Rosetta Stone Inc Annual Report 2013

Plain-text annual report

Table 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, 2013Commission 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 executive offices) 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 per share New York Stock ExchangeSecurities Registered Pursuant to Section 12(g) of the Act:NoneIndicate 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 of 1934during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filingrequirements for the past 90 days. Yes  No oIndicate 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 such shorterperiod that the registrant was required to submit and post such files). Yes  No oIndicate 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, tothe best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):Large accelerated filer o Accelerated filer  Non-accelerated filer o Smaller reporting company o (Do not check if a smaller reporting company) 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 $281.1 million as of June 30, 2013 (basedon the last sale price of such stock as quoted on the New York Stock Exchange).As of February 21, 2014, there were 21,110,250 shares of common stock outstanding.Documents incorporated by reference: Portions of the definitive Proxy Statement to be delivered to stockholders in connection with the 2014 AnnualMeeting of Stockholders to be held on May 20, 2014 are incorporated by reference into Part III.TABLE OF CONTENTS PagePART IItem 1.Business4Item 1A.Risk Factors8Item 1B.Unresolved Staff Comments27Item 2.Properties27Item 3.Legal Proceedings27Item 4.Mine Safety Disclosures27PART IIItem 5.Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities28Item 6.Selected Financial Data29Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations52Item 7A.Quantitative and Qualitative Disclosures About Market Risk54Item 8.Financial Statements and Supplementary Data54Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure55Item 9A.Controls and Procedures55Item 9B.Other Information56PART IIIItem 10.Directors, Executive Officers and Corporate Governance57Item 11.Executive Compensation57Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters57Item 13.Certain Relationships and Related Transactions, and Director Independence57Item 14.Principal Accounting Fees and Services57PART IVItem 15.Exhibits and Financial Statement Schedules582Table 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. The forward-lookingstatements included herein or incorporated herein by reference include or may include, but are not limited to, (and you should read carefully)statements that are predictive in nature, depend upon or refer to future events or conditions, or use or contain words, terms, phrases, or expressionssuch as "achieve," "forecast," "plan," "propose," "strategy," "will," "continue," "potential," "expect," "believe," "anticipate," "project," "estimate,""predict," "intend," "should," "could," "may," "might," or similar words, terms phrases, or expression or the negative of any of these terms, Anystatements in this Form 10-K that are not based upon historical fact are forward-looking statements and represent our best judgment as to what mayoccur in the future. These forward-looking statements include, but are not limited to, statements regarding: our business strategies; informationregarding our future financial performance; our projected plans and objectives; our development of new products, the integration and expansion ofthe products we have acquired through mergers and acquisitions; international expansion in certain markets and contraction in other markets,including our plans to substantially reduce our Japanese and Korean operations; our development of a business model to drive growth; expectedmarket competition and continuation of certain market trends; the sufficiency of our cash flows from operations and available sources of funds; theimpact of inflation on our financial position and results of operations; our technology and product development initiatives; and our intellectualproperty strategy and protection. These forward-looking statements are subject to risks and uncertainties that could cause actual results and events todiffer. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included throughout this filing and particularly in Item 1A: "Risk Factors" section set forth in this Annual Report on Form 10-K.All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation torevise or publicly release any revision to any such forward-looking statement, except as may otherwise be required by law.3Table of ContentsPART IItem 1. BusinessOverviewRosetta Stone Inc. (“Rosetta Stone,” “the Company,” “we” or “us”) is dedicated to changing the way the world learns. Our innovative, technology-drivenlanguage-learning solutions have been purchased by millions of individuals and used by thousands of schools, businesses, and government organizationsaround the world. Rosetta Stone Inc. is a corporation incorporated in Delaware in 2005. Founded in 1992, Rosetta Stone's predecessor pioneered the use ofinteractive software to accelerate language learning. Today we offer courses in 30 languages across a broad range of formats, including online subscriptions,digital downloads, mobile apps, and CD packages. Rosetta Stone has invested more in language learning and expanded into education-technology with itsacquisitions of Livemocha Inc. ("Livemocha") and Lexia Learning Systems Inc, ("Lexia") in 2013 and of Vivity Labs, Inc. ("Vivity"), and Tell Me More S.A.("Tell Me More") in January 2014.Livemocha has developed one of the world’s largest online language-based communities. The acquisition brought us a cloud-based platform, enabling usto accelerate our transition to cloud-based learning solutions. By combining the Livemocha community with Rosetta Stone’s own innovative productdevelopment and marketing capabilities, we are positioned to meet the changing needs of learners around the world.The acquisition of Lexia, a leading reading-technology company, marked our first extension beyond language learning and expanded our footprint in theeducation-technology industry. We are leveraging Lexia’s expertise in children’s reading to deepen our engagement with schools and deliver digital literacysolutions to young learners in the United States ("U.S.") and international consumer markets.The purchase of Tell Me More, headquartered in France, significantly strengthens Rosetta Stone’s Global Enterprise & Education business. Tell MeMore is a global language-learning software company with significant presence throughout Europe, as well as sales in the U.S., Latin America and China. TellMe More offers a robust suite of Software-as-a-Service ("SaaS") based language learning products and services that provide intermediate, advanced andbusiness language solutions in nine languages. We plan to introduce Tell Me More’s products into our Consumer business to increase the options provided tocustomers, and we believe that with Tell Me More, we will be able to offer the most comprehensive suite of products and services--with the broadest number oflanguages, greatest depth of content and largest geographic reach-- in the industry.Vivity is the creator of the Fit Brains brain-training product portfolio, and this acquisition continues Rosetta Stone’s expansion beyond language learningand into adjacent categories of education-technology. Underscoring the connection between brain fitness and language learning, Vivity’s mobile applications arelocalized in multiple languages to serve customers around the world. Vivity’s emphasis on mobile solutions is especially compatible with our focus on cloud-based technology to enable on-the-go learning.Rosetta Stone’s management team has communicated a strategic business plan designed to guide the Company through 2015. The key areas of focusare:1.leveraging the brand;2.innovating the platform; and3.expanding distribution.In pursuing these priorities, we plan to grow the business by continuing to invest in research and development of new products while focusing onmaintaining costs and margins at appropriate levels.Business SegmentsDuring 2012, we instituted 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 Global Enterprise & Education (previously referred to as Institutional). From the first quarter of 2011through the third quarter of 2012, we had two operating segments, Consumer and Global Enterprise & Education. Prior to 2011 we operated as a singlesegment.The North America Consumer and ROW Consumer segments derive revenues from sales to individuals and retail partners. The North AmericaConsumer segment includes sales made within the U.S. and Canada; the ROW Consumer segment4Table of Contentsincludes sales made in countries other than the U.S. and Canada. The Global Enterprise & Education segment derives revenues from sales to educationalinstitutions, government agencies and corporations worldwide.For additional information regarding our segments, see Note 16 of Item 8, Financial Statements and Supplementary Data. Prior periods are presentedconsistent with our current operating segments and definition of segment contribution.Products and ServicesConsumer:Rosetta Stone offers a broad portfolio of technology-based learning products. Powered by our widely recognized brand, and building on our 21-yearheritage in language-learning, our portfolio now extends into reading and brain fitness. In addition to our computer-based interactive learning solutions for adultconsumers, Rosetta Stone also offers a suite of games, mobile apps, and a growing selection of learning products for kids.Learning Solutions: Rosetta Stone provides intuitive, easy-to-use learning programs that are available online and via digital download or CD. Ourlanguage-learning suite offers courses and practice applications in 30 languages, each leveraging our proprietary immersion methodology and innovativetechnology features. Strengthened by the acquisition of Livemocha, Rosetta Stone offers an online, world-wide community of learners that is open to language-learners around the world.Games & Apps: Rosetta Stone mobile apps are available for both tablet and smartphone use to enable learners to continue their lessons on the go. Ourcurrent suite of apps includes companions to our language-learning solutions, as well as a series of introductory language apps for travelers and a high-techSpanish language-learning game called Rosetta Stone Arcade Academy. Developed by Vivity Labs, Fit Brains Trainer and Sparky’s Adventure are brain-training solutions for adults and children. The mobile apps are available through the Apple AppStore and Google Play.Rosetta Stone Kids: Our Rosetta Stone Kids products provide technology-based learning solutions for children that focus on early childhood languageand literacy. In 2013, we launched Rosetta Stone Kids Learning Games, with a small suite of apps for children aged 3-6 that provides blended learningsolutions to introduce kids to both basic literacy skills and a foreign language.Enterprise & EducationRosetta Stone offers a series of technology-based learning products for schools, businesses and organizations. With the acquisition of Lexia, ourEnterprise & Education portfolio now extends into reading and literacy. In addition to our technology-based interactive learning solutions, Rosetta Stone alsooffers administrator tools for performance monitoring, and custom solutions to ensure that organizations achieve desired outcomes.Learning Solutions: Rosetta Stone provides cloud-based learning programs that are available online or in a variety of digital formats. Our core language-learning suite offers courses and practice applications in 30 languages, each leveraging our proprietary immersion methodology and innovative technologyfeatures.Our newly acquired Lexia Learning solutions provide explicit, systematic, personalized reading instruction for students in grades pre-K to 5. Lexia'ssolutions deliver norm-referenced performance data and analysis to enable teachers to monitor and modify their instruction to address specific student needs.With the acquisition of Tell Me More, we also now provide intermediate, advanced and business language instruction in nine languages. Tell Me More’soffering is built on a SaaS platform that includes up to 2,000 hours of instructional content with over 35 learning activities per language, includingassessment, placement and certification testing.Administrator Tools: Our Global Enterprise & Education learning programs come with a set of administrator tools to measure and track learnerprogress. Administrators can use these tools to access real-time dynamic reports and identify areas where learners may require additional attention.Custom Solutions: Rosetta Stone offers tailored solutions to help organizations maximize the success of their learning programs. Our current customsolutions include curriculum development, global collaboration programs that combine language education with business culture training, and languagecourses for mission-critical government programs. Our Advanced English for Business solution serves multinational companies seeking to build theiremployees’ English language proficiency so they are able to communicate and operate in a global business environment.Product DevelopmentsOur product portfolio is a result of significant investment in product development. Our product development efforts include design and build of softwaresolutions across a variety of devices, pedagogy and curriculum development, and the5Table of Contentscreation of language learning content. Our development team builds new solutions and enhances or maintains existing solutions. We have specific expertise inspeech recognition technology, iterative and customer-focused product development, instructional design and language acquisition.Our research and development expenses were $34.0 million, $23.5 million, and $24.2 million for the years ended December 31, 2013, 2012 and 2011,respectively.We continue to evaluate changes to our products to strengthen our brand and improve the relevance of our offerings. We are developing our first set ofproducts for children, including several mobile applications that were released in 2013. In addition, we are enhancing our offering for educational organizationsto expand our Global Enterprise & Education business. We intend to make our products more modular, flexible and mobile.Distribution ChannelsOur global consumer distribution channel comprises a mix of our websites, call centers, third party e-commerce websites such as Digital River andApple iTunes, select retail resellers, such as Amazon.com, Barnes & Noble, Target, Best Buy, Books-a-Million, Staples, Costco, daily deal partners such asGroupon, home shopping networks such as GS Home Shopping in Korea and consignment distributors such as Speed Commerce and third-party resellers ofLexia Core5. We believe these channels complement each other, as consumers who have seen our direct-to-consumer advertising may purchase at our retailers,and vice versa.Direct to consumer. Sales generated through either our websites or call centers.Indirect to consumer. Sales generated through arrangements with third-party e-commerce websites.Retailers. Our retailers enable us to provide additional points of contact to educate consumers about our solutions, expand our presence beyond ourown websites, and further strengthen and enhance our brand image. Our retail relationships include Amazon.com, Barnes & Noble, Best Buy, Books-a-Million, Costco, Groupon, Staples, and others in and 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. On April 4, 2013, we announced the closure of our entire kiosk sales channel in the U.S. and the United Kingdom. As ofDecember 31, 2013, we operated three retail kiosks in Japan that were subsequently closed in the first quarter of fiscal year 2014.Our Global Enterprise & Education distribution channel is focused on targeted sales activity primarily through a direct sales force in five markets: K-12 schools, colleges and universities, federal government agencies, corporations, and not-for-profit organizations. We also have relationships with third-partyresellers focused primarily on the sale of Lexia products and services.Educational Institutions. These customers include primary and secondary schools and colleges and universities.U.S. Federal Government Agencies and Not-for-Profit Organizations. These customers include government agencies and organizations developingworkforces to serve 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 direct mailings.Third-party Resellers. A significant portion of our sales of Lexia Core 5 are generated through our relationships with third-party resellers.Sourcing and FulfillmentOur 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 of 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 manufacturers orsuppliers is not available. We continually review our manufacturing and supply needs against the capacity of our contract manufacturers and suppliers with aview to ensuring that we are able to meet our production goals, reduce costs and operate more efficiently.Competition6Table of ContentsRosetta Stone competes in several categories within the technology-based learning industry, including consumer and institutional language learning,literacy and reading for students, brain fitness and kids-focused learning solutions.The language-learning market is highly fragmented globally and consists of a variety of instructional and learning modes: classroom instructionutilizing the traditional approach of memorization, grammar and translation; immersion-based classroom instruction; self-study books, audio recordings andsoftware that relies primarily on grammar and translation; and free online and mobile offerings that provide content and opportunities to practice writing andspeaking. Within consumer-focused language learning, our competitors include Berlitz International Inc., Simon & Schuster, Inc. (Pimsleur), Random HouseVentures LLC (Living Language), McGraw-Hill Education, Duolingo, Fluenz, Busuu, Babbel.com and many other small and regionally-focused participants.In the institutionally-focused language market, we compete with EF Englishtown, Global English, Wall Street Institute, Inlingua, Imagine Learning as well asmany private language schools and other classroom-based courses.In the literacy and reading category, we compete primarily in the K-12 Digital Reading space in the U.S. with Scholastic, Inc., Imagine Learning,Achieve 3000, Scientific Learning, Odyssey (Compass Learning), Waterford Early Reading (Pearson), Renaissance, and MindPlay.In the brain fitness and training category, the market is new and highly fragmented. We compete with Lumosity and Posit Science as well as manyonline and digital app providers.SeasonalityOur 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 and thirdquarters, due to the timing of when these organizations receive annual funding. In particular, we generate a significant portion of our consumer sales in thefourth quarter during the period from Black Friday to Cyber Monday. We sell to a significant number of our retailers, distributors and enterprise andeducation customers on a purchase order basis and we receive orders when these customers need products and services. As a result, their orders are typicallynot evenly distributed throughout the year and generally are highest in the third and fourth quarters.Intellectual PropertyOur 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 six U.S. patents, eight foreign patents and several U.S. and foreign patent applications pending. This includes patents held by Tell Me More(Auralog) acquired in January 2014 and a patent issued in the U.S. in February 2014. Many of the pending patent applications relate to our language teachingmethods.We hold a perpetual, irrevocable and worldwide license from the University of Colorado allowing us to use speech recognition technology for language-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, The Blue Stone Logo, Adaptive Recall,TOTALe, Livemocha, Lexia Learning, Lexia, Tell Me More, Auralog and Talk to Me. All of these trademarks are the subject of either registrations orpending applications in the U.S., as well as numerous countries worldwide where we do business. We have applied to register our yellow color as a trademarkwith the U.S. Patent and Trademark Office. We intend to continue to strategically register, both domestically and internationally, trademarks we use today andthose we develop in the future. We believe that the distinctive marks that we use in connection with our solutions are important in building our brand imageand distinguishing our solutions from those of our competitors. These marks are among our most valuable assets.In addition to our distinctive marks, we own several copyrights and trade dress rights to our solutions, product packaging and user manuals. We areregistering or have registered copyrights in the U.S. all editions of our Version 3 and TOTALe languages. We have registered copyright for the refreshed RosettaStone Blue Stone Logo artwork in the U.S. We intend to continue to strategically register copyrights in our various products. We also place significant value onour trade dress, which is the overall image and appearance of our solutions, and we believe that our trade dress helps to distinguish our solutions in themarketplace.7Table of ContentsFurthermore, our employees, contractors and other parties with access to our confidential information sign agreements that prohibit the unauthorizeddisclosure of our proprietary rights, information and technology.EmployeesAs of December 31, 2013, we had 1,313 total employees, consisting of 921 full-time and 392 part-time employees. In connection with our acquisition ofTell Me More, we have employees in France, Spain and Italy who are represented by a collective bargaining agreement. We believe our employee relations aregood.Financial Information by Segment and Geographic AreaFor a discussion of financial information by segment and geographic area, see Note 16 to the consolidated financial statements contained in this AnnualReport on Form 10-K.Available InformationThis Annual Report on Form 10-K, along with our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reportsfiled or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of charge through ourwebsite as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission ("SEC").Our website address is www.rosettastone.com. The SEC maintains a website that contains reports, proxy statements and other information regarding issuersthat file electronically with the SEC. These materials may be obtained electronically by accessing the SEC's website at www.sec.gov.Item 1A. Risk FactorsIn addition to the other information set forth in this annual report on Form 10-K, you should carefully consider the risk factors discussed below and inother documents we file with the Securities and Exchange Commission, which could materially affect our business, financial condition or future results.These are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial alsomay 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 our futureperformance that represents our management's estimates as of the date of release. This guidance, which includes forward-looking statements, is based onprojections prepared by our management. These projections are not prepared with a view toward compliance with published guidelines of the AmericanInstitute of Certified Public Accountants, and neither our registered public accountants nor any other independent expert or outside party compiles or examinesthe 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 to significantbusiness, economic and competitive uncertainties and contingencies, many of which are beyond our control and are based upon specific assumptions withrespect to future business decisions, some of which will change. We generally state possible outcomes as high and low ranges, which are intended to provide asensitivity analysis as variables are changed but are not intended to represent that actual results could not fall outside of the suggested ranges. The principalreason that we release 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 in the guidance furnished by us will notmaterialize or will vary significantly from actual results. Accordingly, our guidance is only an estimate8Table of Contentsof what management believes is realizable as of the date of release. Actual results will vary from our guidance and the variations may be material. In light of theforegoing, investors are urged not to rely 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" andin this annual report on Form 10-K could result in the actual operating results being different from our guidance, and such differences may be adverse andmaterial.We may not be able to utilize all of our deferred tax assets.At December 31, 2013, we had gross deferred tax assets of $36.0 million which was offset by a valuation allowance of $33.9 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 before theyexpire. The valuation allowance is based on our estimates of taxable income for the jurisdictions in which we operate and the period over which our deferred taxassets will be realizable. We could in the future be required to increase the valuation allowance to take into account additional deferred tax assets that we may beunable to realize. An increase in the valuation allowance would have an adverse impact, which could be material, on our income tax provision and net incomein the period in which we record the increase.Risks Related to Our BusinessBecause we generate a significant majority of our revenue from language-learning solutions in the U.S., a decline in demand for our language-learning solutions or for language-learning solutions in general could cause our revenue to decline.We generate a significant majority of our revenue from our language-learning solutions, and we expect that we will continue to depend upon language-learning solutions for a significant majority of our revenue in the foreseeable future. In addition, a substantial portion of our language-learning revenue is fromcustomers in the U.S. Because we are dependent on our language-learning solutions, factors such as changes in consumer preferences for these products mayhave a disproportionately greater impact on us than if we offered multiple product categories. If consumer interest in our language-learning software productsdeclines, or if consumer interest in learning foreign languages in general declines, we would likely experience a significant loss of sales. Some of the potentialdevelopments that could negatively affect interest in and demand for 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 U.S.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 brands, 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;•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 and other sales outlets where interested consumers will buy our products;•anticipate and respond to consumer price sensitivity and pricing changes of competitive products; and9Table of Contents•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 in new orexisting markets. In addition, our solutions may become less appealing to consumers due to changes in technologies or reduced life cycles of our solutions. Adecline in consumer demand for our solutions, or any failure on our part to satisfy such changing consumer preferences, could harm our business andprofitability.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 or consumer confidence, as well as numerous other external consumer dynamics may compromiseour 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, includinggeneral economic conditions, consumer confidence, employment levels, business conditions, interest rates, availability of credit, inflation and taxation.Adverse trends in any of these economic indicators may cause consumer spending to decline further, which could hurt our sales and profitability. For ourretail business, we depend on the continued popularity of physical stores and malls to generate customer traffic for retailers. Decreases in physical store ormall retail traffic may adversely affect our consumer sales and our profitability and financial condition. In addition, an increase in the taxation of online salescould result in reduced online purchases or reduced margins on such sales. Furthermore, consumers may defer purchases of our solutions in anticipation ofnew products or new versions from us or our competitors.Because a significant portion of our sales come from sales of our Version 4 TOTALe product, pricing declines of this product could negativelyimpact our revenue and profitability.Historically, reduced pricing of our Version 4 TOTALe product has resulted in increased unit sales volume in the direct-to-consumer web channel of ourNorth America consumer segment, which has offset the impact on sales from lower prices. We expect that the trend of lowering prices resulting in increasedunit volume and overall increased sales will continue in the direct-to-consumer web channel. However, given the scale of our business, if this trend does notcontinue and lowering prices does not result in increased units sales volume, our overall profitability could be negatively impacted.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 and comprises a mix of websites such as Digital River and Apple iTunes App Store, third party e-commerce websites, selectretail resellers, such as Amazon.com, Barnes & Noble, Target, Best Buy, Books-a-Million, Staples, Costco, daily deal partners such as Groupon andconsignment distributors such as Speed Commerce. Sales to or through our retailers and distributors accounted for approximately 18% of our revenue for theyear ended December 31, 2013, compared to 17% for the year ended December 31, 2012.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-termcontracts 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 placement within theirstores. 