulative total return on the NYSE Composite Index andthe SIC Code Index that includes all U.S. public companies in the Standard Industrial Classification (SIC) Code 7372-Prepackaged Software. Thecomparison assumes that $100 was invested on April 16, 2009 in our common stock and in each of the foregoing indices and assumes reinvestment ofdividends, if any.35 High Low Year ended December 31, 2012 Fourth Quarter $13.27 $10.52 Third Quarter 14.28 9.26 Second Quarter 14.69 9.50 First Quarter 10.50 6.95 Year ended December 31, 2011 Fourth Quarter $11.00 $6.55 Third Quarter 16.12 8.92 Second Quarter 16.15 12.57 First Quarter 21.94 12.57 Table of ContentsCOMPARISON OF 44 MONTH CUMULATIVE TOTAL RETURN*Among Rosetta Stone Inc., the NYSE Composite Index, and SIC code 7372 index *$100 invested on 4/16/09 in stock or 3/31/09 in index, including reinvestment of dividends. Fiscal Year ending December 31.Item 6. Selected Consolidated Financial Data The following table sets forth our selected consolidated statement of operations, balance sheet and other data for the periods indicated. The selectedconsolidated statement of operations data for the years ended December 31, 2012, 2011, 2010, 2009 and 2008, and the consolidated balance sheet dataas of December 31, 2012, 2011, 2010, 2009 and 2008 have been derived from Rosetta Stone Inc. audited consolidated financial statements. Thisinformation should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and ourconsolidated36Table of Contentsfinancial statements contained elsewhere in this Annual Report on Form 10-K. Our historical results for any prior period are not necessarily indicativeof results to be expected in any future period.(1)As discussed in Note 15, the Company established a full valuation allowance to reduce the deferred tax assets of the Korea, Brazil, and Japansubsidiaries and the U.S. (2)As discussed in Note 10, on January 4, 2011 the Company's Board of Directors approved the Rosetta Stone Inc Long-Term Incentive Program Year Ended December 31, 2012(1) 2011(2) 2010 2009(3) 2008(4) (in thousands, except per share data) Statements of Operations Data: Revenue $273,241 $268,449 $258,868 $252,271 $209,380 Cost of revenue 48,910 49,116 38,999 33,427 28,676 Gross profit 224,331 219,333 219,869 218,844 180,704 Operating expenses: Sales and marketing 151,646 161,491 130,879 114,899 93,384 Research and development 23,453 24,218 23,437 26,239 18,387 General and administrative 55,262 62,031 53,239 57,182 39,577 Lease abandonment — — (583) (8) 1,831 Total operating expenses 230,361 247,740 206,972 198,312 153,179 Income (loss) from operations (6,030) (28,407) 12,897 20,532 27,525 Other income and expense: Interest income 187 302 262 159 454 Interest expense — (5) (66) (356) (891)Other (expense) income 3 142 (220) 112 239 Interest and other income (expense), net 190 439 (24) (85) (198) Income (loss) before income taxes (5,840) (27,968) 12,873 20,447 27,327 Income tax expense (benefit) 29,991 (7,980) (411) 7,084 13,435 Net income (loss) (35,831) (19,988) 13,284 13,363 13,892 Preferred stock accretion — — — — — Income (loss) attributable to common stockholders $(35,831)$(19,988)$13,284 $13,363 $13,892 Income (loss) per share attributable to common stockholders: Basic $(1.70)$(0.96)$0.65 $0.89 $7.29 Diluted $(1.70)$(0.96)$0.63 $0.67 $0.82 Common shares and equivalents outstanding: Basic weighted average shares 21,045 20,773 20,439 14,990 1,905 Diluted weighted average shares 21,045 20,773 21,187 19,930 16,924 Other Data: Stock-based compensation included in: Cost of sales $288 $55 $39 $34 $2 Sales and marketing 1,185 1,932 774 999 153 Research and development 1,547 2,448 1,181 5,959 482 General and administrative 4,989 7,918 2,393 15,158 953 Total stock-based compensation expense $8,009 $12,353 $4,387 $22,150 $1,590 Intangible amortization included in: Cost of sales $— $— $— $— $13 Sales and marketing — 45 58 42 3,003 Research and development 40 40 — — — Total intangible amortization expense $40 $85 $58 $42 $3,016 ("LTIP") and then subsequently cancelled the LTIP on November 30, 2011, resulting in $4.9 million additional operating expense. (3)In April, 2009 shares of common stock were awarded to key employees as part of the IPO resulting in $18.8 million of additional operatingexpense.37Table of Contents(4)Sales and marketing expenses include amortization expense of intangible assets related to customer relationships associated with the 2006acquisition of Fairfield & Sons, Ltd. These intangible assets were fully amortized by January 2009.Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction withour consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K. Our actual results may differmaterially from those currently anticipated and expressed in such forward-looking statements as a result of a number of factors, including thosediscussed under "Risk Factors" and elsewhere in this Annual Report on Form 10-K.Overview We are a leading provider of technology-based language-learning solutions. We develop, market, and sell language-learning solutions consisting ofsoftware, online services and audio practice tools primarily under our Rosetta Stone brand. Our teaching method, which we call Dynamic Immersion, isdesigned to leverage the innate, natural language-learning ability that children use to learn their native language. Our courses are based on ourproprietary interactive technologies and pedagogical content and utilize a sophisticated sequencing of images, text and sounds to teach a new languagewithout translation or grammar explanation. We believe our award-winning solutions provide an effective, convenient and fun way to learn languages.We currently offer our self-study language-learning solutions in over 30 languages. We derive our revenues from sales to both individual consumers and organizations. Our global consumer distribution model comprises a mix ofour call centers, websites, network of kiosks, select retail resellers, such as Amazon.com, Barnes & Noble, Best Buy, Books-a-Million, Staples andCostco, home shopping networks such as GS Home Shopping, Inc. in Korea and consignment distributors such as Navarre. Our institutionaldistribution model is focused on targeted sales activity primarily through a direct sales force in four markets: schools, colleges and universities; federalgovernment agencies; corporations; and not-for-profit organizations. The strategic plan of the management team through 2015 includes three primary areas of focus:1.leveraging the brand; 2.innovating the platform; and 3.expanding distribution. In pursuing these priorities, we plan to balance margin with growth. During 2012, we had a change in our chief operating decision maker (CODM), which led to a fourth quarter change to what our CODM uses tomeasure profitability and allocate resources. Accordingly, beginning with the fourth quarter of 2012, we have three operating segments, North AmericaConsumer, ROW Consumer and Institutional. From the first quarter of 2011 through the third38 As of December 31, 2012 2011 2010 2009 2008 (in thousands) Consolidated Balance Sheet Data: Cash and cash equivalents $148,190 $106,516 $115,756 $95,188 $30,626 Total assets 275,855 277,181 276,474 225,442 138,818 Deferred revenue 63,416 51,895 47,158 26,106 15,744 Notes payable and capital lease obligation 5 12 — — 9,910 Total stockholders' equity $144,603 $171,205 $178,316 $156,435 $79,071 Table of Contentsquarter of 2012 we had two operating segments, Consumer and Institutional. Prior to 2011 we operated as a single segment. As we focus on balancing growth and margin, we will discuss the profitability of each segment in terms of segment contribution. Segmentcontribution is the measure of profitability used by our CODM. Segment contribution includes segment revenue and expenses incurred directly by thesegment, including material costs, service costs, customer care and coaching costs, sales and marketing expense and bad debt expense. North AmericaConsumer segment contribution improved from 35% for the year ended December 31, 2011 to 41% for the year ended December 31, 2012. Theimprovement in North America Consumer segment contribution is due to an increase in revenue of $15.3 million; this achievement is consistent with thegoal established by management at the onset of 2012 to stabilize the U.S. consumer market. ROW Consumer segment contribution improved$1.8 million from the year ended December 31, 2011 to the year ended December 31, 2012 driven by a reduction in sales and marketing expense of$12.3 million, primarily the result of kiosk closures. Institutional segment contribution decreased to $25.9 million, or 43%, for the year endedDecember 31, 2012 as compared to $34.3 million, or 57%, for the year ended December 31, 2011 primarily due to an increase in sales and marketingexpense related to the addition of sales staff to this group. As our institutional sales team gains traction we anticipate an improvement in contributionmargin. For additional information regarding our segments, see Note 15 of Item 8, Financial Statements and Supplementary Data. For additionalinformation regarding fluctuations in segment revenue, see Results of Operations, below. Prior periods are presented consistent with our currentoperating segments and definition of segment contribution.Business Metrics Beginning in 2012 management used the following key business metrics to measure the success of our combined North America and ROWConsumer segments. Management does not review these metrics at a disaggregated segment level.•Product software units. A unit is a perpetual software license sold as either tangible packaged software or as an online download. •Average revenue per product software unit. Consumer revenues derived from product software units divided by the number of productsoftware units sold in the same period. Revenue from product software includes product revenue associated with product licenses inaddition to service revenues associated with short-term online subscriptions that are bundled with our V4 TOTALe offering.Approximately $36.00 to $49.00 in revenue per unit is derived from service revenues associated with this short-term online subscription.•Paid online learners. The number of paid, active learners derived from the sale of a primarily online offering as of the end of a specifiedperiod. Applicable online offerings include purchases of subscription-based licenses for Rosetta Stone TOTALe, ReFLEX subscriptions,and purchasers of our product software who subsequently purchase renewals of their short-term online services. •Average revenue per paid online learner. Service revenues derived from paid online learners for a specified period divided by theaverage number of paid online learners during the same period, adjusted to a monthly rate. The average number of paid online learnersfor a quarter is calculated as the average of the beginning and ending number of paid online learners for the specified period. The averagenumber of paid online learners for a year-to-date period is calculated as the average of the average number of paid online learners forquarters included in the specified year-to-date period.39Table of Contents The following table sets forth these unit and online learner metrics for the years ended December 31, 2012, 2011 and 2010:Product software Product software revenue includes sales of our Rosetta Stone Version 4 TOTALe product. We anticipate the mix of product units will shift fromour traditional CD-ROM product to digital downloads in future periods. There is no difference in price between the two options. Revenue from product software decreased $1.9 million from the year ended December 31, 2011 to the year ended December 31, 2012, driven by a8% decrease in the average revenue per unit, partially offset by a 8% increase in the number of units sold, compared to the prior year period. Revenuefrom product software increased $2.0 million from the year ended December 31, 2010 to the year ended December 31, 2011, driven by an 11% increasein the number of units sold offset by a 9% decrease in the average revenue per unit, compared to the prior year period. Average revenue per productsoftware unit has decreased as we have experimented with different price points and promotional offerings since the introduction of Version 4 TOTALein 2010 including distribution partnerships within the daily deals market. The increase in product software units is due to our expansion intointernational markets and decreasing price points.Paid online learners Revenue from paid online learners increased $6.9 million from the year ended December 31, 2011 to the year ended December 31, 2012, driven bya 157% increase in the number of paid online learners as of December 31, 2012, compared to the prior period. This increase was partially offset by adecrease in the average revenue per online learner due to continued testing of online products at different price points. Revenue from paid online learnersincreased $1.8 million from the year ended December 31, 2010 to the year ended December 31, 2011, driven by a 58% increase in the number of paidonline learners as of December 31, 2011, compared to the prior period.Components of Our Statement of OperationsRevenue We derive revenue from sales of language learning solutions consisting of product software, audio practice products, professional services, andonline software subscriptions. Revenue is presented as product revenue or subscription and service revenue in our consolidated financial statements.Our audio practice products are normally combined with our product software products and sold as a solution. Our professional services include training, implementation services and dedicated conversational coaching associated with Rosetta Stone TOTALe.Rosetta Stone TOTALe online, combines dedicated conversational coaching and an online software subscription. Rosetta Stone Version 4 TOTALe,which40 Year Ended December 31, 2012 2011 2010 (in thousands, except per unit amounts) Product software revenue $198,075 $199,963 $197,996 Paid online learner revenues 14,999 8,063 6,267 Total consumer revenues $213,074 $208,026 $204,263 Product software units 629,779 585,774 526,455 Total paid online learners 68,393 26,567 16,762 Average revenue per product software unit $315 $341 $376 Average revenue per online learner $26 $35 $35 Table of Contentswas released in September 2010, combines product software and dedicated conversational coaching. The content of our product software andsubscription offerings are the same. We offer our customers the ability to choose which format they prefer without differentiating the learningexperience. We bundle time-based subscription licenses of our web-based TOTALe services with perpetual licenses of our Rosetta Stone languagelearning solutions in the North America Consumer market. As a result, we typically defer 10%-35% of each of these bundled sales over the term of thesubscription license. We sell our solutions directly to individuals, educational institutions, corporations, and government agencies. We distribute our consumer productspredominantly through our direct sales channels, primarily our websites and call centers, which we refer to as our direct-to-consumer channel. We alsodistribute our consumer products through our kiosks, which we operate, as well as through select third-party retailers. The majority of our consumercustomers purchase our product software and audio practice products, online software subscriptions and professional services. We sell to institutionsprimarily through our direct institutional sales force. Many institutions elect to license our products on a subscription basis. For purposes of explainingvariances in our revenue, we separately discuss changes in our consumer and institutional sales channels because the customers and revenue drivers ofthese channels are different. Our consumer revenue is affected by seasonal trends associated with the holiday shopping season. As a result, our fourth quarter endedDecember 31, 2012 accounted for 29% of our annual revenue in 2012. Our institutional revenue is seasonally stronger in the second and third quartersof the calendar year due to education and government purchasing cycles. We expect these trends to continue.Cost of Product and Subscription and Service Revenue Cost of product revenue consists of the direct and indirect materials and labor costs to produce and distribute our products. Such costs includepackaging materials, computer headsets, freight, inventory receiving, personnel costs associated with product assembly, third-party royalty fees andinventory storage, obsolescence and shrinkage. The cost of subscription and service revenue primarily represents costs associated with supporting ouronline language learning service, which includes online language conversation coaching, hosting costs and depreciation. We also include the cost ofcredit card processing and customer technical support in both cost of product revenue and cost of subscription and service revenue. We believe cost ofrevenue will also increase, as a percentage of revenue, in future periods as a result of our launch of Rosetta Stone Version 4 TOTALe and ReFLEXsolutions in our international markets, which includes services that have higher direct costs to deliver to customers than previous versions of ourproduct. However, we are also exploring additional measures to further address coaching costs, including limiting the number of studio sessions in ourVersion 4 TOTALe offering, and unbundling such sessions from our product software offering.Operating Expenses We classify our operating expenses into three categories: sales and marketing, research and development and general and administrative. Our operating expenses primarily consist of personnel costs, direct advertising and marketing expenses and professional fees associated withcontract product development, legal, accounting and consulting. Personnel costs for each category of operating expenses include salaries, bonuses,stock-based compensation and employee benefit costs. Sales and Marketing. Our sales and marketing expenses consist primarily of direct advertising expenses related to television, print, radio, onlineand other direct marketing activities, personnel costs for our sales and marketing staff, rental payments for our kiosks and commissions paid to our salespersonnel. We intend to continue to expand our sales activities within some of our existing regions as well as to expand our presence into newcountries, in addition to expanding our media and advertising41Table of Contentscampaigns in the United States. As part of business assessment in 2012, we are evaluating the profitability and potential of each existing and newmarket. As a result of this process, we consolidated our European presence to the London office and closed the German office in June 2012. We expectsales and marketing expenses to continue to increase in future periods as we seek to stabilize and expand our operations in existing and new markets. Research and Development. Research and development expenses consist primarily of personnel costs and contract development fees associatedwith the development of our solutions. Our development efforts are primarily based in the United States and are devoted to modifying and expandingour product portfolio through the addition of new content and new complementary products and services to our language learning solutions. We expectour investment in research and development expenses to increase in future years as we restructure operations to optimize research and developmentinitiatives and deliver new products that will provide us with significant benefits in the future. General and Administrative. General and administrative expenses consist primarily of personnel costs of our executive, finance, legal, humanresources and other administrative personnel, as well as accounting and legal professional services fees and other corporate expenses. In 2012, therehave been and we expect that there will continue to be increases to certain general and administrative expenses to support our expansion intointernational markets. However, we are also taking steps to reduce certain general and administrative expenses as we realign our cost structure to helpfund investment in areas of growth.Interest and Other Income (Expense) Interest and other income (expense) primarily consist of interest income, interest expense, foreign exchange gains and losses, and income fromlitigation settlements. Interest expense is primarily related to interest on our capital leases. Interest income represents interest received on our cash, cashequivalents, and short-term investments. Fluctuations in foreign currency exchange rates in our foreign subsidiaries cause foreign exchange gains andlosses. Legal settlements are related to agreed upon settlement payments from various anti-piracy enforcement efforts.Income Tax Expense (Benefit) Income tax expense (benefit) consists of federal, state and foreign income taxes. For the year ended December 31, 2012, our worldwide effectivetax rate was approximately 514%. The income tax expense in 2012 was primarily due to an increase in the valuation allowance of $29.9 million relatingto operations in the U.S. and certain foreign jurisdictions. We regularly evaluate the recoverability of our deferred tax assets and establish a valuation allowance, if necessary, to reduce the deferred taxassets to an amount that is more likely than not to be realized (a likelihood of more than 50 percent). Significant judgment is required to determinewhether a valuation allowance is necessary and the amount of such valuation allowance, if appropriate. When assessing the realization of our deferred tax assets, we consider all available evidence, including:•the nature, frequency, and severity of cumulative financial reporting losses in recent years; •the carryforward periods for the net operating loss, capital loss, and foreign tax credit carryforwards; •predictability of future operating profitability of the character necessary to realize the asset;42Table of Contents•prudent and feasible tax planning strategies that would be implemented, if necessary, to protect against the loss of the deferred tax assets;and •the effect of reversing taxable temporary differences. The evaluation of the recoverability of the deferred tax assets requires that we weigh all positive and negative evidence to reach a conclusion that itis more likely than not that all or some portion of the deferred tax assets will not be realized. The weight given to the evidence is commensurate with theextent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it isto support a conclusion that a valuation allowance is not needed. The analysis of the need for a valuation allowance on U.S. deferred tax assets as of December 31, 2012 considers our cumulative loss over ourthree-year evaluation period. Consideration has also been given to the steps taken by new leadership to enhance profitability by cutting costs, the factthat through December 31, 2012 we were ahead of forecast at the beginning of the year, the lengthy period over which these net deferred assets can berealized, and our history of not having tax loss carryforwards in any jurisdiction expire unused. Because historical cumulative losses carry significantlymore weight than other evidence when evaluating a deferred tax assets and because the significant losses incurred, primarily in 2011 will continue to beincluded in the cumulative analysis for the next several quarters, we have concluded the cumulative negative evidence of losses outweighs the positiveevidence. As a result we have concluded that the valuation allowance established as of September 30, 2012 for the U.S. deferred tax assets remained atDecember 31, 2012. The analysis of the need for a valuation allowance on Brazil deferred tax assets as of December 31, 2012 considers that while we anticipate futuretaxable income in Brazil, and there is no expiration period for net operating loss carryforwards, the recovery of the carryforwards is limited to a portionof taxable income each year making the length of time to recover the asset difficult to predict. We have established a valuation allowance as ofDecember 31, 2012. The analysis of the need for a valuation allowance on Japan deferred tax assets as of December 31, 2012 considers anticipated future taxableincome in Japan against evidence of recent losses and the expectation that the Japan subsidiary will be in a three-year cumulative loss with no ability tocarryback net operating losses and limited time to utilize net operating loss carryforwards. We have concluded that a full valuation allowance to reducethe deferred tax assets of the Japan subsidiary should be recorded and we have established a valuation allowance as of December 31, 2012. Our evaluation of the Korea subsidiary as of December 31, 2012 has resulted in no change to our assessment from June 30, 2012, and thevaluation allowance established as of June 30, 2012 remains the same at December 31, 2012. Our evaluation of the remaining jurisdictions as of December 31, 2012 resulted in the determination that no valuation allowances were necessary atthis time. However, we will continue to assess the need for a valuation allowance against its deferred tax assets. The establishment of a valuation allowance has no effect on the ability to use the deferred tax assets in the future to reduce cash tax payments. Wewill continue to assess the likelihood that the deferred tax assets will be realizable at each reporting period, and the valuation allowance will be adjustedaccordingly, which could materially affect our financial position and results of operations.Critical Accounting Policies and Estimates In presenting our financial statements in conformity with accounting principles generally accepted in the U.S., we are required to make estimatesand assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures.43Table of Contents Some of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. Webase these estimates and assumptions on historical experience or on various other factors that we believe to be reasonable and appropriate under thecircumstances. On an ongoing basis, we reconsider and evaluate our estimates and assumptions. Our future estimates may change if the underlyingassumptions change. Actual results may differ significantly from these estimates. We believe that the critical accounting policies listed below involve our more significant judgments, assumptions and estimates and, therefore,could have the greatest potential impact on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessaryto understand and evaluate the consolidated financial statements contained in this annual report on Form 10-K.Revenue Recognition Our primary products include Rosetta Stone TOTALe online and Rosetta Stone Version 4 TOTALe. Rosetta Stone TOTALe online combines anonline software subscription with conversational coaching and is available in a selection of time-based offers (e.g. three, six and 12 months durations).Version 4 TOTALe includes a TOTALe online subscription bundled with perpetual software available as a CD-ROM or download. Rosetta StoneTOTALe online was released in July 2009 and Rosetta Stone Version 4 TOTALe was released in September 2010. We also derive revenue from the saleof audio practice products and professional services, which include training and implementation services. Revenue is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered orservices have been rendered; the fee is fixed or determinable; and collectability is reasonably assured. Revenues are recorded net of discounts. Werecognize revenue for software products and related services in accordance with Accounting Standards Codification subtopic 985-605, Software:Revenue Recognition ("ASC 985-605"). For multi-element arrangements that include TOTALe online subscriptions bundled with auxiliary items, such as headsets and audio practiceproducts which provide stand-alone value to the customer, we allocate revenue to all deliverables based on their relative selling prices in accordance withAccounting Standard Codification (ASC) subtopic 605-25—Revenue Recognition—Multiple-Element Arrangements ("ASC 605-25"). We haveidentified two deliverables generally contained in sales of Rosetta Stone TOTALe online software subscriptions. The first deliverable is the auxiliaryitems, which are delivered at the time of sale, and the second deliverable is the online services. For Rosetta Stone Version 4 TOTALe, which is a multi-element arrangement that includes perpetual software bundled with the subscription andconversational coaching components of our TOTALe online service, we allocate revenue to all deliverables based on vendor-specific objective evidenceof fair value, or VSOE, in accordance with ASC subtopic 985-605-25 Software: Revenue Recognition—Multiple-Element Arrangements ("ASC 985-605-25"). We have identified two deliverables generally contained in Rosetta Stone V4 TOTALe software arrangements. The first deliverable is theperpetual software, which is delivered at the time of sale, and the second deliverable is the subscription service. We allocate revenue between these twodeliverables using the residual method based on the existence of VSOE of the subscription service. Revenue for online service subscriptions including conversational coaching is recognized ratably over the term of the subscription period,assuming all revenue recognition criteria have been met, which typically range from three months to 15 months. Rosetta Stone Version 4 TOTALebundles, which include an online service subscription including conversational coaching and packaged software, allow customers to begin their onlineservices at any point during a registration window, which is up to six months from the date of purchase from us or an authorized reseller. Online servicesubscriptions that are not activated during this registration window are forfeited and revenue is recognized upon44Table of Contentsexpiry. Some online licensing arrangements include a specified number of licenses that can be activated over a period of time, which typically rangesbetween six and 24 months. Revenue for these arrangements is recognized on a per license basis ratably over the term of the individual licensesubscription period, assuming all revenue recognition criteria have been met, which typically ranges between three and 12 months. Revenue for set-upfees related to online licensing arrangements is recognized ratably over the term of the online licensing arrangement, assuming all revenue recognitioncriteria have been met. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding subscription agreement. Software products include sales to end user customers and resellers. In most cases, revenue from sales to resellers is not contingent upon resale ofthe software to the end user and is recorded in the same manner as all other product sales. Revenue from sales of packaged software products and audiopractice products is recognized as the products are shipped and title passes and risks of loss have been transferred. For most of our product sales, thesecriteria are met at the time the product is shipped. For some sales to resellers and certain other sales, we defer revenue until the customer receives theproduct because we legally retain a portion of the risk of loss on these sales during transit. A limited amount of packaged software products are sold toresellers on a consignment basis. Revenue is recognized for these consignment transactions once the end user sale has occurred, assuming the remainingrevenue recognition criteria have been met. In accordance with Accounting Standards Codification subtopic 985-605-50, Software: RevenueRecognition: Customer Payments and Incentives ("ASC 985-605-50"), price protection for changes in the manufacturer suggested retail value grantedto resellers for the inventory that they have on hand at the date the price protection is offered is recorded as a reduction to revenue. In accordance withASC 985-605-50, cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identified benefit is identified and thefair value is reasonably determinable. We offer customers the ability to make payments for packaged software purchases in installments over a period of time, which typically rangesbetween three and five months. Given that these installment payment plans are for periods less than 12 months and a successful collection history hasbeen established, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met. Packaged software isprovided to customers who purchase directly from our company with up to a six month right of return. We also allow our retailers to return unsoldproducts, subject to some limitations. In accordance with Accounting Standards Codification subtopic 985-605-15, Software: Revenue Recognition:Products ("ASC 985-605-15"), product revenue is reduced for estimated returns, which are based on historical return rates. In connection with packaged software product sales and online software subscriptions, technical support is provided to customers, includingcustomers of resellers, via telephone support at no additional cost for up to six months from the time of purchase. As the fee for technical support isincluded in the initial licensing fee, the technical support and services are generally provided within one year, the estimated cost of providing suchsupport is deemed insignificant and no unspecified upgrades/enhancements are offered, technical support revenues are recognized together with thesoftware product and license revenue. Costs associated with the technical support are accrued at the time of sale. We have been engaged to develop language-learning software for certain endangered languages under fixed-fee arrangements. These arrangementsalso include contractual periods of post-contract support ("PCS") and online hosting services ranging from one to ten years. Revenue for multi-elementcontracts are recognized ratably once the PCS and online hosting periods begin, over the longer of the PCS or online hosting period. When the currentestimates of total contract revenue and contract cost indicate a loss for a fixed fee arrangement, a provision for the entire loss on the contract is recorded.45Table of ContentsStock-Based Compensation We account for stock-based compensation in accordance Accounting Standards Codification topic 718, Compensation—Stock Compensation("ASC 718"). Under ASC 718, all stock-based awards, including employee stock option grants, are recorded at fair value as of the grant date andrecognized as expense in the statement of operations on a straight-line basis over the requisite service period, which is the vesting period. As of December 31, 2012 and 2011, there were approximately $6.8 million and $7.9 million of unrecognized stock-based compensation expenserelated to non-vested stock option awards that are expected to be recognized over a weighted average period of 2.52 and 2.67 years, respectively. The following table presents the stock-based compensation expense for stock options and restricted stock included in the related financial statementline items (in thousands): In accordance with ASC topic 718, the fair value of stock-based awards to employees is calculated as of the date of grant. Compensation expenseis then recognized on a straight-line basis over the requisite service period of the award. We use the Black-Scholes pricing model to value our stockoptions, which requires the use of estimates, including future stock price volatility, expected term and forfeitures. Stock-based compensation expenserecognized is based on the estimated portion of the awards that are expected to vest. Estimated forfeiture rates were applied in the expense calculation.The fair value of each option grant is estimated on the date of grant using the Black Scholes option pricing model as follows: Prior to the completion of our initial public offering in April 2009, our stock was not publicly quoted and we had a limited history of stock optionactivity, so we reviewed a group of comparable industry-related companies to estimate our expected volatility over the most recent period commensuratewith the estimated expected term of the awards. In addition to analyzing data from the peer group, we also considered the contractual option term andvesting period when determining the expected option life and forfeiture rate. Subsequent to the initial public offering, we continue to review a group ofcomparable industry-related companies to estimate volatility, but also review the volatility of46 Years Ended December 31, 2012 2011 2010 Included in cost of revenue: Cost of product revenue $110 $30 $25 Cost of subscription and service revenue 178 25 14 Total included in cost of revenue 288 55 39 Included in operating expenses: Sales and marketing 1,185 1,932 774 Research and development 1,547 2,448 1,181 General and administrative 4,989 7,918 2,393 Total included in operating expenses 7,721 12,298 4,348 Total $8,009 $12,353 $4,387 Year Ended December 31, 2012 2011 2010Expected stock price volatility 64% to 66% 57%-64% 58%-66%Expected term of options 6 years 6 years 6 yearsExpected dividend yield — — —Risk-free interest rate 0.60%-0.88% 1.14%-2.59% 1.14%-2.59%Table of Contentsour own stock since the initial public offering. We consider the volatility of the comparable companies to be the best estimate of future volatility. For therisk-free interest rate, we use a U.S. Treasury Bond rate consistent with the estimated expected term of the option award. The following table sets forth a summary of stock option grants since the date of plan inception, through the date of this Annual Report onForm 10-K:Accounts Receivable and Allowance for Doubtful Accounts Accounts receivable consist of amounts due to us from our normal business activities. We provide an allowance for doubtful accounts to reflect theexpected non-collection of accounts receivable based on past collection history and specific risks identified.Goodwill The value of goodwill is primarily derived from the acquisition of Rosetta Stone Ltd. (formerly known as Fairfield & Sons, Ltd.) in January 2006and the acquisition of certain assets of SGLC International Co. Ltd ("SGLC") in November 2009. We test goodwill for impairment annually on June 30of each year at the reporting unit level using a fair value approach, in accordance with the provisions of Accounting Standards Codification topic 350,Intangibles—Goodwill and Other ("ASC 350") or more frequently, if impairment indicators arise. Goodwill impairment is tested using a two-stepprocess that begins with an estimation of the fair value of each reporting unit. The first step is a screen for potential impairment by comparing the fairvalue of a reporting unit with its carrying amount. The second step measures the amount of impairment loss, if any, by comparing the implied fair valueof the reporting unit goodwill with its carrying amount. In estimating the fair value of our reporting units in Step 1, we use a variety of techniques including the income approach (i.e., the discounted cashflow method) and the market approach (i.e., the guideline public company method). Our adjusted EBITDA projections are estimates that cansignificantly affect the outcome of the analysis, both in terms of our ability to accurately project future results and in the allocation of fair value betweenreporting units. The fair value of the Institutional reporting unit exceeded its carrying value by 53% at June 30, 2012. The fair value of our Consumerreporting unit exceeded its carrying value by 50% at June 30, 2012. Beginning in the fourth quarter of 2012, we began reporting our results in three reportable segments, which resulted in three reporting units forgoodwill impairment purposes—North America Consumer, ROW Consumer, and Institutional. Accordingly, we allocated goodwill from our formerConsumer reporting unit to the new reporting units, North America Consumer and ROW Consumer, based on the relative fair value of each reportingunit as of October 31, 2012. In doing so, we evaluated the results of the allocation of goodwill for events or indicators that would require furtherimpairment testing, noting none.47Grant Date Number ofOptions Granted Exercise Price Common StockFair ValuePer Shareat GrantDate2006 1,704,950 $3.85-$3.85 $4.57-$5.922007 436,254 3.85-11.19 6.35-11.302008 402,805 10.36-17.49 10.36-17.492009 472,589 16.74-22.30 16.74-22.302010 593,017 17.10-25.99 17.10-25.992011 698,327 6.88-20.91 6.88-20.912012 662,856 7.51-13.89 7.51-13.89Table of Contents The factors that we consider important, and which could trigger an impairment review, include, but are not limited to: a significant decline in themarket value of our common stock for a sustained period; a material adverse change in economic, financial market, industry or sector trends; a materialfailure to achieve operating results relative to historical levels or projected future levels; and significant changes in operations or business strategy.Although no such indicators occurred during 2012, we will continue to review for impairment indicators.Intangible Assets Intangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and trademark andother intangible assets. Those intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives inaccordance with ASC topic 350, Goodwill and Other Intangible Assets ("ASC 350"). On an annual basis, or more frequently if events or changes incircumstances indicate that the assets might be impaired, we review our indefinite lived intangible assets for impairment based on the fair value ofindefinite lived intangible assets as compared to the carrying value in accordance with ASC 350. In the event the carrying value exceeds the fair value ofthe assets, the assets are written down to their fair value. There has been no impairment of intangible assets during any of the periods presented.Valuation of Long-Lived Assets In accordance with Accounting Standards Codification topic 360, Accounting for the Impairment or Disposal of Long-lived Assets ("ASC 360"),we evaluate the recoverability of our long-lived assets. ASC 360 requires recognition of impairment of long-lived assets in the event that the net bookvalue of such assets exceeds the future undiscounted net cash flows attributable to such assets. Impairment, if any, is recognized in the period ofidentification to the extent the carrying amount of an asset exceeds the fair value of such asset. Based on our analysis, we believe that no impairment ofour long-lived assets was indicated as of December 31, 2012 and 2011.Income Taxes We believe that the accounting estimate for the realization of deferred tax assets is a critical accounting estimate because judgment is required inassessing the likely future tax consequences of events that have been recognized in our financial statements or tax returns. Although it is possible therewill be changes that are not anticipated in our current estimates, we believe it is unlikely such changes would have a material period-to-period impact onour financial position or results of operations. We account for income taxes in accordance with Accounting Standards Codification topic 740, Income Taxes ("ASC 740"), which provides for anasset and liability approach to accounting for income taxes. Deferred tax assets and liabilities represent the future tax consequences of the differencesbetween the financial statement carrying amounts of assets and liabilities versus the tax bases of assets and liabilities. Under this method, deferred taxassets are recognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred tax liabilities are recognized fortaxable temporary differences. ASC 740 requires a reduction of the carrying amounts of deferred tax assets by a valuation allowance if, based on available evidence, it is morelikely than not that such assets will not be realized. Accordingly, the need to establish valuation allowances for deferred tax assets is assessed quarterlybased on the ASC 740 more-likely-than-not ("MLTN") realization threshold criterion. In the assessment, appropriate consideration is given to allpositive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequencyand severity of current and cumulative losses, forecasts of future profitability, the duration of48Table of Contentsstatutory carryforward periods, our experience with operating loss and tax credit carryforwards not expiring unused, and tax planning alternatives.Significant judgment is required to determine whether a valuation allowance is necessary and the amount of such valuation allowance, if appropriate.The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidence exists to support a reversal. When assessing the realization of our deferred tax assets, we consider all available evidence, including:•the nature, frequency, and severity of cumulative financial reporting losses in recent years; •the carryforward periods for the net operating loss, capital loss, and foreign tax credit carryforwards; •predictability of future operating profitability of the character necessary to realize the asset; •prudent and feasible tax planning strategies that would be implemented, if necessary, to protect against the loss of the deferred tax assets;and •the effect of reversing taxable temporary differences. The evaluation of the recoverability of the deferred tax assets requires that we weigh all positive and negative evidence to reach a conclusion that itis more likely than not that all or some portion of the deferred tax assets will not be realized. The weight given to the evidence is commensurate with theextent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it isto support a conclusion that a valuation allowance is not needed. The establishment of a valuation allowance has no effect on the ability to use the deferred tax assets in the future to reduce cash tax payments. Wewill continue to assess the likelihood that the deferred tax assets will be realizable at each reporting period and the valuation allowance will be adjustedaccordingly, which could materially affect our financial position and results of operations. As of December 31, 2012, our net deferred tax liability was $8.1 million compared to a net deferred tax assets of $19.0 million as of December 31,2011. During the second and third quarters of 2012, we established a valuation allowance offsetting certain deferred tax assets which resulted in a non-cash charge in those periods of $26.0 million. Because evidence such as the Company's operating results during the most recent three-year period isafforded more weight than forecasted results for future periods, the Company's cumulative loss in the U.S. and certain foreign jurisdictions representssignificant negative evidence in the determination of whether deferred tax assets are more likely than not to be utilized in certain jurisdictions. Thisdetermination resulted in the need for a valuation allowance on the deferred tax assets of certain jurisdictions. We will release this valuation allowance ifand when it is determined that it is more likely than not that our deferred tax assets will be realized. Any future release of valuation allowance may berecorded as a tax benefit increasing net income in the period of release. See additional discussion by jurisdiction below. The analysis of the need for a valuation allowance on U.S. deferred tax assets as of December 31, 2012 considers our cumulative loss over ourthree-year evaluation period. Consideration has also been given to the steps taken by new leadership to enhance profitability by cutting costs, the factthat through December 31, 2012 we were ahead of forecast at the beginning of the year, the lengthy period over which these net deferred assets can berealized, and our history of not having tax loss carryforwards in any jurisdiction expire unused. Because historical cumulative losses carry significantlymore weight than other evidence when evaluating a deferred tax assets and because the significant losses incurred, primarily in 2011 will continue to beincluded in the cumulative analysis for the next several quarters, we have concluded the cumulative losses outweigh the positive evidence. As a result49Table of Contentswe have concluded that the valuation allowance established as of September 30, 2012 for the U.S. deferred tax assets remained at December 31, 2012. The analysis of the need for a valuation allowance on Brazil deferred tax assets as of December 31, 2012 considers that while we anticipate futuretaxable income in Brazil, and there is no expiration period for net operating loss carryforwards, the recovery of the carryforwards is limited to a portionof taxable income each year making the length of time to recover the asset difficult to predict. As a result we have concluded that the valuation allowanceestablished as of September 30, 2012 for the Brazil deferred tax assets remained at December 31, 2012. The analysis of the need for a valuation allowance on Japan deferred tax assets as of December 31, 2012 considers anticipated future taxableincome in Japan against evidence of recent losses and the expectation that the Japan subsidiary will be in a three-year cumulative loss with no ability tocarryback net operating losses and limited time to utilize net operating loss carryforwards. As a result we have concluded that the valuation allowanceestablished as of September 30, 2012 for the Japan deferred tax assets remained at December 31, 2012. Our evaluation of the Korea subsidiary as of December 31, 2012 has resulted in no change to our assessment from June 30, 2012, and thevaluation allowance established as of June 30, 2012 remained at December 31, 2012. Our evaluation of the remaining jurisdictions as of December 31, 2012 resulted in the determination that no valuation allowances were necessary atthis time. However, we will continue to assess the need for a valuation allowance against its deferred tax assets in the future. In 2010, we recognized a tax benefit of $2.4 million due to the release of the valuation allowance on deferred tax assets of non-U.S. subsidiarieswhich we believe are more likely than not to be realized. Our effective income tax rate in 2010 benefited from the availability of previously unrealizeddeferred tax assets which we utilized to reduce tax expense for United Kingdom and Japanese income tax purposes. A MLTN assessment of deferredtax assets is required on a jurisdiction by jurisdiction basis. Historical operating income and continuing projected income represented sufficient positiveevidence that we used to conclude that it is more likely than not that our deferred tax assets will be realized and accordingly, a release of our valuationallowance was recorded in the fourth quarter of 2010.50Table of ContentsResults of Operations The following table sets forth our consolidated statement of operations for the periods indicated.51 Year Ended December 31, 2012 2011 2010 (in thousands, except per share data) Statements of Operations Data: Revenue Product $180,919 $195,382 $215,590 Subscription and service 92,322 73,067 43,278 Total Revenue 273,241 268,449 258,868 Cost of revenue Cost of product revenue 33,684 36,497 32,549 Cost of subscription and service revenue 15,226 12,619 6,450 Total cost of revenue 48,910 49,116 38,999 Gross profit 224,331 219,333 219,869 Operating expenses: Sales and marketing 151,646 161,491 130,879 Research and development 23,453 24,218 23,437 General and administrative 55,262 62,031 53,239 Lease abandonment — — (583) Total operating expenses 230,361 247,740 206,972 Income (loss) from operations (6,030) (28,407) 12,897 Other income and expense: Interest income 187 302 262 Interest expense — (5) (66)Other (expense) income 3 142 (220) Interest and other income (expense), net 190 439 (24) Income (loss) before income taxes (5,840) (27,968) 12,873 Income tax expense (benefit) 29,991 (7,980) (411) Net income (loss) (35,831) (19,988) 13,284 Income (loss) per share: Basic $(1.70)$(0.96)$0.65 Diluted $(1.70)$(0.96)$0.63 Common shares and equivalents outstanding: Basic weighted average shares 21,045 20,773 20,439 Diluted weighted average shares 21,045 20,773 21,187 Stock-based compensation included in: Cost of sales $288 $55 $39 Sales and marketing 1,185 1,932 774 Research and development 1,547 2,448 1,181 General and administrative 4,989 7,918 2,393 $8,009 $12,353 $4,387 Table of ContentsComparison of the Year Ended December 31, 2012 and the Year Ended December 31, 2011 Our revenue increased to $273.2 million for the year ended December 31, 2012 from $268.4 million for the year ended December 31, 2011. Thechange in revenue is due to an increase in North American Consumer revenues of $15.3 million, partially offset by a $10.2 million decrease in ROWConsumer revenue, over the prior year period. Worldwide Institutional revenues decreased $0.3 million over the same period, driven by a decline in ourgovernment channel which was offset by growth in corporate revenues. Bookings, calculated as revenue plus the change in deferred revenue, increasedto $284.8 million for the year ended December 31, 2012 from $273.2 million for the year ended December 31, 2011. The increase was due to a$21.8 million increase in North America Consumer bookings, partially offset by a $12.8 decrease in ROW Consumer bookings. Additionally,worldwide Institutional bookings increased $2.6 million compared to the prior year period. We reported an operating loss of $6.0 million for the year ended December 31, 2012 compared to an operating loss of $28.4 million for the yearended December 31, 2011. The decrease in operating loss was primarily due to a decrease in operating expenses of $17.4 million and an increase ingross margin of $5.0 million. The decrease in operating expenses was primarily related to a decrease of $12.3 million in kiosk related expenses as thenumber of worldwide kiosks decreased from 174 as of December 31, 2011 to 87 as of December 31, 2012 and $8.2 million decrease in media andmarketing activities related to prior year brand identity campaigns and Version 4 TOTALe launches in the U.K., Japan and Korea, as well as ReFLEX inKorea and Japan. These decreases were offset by a $1.9 million increase in restructuring and other related expenses including severance expense in theU.S., the closing of our Germany office location, and the closing of several kiosks in Japan, a $0.6 million increase in VAT tax related to a change inour transfer pricing agreements, and $0.6 million increase in non-kiosk payroll expenses primarily related to sales and marketing.Revenue by Operating Segment The following table sets forth revenue for each of our three operating segments for the years ended December 31, 2012 and 2011: North America Consumer revenue increased $15.3 million, or 10%, from the year ended December 31, 2011 to the year ended December 31,2012, the result of increases in revenue from our retail and direct-to-consumer sales channels of $12.5 million and $11.4 million, respectively, offset bya reduction of $8.7 million in revenue from our kiosk sales channel. During 2012 we used aggressive promotions in our retail and direct-to-consumerchannels, including several promotions within the daily deals market. The number of kiosks within North America decreased from 103 at December 31,2011 to 57 at December 31, 2012, driving the decrease in revenue from this channel. North America Consumer bookings, calculated as North AmericaConsumer revenue plus the change in North America consumer deferred revenue, increased to $179.2 million for the year ended December 31, 2012from $157.4 million for the year ended December 31, 2011. The increase in North America Consumer bookings was driven by higher sales volume onlower prices. ROW Consumer revenue decreased $10.2 million, or 20%, from the year ended December 31, 2011 to the year ended December 31, 2012. ROWConsumer revenue decreased $4.2 million,52 Year ended December 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages) North America Consumer $172,826 63.3%$157,562 58.7%$15,264 9.7%Rest of World Consumer 40,248 14.7% 50,465 18.8% (10,217) -20.2%Institutional 60,167 22.0% 60,422 22.5% (255) -0.4% Total Revenue $273,241 100.0%$268,449 100.0%$4,792 1.8% Table of Contents$3.7 million and $1.6 million in Japan, Germany and the UK, respectively. ROW Consumer bookings, calculated as ROW Consumer revenue plus thechange in ROW Consumer deferred revenue, decreased to $41.2 million for the year ended December 31, 2012 from $54.0 million for the year endedDecember 31, 2011. Bookings decreased $5.6 million, $3.1 million, $2.4 million and $1.7 million in Japan, Germany, Korea and the UK, respectively.During 2012 we experienced a decrease in revenue and bookings across all consumer channels in Japan. In response to the softness in the Japanconsumer sales we relocated the head of our consumer businesses to this country, strengthened our local management and sales team and entered intonew retail distribution agreements. In Germany the decrease in revenue and bookings is the result of no longer selling box product, closing all kiosklocations, and shifting to an online, subscription-only product. The decline in revenue and bookings in the UK is also due to a decrease in units sold andprice points. Institutional revenue decreased $0.3 million from the year ended December 31, 2011 to the year ended December 31, 2012. Despite the non-renewal of the U.S. Army and U.S. Marine Corps contracts in 2011 which resulted in a $4.4 million decrease in revenue for the year endedDecember 31, 2012, Institutional revenue remained stable year-over-year, primarily driven by a $5.0 million increase in corporate revenues.International institutional revenues increased $2.7 million, or 49%, during the year ended December 31, 2012 compared to the prior year period, drivenby increases in the UK, Korea, and South America. Institutional bookings, calculated as institutional revenue plus the change in institutional deferredrevenue, increased to $64.4 million for the year ended December 31, 2012 from $61.8 million for the year ended December 31, 2011. The increase wasdriven by growth in corporate and non-profit sales, partially offset by declines in our government and education channels. We have recently addedsenior sales executives and sales representatives to this group to allow greater focus on growing this segment of the business.Revenue by Product Revenue and Subscription and Service Revenue We categorize and report our revenue in two categories—product revenue and subscription and service revenue. Product revenue includesrevenues allocated to the software product from sales of Rosetta Stone Version 4 TOTALe and revenues from the sale of audio practice products.Subscription and service revenue includes revenues allocated to time-based subscription licenses of our web-based TOTALe services, as well asrevenues from training and professional services. We began bundling time-based subscription licenses of our web-based TOTALe services with product licenses of our Rosetta Stone Version 3language-learning solutions in the U.S. consumer market during the third quarter of 2010, in Japan during the first quarter of 2011, in the UnitedKingdom during the second quarter of 2011, and in Korea during the third quarter of 2011, with the launch of Rosetta Stone Version 4 TOTALe. As aresult, we typically defer 10%-35% of the revenue of each of these bundled sales. We will recognize the deferred revenue over the term of thesubscription license in accordance with Accounting Standards Codification subtopic 985-605, Software: Revenue Recognition. The following table sets forth revenue for products and subscription and services for the year ended December 31, 2012 and 2011:53 Year ended December 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages) Product revenue $180,919 66.2%$195,382 72.8%$(14,463) -7.4%Subscription and servicerevenue 92,322 33.8% 73,067 27.2% 19,255 26.4% Total revenue $273,241 100.0%$268,449 100.0%$4,792 1.8% Table of ContentsProduct Revenue Product revenue decreased $14.5 million to $180.9 million during the year ended December 31, 2012 from $195.4 million during the year endedDecember 31, 2011. The decrease in product revenue is caused by a $4.9 million decrease in Institutional product revenues as a result of a shift fromsales of product licenses to sales of renewing online subscriptions as well as due to a decline in Federal stimulus funding which drove sales of ournetwork CD product. Consumer product revenue decreased $9.6 million driven by lower prices on our Rosetta Stone Version 4 TOTALe productsoftware bundle.Subscription and Service Revenue Subscription and service revenue increased $19.3 million, or 26%, to $92.3 million for the year ended December 31, 2012. The increase insubscription and service revenues was due to a $14.6 million increase in consumer online service revenue related to Version 4 TOTALe as well as agrowing base of exclusively online subscription sales. Institutional subscription and service revenues also increased $4.6 million related to growth in theinstitutional customer base with renewing online subscriptions. We are currently evaluating changes to our products. If we implement additional subscription-based services, it could result in lower revenues overthe next twelve months as revenues would be spread over the subscription period. There was an $11.5 million increase in deferred revenue during theyear ended December 31, 2012, which is primarily related to increased sales of exclusively online subscriptions. In particular, we sold $0.8 million ofonline subscription products to Barnes & Noble, as part of our strategy to expand our offerings of online subscription services.Cost of Product Revenue and Subscription and Service Revenue and Gross Profit The following table sets forth cost of product revenue and subscription and service revenue, as well as gross profit for the years endedDecember 31, 2012 and 2011:Cost of Product Revenue Cost of product revenue for the year ended December 31, 2012 was $33.7 million, a decrease of $2.8 million, or 8% from the year endedDecember 31, 2011. As a percentage of product revenue, cost of product revenue remained at 19% for the year ended December 31, 2012 compared tothe prior year period. The dollar decrease in cost was primarily attributable to a $0.7 million decrease in inventory obsolescence and scrap associatedwith the international Version 4 TOTALe launches in the prior year period as well as a $2.2 million decrease in our hard product inventory costs. We areexploring the possibility of moving more of our business online, which should reduce the cost of product revenue as we produce and ship fewer CDs.However, in that scenario, we could experience a54 Year EndedDecember 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages) Revenue Product $180,919 $195,382 $(14,463) -7.4%Subscription and service 92,322 73,067 19,255 26.4% Total revenue 273,241 268,449 4,792 1.8%Cost of revenue Cost of product revenue 33,684 36,497 (2,813) -7.7%Cost of subscription and service revenue 15,226 12,619 2,607 20.7% Total