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 and distributors will notpromote competitors' products over our products or enter into exclusive relationships with competitors. Any material adverse change in the principalcommercial terms, material decrease in the volume of sales generated by our larger retailers or distributors or major disruption or termination of a relationshipwith these retailers and distributors could result in a potentially significant decline in our revenue and profitability. Furthermore, product display locations andpromotional activities that retailers undertake can affect the sales of our products. The fact that we also sell our products directly could cause retailers ordistributors to reduce their efforts to promote our products or stop selling our products altogether.As evidenced by the bankruptcy and liquidation of Borders in 2011, book stores and other traditional physical retailers are experiencing diminishedfoot traffic and sales. Reduced customer foot traffic in these stores is likely to reduce their sales of our products. In addition, if one or more of these bookstoresor other retailers 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 U.S., we offer consumers who purchase our packaged software and audio practice products directly from us a 30-day, unconditional, full money-back refund. We also permit some of our retailers and distributors to return packaged products,10Table of Contentssubject to certain limitations. We establish revenue reserves for packaged product returns based on historical experience, estimated channel inventory levels,the timing of new product introductions and other factors. If packaged product returns exceed our reserve estimates, the excess would offset reported revenue,which could hurt our 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 protection onexisting inventories, which would allow these retailers and distributors a credit against amounts owed with respect to unsold packaged product under certainconditions. These price protection reserves could be material in future periods. It is uncertain whether these strategies will prove successful or whether we willbe 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 on us tochange our prices. If our competitors offer deep discounts on certain products or services or develop products that the marketplace considers more valuable, wemay need to lower prices or offer other favorable terms in order to compete successfully. Any such changes may reduce margins and could adversely affectoperating results. Any broad-based change to our prices and pricing policies could cause our revenues to decline or be delayed as our sales force implementsand our customers adjust to the new pricing policies. If we do not adapt our pricing models to reflect changes in customer use of our products or changes incustomer demand, our revenues could decrease.Intense 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 competition topersist and intensify. Increased competition could cause reduced revenue, price reductions, reduced gross margins and loss of market share. Many of ourcurrent and potential competitors have longer operating histories and substantially greater financial, technical, sales, marketing and other resources than wedo, as well as greater name recognition in select local markets. The resources of these competitors also may enable them to respond more rapidly to new oremerging technologies and changes in customer requirements, reduce prices to win new customers and offer free language-learning software or online services.We may not be able to compete successfully against current or future competitors.As the market for foreign language-learning solutions continues to develop, a number of other companies with greater resources than ours could attemptto enter the market or increase their presence by acquiring or forming strategic alliances with our competitors or our distributors or by introducing their owncompeting products. These companies and their products may be superior to any of our current competition. We have also seen increased competition fromimitation products which are lower priced, lower quality products that attempt to capitalize on the popularity of our products by utilizing similar packagingand marketing materials. In addition, we see increased competition from community practice providers which provide low priced entry points for consumersinterested in learning languages. We may not have the financial resources, technical expertise, marketing, distribution or support capabilities to competeeffectively 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 low prices 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 both directly and indirectly through resellers, we expect that we will experience competition from localforeign language-learning companies that have strong brand recognition and more experience in selling to local consumers and a better understanding of localmarketing, sales channels and consumer preferences.Our success will depend on our ability to adapt to these competitive forces, to adapt to technological advances, to develop more advanced products morerapidly and less expensively than our competitors, to continue to develop an international sales network, to adapt to changing consumer preferences and toeducate potential customers about the benefits of using our solutions rather than our competitors' products and services. Existing or new competitors couldintroduce new products and services with superior features and functionality at lower prices. This could impair our ability to sell our 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-learning applications and websites offering limited vocabulary lists, grammar explanations and tips,and crowdsourced text translations. In addition, there are some online services offering limited free lessons and learning tools, including one sponsored by theU.S. Department of Education to help immigrants learn English. Many of these websites offer free language practice opportunities with other language learners.If these free products and applications become more sophisticated and competitive or gain widespread acceptance by the public, demand for our solutionscould decline.11Table 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 our abilityto:•create greater awareness of our brands and our 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 retail partners; 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, and we maynot 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 random timeslots and publication dates that have remained unsold and are offered at discounts to advertisers who are willing to be flexible with respect to time slots. Thereis a limited supply of this type of advertising and the availability of such advertising may decline or the cost of such advertising may increase. In addition, ifwe increase our marketing budget it cannot be assured that we can increase the amount of remnant advertising at the discounted prices we have obtained in thepast. If any of these events occur, we may be forced to purchase time slots and publication dates at higher prices, 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. We engage in an active public relations program, including through social media sites such as Facebook andTwitter.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.A significant portion of our business depends on our Rosetta Stone brand, and if we are not able to maintain and enhance our brand, ourbusiness and operating results may be harmed.We believe that market awareness of our Rosetta Stone brand in the U.S. has contributed significantly to the success of our business. We also believethat maintaining and enhancing the Rosetta Stone brand is critical to maintaining our competitive advantage. As we continue to grow our business, expand ourproducts and services and extend our geographic reach, maintaining the quality and consistency of our language-learning solutions, and thus the quality of ourbrand, may be more difficult. In addition, software piracy and trademark infringement may harm our Rosetta Stone brand by undermining our reputation forquality software programs. We must continue to update our marketing communications in order to maintain and enhance our brand awareness and the valueof our brand. Failure to do so may result in a decrease in brand value and related sales.We 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. We depend,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 search listings, where wepurchase specific search terms that will result in the inclusion of our listing, and algorithmic searches that depend upon the searchable content on our sites.Search engines and other online sources revise their algorithms from time to time in an attempt to optimize their search results.12Table of ContentsIf 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 how itdisplays our websites, resulting in fewer consumers clicking through to our websites, our sales could suffer. If any free search engine on which we rely beginscharging fees for listing or placement, or if one or more of the search engines or other online sources on which we rely for purchased listings, modifies orterminates 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 through retailer anddistributor arrangements with third parties. If we are unable to stabilize losses in our international operations successfully and in a timely manner, our abilityto subsequently pursue our growth strategy will be impaired. Such stabilization and expansion may be more difficult or take longer than we anticipate, and wemay not be able to successfully market, sell, deliver and support our products and services internationally to the extent we expect.Our international operations and our efforts to increase sales in international markets are subject to a number of risks that are in addition to or differentthan those affecting our U.S. operations, including:•difficulty in staffing and managing geographically dispersed operations and culturally diverse work forces and increased travel, infrastructure andlegal compliance costs associated with multiple international locations;•difficulty in effectively managing third-party e-commerce resellers of our products and services;•difficulty in establishing and maintaining financial and other internal controls over geographically dispersed operations;•competition from local language-learning 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 acceptable customeracquisition costs;•inability to drive traffic to our websites, call centers, and distribution channels;•inability to register domain names in Country Code Top Level Domains in order to operate country specific websites to permit consumers to easilylocate our products in other countries due in large part to cybersquatting;•difficulties with providing appropriate and appealing products to suit consumer preferences and capabilities in these markets, such as the potentialneed to customize English-based language-learning 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;13Table of Contents•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 technical standards,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 overall business,revenue and financial results.If the recognition by schools and other organizations of the value of technology-based education does not continue to grow, our ability to generaterevenue from organizations could be impaired.Our success depends in part upon the continued adoption by organizations 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 education processthat can result from offering courses online. If the acceptance of technology-based education does not continue to grow, our ability to continue to grow ourGlobal Enterprise & Education 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 enterprise and education customers are colleges, universities, primary and secondary schools and school districts, other educationproviders, armed forces and government agencies that depend substantially on government funding. Accordingly, any general decrease, delay or change infederal, state or local funding for colleges, universities, primary and secondary schools and school districts, or other education providers or governmentagencies that use our products and services could cause our current and potential customers to reduce their purchases of our products and services, to exercisetheir right to terminate licenses, or to decide not to renew licenses, any of which could cause us to lose revenue. In addition, a specific reduction ingovernmental funding support for products such as ours would also cause us to lose revenue and could hurt our overall gross margins.Included within our Global Enterprise and Education 2013 bookings is $2.0 million related to a Lexia pilot program with a state school system.Typically, Lexia sales are with single schools or local school systems. If this arrangement is not renewed we may not be able to achieve the projected growth inour Global Enterprise and Education segment.Some of our enterprise and education business faces a lengthy and unpredictable sales cycle, which could delay new sales.We face a lengthy sales cycle between our initial contact with some potential enterprise and education customers and the signing of license agreementswith these customers. As a result of this lengthy sales cycle, we have only a limited ability to forecast the timing of such enterprise and education sales. Adelay in or failure to complete license transactions could cause us to lose revenue, and could cause our financial results to vary significantly from quarter toquarter. Our sales cycle varies widely, reflecting differences in our potential enterprise and education customers' decision-making processes, procurementrequirements and budget 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.14Table of ContentsWe 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 and enhancingexisting products, services and applications is complex, costly and uncertain, and any failure by us to anticipate customers' changing needs and emergingtechnological trends accurately could significantly harm our market share and results of operations. For example, the number of individuals who access theinternet through devices other than a personal computer, such as tablet computers, mobile devices, televisions and set-top box devices, has increaseddramatically and this trend is likely to continue. Our products and services may not work or be viewable on these devices because each manufacturer ordistributor may establish unique technical standards for such devices. Accordingly, we may need to devote significant resources to the creation, support andmaintenance of such versions. If we fail to develop or sell products and services that respond to these or other technological developments and changingcustomer needs, such as the demand for products designed for children, cost effectively, we may lose market share and revenue and our business couldsuffer.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 product orversion releases to new Windows and Macintosh operating systems, or to the extent that significant demand arises for our products or competitive products onother platforms before we choose and are able to offer our products on these platforms, our business could be harmed. To the extent new releases of operatingsystems, including for mobile and non-PC devices, or other third-party products, platforms or devices make it more difficult for our products to perform, andour customers are persuaded to use alternative technologies, our business could be harmed.If 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 ourGlobal Enterprise & Education 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 enterprise and education demand and to availourselves of new 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, managementand financial and reporting systems, including warehouse management and inventory control, improve our business processes and controls and identify anddevelop relationships with additional retailers and distributors. We may also be required to expand our distribution facilities and our operational facilities oradd new facilities, which could require significant capital expenditures. Failure to effectively manage our expansion and move our business more online in acost-effective manner could result in difficulty in filling purchase orders, declines in product and service quality and customer satisfaction, increased costs ordisruption 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.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 and qualityexperience for learning languages. Usage of our product varies by individual consumer. If consumers do not perceive our service offering to be of value, or ifwe introduce new or adjust existing features or change the mix of content in a manner that is not favorably received by them, we may not be able to attract andretain customers. Customers may cancel their subscription to our service for many reasons, including a perception that they do not use the service sufficiently,the need to cut household expenses, competitive services providing a better value or experience, or customer service issues not being satisfactorily resolved. Iftoo many 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 advertising expendituresthan we currently anticipate to replace these customers. We expect to derive an increasing portion of our revenues in the future from subscriptions to our cloud-based offerings. This subscription model prices and delivers our products in a way that differs from the historical pricing and delivery methods of ourlanguage learning solutions. These changes reflect a shift from perpetual license sales and distribution of our software in favor of providing our customers theright to access certain of our software in a hosted environment or use downloaded software for a specified subscription period. This cloud strategy requirescontinued investment in product development and cloud operations, and may give rise to a number of risks, including a lag in sales,15Table of Contentsdissatisfaction from perpetual license customers, difficulty setting optimal pricing that could negatively affect sales and/or earnings, revenues that decline overthe short or long term, confusion among our customers, resellers and investors and higher than forecasted costs.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 time ofsale. During the year-ended December 31, 2013 consumer revenue from paid online learners increased to $24.6 million or 12% of consumer revenue comparedto $15.0 million or 7% of consumer revenue for the year-ended December 31, 2012. We are delivering more of our solutions online pursuant to differentduration subscription fees. Selling in this manner will result in substantially less cash and revenue from the initial sale to the customer and could have asubstantially negative impact on our revenue, results of operations and cash flow in the short term.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. Thesevariations are primarily related to increased sales of our products and services to consumers in the fourth quarter during the holiday selling season as well ashigher sales to governmental and educational institutions in the second and third quarters. We sell to a significant number of our retailers, distributors andenterprise and education customers on a purchase order basis and we receive orders when these customers need products and services. As a result, their ordersare typically not evenly distributed throughout the year. Our quarterly results of operations also may fluctuate significantly as a result of a variety of otherfactors, including the timing of holidays and advertising initiatives, changes in our products, services and advertising initiatives and changes in those of ourcompetitors. Budgetary constraints of our enterprise and education 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 or quarterlyfluctuations that we report in the future may differ from the expectations of market analysts and investors. This could cause the price of our common stock tofluctuate significantly.Our introduction of Rosetta Stone Version 4 TOTALe increased our costs as a percentage of revenue, and these and future product introductionsmay not succeed and may harm our business, financial results and reputation.Rosetta Stone Version 4 TOTALe integrates our existing language-learning software solutions with web-based services, which provide opportunities forpractice with dedicated language conversation coaches and other language learners to increase language socialization. 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 have decreased our margins. Rosetta Stone Version 4 TOTALe sells ata higher price per unit than our Version 3 software solutions and customers may choose to not engage with conversation coaches or be willing to pay higherprices to do so. Rosetta Stone Version 4 TOTALe has also presented new management and marketing challenges that differ from the challenges we faced in ourprevious business. In addition, we are now required to defer recognition of a portion of each sale of Version 4 TOTALe in connection with the subscriptionterms of our online socialization services. We cannot assure you that Rosetta Stone Version 4 TOTALe will be successful or profitable, or if it is profitable,that it will provide an adequate return on capital expended. If Rosetta Stone Version 4 TOTALe is not successful, our business, financial results and reputationmay be harmed. We anticipate having to make investments in new products in the future and we may incur significant expenses without achieving theanticipated benefits of our investment or preserving our brand and reputation. Investments in new products and technology are speculative, the developmentcycle for products may exceed planned estimates and commercial success depends on many factors, including innovativeness, developer support, andeffective distribution and marketing. Customers may not perceive our latest offerings as providing significant new value and may reduce their purchases ofour offerings, unfavorably impacting revenue. We may not achieve significant revenue from new product and service investments for a number of years, if atall.During 2013, we discontinued sales of new ReFLEX subscriptions; however we will continue to incur costs to fulfill existing subscriptions.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.16Table of ContentsSubstantially all of our inventory is located in one warehouse facility. We could experience significant interruption in the operation of this facility ordamage or destruction of our inventory due to natural disasters, accidents, failures of the inventory locator or automated packing and shipping systems orother events. If a material portion of our inventory were to be damaged or destroyed, we might be unable to meet our contractual obligations which could causeus significant financial loss, including loss of revenue and harm to our reputation.As part of our ongoing corporate transformation, we have undertaken several restructuring actions as well as changes to our product teamwhich may not deliver the expected results and these actions may adversely affect our business.In the second quarter of 2013 we shuttered our kiosk sales channel in the U.S. Revenue from other sales channels may not replace the lost revenue fromour discontinued U.S. kiosk sales channel. In addition, the recognition of our brand name and our ability to successfully reach potential new customers maysuffer as we are no longer able to expose potential customers to our products and services via our U.S. kiosks. In the first quarter of 2014 we announced ourplan to streamline our Asian operations including closing our office in Japan and streamlining our operations in South Korea. Our future business plan forthese markets includes indirectly distributing our products and services through resellers. Given the challenges we have experienced in successfully expandinginto these markets, our new indirect distribution plan may not be successful.In late 2012 and the first half of 2013 we restructured our product team including hiring a new Chief Product Officer, eliminating approximately seventypositions in our Harrisonburg, Virginia location and hiring personnel in Austin, Texas and San Francisco, California as well as on-boarding productpersonnel from Livemocha in Seattle, Washington and Lexia in Concord, Massachusetts. Our Chief Product Officer resigned in December 2013. Although wefilled this position in February 2014, we may not successfully integrate the new product team into our organization due to a variety of factors including thechange in leadership and the challenges associated with managing personnel spread across multiple locations. We have substantially increased our researchand development expense as a result of expanding our team into more expensive labor markets and our development of new products, including mobileapplications. If we are unsuccessful in introducing new products and services to the marketplace, we may not be able to recover our investment in researchand development.Acquisitions, joint ventures and strategic alliances may have an adverse effect on our business.We have made and may continue to make acquisitions or enter into joint ventures and strategic alliances as part of our long-term business strategy. Suchtransactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we do not realize a satisfactoryreturn on our investment, that we experience difficulty integrating new employees, business systems, and technology, diversion of management's attentionfrom our other 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, ormarket share, or those benefits may ultimately be smaller than anticipated, or may not be realized. These events could harm our operating results or financialcondition.The acquisitions of Livemocha, Lexia, Vivity and Tell Me More are significant to our anticipated future results. The anticipated benefits of theacquisitions could be impacted by a number of risks specific to our business, as well as by risks related to the integration process.The significant risks and challenges that may limit our ability to achieve the anticipated benefits of acquisitions include:•lack of employee retention stemming from the acquisitions;•sales of the acquired products and services may not perform as we anticipated;•the risk of increased attrition of the acquired entities’ customers;•the risk that cross-selling Rosetta Stone products and services to customers of the acquired entities (and vice versa) may not be successful;•the pipeline of the acquired entities’ future products under development may take longer than predicted to launch or may fail to launch at all; and•the difficulty of integrating the acquired entities’ technology into our current and future products and services. If we are unsuccessful in addressing these risks and challenges it may adversely harm our business and prospects.Our existing business may suffer if we are unable to successfully integrate acquired companies into our business or otherwise manage thegrowth associated with multiple acquisitions.We have acquired businesses, personnel and technologies in the past and we intend to continue to evaluate and pursue acquisitions and strategicinvestments. The process of integrating the acquired entities' operations into our operations could result in unforeseen operating difficulties, absorb significantmanagement attention, and require significant resources that would otherwise be available for the ongoing execution and development of our existing operations.17Table of ContentsChallenges and risks from such investments and acquisitions include:•negative effects on products and product pipeline from the changes and potential disruption that may follow the acquisition;•diversion of our management’s attention away from our business;•declining employee morale and retention issues resulting from changes in compensation, or changes in management, reporting relationships, or futureprospects;•the need to integrate the operations, systems, technologies, products and personnel of each acquired company, the inefficiencies and lack of controlthat may result if such integration is delayed or not implemented, and unforeseen difficulties and expenditures that may arise in connection withintegration;•the difficulty in determining the appropriate purchase price of acquired companies may lead to the overpayment from certain acquisitions and thepotential impairment of intangible assets and goodwill acquired in the acquisitions;•the difficulty in successfully evaluating and utilizing the acquired products, technology, or personnel;•the potential incurrence of debt, contingent liabilities, amortization expenses or restructuring charges in connection with any acquisition;•the need to implement controls, procedures and policies appropriate for a larger public company at companies that prior to acquisition had lackedsuch controls, procedures and policies;•the difficulty in accurately forecasting and accounting for the financial impact of an acquisition transaction, including accounting charges andintegrating and reporting results for acquired companies that do not historically follow U.S. GAAP;•risks associated with our expansion into new international markets and doing business internationally, including those described under the riskfactor caption “Our expansion into international markets may not succeed and imposes special risks” elsewhere in this Annual Report on Form 10-K; and•in the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic,currency, political and regulatory risks associated with specific countries.The loss of key personnel or the failure to attract and retain highly qualified personnel, including personnel obtained through acquisitions, couldcompromise our ability to effectively manage our business and pursue our growth strategy.Our future performance depends on the continued service of our key technical, development, sales, services and management personnel, including keypersonnel of entities we have acquired or may acquire in the future. We rely on our executive officers and senior management to execute our existing businessplans and to identify and pursue new opportunities. We rely on our technical and development personnel for product innovation. We generally do not haveemployment agreements with our non-executive personnel and, therefore, they could terminate their employment with us at any time. The loss of key employeescould result in significant disruptions to our business, and the integration of replacement personnel could be costly and time consuming, could causeadditional disruptions to our business, and could be unsuccessful. 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 and managementpersonnel. Competition for such personnel is intense, and we may fail to retain our key employees or attract or retain other highly qualified personnel in thefuture.In addition, wage inflation and the cost of retaining our key personnel in the face of competition for such personnel may increase our costs faster than wecan offset these costs with increased prices or increased sales volume.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 learning solutions. Any damage, interruption or failure of our systems, networksand databases could prevent us from processing customer orders and result in degradation or interruptions in delivery of our products and services.Notwithstanding our efforts to protect against interruptions in the availability of our e-commerce websites and internet-based products and services, we dooccasionally experience unplanned outages or technical difficulties. In addition, we do not have complete redundancy for all of our systems. We do notmaintain real-time back-up of all of our data, and in the event of system disruptions, we could experience loss of data which could cause us to lose customersand could harm our reputation and cause us to face unexpected liabilities and expenses. If we continue to expand our business, we will put additional strainson these systems. If we move additional product features to online systems or more of our business online, all of these considerations will become moresignificant.We 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.18Table of ContentsWe 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 international laws andregulations to us relating to issues such as user privacy and data protection, data security, defamation, promotions, billing, consumer protection,accessibility, content regulation, quality of services, and intellectual property ownership and infringement in many instances is unclear or unsettled. Also, thecollection and protection of information from children under the age of 13 is subject to the provisions of the Childrens’ Online Privacy ProtectionAct (COPPA), which is particularly relevant to our learning solutions focused on children. In addition, we will also be subject to any new laws and regulationsdirectly applicable to our domestic and international activities. Internationally, we may also be subject to laws regulating our activities in foreign countries andto foreign laws and regulations that are inconsistent from country to country. We may incur substantial liabilities for expenses necessary to defend litigation inconnection with such regulations and laws or to 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. Our services enable individuals to exchange information and engage in various online activities on a domestic and an international basis. The law relatingto the liability of providers of online services for activities of their users is currently unsettled both within the United States and internationally. Claims may bebrought against us for defamation, negligence, copyright or trademark infringement, unlawful activity, tort, including personal injury, fraud, or other theoriesbased on the nature and content of information that may be posted online or generated by our users. Defense of any such actions could be costly and involvesignificant time and attention of our management and other resources and may require us to change our business 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 our products andservices as well as harm our reputation and brand and, therefore, our business. We may also need to expend significant resources to protect against securitybreaches. The risk that these types of events could seriously harm our business is likely to increase as we expand the number of web based products andservices 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 user confidencein 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 commerce website, products and services and gainaccess to our networks and data centers. Groups of hackers may also act in a coordinated manner to launch distributed denial of service attacks, or othercoordinated attacks. Sophisticated organizations or individuals may launch targeted attacks using novel methods to gain access to computers running oursoftware. These threats may result in breaches of our network or data security, disruptions of our internal systems and business applications, impairment ofour ability to complete sale transactions on our website or provide services to our customers, product development delays, harm to our competitive positionfrom the compromise of confidential business information, or other negative impacts on our business.Our 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 our GlobalEnterprise & Education 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. We and ourvendors use commercially available encryption technology to transmit personal information when taking orders. We use security and business controls to limitaccess and use of personal information. However, third parties may be able to circumvent these security and business measures by developing and deployingviruses, worms and other malicious software programs that are designed to attack or attempt to infiltrate our systems and networks. In addition, employeeerror, malfeasance or other errors in the storage, use or transmission of personal information could result in a breach of customer or employee privacy. Weemploy contractors and temporary and part-time employees who may have access to the personal information of customers and employees. It is possible suchindividuals could circumvent our controls, which could result in a breach of customer or employee privacy.19Table of ContentsPossession and use of personal information in conducting our business subjects us to legislative and regulatory burdens that could require notificationof data breaches, restrict our use of personal information and hinder our ability to acquire new customers or market to existing customers. As our businessevolves and as we expand internationally, we may become subject to additional and/or more stringent legal obligations concerning our treatment of customerinformation. We have incurred, and will continue to incur, expenses to comply with privacy and security standards and protocols imposed 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 significant resources toresolve these problems. A major breach of our network security and systems could have serious negative consequences for our businesses, including possiblefines, penalties and damages, reduced customer demand for our products and services, harm to our reputation and brand and loss of our ability to accept andprocess 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 credit cardpractices, 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 employtechnology solutions to help us detect fraudulent transactions. However, the failure to detect or control payment fraud could cause us to lose sales 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 our businesspractices 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 it difficult orimpossible for us to comply. A failure to comply with these rules or requirements could make us subject to fines and higher transaction fees and we could loseour ability to accept these payment methods. Our business and results of operations could be adversely affected if these changes were to occur.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 website, call center or third-party call centers could cause us to lose sales and disrupt ourability to process orders and deliver our solutions in a timely manner.We rely on our website, an in-house call center and third-party call centers to sell our solutions, respond to customer service and technical supportrequests and 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 products andservices, which could result in lost and cancelled sales and damage to our brand and reputation.As we grow and offer more products, we will need to update our website and also may need more capacity from existing call centers or we will need toidentify and contract with new call centers. We may not 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 may increase 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 website and call centers to purchase our solutions. If we experiencetechnical difficulties with our websites or if our call center operators do not convert inquiries into sales at expected rates, our ability to generate revenue could beimpaired. Training and retaining qualified call center operators is challenging due to the expansion of our product and service offerings and the seasonality ofour business. If we do not adequately train 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 our business andprofitability. In addition, high employee turnover could increase our exposure to employee-related litigation. Likewise, the third-party call centers we utilize facesimilar issues.20Table of ContentsIf any of our products or services contain defects or errors or if new product releases or services are delayed, our reputation could be harmed,resulting in significant costs to us and impairing our ability to sell our solutions.If our products or services contain defects, errors or security vulnerabilities, our reputation could be harmed, which could result in significant costs tous and impair 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 or servicescould 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 enterprise and education customers;•injury to our reputation; or•increased service expenses or payment of damages.In addition, we could face claims for product liability, tort or breach of warranty. Our contracts with customers contain provisions relating to warrantydisclaimers and liability limitations, which may not be upheld. Defending a lawsuit, regardless of its merit, is costly and may divert management's attentionand adversely affect the market's perception of us and our products and services. In addition, if our business liability insurance coverage proves inadequate orfuture 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 in 2011.These risks include the following:•government contracts are subject to the approval of appropriations by the U.S. Congress to fund the expenditures by the agencies under thesecontracts. Congress often appropriates funds for government agencies on a yearly basis, even though their contracts may call for performance over anumber of years;•our products and services are included on a General Services Administration, or GSA, schedule. The loss of the GSA schedule covering oursoftware products and related services could cause us to lose our ability to sell our products and services to U.S. government customers;•we must comply with complex federal procurement laws and regulations in connection with government contracts, which may impose added costs onour business; and•federal government contracts contain provisions and are subject to laws and regulations that provide government customers with rights and remediesnot typically found in commercial contracts. These rights and remedies allow government clients, among other things, to terminate existing contracts,with short notice, for convenience, without cause, reduce or modify contracts or subcontracts, and claim rights in products, systems, andtechnology 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 in transitioning tothese upgraded systems, including loss of data and decreases in productivity, as personnel become familiar with these new systems. In addition, ourmanagement information systems will require modification and refinement as we grow and as our business needs change, which could prolong difficulties weexperience with systems transitions, and we may not always employ the most effective systems for our purposes. If we experience difficulties in implementingnew or upgraded information systems or experience significant system failures, or if we are unable to successfully modify our management informationsystems or respond to changes in our business needs, we may not be able to effectively manage our business and we may fail to meet our reporting obligations.In addition, as a result of the automation of these manual processes, the data produced may cause us to question the accuracy of previously reported financialresults.21Table of ContentsOur 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 enterprise and educationcustomers. As a result, we must continually ensure that our products interoperate properly with these systems. Changes in operating systems, the technologieswe incorporate into our products or the computer systems our customers use may damage our business.Our Fit Brains products are based on research in the field of neuroscience. The goal of Fit Brains is to help improve concentration, enhancememory and strengthen overall cognitive functions. If the validity of the associated neuroscience or the conclusions that we draw from it ischallenged, our reputation could be harmed and our business prospects and financial results could be materially and adversely affected.We rely heavily on neuroscience to demonstrate that our products help to improve concentration, memory and overall cognitive functions, which involvecertain risks. In particular, our products are designed to develop key cognitive areas and help build stronger connections within the brain, also known ascognitive reserve, may be unfamiliar to customers. Therefore, it may be difficult to convince customers about the effectiveness of our products. Our sales andmarketing efforts, as well as our reputation, could be adversely impacted if related areas of neuroscience are proven to be false. If we are unable to successfully cross-sell Fit Brains' products to Rosetta Stone customers, our growth prospects could be adversely impacted. As our product and service offerings become more complex, our reported revenue may become less predictable.During 2013, we continued to transition our distribution to more online in the consumer business. The accounting policies that apply to these sources ofrevenue may be more complex than those that apply to our traditional products and services. In addition, we may change the manner in which we sell oursoftware licenses, and such change could cause delays in revenue recognition in accordance with accounting standards. Under these accounting standards,even if we deliver products and services to, and collect cash from, a customer in a given fiscal period, we may be required to defer recognizing revenue fromthe sale of such product or service until a future period when all the conditions necessary for revenue recognition have been satisfied. If we move more of ourconsumer business online we will also collect less cash from our initial transactions with consumers which could substantially decrease our revenues in theshort term. Conditions that can cause delays in revenue recognition include software arrangements that have undelivered elements for which we have not yetestablished vendor specific objective evidence of fair value, requirements that we deliver services for significant enhancements or modifications to customizeour software for a particular 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 a result,we may be unable to adjust our spending in a timely manner if our revenue falls short of our expectations. Accordingly, any significant shortfall of revenue inrelation to our estimates could have an immediate negative effect on our profitability. In addition, as our business evolves, we anticipate increasing ouroperating expenses to expand our product development, technical support, sales and marketing and administrative organizations. Any such expansion couldcause 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 might choose toengage in foreign currency hedging transactions. If the foreign currency hedging markets are negatively affected by clearing and trade execution regulationsimposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the cost of hedging our foreign exchange exposure 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 markets22Table of Contentschange, or other circumstances arise that have a material effect on our cash flow, the anticipated cash needs of our business as well as our conclusions as tothe adequacy of our available sources of capital could change significantly. Any of these events or circumstances could result in significant additional fundingneeds, requiring us to raise additional capital. We cannot predict the timing or amount of any such capital requirements at this time. If financing is notavailable on satisfactory terms, or at all, we may be unable to expand our business or to develop new business at the rate desired and our results of operationsmay suffer.Changes in applicable accounting principles could negatively affect our financial performance.Our financial statements are prepared in accordance with accounting principles generally accepted in the U.S. ("GAAP") and are subject to interpretationby the SEC and the Financial Accounting Standards Board ("FASB"). A change in GAAP or interpretations of GAAP may have a negative effect on ourreported financial results and even retroactively affect previously reported results. The FASB is currently working together with the International AccountingStandards Board ("IASB") on several projects to align accounting principles internationally. These efforts by the FASB and IASB could change theaccounting principles applicable to us and result in materially worse financial results for us in areas including, but not limited to, principles for recognizingrevenue.If our goodwill or indefinite-lived 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 period inwhich 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 rates couldaffect our future results of operations. Our future effective tax rates could be unfavorably affected by changes in the tax rates in jurisdictions where our incomeis earned or by changes in the valuation of our deferred tax assets and liabilities.Our 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. The policy setsforth credit quality standards and limits our exposure to any one issuer, as well as our maximum exposure to various asset classes. As of December 31, 2013,our cash consisted of highly liquid investments with original maturities of three months or less and demand deposits with financial institutions. If financialmarket conditions worsen in the future, investments in some financial instruments may suffer from market liquidity and credit problems. We cannot predictfuture market conditions or market liquidity, or credit availability, and can provide no assurance that our investment portfolio will remain materiallyunimpaired.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 rely on forsome of our business systems could, in the event of a major earthquake, fire, flood, power loss, telecommunications failure, software or hardwaremalfunctions, cyber-attack, war, terrorist attack or other catastrophic event, cause system interruptions, reputational harm, loss of intellectual property,delays in our product development, lengthy interruptions in our services, breaches of data security and loss of critical data and could prevent us fromfulfilling our customers' orders. We have developed certain disaster recovery plans and backup systems to reduce the potentially adverse effect of such events,but a catastrophic event that results in the destruction or disruption of any of our data centers or our critical business or information technology systems couldseverely affect our ability to conduct normal business operations and, as a result, our future operating results could be adversely 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 affect themanner in which we currently conduct our business. In addition, the growth and development of23Table of Contentsthe market for online commerce may lead to more stringent consumer protection laws, which may impose additional burdens on us. If we are required tocomply with new regulations or legislation or new interpretations of existing regulations or legislation, this compliance could cause us to incur additionalexpenses 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 network operatorsimplement usage based pricing, including meaningful bandwidth caps, or otherwise try to monetize access to their networks by data providers, we could incurgreater operating expenses and our subscriber acquisition and retention could be negatively impacted. Furthermore, to the extent network operators were to createtiers of Internet access service and either charge us for or prohibit us from being available through these tiers, our business could be negatively impacted.Risks 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, patents, pending patent applications, tradedress and designs are 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 six issued patents in the U.S. and eight foreign patents. This includes patents held by Tell Me More (Auralog) acquired in January 2014. Wehave several patent applications on file in the U.S. and other countries. However, we do not know whether any of our pending patent applications will result inthe issuance of patents or whether the examination process will require us to narrow our claims. Even if patents are issued from our patent applications, whichare not certain, they may be contested, circumvented or invalidated in the future. Moreover, the rights granted under any issued patents may not provide uswith proprietary protection or competitive advantages, and, as with any technology, competitors may be able to develop similar or superior technologies now orin the future. In addition, we have not emphasized patents as a source of significant competitive advantage and have instead sought to primarily protect ourproprietary rights under laws affording protection for trade secrets, copyright and trademark protection of our products, brands, trademarks and otherintellectual property 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-engineeringour products. Third parties could copy all or portions of our products or otherwise obtain, use, distribute and sell our proprietary information withoutauthorization. Third parties may also develop similar or superior technology independently by designing around our intellectual property, which woulddecrease demand for our products. In addition, our patents may not provide us with any competitive advantages and the patents of others may seriouslyimpede 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 for themaintenance of confidentiality and the assignment of rights to inventions made by them while employed by us. We also enter into non-disclosure agreementswith our technical consultants, customers, vendors and resellers to protect our confidential and proprietary information. We cannot guarantee that ourconfidentiality agreements with our employees, consultants and other third parties will not be breached, that we will be able to effectively enforce theseagreements, that we will have adequate remedies for any breach, or that our trade secrets and other proprietary information will not be disclosed or willotherwise 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 guarantee thatsuch 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 many instances, on"click-wrap" and "shrink-wrap" licenses, which are not negotiated or signed by individual licensees. Accordingly, some provisions of our licenses, includingprovisions protecting against unauthorized use, copying, transfer, resale and disclosure of the licensed software program, may be unenforceable under thelaws 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 property rights.Although we defend our intellectual property rights and combat unlicensed copying and use of software and intellectual property rights through a variety oftechniques, preventing unauthorized use or infringement of our intellectual property rights is inherently difficult. Despite our enforcement efforts24Table of Contentsagainst software piracy, we lose significant revenue due to illegal use of our software and from counterfeit copies of our software. If piracy activities increase, itmay 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 develop productsthat are similar to ours, which may infringe on our proprietary rights. In addition, we could potentially lose future trade secret protection for our source code ifany unauthorized disclosure of such code occurs. The loss of future trade secret protection could make it easier for third parties to compete with our productsby copying functionality. In addition, any changes in, or unexpected interpretations of, the trade secret and other intellectual property laws in any country inwhich we operate may compromise our ability to enforce our trade secret and intellectual property rights. Costly and time-consuming litigation could benecessary to enforce and determine the scope of our confidential information and trade secret protection. If we are unable to protect our proprietary rights or ifthird 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 their websites.Preventing such unauthorized use is inherently difficult. If we are unable to protect our trademarks and confusingly similar terms from such unauthorizeduse, competitors and other third parties may continue to drive potential online customers away from our websites to competing and unauthorized 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 U.S. trademark registrations, including registrations of the Rosetta Stone, Tell Me More, Livemocha, Lexia Learning and Lexiatrademarks, hold common law trademark rights and have trademark applications pending in the U.S. and abroad for additional trademarks. Even if federalregistrations and registrations in other countries are granted to us, our trademark rights may be challenged. It is also possible that our competitors will adopttrademarks similar to ours, thus impeding our ability to build brand identity and possibly leading to customer confusion. In fact, various third parties haveregistered trademarks that are similar to ours in the U.S. and overseas. We could incur substantial costs in prosecuting or defending trademark infringementsuits. If we fail to effectively enforce 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. The U.S.Copyright Act automatically protects all of our copyrightable works, but without a registration we cannot enforce those copyrights against infringers or seekcertain statutory remedies for any such infringement. Preventing others from copying our products, written materials and other copyrightable works isimportant 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 toregister the relevant copyrights, and we cannot be sure that all of the material for which we seek copyright registration would be registrable in whole or in part,or that once registered, we would be successful in bringing a copyright claim against any such infringers.We must monitor and protect our internet domain names to preserve their value. We may be unable to prevent third parties from acquiring domainnames that are similar to, infringe on or otherwise decrease the value of our trademarks.We own several domain names related to our business. Third parties may acquire substantially similar domain names that decrease the value of ourdomain names and trademarks and other proprietary rights which may hurt our business. Third parties also may acquire country specific domain names inthe form of Country Code Top Level Domains which include our trademarks and which prevent us from operating country specific websites from whichcustomers can view our products and engage in transactions with us. Moreover, the regulation of domain names in the United States and foreign countries issubject to change. Governing bodies could appoint additional domain name registrars or modify the requirements for holding domain names. Recently,ICANN (the Internet Corporation for Assigned Names and Numbers), the international authority over top-level domain names, expanded the number of genericTop Level Domains ("TLDs") which allow companies and organizations to create additional Web addresses that appear to the right of the "dot," such as thelong-standing TLDs, ".com," ".gov" and ".org." ICANN may also add additional TLDs in the future. As a result, we may not maintain exclusive rights to allpotentially relevant domain names in the United States or in other countries in which we conduct business, which could harm our business or reputation.Moreover, attempts may be made to register our trademarks as new TLDs or as domain names within the selected new TLDs and we will have to make effortsto enforce our rights against such registration attempts.25Table of ContentsClaims 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-commerceand other web-related technologies, online business methods, trademarks or other proprietary rights. Our competitors, some of which may have substantiallygreater resources than we have and they have made significant investments in competing products and technologies, may have, or seek to apply for andobtain, patents, copyrights or trademarks that will prevent, limit or interfere with our ability to make, use and sell our current and future products andtechnologies, and we may not be successful in defending allegations of infringement of these patents, copyrights or trademarks. Further, we may not be awareof all of the patents and other intellectual property rights owned by third parties that may be potentially adverse to our interests. We may need to resort tolitigation to enforce our proprietary rights or to determine the scope and validity of a third-party's patents or other proprietary rights, including whether any ofour products, technologies or processes infringe the patents or other proprietary rights of third parties. We may incur substantial expenses in defending againstthird-party infringement claims regardless of the merit of such claims. The outcome of any such proceedings is uncertain and, if unfavorable, could force usto discontinue sales of the affected products or impose significant penalties or restrictions on our business. We do not conduct comprehensive patent searchesto determine whether the technologies used in our products infringe upon patents held by others. In addition, product development is inherently uncertain in arapidly evolving technological environment in which there may be numerous patent applications pending, many of which are confidential when filed, withregard 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 internally developedsoftware and a portion of our voice recognition software, which we license from the University of Colorado. From time to time we may be required torenegotiate with these third parties or negotiate with new third parties to include their technology or content in our existing products, in new versions of ourexisting products or in wholly new products. We may not be able to negotiate or renegotiate licenses on commercially reasonable terms, or at all, and the third-party software may not be appropriately supported, maintained or enhanced by the licensors. If we are unable to obtain the rights necessary to use or continueto use third-party technology or content in our products and services, the inability to support, maintain and enhance any software could result in increasedcosts, or in delays or reductions 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 licenses couldbe construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. In such event, we could berequired to seek licenses from third parties in order to continue offering our products, make generally available, in source code form, proprietary code thatlinks to certain open source modules, re-engineer our products, discontinue the sale of our products if re-engineering could not be accomplished on a cost-effective and timely basis, or become subject to other consequences. In addition, open source licenses generally do not provide warranties or other contractualprotections regarding infringement claims or the quality of the code. Thus, we may have little or no recourse if we become subject to infringement claimsrelating to the open source software or if the open source software is defective in any manner.Risks Related to Owning Our Common StockIf 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 or more of theanalysts cease providing research coverage on our stock, the price of our stock could decline. If one or more of these analysts cease providing research coverageon 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 control andwhich 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,26Table of Contentsearnings or key performance metrics, confusion on the part of industry analysts and investors about the impact of our subscription offerings, shortfalls in thenumber of subscribers, changes in analyst estimates or recommendations, new product announcements by competitors, seasonal variations in demand, lossof a large customer, variations in competitors' financial performance and regulatory or macro-economic effects.