cost of revenue 48,910 49,116 (206) -0.4% Gross profit $224,331 $219,333 $4,998 2.3% Gross margin percentages 82.1% 81.7% 0.4% Table of Contentstemporary increase in the cost of our product revenue as we scrap existing packaging and develop and set up packaging for new products.Cost of Subscription and Service Revenue Cost of subscription and service revenue for the year ended December 31, 2012 was $15.2 million, an increase of $2.6 million, or 21% from theyear ended December 31, 2011. As a percentage of subscription and service revenue, cost of subscription and service revenue remained at 17% for theyear ended December 31, 2012 compared to the prior year period. The increase in cost was primarily attributable to an increase in paid onlinesubscribers. Our web-based service offerings in our Version 4 TOTALe and ReFLEX products include a component of dedicated online languageconversation coaching and higher direct costs to deliver to customers than our previous software solutions. This increase in costs includes a $1.8 millionincrease in product support activities including personnel-related costs and third-party expenses for coaches, product support, and success agents. Weexpect our cost of subscription and service revenue will increase in future periods, as a percent of revenue, associated with the launch of our Version 4TOTALe and ReFLEX solutions in our international markets. However, we took additional measures to further address coaching costs in the fourthquarter of 2012, capping the number of studio sessions compared to our former unlimited policy.Operating ExpensesSales and Marketing Expenses Sales and marketing expenses for the year ended December 31, 2012 were $151.6 million, a decrease of $9.9 million, or 6%, from the year endedDecember 31, 2011. As a percentage of total revenue, sales and marketing expenses were 55% for the year ended December 31, 2012, compared to60% for the year ended December 31, 2011. The dollar and percentage decreases in sales and marketing expenses were primarily attributable to ourefforts to continually evaluate our kiosk performance and closing underperforming kiosk locations. As of December 31, 2012 we operated 87 kiosksworldwide, a decrease from 174, or 50% from the year ended December 31, 2011. As a result, kiosk-related expenses decreased $12.3 millionincluding rent, commissions, and personnel costs. Additionally, media and marketing activities have decreased $8.3 million primarily related to theincrease in prior year expenses from advertising campaigns launched last year, as well as increased media in 2011 with the launch of Version 4TOTALe in the U.K., Japan, and Korea, and ReFLEX in Korea. These decreases were partially offset by a $4.5 million increase in non-kiosk relatedpersonnel-related expenses related to growth in our institutional sales channel, non-kiosk consumer, and marketing and sales support activities, andbonus compensation as a result of our improved financial performance year over year. Additionally, professional services expenses increased$4.7 million primarily related to institutional sales and customer success projects as well as web consulting services. We plan to continually evaluate ourkiosk performance as we balance the positive branding with the profitability of our kiosk locations, closing additional underperforming kiosk locations.55 Year endedDecember 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages) Sales and marketing $151,646 $161,491 $(9,845) -6.1%Research and development 23,453 24,218 (765) -3.2%General and administrative 55,262 62,031 (6,769) -10.9% Total operating expenses $230,361 $247,740 $(17,379) -7.0% Table of ContentsResearch and Development Expenses Research and development expenses were $23.5 million for the year ended December 31, 2012, a decrease of $0.8 million, or 3%, from the yearended December 31, 2011. As a percentage of revenue, research and development expenses remained flat at 9% for the year ended December 31, 2012compared to the year ended December 31, 2011. The dollar decrease was primarily attributable to a $0.9 million decrease in consulting expenses and$0.1 million decrease in stock photography primarily related to the decrease in development costs of our ReFLEX product which launched in Korea inthe third quarter of 2011. This decrease in expense is partially offset by an increase in personnel-related expenses of $0.3 million. Although salary andbenefits compensation decreased $0.9 million over the prior year period, we incurred an $0.8 million increase in severance expenses as a result of ourrestructuring efforts to better align our business as well as the separation of an executive employee in the second quarter of 2012 and an increase of$0.3 million in sign-on bonuses and stock compensation as a result of our improved financial performance year over year. We will continue to developnew products, including a children's product offering, and improve our offering to educational organizations. We intend to make our products moremodular, flexible and mobile. We also intend to restructure operations to optimize research and development initiatives. As a result of these initiatives,we expect an increase in research and development expense in 2013.General and Administrative Expenses General and administrative expenses for the year ended December 31, 2012 were $55.3 million, a decrease of $6.8 million, or 11%, from the yearended December 31, 2011. As a percentage of revenue, general and administrative expenses decreased to 20% for the year ended December 31, 2012compared to 23% for year ended December 31, 2011. The dollar and percentage decreases were primarily attributable to a $4.2 million decrease inconsulting expenses, a $2.7 million decrease in personnel-related expenses, $0.9 million decrease in hardware and software upgrades, hosting, andtelephone expenses related to investment in our technology infrastructure and cost realignment initiatives during the prior year period and a $0.9 milliondecrease in depreciation expense related to certain fixed assets being fully depreciated early in the second quarter of 2012. These decreases were partiallyoffset by a $1.3 million increase in outside legal expenses in connection with our Google lawsuit and a $0.7 million increase in VAT expenses. During2012, we took additional steps to reduce certain general and administrative expenses as well as realign our cost structure to help fund investments inareas of growth. We expect there to be increases in general and administrative expenses to support our expansion into international markets in 2013.Stock-Based Compensation As a result of the loss of the incentive and retentive value of the Long Term Incentive Plan ("LTIP"), on November 30, 2011 the board of directorscancelled the LTIP resulting in the recognition of a non-cash charge of $4.9 million, which is included in each of the respective operating expense linesfor the year ended December 31, 2011 as follows, $0.8 million in sales and marketing, $1.1 million in research and development, and $4.0 million ingeneral and administrative. There were no shares issued from the LTIP to any executive prior to its cancellation. Total stock-based compensation byexpense line item is as follows:56 Year EndedDecember 31, 2012 2011 Change % Change (dollars in thousands) Cost of revenue $288 $55 $233 424%Sales and marketing 1,185 1,932 (747) (39)%Research and development 1,547 2,448 (901) (37)%General and administrative 4,989 7,918 (2,929) (37)% Total $8,009 $12,353 $(4,344) (35)% Table of ContentsInterest and Other Income (Expense) Interest income represents interest earned on our cash, cash equivalents, and short-term investments. Interest income for the year endedDecember 31, 2012 was $187,000, a decrease of $115,000, or 38%, from the year ended December 31, 2011. Interest expense is primarily related to our capital leases. Interest expense for the year ended December 31, 2012 was zero, a decrease of $5,000 or100%, from the year ended December 31, 2011. We expect interest expense to be minimal in future periods as we allowed the revolving line of creditwith Wells Fargo to expire on January 17, 2011. Other income for the year ended December 31, 2012 was $3,000 as compared to other income of $142,000 for the year ended December 30, 2011,a decrease of $139,000 or 98%. The decrease was primarily due to foreign exchange losses partially offset by an increase in legal settlements inconnection with our anti-piracy enforcement efforts.Income Tax Expense (Benefit) Income tax expense for the year ended December 31, 2012 was $30.0 million, compared to an $8.0 million income tax benefit for the year endedDecember 31, 2011. The change primarily resulted from a $26.0 million non-cash charge associated with establishing a valuation allowance for ourU.S. and certain foreign operations in 2012, $2.3 million related to our inability to recognize tax benefits associated with current year losses in certainforeign operations and $9.0 million U.S. tax benefit in 2011 related to carry back of operating losses and credits to prior yearsComparison of the Year Ended December 31, 2011 and the Year Ended December 31, 2010 Our revenue increased $9.6 million to $268.4 million for the year ended December 31, 2011. The change in revenue is due to an increase in ROWConsumer revenues of $7.8 million, partially offset by a $4.0 million decrease in North America Consumer revenue, over the prior year period.Worldwide Institutional revenues increased $5.8 million over the same period, driven by growth in our education and corporate channels. Bookings,calculated as revenue plus the change in deferred revenue, decreased to $273.2 million for the year ended December 31, 2011 from $279.9 million forthe year ended December 31, 2010. The decrease was due to a $16.3 million decrease in North America Consumer bookings, partially offset by a$10.8 million increase in ROW Consumer bookings. Additionally, worldwide Institutional bookings decreased $1.2 million compared to the prior yearperiod. We reported an operating loss of $28.4 million for the year ended December 31, 2011 compared to operating income of $12.9 million for the yearended December 31, 2010. The operating loss was due57 Year EndedDecember 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages) Interest Income $187 $302 $(115) -38.1%Interest Expense — (5) 5 100.0%Other Income (Expense) 3 142 (139) -97.9% Total other income (expense) $190 $439 $(249) -56.7% Year EndedDecember 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages) Income tax expense (benefit) $29,991 $(7,980)$(37,971) -475.8%Table of Contentsto a decrease in gross profit of $0.6 million, from $219.9 million to $219.3 million, and an increase in operating expenses of $40.8 million. The decreasein gross profit was primarily due to higher direct costs associated with our web-based services offering Version 4 TOTALe that include higher directcosts to deliver to customers than our previous software solutions. The increase in operating expenses was primarily due to $16.2 million in personnel-related costs, $20.2 million in increased media and marketing activities, primarily outside of the U.S., $1.8 million increase in professional services and$2.0 million increase in depreciation and amortization expenses incurred to support the business expansion outside of the U.S., and $0.6 millionincrease in lease abandonment due to the reversal of the lease abandonment expenses in the third quarter of 2010.Revenue by Operating Segment The following table sets forth revenue for each of our three operating segments for the years ended December 31, 2011 and 2010: North America Consumer revenue decreased $4.0 million or 3% from the year ended December 31, 2010 to the year ended December 31, 2011,the result of decreases of $9.5 million and $5.4 million from our retail and kiosk sales channels, respectively, partially offset by an increase of$10.9 million from our direct-to-consumer sales channel. In 2011 we experienced a shift in North America consumer revenue from retail to our direct-to-consumer sales channel. The number of kiosks within North America decreased from 173 at December 31, 2010 to 103 at December 31, 2011,driving the decrease in revenue from this channel. North America Consumer bookings, calculated as North America Consumer revenue plus the changein North America Consumer deferred revenue decreased $16.3 million to $157.4 million for the year ended December 31, 2011 from $173.8 million forthe year ended December 31, 2010, driven by lower prices across the North America Consumer channels. ROW Consumer revenue increased $7.8 million or 18% from the year ended December 31, 2010 to the year ended December 31, 2011. ROWConsumer revenue increased $3.3 million, $3.1 million and $1.9 million in Korea, Germany and the UK, respectively. During 2011 we experienced anincrease in revenue across all consumer channels in Korea and Germany in addition to increases in all channels except retail in the UK. ROW Consumerbookings, calculated as ROW Consumer revenue plus the change in ROW deferred revenue increased $10.8 million, from $43.2 million for the yearended December 31, 2010 to $54.0 million for the year ended December 31, 2011. The increase in revenue and bookings was driven by expandedinternational sales and marketing efforts. Institutional revenue increased $5.8 million or 11% from the year ended December 31, 2010 to the year ended December 31, 2011. The increase inInstitutional revenue was primarily due to the expansion of our direct sales force and a shift from sales of perpetual licenses to sales of renewing onlinesubscriptions. As a result, we had a $5.8 million increase in education revenue and a $2.7 million increase in corporate and non-profit revenue in 2011,compared to the prior year period. These increases were partially offset by a $2.7 million decrease in governmental revenues, primarily as a result ofgovernment budget cuts including the non-renewal of the U.S. Army and U.S. Marines Corps contracts. Institutional bookings, calculated asInstitutional revenue plus the change in Institutional deferred revenue, decreased to $61.8 million for the year ended December 31, 2011 from$62.9 million for the year ended December 31, 2010. The decrease in bookings was due to an $8.6 million decrease in government bookings primarilyas a result of the non-renewal of the U.S. Army and the U.S.58 Year ended December 31, 2011 versus 2010 2011 2010 Change % Change (in thousands, except percentages) North America Consumer $157,561 58.7%$161,575 62.4%$(4,014) -2.5%Rest of World Consumer 50,465 18.8% 42,688 16.5% 7,776 18.2%Institutional 60,423 22.5% 54,605 21.1% 5,818 10.7% Total Revenue $268,449 100.0%$258,868 100.0%$9,581 3.7% Table of ContentsMarines Corps contracts, partially offset by a $4.5 million increase in education bookings and a $2.9 million increase in corporate and non-profitbookings in 2011 compared to the prior year period.Revenue by Product Revenue and Subscription and Service Revenue We categorize and report our revenue in two categories—product revenue and subscription and service revenue. Product revenue includesrevenues allocated to the software product from sales of Rosetta Stone Version 4 TOTALe and revenues from the sale of audio practice products.Subscription and service revenue includes revenues allocated to time-based subscription licenses of our web-based TOTALe services, as well asrevenues from training and professional services. We began bundling time-based subscription licenses of our web-based TOTALe services with product licenses of our Rosetta Stone Version 3language-learning solutions in the U.S. consumer market during the third quarter of 2010, in Japan during the first quarter of 2011, in the UnitedKingdom during the second quarter of 2011, and in Korea during the third quarter of 2011, with the launch of Rosetta Stone Version 4 TOTALe. As aresult, we typically defer 10%-35% of the revenue of each of these bundled sales. We will recognize the deferred revenue over the term of thesubscription license in accordance with Accounting Standards Codification subtopic 985-605, Software: Revenue Recognition.Product Revenue Product revenue decreased $20.2 million, to $195.4 million during the year ended December 31, 2011 from $215.6 million during the year endedDecember 31, 2010. Consumer product revenue decreased $16.8 million, primarily as a result of the allocation of revenue to the online servicescomponent of our software from the launch of Rosetta Stone Version 4 TOTALe in the U.S. consumer market during the third quarter of 2010 andROW consumer markets throughout 2011, as described above. Rosetta Stone Version 4 TOTALe bundles time-based subscription licenses of our web-based TOTALe Studio and Rosetta World services with perpetual licenses of Rosetta Course, the product feature which previously comprised ourRosetta Stone Version 3 language-learning solutions. Approximately 10%-25% of each of these bundled sales is allocated to online services.Institutional product revenue decreased $3.4 million as a result of a shift from sales of perpetual licenses to sales of renewing online subscriptions.Service and Support Revenue Subscription and service revenue increased approximately 69%, or $29.8 million, to $73.1 million for the year ended December 31, 2011, from$43.3 million during the year ended December 31, 2010. The increase in subscription and service revenues was due to a $20.6 million increase in onlineservice revenue related to Version 4 TOTALe and a $9.2 million increase in Institutional subscription and service revenue related to growth in theinstitutional customer base with renewing online subscriptions. There was a $4.7 million increase in deferred revenue during the year ended December 31, 2011 related to the launch of Rosetta Stone V4TOTALe and increased sales of exclusively online subscriptions.59 Year Ended December 31, 2011 versus 2010 2011 2010 Change % Change (in thousands, except percentages) Product revenue $195,382 72.8%$215,590 83.3%$(20,208) (9.4)%Subscription and servicerevenue 73,067 27.2% 43,278 16.7% 29,789 68.8% Total revenue 268,449 100.0% 258,868 100.0% 9,581 3.7% Table of ContentsCost of Product Revenue and Subscription and Service Revenue and Gross Profit The following table sets forth cost of product revenue and subscription and service revenue, as well as gross profit for the year endedDecember 31, 2011 and 2010:Cost of Product Revenue Cost of product revenue for the year ended December 31, 2011 was $36.5 million, an increase of $3.9 million, or 12%, from the year endedDecember 31, 2010. As a percentage of product revenue, cost of product revenue increased to 19% for the year ended December 31, 2011 compared to15% for the prior year period. The dollar increase in cost was primarily attributable to a $2.9 million increase in expense associated with product supportactivities, a $0.6 million increase in freight, and a $0.4 million increase in commission expenses associated with our partners and affiliates. This increasewas slightly offset by a $0.6 million decrease in inventory obsolescence and scrap associated with the U.S. Version 4 TOTALe launch in the thirdquarter of 2010.Cost of Subscription and Service Revenue Cost of subscription and service revenue for the year ended December 31, 2011 was $12.6 million, an increase of $6.2 million, or 96% from theyear ended December 31, 2010. As a percentage of subscription and service revenue, cost of subscription and service revenue increased to 17% for theyear ended December 31, 2011 compared to 15% for the prior year period. The increase in cost was primarily attributable to our web-based serviceofferings in our Version 4 TOTALe and ReFLEX products that include a component of dedicated online language conversation coaching and higherdirect costs to deliver to customers than our previous software solutions.Operating Expenses60 Year EndedDecember 31, 2011 versus 2010 2011 2010 Change % Change (in thousands, except percentages) Revenue Product $195,382 $215,590 $(20,208) (9.4)%Subscription and service 73,067 43,278 29,789 68.8% Total revenue 268,449 258,868 9,581 3.7%Cost of revenue Cost of product revenue 36,497 32,549 3,948 12.1%Cost of subscription and service revenue 12,619 6,450 6,169 95.6% Total cost of revenue 49,116 38,999 10,117 25.9% Gross profit $219,333 $219,869 $(536) (0.2)% Gross margin percentages 81.7% 84.9% (3.2)% Year EndedDecember 31, 2011 versus 2010 2011 2010 Change % Change (in thousands, except percentages) Sales and marketing $161,491 $130,879 $30,612 23.4%Research and development 24,218 23,437 781 3.3%General and administrative 62,031 53,239 8,792 16.5%Lease abandonment — (583) 583 100.0% Total operating expenses $247,740 $206,972 $40,768 19.7% Table of ContentsSales and Marketing Expenses Sales and marketing expenses for the year ended December 31, 2011 were $161.5 million, an increase of $30.6 million, or 23%, from the yearended December 31, 2010. As a percentage of total revenue, sales and marketing expenses were 60% for the year ended December 31, 2011, comparedto 51% for the year ended December 31, 2010. The dollar and percentage increase in sales and marketing expenses were primarily attributable to thecontinued expansion of our direct marketing activities in the U.S. and international markets. Media and marketing activities grew by $20.2 million,primarily outside of the U.S., including the launch of our new advertising campaign focused on promoting language learning and our brand, increasedmedia associated with the launch of Version 4 TOTALe in the United Kingdom, Japan and Korea as well as ReFLEX in Korea, and increased internetmarketing due to increased spending in online social media networks. Professional services increased by $4.7 million over the prior year period as aresult of increased consulting related to international brand strategy, segmentation study and market research conducted in 2011, as well as clericalservice expenses related to institutional and international retail sales. Personnel-related costs as a result of growth in our institutional sales channel, non-kiosk consumer, and marketing and sales support activities increased by $6.0 million over the prior year period of which, $0.8 million related to theaddition of the Long Term Incentive Program, or LTIP, which was subsequently cancelled late in 2011. Additionally, travel and training expenseincreased by $0.5 million over the prior year period as a result of increased travel in our institutional sales channel and global initiatives, commissionsincreased by $0.7 million as a result of increased institutional and international consumer revenue, $0.5 million increase in depreciation and amortizationdue to increased capitalized software costs in 2011, $1.0 million increase in IT related product development and improvement projects, $0.6 million inrecruitment expenses due to our entry into new international markets, as well as $0.3 million increase in trade shows driven by Korea and U.S. Thesecosts were partially offset by a decrease of $4.4 million in kiosk related expenses as the number of worldwide kiosks decreased from 259 as ofDecember 31, 2010 to 174 as of December 31, 2011.Research and Development Expenses Research and development expenses were $24.2 million for the year ended December 31, 2011, an increase of $0.8 million, or 3%, from the yearended December 31, 2010. As a percentage of revenue, research and development expenses remained flat at 9% for the years ended December 31, 2011and 2010. The dollar increases were primarily attributable to personnel-related increases in development personnel of $2.9 million of which,$1.1 million related to the addition of the LTIP compensation program which was subsequently cancelled in the fourth quarter of 2011. This increase inpersonnel costs was partially offset by a $1.3 million decrease in consulting-related costs, $0.3 million decrease in travel expenses, and $0.3 milliondecrease in hardware and software expenses related to the increased costs in 2010 associated with the development of new products and services as welaunched our new Version 4 product in the fourth quarter of 2010. Additionally, communications expenses decrease $0.2 million as a result ofdecreased hosting expenses.General and Administrative Expenses General and administrative expenses for the year ended December 31, 2011 were $62.0 million, an increase of $8.8 million, or 17%, from the yearended December 31, 2010. As a percentage of revenue, general and administrative expenses increased to 23% for the year ended December 31, 2011compared to 21% for the year ended December 31, 2010. The dollar and percentage increases were primarily attributable to an $8.5 million increase inpersonnel-related costs of which $4.0 million related to the addition of the LTIP compensation program which was subsequently cancelled in the fourthquarter of 2011. The remaining increase in personnel-related costs related to severance expenses due to company restructuring, executive compensationand recruiting costs related to our search for a new chief executive officer, and international expansion. IT and infrastructure expenses increased$3.0 million61Table of Contentsrelated to hardware and software upgrades, hosting, and telephone. Additionally, consulting expenses increased $4.0 million primarily related toinvestment in our IT infrastructure and cost realignment initiatives. These increases were partially offset by a $5.8 million decrease in legal feesassociated with our trademark infringement lawsuit against Google, Inc. and other intellectual property enforcement actions as well as a $0.5 milliondecrease in bad debt related to the Border's Group Inc. reserve taken in the fourth quarter of 2010.Stock-Based Compensation As a result of the loss of the incentive and retentive value of the Long Term Incentive Plan ("LTIP"), on November 30, 2011 the board of directorscancelled the LTIP resulting in the recognition of a non-cash charge of $4.9 million, which is included in each of the respective operating expense linesfor the year ended December 31, 2011 as follows, $0.7 million in sales and marketing, $0.9 million in research and development, and $3.3 million ingeneral and administrative. There were no shares issued from the LTIP to any executive prior to its cancellation. Total stock-based compensation byexpense line item is as follows:Lease Abandonment Expenses As a result of accelerated growth in our Arlington, Virginia headquarters, we exceeded the maximum capacity in our leased office space in the thirdquarter of 2010. At that time, there was no additional space available for lease in the 1919 N. Lynn St. location and additional space was needed tosupport continued growth. Our previously abandoned office space at 1101 Wilson Blvd was unoccupied, and as a result of its close proximity to the1919 N. Lynn St. location, we made the decision to reoccupy the formerly abandoned space. As of December 31, 2010, the remaining liabilityassociated with the abandonment of the operating lease at 1101 Wilson Blvd was reversed resulting in a $0.6 million decrease in expense for the yearended December 31, 2010. For the year ended December 31, 2011, there were no lease abandonment expenses.Interest and Other Income (Expense)62 Year EndedDecember 31, 2011 2010 Change % Change (dollars in thousands) Cost of revenue $55 $39 $16 41%Sales and marketing 1,932 774 1,158 150%Research and development 2,448 1,181 1,267 107%General and administrative 7,918 2,393 5,525 231% Total 12,298 4,348 7,966 183% Year EndedDecember 31, 2011 versus 2010 2011 2010 Change % Change (in thousands, except percentages) Interest Income 302 $262 $40 15.3%Interest Expense (5) (66) 61 92.4%Other Income (Expense) 142 (220) 362 164.5% Total $439 $(24)$463 1929.2% Table of Contents Interest income represents interest earned on our cash and cash equivalents. Interest income for the year ended December 31, 2011 was $302,000,an increase of $40,000, or 15%, from the year ended December 31, 2010. Interest expense is primarily related to our short-term investment account as well as interest related to our capital leases. Interest expense for theyear ended December 31, 2011 was $5,000, a decrease of $61,000 or 92%, from the year ended December 31, 2010. We expect interest expense to be minimal in upcoming quarters as we allowed the revolving line of credit with Wells Fargo to expire onJanuary 17, 2011. Other income for the year ended December 31, 2011 was $142,000, an increase of $0.4 million, or 165%, from the year ended December 31,2010. The increase was primarily due to an increase in foreign exchange gains and an increase in copyright infringement settlements compared to theprior year period.Income Tax Expense (Benefit) Income tax benefit for the year ended December 31, 2011 was $8.0 million, an increase of $7.6 million, compared to the year ended December 31,2010. The increase was the result of a decrease of $40.8 million in pre-tax income for the year ended December 31, 2011 and a higher effective tax rate,compared to the year ended December 31, 2010. Our effective tax rate increased to 29% for the year ended December 31, 2011 compared to (3%) forthe year ended December 31, 2010. The increase in our effective tax rate was a result of changes in the geographic distribution of our income, the non-deductibility of expenses related to the cancellation of the LTIP and the release in the year ended December 31, 2010 of the valuation allowance on netoperating loss carryforwards and other deferred tax assets of our United Kingdom and Japan subsidiaries.Liquidity and Capital Resources Cash, cash equivalents, and short-term investments were $148.3 million and $116.3 million for the years ended December 31, 2012 and 2011,respectively. Our primary operating cash requirements include the payment of salaries, incentive compensation, employee benefits and other personnelrelated costs, as well as direct advertising expenses, costs of office facilities and costs of information technology systems. We fund these requirementsthrough cash flow from our operations. We expect that our future growth may continue to require additional working capital. Our future capital requirements will depend on many factors,including development of new products, market acceptance of our products, the levels of advertising and promotion required to launch additionalproducts and improve our competitive position in the marketplace, the expansion of our sales, support and marketing organizations, the establishment ofadditional offices in the United States and worldwide and building the infrastructure necessary to support our growth, the response of competitors toour products and our relationships with suppliers and clients. We have experienced increases in our expenditures consistent with the growth in ouroperations and personnel, and we anticipate that our expenditures will continue to increase in the future. We believe that anticipated cash flows fromoperations and existing cash reserves will provide sufficient liquidity to fund our business and meet our obligations for at least the next 12 months. On January 17, 2011, we allowed our $12.5 million revolving line of credit with Wells Fargo to expire.63 Year EndedDecember 31, 2011 versus 2010 2011 2010 Change % Change (in thousands, except percentages) Income tax expense (benefit) $(7,980)$(411)$(7,569) 1841.6%Table of Contents The total amount of cash that was held by foreign subsidiaries as of December 31, 2012 was $18.6 million. If we were to repatriate the cash fromour foreign subsidiaries, a significant tax liability may result.Cash Flow AnalysisNet Cash Provided By Operating Activities Net cash provided by operating activities was $34.9 million for the year ended December 31, 2012 compared to $3.4 million for the year endedDecember 31, 2011, an increase of $31.5 million. Net cash provided by operating activities was primarily due to an increase in deferred revenue of$11.5 million as a result of increased online subscription revenue, an increase in accrued compensation of $5.1 million related to an increase in ouraccrued bonus, and a decrease in our net loss after adjusted for depreciation, amortization, stock compensation, and valuation allowance. The net losstotaled $35.8 million for the year ended December 31, 2012 compared to net loss of $20.0 million for the year ended December 31, 2011. For the yearended December 31, 2012, we incurred depreciation, amortization, stock compensation expense, and tax expenses incurred as a result of the valuationallowance of $43.1 million, compared to $19.8 million for the year ended December 31, 2011.Net Cash Provided By (Used In) Investing Activities Net cash provided by investing activities was $5.5 million for the year ended December 31, 2012, compared to net cash used of $13.3 million forthe year ended December 31, 2011, an increase of $18.8 million. This increase is primarily related to less spending on property and equipmentassociated with the expansion of our technology infrastructure and our facilities in the prior year period as well as the expiry of our short-terminvestments that were not reinvested.Net Cash Provided By Financing Activities Net cash provided by financing activities was $0.6 million for the year ended December 31, 2012 compared to $0.9 million for the year endedDecember 31, 2011. Net cash provided by financing activities during the year ended December 31, 2012 primarily related to the decrease in tax benefitof stock options exercised. We believe our current cash and cash equivalents, short term investments and funds generated from our operations will be sufficient to meet ourworking capital and capital expenditure requirements through the foreseeable future, including at least the next 12 months. Thereafter, we may need toraise additional funds through public or private financings or borrowings to develop or enhance products, to fund expansion, to respond to competitivepressures or to acquire complementary products, businesses or technologies. If required, additional financing may not be available on terms that arefavorable to us, if at all. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of ourstockholders will be reduced and these securities might have rights, preferences and privileges senior to those of our current stockholders. No assurancecan be given that additional financing will be available or that, if available, such financing can be obtained on terms favorable to our stockholders and us. During the last three years, inflation has not had a material effect on our business and we do not expect that inflation or changing prices willmaterially affect our business in the foreseeable future.Off-Balance Sheet Arrangements We do not engage in any off-balance sheet financing arrangements. We do not have any interest in entities referred to as variable interest entities,which include special purpose entities and other structured finance entities.64Table of ContentsContractual Obligations The following table summarizes our contractual obligations at December 31, 2012 and the effect such obligations are expected to have on ourliquidity and cash flow in future periods. The operating lease obligations reflected in the table above include our corporate office leases and site licenses for our kiosks.Recent Accounting Pronouncements In June 2011, the FASB issued new guidance on comprehensive income presentation (ASU o. 2011-05—Comprehensive Income (Topic 220).Under the amendments to Topic 220, an entity has the option to present the total of comprehensive income, the components of net income, and thecomponents of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutivestatements. In both choices, an entity is required to present each component of net income along with total net income, each component of othercomprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This update eliminates theoption to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments in thisupdate do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must bereclassified to net income, thus the adoption of such standard did not have a material impact on the Company's reported results of operations andfinancial position. In September 2011, the FASB issued new guidance on goodwill impairment testing (ASU 2011-08, Intangibles—Goodwill and Other (Topic350): Testing Goodwill for Impairment), effective for calendar years beginning after December 15, 2011. Early adoption is permitted. The objective ofthis standard is to simplify how an entity tests goodwill for impairment. The amendments in this standard will allow an entity to first assess qualitativefactors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value as a basis for determiningwhether it needs to perform the quantitative two-step goodwill impairment test. Only if an entity determines, based on qualitative assessment, that it ismore likely than not that a reporting unit's fair value is less than its carrying value will it be required to calculate the fair value of the reporting unit. TheCompany adopted this guidance beginning in fiscal year 2012, and the adoption of such guidance did not have a material impact on the Company'sreported results of operations or financial position. In July 2012, the FASB issued new guidance on the impairment testing of indefinite-lived intangible assets (ASU 2012-02, Intangibles—Goodwilland Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment), effective for calendar years beginning after September 15, 2012.Early adoption is permitted. The objective of this standard is to simplify how an entity tests indefinite-lived intangible assets for impairment. Theamendments in this standard will allow an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-livedintangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test. Only if an entity determines,based on qualitative assessment, that it is more likely than not that the indefinite-lived intangible asset is impaired will it be required to determine the fairvalue of the indefinite-lived intangible asset and perform the quantitative impairment test. The Company intends to adopt this guidance beginning infiscal year 2013, and the adoption of such65 Total Less than1 Year 1-3 Years 3-5 Years More than5 Years (in thousands) Kiosk $1,977 $1,356 $480 $72 $69 Non-Kiosk $15,609 $4,085 $5,646 $4,014 $1,864 Total $17,586 $5,441 $6,126 $4,086 $1,933 Table of Contentsguidance is not anticipated to have a material impact on the Company's reported results of operations or financial position. In February 2013, the FASB issued ASU No. 2013-02, "Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out ofAccumulated Other Comprehensive Income," or "ASU 2013-02" which requires disclosure of significant amounts reclassified out of accumulated othercomprehensive income by component and their corresponding effect on the respective line items of net income. This guidance is effective for reportingperiods beginning after December 15, 2012 and is not expected to have a material impact on the Company's consolidated financial statements orfinancial statement disclosures.Item 7A. Quantitative and Qualitative Disclosures About Market Risk Foreign Currency Exchange Risk The functional currency of our foreign subsidiaries is their local currency. Accordingly, our results of operations and cash flows are subject tofluctuations due to changes in foreign currency exchange rates. The volatility of the prices and applicable rates are dependent on many factors that wecannot forecast with reliable accuracy. In the event our foreign sales and expenses increase, our operating results may be more greatly affected byfluctuations in the exchange rates of the currencies with which we do business. At this time we do not, but we may in the future, invest in derivatives orother financial instruments in an attempt to hedge our foreign currency exchange risk.Interest Rate Sensitivity Interest income and expense are sensitive to changes in the general level of U.S. interest rates. However, based on the nature and current level ofour marketable securities, which are primarily short-term investment grade and government securities and our notes payable, we believe that there is nomaterial risk of exposure.Item 8. Financial Statements and Supplementary Data Our consolidated financial statements, together with the related notes and the report of independent registered public accounting firm, are set forthon the pages indicated in Item 15.Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure None.Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of ourdisclosure controls and procedures as of December 31, 2012. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files orsubmits under the Exchange Act is accumulated and communicated to the Company's management, including its principal66Table of Contentsexecutive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that anycontrols and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, andmanagement necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation ofour disclosure controls and procedures as of December 31, 2012, our Chief Executive Officer and Chief Financial Officer concluded that, as of suchdate, our disclosure controls and procedures were effective at the reasonable assurance level.Management's annual report on internal control over financial reporting Management is responsible for establishing and maintaining adequate internal control over our financial reporting. Management has assessed theeffectiveness of internal control over financial reporting as of December 31, 2012. Management's assessment was based on criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission, or COSO, in Internal Control—Integrated Framework. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control overfinancial reporting includes those policies and procedures that:(1)pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of ourassets; (2)provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations ofour management and board of directors; and (3)provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets thatcould have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of anyevaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate. Based on using the COSO criteria, management believes our internal control over financial reporting as of December 31, 2012 was effective. Our independent registered public accounting firm, Deloitte & Touche LLP, has audited the financial statements included in this Annual Report onForm 10-K and has issued a report on the effectiveness of our internal control over financial reporting. The attestation report of Deloitte & Touche LLPis included on page F-3 of this Form 10-K.Changes in Internal Control over Financial Reporting There was no change in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) or 15d-15(d) of the Exchange Act that occurred during the quarter ended December 31, 2012 that had materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.Item 9B. Other Information None.67Table of ContentsPART III Certain information required by Part III is omitted from this Annual Report on Form 10-K as we intend to file our definitive Proxy Statement forthe 2012 Annual Meeting of Stockholders pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, not later than 120 daysafter the end of the fiscal year covered by this Annual Report, and certain information included in the Proxy Statement is incorporated herein byreference.Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is incorporated herein by reference to the information provided under the headings "Our Board of Directorsand Nominees," "Security Ownership of Certain Beneficial Owners and Management—Section 16(A) Beneficial Ownership Reporting Compliance,""Corporate Governance—Code of Ethics," "Corporate Governance—Composition of our Board of Directors; Classified Board," "CorporateGovernance—Committees of our Board of Directors," "Corporate Governance—Audit Committee," "Corporate Governance—CompensationCommittee," and "Corporate Governance—Corporate Governance and Nominating Committee" in our definitive proxy statement for the 2012 AnnualMeeting of Stockholders to be filed with the Securities and Exchange Commission no later than 120 days after the fiscal year ended December 31, 2012(the "2013 Proxy Statement").Code of Ethics and Business Conduct We have adopted a code of ethics and business conduct ("code of conduct") that applies to all of our employees, officers and directors, includingwithout limitation our principal executive officer, principal financial officer and controller or principal accounting officer. Copies of both the code ofconduct, as well as any waiver of a provision of the code of conduct granted to any senior officer or director or material amendment to the code ofconduct, if any, are available, without charge, under the "Corporate Governance" tab of the "Investor Relations" section on our website atwww.rosettastone.com. We intend to disclose any amendments or waivers of this code on our website.Item 11. Executive Compensation The information required by this Item is incorporated herein by reference to the information provided under the headings "CompensationCommittee Report", "Executive Compensation," "Director Compensation" and "Compensation Committee" and "Corporate Governance—Interlocksand Insider Participation" in the 2013 Proxy Statement.Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is incorporated herein by reference to the information provided under the headings "Security Ownership ofCertain Beneficial Owners and Management" and "Equity Compensation" in the 2013 Proxy Statement.Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is incorporated herein by reference to the information provided under the headings "Corporate Governance—Director Independence," and "Transactions with Related Persons" in the 2013 Proxy Statement.Item 14. Principal Accounting Fees and Services The information required by this Item is incorporated herein by reference to the information provided under the heading "Principal AccountantFees and Services" in the 2013 Proxy Statement.68Table of ContentsPART IV Item 15. Exhibits and Financial Statement Schedules (a)Consolidated Financial Statements1.Consolidated Financial Statements. The consolidated financial statements as listed in the accompanying "Index to ConsolidatedFinancial Information" are filed as part of this Annual Report. 2.Consolidated Financial Statement Schedules. Schedules have been omitted because they are not applicable or are not required or theinformation required to be set forth in those schedules is included in the consolidated financial statements or related notes.All other schedules not listed in the accompanying index have been omitted as they are either not required or not applicable, or therequired information is included in the consolidated financial statements or the notes thereto.(b)Exhibits The exhibits listed in the Index to Exhibits are filed as part of this Annual Report on Form 10-K.69Table of ContentsSIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.Date: March 7, 2013 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of theregistrant and in the capacities indicated on the 7th day of March, 2013.70 ROSETTA STONE INC. By: /s/ STEPHEN M. SWADStephen M. SwadChief Executive OfficerSignature Title /s/ STEPHEN M. SWADStephen M. Swad Chief Executive Officer and Director(Principal Executive Officer)/s/ THOMAS M. PIERNOThomas M. Pierno Chief Financial Officer(Principal Financial Officer and Principal AccountingOfficer)/s/ TOM P.H. ADAMSTom P.H. Adams Chairman of the Board, Director/s/ PHILLIP A. CLOUGHPhillip A. Clough Director/s/ JAMES P. BANKOFFJames P. Bankoff Director/s/ JOHN T. COLEMANJohn T. Coleman Director/s/ LAURENCE FRANKLINLaurence Franklin DirectorTable of Contents71Signature Title /s/ PATRICK W. GROSSPatrick W. Gross Director/s/ MARGUERITE W. KONDRAKEMarguerite W. Kondrake Director/s/ THEODORE J. LEONSISTheodore J. Leonsis Director/s/ JOHN E. LINDAHLJohn E. Lindahl Director/s/ LAURA L. WITTLaura L. Witt DirectorTable of ContentsINDEX TO CONSOLIDATED FINANCIAL STATEMENTS F-1 PageReports of Independent Registered Public Accounting Firm F-2Consolidated Balance Sheets F-4Consolidated Statements of Operations F-5Consolidated Statements of Comprehensive Income (Loss) F-6Consolidated Statements of Changes in Stockholders' Equity F-7Consolidated Statements of Cash Flows F-8Notes to Consolidated Financial Statements F-9Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders ofRosetta Stone Inc.Arlington, VA We have audited the accompanying consolidated balance sheets of Rosetta Stone Inc. and subsidiaries (the "Company") as of December 31, 2012and 2011, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows for each of the threeyears in the period ended December 31, 2012. These financial statements are the responsibility of the Company's management. Our responsibility is toexpress an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. Anaudit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessingthe accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Webelieve that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Rosetta Stone Inc. andsubsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period endedDecember 31, 2012, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company'sinternal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control—Integrated Framework issuedby the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 7, 2013 expressed an unqualified opinion onthe Company's internal control over financial reporting./s/ Deloitte & Touche LLPMcLean, VirginiaMarch 7, 2013F-2Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders ofRosetta Stone Inc.Arlington, VA We have audited the internal control over financial reporting of Rosetta Stone Inc. and subsidiaries (the "Company") as of December 31, 2012,based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the TreadwayCommission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting, included in the accompanying Management's annual report on internal control over financialreporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that amaterial weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performingsuch other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive andprincipal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnelto provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and proceduresthat (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of thecompany; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations ofmanagement and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition,use, or disposition of the company's assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper managementoverride of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluationof the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequatebecause of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, basedon the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the TreadwayCommission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidatedfinancial statements as of and for the year ended December 31, 2012 of the Company and our report dated March 7, 2013 expressed an unqualifiedopinion on those consolidated financial statements./s/ Deloitte & Touche LLPMcLean, VirginiaMarch 7, 2013F-3Table of ContentsROSETTA STONE INC. CONSOLIDATED BALANCE SHEETS (in thousands, except per share amounts) As of December 31, 2012 2011 Assets Current assets: Cash and cash equivalents $148,190 $106,516 Restricted cash 73 74 Short term investments — 9,711 Accounts receivable (net of allowance for doubtful accounts of $1,297 and $1,951,respectively) 49,946 51,997 Inventory, net 6,581 6,723 Prepaid expenses and other current assets 5,204 7,081 Income tax receivable 1,104 7,678 Deferred income taxes 79 10,985 Total current assets 211,177 200,765 Property and equipment, net 17,213 20,869 Goodwill 34,896 34,841 Intangible assets, net 10,825 10,865 Deferred income taxes 260 8,038 Other assets 1,484 1,803 Total assets $275,855 $277,181 Liabilities and stockholders' equity Current liabilities: Accounts payable $6,064 $7,291 Accrued compensation 16,830 11,703 Other current liabilities 36,387 34,911 Deferred revenue 59,195 49,375 Total current liabilities 118,476 103,280 Deferred revenue 4,221 2,520 Deferred income taxes 8,400 — Other long-term liabilities 155 176 Total liabilities 131,252 105,976 Commitments and contingencies (Note 13) Stockholders' equity: Preferred stock, $0.001 par value; 10,000 and 10,000 shares authorized, zero and zeroshares issued and outstanding at December 31, 2012 and December 31, 2011,respectively — — Non-designated common stock, $0.00005 par value, 190,000 and 190,000 sharesauthorized, 21,951 and 21,258 shares issued and outstanding at December 31, 2012 andDecember 31, 2011, respectively 2 2 Additional paid-in capital 160,693 151,823 Accumulated income (loss) (16,749) 19,082 Accumulated other comprehensive income 657 298 Total stockholders' equity 144,603 171,205 Total liabilities and stockholders' equity $275,855 $277,181  See accompanying notes to consolidated financial statements.F-4Table of ContentsROSETTA STONE INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) See accompanying notes to consolidated financial statementsF-5 Year Ended December 31, 2012 2011 2010 Revenue: Product $180,919 $195,382 $215,590 Subscription and service 92,322 73,067 43,278 Total revenue 273,241 268,449 258,868 Cost of revenue: Cost of product revenue 33,684 36,497 32,549 Cost of subscription and service revenue 15,226 12,619 6,450 Total cost of revenue 48,910 49,116 38,999 Gross profit 224,331 219,333 219,869 Operating expenses Sales and marketing 151,646 161,491 130,879 Research and development 23,453 24,218 23,437 General and administrative 55,262 62,031 53,239 Lease Abandonment — — (583) Total operating expenses 230,361 247,740 206,972 Income (loss) from operations (6,030) (28,407) 12,897 Other income and (expense): Interest income 187 302 262 Interest expense — (5) (66)Other income (expense) 3 142 (220) Total other income (expense) 190 439 (24)Income (loss) before income taxes (5,840) (27,968) 12,873 Income tax expense (benefit) 29,991 (7,980) (411) Net income (loss) $(35,831)$(19,988)$13,284 Income (loss) per share: Basic $(1.70)$(0.96)$0.65 Diluted $(1.70)$(0.96)$0.63 Common shares and equivalents outstanding: Basic weighted average shares 21,045 20,773 20,439 Diluted weighted average shares 21,045 20,773 21,187 Table of ContentsROSETTA STONE INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (in thousands) See accompanying notes to consolidated financial statementsF-6 Years Ended December 31, 2012 2011 2010 Net income (loss) $(35,831)$(19,988)$13,284 Other comprehensive income (loss), net of tax: Foreign currency translation gain (loss) 336 98 447 Unrealized gain (loss) on available-for-sale securities 23 (23) — Other comprehensive income (loss) 359 75 447 Comprehensive income (loss) $(35,472)$(19,913)$13,731 Table of ContentsROSETTA STONE INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (in thousands) Non-DesignatedCommon Stock AccumulatedOtherComprehensiveIncome (Loss) TotalStockholders'Equity(Deficit) AdditionalPaid-inCapital AccumulatedIncome(Loss) Shares Amount Balance—January 1,2010 20,249 $2 $130,872 $25,785 $(224)$156,435 Stock Issued Uponthe Exercise ofStock Options 364 — 2,387 — — 2,387 Restricted StockAward Vesting 54 — — — — — Stock-basedCompensationExpense — — 4,387 — — 4,387 Tax Benefit onStock OptionExercised — — 1,376 — — 1,376 Net income — — — 13,284 — 13,284 Othercomprehensiveincome — — — — 447 447 Balance—December 31,2010 20,667 $2 $139,022 $39,069 $223 $178,316 Stock Issued Uponthe Exercise ofStock Options 182 — 800 — — 800 Restricted StockAward Vesting 87 — — — — — Stock-basedCompensationExpense — — 12,353 — — 12,353 Tax Benefit onStock OptionExercised — — (351) — — (351)Net loss — — — (19,988) — (19,988)Othercomprehensiveincome — — — — 75 75 Balance—December 31,2011 20,936 $2 $151,824 $19,081 $298 $171,205 Stock Issued Uponthe Exercise of See accompanying notes to consolidated financial statementsF-7the Exercise ofStock Options 118 — 861 — — 861 Restricted StockAward Vesting 134 — — — — — Stock-basedCompensationExpense — — 8,009 — — 8,009 Tax Benefit onStock OptionExercised — — 0 — — 0 Net loss — — — (35,831) — (35,831)Othercomprehensiveincome — — — — 359 359 Balance—December 31,2012 21,188 $2 $160,693 (16,749)$657 $144,603 Table of ContentsROSETTA STONE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Year Ended December 31, 2012 2011 2010 CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $(35,831)$(19,988)$13,284 Adjustments to reconcile net income (loss) to cash provided by (used in)operating activities: Stock-based compensation expense 8,009 12,353 4,387 Bad debt expense 1,820 1,228 1,750 Depreciation and amortization 8,077 8,724 6,615 Deferred income tax expense (benefit) 27,035 (1,297) (6,057)Loss on disposal of equipment 783 318 37 Net change in: Restricted cash 1 11 (30)Accounts receivable 309 (5,058) (12,260)Inventory 185 3,168 (935)Prepaid expenses and other current assets 1,870 659 (236)Income tax receivable 6,515 (5,812) (5,028)Other assets 225 (25) (761)Accounts payable (1,240) (447) 5,987 Accrued compensation 5,093 1,200 (16)Other current liabilities 635 3,979 6,106 Excess tax benefit from stock options exercised — (365) (1,377)Other long term liabilities (99) (52) (789)Deferred revenue 11,514 4,777 21,029 Net cash provided by (used in) operating activities 34,901 3,373 31,706 CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (4,187) (9,940) (8,256)Proceeds from sales (purchases) of available-for-sale securities 9,711 (3,301) (6,410)Acquisition, net of cash acquired — (75) (225) Net cash provided by (used in) investing activities 5,524 (13,316) (14,891) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from the exercise of stock options 862 800 2,387 Tax benefit of stock options exercised — 365 1,377 Payments under capital lease obligations (215) (285) (367) Net cash provided by financing activities 647 880 3,397 Increase (decrease) in cash and cash equivalents 41,072 (9,063) 20,212 Effect of exchange rate changes in cash and cash equivalents 602 (177) 356 Net increase (decrease) in cash and cash equivalents 41,674 (9,240) 20,568 Cash and cash equivalents—beginning of year 106,516 115,756 95,188 Cash and cash equivalents—end of year $148,190 $106,516 $115,756 SUPPLEMENTAL CASH FLOW DISCLOSURE: Cash paid during the periods for: Interest $— $5 $66 Income taxes $4,040 $1,683 $9,989  See accompanying notes to consolidated financial statementsF-8Noncash financing and investing activities: Accrued liability for purchase of property and equipment $1,228 $204 $1,567 Equipment acquired under capital lease $— $16 $— Table of ContentsROSETTA STONE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS Rosetta Stone Inc. and its subsidiaries ("Rosetta Stone," or the "Company") develop, market and support a suite of language-learning solutionsconsisting of software products, online services and audio practice tools under the Rosetta Stone brand name. The Company's software products aresold on a direct basis and through select retailers. The Company provides its software applications to customers through the sale of packaged softwareand online subscriptions, domestically and in certain international markets.2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESPrinciples of Consolidation The accompanying condensed consolidated financial statements include the accounts of Rosetta Stone Inc. and its wholly owned subsidiaries. Allintercompany accounts and transactions have been eliminated in consolidation.Use of Estimates The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires thatmanagement make certain estimates and assumptions. Significant estimates and assumptions have been made regarding the allowance for doubtfulaccounts, estimated sales returns, stock-based compensation, fair value of intangibles and goodwill, inventory reserve, disclosure of contingent assetsand liabilities and disclosure of contingent litigation. Actual results may differ from these estimates.Revenue Recognition The Company's primary products include Rosetta Stone TOTALe online and Rosetta Stone Version 4 TOTALe. Rosetta Stone TOTALe onlinecombines an online software subscription with conversational coaching and is available in a selection of time-based offers (e.g. three, six and 12 monthsdurations). Version 4 TOTALe includes a TOTALe online subscription bundled with perpetual software available as a CD-ROM or download. RosettaStone TOTALe online was released in July 2009 and Rosetta Stone Version 4 TOTALe was released in September 2010. Revenue is also derived fromthe sale of audio practice products and professional services, which include training and implementation services. Revenue is recognized when all of the following criteria are met: there is persuasive evidence of an arrangement; the product has been delivered orservices have been rendered; the fee is fixed or determinable; and collectability is reasonably assured. Revenues are recorded net of discounts. TheCompany recognizes revenue for software products and related services in accordance with Accounting Standards Codification subtopic 985-605,Software: Revenue Recognition ("ASC 985-605"). For multiple element arrangements that include TOTALe online software subscriptions bundled with auxiliary items, such as headsets and audiopractice products which provide stand-alone value to the customer, the Company allocates revenue to all deliverables based on their relative sellingprices in accordance with Accounting Standard Codification ("ASC") subtopic 605-25—Revenue Recognition—Multiple-Element Arrangements("ASC 605-25"). The Company has identified two deliverables generally contained in sales of Rosetta Stone TOTALe online software subscriptions.The first deliverable is the auxiliary items, which are delivered at the time of sale, and the second deliverable is the online services.F-9Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) For Rosetta Stone Version 4 TOTALe, which is a multiple-element arrangement that includes perpetual software bundled with the subscription andconversational coaching components of our TOTALe online service, the Company allocates revenue to all deliverables based on vendor-specificobjective evidence of fair value, or VSOE, in accordance with ASC subtopic 985-605-25 Software: Revenue Recognition—Multiple-ElementArrangements ("ASC 985-605-25"). The Company has identified two deliverables generally contained in Rosetta Stone V4 TOTALe softwarearrangements. The first deliverable is the perpetual software, which is delivered at the time of sale, and the second deliverable is subscription service.Revenue is allocated between these two deliverables using the residual method based on the existence of VSOE of the subscription service. Revenue for online service subscriptions including conversational coaching is recognized ratably over the term of the subscription period,assuming all revenue recognition criteria have been met, which typically range from three months to 15 months. Rosetta Stone Version 4 TOTALebundles, which include packaged software and an online service subscription including conversational coaching, allow customers to begin their onlineservices at any point during a registration window, which is up to six months from the date of purchase from the Company or an authorized reseller.Online service subscriptions that are not activated during this registration window are forfeited and revenue is recognized upon expiry. Some onlinelicensing arrangements include a specified number of licenses that can be activated over a period of time, which typically ranges between six and24 months. Revenue for these arrangements is recognized on a per license basis ratably over the term of the individual license subscription period,assuming all revenue recognition criteria have been met, which typically ranges between three and 12 months. Revenue for set-up fees related to onlinelicensing arrangements is recognized ratably over the term of the online licensing arrangement, assuming all revenue recognition criteria have been met.Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding subscription agreement. Software products include sales to end user customers and resellers. In most cases, revenue from sales to resellers is not contingent upon resale ofthe software to the end user and is recorded in the same manner as all other product sales. Revenue from sales of packaged software products and audiopractice products is recognized as the products are shipped and title passes and risks of loss have been transferred. For most of our product sales, thesecriteria are met at the time the product is shipped. For some sales to resellers and certain other sales, the Company defers revenue until the customerreceives the product because Rosetta Stone legally retains a portion of the risk of loss on these sales during transit. A limited amount of packagedsoftware products are sold to resellers on a consignment basis. Revenue is recognized for these consignment transactions once the end user sale hasoccurred, assuming the remaining revenue recognition criteria have been met. In accordance with Accounting Standards Codification subtopic 985-605-50, Software: Revenue Recognition: Customer Payments and Incentives ("ASC 985-605-50"), price protection for changes in the manufacturersuggested retail value granted to resellers for the inventory that they have on hand at the date the price protection is offered is recorded as a reduction torevenue. In accordance with ASC 985-605-50, cash sales incentives to resellers are accounted for as a reduction of revenue, unless a specific identifiedbenefit is identified and the fair value is reasonably determinable. The Company offers customers the ability to make payments for packaged software purchases in installments over a period of time, whichtypically ranges between three and five months. Given that these installment payment plans are for periods less than 12 months and a successfulcollection history has been established, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have been met.Packaged software is provided to customers who purchase directlyF-10Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)from our company with up to a six month right of return. The Company also allows our retailers to return unsold products, subject to some limitations.In accordance with Accounting Standards Codification subtopic 985-605-15, Software: Revenue Recognition: Products ("ASC 985-605-15"), productrevenue is reduced for estimated returns, which are based on historical return rates. Returns have historically been within the Company's previouslyestablished estimates. In connection with packaged software product sales and online software subscriptions, technical support is provided to customers, includingcustomers of resellers, via telephone support at no additional cost for up to six months from time of purchase. As the fee for technical support isincluded in the initial licensing fee, the technical support and services are generally provided within one year, the estimated cost of providing suchsupport is deemed insignificant and no unspecified upgrades/enhancements are offered, technical support revenues are recognized together with thesoftware product and license revenue. Costs associated with the technical support are accrued at the time of sale. The Company has been engaged to develop language-learning software for certain endangered languages under fixed-fee arrangements. Thesearrangements also include contractual periods of post-contract support ("PCS") and online hosting services ranging from one to ten years. Revenue formulti-element contracts are recognized ratably once the PCS and online hosting periods begin, over the longer of the PCS or online hosting period.When the current estimates of total contract revenue and contract cost indicate a loss for a fixed fee arrangement, a provision for the entire loss on thecontract is recorded.Cash and Cash Equivalents Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less and demand deposits with financialinstitutions.Restricted Cash Restricted cash is restricted for the reimbursement of funds to employees under the Company's flexible benefit plan and security for a credit cardprocessing vendor.Short-Term Investments Short-term investments generally consist of highly liquid, fixed-income investments with an original maturity at the time of purchase of greaterthan three months. Such investments consist of obligations of the U.S. government and its agencies. Investments are classified as available-for-sale and stated at fair value. The net unrealized gains or losses on available-for-sale securities arereported as a component of comprehensive income. The specific identification method is used to compute the realized gains and losses on investments.Investments are periodically reviewed for impairment. If the carrying value of an investment exceeds its fair value and the decline in value is determinedto be other-than-temporary, an impairment loss is recognized for the difference.F-11Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)Accounts Receivable and Allowance for Doubtful Accounts Accounts receivable consist of amounts due to the Company from its normal business activities. The Company provides an allowance for doubtfulaccounts to reflect the expected non-collection of accounts receivable based on past collection history and specific risks identified.Inventories Inventories are stated at the lower of cost, determined on a first-in first-out basis, or market. The Company reviews inventory for excess quantitiesand obsolescence based on its best estimates of future demand, product lifecycle status and product development plans. The Company uses historicalinformation along with these future estimates to establish a new cost basis for obsolete and potential obsolete inventory.Concentrations of Credit Risk Accounts receivable and cash and cash equivalents subject the Company to its highest potential concentrations of credit risk. The Companyreserves for credit losses and does not require collateral on its trade accounts receivable. In addition, the Company maintains cash and investmentbalances in accounts at various banks and brokerage firms. The Company is insured by the Federal Deposit Insurance Corporation for up to $250,000at each bank. The Company's cash and cash equivalents generally exceed the insured limits. The Company has not experienced any losses on cash andcash equivalent accounts to date and the Company believes it is not exposed to any significant credit risk related to cash. The Company sells products toretailers, resellers, government agencies, and individual consumers and extends credit based on an evaluation of the customer's financial condition,without requiring collateral. Exposure to losses on receivables is principally dependent on each customer's financial condition. The Company monitorsits exposure for credit losses and maintains allowances for anticipated losses. No customer accounted for more than 10% of the Company's revenueduring the years ended December 31, 2012, 2011 or 2010. The Company had four customers that collectively accounted for 32% of accounts receivableat December 31, 2012 and four customers that collectively accounted for 27% of accounts receivable at December 31, 2011. The Company maintainstrade credit insurance for certain customers to provide coverage, up to a certain limit, in the event of insolvency of some customers.Fair Value of Financial Instruments The Company values its assets and liabilities using the methods of fair value as described in ASC 820, Fair Value Measurements andDisclosures. ASC 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The three levels of fairvalue hierarchy are described below: Level 1: Quoted prices for identical instruments in active markets. Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are notactive; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. Level 3: Significant inputs to the valuation model are unobservable.F-12Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, restricted cash, accounts receivable, accountspayable and other accrued expenses approximate fair value due to relatively short periods to maturity. On November 1, 2009, the Company acquired certain assets from SGLC International Co. Ltd. ("SGLC"), a software reseller headquartered inSeoul, South Korea. As the assets acquired constituted a business, this transaction was accounted for under ASC topic 805, Business Combinations("ASC 805"). The purchase price consisted of an initial cash payment of $100,000, followed by three annual cash installment payments if the acquiredcompany's revenues exceed certain targeted levels each of these years. The amount was calculated as the lesser of a percentage of the revenue generatedor a fixed amount for each year, based on the terms of the agreement. Based on these terms, the minimum additional cash payment would have been zero if none of the minimum revenue targets were met, and themaximum additional payment was $1.1 million, which amount was recorded as contingent consideration at its fair value of $850,000, resulting in a totalpurchase price of $950,000 including the initial cash payment of $100,000 above. Together with the initial cash payment and the first contingentpayment made, we made additional payments of $300,000 and $350,000 in accordance with the terms of the purchase in 2012 and 2011, respectively. See table below for a summary of the opening balances to the closing balances of the contingent purchase consideration (in thousands): See table below for summary of the Company's financial instruments accounted for at fair value on a recurring basis, which consist only of short-term investments that are marked to fair value at each balance sheet date, as well as the fair value of the accrual for the contingent purchase price of theacquisition of SGLC in 2009:F-13 As ofDecember 31, 2012 2011 Contingent purchase price accrual, beginning of period $300 $573 Minimum revenue target met, increase in contingent liability charged to expense inthe period — 77 Payment of contingent purchase liability (300) (350) Contingent purchase price accrual, end of period $— $300 Fair Value as of December 31, 2012 using: Fair Value as of December 31, 2011 using: December 31,2012 QuotedPricesinActiveMarketsforIdenticalAssets(Level 1) SignificantOtherObservableInputs(Level 2) SignificantUnobservableInputs(Level 3) December 31,2011 QuotedPricesinActiveMarketsforIdenticalAssets(Level 1) SignificantOtherObservableInputs(Level 2) SignificantUnobservableInputs(Level 3) Assets: Short-terminvestments $— $— $— $— $9,711 $9,711 $— $— Total $— $— $— $— $9,711 $9,711 $— $— Liabilities: Contingentpurchasepriceaccrual $— $— $— $— $300 $— $— $300 Total $— $— $— $— $300 $— $— $300 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)There were no changes in the valuation techniques or inputs used as the basis to calculate the contingent purchase price accrual.Property and Equipment Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation on property, leasehold improvements,equipment, and software is computed on a straight-line basis over the estimated useful lives of the assets, as follows: Expenses for repairs and maintenance that do not extend the life of equipment are charged to expense as incurred. Expenses for major renewals andbetterments, which significantly extend the useful lives of existing property and equipment, are capitalized and depreciated. Upon retirement ordisposition of property and equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss isrecognized.Intangible Assets Intangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and trademark, andother intangible assets. Those intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives inaccordance with ASC topic 350, Intangibles—Goodwill and Other ("ASC 350"). Annually, as of December 31, the Company reviews its indefinitelived intangible assets for impairment based on the fair value of indefinite lived intangible assets as compared to the carrying value in accordance withASC 350. In the event the carrying value exceeds the fair value of the assets, the assets are written down to their fair value. There has been noimpairment of intangible assets during any of the periods presented.Goodwill The value of goodwill is primarily derived from the acquisition of Rosetta Stone Ltd. (formerly known as Fairfield & Sons, Ltd.) in January 2006and the acquisition of certain assets of SGLC in November 2009. The Company tests goodwill for impairment annually on June 30 of each year at thereporting unit level using a fair value approach, in accordance with the provisions of ASC topic 350, Intangibles—Goodwill and Other ("ASC 350") ormore frequently, if impairment indicators arise. The Company's annual testing resulted in no impairments of goodwill since the dates of acquisition. Beginning in the fourth quarter of 2012, the Company began reporting its results in three reportable segments, which resulted in three reportingunits for goodwill impairment purposes—North America Consumer, ROW Consumer, and Institutional. Accordingly, the Company allocated goodwillfrom our former Consumer reporting unit to the new reporting units, North America Consumer andF-14Software 3 yearsComputer equipment 3-5 yearsAutomobiles 5 yearsFurniture and equipment 5-7 yearsBuilding 39 yearsBuilding improvements 15 yearsLeasehold improvements lesser of lease term or economic lifeAssets under capital leases lesser of lease term or economic lifeTable of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)ROW Consumer, based on the relative fair value of each reporting unit as of October 31, 2012. In doing so, the Company evaluated the results of theallocation of goodwill for events or indicators that would require further impairment testing, noting none. The Company will continue to review forimpairment indicators in future periods. For income tax purposes, the goodwill balance is amortized over a period of 15 years.Valuation of Long-Lived Assets In accordance with ASC topic 360, Accounting for the Impairment or Disposal of Long-lived Assets ("ASC 360"), the Company evaluates therecoverability of its long-lived assets. ASC 360 requires recognition of impairment of long-lived assets in the event that the net book value of suchassets exceeds the future undiscounted net cash flows attributable to such assets. Impairment, if any, is recognized in the period of identification to theextent the carrying amount of an asset exceeds the fair value of such asset. Based on its analysis, the Company believes that no impairment of its long-lived assets was indicated as of December 31, 2012 and 2011.Guarantees Indemnifications are provided of varying scope and size to certain institutional customers against claims of intellectual property infringement madeby third parties arising from the use of its products. The Company has not incurred any costs or accrued any liabilities as a result of such obligations.Cost of Product and Subscription and Service Revenue Cost of product revenue consists of the direct and indirect materials and labor costs to produce and distribute the Company's products. Such costsinclude packaging materials, computer headsets, freight, inventory receiving, personnel costs associated with product assembly, third-party royalty feesand inventory storage, obsolescence and shrinkage. The Company believes cost of subscription and service revenue primarily represents costsassociated with supporting the online language learning service, which includes online language conversation coaching, hosting costs and depreciation.Also included are the cost of credit card processing and customer technical support in both cost of product revenue and cost of subscription and servicerevenue.Research and Development Research and development expenses include employee compensation costs, professional services fees and overhead costs associated with productdevelopment. Software products are developed for sale to external customers. The Company considers technological feasibility to be established whenall planning, designing, coding, and testing has been completed according to design specifications. The Company has determined that technologicalfeasibility for its software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility isestablished have not been material, and accordingly, the Company has expensed all research and development costs when incurred.Software Developed for Internal Use Product development also includes certain software products for internal use. Development costs for internal use software are expensed as incurreduntil the project reaches the application developmentF-15Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)stage, in accordance with ASC topic 350, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use ("ASC 350").Internal-use software is defined to have the following characteristics: (a) the software is internally developed, or modified solely to meet the entity'sinternal needs, and (b) during the software's development or modification, no substantive plan exists or is being developed to market the softwareexternally. Internally developed software is amortized over a three-year useful life. For the years ended December 31, 2012, 2011 and 2010, the Company capitalized $2.2 million, $2.5 million, and zero in internal-use software,respectively. For the years ended December 31, 2012, 2011 and 2010, the Company recorded amortization expense relating to internal-use software of$0.9 million, $0.4 million, and $0.3 million.Income Taxes The Company accounts for income taxes in accordance with ASC topic 740, Income Taxes ("ASC 740"), which provides for an asset and liabilityapproach to accounting for income taxes. Deferred tax assets and liabilities represent the future tax consequences of the differences between the financialstatement carrying amounts of assets and liabilities versus the tax basis of assets and liabilities. Under this method, deferred tax assets are recognized fordeductible temporary differences, and operating loss and tax credit carryforwards. Deferred liabilities are recognized for taxable temporary differences.Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of thedeferred tax assets will not be realized. The impact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change isenacted. ASC 740 requires a reduction of the carrying amounts of deferred tax assets by a valuation allowance if, based on available evidence, it is morelikely than not that such assets will not be realized. Accordingly, the need to establish valuation allowances for deferred tax assets is assessedperiodically based on the ASC 740 more-likely-than-not realization ("MLTN") threshold criterion. In the assessment for a valuation allowance,appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers,among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the duration of statutorycarryforward periods, the Company's experience with operating loss and tax credit carryforwards not expiring unused, tax credits, and tax planningalternatives. Significant judgment is required to determine whether a valuation allowance is necessary and the amount of such valuation allowance, ifappropriate. The valuation allowance is reviewed at each reporting period and is maintained until sufficient positive evidence exists to support a reversal.F-16Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) When assessing the realization of the Company's deferred tax assets, the Company considers all available evidence, including:•the nature, frequency, and severity of cumulative financial reporting losses in recent years; •the carryforward periods for the net operating loss, capital loss, and foreign tax credit carryforwards; •predictability of future operating profitability of the character necessary to realize the asset; •prudent and feasible tax planning strategies that would be implemented, if necessary, to protect against the loss of the deferred tax assets;and •the effect of reversing taxable temporary differences. The evaluation of the recoverability of the deferred tax assets requires that the Company weigh all positive and negative evidence to reach aconclusion that it is more likely than not that all or some portion of the deferred tax assets will not be realized. The weight given to the evidence iscommensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary andthe more difficult it is to support a conclusion that a valuation allowance is not needed. The establishment of a valuation allowance has no effect on the ability to use the deferred tax assets in the future to reduce cash tax payments. TheCompany will continue to assess the likelihood that the deferred tax assets will be realizable at each reporting period and the valuation allowance will beadjusted accordingly, which could materially affect the Company's financial position and results of operations.Stock-Based Compensation The Company accounts for its stock-based compensation in accordance ASC topic 718, Compensation—Stock Compensation ("ASC 718").Under ASC 718, all stock-based awards, including employee stock option grants, are recorded at fair value as of the grant date and recognized asexpense in the statement of operations on a straight-line basis over the requisite service period, which is the vesting period.Net Income (Loss) Per Share Net income (loss) per share is computed under the provisions of ASC topic 260, Earnings Per Share. Basic income (loss) per share is computedusing net income (loss) and the weighted average number of shares of common stock outstanding. Diluted earnings per share reflect the weightedaverage number of shares of common stock outstanding plus any potentially dilutive shares outstanding during the period. Potentially dilutive sharesconsist of shares issuable upon the exercise of stock options, restricted stock awards, restricted stock units and conversion of shares of preferred stock.Common stock equivalent shares are excluded from the diluted computation if their effect is anti-dilutive.F-17Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) The following table sets forth the computation of basic and diluted net income (loss) per common share: The following table sets forth common stock equivalent shares included in the calculation of the Company's diluted net income (loss) per share (inthousands): Share-based awards to purchase approximately 470,000 shares of common stock that had an exercise price in excess of the average market price ofthe common stock during the year ended December 31, 2010, were not included in the calculation of diluted earnings per share because they were anti-dilutive.Comprehensive Income (Loss) Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers torevenues, expenses, gains, and losses that are not included in net income (loss), but rather are recorded directly in stockholders' equity. For the yearsended December 31, 2012, 2011 and 2010, the Company's comprehensive income (loss) consisted of net income (loss), foreign currency translationgains (losses) and the net unrealized gains (losses) on available-for-sale securities.Foreign Currency Translation and Transactions The functional currency of the Company's foreign subsidiaries is their local currency. Accordingly, assets and liabilities of the foreign subsidiariesare translated into U.S. dollars at exchange rates inF-18 Year Ended December 31, 2012 2011 2010 (dollars in thousands, except per shareamounts) Numerator: Net income (loss) $(35,831)$(19,988)$13,284 Denominator: Weighted average number of common shares: Basic 21,045 20,773 20,439 Diluted 21,045 20,773 21,187 Income (loss) per common share: Basic $(1.70)$(0.96)$0.65 Diluted $(1.70)$(0.96)$0.63 Year EndedDecember 31, 2012 2011 2010 Equity Instruments: Restricted common stock units — — 11 Restricted common stock — — 86 Stock options — — 651 Total common stock equivalent shares — — 748 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)effect on the balance sheet date. Income and expense items are translated at average rates for the period. Translation adjustments are recorded as acomponent of other comprehensive income (loss) in stockholders' equity. Cash flows of consolidated foreign subsidiaries, whose functional currency is the local currency, are translated to U.S. dollars using averageexchange rates for the period. The Company reports the effect of exchange rate changes on cash balances held in foreign currencies as a separate item inthe reconciliation of the changes in cash and cash equivalents during the period. The following table presents the effect of exchange rate changes and thenet unrealized gains and losses from the available-for-sale securities on total comprehensive income (loss) (dollars in thousands):Advertising Costs Costs for advertising are expensed as incurred. Advertising expense for the years ended December 31, 2012, 2011, and 2010 were $66.2 million,$74.4 million, and $54.2 million, respectively.Recently Issued Accounting Standards In June 2011, the FASB issued new guidance on comprehensive income statement presentation (ASU 2011-05—Comprehensive Income (Topic220)). Under the amendments to Topic 220, an entity has the option to present the total of comprehensive income, the components of net income, andthe components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutivestatements. In both choices, an entity is required to present each component of net income along with total net income, each component of othercomprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This update eliminates theoption to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments in thisupdate do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must bereclassified to net income, thus the adoption of such standard did not have a material impact on the Company's reported results of operations andfinancial position. In September 2011, the FASB issued new guidance on goodwill impairment testing (ASU 2011-08, Intangibles—Goodwill and Other (Topic350): Testing Goodwill for Impairment), effective for calendar years beginning after December 15, 2011. Early adoption is permitted. The objective ofthis standard is to simplify how an entity tests goodwill for impairment. The amendments in this standard will allow an entity to first assess qualitativefactors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value as a basis for determiningwhether it needs to perform the quantitative two-step goodwill impairment test. Only if an entity determines, based on qualitative assessment, that it ismore likely than not that a reporting unit's fair value is less than its carrying value will it be required to calculate the fair value of the reporting unit. TheCompanyF-19 Year Ended December 31, 2012 2011 2010 Net income (loss) $(35,831)$(19,988)$13,284 Foreign currency translation gain (loss) 336 98 447 Unrealized gain (loss) on available-for-sale securities 23 (23) — Total comprehensive income (loss) $(35,472)$(19,913)$13,731 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)adopted this guidance beginning in fiscal year 2012, and the adoption of such guidance did not have a material impact on the Company's reported resultsof operations or financial position. In July 2012, the FASB issued new guidance on the impairment testing of indefinite-lived intangible assets (ASU 2012-02, Intangibles—Goodwilland Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment), effective for calendar years beginning after September 15, 2012.Early adoption is permitted. The objective of this standard is to simplify how an entity tests indefinite-lived intangible assets for impairment. Theamendments in this standard will allow an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-livedintangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test. Only if an entity determines,based on qualitative assessment, that it is more likely than not that the indefinite-lived intangible asset is impaired will it be required to determine the fairvalue of the indefinite-lived intangible asset and perform the quantitative impairment test. The Company intends to adopt this guidance beginning infiscal year 2013, and the adoption of such guidance is not anticipated to have a material impact on the Company's reported results of operations orfinancial position. In February 2013, the FASB issued ASU No. 2013-02, "Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out ofAccumulated Other Comprehensive Income," or "ASU 2013-02" which requires disclosure of significant amounts reclassified out of accumulated othercomprehensive income by component and their corresponding effect on the respective line items of net income. This guidance is effective for reportingperiods beginning after December 15, 2012 and is not expected to have a material impact on the Company's consolidated financial statements orfinancial statement disclosures.3. INVENTORY Inventory consisted of the following (in thousands):4. ACQUISITIONS On November 1, 2009, the Company acquired certain assets from SGLC International Co. Ltd. ("SGLC"), a software reseller headquartered inSeoul, South Korea. As the assets acquired constituted a business, this transaction was accounted for under ASC topic 805, Business Combinations("ASC 805"). The purchase price consisted of an initial cash payment of $100,000, followed by three annual cash installment payments, if the acquiredcompany's revenues exceed certain targeted levels each of these years. The amount was calculated as the lesser of a percentage of the revenue generatedor a fixed amount for each year, based on the terms of the agreement. Based on these terms, the minimum additional cash payment would have been zero if none of the minimum revenue targets were met, and themaximum additional payment is $1.1 million. ManagementF-20 As ofDecember 31, 2012 2011 Raw materials $3,570 $2,458 Finished goods 3,011 4,265 Total inventory $6,581 $6,723 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)4. ACQUISITIONS (Continued)determined that the total contingent consideration for inclusion in the purchase price was the maximum was $1.1 million, the fair value of which was$850,000. Including the cash paid upon the acquisition date of $100,000, the total purchase price was $950,000. Together with the initial payment andthe first contingent payment made in 2009 and 2010, respectively, we made