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 our companywould be beneficial to the interests of our stockholders. Any provision of our second amended and restated certificate of incorporation or second amended andrestated bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our stockholders to receive apremium for their shares of our common stock, and could also affect the price that some investors are willing to pay for our common stock. Our board ofdirectors 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 serieswithout stockholder approval. The ability to issue preferred stock could discourage unsolicited acquisition proposals or make it more difficult for a thirdparty to gain control of our company, or otherwise could adversely affect the market price of our common stock. Further, as a Delaware corporation, we aresubject to Section 203 of the Delaware General Corporation Law. This section generally prohibits us from engaging in mergers and other businesscombinations with stockholders that beneficially own 15% or more of our voting stock, or with their affiliates, unless our directors or stockholders approvethe business combination in the prescribed manner.Item 1B. Unresolved Staff CommentsNone.Item 2. PropertiesOur corporate headquarters are located in Arlington, Virginia, where we sublease space on two floors of a large office building. The term of this subleasewas amended in the fourth quarter of 2012 and runs through December 31, 2018. In the first quarter of 2014, we vacated one of the floors of our Arlington,Virginia headquarters and are currently in the process of trying to sublease a portion of the excess space.We currently own two facilities in Harrisonburg, Virginia, that serve as our operations offices. In addition, we lease a facility in Harrisonburg, Virginiafor use as a packing and distribution center for all of our U.S. and some of our international fulfillment, in addition to sales operations.We also lease space for small offices used primarily for research and development activities in various locations in the United States and for regionalsales offices in London, United Kingdom, San Paulo, Brazil, Seoul, South Korea, and Toyko, Japan. With the acquisitions of Vivity and Tell Me More in January 2014, we gained office space in various additional international locations, including nearVersailles, France, and Beijing, China.Item 3. Legal ProceedingsIn April 2010, a purported class action lawsuit was filed against us in the Superior Court of the State of California, County of Alameda for 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 salaried managers by us in ourretail locations in California are due unpaid wages and other relief for our violations of state wage and hour laws. Plaintiffs moved to amend their complaint toinclude a nationwide class in January 2011. In March 2011, the case was removed to the United States District Court for the Northern District of California.In November 2011, the parties agreed to a mediator’s proposed settlement terms, and as a result, as of September 30, 2011, we reserved $0.6 million for theproposed settlement amount. We dispute the plaintiffs’ claims and have not admitted any wrongdoing with respect to the case. In September 2013, the courtentered a final order directing payment of the $0.6 million settlement amount and in October 2013, the Company paid this amount in final settlement of thelawsuit.In June 2011, Rosetta Stone GmbH was served with a writ filed by Langenscheidt KG (“Langenscheidt”) in the District Court of Cologne, Germanyalleging trademark infringement due to Rosetta Stone GmbH’s use of the color yellow on its packaging of its language-learning software and the advertisingthereof in Germany. In January 2012, the District Court of Cologne ordered an injunction of Rosetta Stone GmbH’s use of the color yellow in packaging, on itswebsite and in television commercials and declared Rosetta Stone liable for damages, attorneys’ fees and costs to Langenscheidt. No dollar amounts have beenspecified yet for the award of damages by the District Court of Cologne. In its decision, the District Court of Cologne also ordered the destruction of RosettaStone GmbH’s product and packaging which utilized the color yellow and which was deemed to have infringed Langenscheidt’s trademark. The Court ofAppeals in Cologne affirmed the District Court's decision. Langenscheidt has not posted the necessary bond to immediately enforce that decision. Wecommenced a separate proceeding for the cancellation of Langenscheidt’s German trademark registration of yellow as an abstract color mark. In June 2012, theGerman Patent and Trademark Office rendered a decision in the cancellation proceeding denying our request to cancel Langenscheidt’s German trademarkregistration. We have filed appeals of the decisions in both cases to the German Federal Supreme Court on the grounds of law. We cannot predict the timing andultimate outcome of this matter, however, we believe the range of possible loss is immaterial to our financial statements. Even if the plaintiff is unsuccessful inits claims against us, we will incur legal 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 involved in anylegal proceeding the ultimate outcome of which, in our judgment based on information currently available, would have a material impact on our business,financial condition or results of operations.Item 4. Mine Safety DisclosuresNot applicable.27Table of ContentsPART IIItem 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesMarket for Common StockOur 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. High LowYear ended December 31, 2013 Fourth Quarter $16.53 $11.34Third Quarter 17.30 14.70Second Quarter 18.30 14.46First Quarter 15.44 11.55Year ended December 31, 2012 Fourth Quarter $13.27 $10.52Third Quarter 14.28 9.26Second Quarter 14.69 9.50First Quarter 10.50 6.95On February 21, 2014, the last reported sales price of our common stock on the NYSE was $12.35 per share. As of that date, there were approximately213 holders of record of our common stock.Repurchases of Equity SecuritiesThe following is a summary of common shares repurchased by the Company under its stock repurchase program during the three months endedDecember 31, 2013:Date Total Numberof SharesPurchased AveragePrice Paidper Share Total Number of SharesPurchased as Part ofPublicly announced Plans orPrograms (1) Approximate Dollar Value ofShares that May Yet BePurchased Under the Plansor ProgramsNovember 26, 2013 (2) 500,000 $11.45 500,000 $19,275,000December 6, 2013 (2) 500,000 $11.42 500,000 $13,565,000Total 1,000,000 $11.44 1,000,000 $13,565,000(1) On August 22, 2013, our Board of Directors approved a share repurchase program under which we are authorized to repurchase up to $25 million of ouroutstanding common stock from time to time from August 22, 2013 to August 22, 2015.(2) Purchase was a privately negotiated transaction.DividendsWe 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 PlansFor information regarding securities authorized for issuance under equity compensation plans, see Part III "Item 12—Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters."Stockholder Return Performance PresentationThe following graph compares the change in the cumulative total stockholder return on our common stock during the period from April 16, 2009 (thefirst day our stock began trading on the NYSE) through December 31, 2013, with the28Table of Contentscumulative total return on the NYSE Composite Index and the SIC Code Index that includes all U.S. public companies in the Standard IndustrialClassification (SIC) Code 7372-Prepackaged Software. The comparison assumes that $100 was invested on April 16, 2009 in our common stock and in eachof the foregoing indices and assumes reinvestment of dividends, if any._______________________________________________________________________________Item 6. Selected Consolidated Financial DataThe 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, 2013, 2012, 2011, 2010 and 2009, and the consolidated balance sheet data as ofDecember 31, 2013, 2012, 2011, 2010 and 2009 have been derived from Rosetta Stone Inc. audited consolidated financial statements. The selectedconsolidated financial data should be read in conjunction with the information under “Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations,” our consolidated financial statements, the related notes and the accompanying independent registered public accounting firm’sreport which refers to a change in accounting for costs associated with sales commissions, which are included in “Item 15. Exhibits and Financial StatementSchedules.” The selected consolidated financial data below has been adjusted to the reflect the impact of this change retrospectively to all prior periods. Ourhistorical results for any prior period are not necessarily indicative of results to be expected in any future period.29Table of Contents Year Ended December 31, 2013(1) 2012(2) 2011(3) 2010 2009(4) (in thousands, except per share data)Statements of Operations Data: Revenue $264,645 $273,241 $268,449 258,868 $252,271Cost of revenue 45,714 48,910 49,116 38,999 33,427Gross profit 218,931 224,331 219,333 219,869 218,844Operating expenses: Sales and marketing 146,104 150,882 160,942 130,335 115,108Research and development 33,995 23,453 24,218 23,437 26,239General and administrative 56,432 55,262 62,031 53,239 57,182Lease abandonment 842 — — (583) (8)Total operating expenses 237,373 229,597 247,191 206,428 198,521Income (loss) from operations (18,442) (5,266) (27,858) 13,441 20,323Other income and expense: Interest income 117 187 302 262 159Interest expense (61) — (5) (66) (356)Other (expense) income 368 3 142 (220) 112Interest and other income (expense), net 424 190 439 (24) (85)Income (loss) before income taxes (18,018) (5,076) (27,419) 13,417 20,238Income tax expense (benefit) (1,884) 28,909 (7,769) (178) 7,010Income (loss) attributable to common stockholders (16,134) (33,985) (19,650) 13,595 $13,228Income (loss) per share attributable to commonstockholders: Basic $(0.75) $(1.61) $(0.95) 0.67 $0.88Diluted $(0.75) $(1.61) $(0.95) 0.64 $0.66Common shares and equivalents outstanding: Basic weighted average shares 21,528 21,045 20,773 20,439 14,990Diluted weighted average shares 21,528 21,045 20,773 21,187 19,930Other Data: Stock-based compensation included in: Cost of revenue $175 $288 $55 $39 $34Sales and marketing 1,840 1,185 1,932 774 999Research and development 1,460 1,547 2,448 1,181 5,959General and administrative 5,766 4,989 7,918 2,393 15,158Total stock-based compensation expense $9,241 $8,009 $12,353 $4,387 $22,150Intangible amortization included in: Cost of revenue $244 $— $— $— $—Sales and marketing 1,028 — 45 58 42Research and development 550 40 40 — —General and administrative — — — — —Total intangible amortization expense $1,822 $40 $85 $58 $42_______________________________________________________________________________(1)As discussed in Note 5, the Company acquired Livemocha, Inc. on April 1, 2013 and acquired Lexia Learning Systems, Inc. on August 1, 2013.The results of operations from these entities have been included from the acquisition date.(2)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.30Table of Contents(3)As discussed in Note 11, on January 4, 2011 the Company's Board of Directors approved the Rosetta Stone Inc. Long Term Incentive Program("LTIP") and then subsequently cancelled the LTIP on November 30, 2011, resulting in $4.9 million additional operating expense.(4)In April 2009 shares of common stock were awarded to key employees as part of the IPO resulting in $18.8 million of additional operating expense. As of December 31, 2013 2012 2011 2010 2009 (in thousands)Consolidated Balance Sheet Data: Cash and cash equivalents $98,825 $148,190 $106,516 $115,756 $95,188Total assets 290,776 279,446 280,059 278,804 227,228Deferred revenue 78,857 63,416 51,895 47,158 26,106Notes payable and capital lease obligation 242 5 12 — —Total stockholders' equity $131,243 $148,194 $172,951 $179,724 $157,531Item 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.OverviewRosetta Stone Inc. (“Rosetta Stone,” “the Company,” “we” or “us”) is dedicated to changing the way the world learns. Our innovative, technology-drivenlanguage-learning solutions have been purchased by millions of individuals and used by thousands of schools, businesses, and government organizationsaround the world. Founded in 1992, Rosetta Stone pioneered the use of interactive software to accelerate language learning. Today we offer courses in 30languages across a broad range of formats, including online subscriptions, digital downloads, mobile apps, and perpetual CD-Rom packages. Rosetta Stonehas invested more in language learning and expanded beyond language learning and deeper into education-technology with its acquisitions of Livemocha Inc.("Livemocha") and Lexia Learning Systems Inc, ("Lexia") in 2013 and Vivity Labs, Inc. ("Vivity""), and Tell Me More S.A. ("Tell Me More") in January2014.We derive our revenues from sales to both individual consumers and organizations. Our global consumer distribution model comprises a mix of our callcenters, websites, third party e-commerce websites such as Digital River and Apple iTunes, select retail resellers, such as Amazon.com, Barnes & Noble,Target, Best Buy, Books-a-Million, Staples, Costco, daily deal partners such as Groupon, home shopping networks such as GS Home Shopping in Koreaand consignment distributors such as Speed Commerce and third-party resellers of Lexia solutions. Our Global Enterprise & Education distribution model isfocused on targeted sales activity primarily through a direct sales force in five markets: K-12 schools; colleges and universities; federal government agencies;corporations; and not-for-profit organizations.Rosetta Stone’s management team has communicated a strategic business plan designed to guide the Company through 2015. The key areas of focusare:1.leveraging the brand;2.innovating the platform; and3.expanding distribution.In pursuing these priorities, we plan to grow the business by continuing to invest in research and development of new products while focusing onmaintaining costs and margins at appropriate levels.During 2012, we instituted 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, Rest of World ("ROW") Consumer and Global Enterprise & Education. From the first quarter of 2011 through the third quarter of 2012, we hadtwo operating segments, Consumer and Global Enterprise & Education. Prior to 2011 we operated as a single segment.31Table of ContentsWe will discuss the profitability of each segment in terms of segment contribution. Segment contribution is the measure of profitability used by ourCODM. Segment contribution includes segment revenue and expenses incurred directly by the segment, including material costs, service costs, customer careand coaching costs, sales and marketing expense and bad debt expense. North America Consumer segment contribution improved from 41% of segmentrevenue for the year ended December 31, 2012 to 42% of segment revenue for the year ended December 31, 2013. The improvement in North AmericaConsumer segment contribution is due to an increase in revenue of $1.2 million; this achievement is consistent with the goal established by management at theonset of 2012 to stabilize the U.S. consumer market. ROW Consumer segment contribution improved $1.9 million from the year ended December 31, 2012 tothe year ended December 31, 2013 driven by a reduction in sales and marketing expense of $5.9 million, primarily the result of kiosk closures. GlobalEnterprise & Education segment contribution decreased to $21.0 million or 35%, for the year ended December 31, 2013 as compared to $26.6 million, or44%, for the year ended December 31, 2012 primarily due to an increase in sales and marketing expense related to the addition of sales staff to this group. Asour enterprise and education sales team gains traction we anticipate an improvement in contribution margin.For additional information regarding our segments, see Note 16 of Item 8, Financial Statements and Supplementary Data. For additional informationregarding fluctuations in segment revenue, see Results of Operations, below. Prior periods are presented consistent with our current operating segments anddefinition of segment contribution.Business MetricsManagement uses the following key business metrics to measure the success of sales of our Rosetta Stone language-learning solutions in our combinedNorth America and ROW Consumer segments. Management does not review these metrics at a disaggregated segment level. In addition, management does notcurrently use any comparable metrics to measure success of our Global Enterprise & Education segment.•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 product softwareunits sold in the same period. Revenue from product software includes product revenue associated with product licenses in addition to servicerevenues associated with short-term online subscriptions that are bundled with our V4 TOTALe offering. Approximately $25 to $49 in revenue perunit 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 specified period.Applicable online offerings include purchases of subscription-based licenses for Rosetta Stone TOTALe, ReFLEX subscriptions, and purchasers ofour 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 the average numberof paid online learners during the same period, adjusted to a monthly rate. The average number of paid online learners for a quarter is calculated asthe average of the beginning and ending number of paid online learners for the specified period. The average number of paid online learners for a year-to-date period is calculated as the average of the average number of paid online learners for quarters included in the specified year-to-date period.The following table sets forth these unit and online learner metrics for the years ended December 31, 2013, 2012 and 2011: Year Ended December 31, 2013 2012 2011 (in thousands, except per unit amounts)Product software revenue $179,211 $198,075 $199,963Paid online learner revenues* 24,703 14,999 8,063Total consumer revenues $203,914 $213,074 $208,026Product software units 681,612 629,779 585,774Total paid online learners* 94,056 68,393 26,567Average revenue per product software unit $263 $315 $341Average revenue per online learner* $25 $26 $3532Table of Contents* Excludes revenue and learners from Livemocha operations and mobile applications.Product softwareProduct software revenue includes sales of our Rosetta Stone Version 4 TOTALe product. We anticipate the mix of product units will shift from ourtraditional CD-ROM product to digital downloads in future periods. There is no difference in price between the two options.Worldwide consumer revenue from product software decreased $18.9 million from the year ended December 31, 2012 to the year ended December 31,2013, driven by a 17% decrease in the average revenue per unit, partially offset by a 8% increase in the number of units sold, compared to the prior yearperiod. Worldwide consumer revenue from product software decreased $1.9 million from the year ended December 31, 2011 to the year ended December 31,2012, driven by an 8% decrease in the average revenue per unit, partially offset by an 8% increase in the number of units sold, compared to the prior yearperiod. Average revenue per product software unit has decreased as we have experimented with different price points and promotional offerings since theintroduction of Version 4 TOTALe in 2010 including distribution partnerships within the daily deals market. The increase in product software units is due toour expansion into international markets and decreasing price points.Average Revenue Per Product Software Unit (ARPU)Worldwide ARPU decreased $52, or 17%, from $315 for the year ended December 31, 2012 to $263 for the year ended December 31, 2013. Thedecline in ARPU is the result of multiple factors; 94% of the 17% reduction is associated with lower prices, which was driven by promotional pricing inNorth American Consumer, increased levels of daily deals at lower prices and increased price discounting in ROW Consumer. 6% of the 17% decrease inARPU is due to our overall change in our sales channel mix. In the second quarter of 2013, we closed our entire U.S. kiosk sales channel. As a result,customers who would have purchased our products via kiosks made those purchases mainly in our 3rd party retail sales channel, which are sold to theretailers at lower prices. 79% of the decline in ARPU is attributable to declines in North America Consumer and 21% is due to declines in ROW Consumer.We are testing ways to stabilize prices and reduce discounting, however, in the near term we expect ARPU to continue to decline.Paid online learnersRevenue from paid online learners increased $9.7 million from the year ended December 31, 2012 to the year ended December 31, 2013, driven by a38% increase in the number of paid online learners as of December 31, 2013, compared to the prior period. This increase was partially offset by a decrease inthe average revenue per online learner due to the decrease in paid online subscription price points implemented in September 2013. Revenue from paid onlinelearners increased $6.9 million from the year ended December 31, 2011 to the year ended December 31, 2012, driven by a 157% increase in the number ofpaid online learners as of December 31, 2012, compared to the prior period. This increase was partially offset by a decrease in the average revenue per onlinelearner due to continued testing of online products at different price points.BookingsIn addition to the unit and learner metrics described above, management also uses bookings to evaluate the overall health of the business and evaluateperformance. Bookings represent executed sales contracts received by the Company that are either recorded immediately as revenue or as deferred revenue.Management believes that bookings provides useful information to investors regarding certain financial and business trends relating to the Company’sfinancial condition and results of operations.Components of Our Statement of OperationsRevenueWe derive revenue from sales of language learning and reading solutions consisting of product software, audio practice products, professional services,and online software subscriptions. Revenue is presented as product revenue or subscription and service revenue in our consolidated financial statements. Ouraudio 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 combinesproduct software and dedicated conversational coaching. The content of our product software and subscription offerings are the same. We offer our customersthe ability to choose which format they prefer without differentiating the learning experience. We bundle time-based subscription licenses of our web-basedTOTALe33Table of Contentsservices with perpetual licenses of our Rosetta Stone language learning 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 the subscription 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 select third-party retailers. The majority of our consumer customers purchase our product software and audiopractice products, online software subscriptions and professional services. We sell to enterprise and education organizations primarily through our directenterprise and education sales force as well as our network of resellers. Many organizations elect to license our products on a subscription basis. For purposesof explaining variances in our revenue, we separately discuss changes in our consumer and enterprise and education sales channels because the customers andrevenue drivers of these channels are different.Our consumer revenue is affected by seasonal trends associated with the holiday shopping season. As a result, our fourth quarter ended December 31,2013 accounted for 29% of our annual revenue in 2013. Our enterprise and education revenue is seasonally stronger in the second and third quarters of thecalendar year due to education and government purchasing cycles. We expect these trends to continue.Cost of Product and Subscription and Service RevenueCost 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 our onlinelanguage learning service, which includes online language conversation coaching, hosting costs and depreciation. We also include the cost of credit cardprocessing and customer technical support in both cost of product revenue and cost of subscription and service revenue. We are also exploring additionalmeasures to further address coaching costs including unbundling studio sessions from our product software offering.Operating ExpensesWe 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 with contractproduct development, legal, accounting and consulting. Personnel costs for each category of operating expenses include salaries, bonuses, stock-basedcompensation and employee benefit costs.Sales and Marketing Our sales and marketing expenses consist primarily of direct advertising expenses related to television, print, radio, online andother direct marketing activities, personnel costs for our sales and marketing staff, rental payments for our kiosks (most of which were closed in the first halfof 2013) and commissions earned by our sales personnel. Sales commissions are generally paid at the time the customer is invoiced. However, salescommissions are deferred and recognized as expense in proportion to when the related revenue is recognized. We intend to continue to expand our sales activitieswithin some of our existing regions as well as to expand our presence into new countries, in addition to expanding our media and advertising campaigns in theU.S. We expect sales and marketing expenses 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 associated withthe development of our solutions. Our development efforts are primarily based in the U.S. and are devoted to modifying and expanding our product portfoliothrough the addition of new content and new complementary products and services to our language learning and reading solutions. We expect our investment inresearch and development expenses to increase in future years as we deliver new products that will provide us with significant benefits in the future. In 2013we restructured our product team, including the elimination of approximately seventy positions in our Harrisonburg, Virginia office and hiring personnel inAustin, Texas and San Francisco, California. We also acquired Livemocha and gained additional product personnel in Seattle, Washington. Payroll expenseshave increased during 2013 due to hiring product team members in these more competitive labor markets. Rent has also increased due to our additional officesopened in 2013.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 including professional service fees related toacquisition and other corporate expenses. In 2013, there have been and we expect that there will continue to be increases to certain general and administrativeexpenses to support our due diligence efforts and integration of our recent acquisitions and continued expansion into international markets. However, we arealso taking steps to reduce certain general and administrative expenses as we realign our cost structure to help fund investment in areas of growth.34Table of ContentsInterest and Other Income (Expense)Interest and other income (expense) primarily consist of interest income, interest expense, foreign exchange gains and losses, and income from litigationsettlements. Interest expense is primarily related to interest on our capital leases. Interest income represents interest received on our cash and cash equivalents.Fluctuations in foreign currency exchange rates in our foreign subsidiaries cause foreign exchange gains and losses. Legal settlements are related to agreed uponsettlement 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, 2013, our worldwide effective tax ratewas approximately 10%. The income tax benefit in 2013 was primarily attributable to partial valuation releases related to the Livemocha and Lexia acquisitionsoffset by tax expense related to current year taxable income in Canada, Germany and the U.K., foreign withholding taxes, and the tax impact of amortization ofindefinite-lived intangible assets.We regularly evaluate the recoverability of our deferred tax assets and establish a valuation allowance, if necessary, to reduce the deferred tax assets to anamount that is more likely than not to be realized (a likelihood of more than 50 percent). Significant judgment is required to determine whether a valuationallowance is necessary and the amount of such valuation allowance, if appropriate.In assessing the recoverability 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 it ismore 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 the extent towhich it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support aconclusion that a valuation allowance is not needed.As of December 31, 2012, we performed an analysis on the need for a valuation allowance on our deferred tax assets in various jurisdictions. Ouranalysis considered a number of factors, including our cumulative loss over the last three years, our expectation of future taxable income and the time frameover which our net operating losses expire. This analysis resulted in the need for valuation allowances in the U.S., Korea, Japan and Brazil. We havemaintained a valuation allowance against our deferred tax assets in the U.S., Korea, Japan and Brazil through December 31, 2013. All four jurisdictions havecumulative losses and pre-tax losses for the most recent year ended December 31, 2013.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. We willcontinue to assess the likelihood that the deferred tax assets will be realizable at each reporting period, and the valuation allowance will be adjusted accordingly,which could materially affect our financial position and results of operations.Critical Accounting Policies and EstimatesIn presenting our financial statements in conformity with accounting principles generally accepted in the U.S., we are required to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures.Some of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. We basethese estimates and assumptions on historical experience or on various other factors that we believe to be reasonable and appropriate under the circumstances.On an ongoing basis, we reconsider and evaluate our estimates and assumptions. Our future estimates may change if the underlying assumptions change.Actual results may differ significantly from these estimates.35Table of ContentsWe believe that the critical accounting policies listed below involve our more significant judgments, assumptions and estimates and, therefore, couldhave the greatest potential impact on our consolidated financial statements. In addition, we believe that a discussion of these policies is necessary to understandand evaluate the consolidated financial statements contained in this annual report on Form 10-K.Revenue RecognitionOur primary sources of revenue are online subscriptions, software and bundles of software and online subscriptions. We also generate revenue fromthe sale of audio practice products and training and implementation services. Revenue is recognized when all of the following criteria are met: there ispersuasive evidence of an arrangement; the product has been delivered or services have been rendered; the fee is fixed or determinable; and collectability isreasonably assured. Revenues are recorded net of discounts.We identify the units of accounting contained within our sales arrangements in accordance with ASC 605-25 Revenue Recognition - Multiple ElementArrangements (“ASC 605-25”). In doing so, we evaluate a variety of factors including whether the undelivered element(s) have value to our customer on astand-alone basis or if the undelivered element(s) could be sold by another vendor on a stand-alone basis.For multiple element arrangements that contain software products and related services, we allocate the total arrangement consideration to alldeliverables based on vendor-specific objective evidence of fair value, or VSOE, in accordance with ASC subtopic 985-605-25 Software: RevenueRecognition-Multiple-Element Arrangements ("ASC 985-605-25"). We generate a substantial portion of our consumer revenue from Rosetta Stone Version 4TOTALe which is a multi-element arrangement that includes perpetual software bundled with the subscription and conversational coaching components of ourTOTALe online service. We have identified two deliverables generally contained in Rosetta Stone V4 TOTALe software arrangements. The first deliverable isthe perpetual 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. In the U.S., we offer consumers who purchase ourpackaged software and audio practice products directly from us a 30-day, unconditional, full money-back refund. We also permit some of our retailers anddistributors to return packaged products, subject to certain limitations. We establish revenue reserves for packaged product returns based on historicalexperience, estimated channel inventory levels, the timing of new product introductions and other factors.For non-software multiple element arrangements we allocate revenue to all deliverables based on their relative selling prices.We distribute our products and services both directly to the end customer and indirectly through resellers. Our resellers earn commissions generallycalculated as a fixed percentage of the gross sale to the end customer. We evaluate each of our reseller relationships in accordance with ASC 605-45 RevenueRecognition - Principal Agent Considerations (“ASC 605-45”) to determine whether the revenue we recognize from indirect sales should be the gross amount ofthe contract with the end customer or reduced for the reseller commission. In making this determination we evaluate a variety of factors including whether weare the primary obligor to the end customer.Revenue for online service subscriptions is recognized ratably over the term of the subscription period, assuming all revenue recognition criteria havebeen met. Rosetta Stone Version 4 TOTALe bundles, which include an online service subscription including conversational coaching and packaged software,allow customers to begin their online services at any point during a registration window, which is up to six months from the date of purchase from us or anauthorized reseller. Online service subscriptions that are not activated during this registration window are forfeited and revenue is recognized upon expiry.Revenue from non-refundable upfront fees that are not related to products already delivered or services already performed is deferred and recognized over theterm of the related arrangement or the estimated customer life. Accounts receivable and deferred revenue are recorded at the time a customer enters into a bindingsubscription agreement.Software products include sales to end user customers and resellers. In most cases, revenue from sales to resellers is not contingent upon resale of thesoftware to the end user and is recorded in the same manner as all other product sales. Revenue from sales of packaged software products and audio practiceproducts is recognized as the products are shipped and title passes and risks of loss have been transferred. For most of our product sales, these criteria are metat the time the product is shipped. For some sales to resellers and certain other sales, we defer revenue until the customer receives the product because we legallyretain a portion of the risk of loss on these sales during transit. A limited amount of packaged software products are sold to resellers on a consignment basis.Revenue is recognized for these consignment transactions once the end user sale has occurred, assuming the remaining revenue recognition criteria have beenmet. In accordance with ASC 985-605-50 Revenue Recognition: Customer Payments and Incentives (“ASC 605-50”), cash sales incentives to resellers areaccounted for as a reduction of revenue, unless a specific identified benefit is identified and the fair value is reasonably determinable. Price36Table of Contentsprotection for changes in the manufacturer suggested retail value granted to resellers for the inventory that they have on hand at the date the price protection isoffered is recorded as a reduction to revenue.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, a successful collection history has beenestablished and these fees are fixed and determinable, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have beenmet. Packaged software is provided to customers who purchase directly from our company with a limited right of return. We also allow our retailers to returnunsold products, subject to some limitations. In accordance with ASC 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 is includedin the initial licensing fee, the technical support and services are generally provided within one year, the estimated cost of providing such support is deemedinsignificant and no unspecified upgrades/enhancements are offered, technical support revenues are recognized together with the software product and licenserevenue. Costs associated with the technical support are accrued at the time of sale.Sales commissions from non-cancellable SaaS contracts are deferred and amortized in proportion to the revenue recognized from the related contract.Stock-Based CompensationWe account for stock-based compensation in accordance Accounting Standards Codification topic 718, Compensation—Stock Compensation ("ASC718"). 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.As of December 31, 2013 and 2012, there were approximately $6.8 million and $6.8 million of unrecognized stock-based compensation expense relatedto non-vested stock option awards that are expected to be recognized over a weighted average period of 2.53 and 2.52 years, respectively.The following table presents the stock-based compensation expense for stock options and restricted stock included in the related financial statement lineitems (in thousands): Year Ended December 31, 2013 2012 2011Included in cost of revenue: Cost of product revenue $109 $110 $30Cost of subscription and service revenue 66 178 25Total included in cost of revenue 175 288 55Included in operating expenses: Sales and marketing 1,840 1,185 1,932Research and development 1,460 1,547 2,448General and administrative 5,766 4,989 7,918Total included in operating expenses 9,066 7,721 12,298Total $9,241 $8,009 $12,353In accordance with ASC topic 718, the fair value of stock-based awards to employees is calculated as of the date of grant. Compensation expense is thenrecognized on a straight-line basis over the requisite service period of the award. We use the Black-Scholes pricing model to value our stock options, whichrequires the use of estimates, including future stock price volatility, expected term and forfeitures. Stock-based compensation expense recognized is based onthe estimated portion of the awards that are expected to vest. Estimated forfeiture rates were applied in the expense calculation. The fair value of each optiongrant is estimated on the date of grant using the Black Scholes option pricing model as follows:37Table of Contents Year Ended December 31, 2013 2012 2011Expected stock price volatility 64%-67% 64%-66% 57%-64%Expected term of options 6 years 6 years 6 yearsExpected dividend yield — — —Risk-free interest rate 0.75%-1.65% 0.60%-0.88% 1.14%-2.59%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 commensurate with theestimated expected term of the awards. In addition to analyzing data from the peer group, we also considered the contractual option term and vesting periodwhen determining the expected option life and forfeiture rate. Subsequent to the initial public offering, we continue to review a group of comparable industry-related companies to estimate volatility, but also review the volatility of our own stock since the initial public offering. We consider the volatility of thecomparable companies to be the best estimate of future volatility. For the risk-free interest rate, we use a U.S. Treasury Bond rate consistent with the estimatedexpected 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 on Form 10-K:Grant 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 7.51-13.892013 636,656 12.34-16.96 12.34-16.96GoodwillThe value of goodwill is primarily derived from the acquisition of Rosetta Stone Ltd. (formerly known as Fairfield & Sons, Ltd.) in January 2006, theacquisition of certain assets of SGLC International Co. Ltd ("SGLC") in November 2009, the acquisition of Livemocha in April 2013 and the acquisition ofLexia in August 2013.Beginning in the fourth quarter of 2012, we began reporting our results in three reportable segments, which resulted in three reporting units for goodwillimpairment purposes—North America Consumer, ROW Consumer, and Global Enterprise & Education (previously referred to as Institutional). Accordingly,we allocated goodwill from our former Consumer reporting unit to the new reporting units, North America Consumer and ROW Consumer, based on therelative fair value of each reporting unit as of October 31, 2012. In doing so, we evaluated the results of the allocation of goodwill for events or indicators thatwould require further impairment testing, noting none.We test goodwill for impairment annually on June 30 of each year at the reporting unit level using a fair value approach, in accordance with theprovisions of Accounting Standards Codification topic 350, Intangibles—Goodwill and Other ("ASC 350") or more frequently, if impairment indicatorsarise. This guidance provides the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit isless than its carrying value, a "Step 0" analysis. If, based on a review of qualitative factors, it is more likely than not that the fair value of a reporting unit isless than its carrying value we perform "Step 1" of the traditional two-step goodwill impairment test by comparing the fair value of a reporting unit with itscarrying amount. If the carrying value exceeds the fair value, we measure the amount of impairment loss, if any, by comparing the implied fair value of thereporting unit goodwill with its carrying amount. At June 30, 2013 we performed our annual impairment test beginning with Step 1. There has been noimpairment of goodwill during any of the periods presented.38Table of ContentsIn 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 cash flowmethod) and the market approach (i.e., the guideline public company method). Our adjusted EBITDA projections are estimates that can significantly affect theoutcome of the analysis, both in terms of our ability to accurately project future results and in the allocation of fair value between reporting units. The fairvalue of each of our reporting units substantially exceeded its carrying value at June 30, 2013.The factors that we consider important, and which could trigger an interim 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 nosuch indicators occurred during 2013, we will continue to review for impairment indicators.In January 2014 we announced plans to substantially reduce our Asian operations. As part of our interim review for triggers noted above, we consideredwhether any circumstances or events in 2013 predicating our 2014 decision represented events that would trigger an interim impairment assessment for ROWConsumer and if so, whether it was more likely than not that the fair value of that reporting unit is less than its carrying value. Based on our analysis, whichincluded a review of financial projections, we determined that there were no such triggers requiring further impairment testing as of December 31, 2013.Intangible AssetsIntangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and trademark and otherintangible assets. Those intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives in accordance withASC 350. This guidance provides the option to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangibleasset is impaired as a basis for determining whether it is necessary to perform the quantitative test. If necessary, the quantitative test is performed bycomparing the fair value of indefinite lived intangible assets to the carrying value in accordance with ASC 350. In the event the carrying value exceeds the fairvalue of the 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 AssetsIn accordance with Accounting Standards Codification topic 360, Accounting for the Impairment or Disposal of Long-lived Assets ("ASC 360"), weevaluate the recoverability of our 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 the extentthe carrying amount of an asset exceeds the fair value of such asset. Based on our analysis, we believe that no impairment of our long-lived assets wasindicated as of December 31, 2013 and 2012.Income TaxesWe believe that the accounting estimate for the realization of deferred tax assets is a critical accounting estimate because judgment is required in assessingthe likely future tax consequences of events that have been recognized in our financial statements or tax returns. Although it is possible there will be changesthat are not anticipated in our current estimates, we believe it is unlikely such changes would have a material period-to-period impact on our financial positionor results of operations.We account for income taxes in accordance with Accounting Standards Codification topic 740, Income Taxes ("ASC 740"), which provides for an assetand liability approach to accounting for income taxes. Deferred tax assets and liabilities represent the future tax consequences of the differences between thefinancial statement carrying amounts of assets and liabilities versus the tax bases of assets and liabilities. Under this method, deferred tax assets arerecognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred tax liabilities are recognized for taxable temporarydifferences.ASC 740 requires a reduction of the carrying amounts of deferred tax assets by a valuation allowance if, based on available evidence, it is more likelythan not ("MLTN") 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 MLTN realization threshold criterion. In the assessment, appropriate consideration is given to all positive and negative evidence relatedto the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and39Table of Contentscumulative losses, forecasts of future profitability, the duration of statutory carryforward periods, our experience with operating loss and tax creditcarryforwards not expiring unused, and tax planning alternatives. Significant judgment is required to determine whether a valuation allowance is necessaryand the amount of such valuation allowance, if appropriate. The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidenceexists to support a reversal.In assessing the recoverability 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 it ismore 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 the extent towhich it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support aconclusion that a valuation allowance is not needed.As of December 31, 2012, we performed an analysis on the need for a valuation allowance on our deferred tax assets in various jurisdictions. Ouranalysis considered a number of factors, including our cumulative loss over the last three years, our expectation of future taxable income and the time frameover which our net operating losses expire. This analysis resulted in the need for valuation allowances in the U.S., Korea, Japan and Brazil. We havemaintained a valuation allowance against our deferred tax assets in the U.S., Korea, Japan and Brazil through December 31, 2013. All four jurisdictions havecumulative losses and pre-tax losses for the most recent year ended December 31, 2013. The establishment of a valuation allowance has no effect on the abilityto use the deferred tax assets in the future to reduce cash tax payments. We will continue to assess the likelihood that the deferred tax assets will be realizable ateach reporting period and the valuation allowance will be adjusted accordingly, which could materially affect our financial position and results of operations.As of December 31, 2013 and 2012 , our net deferred tax liability was $9.6 million and $8.1 million, respectively.Changes in Accounting PrincipleIn the third quarter of 2013, we voluntarily changed our accounting policy for sales commissions related to non-cancellable Software-as-a-Service(“SaaS”) contracts, from recording an expense when incurred, to deferral of the sales commission in proportion to the consideration allocated to each of theelements in the arrangement and in, or over, the same period the revenue is recognized for each of the elements in the arrangement (i.e. over the non-cancellableterm of the contract for the SaaS deliverable). We anticipate a significant increase in contracts with multi-year subscriptions and a corresponding increase insales commissions due, among other reasons, to our acquisition of Lexia. Lexia provides its services using a SaaS model and has historically had longer-termarrangements, with material sales commissions paid to its network of resellers and has applied a sales commission deferral and amortization policy.We believe the deferral method described above is preferable primarily because (i) the sales commission charges are so closely related to obtaining therevenue from the non-cancellable contracts that they should be deferred and charged to expense over the same period that the related revenue is recognized; and(ii) it provides a single accounting policy, consistent with that used by Lexia, that makes it easier for financial statement users to understand. Furthermore, theadoption of this accounting policy enhances the comparability of our consolidated financial statements by changing to a method that is widely utilized in ourindustry. Deferred commission amounts are recoverable through the future revenue streams under the non-cancellable arrangements. Short-term deferredcommissions are included in prepaid expenses and other current assets, while long-term deferred commissions are included in other assets in theaccompanying consolidated balance sheets. The amortization of deferred commissions is included in sales and marketing expense in the accompanyingconsolidated statements of operations.Results of Operations40Table of ContentsThe following table sets forth our consolidated statement of operations for the periods indicated. Year Ended December 31, 2013 2012 2011 (in thousands, except per share data)Statements of Operations Data: Revenue Product $156,792 $180,919 $195,382Subscription and service 107,853 92,322 73,067Total Revenue 264,645 273,241 268,449Cost of revenue Cost of product revenue 32,191 33,684 36,497Cost of subscription and service revenue 13,523 15,226 12,619Total cost of revenue 45,714 48,910 49,116Gross profit 218,931 224,331 219,333Operating expenses: Sales and marketing 146,104 150,882 160,942Research and development 33,995 23,453 24,218General and administrative 56,432 55,262 62,031Lease abandonment 842 — —Total operating expenses 237,373 229,597 247,191Loss from operations (18,442) (5,266) (27,858)Other income and expense: Interest income 117 187 302Interest expense (61) — (5)Other income 368 3 142Interest and other income, net 424 190 439Loss before income taxes (18,018) (5,076) (27,419)Income tax (benefit) expense (1,884) 28,909 (7,769)Net loss $(16,134) $(33,985) $(19,650)Loss per share: Basic $(0.75) $(1.61) (0.95)Diluted $(0.75) $(1.61) $(0.95)Common shares and equivalents outstanding: Basic weighted average shares 21,528 21,045 20,773Diluted weighted average shares 21,528 21,045 20,773Stock-based compensation included in: Cost of sales 175 288 55Sales and marketing 1,840 1,185 1,932Research and development 1,460 1,547 2,448General and administrative 5,766 4,989 7,918 $9,241 $8,009 $12,35341Table of ContentsComparison of the Year Ended December 31, 2013 and the Year Ended December 31, 2012Our revenue decreased to $264.6 million for the year ended December 31, 2013 from $273.2 million for the year ended December 31, 2012. The changein revenue is due to a decrease in ROW Consumer revenues of $9.8 million, partially offset by a $1.2 million increase in North American Consumerrevenues. Global Enterprise & Education revenues were essentially flat year over year. Bookings, calculated as revenue plus the change in deferred revenue,decreased to $278.1 million for the year ended December 31, 2013 from $284.8 million for the year ended December 31, 2012. The decline was due to a $7.3million decrease in North America Consumer bookings and a $11.2 million decrease in ROW Consumer bookings, offset by an increase of $11.9 million inworldwide Global Enterprise & Education bookings compared to the prior year.We reported an operating loss of $18.4 million for the year ended December 31, 2013 compared to an operating loss of $5.3 million for the year endedDecember 31, 2012. The increase in operating loss was due to a decrease in gross profit of $5.4 million, driven by an $8.6 million decrease in revenue,partially offset by a $3.2 million decrease in cost of revenue. Operating expenses increased $7.8 million due to an increase of $10.5 million in research anddevelopment, an increase of $1.1 million in general and administrative expenses and an increase of $0.8 million in lease abandonment expense, partially offsetby a decrease of $4.8 million in sales and marketing expenses.Revenue by Operating SegmentThe following table sets forth revenue for each of our three operating segments for the years ended December 31, 2013 and 2012: Year ended December 31, 2013 versus 2012 2013 2012 Change % Change (in thousands, except percentages) North America Consumer $174,016 65.7% $172,826 63.3% $1,190 0.7 %Rest of World Consumer 30,420 11.5% 40,248 14.7% $(9,828) (24.4)%Global Enterprise & Education 60,209 22.8% 60,167 22.0% $42 0.1 %Total Revenue $264,645 100.0% $273,241 100.0% $(8,596) (3.1)%North America Consumer revenue increased $1.2 million, or 1%, from the year ended December 31, 2012 to the year ended December 31, 2013, theresult of increases in revenue from our direct-to-consumer and retail sales channels of $12.6 million and $1.3 million, respectively, offset by reductions of$11.8 million and $1.0 million in revenue from our kiosk and homeschool sales channels, respectively. In the second quarter of 2013 we closed our entirekiosk sales channel in the U.S. North America Consumer bookings, calculated as North America Consumer revenue plus the change in North Americaconsumer deferred revenue, decreased $7.3 million to $171.9 million for the year ended December 31, 2013 from $179.2 million for the year endedDecember 31, 2012. The year-over-year variance by sales channel includes decreases of $12.0 million, $2.5 million and $0.9 million in our kiosk, retail andhomeschool sales channels, respectively, partially offset by an increase of $8.1 million in our direct-to-consumer channel. During 2013 we focused on drivingcustomers to purchase through our direct-to-consumer channel, particularly through our website. Lower pricing is one tactic we used to increase sales volumein this channel. Although we successfully increased volume and bookings in our direct-to-consumer channel year-over-year, the decrease in overall pricingcombined with the closure of our U.S. kiosks resulted in lower North America Consumer bookings year-over-year. We expect that the trend of lowering pricesresulting in increased unit volume and overall increased sales will continue.ROW Consumer revenue decreased $9.8 million, or 24%, from the year ended December 31, 2012 to the year ended December 31, 2013. ROWConsumer revenue decreased $5.8 million, $3.7 million and $2.0 million in Korea, Japan, and the UK, respectively, offset by an increase of $1.7 million inGermany. ROW Consumer bookings, calculated as ROW Consumer revenue plus the change in ROW Consumer deferred revenue, decreased to $30.0 millionfor the year ended December 31, 2013 from $41.2 million for the year ended December 31, 2012. Bookings decreased $5.0 million, $4.7 million, and $2.3million in Korea, Japan and the UK, respectively, offset by an increase of $0.6 million in Germany. On January 10, 2014, we announced plans to streamlineour Japan and Korea operations. We will use a partner model to continue to serve the Japanese market and will reorganize our Korea operations to focus moredirectly on further scaling the Proctor Assisted Learning (“PAL”) channel. The increase in revenue and bookings in Germany is due to the increase in sales ofdownloads of our perpetual software.Global Enterprise & Education revenue was $60.2 million for the years ended December 31, 2013 and December 31, 2012. Within the U.S., enterpriseand education revenue decreased $1.6 million due to decreases of $2.2 million and $1.7 million in our government and education channels, respectively,offset by an increase of $1.2 million in revenue from Lexia,42Table of Contentswhich was acquired on August 1, 2013. International enterprise and education revenues increased $1.6 million driven by increases in the United Kingdom("U.K.") and Germany. Global Enterprise & Education bookings, calculated as enterprise and education revenue plus the change in enterprise and educationdeferred revenue, increased $11.8 million to $76.3 million for the year ended December 31, 2013 from $64.4 million for the year ended December 31, 2012.$8.3 million of the increase in bookings was driven by the acquisition of Lexia and $2.1 million of the increase is due to an increase in the U.K.43Table of ContentsRevenue by Product Revenue and Subscription and Service RevenueWe categorize and report our revenue in two categories—product revenue and subscription and service revenue. Product revenue includes revenuesallocated to our software products, revenues from the sale of audio practice products and mobile applications. Subscription and service revenue includesrevenues allocated to time-based subscription licenses of our web-based services, as well as revenues from training and professional services.We bundle time-based subscription licenses of our web-based TOTALe services with product licenses of our language-learning solutions. As a result, wetypically defer 10%-35% of the revenue of each of these bundled sales. We recognize the deferred revenue over the term of the subscription license in accordancewith Accounting Standards Codification subtopic 985-605, Software: Revenue Recognition. In the fourth quarter in 2013, we reduced the stand alone pricesof renewals of our TOTALe services. Accordingly, the amount we defer related to each bundled sale has decreased.The following table sets forth revenue for products and subscription and services for the years ended December 31, 2013 and 2012: Year ended December 31, 2013 versus 2012 2013 2012 Change % Change (in thousands, except percentages) Product revenue $156,792 59.2% $180,919 66.2% $(24,127) (13.3)%Subscription and service revenue 107,853 40.8% 92,322 33.8% 15,531 16.8 %Total revenue $264,645 100.0% $273,241 100.0% $(8,596) (3.1)%Product RevenueProduct revenue decreased $24.1 million, or 13%, to $156.8 million during the year ended December 31, 2013 from $180.9 million during the yearended December 31, 2012. Consumer product revenue decreased $19.7 million driven by lower prices on our Rosetta Stone Version 4 TOTALe productsoftware bundle driven by promotional pricing in our North America Consumer segment, increased levels of daily deals and a shift in our sales channel mix.