additional payments of $300,000 and $350,000 in accordance with theterms of the purchase in 2012 and 2011, respectively. Under the purchase method of accounting, the total purchase price was allocated to the tangible and intangible assets acquired on the basis of theirrespective estimated fair values at the date of acquisition. The valuation of the identifiable intangible assets and their useful lives acquired reflectsmanagement's estimates. The summary of fair value of assets acquired in the asset acquisition is as follows (in thousands): A total of $100,000 was allocated to amortizable intangible assets consisting of customer relationships, and a total of $620,257 was allocated togoodwill. Goodwill represents the excess of the purchase price over the fair value of tangible and amortizable intangible assets acquired.5. PROPERTY AND EQUIPMENT Property and equipment consisted of the following (in thousands): The Company leases certain computer equipment, software and machinery under capital lease agreements. As of December 31, 2012 and 2011,leased computer equipment and software included in property and equipment above was $72,000 and $72,000, respectively. The Company recorded depreciation expense for the years ended December 31, 2012, 2011 and 2010 in the amount of $8.1 million, $8.6 million,and $6.6 million, respectively.F-21Tangible assets: Inventory $135 Property and equipment 95 Intangible assets: Customer relationships 100 Goodwill 620 Total assets acquired $950 As of December 31, 2012 2011 Land $390 $390 Buildings and improvements $8,145 8,120 Leasehold improvements $1,854 1,739 Computer equipment $15,704 14,534 Software $18,754 17,168 Furniture and equipment $4,895 5,980 49,742 47,931 Less: accumulated depreciation (32,529) (27,062) Property and equipment, net $17,213 $20,869 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)6. GOODWILL The value of goodwill is primarily derived from the acquisition of Rosetta Stone Ltd. (formerly known as Fairfield & Sons, Ltd.) in January 2006and the acquisition of certain assets of SGLC in November 2009. The Company tests goodwill for impairment annually on June 30 of each year at thereporting unit level using a fair value approach, in accordance with the provisions of ASC topic 350, Intangibles—Goodwill and Other ("ASC 350") ormore frequently, if impairment indicators arise. The Company's annual testing resulted in no impairments of goodwill since the dates of acquisition.Beginning in the fourth quarter of 2012, the Company began reporting its results in three reportable segments, which resulted in three reporting units forgoodwill impairment purposes—North America Consumer, ROW Consumer, and Institutional. The table below has been updated to present the currentreporting units and the change in the allocation of goodwill. The following table represents the balance and changes in goodwill for the years ended December 31, 2012 and 2011 (in thousands):7. INTANGIBLE ASSETS Intangible assets consisted of the following items as of the dates indicated (in thousands): The Company recorded intangible assets of $23.8 million, associated with the acquisition of Rosetta Stone Ltd. in January 2006, and $0.1 millionwith the acquisition of certain assets of SGLC in November 2009. During 2010, the Company recorded the purchase of two patents associated with thedevelopment of new products in the amount of $0.3 million. The estimated lives of the acquired core technology and customer relationships are between18 to 36 months. The intangible asset associatedF-22 Rest of WorldConsumerReportingUnit NorthAmericaConsumerReportingUnit InstitutionalReportingUnit Total Balance as of January 1, 2011 — 15,669 19,150 34,819 Effect of change in foreign currency rate — 10 12 22 Balance as of December 31, 2011 — 15,679 19,162 34,841 Effect of change in foreign currency rate — 17 23 40 Balance as of October 30, 2012 — 15,696 19,185 34,881 Change in reporting units 2,197 (2,197) — — Effect of change in foreign currency rate 2 — 13 15 Balance as of December 31, 2012 2,199 13,499 19,198 34,896 December 31, 2012 December 31, 2011 GrossCarryingAmount AccumulatedAmortization NetCarryingAmount GrossCarryingAmount AccumulatedAmortization NetCarryingAmount Trade name/trademark $10,607 $— $10,607 $10,608 $— $10,608 Coretechnology 2,453 (2,453) — 2,453 (2,453) — Customerrelationships 10,850 (10,850) — 10,842 (10,842) — Website 12 (12) — 12 (12) — Patents 300 (82) 218 300 (43) 257 Total $24,222 $(13,397)$10,825 $24,215 $(13,350)$10,865 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)7. INTANGIBLE ASSETS (Continued)with the trade name and trademark has an indefinite useful life. The estimated life of the website rights is 60 months, and estimated useful life of thepatents are based on the effective date of the purchase agreement through the expiration date of the patents. The Company computes amortization ofintangible assets on a straight-line basis over the estimated useful life. Below are the estimated useful lives of the intangible assets acquired: In accordance with ASC topic 360, Property, Plant, and Equipment, the Company reviews its long-lived assets, including property and equipmentand definite-lived intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets maynot be fully recoverable. If the total of the expected undiscounted future net cash flows is less than the carrying amount of the asset, a loss is recognizedfor the difference between the fair value and carrying amount of the asset. There were no impairment charges for the year ended December 31, 2012 and2011. Amortization expense consisted of the following (in thousands): The following table summarizes the estimated future amortization expense related to intangible assets as of December 31, 2012 (in thousands):F-23 Weighted Average LifeTrade name / trademark IndefiniteCore technology 24 monthsCustomer relationships 24 monthsWebsite 60 monthsPatents 72-100 months Years EndedDecember 31, 2012 2011 2010 Included in cost of revenue: Cost of product revenue $— $— $— Cost of subscription and service revenue — — — Total included in cost of revenue — — — Included in operating expenses: $40 $85 $58 Total $40 $85 $58 As ofDecember 31, 2012 2013 $40 2014 40 2015 40 2016 40 2017 40 Thereafter 18 Total $218 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)8. OTHER CURRENT LIABILITIES The following table summarizes other current liabilities (in thousands):9. BORROWING AGREEMENT On January 16, 2009, the Company entered into a credit agreement with Wells Fargo Bank, N.A. ("Wells Fargo"), which provided the Companywith a $12.5 million revolving line of credit. This revolving credit facility had a two-year term and the applicable interest rate was 2.5% above onemonth LIBOR. Interest expense for the year ended December 31, 2012 and 2011 was zero and $5,000, respectively. On January 17, 2011, the Company allowed its $12.5 million revolving line of credit with Wells Fargo to expire and we had no borrowingsoutstanding for any of the periods presented.10. STOCK-BASED COMPENSATION2006 Stock Incentive Plan On January 4, 2006, the Company established the Rosetta Stone Inc. 2006 Stock Incentive Plan (the "2006 Plan") under which the Company'sBoard of Directors, at its discretion, could grant stock options to employees and certain directors of the Company and affiliated entities. The 2006 Planinitially authorized the grant of stock options for up to 1,942,200 shares of common stock. On May 28, 2008, the Board of Directors authorized thegrant of additional stock options for up to 195,000 shares of common stock under the plan, resulting in total stock options available for grant under the2006 Plan of 2,137,200 as of December 31, 2008. The stock options granted under the 2006 Plan generally expire at the earlier of a specified periodafter termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from suchgrant date. Stock issued as a result of exercises of stock options will be issued from the Company's authorized available stock.2009 Omnibus Incentive Plan On February 27, 2009, the Company's Board of Directors approved a new Stock Incentive and Award Plan (the "2009 Plan") that provides for theability of the Company to grant up to 2,437,744 new stock incentive awards or options including Incentive and Nonqualified Stock Options, StockAppreciation Rights, Restricted Stock, Restricted Stock Units, Performance Units, Performance Shares, Performance based Restricted Stock, ShareAwards, Phantom Stock and Cash Incentive Awards. TheF-24 December 31, 2012 2011 Marketing expenses $16,922 $12,726 Professional and consulting fees 3,282 3,322 Sales return reserve 5,883 9,931 Sales, withholding, and property taxes payable 3,451 2,413 Other 6,849 6,519 $36,387 $34,911 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued)stock incentive awards and options granted under the 2009 Plan generally expire at the earlier of a specified period after termination of service or thedate specified by the Board or its designated committee at the date of grant, but not more than ten years from such grant date. On May 26, 2011 theBoard of Directors authorized and the Company's shareholders' approved the allocation of an additional 1,000,000 shares of common stock to the 2009Plan. On May 23, 2012, the Board of Directors authorized and the Company's shareholders approved the allocation of 1,122,930 additional shares ofcommon stock to the 2009 Plan. Concurrent with the approval of the 2009 Plan, the 2006 Plan was terminated for purposes of future grants. At December 31, 2012 there were1,471,063 shares available for future grant under the 2009 Plan. In accordance with ASC topic 718, Compensation—Stock Compensation ("ASC 718"), the fair value of stock-based awards to employees iscalculated as of the date of grant. Compensation expense is then recognized on a straight-line basis over the requisite service period of the award. TheCompany uses the Black-Scholes pricing model to value its stock options, which requires the use of estimates, including future stock price volatility,expected term and forfeitures. Stock-based compensation expense recognized is based on the estimated portion of the awards that are expected to vest.Estimated forfeiture rates were applied in the expense calculation. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model as follows: Prior to the completion of the Company's initial public offering in April 2009, the Company's stock was not publicly quoted and the Company hada limited history of stock option activity, so the Company reviewed a group of comparable industry-related companies to estimate its expected volatilityover the most recent period commensurate with the estimated expected term of the awards. In addition to analyzing data from the peer group, theCompany also considered the contractual option term and vesting period when determining the expected option life and forfeiture rate. Subsequent to theinitial public offering, the Company continues to review a group of comparable industry-related companies to estimate volatility, but also reviews thevolatility of its own stock since the initial public offering. The Company considers the volatility of the comparable companies to be the best estimate offuture volatility. For the risk-free interest rate, the Company uses a U.S. Treasury Bond rate consistent with the estimated expected term of the optionaward.F-25 Year Ended December 31, 2012 2011 2010Expected stock price volatility 64%-66% 57%-64% 58%-66%Expected term of options 6 years 6 years 6 yearsExpected dividend yield — — —Risk-free interest rate 0.60%-0.88% 1.14%-2.59% 1.14%-2.59%Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued) Stock Options—The following table summarizes the Company's stock option activity from January 1, 2012 to December 31, 2012: As of December 31, 2012 and 2011, there was approximately $6.8 million and $7.9 million of unrecognized stock-based compensation expenserelated to non-vested stock option awards that is expected to be recognized over a weighted average period of 2.52 and 2.67 years, respectively. Stock options are granted at the discretion of the Board of Directors or the Compensation Committee (or its authorized member(s) and expire10 years from the date of the grant. Options generally vest over a four-year period based upon required service conditions. No options haveperformance or market conditions. The Company calculates the pool of additional paid-in capital associated with excess tax benefits using the"simplified method" in accordance with ASC 718. The weighted average remaining contractual term and the aggregate intrinsic value for options outstanding at December 31, 2012 was 6.98 yearsand $6.8 million, respectively. The weighted average remaining contractual term and the aggregate intrinsic value for options exercisable atDecember 31, 2011 was 7.14 years and $2.3 million, respectively. As of December 31, 2012, options that were vested and exercisable totaled1,299,947 shares of common stock with a weighted average exercise price per share of $11.70. The weighted average grant-date fair value per share of stock options granted was $5.94 and $7.35 for the years ended December 31, 2012 and2011, respectively. The aggregate intrinsic value disclosed above represents the total intrinsic value (the difference between the fair market value of the Company'scommon stock as of December 31, 2012, and the exercise price, multiplied by the number of in-the-money options) that would have been received bythe option holders had all option holders exercised their options on December 31, 2012. This amount is subject to change based on changes to the fairmarket value of the Company's common stock.F-26 OptionsOutstanding WeightedAverageExercisePrice WeightedAverageContractualLife (years) AggregateIntrinsicValue Options Outstanding, January 1, 2012 2,223,749 $13.29 7.14 $2,288,131 Options granted 662,856 10.13 Options exercised (118,024) 7.31 Options cancelled (298,234) 14.61 Options Outstanding, December 31, 2012 2,470,347 12.57 6.98 6,760,327 Vested and expected to vest at December 31, 2012 2,321,437 12.63 6.85 6,465,961 Exercisable at December 31, 2012 1,299,947 11.70 5.50 4,965,104 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued) The following table summarizes the Company's restricted stock activity for the years ended December 31, 2012 and 2011, respectively: During 2012 and 2011, 651,978 and 170,260 shares of restricted stock were granted, respectively. The aggregate grant date fair value of theawards in 2012 and 2011 was $5.8 million and $2.4 million, respectively, which will be recognized as expense on a straight-line basis over the requisiteservice period of the awards, which is also the vesting period. The Company's restricted stock grants are accounted for as equity awards. The grant datefair value is based on the market price of the Company's common stock at the date of grant. The Company did not grant any restricted stock prior toApril 2009. During 2012, 83,054 shares of restricted stock were forfeited. As of December 31, 2012, future compensation cost related to the nonvested portionof the restricted stock awards not yet recognized in the statement of operations was $5.6 million and is expected to be recognized over a period of2.18 years. Restricted stock awards are considered outstanding at the time of grant as the stock holders are entitled to voting rights and to receive anydividends declared subject to the loss of the right to receive accumulated dividends if the award is forfeited prior to vesting. Unvested restricted stockawards are not considered outstanding in the computation of basic earnings per share. Restricted Stock Units—During 2012 and 2011, 44,241 and 22,227 restricted stock units were granted, respectively. The aggregate grant date fairvalue of the awards in 2012 and 2011 was $0.6 million and $0.3 million, respectively, which was recognized as expense on the grant date, as theawards were immediately vested. The Company's restricted stock units are accounted for as equity awards. The grant date fair value is based on themarket price of the Company's common stock at the date of grant. The Company did not grant any restricted stock units prior to April 2009. Long Term Incentive Program—On January 4, 2011, the Company's Board of Directors approved the Rosetta Stone Inc. Long Term IncentiveProgram ("LTIP"), a long-term incentive plan for certain of the Company's executives. The LTIP was administered under the Rosetta Stone Inc. 2009Omnibus Incentive Plan (the "Plan"), and the 1,000,000 shares allocated to the LTIP were taken from the shares reserved under the Plan. The purposeof the LTIP was to: advance the best interests of the Company;F-27 NonvestedOutstanding WeightedAverageGrant DateFair Value AggregateIntrinsicValue Nonvested Awards, January 1, 2011 307,524 $21.69 $6,670,196 Awards granted 170,260 14.09 Awards vested (87,436) 21.58 Awards cancelled (67,338) 19.26 Nonvested Awards, December 31, 2011 323,010 18.22 5,885,242 Awards granted 651,978 8.88 Awards vested (133,831) 16.85 Awards cancelled (83,054) 12.68 Nonvested Awards, December 31, 2012 758,103 11.00 8,339,133 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued)motivate senior management to achieve key financial and strategic business objectives of the Company; offer eligible executives a competitive totalcompensation package; reward executives in the success of the Company; provide ownership in the Company; and retain key talent. Executivesdesignated by the Board of Directors were eligible to receive a minimum number of shares of restricted common stock for each milestone level of totalmarket capitalization achieved, as specified in individual award agreements. The shares received would be restricted in that after issuance of the shares,they would be subject to vesting over a two-year period. For each milestone level of market capitalization reached above the base market capitalization asof October 1, 2010, the compensation committee of the Board of Directors would allocate the pre-defined share incentive pool for that milestone reachedamongst the participating executives with the minimum number of shares specified in individual award agreements. Although minimum participationpercentages were communicated to certain plan participants, all share grants under the LTIP were contingent upon achievement of the marketcapitalization thresholds. In accordance with the agreements communicated to the executives after the approval of the plan by the Board of Directors, the LTIP participantswere granted minimum participation percentages of each tranche of shares issued at each milestone level reached. Throughout the year endedDecember 31, 2011, the target market capitalization required to trigger the first issuance of shares was below the minimum threshold, and no shareswere issued. The minimum participation percentages given to plan participants were considered grants in accordance with the provisions of ASC 718.The grant date fair value of the minimum awards was $6.1 million, which was derived using a Monte Carlo valuation model. This value would havebeen amortized as stock-based compensation expense over the derived service period of five years. On November 30, 2011, as a result of the substantial reduction in incentive and retentive value of the plan, the board of directors cancelled theLTIP. As a result of the cancellation, the company recognized $4.9 million in stock-based compensation expense equal to the total unamortized value ofthe awards. There were no shares issued from the LTIP to any executive prior to its cancellation. Stock-based compensation expense related to the LTIP was $6.0 million for the year ended December 31, 2011. As of December 31, 2011, therewas no unrecognized stock-based compensation expense related to awards under the LTIP.F-28Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)10. STOCK-BASED COMPENSATION (Continued) The following table presents the stock-based compensation expense for stock options and restricted stock included in the related financial statementline items (in thousands):11. COMMON STOCK At December 31, 2012, the Company's Board of Directors had the authority to issue 200,000,000 shares of stock, of which 190,000,000 weredesignated as Common Stock, with a par value of $0.00005 per share, and 10,000,000 were designated as Preferred Stock, with a par value of $0.001per share. At December 31, 2012 and 2011, the Company had shares of Common Stock issued and outstanding of 21,950,671 and 21,258,249,respectively.12. EMPLOYEE BENEFIT PLAN The Company maintains a defined contribution 401(k) Plan (the "Plan"). The Company matches employee contributions to the Plan up to 4% oftheir compensation that vest immediately. The Company recorded expenses for the Plan totaling $1.6 million and $1.4 million for the years endedDecember 31, 2012 and 2011, respectively.13. COMMITMENTS AND CONTINGENCIESOperating Leases The Company leases many kiosks, copiers, parking spaces, buildings, a warehouse and office space under operating lease and site licensearrangements, some of which contain renewal options. The rental payments under some kiosk site licenses are based on a minimum rental plus apercentage of the kiosk's sales in excess of stipulated amounts. Kiosk site licenses range from a period of one month to 89 months. Building, warehouseand office space leases range from 12 months to 89 months. Certain leases also include lease renewal options.F-29 Years Ended December 31, 2012 2011 2010 Included in cost of revenue: Cost of product revenue $110 $30 $25 Cost of subscription and service revenue 178 25 14 Total included in cost of revenue 288 55 39 Included in operating expenses: Sales and marketing 1,185 1,932 774 Research & development 1,547 2,448 1,181 General and administrative 4,989 7,918 2,393 Total included in operating expenses 7,721 12,298 4,348 Total $8,009 $12,353 $4,387 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)13. COMMITMENTS AND CONTINGENCIES (Continued) The following table summarizes future minimum operating lease payments as of December 31, 2012 and the years thereafter (in thousands): Total expenses under operating leases were $9.5 million and $13.5 million during the years ended December 31, 2012 and 2011, respectively. The Company accounts for its leases under the provisions of ASC topic 840, Accounting for Leases ("ASC 840"), and subsequent amendments,which require that leases be evaluated and classified as operating leases or capital leases for financial reporting purposes. Certain operating leasescontain rent escalation clauses, which are recorded on a straight-line basis over the initial term of the lease with the difference between the rent paid andthe straight-line rent recorded as either a deferred rent asset or liability depending on the calculation. Lease incentives received from landlords arerecorded as deferred rent liabilities and are amortized on a straight-line basis over the lease term as a reduction to rent expense. The deferred rent liabilitywas $439,000 at December 31, 2012. The deferred rent asset was $78,000 at December 31, 2012. The deferred rent asset is classified in prepaid andother assets as all associated leases have less than one year remaining on their term.Royalty Agreement On December 28, 2006 the Company entered into an agreement to license software from a vendor for incorporation in software products that theCompany is developing. The agreement required a one-time, non-refundable payment of $0.3 million, which was expensed in full as research anddevelopment costs during 2006 because the products into which the licensed software were to be incorporated had not yet reached technologicalfeasibility. In addition, the agreement specifies that, in the event the software is incorporated into specified Company software products, royalties will bedue at a rate of 20% of sales for those products up to an additional amount totaling $0.4 million. There were no additional royalty payments made underthis agreement in 2012 or 2011.Employment Agreements The Company has agreements with certain of its executives and key employees which provide guaranteed severance payments upon termination oftheir employment without cause. The severance payments range from six to eighteen months of base salary.F-30 As ofDecember 31,2012 Periods Ending December 31, 2013 $5,441 2014 3,725 2015 2,402 2016 2,125 2017 1,960 2018 and thereafter 1,933 $17,586 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)13. COMMITMENTS AND CONTINGENCIES (Continued)Litigation In July 2009, the Company filed a lawsuit in the United States District Court for the Eastern District of Virginia against Google Inc., seeking,among other things, to prevent Google from infringing upon its trademarks. In August 2010, the U.S. District Court for the Eastern District of Virginiaissued its final order dismissing the Company's trademark infringement lawsuit against Google. The Company appealed the District Court's decision tothe U.S. Court of Appeals for the Fourth Circuit. In April 2012, the appellate court reversed the District Court's grant of summary judgment in Google'sfavor and remanded the case to the District Court for further consideration. The case was settled pursuant to the terms of a confidential settlementagreement and dismissed with prejudice in October 2012. In April 2010, a purported class action lawsuit was filed against the Company in the Superior Court of the State of California, County of Alamedafor damages, injunctive relief and restitution in the matter of Michael Pierce, Patrick Gould, individually and on behalf of all others similarly situated v.Rosetta Stone Ltd. and DOES 1 to 50. The complaint alleges that plaintiffs and other persons similarly situated who are or were employed as salariedmanagers by the Company in its retail locations in California are due unpaid wages and other relief for the Company's violations of state wage and hourlaws. Plaintiffs moved to amend their complaint to include a nationwide class in January 2011. In March 2011, the case was removed to the UnitedStates District Court for the Northern District of California. In November 2011, the parties agreed to the mediator's proposed settlement terms, and as aresult, as of September 30, 2011, the Company reserved $0.6 million for the proposed settlement amount. The Company disputes the plaintiffs' claimsand it has not admitted any wrongdoing with respect to the case. In June 2011, Rosetta Stone GmbH was served with a writ filed by Langenscheidt KG ("Langenscheidt") in the District Court of Cologne,Germany alleging trademark infringement due to Rosetta Stone GmbH's use of the color yellow on its packaging of its language-learning software andthe advertising thereof in Germany. In January 2012, the District Court of Cologne ordered an injunction of Rosetta Stone GmbH's use of the coloryellow in packaging, on its website and in television commercials and declared Rosetta Stone liable for damages, attorneys' fees and costs toLangenscheidt. No dollar amounts have been specified yet for the award of damages by the District Court of Cologne. In its decision, the District Courtof Cologne also ordered the destruction of Rosetta Stone GmbH's product and packaging which utilized the color yellow and which was deemed tohave infringed Langenscheidt's trademark. Langenscheidt has not posted the necessary bond to immediately enforce that decision. Rosetta Stone GmbHhas continued to vigorously defend this matter through an appeal to the Court of Appeals in Cologne. The Court of Appeals in Cologne affirmed thedecision in November of 2012 and Rosetta Stone GmbH moved to have a further appeal heard before the German Federal Supreme Court. TheCompany also commenced a separate proceeding for the cancellation of Langenscheidt's German trademark registration of yellow as an abstract colormark. In June 2012, the German Patent and Trademark Office rendered a decision in the cancellation proceeding denying Rosetta Stone's request tocancel Langenscheidt's German trademark registration. The Company has appealed that decision and a hearing on the appeal is scheduled to be held inApril 2013 before the German Federal Patent Court. The Company cannot predict the timing and ultimate outcome of this matter, however the Companybelieves the range of possible loss is immaterial to the financial statements. Even if the plaintiff is unsuccessful in its claims against the Company, theCompany will incur legal fees and other costs in the defense of these claims and appeals.F-31Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)13. COMMITMENTS AND CONTINGENCIES (Continued) From time to time, the Company has been subject to various claims and legal actions in the ordinary course of its business. The Company is notcurrently involved in any legal proceeding the ultimate outcome of which, in its judgment based on information currently available, would have amaterial impact on its business, financial condition or results of operations.14. INCOME TAXES The following table summarizes the significant components of the Company's deferred tax assets and liabilities as of December 31, 2012 and 2011(in thousands): During the quarter ended December 31, 2010, the Company determined that the relative weight of positive and negative evidence supported that itis more likely than not that the deferred tax assets relating to foreign operations will be realized and accordingly the Company released its valuationallowance. The Company had evaluated the valuation allowance on its foreign deferred tax assets quarterly prior to making the determination to releasethe valuation allowance during the quarter ended December 31, 2010. As of December 31, 2011, the Company had fully utilized the net operating loss("NOL") carryforwards for U.K. income tax purposes and the NOL carryforwards for Japanese income tax purposes upon which the valuationallowance had been released. During the second quarter of 2012, the Company established a full valuation allowance to reduce the deferred tax assets of the Korea subsidiaryresulting in a non-cash charge of $0.4 million. During the third quarter of 2012, the Company established a full valuation allowance to reduce thedeferredF-32 As ofDecember 31, 2012 2011 Deferred tax assets: Inventory $873 $478 Amortization and depreciation 7,273 7,710 Net operating loss carryforwards 3,107 1,002 Deferred revenue 2,548 1,826 Accrued liabilities 10,189 9,117 Stock-based compensation 5,613 4,271 Bad debt reserve 441 770 Foreign currency translation 286 77 Foreign and other tax credits 445 1,704 Gross deferred tax assets 30,775 26,955 Valuation allowance (29,671) — Net deferred tax assets 1,104 26,955 Deferred tax liabilities: Goodwill and indefinite lived intangibles (8,400) (7,201)Prepaid expenses (759) (727)Other (6) (4) Gross deferred tax liabilities (9,165) (7,932) Net deferred tax assets (liabilities) $(8,061)$19,023 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)14. INCOME TAXES (Continued)tax assets of its operations in Brazil, Japan, and the U.S. resulting in a non-cash charge of $0.4 million, $2.1 million, and $23.1 million, respectively.Additionally, no tax benefits were provided on 2012 losses incurred in foreign jurisdictions where the Company has determined a valuation allowanceis required. As of December 31, 2012, a full valuation allowance was provided for domestic and certain foreign deferred tax assets in those jurisdictionswhere the Company has determined the deferred tax assets will more likely than not be realized. As of December 31, 2012, the