$2.9 million of the decrease in Global Enterprise & Education product revenues is a result of a shift from sales of product licenses to sales associated with therenewal of online subscriptions.Subscription and Service RevenueSubscription and service revenue increased $15.5 million, or 17%, to $107.9 million for the year ended December 31, 2013. The increase insubscription and service revenues was due to an $11.1 million increase in consumer online service revenue related to Version 4 TOTALe as well as a growingbase of exclusively online subscription sales. Enterprise and education subscription and service revenues also increased $4.5 million related to growth in theenterprise and education customer base with renewing online subscriptions. $1.2 million of the increase in the enterprise & education revenue is attributable toLexia.Deferred revenue increased $15.4 million during the year ended December 31, 2013, primarily related to acquired deferred revenue of $2.0 million, anincrease of $7.1 million in Lexia deferred revenue and the increase in our base of paid subscribers.We are currently evaluating changes to our existing solutions as well as the introduction of new solutions, including additional solutions for kids. If weimplement additional subscription-based solutions, it could result in lower revenues over the next twelve months as revenues would be spread over thesubscription period.Cost of Product Revenue and Subscription and Service Revenue and Gross ProfitThe following table sets forth cost of product revenue and subscription and service revenue, as well as gross profit for the years ended December 31,2013 and 2012:44Table of Contents Year EndedDecember 31, 2013 versus 2012 2013 2012 Change % Change (in thousands, except percentages)Revenue Product $156,792 $180,919 $(24,127) (13.3)%Subscription and service 107,853 92,322 15,531 16.8 %Total revenue 264,645 273,241 (8,596) (3.1)%Cost of revenue Cost of product revenue 32,191 33,684 (1,493) (4.4)%Cost of subscription and service revenue 13,523 15,226 (1,703) (11.2)%Total cost of revenue 45,714 48,910 (3,196) (6.5)%Gross profit $218,931 $224,331 $(5,400) (2.4)%Gross margin percentages 82.7% 82.1% 0.6% Cost of Product RevenueCost of product revenue for the year ended December 31, 2013 was $32.2 million, a decrease of $1.5 million, or 4% from the year ended December 31,2012. As a percentage of product revenue, cost of product revenue increased to 20% from 19% for the year ended December 31, 2013 compared to the prioryear period. The percent increase in cost as a percentage of revenue was primarily attributable to a decline in product revenue while fixed costs remained thesame. The dollar decrease in cost of product is due to the decrease in product revenue.We are exploring the possibility of moving more of our business online, which should reduce the cost of product revenue as we produce and ship fewerCDs. However, in that scenario, we could experience a temporary increase in the cost of our product revenue as we scrap existing packaging and develop andset up packaging for new products.Cost of Subscription and Service RevenueCost of subscription and service revenue for the year ended December 31, 2013 was $13.5 million, a decrease of $1.7 million, or 11% from the yearended December 31, 2012. As a percentage of subscription and service revenue, cost of subscription and service revenue decreased to 13% from 17% for theyear ended December 31, 2013 compared to the prior year period. Beginning in the fourth quarter of 2012, we capped the number of studio sessions comparedto our former unlimited policy, decreasing our coaching costs for the year-ended December 31, 2013.Operating Expenses Year endedDecember 31, 2013 versus 2012 2013 2012 Change % Change (in thousands, except percentages)Sales and marketing $146,104 $150,882 $(4,778) (3.2)%Research and development 33,995 23,453 10,542 44.9 %General and administrative 56,432 55,262 1,170 2.1 %Lease abandonment 842 — 842 n/aTotal operating expenses $237,373 $229,597 $7,776 3.4 %45Table of ContentsSales and Marketing ExpensesSales and marketing expenses for the year ended December 31, 2013 were $146.1 million, a decrease of $4.8 million, or 3%, from the year endedDecember 31, 2012. As a percentage of total revenue, sales and marketing expenses were 55% for the years ended December 31, 2013, and 2012. The dollardecrease in sales and marketing expenses were primarily attributable to a $2.8 million decrease in rent as the number of kiosk leases decreased from 87 atDecember 31, 2012 to three as of December 31, 2013. We exited our U.S. kiosks in the second quarter of 2013. In addition, media and marketing expensesdecreased $1.7 million as we focused our efforts on advertising through online channels such as Facebook, Google AdWords, and email, and less on moreexpensive television and radio commercials, which generally drive potential customers to our call centers. If we continue to move our media spend online thiscould result in less traffic to our call centers that may not be offset by increases in web sales. Professional services expenses decreased $2.7 million. Thesedecreases were partially offset by a $2.1 million increase in payroll and benefits from the addition of Lexia and Livemocha personnel, severance expenses andthe 2013 long-term incentive plan and a $1.1 million increase in amortization due to the intangible assets acquired in the Livemocha and Lexia acquisitions.Research and Development ExpensesResearch and development expenses were $34.0 million for the year ended December 31, 2013, an increase of $10.5 million, or 45%, from the yearended December 31, 2012. As a percentage of revenue, research and development expenses increased to 13% from 9% for the year ended December 31, 2013compared to the year ended December 31, 2012. The dollar and percentage increases were the result of our investment in strengthening our platforms andbringing new innovative products to market including the opening of our new offices in San Francisco, CA and Austin, TX in the first quarter of 2013 andour newly acquired office in Seattle, WA with the acquisition of Livemocha in April 2013. Compensation and relocation expenses increased $5.1 million as aresult of hiring more senior level managers as well as hiring in the more expensive markets of San Francisco, CA, and Seattle, WA. As a result of opening newoffices in 2013, rent expenses increased $0.6 million. In addition, with the acquisitions of Livemocha and Lexia, amortization of intangible assets increased$0.5 million. Consulting expenses increased $3.6 million as we continue to develop new products. General and Administrative ExpensesGeneral and administrative expenses for the year ended December 31, 2013 were $56.4 million, an increase of $1.2 million, or 2%, from the year endedDecember 31, 2012. As a percentage of revenue, general and administrative expenses increased to 21% for the year ended December 31, 2013 compared to 20%for year ended December 31, 2012. The dollar and percentage increases were primarily attributable to a $1.0 million increase in personnel related expenses dueto the start of the 2013 Rosetta Stone Inc. Long Term Incentive Plan ("2013 LTIP"), $0.5 million increase in professional services and a $0.4 million increasein rent expense. These increases were partially offset by a $0.4 million increase in bad debt recoveries and $0.4 million decrease in depreciation expense relatedto certain assets being fully depreciated early in the second quarter of 2012.Lease AbandonmentIn March 2013, we exited a portion of our facility in Japan as a result of excess office space. Accrued exit costs of $0.8 million associated with the partialabandonment were charged to lease abandonment expenses in the first quarter of 2013.Stock-Based CompensationTotal stock-based compensation by expense line item is as follows: Year EndedDecember 31, 2013 versus 2012 2013 2012 Change % Change (dollars in thousands)Cost of revenue $175 $288 $(113) (39.2)%Sales and marketing 1,840 1,185 655 55.3 %Research and development 1,460 1,547 (87) (5.6)%General and administrative 5,766 4,989 777 15.6 %Total $9,241 $8,009 $1,232 15.4 %Interest and Other Income (Expense)46Table of Contents Year EndedDecember 31, 2013 versus 2012 2013 2012 Change % Change (in thousands, except percentages)Interest Income $117 $187 $(70) (37.4)%Interest Expense (61) — (61) n/aOther Income (Expense) 368 3 365 12,166.7 %Total other income (expense) $424 $190 $234 123.2 %Interest income represents interest earned on our cash and cash equivalents. Interest income for the year ended December 31, 2013 was $117,000, adecrease of $70,000, or 37%, from the year ended December 31, 2012.Interest expense for the year ended December 31, 2013 was $61,000, an increase of $61,000, or 100% from the year ended December 31, 2012. Thisincrease was primarily attributable to interest on our capital leases.Other income for the year ended December 31, 2013 was $368,000, an increase of $365,000, as compared to other income of $3,000 for the year endedDecember 31, 2012. The increase was primarily due to a donation of software to a children's foundation in Korea and an increase in legal settlements inconnection with our anti-piracy enforcement efforts, partially offset by foreign exchange losses.Income Tax Expense (Benefit) Year EndedDecember 31, 2013 versus 2012 2013 2012 Change % Change (in thousands, except percentages)Income tax expense (benefit) $(1,884) $28,909 $(30,793) (106.5)%Our income tax benefit for the year ended December 31, 2013 was $1.9 million, compared to income tax expense of $28.9 million for the year endedDecember 31, 2012. The change primarily resulted from partial valuation allowance releases of $5.4 million related to the Livemocha and Lexia acquisitions in2013 and a $26.0 million non-cash charge associated with establishing a valuation allowance for our U.S. and certain foreign operations in 2012.Comparison of the Year Ended December 31, 2012 and the Year Ended December 31, 2011Our revenue increased to $273.2 million for the year ended December 31, 2012 from $268.4 million for the year ended December 31, 2011. The changein revenue is due to an increase in North American Consumer revenues of $15.3 million, partially offset by a $10.2 million decrease in ROW Consumerrevenue, over the prior year period. Global Enterprise & Education 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, increased to$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 millionincrease in North America Consumer bookings, partially offset by a $12.8 decrease in ROW Consumer bookings. Additionally, Global Enterprise &Education bookings increased $2.6 million compared to the prior year period.We reported an operating loss of $5.3 million for the year ended December 31, 2012 compared to an operating loss of $27.9 million for the year endedDecember 31, 2011. The decrease in operating loss was primarily due to a decrease in operating expenses of $17.6 million and an increase in gross 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 the number of worldwidekiosks decreased from 174 as of December 31, 2011 to 87 as of December 31, 2012 and $8.2 million decrease in media and marketing activities related toprior year brand identity campaigns and Version 4 TOTALe launches in the U.K., Japan and Korea, as well as ReFLEX in Korea and Japan. These decreaseswere offset by a $1.9 million increase in restructuring and other related expenses including severance expense in the U.S., the closing of our Germany officelocation, and the closing of several kiosks in Japan, a $0.6 million increase in VAT tax related to a change in our transfer pricing agreements, and$0.6 million increase in non-kiosk payroll expenses primarily related to sales and marketing.Revenue by Operating SegmentThe following table sets forth revenue for each of our three operating segments for the years ended December 31, 2012 and 2011:47Table of Contents Year ended December 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages) North America Consumer $172,826 63.3% $157,561 58.7% $15,264 9.7 %Rest of World Consumer 40,248 14.7% 50,465 18.8% (10,217) (20.2)%Global Enterprise & Education 60,167 22.0% 60,423 22.5% (255) (0.4)%Total Revenue $273,241 100.0% $268,449 100.0% $4,792 1.8 %North America Consumer revenue increased $15.3 million, or 10%, from the year ended December 31, 2011 to the year ended December 31, 2012, theresult of increases in revenue from our retail and direct-to-consumer sales channels of $12.5 million and $11.4 million, respectively, offset by a reduction of$8.7 million in revenue from our kiosk sales channel. During 2012 we used aggressive promotions in our retail and direct-to-consumer channels, includingseveral promotions within the daily deals market. The number of kiosks within North America decreased from 103 at December 31, 2011 to 57 atDecember 31, 2012, driving the decrease in revenue from this channel. North America Consumer bookings, calculated as North America Consumer revenueplus the change in North America consumer deferred revenue, increased to $179.2 million for the year ended December 31, 2012 from $157.4 million for theyear ended December 31, 2011. The increase in North America Consumer bookings was driven by higher sales volume on lower 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, $3.7 million and $1.6 million in Japan, Germany and the UK, respectively. ROW Consumer bookings,calculated as ROW Consumer revenue plus the change in ROW Consumer deferred revenue, decreased to $41.2 million for the year ended December 31, 2012from $54.0 million for the year ended December 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. Inresponse to the softness in the Japan consumer sales we relocated the head of our consumer businesses to this country, strengthened our local management andsales team and entered into new retail distribution agreements. In Germany the decrease in revenue and bookings is the result of no longer selling box product,closing all kiosk locations, and shifting to an online, subscription-only product. The decline in revenue and bookings in the UK is also due to a decrease inunits sold and price points.Global Enterprise & Education revenue decreased $0.3 million from the year ended December 31, 2011 to the year ended December 31, 2012. Despite thenon-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 ended December 31,2012, Global Enterprise & Education revenue remained stable year-over-year, primarily driven by a $5.0 million increase in corporate revenues. Internationalenterprise and education revenues increased $2.7 million, or 49%, during the year ended December 31, 2012 compared to the prior year period, driven byincreases in the UK, Korea, and South America. Global Enterprise & Education bookings, calculated as enterprise and education revenue plus the change inenterprise and education deferred revenue, increased to $64.4 million for the year ended December 31, 2012 from $61.8 million for the year endedDecember 31, 2011. The increase was driven by growth in corporate and non-profit sales, partially offset by declines in our government and educationchannels. We have recently added senior 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 RevenueWe categorize and report our revenue in two categories—product revenue and subscription and service revenue. Product revenue includes revenuesallocated to the software product from sales of Rosetta Stone Version 4 TOTALe and revenues from the sale of audio practice products. Subscription andservice revenue includes revenues allocated to time-based subscription licenses of our web-based TOTALe services, as well as revenues from training andprofessional services.We began bundling time-based subscription licenses of our web-based TOTALe services with product licenses of our Rosetta Stone Version 3 language-learning solutions in the U.S. consumer market during the third quarter of 2010, in Japan during the first quarter of 2011, in the United Kingdom during thesecond quarter of 2011, and in Korea during the third quarter of 2011, with the launch of Rosetta Stone Version 4 TOTALe. As a result, we typically defer10%-35% of the revenue of each of these bundled sales. We will recognize the deferred revenue over the term of the subscription license in accordance withAccounting 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 2011:48Table of Contents 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 service revenue 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 %Product RevenueProduct 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 Global Enterprise & Education product revenues as a result of ashift from sales 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 product softwarebundle.Subscription and Service RevenueSubscription 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 a growingbase of exclusively online subscription sales. Global Enterprise & Education subscription and service revenues also increased $4.6 million related to growthin the enterprise and education 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 over thenext twelve months as revenues would be spread over the subscription period. There was an $11.5 million increase in deferred revenue during the year endedDecember 31, 2012, which is primarily related to increased sales of exclusively online subscriptions. In particular, we sold $0.8 million of online subscriptionproducts 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 ProfitThe following table sets forth cost of product revenue and subscription and service revenue, as well as gross profit for the years ended December 31,2012 and 2011: 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% Cost of Product RevenueCost 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 ended December 31,2011. As a percentage of product revenue, cost of product revenue remained at 19% for the year ended December 31, 2012 compared to the prior year period.The dollar decrease in cost was primarily attributable to a $0.7 million decrease in inventory obsolescence and scrap associated with the international Version 4TOTALe launches in the prior year period as well as a $2.2 million decrease in our hard product inventory costs. We are exploring the possibility of49Table of Contentsmoving 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 couldexperience a temporary 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 RevenueCost 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 the yearended December 31, 2011. As a percentage of subscription and service revenue, cost of subscription and service revenue remained at 17% for the year endedDecember 31, 2012 compared to the prior year period. The increase in cost was primarily attributable to an increase in paid online subscribers. Our web-basedservice offerings in our Version 4 TOTALe and ReFLEX products include a component of dedicated online language conversation coaching and higher directcosts to deliver to customers than our previous software solutions. This increase in costs includes a $1.8 million increase in product support activitiesincluding personnel-related costs and third-party expenses for coaches, product support, and success agents. We expect our cost of subscription and servicerevenue will increase in future periods, as a percent of revenue, associated with the launch of our Version 4 TOTALe and ReFLEX solutions in ourinternational markets. However, we took additional measures to further address coaching costs in the fourth quarter of 2012, capping the number of studiosessions compared to our former unlimited policy.Operating Expenses Year endedDecember 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages)Sales and marketing $150,882 $160,942 $(10,060) (6.3)%Research and development 23,453 24,218 (765) (3.2)%General and administrative 55,262 62,031 (6,769) (10.9)%Total operating expenses $229,597 $247,191 $(17,594) (7.1)%Sales and Marketing ExpensesSales and marketing expenses for the year ended December 31, 2012 were $150.9 million, a decrease of $10.1 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 to 60% for theyear ended December 31, 2011. The dollar and percentage decreases in sales and marketing expenses were primarily attributable to our efforts to continuallyevaluate our kiosk performance and closing underperforming kiosk locations. As of December 31, 2012 we operated 87 kiosks worldwide, a decrease from174, or 50% from the year ended December 31, 2011. As a result, kiosk-related expenses decreased $12.3 million including rent, commissions, and personnelcosts. Additionally, media and marketing activities have decreased $8.3 million primarily related to the increase in prior year expenses from advertisingcampaigns launched last year, as well as increased media in 2011 with the launch of Version 4 TOTALe in the U.K., Japan, and Korea, and ReFLEX inKorea. These decreases were partially offset by a $3.8 million increase in non-kiosk related personnel-related expenses related to growth in our enterprise andeducation sales channel, non-kiosk consumer, and marketing and sales support activities, and bonus compensation as a result of our improved financialperformance year over year. Additionally, professional services expenses increased $4.7 million primarily related to enterprise and education sales andcustomer success projects as well as web consulting services. We plan to continually evaluate our kiosk performance as we balance the positive branding withthe profitability of our kiosk locations, closing additional underperforming kiosk locations.Research and Development ExpensesResearch and development expenses were $23.5 million for the year ended December 31, 2012, a decrease of $0.8 million, or 3%, from the year endedDecember 31, 2011. As a percentage of revenue, research and development expenses remained flat at 9% for the year ended December 31, 2012 compared to theyear ended December 31, 2011. The dollar decrease was primarily attributable to a $0.9 million decrease in consulting expenses and $0.1 million decrease instock photography primarily related to the decrease in development costs of our ReFLEX product which launched in Korea in the third quarter of 2011. Thisdecrease in expense is partially offset by an increase in personnel-related expenses of $0.3 million. Although salary and benefits compensation decreased$0.9 million over the prior year period, we incurred an $0.8 million increase in severance expenses as a result of our restructuring efforts to better align ourbusiness 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 stockcompensation as a result of our improved financial performance year over year. We will continue to develop new products, including a children's productoffering, and improve our offering to educational organizations. We intend to make our products more modular, flexible and50Table of Contentsmobile. We also intend to restructure operations to optimize research and development initiatives. As a result of these initiatives, we expect an increase inresearch and development expense in 2013.General and Administrative ExpensesGeneral and administrative expenses for the year ended December 31, 2012 were $55.3 million, a decrease of $6.8 million, or 11%, from the year endedDecember 31, 2011. As a percentage of revenue, general and administrative expenses decreased to 20% for the year ended December 31, 2012 compared to 23%for year ended December 31, 2011. The dollar and percentage decreases were primarily attributable to a $4.2 million decrease in consulting expenses, a$2.7 million decrease in personnel-related expenses, $0.9 million decrease in hardware and software upgrades, hosting, and telephone expenses related toinvestment in our technology infrastructure and cost realignment initiatives during the prior year period and a $0.9 million decrease in depreciation expenserelated to certain fixed assets being fully depreciated early in the second quarter of 2012. These decreases were partially offset by a $1.3 million increase inoutside legal expenses in connection with our Google lawsuit and a $0.7 million increase in VAT expenses. During 2012, we took additional steps to reducecertain general and administrative expenses as well as realign our cost structure to help fund investments in areas of growth. We expect there to be increases ingeneral and administrative expenses to support our expansion into international markets in 2013.Stock-Based CompensationAs 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 lines for theyear ended December 31, 2011 as follows, $0.8 million in sales and marketing, $1.1 million in research and development, and $4.0 million in general andadministrative. There were no shares issued from the LTIP to any executive prior to its cancellation. Total stock-based compensation by expense line item is asfollows: 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)%Interest and Other Income (Expense) 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)%Interest income represents interest earned on our cash, cash equivalents, and short-term investments. Interest income for the year ended December 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 or 100%,from the year ended December 31, 2011. We expect interest expense to be minimal in future periods as we allowed the revolving line of credit with Wells Fargoto 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, adecrease of $139,000 or 98%. The decrease was primarily due to foreign exchange losses partially offset by an increase in legal settlements in connection withour anti-piracy enforcement efforts.Income Tax Expense (Benefit)51Table of Contents Year EndedDecember 31, 2012 versus 2011 2012 2011 Change % Change (in thousands, except percentages)Income tax expense (benefit) $28,909 $(7,769) $36,678 (472.1)%Income tax expense for the year ended December 31, 2012 was $28.9 million, compared to an $7.8 million income tax benefit for the year endedDecember 31, 2011. The change primarily resulted from a $24.9 million non-cash charge associated with establishing a valuation allowance for our U.S. andcertain foreign operations in 2012, $2.3 million related to our inability to recognize tax benefits associated with current year losses in certain foreign operationsand $9.0 million U.S. tax benefit in 2011 related to carry back of operating losses and credits to prior years.Liquidity and Capital ResourcesCash, cash equivalents, and short-term investments were $98.8 million and $148.2 million for the years ended December 31, 2013 and 2012,respectively. The decrease in cash is the result of the acquisitions of Livemocha and Lexia in 2013. In addition, $12.3 million of cash was held in escrow andclassified as restricted cash at December 31, 2013 related to our acquisition of Vivity which closed on January 2, 2014. Our primary operating cashrequirements include the payment of salaries, incentive compensation, employee benefits and other personnel related costs, as well as direct advertisingexpenses, costs of office facilities and costs of information technology systems. We fund these requirements through cash flow from our operations.We expect that our future growth, including future acquisitions, may continue to require additional working capital. Our future capital requirements willdepend on many factors, including development of new products, market acceptance of our products, the levels of advertising and promotion required tolaunch additional products and improve our competitive position in the marketplace, the expansion of our sales, support and marketing organizations, theestablishment of additional offices in the United States and worldwide and building the infrastructure necessary to support our growth, the response ofcompetitors to our products and our relationships with suppliers and clients. We have experienced increases in our expenditures consistent with the growth inour operations 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.The total amount of cash that was held by foreign subsidiaries as of December 31, 2013 was $19.1 million. If we were to repatriate the cash from ourforeign subsidiaries, a significant tax liability may result.Cash Flow AnalysisNet Cash Provided By Operating ActivitiesNet cash provided by operating activities was $8.1 million for the year ended December 31, 2013 compared to $34.9 million for the year endedDecember 31, 2012, a decrease of $26.8 million. The decrease in net cash provided by operating activities was primarily due to an increase in our net lossafter adjusting for depreciation, amortization, stock compensation, bad debt expense, deferred income taxes and loss on disposal of equipment. Net loss,adjusted for these items, totaled $0.6 million for the year ended December 31, 2013 compared to $10.7 million for the year ended December 31, 2012. In 2012,we also collected $6.5 million of income tax refunds compared to $0.8 million in 2013, a decrease of $5.7 million. The remainder of the decrease in cashprovided by operating activities is due to fluctuations in working capital including increases in accounts receivable and increases in prepaids and other currentassets.Net Cash (Used in) Provided By Investing ActivitiesNet cash used in investing activities was $46.9 million for the year ended December 31, 2013, compared to net cash provided of $5.5 million for theyear ended December 31, 2012, a decrease of $52.5 million. Net cash used by investing activities related primarily to the $25.7 million for the acquisitions(net of cash) of Livemocha and Lexia, a payment of $12.3 million, representing funds in escrow at year end related to the pending acquisition of Vivity LabsInc., and $8.9 million in purchase of property and equipment.Net Cash (Used in) Provided By Financing ActivitiesNet cash used in financing activities was $10.5 million for the year ended December 31, 2013 compared to cash provided by financing activities of$0.6 million for the year ended December 31, 2012. Net cash used in financing activities during the52Table of Contentsyear ended December 31, 2013 was primarily due to the purchase of our own common stock as treasury stock of $11.4 million, and net cash provided of$1.4 million from the exercise and repurchase of shares from exercised stock options.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 to raiseadditional funds through public or private financings or borrowings to develop or enhance products, to fund expansion, to respond to competitive pressures orto acquire complementary products, businesses or technologies. If required, additional financing may not be available on terms that are favorable to us, if atall. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced andthese securities might have rights, preferences and privileges senior to those of our current stockholders. No assurance can be given that additional financingwill 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 will materiallyaffect our business in the foreseeable future.Off-Balance Sheet ArrangementsWe do not engage in any off-balance sheet financing arrangements. We do not have any interest in entities referred to as variable interest entities, whichinclude special purpose entities and other structured finance entities.Contractual ObligationsThe following table summarizes our contractual obligations at December 31, 2013 and the effect such obligations are expected to have on our liquidityand cash flow in future periods. Total Less than1 Year 1-3 Years 3-5 Years More than5 Years (in thousands)Contractual obligations $23,896 $6,342 $9,488 $8,066 $—The operating lease obligations reflected in the table above include our corporate office leases.Recent Accounting PronouncementsIn July 2012, the Financial Accounting Standards Board (“FASB”) issued new guidance on the impairment testing of indefinite-lived intangible assets(Accounting Standards Update (“ASU”) 2012-02, Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets forImpairment), effective for calendar years beginning after September 15, 2012. Early adoption is permitted. The objective of this standard update is to simplifyhow an entity tests indefinite-lived intangible assets for impairment. The amendments in this standard will allow an entity to first assess qualitative factors todetermine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform thequantitative impairment test. Only if an entity determines, based on qualitative assessment, that it is more likely than not that the indefinite-lived intangibleasset is impaired will it be required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test. TheCompany adopted this guidance beginning in fiscal year 2013, and the adoption of such guidance did not have a material impact on the Company’s reportedresults of operations or financial position.In February 2013, the FASB issued ASU No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of AccumulatedOther Comprehensive Income (“ASU 2013-02”), which requires disclosure of significant amounts reclassified out of accumulated other comprehensiveincome by component and their corresponding effect on the respective line items of net income. The Company adopted this guidance beginning in fiscal year2013, and the adoption of such guidance did not have a material impact on the presentation of the Company’s reported results of operations or financialposition.In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740): Presentation of Unrecognized Tax Benefit When a Net OperatingLoss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (“ASU 2013-11”), which requires that an unrecognized tax benefit bepresented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward,except for a situation in which some or all of such net operating loss carryforward, a similar loss, or a tax credit carryforward is not available at the reportingdate under the tax law of the applicable tax jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the taxlaw of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the53Table of Contentsdeferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined withdeferred tax assets. ASU 2013-11 is effective for the Company beginning January 1, 2014. The Company believes the adoption of ASU 2013-11 will not havea material impact on the Company’s reported results of operations or financial position.Item 7A. Quantitative and Qualitative Disclosures About Market RiskForeign Currency Exchange RiskThe 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 we cannotforecast with reliable accuracy. In the event our foreign sales and expenses increase, our operating results may be more greatly affected by fluctuations in theexchange rates of the currencies with which we do business. At this time we do not, but we may in the future, invest in derivatives or other financialinstruments in an attempt to hedge our foreign currency exchange risk.Interest Rate SensitivityInterest income and expense are sensitive to changes in the general level of U.S. interest rates. However, based on the nature and current level of ourmarketable securities, which are primarily short-term investment grade and government securities and our notes payable, we believe that there is no materialrisk of exposure.Item 8. Financial Statements and Supplementary DataOur consolidated financial statements, together with the related notes and the report of independent registered public accounting firm, are set forth on thepages indicated in Item 15.54Table of ContentsItem 9. Changes In and Disagreements with Accountants on Accounting and Financial DisclosureNone.Item 9A. Controls and ProceduresEvaluation of Disclosure Controls and ProceduresOur management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosurecontrols and procedures as of December 31, 2013. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the "Exchange Act"), means controls and other procedures of a company that are designed to ensure thatinformation required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls andprocedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the Company's management, including its principal executive and principal financial officers, as appropriate to allowtimely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2013, our Chief Executive Officer andChief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.Management's annual report on internal control over financial reportingManagement 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, 2013. Management's assessment was based on criteria set forth by the Committeeof Sponsoring Organizations of the Treadway Commission, or COSO, in Internal Control—Integrated Framework (1992).Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financialreporting 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 our assets;(2)provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generallyaccepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management andboard of directors; and(3)provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have amaterial effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluationof effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.Based on using the COSO criteria, management believes our internal control over financial reporting as of December 31, 2013 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 LLP isincluded on page F-3 of this Form 10-K.Changes in Internal Control over Financial ReportingThere 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, 2013 that had materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.55Table of ContentsItem 9B. Other InformationNone.56Table of ContentsPART IIICertain information required by Part III is omitted from this Annual Report on Form 10-K as we intend to file our definitive Proxy Statement for the 2013Annual Meeting of Stockholders pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, not later than 120 days after the end of thefiscal year covered by this Annual Report, and certain information included in the Proxy Statement is incorporated herein by reference.Item 10. Directors, Executive Officers and Corporate GovernanceThe information required by this Item is incorporated herein by reference to the information provided under the headings "Our Board of Directors andNominees," "Security Ownership of Certain Beneficial Owners and Management—Section 16(A) Beneficial Ownership Reporting Compliance," "CorporateGovernance—Code of Ethics," "Corporate Governance—Composition of our Board of Directors; Classified Board," "Corporate Governance—Committees ofour Board of Directors," "Corporate Governance—Audit Committee," "Corporate Governance—Compensation Committee," and "Corporate Governance—Corporate Governance and Nominating Committee" in our definitive proxy statement for the 2014 Annual Meeting of Stockholders to be filed with theSecurities and Exchange Commission no later than 120 days after the fiscal year ended December 31, 2013 (the "2014 Proxy Statement").Code of Ethics and Business ConductWe 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 of conduct,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 of conduct, if any, areavailable, without charge, under the "Corporate Governance" tab of the "Investor Relations" section on our website at www.rosettastone.com. We intend todisclose any amendments or waivers of this code on our website.Item 11. Executive CompensationThe information required by this Item is incorporated herein by reference to the information provided under the headings "Compensation CommitteeReport," "Executive Compensation," "Director Compensation," "Compensation Committee" and "Corporate Governance—Interlocks and InsiderParticipation" in the 2014 Proxy Statement.Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersThe information required by this Item is incorporated herein by reference to the information provided under the headings "Security Ownership of CertainBeneficial Owners and Management" and "Equity Compensation" in the 2014 Proxy Statement.Item 13. Certain Relationships and Related Transactions, and Director IndependenceThe 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 2014 Proxy Statement.Item 14. Principal Accounting Fees and ServicesThe information required by this Item is incorporated herein by reference to the information provided under the heading "Principal Accountant Fees andServices" in the 2014 Proxy Statement.57Table of ContentsPART IVItem 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 the requiredinformation is included in the consolidated financial statements or the notes thereto.(b)ExhibitsThe exhibits listed in the Index to Exhibits are filed as part of this Annual Report on Form 10-K.58Table 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.ROSETTA STONE INC.By: /s/ STEPHEN M. SWAD Stephen M. Swad Chief Executive OfficerDate: March 3, 2014 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 3rd day of March, 2014.Signature Title /s/ STEPHEN M. SWAD Chief Executive Officer and Director(Principal Executive Officer)Stephen M. Swad /s/ THOMAS M. PIERNO Chief Financial Officer(Principal Financial Officer and Principal Accounting Officer)Thomas M. Pierno /s/ PATRICK W. GROSS Chairman of the Board, DirectorPatrick W. Gross /s/ PHILLIP A. CLOUGH DirectorPhillip A. Clough /s/ JAMES P. BANKOFF DirectorJames P. Bankoff /s/ JOHN T. COLEMAN DirectorJohn T. Coleman /s/ LAURENCE FRANKLIN DirectorLaurence Franklin /s/ MARGUERITE W. KONDRAKE DirectorMarguerite W. Kondrake /s/ LAURA L. WITT DirectorLaura L. Witt 59Table of ContentsINDEX TO CONSOLIDATED FINANCIAL STATEMENTS PageReports of Independent Registered Public Accounting FirmF-2Consolidated Balance SheetsF-4Consolidated Statements of OperationsF-5Consolidated Statements of Comprehensive Income (Loss)F-6Consolidated Statements of Changes in Stockholders' EquityF-7Consolidated Statements of Cash FlowsF-8Notes to Consolidated Financial StatementsF-9F-1Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Stockholders ofRosetta Stone Inc.Arlington, VAWe have audited the accompanying consolidated balance sheets of Rosetta Stone Inc. and subsidiaries (the "Company") as of December 31, 2013 and 2012,and the related consolidated statements of operations, comprehensive loss, changes in stockholders' equity, and cash flows for each of the three years in theperiod ended December 31, 2013. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinionon the financial statements based on our audits.We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our auditsprovide 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. and subsidiaries as ofDecember 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013, inconformity with accounting principles generally accepted in the United States of America.As discussed in Note 3 to the financial statements, the Company changed its accounting policy for sales commissions related to non-cancellable Software-as-a-Service contracts. The effect of the change is included in the accompanying financial statements retrospectively for all periods presented.We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal controlover financial reporting as of December 31, 2013, based on the criteria established in Internal Control - Integrated Framework (1992) issued by theCommittee of Sponsoring Organizations of the Treadway Commission and our report dated March 3, 2014 expressed an unqualified opinion on theCompany's internal control over financial reporting./s/ Deloitte & Touche LLPMcLean, VirginiaMarch 3, 2014 F-2Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Stockholders ofRosetta Stone Inc.Arlington, VAWe have audited the internal control over financial reporting of Rosetta Stone Inc. and subsidiaries (the “Company”) as of December 31, 2013, based oncriteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission.The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting, included in the accompanying Management’s annual report on internal control over financial reporting. Ourresponsibility 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 standards require thatwe plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all materialrespects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testingand evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considerednecessary 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 and principalfinancial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to providereasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company'sassets 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 management override ofcontrols, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of theeffectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changesin 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, 2013, based on thecriteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission.We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financialstatements as of and for the year ended December 31, 2013 of the Company and our report dated March 3, 2014 expressed an unqualified opinion on thoseconsolidated financial statements and included an explanatory paragraph regarding the Company’s change in its accounting policy for sales commissionsrelated to non-cancellable Software-as-a-Service contracts./s/ Deloitte & Touche LLPMcLean, VirginiaMarch 3, 2014F-3Table of ContentsROSETTA STONE INC.CONSOLIDATED BALANCE SHEETS(in thousands, except per share amounts) As of December 31, 2013 2012 (As Adjusted)*Assets Current assets: Cash and cash equivalents $98,825 $148,190Restricted cash 12,424 73Accounts receivable (net of allowance for doubtful accounts of $1,000 and $1,297, respectively) 60,342 49,946Inventory, net 6,639 6,581Prepaid expenses and other current assets 12,294 8,681Income tax receivable 197 1,104Total current assets 190,721 214,575Property and equipment, net 17,766 17,213Goodwill 50,059 34,896Intangible assets, net 29,006 10,825Other assets 3,224 1,937Total assets $290,776 $279,446Liabilities and stockholders' equity Current liabilities: Accounts payable $10,326 $6,064Accrued compensation 16,380 16,830Other current liabilities 42,192 36,387Deferred revenue 67,173 59,195Total current liabilities 136,071 118,476Deferred revenue 11,684 4,221Deferred income taxes 9,022 8,400Other long-term liabilities 2,756 155Total liabilities 159,533 131,252Commitments and contingencies (Note 14) Stockholders' equity: Preferred stock, $0.001 par value; 10,000 and 10,000 shares authorized, zero and zero sharesissued and outstanding at December 31, 2013 and December 31, 2012, respectively — —Non-designated common stock, $0.00005 par value, 190,000 and 190,000 shares authorized,22,588 and 21,951 shares issued and 21,588 and 21,951 shares outstanding at December 31,2013 and December 31, 2012, respectively 2 2Additional paid-in capital 171,123 160,693Accumulated loss (29,292) (13,158)Accumulated other comprehensive income 845 657Treasury stock, at cost, 1,000 shares at December 31, 2013 and zero shares at December 31,2012 (11,435) —Total stockholders' equity 131,243 148,194Total liabilities and stockholders' equity $290,776 $279,446 See accompanying notes to consolidated financial statements* Certain amounts have been adjusted for the retrospective change in accounting principle for sales commissions (See Note 3)F-4Table of ContentsROSETTA STONE INC.CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share amounts) Year Ended December 31, 2013 2012 2011 (As Adjusted)* (As Adjusted)*Revenue: Product $156,792 $180,919 $195,382Subscription and service 107,853 92,322 73,067Total revenue 264,645 273,241 268,449Cost of revenue: Cost of product revenue 32,191 33,684 36,497Cost of subscription and service revenue 13,523 15,226 12,619Total cost of revenue 45,714 48,910 49,116Gross profit 218,931 224,331 219,333Operating expenses Sales and marketing 146,104 150,882 160,942Research and development 33,995 23,453 24,218General and administrative 56,432 55,262 62,031Lease abandonment 842 — —Total operating expenses 237,373 229,597 247,191Loss from operations (18,442) (5,266) (27,858)Other income and (expense): Interest income 117 187 302Interest expense (61) — (5)Other income 368 3 142Total other income 424 190 439Loss before income taxes (18,018) (5,076) (27,419)Income tax (benefit) expense (1,884) 28,909 (7,769)Net loss $(16,134) $(33,985) $(19,650)Loss per share: Basic $(0.75) $(1.61) $(0.95)Diluted $(0.75) $(1.61) $(0.95)Common shares and equivalents outstanding: Basic weighted average shares 21,528 21,045 20,773Diluted weighted average shares 21,528 21,045 20,773 See accompanying notes to consolidated financial statements* Certain amounts have been adjusted for the retrospective change in accounting principle for sales commissions (See Note 3)F-5Table of ContentsROSETTA STONE INC.CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS(in thousands) Years Ended December 31, 2013 2012 2011 (As Adjusted)* (As Adjusted)*Net loss $(16,134) $(33,985) $(19,650)Other comprehensive income, net of tax: Foreign currency translation gain 188 336 98Unrealized gain (loss) on available-for-sale securities — 23 (23)Other comprehensive income 188 359 75Comprehensive loss $(15,946) $(33,626) $(19,575) See accompanying notes to consolidated financial statements* Certain amounts have been adjusted for the retrospective change in accounting principle for sales commissions (See Note 3)F-6Table of ContentsROSETTA STONE INC.CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY(in thousands)(As Adjusted)* Non-DesignatedCommon Stock AccumulatedOtherComprehensiveIncome (Loss) TotalStockholders'Equity(Deficit) AdditionalPaid-inCapital TreasuryStock AccumulatedIncome (Loss) Shares Amount Balance—January 1, 2011 20,667 $2 $139,022 $— $40,477 $223 $179,724Stock Issued Upon the Exercise ofStock Options 182 — 800 — — — 800Restricted Stock Award Vesting 87 — — — — — —Stock-based CompensationExpense — — 12,353 — — — 12,353Tax Benefit on Stock OptionExercised — — (351) — — — (351)Net loss — — — — (19,650) — (19,650)Other comprehensive income — — — — — 75 75Balance—December 31, 2011 20,936 $2 $151,824 $— $20,827 $298 $172,951Stock Issued Upon the Exercise ofStock Options 118 — 860 — — — 860Restricted Stock Award Vesting 134 — — — — — —Stock-based CompensationExpense — — 8,009 — — — 8,009Net loss — — — — (33,985) — (33,985)Other comprehensive income — — — — — 359 359Balance—December 31, 2012 21,188 $2 $160,693 $— $(13,158) $657 $148,194Stock Issued Upon the Exercise ofStock Options 550 — 2,457 — — — 2,457Restricted Stock Award Vesting 301 — — — — — —Stock-based CompensationExpense — — 9,241 — — — 9,241Repurchase of Stock OptionExercised (123) — (1,040) — — — (1,040)Sale of Shares in SecondaryOffering 10 — 160 — — — 160Secondary Offering Costs — — (388) — — — (388)Purchase of Treasury Stock (1,000) — (11,435) — — (11,435)Net loss — — — — (16,134) — (16,134)Other comprehensive income — — — — — 188 188Balance—December 31, 2013 20,926 $2 $171,123 $(11,435) $(29,292) $845 $131,243 See accompanying notes to consolidated financial statements* Certain amounts have been adjusted for the retrospective change in accounting principle for sales commissions (See Note 3)F-7Table of ContentsROSETTA STONE INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands) Year Ended December 31, 2013 2012 2011 (As Adjusted)* (As Adjusted)*CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $(16,134) $(33,985) $(19,650)Adjustments to reconcile net loss to cash provided by operating activities: Stock-based compensation expense 9,241 8,009 12,353Bad debt expense 1,420 1,820 1,228Depreciation and amortization 9,635 8,077 8,724Deferred income tax (benefit) expense (3,869) 25,953 (1,086)Loss on disposal of equipment 278 783 318Net change in: Restricted cash (37) 1 11Accounts receivable (9,477) 309 (5,058)Inventory (108) 185 3,168Prepaid expenses and other current assets (3,511) 1,165 110Income tax receivable 827 6,515 (5,812)Other assets (1,680) 166 (25)Accounts payable 3,702 (1,240) (447)Accrued compensation (897) 5,093 1,200Other current liabilities 4,250 635 3,979Excess tax benefit from stock options exercised — — (365)Other long term liabilities 481 (99) (52)Deferred revenue 13,947 11,514 4,777Net cash provided by operating activities 8,068 34,901 3,373CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (8,941) (4,187) (9,940)Proceeds from sales (purchases) of available-for-sale securities — 9,711 (3,301)Increase in restricted cash related to Vivity Labs acquisition (12,314) — —Acquisitions, net of cash acquired (25,675) — (75)Net cash (used in) provided by investing activities (46,930) 5,524 (13,316)CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from the exercise of stock options 2,457 862 800Repurchase of shares from exercised stock options (1,040) — —Purchase of treasury stock (11,435) — —Tax benefit of stock options exercised — — 365Proceeds from equity offering, net of issuance costs (228) — —Payments under capital lease obligations (241) (215) (285)Net cash (used in) provided by financing activities (10,487) 647 880(Decrease) increase in cash and cash equivalents (49,349) 41,072 (9,063)Effect of exchange rate changes in cash and cash equivalents (16) 602 (177)Net (decrease) increase in cash and cash equivalents (49,365) 41,674 (9,240)Cash and cash equivalents—beginning of year 148,190 106,516 115,756Cash and cash equivalents—end of year $98,825 $148,190 $106,516SUPPLEMENTAL CASH FLOW DISCLOSURE: Cash paid during the periods for: Interest $18 $— $5Income taxes $3,290 $4,040 $1,683Noncash financing and investing activities: Accrued purchase price of business acquisition $3,375 $— $—Accrued liability for purchase of property and equipment $192 $1,228 $204Equipment acquired under capital lease $702 $— $16See accompanying notes to consolidated financial statements* Certain amounts have been adjusted for the retrospective change in accounting principle for sales commissions (See Note 3)F-8Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS1. NATURE OF OPERATIONSRosetta Stone Inc. and its subsidiaries ("Rosetta Stone," or the "Company") develop, market and support a suite of language and reading learningsolutions consisting of software products, online services, audio practice tools and mobile applications under the Rosetta Stone, Livemocha and Lexia brandnames. The Company's software products are sold on a direct basis and through select retailers. The Company provides its software applications to customersthrough the sale of packaged software and online subscriptions, domestically and in certain international markets. Following the Company's acquisitions inJanuary 2014, of Vivity Labs, Inc. and Tell Me More S.A. (see Footnote 20, Subsequent Events), the Company also sells Vivity's brain fitness mobileapplications and Tell Me More language learning solutions. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESPrinciples of ConsolidationThe accompanying consolidated financial statements include the accounts of Rosetta Stone Inc. and its wholly owned subsidiaries. All intercompanyaccounts and transactions have been eliminated in consolidation. Certain numbers in the prior period consolidated financial statements have been reclassifiedto conform to the current period presentation. Use of EstimatesThe 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 doubtful accounts,estimated sales returns, stock-based compensation, fair value of intangibles and goodwill, inventory reserve, disclosure of contingent assets and liabilities,disclosure of contingent litigation, and allowance for valuation of deferred tax assets. Actual results may differ from these estimates.Revenue RecognitionThe Company's primary sources of revenue are online subscriptions, software and bundles of software and online subscriptions. The Companyalso generates revenue from the sale of audio practice products and training and implementation services. Revenue is recognized when all of the followingcriteria are met: there is persuasive evidence of an arrangement; the product has been delivered or services have been rendered; the fee is fixed or determinable;and collectability is reasonably assured. Revenues are recorded net of discounts.The Company identifies the units of accounting contained within our sales arrangements in accordance with ASC 605-25 Revenue Recognition -Multiple Element Arrangements (“ASC 605-25”). In doing so, the Company evaluates a variety of factors including whether the undelivered element(s) havevalue to the customer on a stand-alone basis or if the undelivered element(s) could be sold by another vendor on a stand-alone basis.For multiple element arrangements that contain software products and related services, the Company allocates the total arrangement consideration toall deliverables based on vendor-specific objective evidence of fair value, or VSOE, in accordance with ASC subtopic 985-605-25 Software: RevenueRecognition-Multiple-Element Arrangements ("ASC 985-605-25"). The Company generates a substantial portion of its consumer revenue from Rosetta StoneVersion 4 TOTALe which is a multi-element arrangement that includes perpetual software bundled with the subscription and conversational coachingcomponents of the Company's TOTALe online service. The Company has identified two deliverables generally contained in Rosetta Stone V4 TOTALesoftware arrangements. The first deliverable is the perpetual software, which is delivered at the time of sale, and the second deliverable is the subscriptionservice. The Company allocates revenue between these two deliverables using the residual method based on the existence of VSOE of the subscription service.In the U.S., the Company offers consumers who purchase packaged software and audio practice products directly from the Company a 30-day,unconditional, full money-back refund. The Company also permits some of our retailers and distributors to return packaged products, subject to certainlimitations. The Company establishes revenue reserves for packaged product returns based on historical experience, estimated channel inventory levels, thetiming of new product introductions and other factors.For non-software multiple element arrangements the Company allocates revenue to all deliverables based on their relative selling prices.F-9Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)The Company distributes its products and services both directly to the end customer and indirectly through resellers. Our resellers earn commissionsgenerally calculated as a fixed percentage of the gross sale to the end customer. The Company evaluates each of its reseller relationships in accordance withASC 605-45 Revenue Recognition - Principal Agent Considerations (“ASC 605-45”) to determine whether the revenue recognized from indirect sales should bethe gross amount of the contract with the end customer or reduced for the reseller commission. In making this determination the Company evaluates a varietyof factors including whether it is the primary obligor to the end customer. Revenue for online service subscriptions is recognized ratably over the term of the subscription period, assuming all revenue recognition criteria havebeen met. Rosetta Stone Version 4 TOTALe bundles, which include an online service subscription including conversational coaching and packaged software,allow customers to begin their online services at any point during a registration window, which is up to six months from the date of purchase from us or anauthorized reseller. Online service subscriptions that are not activated during this registration window are forfeited and revenue is recognized upon expiry.Revenue from non-refundable upfront fees that are not related to products already delivered or services already performed is deferred and recognized over theterm of the related arrangement or the estimated customer life. Accounts receivable and deferred revenue are recorded at the time a customer enters into a bindingsubscription agreement.Software products include sales to end user customers and resellers. In most cases, revenue from sales to resellers is not contingent upon resale of thesoftware to the end user and is recorded in the same manner as all other product sales. Revenue from sales of packaged software products and audio practiceproducts is recognized as the products are shipped and title passes and risks of loss have been transferred. For most product sales, these criteria are met at thetime the product is shipped. For some sales to resellers and certain other sales, the Company defers revenue until the customer receives the product because theCompany legally retains a portion of the risk of loss on these sales during transit. A limited amount of packaged software products are sold to resellers on aconsignment basis. Revenue is recognized for these consignment transactions once the end user sale has occurred, assuming the remaining revenue recognitioncriteria have been met. In accordance with ASC 985-605-50 Revenue Recognition: Customer Payments and Incentives (“ASC 605-50”), cash sales incentivesto resellers are accounted for as a reduction of revenue, unless a specific identified benefit is identified and the fair value is reasonably determinable. Priceprotection for changes in the manufacturer suggested retail value granted to resellers for the inventory that they have on hand at the date the price protection isoffered is recorded as a reduction to revenue.The Company offers customers the ability to make payments for packaged software purchases in installments over a period of time, which typicallyranges between three and five months. Given that these installment payment plans are for periods less than 12 months, a successful collection history has beenestablished and these fees are fixed and determinable, revenue is recognized at the time of sale, assuming the remaining revenue recognition criteria have beenmet. Packaged software is provided to customers who purchase directly from our company with a limited right of return. The Company allows its retailers toreturn unsold products, subject to some limitations. In accordance with ASC 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 is includedin the initial licensing fee, the technical support and services are generally provided within one year, the estimated cost of providing such support is deemedinsignificant and no unspecified upgrades/enhancements are offered, technical support revenues are recognized together with the software product and licenserevenue. Costs associated with the technical support are accrued at the time of sale.Sales commissions from non-cancellable SaaS contracts are deferred and amortized in proportion to the revenue recognized from the related contract.Business Combinations The Company recognized all of the assets acquired, liabilities assumed and contractual contingencies from the acquired company as well as contingentconsideration at fair value on the acquisition date. The excess of the total purchase price over the fair value of the assets and liabilities acquired is recognized asgoodwill. Acquisition-related costs are recognized separately from the acquisition and expensed as incurred. Generally, restructuring costs incurred in periodssubsequent to the acquisition date are expensed when incurred. Subsequent changes to the purchase price (i.e., working capital adjustments) or other fair valueadjustments determined during the measurement period are recorded as adjustments to goodwill.Cash and Cash EquivalentsF-10Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less and demand deposits with financialinstitutions.Restricted Cash$12.3 million of restricted cash as of December 31, 2013 is restricted for the payment of the purchase price for the acquisition of Vivity Labs, Inc.which occurred on January 2, 2014 (see Footnote 20, Subsequent Events) and the remainder is restricted for the reimbursement of funds to employees underthe Company's flexible benefit plan and security for a credit card processing vendor.Accounts Receivable and Allowance for Doubtful AccountsAccounts 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.InventoriesInventories are stated at the lower of cost, determined on a first-in first-out basis, or market. The Company reviews inventory for excess quantities andobsolescence based on its best estimates of future demand, product lifecycle status and product development plans. The Company uses historical informationalong with these future estimates to establish a new cost basis for obsolete and potential obsolete inventory.Concentrations of Credit RiskAccounts receivable and cash and cash equivalents subject the Company to its highest potential concentrations of credit risk. The Company reserves forcredit losses and does not require collateral on its trade accounts receivable. In addition, the Company maintains cash and investment balances in accounts atvarious banks and brokerage firms. The Company has not experienced any losses on cash and cash equivalent accounts to date and the Company believes itis not exposed to any significant credit risk related to cash. The Company sells products to retailers, resellers, government agencies, and individual consumersand extends credit based on an evaluation of the customer's financial condition, without requiring collateral. Exposure to losses on receivables is principallydependent on each customer's financial condition. The Company monitors its exposure for credit losses and maintains allowances for anticipated losses. Nocustomer accounted for more than 10% of the Company's revenue during the years ended December 31, 2013, 2012 or 2011. The Company had fourcustomers that collectively accounted for 31% of accounts receivable at December 31, 2013 and four customers that collectively accounted for 32% of accountsreceivable at December 31, 2012. The Company maintains trade credit insurance for certain customers to provide coverage, up to a certain limit, in the eventof insolvency of some customers.Fair Value of Financial InstrumentsThe Company values its assets and liabilities using the methods of fair value as described in ASC 820, Fair Value Measurements and Disclosures,("ASC 820"). ASC 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The three levels of fair valuehierarchy are described below:Level 1: Quoted prices for identical instruments in active markets.Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active;and model-derived valuations whose inputs are observable or whose significant value drivers are observable.Level 3: Significant inputs to the valuation model are unobservable.The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, restricted cash, accounts receivable, accounts payableand other accrued expenses approximate fair value due to relatively short periods to maturity.During 2012, the Company made a payment of $300,000 in accordance with the terms of the November 1, 2009 acquisition of certain assets fromSGLC International Co. Ltd., a software reseller headquartered in Seoul, South Korea.Property and EquipmentF-11Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)Property and equipment are stated at cost, less accumulated depreciation. Depreciation on property, leasehold improvements, equipment, and software iscomputed on a straight-line basis over the estimated useful lives of the assets, as follows:Software 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 lifeExpenses 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 or disposition ofproperty and equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized.Valuation of Long-Lived AssetsIn accordance with ASC topic 360, Property, Plant and Equipment ("ASC 360"), the Company evaluates the recoverability of its long-lived assets.ASC 360 requires recognition of impairment of long-lived assets in the event that the net book value of such assets exceeds the future undiscounted net cashflows attributable to such assets. Impairment, if any, is recognized in the period of identification to the extent the carrying amount of an asset exceeds the fairvalue of such asset. Based on its analysis, the Company believes that no impairment of its long-lived assets was indicated as of December 31, 2013 and 2012.Intangible AssetsIntangible assets consist of acquired technology, including developed and core technology, customer related assets, trade name and trademark, and otherintangible assets. Those intangible assets with finite lives are recorded at cost and amortized on a straight line basis over their expected lives in accordance withASC topic 350, Intangibles—Goodwill and Other ("ASC 350"). Annually, as of December 31, and more frequently if a triggering event occurs, theCompany reviews its indefinite lived intangible assets for impairment in accordance with ASC 350. This guidance provides the option to first assessqualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it isnecessary to perform the quantitative test. If necessary, the quantitative test is performed by comparing the fair value of indefinite lived intangible assets to thecarrying value. 