Company had state tax NOL carryforwards in the amount of $0.6 million in the U.S. that if not utilized, wouldbegin to expire in 2017. Additionally, the Company has foreign tax credit carryforwards of $0.4 million, which if not utilized, would expire in 2022. As of December 31, 2012, the Company had foreign net operating loss carryforwards related to operations in Japan of $2.4 million which expirein 2020, Brazil of $2.9 million which have an unlimited carryforward, Korea of $2.9 million which expire in 2024, and German trade tax of $0.7 millionwhich expire in 2018. If future events change the outcome of the Company's projected return to profitability, a valuation allowance may not be required to reduce thedeferred tax assets. The Company will continue to assess the need for a valuation allowance. The components of income (loss) before income taxes are as follows (in thousands):F-33 Year Ended December 31, 2012 2011 2010 United States $(1,585)$(33,199)$1,683 Foreign (4,255) 5,231 11,190 Income (loss) before income taxes $(5,840)$(27,968)$12,873 The provision for taxes on income consists of the following (in thousands): Federal $288 $(8,758)$2,739 State 333 (582) 1,066 Foreign 2,150 3,458 1,738 Total current $2,771 $(5,882)$5,543 Deferred: Federal $21,026 $(682)$(3,099)State 3,418 (870) (456)Foreign 2,776 (546) (2,399) Total deferred 27,220 (2,098) (5,954) Provision (benefit) for income taxes $29,991 $(7,980)$(411) Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)14. INCOME TAXES (Continued) Reconciliation of income tax provision (benefit) computed at the U.S. federal statutory rate to income tax expense is as follows (in thousands): The Company accounts for uncertainty in income taxes under ASC topic 740-10-25, Income Taxes: Overall: Recognition, ("ASC 740-10-25").ASC 740-10-25 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax positiontaken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on de-recognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition. The Company recognizes interest and penalties related to unrecognized tax benefits as a component of income tax expense. As of December 31,2012, the Company had $9,000 accrued for interest and penalties in "Other Long Term Liabilities". During the year ended December 31, 2012, theCompany accrued $42,000 of interest expense and paid $57,000 as settlement of its Japan audit. A reconciliation of the beginning and ending amount of unrecognized tax benefits, excluding interest and penalties, is as follows (in thousands): During the year ended December 31, 2012, the Company recognized $239,000 for unrecognized tax benefits and paid $261,000 as settlement of itsJapan audit for the tax years 2008, 2009, and 2010. These liabilities for unrecognized tax benefits are included in "Other Long Term Liabilities". As ofDecember 31, 2012 and 2011, the Company had $143,000 and $165,000 of unrecognized tax benefits,F-34 Year Ended December 31, 2012 2011 2010 Income tax expense at statutory federal rate $(2,044)$(9,789)$4,506 State income tax expense, net of federal income tax effect 216 (869) 229 Domestic production activities deduction (81) 580 (315)Nondeductible LTIP expense — 2,062 — Nondeductible intercompany interest — 29 134 Other nondeductible expenses 504 698 161 Tax rate differential on foreign operations (340) (206) 16 Increase (decrease) in valuation allowance 29,775 — (4,872)Tax Audit Settlements 281 — — Change in prior year estimates 1,608 — — Other tax credits — (619) — Other 72 134 (270) Income tax expense (benefit) $29,991 $(7,980)$(411) Year EndedDecember 31, 2012 2011 Balance at January 1, $165 — Increases for tax positions taken during prior period — — Increases for tax positions taken during current period 239 165 Settlements (261) — Balance at December 31, $143 $165 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)14. INCOME TAXES (Continued)respectively, which if recognized, would affect income tax expense. The Company does not expect that the amounts of unrecognized tax benefits willchange significantly within the next twelve months. The Company is subject to taxation in the U.S. and various states and foreign jurisdictions. The Company's tax years 2008, 2009, 2010, and 2011are subject to examination by the tax authorities. As of December 31, 2012, the Company has no ongoing income tax examinations. During 2012, theCompany closed its U.S. exam related to tax year 2008 and its Japan audit related to the tax years 2008, 2009, and 2010. The audits resulted in nomaterial audit assessments. No provision was made in 2012 for U.S. income taxes on undistributed earnings of the foreign subsidiaries as it is the Company's intention toutilize those earnings in the foreign operations for an indefinite period of time or to repatriate such earnings only when it is tax effective to do so. The Company made income tax payments of $4.0 million, $1.7 million, and $10.0 million in 2012, 2011 and 2010, respectively.15. SEGMENT INFORMATION During 2012, the Company had a change in our chief operating decision maker (CODM), which led to a change in the fourth quarter to what ourCODM uses to measure profitability and allocate resources. Accordingly, beginning with the fourth quarter of 2012, the Company is managed in threeoperating segments—North America Consumer, ROW Consumer and Institutional. These segments also represent the Company's reportable segments.Concurrent with the change in reportable segments, the Company reviewed the expenses included in segment contribution. The Company identifiedadditional expenses including certain customer care, coaching, finance and sales and marketing costs that directly benefit individual reportable segmentsand are included in segment contribution. Prior period data has been restated to be consistent with the current year presentation. Segment contribution includes segment revenue and expenses incurred directly by the segment, including material costs, service costs, customercare and coaching costs, and sales and marketing expense. The Company does not allocate expenses beneficial to all segments, which include certaingeneral and administrative expenses, facilities and communication expenses, purchasing expenses and manufacturing support and logistic expenses.These expenses are included in the unallocated expenses section of the table presented below. Revenue from transactions between the Company'soperating segments is not material.F-35Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. SEGMENT INFORMATION (Continued) With the exception of goodwill, the Company does not identify or allocate its assets by operating segment. Consequently, the Company does notpresent assets or liabilities by operating segment. Operating results by segment for the twelve months ended December 31, 2012, 2011 and 2010 were as follows (in thousands):Geographic Information Revenue by major geographic region is based primarily upon the geographic location of the customers who purchase the Company's products. Thegeographic locations of distributors and resellers who purchase and resell the Company's products may be different from the geographic locations ofend customers. The information below summarizes revenue from customers by geographic area for the years ended December 31, 2012, 2011 and 2010,respectively (in thousands):F-36 Years Ended December 31, 2012 2011 2010 Revenue: North America consumer $172,826 $157,561 $161,575 Rest of world consumer 40,248 50,465 42,688 Global institutional 60,167 60,423 54,605 Total revenue $273,241 $268,449 $258,868 Segment contribution: North America consumer $70,767 $54,985 $58,459 Rest of world consumer (3,536) (5,317) 9,628 Global institutional 25,857 34,270 35,317 Total segment contribution 93,088 83,938 103,404 Unallocated expenses, net: Unallocated cost of sales 6,104 7,042 5,265 Unallocated sales and marketing 16,633 22,581 13,571 Unallocated research and development 23,455 24,145 23,247 Unallocated general and administrative 52,926 58,577 48,424 Unallocated non-operating income/(expense) (190) (439) 24 Total unallocated expenses, net 98,928 111,906 90,531 Income (loss) before income taxes (5,840) (27,968) 12,873 Years Ended December 31, 2012 2011 2010 United States $223,747 $212,122 $212,629 International 49,494 56,327 46,239 Total Revenue $273,241 $268,449 $258,868 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. SEGMENT INFORMATION (Continued) The information below summarizes long-lived assets by geographic area for the years ended December 31, 2012, 2011 and 2010, respectively (inthousands):16. RELATED PARTIES As of December 31, 2012 and 2011, the Company had outstanding receivables from stockholders of $0, and outstanding receivables fromemployees in the amount of $60,000 and $10,000, respectively.17. VALUATION AND QUALIFYING ACCOUNTS The following table includes the Company's valuation and qualifying accounts for the respective periods (in thousands):F-37 As of December 31, 2012 2011 2010 United States $15,986 $18,417 $18,802 International 1,227 2,452 2,271 Total $17,213 $20,869 $21,073 Year Ended December 31, 2012 2011 2010 Allowance for doubtful accounts: Beginning balance $1,951 $1,761 $1,349 Charged to costs and expenses 1,820 1,228 1,750 Deductions—accounts written off (2,474) (1,038) (1,338) Ending balance $1,297 $1,951 $1,761 Sales return reserve: Beginning balance $9,931 $8,391 $4,708 Charged against revenue 11,148 24,922 36,348 Deductions—reserves utilized (15,196) (23,382) (32,665) Ending balance $5,883 9,931 8,391 Deferred income tax asset valuation allowance: Beginning balance — — 5,012 Charged to costs and expenses $29,671 — — Deductions — — (5,012) Ending balance $29,782 $— $— Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)18. SUPPLEMENTAL QUARTERLY FINANCIAL INFORMATION (Unaudited) Summarized quarterly supplemental consolidated financial information for 2012 and 2011 are as follows (in thousands, except per share amounts):19. SUBSEQUENT EVENTS On February 21, 2013, the Company's board of directors approved the 2013 Rosetta Stone Inc. Long Term Incentive Program ("2013 LTIP"), anew long-term incentive program. The 2013 LTIP, which will be administered under the Rosetta Stone Inc. 2009 Omnibus Incentive Plan (the "Plan")and the shares awarded under the 2013 LTIP will be taken from the shares reserved under the Plan. The purpose of the 2013 LTIP is to: motivate seniormanagement to achieve key financial and strategic business objectives of the Company; offer eligible employees of the Company a competitive totalcompensation package; reward employees in the success of the Company; provide ownership in the Company; and retain key talent. The 2013 LTIP iseffective from January 1, 2013 until December 31, 2014. Executives designated by the board of directors will be eligible to receive performance stock awards and cash upon the Company's achievement ofspecified performance goals between January 1, 2013 and December 31, 2014. In order for the granting of any performance stock award or any cashpayment to be made under the 2013 LTIP, the Company must meet the minimum threshold requirements for each performance goal for the 2014 fiscalyear in addition to the 2013 fiscal year results and/or the total results for each performance goal. Each performance goal is mutually exclusive.F-38 Three Months Ended March 31, June 30, September 30, December 31, 2012 Revenue $69,449 $60,812 $64,279 $78,701 Gross profit $55,975 $49,492 $53,094 $65,770 Net income (loss) $(1,903)$(4,544)$(33,390)$4,006 Basic loss per share $(0.09)$(0.22)$(1.58)$0.19 Shares used in basic per share computation 20,942 20,995 21,073 21,166 Diluted loss per share $(0.09)$(0.22)$(1.58)$0.18 Shares used in diluted per share computation 20,942 20,995 21,073 21,828 2011 Revenue $56,978 $66,743 $64,202 $80,527 Gross profit $45,516 $55,223 $52,893 $65,702 Net income (loss) $(9,281)$(4,550)$(1,177)$(4,979) Basic income per share $(0.45)$(0.22)$(0.06)$(0.24) Shares used in basic per share computation 20,675 20,716 20,780 20,920 Diluted income per share $(0.45)$(0.22)$(0.06)$(0.24) Shares used in diluted per share computation 20,675 20,716 20,780 20,920 Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)19. SUBSEQUENT EVENTS (Continued)Each performance goal has a range of payout levels depending on the achievement of the goal ranging from zero to 200% of the incentive target. The maximum number of shares to be issued as performance share awards is 883,262 and the maximum cash payout is $3.17 million, althoughexecutives hired after the approval of the plan may be allowed to participate in the plan at the discretion of the board of directors, which could raise theoverall share awards and cash payouts. The minimum number of shares to be issued as performance stock awards is zero and the minimum cash payoutis zero. If performance stock awards are granted, the shares will be 100% vested as of the date of grant. There will be no subsequent holding periodrequirement. Before any payment of cash or the granting of performance stock awards pursuant to an award granted under the LTIP can be made, the materialterms of the performance goals must be disclosed to, and subsequently approved by, the stockholders, in accordance with Treasury RegulationSection 1.162-27(e)(4). If the Company's stockholders do not approve the material terms of the performance goals prior to the end of the 2013 fiscalyear, then any award under the LTIP shall be null and void, and any executive who has received an award under the LTIP shall have no rights to anypayment of cash or performance stock awards pursuant to such award.F-39Table of ContentsEXHIBIT INDEX Index to exhibits 3.1(1)Second Amended and Restated Certificate of Incorporation 3.2(1)Second Amended and Restated Bylaws 4.1(1)Specimen certificate evidencing shares of common stock 4.2(1)Registration Rights Agreement dated as of January 4, 2006 among Rosetta Stone Inc. and the InvestorShareholders and other Shareholders listed on Exhibit A Thereto 10.1+(1)2006 Incentive Option Plan 10.2+(1)2009 Omnibus Incentive Plan 10.3+(1)Director Form of Option Award Agreement under the 2006 Plan 10.4+(1)Executive Form of Option Award Agreement under the 2006 Plan 10.5+(1)Standard Form of Option Award Agreement under the 2006 Plan 10.6+(1)Form of Option Award Agreement under the 2009 Plan 10.7(1)Form of Indemnification Agreement entered into with each director and executive officer 10.8(1)Lease Agreement dated as of February 26, 2006, by and between Premier Flex Condos, LLC and FairfieldLanguage Technologies, Inc., as amended 10.9(1)Sublease Agreement dated as of October 6, 2008, by and between The Corporate Executive Board Companyand Rosetta Stone Ltd. 10.10(1)Software License Agreement by and between The Regents of the University of Colorado and Fairfield &Sons, Ltd. dated as of December 22, 2006*** 10.11+(1)Form of Restricted Stock Award under the 2009 Plan 10.12+(1)Executive Employment Agreement between Rosetta Stone Ltd. and Michael Wu dated February 20, 2009 10.13+(2)Executive Employment Agreement between Rosetta Stone Ltd. and Stephen Swad effective as ofNovember 9, 2010 10.14+(3)Executive Employment Agreement between Rosetta Stone Ltd. and Judy Verses effective as of October 5,2011 10.15+(3)Executive Employment Agreement between Rosetta Stone Ltd. and Pragnesh Shah effective as ofNovember 14, 2011 10.16+(3)Amendment to Executive Employment Agreement between Rosetta Stone Ltd. and Michael Wu effective asof December 22, 2011 +(3) 10.17+(3)Amendment to Executive Employment Agreement between Rosetta Stone Ltd. and Stephen Swad effectiveas of December 22, 2011 10.18+(3)Second Amendment to Executive Employment Agreement between Rosetta Stone Ltd. and Stephen Swadeffective as of February 22, 2012 10.19+(3)Amended Executive Form of Option Award Agreement under 2009 Plan effective for awards afterOctober 1, 2011. 10.20+(3)Amended Executive Form of Restricted Stock Award Agreement under 2009 Plan effective for awards afterOctober 1, 2011. 10.21+(3)Amended Employee Form of Option Award Agreement Under 2009 Plan effective for awards afterMarch 1, 2012. 10.22+(3)Amended Employee Form of Restricted Stock Award Agreement under 2009 Plan effective for awards afterMarch 1, 2012.Table of Contents Index to exhibits 10.23 First Amendment to Sublease Agreement with The Corporate Executive Board, dated as of November 1,2013. 21.1 Rosetta Stone Inc. Subsidiaries 23.1 Consent of Deloitte & Touche LLP, independent registered public accounting firm 24.1 The Power of Attorney with Board of Directors' Signatures 31.1 Certifications of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certifications of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certifications of Principal Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certifications of Principal Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 101++Interactive Data Files***Portions of this exhibit have been omitted pursuant to a request for confidential treatment. +Identifies management contracts and compensatory plans or arrangements. ++Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement orprospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934and otherwise are not subject to liability. (1)Incorporated by reference to exhibit filed with Registrant's registration statement on Form S-1 (File No. 333-153632), asamended. (2)Incorporated by reference to exhibit filed with Rosetta Stone's Current Report on Form 8-K dated October 13, 2010. (3)Incorporated by reference to exhibit filed with Rosetta Stone Form 10-K for the fiscal year ended December 31, 2011.Exhibit 10.23 Execution Copy FIRST AMENDMENT TO SUBLEASE AGREEMENT THIS FIRST AMENDMENT TO SUBLEASE AGREEMENT (this “First Amendment”) is made this 1st day of November, 2012 (the“Effective Date”), by and between THE CORPORATE EXECUTIVE BOARD COMPANY (“Sublessor”) and ROSETTA STONE LTD. (“Subtenant”). RECITALS A. Sublessor and Subtenant are parties to that certain Sublease Agreement dated October 6, 2008 (the “Original Sublease”), pursuant towhich Sublessor leased to Subtenant, and Subtenant leased from Sublessor, approximately 31,281 rentable square feet of office space (the “Original SubletPremises”) on the seventh (7th) floor of the building located at 1919 N. Lynn Street, Arlington, Virginia (the “Building”). B. The term of the Original Sublease (the “Original Sublease Term”) expires on December 31, 2013. C. Sublessor and Subtenant desire to amend the Original Sublease (i) to extend the Original Sublease Term to December 31, 2018, and (ii) tolease to Subtenant approximately 31,281 rentable square feet of additional office space on the sixth (6th) floor of the Building as shown on the attachedExhibit A (the “Expansion Area”) upon and subject to the terms and conditions set forth in this First Amendment. NOW, THEREFORE, in consideration of the foregoing and for other good and valuable consideration and of the mutual agreements hereinafter setforth, it is hereby mutually agreed as follows: 1. Incorporation of Recitals. The foregoing recitals are hereby incorporated in this First Amendment and made a part hereof by thisreference. 2. Definitions. Except as otherwise specified in this First Amendment, all capitalized terms used in this First Amendment shall have themeanings ascribed to them in the Original Sublease. As used in this First Amendment and in the Original Sublease, the term “Sublease” shall mean theOriginal Sublease, as amended by this First Amendment. As used in this First Amendment and in the Original Sublease, from and after the Expansion Date(hereafter defined), the term “Sublet Premises” shall mean collectively, the Original Sublet Premises and the Expansion Area. 3. Extension of Original Sublease Term. The Original Sublease Term is hereby extended to December 31, 2018, unless otherwise earlierterminated in accordance with the terms and conditions of the Sublease. From and after the Effective Date, the term “Sublease Expiration Date” as usedherein and in the Original Sublease shall mean December 31, 2018. As used herein and in the Original Sublease, the term “Sublease Term” shall mean theOriginal Sublease Term as extended by this First Amendment. Sublessor hereby leases the Original Sublet Premises to Subtenant, and Subtenant herebyleases the Original Sublet Premises from  Sublessor, for the Sublease Term, subject to all the terms and conditions of the Sublease. Subtenant shall lease the Original Sublet Premises for the SubleaseTerm in its “as-is” condition as of the Effective Date and Sublessor shall have no obligation to perform or pay for, any work, improvements or alterations inor to the Original Sublet Premises in connection with this First Amendment or the extension of the Original Sublease Term. 4. Expansion Area. A. Subject to all the terms and conditions of the Lease, Sublessor hereby leases the Expansion Area to Subtenant, and Subtenanthereby leases the Expansion Area from Sublessor, for a term (the “Expansion Term”) commencing on September 1, 2013, or such later date, as applicable,as the Expansion Area is delivered to Subtenant in the condition required by Section 5 below (the “Expansion Date”) and expiring on the Sublease ExpirationDate, unless otherwise earlier terminated in accordance with the terms and conditions of the Sublease, including without limitation the provisions of thisSubsection 4.A., below. Sublessor and Subtenant hereby stipulate and agree that the rentable area for the Expansion Area is 31,281 square feet, and from andafter the Expansion Date, the Sublet Premises shall contain 62,562 rentable square feet. The parties hereto acknowledge that the Expansion Area is currentlyoccupied by Sublessor, and that Sublessor is in the process of negotiating a new lease for space that will accommodate the employees of Sublessor currentlyoccupying the Expansion Area (the “New Lease”). If the space under the New Lease is not ready for Sublessor’s occupancy or if, for any reason whatsoever,the New Lease is terminated, Subtenant acknowledges that Sublessor shall be delayed in delivering the Expansion Area to Subtenant. If, for any reason,Sublessor is unable to deliver possession of the Expansion Area to Subtenant on the Expansion Date, Sublessor shall not be liable for any damage causedthereby, nor shall the Sublease or this First Amendment be void or voidable, but rather the commencement of the Expansion Term shall be delayed until, andshall commence upon (and the Expansion Date shall be), the date that possession of the Expansion Area is tendered to Subtenant in the condition required bySection 5, below. Notwithstanding anything contained in this First Amendment or Original Sublease to the contrary, in the event that Sublessor is unable todeliver possession of the Expansion Area to Subtenant on or before December 31, 2013 due to either (i) failure of the new landlord under the New Lease todeliver timely possession of the space under the New Lease to Sublessor or (ii) casualty or condemnation of the space under the New Lease or ExpansionArea), Sublessor shall have the right to terminate the Sublease with respect to the Expansion Area only by delivering written notice of such termination toSubtenant at any time from and after December 31, 2013 and prior to the delivery of possession of the Expansion Area by Sublessor to Subtenant, time beingof the essence. Further, notwithstanding anything contained in this First Amendment or Original Sublease to the contrary, in the event that Sublessor is unableto deliver possession of the Expansion Area to Subtenant on or before December 31, 2013 for any reason whatsoever, Subtenant shall have the right toterminate the Sublease with respect to the Expansion Area only by delivering written notice of such termination to Sublessor at any time from and afterDecember 31, 2013 and prior to the delivery of possession of the Expansion Area by Sublessor to Subtenant, time being of the essence. Termination of theSublease with respect to the Expansion Area shall be effective at 6:00 p.m. on the date that is five (5) business days after delivery of the Expansion Areatermination notice (the “Expansion Area Termination Date”); provided, however, if Sublessor delivers the Expansion Area prior to the Expansion AreaTermination Date, then the termination notice shall itself terminate, all rights to terminate the Sublease with respect to the Expansion Area set forth in thisSubsection 4.A. shall be null and 2 void, and the Sublease shall continue in full force and effect, unmodified. On the Expansion Area Termination Date, all rights and obligations of each ofSublessor and Subtenant with respect to the Expansion Area, including without limitation all references to Expansion Area Walls/Partitions, Expansion AreaSystems Furniture and Expansion Area Personal Property, shall terminate (except for those rights and obligations that expressly survive termination of theSublease with respect to the Expansion Area), and, if Subtenant has accessed the Expansion Area prior to the Expansion Area Termination Date, Subtenantshall vacate and surrender the Expansion Area in the condition required by the Sublease, including, without limitation, Section 15 thereof. Termination of theSublease with respect to the Expansion Area shall in no event serve to terminate or modify the Sublease with respect to the Original Sublet Premises, whichshall continue in full force and effect as set forth in the Original Sublease as modified by this First Amendment. B. Reference is made to the form of Declaration of Expansion Date (the “Declaration”) attached hereto as Exhibit C. After theExpansion Date, Sublessor shall complete the Declaration and deliver the completed Declaration to Subtenant. Within five (5) business days after Subtenantreceives the completed Declaration from Sublessor, Subtenant shall execute and return the Declaration to Sublessor to confirm the Expansion Date. Failure toexecute the Declaration shall not affect the Expansion Date or expiration of the Term. 5. Condition of the Expansion Area; Walls/Partitions; Office Furniture; Supplemental HVAC. A. Condition of Expansion Area, Generally. On the Expansion Date, Sublessor shall tender possession of the Expansion Area toSubtenant vacant of occupants, with all mechanical, electrical, and plumbing systems servicing the Expansion Area in good working order and condition asof the Expansion Date, and otherwise in broom-clean condition. Subtenant has fully inspected the Expansion Area and Subtenant shall accept the ExpansionArea in its “as is,” “where is” condition, subject only to (i) the provisions of Section 5.E. hereof and (ii) Sublessor’s obligation to deliver the mechanical,electrical, and plumbing systems servicing the Expansion Area in good working order and condition as of the Expansion Date. Subtenant acknowledges that,except as specifically set forth in this First Amendment, no representations, statements, or warranties, express or implied, have been made by or on behalf ofSublessor with respect to the condition of the Expansion Area or the Building, and that Sublessor has made no representation, statement or warranty as to theleasing of any personal property, fixtures or equipment in the Expansion Area other than the Expansion Area Walls/Partitions, Expansion Area SystemsFurniture and Expansion Area Personal Property (each as defined in, and as set forth in, subsections B and C, respectively, below). Sublessor shall have noobligation to undertake or pay for, any improvements or alterations with respect to the Expansion Area. Subtenant shall accept and take possession of theExpansion Area on the Expansion Date, and the taking of possession of the Expansion Area by Subtenant shall constitute an acknowledgment by Subtenantthat Sublessor has delivered the Expansion Area in the condition required by this First Amendment. B. Expansion Area Systems Furniture and Modular Walls/Partitions. The configuration of the Expansion Area includesmodular walls and partitions, approximately as shown on Exhibit B-l, attached hereto, (“Expansion Area Walls/Partitions”) and office systems furniturealso shown on Exhibit B-l, attached hereto (“Expansion Area Systems 3 Furniture”) and in “as is” condition, subject only to Section 5.E., below. Subtenant shall have the right to use the Expansion Area Walls/Partitions andExpansion Area Systems Furniture as part of the Expansion Area at no additional charge, subject to the conditions hereof. Notwithstanding the foregoing, theExpansion Area Walls/Partitions and Expansion Area Systems Furniture shall remain the property of Sublessor at all times during the Sublease Term.Subtenant shall be responsible to keep and maintain the Expansion Area Walls/Partitions and Expansion Area Systems Furniture in good order and condition,reasonable wear and tear excepted, and shall insure the Expansion Area Walls/Partitions and Expansion Area Systems Furniture under the special cause of lossbusiness property insurance required by Section 17.A.(1) of the Prime Lease, naming Sublessor as loss payee under such policy for the Expansion AreaWalls/Partitions and Expansion Area Systems Furniture. Subtenant shall have the right to perform modifications in the nature of reconfigurations to theExpansion Area Systems Furniture and Expansion Area Walls/Partitions in order to accommodate its employees in the Sublet Premises, so long as(i) Subtenant provides written notice to Sublessor (including a description of the modifications performed, but without need of plans preparation or approvalof same by Sublessor), (ii) Subtenant employs vendors and contractors selected by Subtenant and reasonably approved by Sublessor in connection with theperformance of such modifications, and (iii) Subtenant performs such modifications in accordance with the provisions of the Sublease, including Section 7 ofthe Original Sublease (as modified hereby), (iv) removal and storage of Expansion Area Walls/Partitions and Expansion Area Systems Furniture are performedin accordance with the provisions of Section 7(a)(i) of the Original Sublease (as modified by Section 8.A.(ii) of this First Amendment), and (iv) Subtenantremoves and restores any such modifications as set forth in Section 15 of the Original Sublease (as modified by Section 8.B. of this First Amendment). C. Expansion Area Office Furniture. In consideration for the rents and other promises contained in this Sublease, Sublessor shall lease toSubtenant (and Subtenant shall lease from Sublessor) the furniture and equipment listed on Exhibit B-2 attached hereto (the “Expansion Area PersonalProperty”) in its “as is, where is” condition, subject only to Section 5.E., below, at no extra cost or expense to Subtenant. At all times during the SubleaseTerm, Subtenant shall maintain and keep in good order and condition the Expansion Area Personal Property. The Expansion Area Personal Property shallremain in the Sublet Premises upon Sublease termination, and Subtenant shall surrender the Expansion Area Personal Property to Sublessor in the samecondition as on the Expansion Date, reasonable wear and tear excepted. Subtenant shall be responsible to insure the Expansion Area Personal Property underthe special cause of loss business property insurance required by Section 17.A.(1) of the Prime Lease, naming Sublessor as loss payee under such policy forthe Expansion Area Personal Property. D. Expansion Area Supplemental HVAC. As of the date of this First Amendment, the Expansion Area contains and/or is served bysupplemental HVAC equipment as set forth on Exhibit B-3 (“Expansion Area Sublessor’s HVAC”). Subtenant shall have the right to use the ExpansionArea Sublessor’s HVAC under the terms and conditions hereinafter set forth. Sublessor reserves the right to reasonably prescribe the amount and level of usefor the Expansion Area Sublessor’s HVAC, and Subtenant’s use shall not exceed such levels and amounts at any time. Sublessor makes no representation orwarranty as to the capacity or output of the Expansion Area Sublessor’s HVAC or to its sufficiency to service Subtenant’s particular requirements in theExpansion Area or Sublet Premises, and Subtenant acknowledges that the Expansion Area Sublessor’s HVAC equipment is in its “as is, where is” condition,subject only to Section 5.E., below. Sublessor shall maintain the Expansion Area Sublessor’s HVAC under the same contracts as the other supplemental 4 HVAC units in the Building, and Subtenant shall reimburse Sublessor the costs of such maintenance (without markup for profit by Sublessor) from time totime, within thirty (30) days after invoice therefor. Subtenant shall reimburse Sublessor from time to time, within thirty (30) days after invoice therefor, allcosts for use of the Expansion Area Sublessor’s HVAC, including, without limitation, costs for electricity and chilled water or condenser water (including anycosts for depreciation charged by Landlord as set forth below) serving the Expansion Area Sublessor’s HVAC. Sublessor shall not be required, under anycircumstance, to replace the Expansion Area Sublessor’s HVAC or to perform repairs or maintenance that are not covered by the service contracts. E. Operational Condition. Notwithstanding the foregoing provisions respecting the “as is” condition of the Expansion Area SystemsFurniture, Expansion Area Modular Walls/Partitions, Expansion Area Personal Property, and Expansion Area Supplemental HVAC, Sublessor will agree torepair any Expansion Area Systems Furniture, Expansion Area Modular Walls/Partitions, Expansion Area Personal Property or Expansion Area Sublessor’sHVAC that are not operational or improperly functioning in a material manner on the Expansion Date, subject to the provisions hereof. On or about theExpansion Date, but in any event prior to Subtenant’s occupancy or move-in to the Expansion Area, a representative of each of Sublessor and Subtenant shalljointly inspect the Expansion Area to identify material, malfunctioning Expansion Area Systems Furniture, Expansion Area Modular Walls/Partitions,Expansion Area Personal Property or Expansion Area Sublessor’s HVAC units, and shall, each acting in good faith, jointly prepare a list of such items (the“Punch List”). In no event shall items be added to the Punch List after Subtenant’s move-in or occupancy of the Expansion Area. It is expressly understoodand agreed that the Punch List shall be limited to only those matters that result in the item in general being unusable for its intended purpose, as opposed toaesthetic imperfections or non-material items of repair (e.g., sticky drawers). Sublessor shall repair or cause to be repaired Punch List items at Sublessor’ssole cost and expense. Except as may be expressly set forth to the contrary in Subsections 5 A. through D., and except for the Punch List items, each of theExpansion Area, Expansion Area Systems Furniture, Expansion Area Modular Walls/Partitions, Expansion Area Personal Property and Expansion AreaSublessor’s HVAC shall be delivered by Sublessor and accepted by Subtenant in its “as is, where is” condition. 6. Annual Base Subrent. A. Annual Base Subrent for the Original Sublet Premises. Commencing on January 1, 2014 (the “Renewal Date”) andcontinuing thereafter during the Sublease Term, the Annual Base Subrent and Monthly Base Subrent payable by Subtenant with respect to the Original SubletPremises shall be as follows: 5 Sublet TermAnnual Base SubrentPer Square FootAnnual Base SubrentMonthly Base SubrentJanuary 1, 2014 to December 31, 2014$54.00$1,689,174.00$140,764.50January 1, 2015 to December 31, 2015$55.35$1,731,403.35$144,283.61January 1, 2016 to December 31, 2016$56.73$1,774,571.13$147,880.93January 1, 2017 to December 31, 2017$58.15$1,818,990.15$151,582.51January 1, 2018 to December 31, 2018$59.60$1,864,347.60$155,362.30 From the Effective Date until the Renewal Date, Subtenant shall continue to pay Annual Base Subrent and Monthly Base Subrent with respect to theOriginal Sublet Premises in accordance with the terms and provisions of the Original Sublease. B. Annual Base Subrent for the Expansion Area. Commencing on the Expansion Date, Subtenant shall pay, in addition to theAnnual Base Subrent payable for the Original Sublet Premises, Annual Base Subrent and Monthly Base Subrent for the Expansion Area as follows: Sublet TermAnnual Base SubrentPer Square FootAnnual Base SubrentMonthly Base SubrentExpansion Date to December 31, 2014$54.00$1,689,174.00$140,764.50January 1, 2015 to December 31, 2015$55.35$1,731,403.35$144,283.61January 1, 2016 to December 31, 2016$56.73$1,774,571.13$147,880.93January 1, 2017 to December 31, 2017$58.15$1,818,990.15$151,582.51January 1, 2018 to December 31, 2018$59.60$1,864,347.60$155,362.30 Payment of Annual Base Subrent for the Expansion Area shall be in accordance with the terms and provisions set forth in Section 4 of the OriginalSublease applicable to payments of Annual Base Subrent for the Original Sublet Premises. The term “Base Subrent” shall mean the amount of BaseSubrent for both the Original Sublet Premises and Expansion Area. 6 7. Pass-Through Costs. A. Effective as of the Renewal Date, the second sentence of Section 4(c) of the Original Sublease shall be deleted and the followingshall substitute therefor: “Subtenant shall pay to Sublessor, as additional rent (“Pass-Through Expense Rental”), (1) Subtenant’s Proportionate Share(hereafter defined) of the amount by which Tenant’s Share of Increased Operating Expenses (as defined in Section 5.C. of the Prime Lease) exceeds Tenant’sShare of Increased Operating Expenses for calendar year 2014, plus (2) Subtenant’s Proportionate Share of the amount by which Tenant’s Share of IncreasedReal Estate Tax Expenses (as defined in Section 5.C. of the Prime Lease) exceeds Tenant’s Share of Increased Real Estate Tax Expenses for calendar year2014.” For the period preceding the Renewal Date, Subtenant’s Pass-Through Expense Rental for the Original Sublet Premises shall be calculated bySublessor, and paid by Subtenant, in accordance with all the terms and conditions of the Original Sublease. B. Effective as of the Expansion Date, to reflect the increase in the rentable area of the Sublet Premises, the term “Subtenant’sProportionate Share” as used in the Sublease shall be amended to mean Ten and 00/100 percent (10.0%). For clarity, assuming the Expansion Date occursprior to the Renewal Date, Subtenant shall pay Subtenant’s Proportionate Share (as increased hereby) of Pass-Through Expense Rental from the ExpansionDate until the Renewal Date in the same manner as set forth in Section 4(c) of the Sublease. From January 1, 2014 through then end of calendar year 2014,Subtenant shall not be responsible to pay Pass-Through Expense Rental, and the obligation to pay Pass-Through Expense Rental shall re-commence onJanuary 1, 2015 for the entire Sublet Premises and thereafter throughout the Sublease Term. 8. Amendments. A. Systems Furniture and Modular Walls/Partitions. (i) Effective as of the Effective Date, Section 2(b) of the Original Sublease shall be modified by deleting the last sentence ofsuch subsection and substituting the following therefor: Subtenant shall have the right to perform modifications in the nature of reconfigurations to the Systems Furniture and Walls/Partitions in order toaccommodate its employees in the Sublet Premises, so long as (i) Subtenant provides written notice to Sublessor (including a description of themodifications performed, but without need of plans preparation or approval of same by Sublessor), (ii) Subtenant employs vendors and contractorsselected by Subtenant and reasonably approved by Sublessor in connection with the performance of such modifications, and (iii) Subtenantperforms such modifications in accordance with the provisions of the Sublease, including Section 7 of the Original Sublease (as modified by theFirst Amendment), (iv) removal and storage of Walls/Partitions and Systems Furniture are performed in accordance with the provisions ofSection 7(a)(i) of the Original Sublease (as modified by Section 8.A.(ii) of the First Amendment), and (iv) Subtenant removes and restores any suchmodifications as set forth in Section 15 of the Original Sublease (as modified by Section 8.B of the First Amendment). 7 (ii) Effective as of the Effective Date, Section 7(a)(i) of the Original Sublease shall be modified by adding the following language to the end ofsuch subsection: Notwithstanding anything contained in this Subsection 7(a)(i) to the contrary, (a) Subtenant shall be permitted to make modifications in the nature ofreconfigurations to Systems Furniture and Walls/Partitions in accordance with Section 2(b) of the Original Sublease (as modified bySection 8(a)(i) of the First Amendment); (b) Subtenant shall not be required to use contractors, subcontractors or vendors designated by Sublessor inconnection with alterations affecting Walls/Partitions or Systems Furniture, but any such proposed contractor, subcontractor or vendor selected bySubtenant shall be subject to Sublessor’s reasonable prior written approval; (b) Subtenant shall use Sublessor’s storage vendors for storage ofWalls/Partitions or Systems Furniture, the costs of removal and transport to storage shall be borne by Subtenant, but the costs to store suchWalls/Partitions or Systems Furniture shall be borne by Sublessor. B. Restoration; Surrender. Section 15 of the Original Sublease is hereby amended by adding the following to the end of suchSection: “Notwithstanding anything contained herein to the contrary, Subtenant shall not be required to restore the Sublet Premises to the original conditionimmediately prior to (i) the Sublet Commencement Date with respect to the Original Sublet Premises and (ii) the Expansion Date with respect to the ExpansionArea, except that all substantial or structural alterations shall be removed and alterations to Walls/Partitions, Expansion Area Walls/Partitions, SystemsFurniture, or Expansion Area Systems Furniture configurations in the Sublet Premises that were substantial and resulted in a configuration of the SubletPremises that is inconsistent with standard, typical office space configurations, as determined by Sublessor in its reasonable discretion, shall be restored orremoved. Subtenant may request Sublessor’s determination of the restoration or removal of Walls/Partitions, Expansion Area Walls/Partitions, SystemsFurniture and/or Expansion Area Systems Furniture proposed by Subtenant to be modified in accordance with the provisions of this Sublease, by deliveringwritten request of such determination to Sublessor, accompanied by a set of plans and specifications showing the proposed modifications (includingidentifying items that will be removed or altered). Within ten (10) business days following receipt of Subtenant’s written request for Sublessor’s removal andrestoration determination (together with the plans and specifications regarding the proposed modification), Sublessor shall notify Subtenant in writing whetherSublessor will require the restoration or removal of the proposed modifications to the Walls/Partitions, Expansion Area Walls/Partitions, Systems Furnitureand/or Expansion Area Systems Furniture at the end of the Sublease Term. Except for only those items that Sublessor has agreed in writing need not berestored or removed as aforesaid following written request for Sublessor’s determination as set forth above, Sublessor shall notify Subtenant of anyinconsistencies with standard, typical office space configurations in the Sublet Premises and requirements for restoration of the Walls/Partitions, ExpansionArea Walls/Partitions, Systems Furniture and/or Expansion Area Systems Furniture that had been modified by Subtenant, not later than thirty (30) days priorto the expiration of the Sublease Term. Subtenant shall be responsible for all costs of such required restoration, including costs to transfer Walls/Partitions,Expansion Area Walls/Partitions, Systems Furniture, and Expansion Area Systems Furniture from storage to the Sublet Premises and installation of samepursuant to plans prescribed by Sublessor. 8 9. Parking. On the Expansion Date, Sublessor agrees to cause the Garage Operator to offer Subtenant twelve (12) additional parkingcontracts (the “Additional Parking Spaces”) for unreserved parking spaces subject to, and in accordance with the terms and conditions set forth inSection 18 of the Original Sublease. Subtenant shall enter into a contract with the Garage Operator within one hundred twenty (120) days after the ExpansionDate and Sublessor shall use commercially reasonable efforts to cause the Garage Operator to offer the Additional Parking Spaces to Subtenant at the same costas Subtenant’s other unreserved parking contracts. If Subtenant fails to execute the monthly parking contracts for the Additional Parking Spaces within said30-day period, or subsequently relinquishes all or any of such parking contracts, Subtenant shall be deemed to have forfeited its right to such unused orrelinquished Additional Parking Spaces and Sublessor shall thereafter have no obligation to provide such Additional Parking Spaces to Subtenant; provided,however, if, after the Expansion Date, Subtenant shall require additional parking contracts (up to the initial 12 Additional Parking Spaces allotted hereby)then Sublessor shall make such contracts available to Subtenant to the extent the same are available. Except as otherwise expressly set forth in thisSection 9, the Additional Parking Spaces shall be provided to Subtenant in accordance with, and Subtenant’s use of the Additional Parking Spaces shall besubject to, the terms and conditions of Section 18 of the Original Sublease. 10. Estoppel. Subtenant represents, warrants, and covenants to Sublessor that (a) the Original Sublease is in full force and effect and, exceptas set forth in this First Amendment, has not been modified, altered, or amended; (b) Sublessor is not required to perform any work or furnish anyimprovements to the Sublet Premises under the Original Sublease and Sublessor has fulfilled all of its obligations under the Original Sublease as of the datehereof; (c) there are no defaults by Sublessor under the Original Sublease and there is no defense, claim, or right of set-off whatsoever existing for the benefit ofSubtenant as of the date hereof to the obligations evidenced by the Sublease, and that Subtenant has waived and relinquished, and is forever estopped toassert, any such defense, claim or set-off; and (d) the amount of the Security Deposit held by Sublessor as of the Effective Date is $351,911.25, which, asof the Effective Date, is in the form of a letter of credit. 11. Consent of Landlord. Sublessor believes that, under the terms of the Prime Lease, this First Amendment is not subject to Landlord’sconsent. Promptly following the execution and delivery of this First Amendment, Sublessor shall deliver the notice to Landlord required by Section 23 of thePrime Lease, identifying the Subtenant, Subtenant’s business, the anticipated Effective Date of this First Amendment and Expansion Date, a certification as tothe Monthly Sublet Profit (if any), and, if validly requested by Landlord, providing to Landlord a copy of this First Amendment. If, for any reason, it isdetermined that Landlord’s consent is required for this First Amendment, and if such consent is not received within thirty (30) days after Landlord hasnotified Sublessor of the requirement of Landlord’s approval, then Sublessor shall have the right, by notice to Subtenant, given prior to receipt of Landlord’sconsent, to cancel this First Amendment, in which case the Original Sublease shall continue, unmodified, and shall terminate in accordance with its expressprovisions. Further, if for any reason, it is determined that Landlord’s consent is required for this First Amendment, any fees and costs due to Landlordpursuant to Section 23.B. of the Prime Lease shall be split evenly between Sublessor and Subtenant. Sublessor shall promptly deliver a copy of any noticefrom Landlord regarding Landlord’s consent of this First Amendment. 9 12. Expansion Option. Section 26 of the Original Sublease (captioned “Expansion Option”) is hereby deleted in its entirety. 13. Renewal Option. Section 27 of the Original Sublease (captioned, “Renewal Option”) is hereby deleted in its entirety. 14. Broker. Sublessor and Subtenant recognize Cushman and Wakefield of Virginia, Inc. and Jones Lang LaSalle Brokerage, Inc.(collectively, the “Brokers”), as the sole brokers with respect to this First Amendment. Sublessor agrees to be responsible for the payment of any leasingcommission owed to the Brokers in accordance with the terms of a separate commission agreement(s) entered into between Sublessor and the Brokers. Subtenant represents and warrants to Sublessor that, except for Brokers, no broker has been employed in carrying on any negotiations relating to this FirstAmendment, and Subtenant shall indemnify and hold harmless Sublessor from any claim for a brokerage commission and any other claims, fees andexpenses arising from or out of any breach of the foregoing representation and warranty. 15. Notices. Sublessor’s address for Notices set forth in Section 17 of the Original Sublease is hereby amended to be as follows: CEB, 1919North Lynn Street, Arlington, Virginia 22209, Attention: Barron Anschutz, Controller, with a copy to Holland & Knight LLP, 800 17 Street, N.W.,Suite 1100, Washington, DC 20006, Attention: Robin F. Gonzales, Esq. 16. Successors; Governing Law. This First Amendment shall be (a) binding upon and inure to the benefit of the parties hereto and theirrespective representatives, transferees, successors and permitted assigns and (b) governed by and construed in accordance with the laws of the Commonwealthof Virginia. 17. Ratification; Entire Agreement. Except as expressly amended by this First Amendment, all terms, conditions and provisions of theOriginal Sublease are hereby ratified and confirmed. This First Amendment contains and embodies the entire agreement of the parties hereto with respect to thesubject matter hereof. This First Amendment may not be modified or changed in whole or in part in any manner other than by an instrument in writing dulysigned by the parties hereto. In the event of any inconsistencies between the provisions of the Original Sublease and this First Amendment, the provisions ofthis First Amendment shall control. 18. No Offer. The submission of this First Amendment to Subtenant, does not constitute an offer to amend the Original Sublease. This FirstAmendment shall have no force and effect until it is fully executed and delivered by both parties. 19. Counterpart Copies. This First Amendment may be executed in two (2) or more counterpart copies, all of which counterparts shall havethe same force and effect as if all parties hereto had executed a single copy of this First Amendment. [signatures appear on the following page] 10th IN WITNESS WHEREOF, the parties hereto have executed this First Amendment to Sublease Agreement under seal as of the day and year firsthereinabove written. SUBLESSOR: THE CORPORATE EXECUTIVE BOARD COMPANY By:/s/ Richard Lindahl [Seal]Name: Richard LindahlTitle: Chief Financial Officer SUBTENANT: ROSETTA STONE LTD. By:/s/ Stephen Swad [Seal]Name: Stephen SwadTitle: Chief Executive Officer 11EXHIBIT AExpansion SpaceWaterview 1919 NorthLynn Street,Arlington, VA 22209FLOOR 06 Exhibit A EXHIBIT B-1 6thFloorWalls/Partitons andSystemsFurnitureExhibit B-1Waterview 1919 NorthLynn StreetArlington, VA 22209FLOOR 06 Al CapacityUnder Utilized OverUtilized EXHIBIT B-2 6th FloorPersonal PropertyConference RoomsBlack Mesh ConferenceRoom Chair (CC.1) 50Propeller Tables in12-person Conf Room(TT.1) 1 Round Tablein 8-Person Conf Room(TC.2) 1 Round Tablein 6-Person Conf Room(TC.1) 2 RectangularTable in 10-PersonConf Room 1 RoundTable in Team Room 1Round Table in EXOConf Room 1 Privacyand Call RoomsPrivacy and CallChairs (CS.1) 20 CallRoom Table (TC.4) 4Privacy Room Table(CS.1) 2 ModularWorkspacesSteelcase Think Chair167 Wooden Guest Chair42 Office Overheads 51Castered Peds 157 2-Shell Office Bookcase15 2-Drawer OfficeLateral File 4 2-DrawerOffice/WorkstationBox File 169 36-inchRound Table 6 Pantry /Coffee Bar Coffe BarStool 3 GE ProfileRefrigerator 2 SnackVending Machine 1Beverage VendingMachine 1 Exhibit B-2 EXHIBIT B-3 6th FloorSublessor’s HVAC 1DFCloset containing:(i) Two 4-postracks; (ii) LiebertMini Mate 1.5 Tsupplementalcooling Unit AHU-T-6-1, with condensingpump Modelnumber:MMD23CX0000 S/N:0720N148061 ExhibitB-3 EXHIBIT C DECLARATION OF EXPANSION DATE This Declaration of Expansion Date is made as of , 20 , by and between THE CORPORATE EXECUTIVE BOARDCOMPANY (“Sublessor”), and ROSETTA STONE LTD. (“Subtenant”), who agree as follows: 1. Sublessor and Subtenant entered into that certain Sublease Agreement dated October 6, 2008 (the “Original Sublease”), in whichSublessor subleased to Subtenant, and Subtenant subleased from Sublessor, certain subleased premises described therein and located at 1919 N. LynnStreet, Arlington, Virginia. Sublessor and Subtenant have entered into that certain First Amendment to Sublease Agreement dated , 2012, (the“Amendment”), which, among other things, added Expansion Area to the Sublet Premises, extended the Sublease Term, and made certain othermodifications, all in accordance with the provisions thereof. All capitalized terms herein are as defined in the Amendment. 2. Pursuant to the Amendment, Sublessor and Subtenant agreed to and do hereby confirm the “Expansion Date” is , 20 . 3. Subtenant confirms that: a. it has accepted possession of the Expansion Area as provided in the Amendment as of the Expansion Date. b. Sublessor is not required to perform any work or furnish any improvements to the Expansion Area under the Amendment; c. Sublessor has fulfilled all of its obligations under the Sublease as of the date hereof; d. the Sublease is in full force and effect and has not been modified, altered, or amended, except as follows: ; and e. there are no set-offs or credits against Annual Base Subrent, and no Security Deposit or prepaid Subrent has been paid except asprovided by the Sublease. [signatures appear on the following page] 1 The provisions of this Declaration of Expansion Date shall inure to the benefit of, or bind, as the case may require, the parties and their respectivesuccessors and assigns, subject to the restrictions on assignment and subleasing contained in the Sublease, and are hereby attached to and made a part of theSublease. SUBLESSOR: THE CORPORATE EXECUTIVE BOARD COMPANY By:/s/ Richard Lindahl[Seal]Name:Richard LindahlTitle:Chief Financial Officer SUBTENANT: ROSETTA STONE LTD By:/s/ Stephen Swad[Seal]Name:Stephen SwadTitle:Chief Executive Officer 2QuickLinks -- Click here to rapidly navigate through this documentExhibit 21.1 ROSETTA STONE INC. SUBSIDIARIESEntity Jurisdiction of IncorporationRosetta Stone Holdings Inc. DelawareRosetta Stone Brazil Holding, LLC DelawareRosetta Stone Ltd. (Formerly Fairfield & Sons Ltd., d/b/a Fairfield Language Technologies) VirginiaRosetta Stone (UK) Limited (Formerly Fairfield & Sons Limited) England and WalesRosetta Stone Japan Inc. (Formerly Rosetta World K.K.) JapanRosetta Stone International Inc. DelawareRosetta Stone GmbH GermanyRosetta Stone Korea Ltd. Republic of KoreaRosetta Stone Canada Inc. CanadaRosetta Stone Hong Kong Limited Hong KongRosetta Stone Ensino de Linguas Ltda. BrazilQuickLinksExhibit 21.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in Registration Statement Nos. 333-183148, 333-180483, and 333-158828 on Form S-8 of ourreports dated March 7, 2013, relating to the consolidated financial statements of Rosetta Stone Inc. and subsidiaries, and the effectiveness of RosettaStone Inc. and subsidiaries' internal control over financial reporting, appearing in this Annual Report on Form 10-K of Rosetta Stone Inc. andsubsidiaries for the year ended December 31, 2012./s/ Deloitte & Touche LLPMcLean, VirginiaMarch 7, 2013QuickLinksExhibit 23.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 24.1 ROSETTA STONE INC.POWER OF ATTORNEY Each person whose signature appears below hereby constitutes and appoints Stephen M. Swad and Michael C. Wu, or either of them, each withpower to act without the other, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name,place and stead, in any and all capacities, to sign the Annual Report on Form 10-K of Rosetta Stone Inc. (the "Company") and any or all subsequentamendments and supplements to the Annual Report on Form 10-K, and to file the same, or cause to be filed the same, with all exhibits thereto, and otherdocuments in connection therewith, with the Securities and Exchange Commission, granting unto each said attorney-in-fact and agent full power to doand perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he mightor could do in person, hereby qualifying and confirming all that said attorney-in-fact and agent or his substitute or substitutes may lawfully do or causeto be done by virtue hereof. Each person whose signature appears below may at any time revoke this power of attorney as to himself or herself only by an instrument inwriting specifying that this power of attorney is revoked as to him or her as of the date of execution of such instrument or at a subsequent specified date.This power of attorney shall be revoked automatically with respect to any person whose signature appears below effective on the date he or she ceasesto be a member of the Board of Directors or an officer of the Company. Any revocation hereof shall not void or otherwise affect any acts performed byany attorney-in-fact and agent named herein pursuant to this power of attorney prior to the effective date of such revocation.Dated: March 7, 2013Signature Title /s/ STEPHEN M. SWADStephen M. Swad Chief Executive Officer and Director(Principal Executive Officer)/s/ THOMAS M. PIERNOThomas M. Pierno Chief Financial Officer(Principal Financial Officer and Principal AccountingOfficer)/s/ TOM P.H. ADAMSTom P.H. Adams Director/s/ PHILLIP A. CLOUGHPhillip A. Clough Director/s/ JAMES P. BANKOFFJames P. Bankoff Director/s/ JOHN T. COLEMANJohn T. Coleman Director/s/ LAURENCE FRANKLINLaurence Franklin DirectorSignature Title /s/ PATRICK W. GROSSPatrick W. Gross Director/s/ MARGUERITE W. KONDRACKEMarguerite W. Kondracke Director/s/ THEODORE J. LEONSISTheodore J. Leonsis Director/s/ JOHN E. LINDAHLJohn E. Lindahl Director/s/ LAURA L. WITTLaura L. Witt DirectorQuickLinksExhibit 24.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 31.1 CERTIFICATION OFPRINCIPAL EXECUTIVE OFFICEROF ROSETTA STONE INC.PURSUANT TO 15 U.S.C. SECTION 7241, AS ADOPTEDPURSUANT TO SECTION 302 OF THESARBANES-OXLEY ACT OF 2002I, Stephen M. Swad, certify that:1.I have reviewed this Annual Report on Form 10-K of Rosetta Stone Inc. (the "Registrant"); 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report; 4.I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Registrant and have: a.designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which this report is being prepared; b.Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles; c.evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and d.disclosed in this report any change in the Registrant's internal control over financial reporting that occurred during the Registrant's mostrecent fiscal quarter (the Registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, the Registrant's internal control over financial reporting; and 5.I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the auditcommittee of the Registrant's Board of Directors (or persons performing the equivalent functions): a.all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which arereasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial information; and b.any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internalcontrol over financial reporting. Date: March 7, 2013 By: /s/ STEPHEN M. SWAD Stephen M. Swad(Principal Executive Officer)QuickLinksExhibit 31.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 31.2 CERTIFICATION OFPRINCIPAL FINANCIAL OFFICEROF ROSETTA STONE INC.PURSUANT TO 15 U.S.C. SECTION 7241, AS ADOPTEDPURSUANT TO SECTION 302 OF THESARBANES-OXLEY ACT OF 2002I, Thomas M. Pierno, certify that:1.I have reviewed this Annual Report on Form 10-K of Rosetta Stone Inc. (the "Registrant"); 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report; 4.I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Registrant and have: a.designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which this report is being prepared; b.Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles; c.evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and d.disclosed in this report any change in the Registrant's internal control over financial reporting that occurred during the Registrant's mostrecent fiscal quarter (the Registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, the Registrant's internal control over financial reporting; and 5.I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the auditcommittee of the Registrant's Board of Directors (or persons performing the equivalent functions): a.all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which arereasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial information; and b.any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internalcontrol over financial reporting. Date: March 7, 2013 By: /s/ THOMAS M. PIERNO Thomas M. Pierno(Principal Financial Officer)QuickLinksExhibit 31.2QuickLinks -- Click here to rapidly navigate through this documentExhibit 32.1 CERTIFICATION OFPRINCIPAL EXECUTIVE OFFICEROF ROSETTA STONE INC.PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTEDPURSUANT TO SECTION 906 OF THESARBANES-OXLEY ACT OF 2002 In connection with the accompanying Annual Report on Form 10-K for the calendar year ended December 31, 2012 filed with the Securities andExchange Commission on the date hereof (the "Report"), I, Stephen M. Swad, Chief Executive Officer of Rosetta Stone Inc. (the "Company"), herebycertify, to my knowledge, that:1.the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2.the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of theCompany.Date: March 7, 2013 /s/ STEPHEN M. SWAD Stephen M. Swad(Principal Executive Officer)QuickLinksExhibit 32.1QuickLinks -- Click here to rapidly navigate through this documentExhibit 32.2 CERTIFICATION OFPRINCIPAL FINANCIAL OFFICEROF ROSETTA STONE INC.PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTEDPURSUANT TO SECTION 906 OF THESARBANES-OXLEY ACT OF 2002 In connection with the accompanying Annual Report on Form 10-K for the calendar year ended December 31, 2012 filed with the Securities andExchange Commission on the date hereof (the "Report"), I, Thomas M. Pierno, Chief Financial Officer of Rosetta Stone Inc. (the "Company"), herebycertify, to my knowledge, that:1.the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2.the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of theCompany.Date: March 7, 2013 /s/ THOMAS M. PIERNO Thomas M. Pierno(Principal Financial Officer)QuickLinksExhibit 32.2

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