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 no impairmentof intangible assets during any of the periods presented.GoodwillGoodwill represents purchase consideration paid in a business combination that exceeds the values assigned to the net assets of acquired businesses.The Company tests goodwill for impairment annually on June 30 of each year or more frequently if impairment indicators arise. Goodwill is tested forimpairment at the reporting unit level using a fair value approach, in accordance with the provisions of ASC 350. This guidance provides the option to firstassess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value, a "Step 0"analysis. If, based on a review of qualitative factors, it is more likely than not that the fair value of a reporting unit is less than its carrying value theCompany performs "Step 1" of the traditional two-step goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. Ifthe carrying value exceeds the fair value, the Company measures the amount of impairment loss, if any, by comparing the implied fair value of the reportingunit goodwill with its carrying amount. At June 30, 2013 the Company performed our annual impairment test beginning with Step 1. The Company's annualtesting resulted in no impairments of goodwill since the dates of acquisition.F-12Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)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 Global Enterprise & Education. Accordingly, the Company allocatedgoodwill from the former Consumer reporting unit to the new reporting units, North America Consumer and ROW Consumer, based on the relative fair valueof each reporting unit as of October 31, 2012. In doing so, the Company evaluated the results of the allocation of goodwill for events or indicators that wouldrequire further impairment testing, noting none. The Company will continue to review for impairment indicators in future periods.For income tax purposes, the goodwill balance is amortized over a period of 15 years.GuaranteesIndemnifications are provided of varying scope and size to certain enterprise and education customers against claims of intellectual propertyinfringement made by third parties arising from the use of its products. The Company has not incurred any costs or accrued any liabilities as a result of suchobligations.Cost of Product and Subscription and Service RevenueCost 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 fees andinventory storage, obsolescence and shrinkage. The Company believes cost of subscription and service revenue primarily represents costs associated withsupporting the online language learning service, which includes online language conversation coaching, hosting costs and depreciation. Also included are thecosts of credit card processing and customer technical support in both cost of product revenue and cost of subscription and service revenue.Research and DevelopmentResearch and development expenses include employee compensation costs, consulting fees and overhead costs associated with product development.Software products are developed for sale to external customers. The Company considers technological feasibility to be established when all planning,designing, coding, and testing has been completed according to design specifications. The Company has determined that technological feasibility for itssoftware products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established have notbeen material, and accordingly, the Company has expensed all research and development costs when incurred.Software Developed for Internal UseProduct development also includes certain software products for internal use. Development costs for internal use software are expensed as incurred untilthe project reaches the application development stage, in accordance with ASC 350. Internal-use software is defined to have the following characteristics: (a) thesoftware is internally developed, or modified solely to meet the entity's internal needs, and (b) during the software's development or modification, nosubstantive plan exists or is being developed to market the software externally. Internally developed software is amortized over a three-year useful life.For the years ended December 31, 2013, 2012 and 2011, the Company capitalized $4.8 million, $2.2 million, and $2.5 million in internal-usesoftware, respectively.For the years ended December 31, 2013, 2012 and 2011, the Company recorded amortization expense relating to internal-use software of $1.8 million,$0.4 million, and $0.9 million.Income TaxesThe 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. Deferredtax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assetswill not be realized. The impact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted.F-13Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)ASC 740 requires a reduction of the carrying amounts of deferred tax assets by a valuation allowance if, based on available evidence, it is more likelythan not that such assets will not be realized. Accordingly, the need to establish valuation allowances for deferred tax assets is assessed periodically based onthe ASC 740 more-likely-than-not realization ("MLTN") threshold criterion. In the assessment for a valuation allowance, appropriate consideration is given toall positive 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 of statutory carryforward periods, the Company's experience withoperating loss and tax credit carryforwards not expiring unused, tax credits, 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 at each reporting period and is maintained until sufficient positive evidence exists to support a reversal.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 a conclusionthat 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 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 is tosupport 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 CompensationThe Company accounts for its stock-based compensation in accordance ASC topic 718, Compensation—Stock Compensation ("ASC 718"). UnderASC 718, all stock-based awards, including employee stock option grants, are recorded at fair value as of the grant date and recognized as expense in thestatement of operations on a straight-line basis over the requisite service period, which is the vesting period.Net Loss Per ShareNet loss per share is computed under the provisions of ASC topic 260, Earnings Per Share. Basic loss per share is computed using net loss and theweighted average number of shares of common stock outstanding. Diluted earnings per share reflect the weighted average number of shares of common stockoutstanding plus any potentially dilutive shares outstanding during the period. Potentially dilutive shares consist of shares issuable upon the exercise of stockoptions, restricted stock awards, restricted stock units and conversion of shares of preferred stock. Common stock equivalent shares are excluded from thediluted computation if their effect is anti-dilutive. When there is a net loss, there is a presumption that there are no dilutive shares as these would be anti-dilutive.The following table sets forth the computation of basic and diluted net loss per common share:F-14Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Year Ended December 31, 2013 2012 2011 (dollars in thousands, except per share amounts)Numerator: Net loss $(16,134) $(33,985) $(19,650)Denominator: Weighted average number of common shares: Basic 21,528 21,045 20,773Diluted 21,528 21,045 20,773Loss per common share: Basic $(0.75) $(1.61) $(0.95)Diluted $(0.75) $(1.61) $(0.95)Share-based awards to purchase approximately1.3 million, 1.4 million and1.0 million shares of common stock that had an exercise price in excess of theaverage market price of the common stock during the years ended December 31, 2013, 2012 and 2011, respectively, were not included in the calculation ofdiluted 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 years endedDecember 31, 2013, 2012 and 2011, the Company's comprehensive income (loss) consisted of net income (loss), foreign currency translation gains (losses)and the net unrealized gains (losses) on available-for-sale securities.Components of accumulated other comprehensive income (loss) as of December 31, 2013 are as follows (in thousands): Foreign CurrencyTotalBalance at beginning of period $657$657Other comprehensive income before reclassifications 188188Amounts reclassified from accumulated other comprehensive income ——Net current period other comprehensive income, net 188188Accumulated other comprehensive loss $845$845During the year ended December 31, 2013, there were no reclassifications out of accumulated other comprehensive income.Foreign Currency Translation and TransactionsThe functional currency of the Company's foreign subsidiaries is their local currency. Accordingly, assets and liabilities of the foreign subsidiaries aretranslated into U.S. dollars at exchange rates in effect on the balance sheet date. Income and expense items are translated at average rates for the period.Translation adjustments are recorded as a component of other comprehensive 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 average exchangerates for the period. The Company reports the effect of exchange rate changes on cash balances held in foreign currencies as a separate item in the reconciliationof the changes in cash and cash equivalents during the period.F-15Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)The following table presents the effect of exchange rate changes and the net unrealized gains and losses from the available-for-sale securities on totalcomprehensive income (loss) (dollars in thousands): Year Ended December 31, 2013 2012 2011Net loss $(16,134) $(33,985) $(19,650)Foreign currency translation gain 188 336 98Unrealized gain (loss) on available-for-sale securities — 23 (23)Total comprehensive loss $(15,946) $(33,626) $(19,575)Advertising CostsCosts for advertising are expensed as incurred. Advertising expense for the years ended December 31, 2013, 2012, and 2011 were $63.6 million, $66.2million and $74.4 million, respectively.Recently Issued Accounting StandardsIn July 2012, the Financial Accounting Standards Board (“FASB”) issued new guidance on the impairment testing of indefinite-lived intangible assets(Accounting Standards Update (“ASU”) 2012-02, Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets forImpairment), effective for calendar years beginning after September 15, 2012. Early adoption is permitted. The objective of this standard update is to simplifyhow an entity tests indefinite-lived intangible assets for impairment. The amendments in this standard will allow an entity to first assess qualitative factors todetermine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform thequantitative impairment test. Only if an entity determines, based on qualitative assessment, that it is more likely than not that the indefinite-lived intangibleasset is impaired will it be required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test. TheCompany adopted this guidance beginning in fiscal year 2013, and the adoption of such guidance did not have a material impact on the Company’s reportedresults of operations or financial position.In February 2013, the FASB issued ASU No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of AccumulatedOther Comprehensive Income (“ASU 2013-02”), which requires disclosure of significant amounts reclassified out of accumulated other comprehensiveincome by component and their corresponding effect on the respective line items of net income. The Company adopted this guidance beginning in fiscal year2013, and the adoption of such guidance did not have a material impact on the presentation of Company’s reported results of operations or financial position.In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740): Presentation of Unrecognized Tax Benefit When a Net OperatingLoss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (“ASU 2013-11”), which requires that an unrecognized tax benefit bepresented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward,except for a situation in which some or all of such net operating loss carryforward, a similar loss, or a tax credit carryforward is not available at the reportingdate under the tax law of the applicable tax jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the taxlaw of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, theunrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. ASU 2013-11 iseffective for the Company beginning January 1, 2014. The Company believes the adoption of ASU 2013-11 will not have a material impact on the Company’sreported results of operations or financial position.F-16Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)3. CHANGES IN ACCOUNTING PRINCIPLEIn the third quarter of 2013, the Company voluntarily changed its accounting policy for sales commissions related to non-cancellable Software-as-a-Service (“SaaS”) contracts, from recording an expense when incurred, to deferral of the sales commission in proportion to the consideration allocated to each ofthe elements in the arrangement and in, or over, the same period the revenue is recognized for each of the elements in the arrangement (i.e. over the non-cancellable term of the contract for the SaaS deliverable). The Company is anticipating a significant increase in contracts with multi-year subscriptions and acorresponding increase in sales commissions due, among other reasons, to its acquisition of Lexia Learning Systems, Inc. (“Lexia”) in August 2013. Lexiaprovides services using a SaaS model and has historically had long-term arrangements with material sales commissions paid to its network of resellers andhas applied a sales commission deferral and amortization policy.The Company believes the deferral method described above is preferable primarily because (i) the sales commission charges are so closely related toobtaining the revenue from the non-cancellable contracts that they should be deferred and charged to expense over the same period that the related revenue isrecognized; and (ii) it provides a single accounting policy, consistent with that used by Lexia, that makes it easier for financial statement users to understand.Deferred commission amounts are recoverable through the future revenue streams under the non-cancellable arrangements.Short-term deferred commissions are included in prepaid expenses and other current assets, while long-term deferred commissions are included in otherassets in the accompanying consolidated balance sheets. The amortization of deferred commissions is included in sales and marketing expense in theaccompanying consolidated statements of operations.The accompanying consolidated financial statements and related notes have been adjusted to reflect the impact of this change and the associated deferredtax impact retrospectively to all prior periods. Under the as previously reported basis, there was no book / tax basis difference related to commission expense. Under the as adjusted basis, the deferred commission asset creates a deferred tax liability related to commissions expense which has been deducted for taxpurposes.The following tables present the effects of the retrospective application of the voluntary change in accounting principle for sales commissions related tonon-cancellable SaaS contracts for all periods presented, effective as of January 1, 2011 (in thousands):Consolidated Balance Sheets (in thousands) December 31, 2013 Computed under PriorMethod Impact of CommissionAdjustment As ReportedPrepaid expense and other current assets$7,707 $4,587 $12,294Total current assets$186,134 $4,587 $190,721Other assets$3,111 $113 $3,224Total assets$286,076 $4,700 290,776Accumulated loss$(33,992) $4,700 $(29,292)Total stockholders' equity$126,543 $4,700 $131,243Total liabilities and stockholders' equity$286,076 $4,700 $290,776F-17Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)3. CHANGES IN ACCOUNTING PRINCIPLE (Continued) December 31, 2012 As Previously Reported Impact of CommissionAdjustment As AdjustedPrepaid expense and other current assets$5,283 $3,398 $8,681Total current assets$211,177 $3,398 $214,575Other assets$1,744 $193 $1,937Total assets$275,855 $3,591 $279,446Accumulated loss$(16,749) $3,591 $(13,158)Total stockholders' equity$144,603 $3,591 $148,194Total liabilities and stockholders' equity$275,855 $3,591 $279,446Consolidated Statements of Operations (in thousands, except per share data) Year Ended December 31, 2013 Computed under PriorMethod Impact of CommissionAdjustment As ReportedSales and marketing$147,242 $(1,138) $146,104Loss from operations$(19,580) $1,138 $(18,442)Income tax benefit (provision)$(1,913) $29 $(1,884)Net loss$(17,242) $1,108 $(16,134)Basic net loss per share$(0.80) $0.05 $(0.75)Diluted net loss per share$(0.80) $0.05 $(0.75)Shares used in computing basic net loss per share21,528 21,528Shares used in computing diluted net loss per share21,528 21,528 Year Ended December 31, 2012 As Previously Reported Impact of CommissionAdjustment As AdjustedSales and marketing$151,646 $(764) $150,882Loss from operations$(6,030) $764 $(5,266)Income tax benefit (provision)$29,991 $(1,082) $28,909Net loss$(35,831) $1,846 $(33,985)Basic net loss per share$(1.70) $0.09 $(1.61)Diluted net loss per share$(1.70) $0.09 $(1.61)Shares used in computing basic net loss per share21,045 21,045Shares used in computing diluted net loss per share21,045 21,045F-18Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)3. CHANGES IN ACCOUNTING PRINCIPLE (Continued) Year Ended December 31, 2011 As Previously Reported Impact of CommissionAdjustment As AdjustedSales and marketing$161,491 $(549) $160,942Loss from operations$(28,407) $549 $(27,858)Income tax benefit (provision)$(7,980) $211 $(7,769)Net loss$(19,988) $338 $(19,650)Basic net loss per share$(0.96) $0.01 $(0.95)Diluted net loss per share$(0.96) $0.01 $(0.95)Shares used in computing basic net loss per share20,773 20,773Shares used in computing diluted net loss per share20,773 20,773Consolidated Statements of Comprehensive Loss (in thousands) Year Ended December 31, 2013 Computed under PriorMethod Impact of CommissionAdjustment As ReportedNet loss$(17,242) $1,108 $(16,134)Other comprehensive income (loss)(17,054) $1,108 $(15,946) Year Ended December 31, 2012 As Previously Reported Impact of CommissionAdjustment As AdjustedNet loss$(35,831) $1,846 $(33,985)Other comprehensive income (loss)$(35,472) $1,846 $(33,626) Year Ended December 31, 2011 As Previously Reported Impact of CommissionAdjustment As AdjustedNet loss$(19,988) $338 $(19,650)Other comprehensive income (loss)$(19,913) $338 $(19,575)F-19Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)3. CHANGES IN ACCOUNTING PRINCIPLE (Continued)Consolidated Statements of Cash Flows (in thousands) Year Ended December 31, 2013 Computed under PriorMethod Impact of CommissionAdjustment As ReportedNet loss$(17,242) $1,108 $(16,134)Deferred income tax provision$(3,898) $29 $(3,869)Prepaid expenses and other current assets$(2,295) $(1,216) $(3,511)Other assets$(1,759) $79 $(1,680)Net cash provided by operating activities$8,068 $— $8,068 Year Ended December 31, 2012 As Previously Reported Impact of CommissionAdjustment As AdjustedNet loss$(35,831) $1,846 $(33,985)Deferred income tax provision$27,035 $(1,082) $25,953Prepaid expenses and other current assets$1,870 $(705) $1,165Other assets$225 $(59) $166Net cash provided by operating activities$34,901 $— $34,901 Year Ended December 31, 2011 As Previously Reported Impact of CommissionAdjustment As AdjustedNet loss$(19,988) $338 $(19,650)Deferred income tax provision$(1,297) $211 $(1,086)Prepaid expenses and other current assets$659 $(549) $110Other assets$(25) $— $(25)Net cash provided by operating activities$3,373 $— $3,373The change in accounting principle resulted in an increase to accumulated income of $1,407 thousand as of January 1, 2011 to $40,476 thousand from$39,069 thousand, as previously reported.4. INVENTORYInventory consisted of the following (in thousands): As ofDecember 31, 2013 2012Raw materials $3,267 $3,570Finished goods 3,372 3,011Total inventory $6,639 $6,5815. BUSINESS COMBINATIONSLivemochaF-20Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)5. BUSINESS COMBINATIONS (Continued)On April 1, 2013, the Company completed its acquisition of Livemocha (the “Livemocha Merger”). Livemocha is one of the world’s largest onlinelanguage-learning communities with over 16 million registered members. The acquisition of Livemocha’s technology platform will accelerate the Company’stransition to cloud-based learning solutions and reinforce its leadership position in the competitive language-learning industry. The aggregate amount ofconsideration paid by the Company was $8.4 million in cash.The acquisition of Livemocha resulted in goodwill of approximately $5.2 million, none of which is deductible for tax purposes. This amount representsthe residual amount of the total purchase price after allocation to the assets acquired and liabilities assumed.All expenditures incurred in connection with the Livemocha Merger were expensed and are included in general and administrative expenses. Transactioncosts incurred in connection with the Merger were $0.4 million during the year ended December 31, 2013. The results of operations for Livemocha have beenincluded in the consolidated results of operations for the period April 1, 2013 through December 31, 2013.The Company has allocated the purchase price based on current estimates of the fair values of assets acquired and liabilities assumed in connection withthe Livemocha Merger. The table below summarizes the estimates of fair value of the Livemocha assets acquired, liabilities assumed and related deferredincome taxes as of the acquisition date.The purchase price is allocated as follows (in thousands):Cash $191Accounts receivable 227Other current assets 93Fixed assets 35Accounts payable and accrued expenses (956)Deferred revenue (743)Net deferred tax liability (1,161)Net tangible assets acquired (2,314)Goodwill 5,185Amortizable intangible assets 5,500Purchase Price $8,371The acquired amortizable intangible assets and the related estimated useful lives consist of the following (in thousands): Preliminary EstimatedUseful Lives Preliminary EstimatedValue April 1, 2013Online community 3 years $1,800Enterprise relationships 5 years 100Technology platform 5 years 3,400Tradename 2 years 200Total assets $5,500In connection with the Livemocha Merger, the Company recorded deferred tax liabilities related to definite-lived intangible assets that were acquired. As aresult of this deferred tax liability balance, the Company reduced its deferred tax asset valuation allowance by $1.2 million. Such reduction was recognized asan income tax benefit in the consolidated statements of operations for the year ended December 31, 2013.LexiaF-21Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)5. BUSINESS COMBINATIONS (Continued)On August 1, 2013, the Company completed its acquisition of Lexia (the “Lexia Merger”). Lexia is one of the most trusted and established companies inthe reading technology market. The transaction marks the Company’s first extension beyond language learning and takes the Company deeper into the EdTechindustry. The aggregate amount of consideration paid by the Company was $21.1 million in cash, net of working capital and deferred revenue adjustments,including a holdback of $3.4 million with 50% of such holdback to be paid within 30 days of the Company filing its Form 10-K for the year ended December31, 2013 and 50% of such holdback to be paid on the 18 month anniversary of the acquisition.The acquisition of Lexia resulted in goodwill of approximately $9.9 million, none of which is deductible for tax purposes. This amount represents theresidual amount of the total purchase price after allocation to the assets acquired and liabilities assumed.All expenditures incurred in connection with the Lexia Merger were expensed and are included in general and administrative expenses. Transaction costsincurred in connection with the Lexia Merger were $0.1 million during the year ended December 31, 2013. The results of operations for Lexia have beenincluded in the consolidated results of operations for the period August 1, 2013 through December 31, 2013.The Company has preliminarily allocated the purchase price based on current estimates of the fair values of assets acquired and liabilities assumed inconnection with the Lexia acquisition. The table below summarizes the preliminary estimates of fair value of the Lexia assets acquired, liabilities assumed andrelated deferred income taxes as of the acquisition date. Any changes to the initial estimates of the fair value of the assets and liabilities will be recorded asadjustments to those assets and liabilities and residual amounts will be allocated to goodwill. The Company has substantially completed the purchase priceallocations for the 2013 acquisitions. However, if additional information is obtained about these assets and liabilities within the measurement period (not toexceed one year from the date of acquisition), including finalization of asset appraisals, the Company will refine its estimates of fair value to allocate thepurchase price more accurately; however, any such revisions are not expected to be significant.The preliminary purchase price is allocated as follows (in thousands):Cash $263Accounts receivable 2,404Other current assets 105Fixed assets 255Accounts payable and accrued expenses (899)Deferred revenue (1,223)Net deferred tax liability (4,210)Net tangible assets acquired (3,305)Goodwill 9,938Amortizable intangible assets 14,500Preliminary purchase price $21,133The acquired amortizable intangible assets and the related estimated useful lives consist of the following (in thousands): PreliminaryEstimated UsefulLives PreliminaryEstimated ValueAugust 1, 2013Enterprise relationships 10 years $9,400Technology platform 7 years 4,100Tradename 5 years 1,000Total assets $14,500F-22Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)5. BUSINESS COMBINATIONS (Continued)Pro Forma Adjusted SummaryThe results of Livemocha and Lexia’s operations have been included in the consolidated financial statements subsequent to the acquisition date.The following schedule presents unaudited consolidated pro forma results of operations data as if the Livemocha and Lexia Mergers (the "Mergers”) hadoccurred on January 1, 2012. This information does not purport to be indicative of the actual results that would have occurred if the Mergers had actuallybeen completed on the date indicated, nor is it necessarily indicative of the future operating results or the financial position of the combined company (inthousands, except per share amounts): Year Ended December 31, 2013 2012Revenue $266,998 $277,033Net loss $(25,212) $(54,152)Basic loss per share $(1.17) $(2.57)Diluted loss per share $(1.17) $(2.57)The operations of Livemocha have been integrated into the overall operations of the Company. The results of Livemocha are reported within the results ofthe Company’s operating segments and are not recorded on a stand-alone basis. Therefore it is impracticable to report revenue and earnings from Livemochafor the year ended December 31, 2013. The Company recorded revenue of $1.2 million and a net loss of $4.5 million from Lexia for the year ended December31, 2013.During 2012, the Company made a payment of $300,000 in accordance with the terms of the November 1, 2009 acquisition of certain assets fromSGLC International Co. Ltd., a software reseller headquartered in Seoul, South Korea.Under the acquisition 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.6. PROPERTY AND EQUIPMENTProperty and equipment consisted of the following (in thousands): As of December 31, 2013 2012Land $390 $390Buildings and improvements 8,170 8,145Leasehold improvements 1,657 1,854Computer equipment 17,077 15,704Software 24,594 18,754Furniture and equipment 4,190 4,895 56,078 49,742Less: accumulated depreciation (38,312) (32,529)Property and equipment, net $17,766 $17,213 The Company leases certain computer equipment, software and machinery under capital lease agreements. As of December 31, 2013 and 2012,leased computer equipment and software included in property and equipment above was $0.7 million and $0.1 million, respectively.F-23Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)6. PROPERTY AND EQUIPMENT (Continued)The Company recorded depreciation expense for the years ended December 31, 2013, 2012 and 2011 in the amount of $7.8 million, $8.0 million, and$8.6 million, respectively.There were no impairment charges for the years ended December 31, 2013 and 2012.7. GOODWILLThe value of goodwill is primarily derived from the acquisition of Rosetta Stone Ltd. (formerly known as Fairfield & Sons, Ltd.) in January 2006, theacquisition of certain assets of SGLC International Co. Ltd ("SGLC") in November 2009, the acquisition of Livemocha in April 2013 and the acquisition ofLexia in August 2013.The Company tests goodwill for impairment annually on June 30 of each year at the reporting unit level using a fair value approach, in accordance withthe provisions of ASC 350, or more frequently, if impairment indicators arise. The Company's annual testing resulted in no impairments of goodwill since thedates of acquisition. Beginning in the fourth quarter of 2012, the Company began reporting its results in three reportable segments, which resulted in threereporting units for goodwill impairment purposes—North America Consumer, ROW Consumer, and Global Enterprise & Education. The table below hasbeen updated to present the current reporting 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, 2013 and 2012 (in thousands): North AmericaConsumer Rest of WorldConsumer Global Enterprise &Education TotalBalance as of January 1, 2012 $15,679 $— $19,162 $34,841Effect of change in foreign currency rate 17 — 23 40Balance as of October 30, 2012 15,696 — 19,185 34,881Change in reporting units (2,197) 2,197 — —Effect of change in foreign currency rate — 2 13 15Balance as of December 31, 2012 13,499 2,199 19,198 34,896Acquisition of Livemocha 4,472 — 720 5,192Acquisition of Lexia — — 9,962 9,962Effect of change in foreign currency rate — 1 8 9Balance as of December 31, 2013 $17,971 $2,200 $29,888 $50,0598. INTANGIBLE ASSETSIntangible assets consisted of the following items as of the dates indicated (in thousands): December 31, 2013 December 31, 2012 GrossCarryingAmount AccumulatedAmortization NetCarryingAmount GrossCarryingAmount AccumulatedAmortization NetCarryingAmountTrade name/ trademark $11,807 $(158) $11,649 $10,607 $— $10,607Core technology 9,954 (3,207) 6,747 2,453 (2,453) —Customer relationships 22,152 (11,720) 10,432 10,850 (10,850) —Website 12 (12) — 12 (12) —Patents 300 (122) 178 300 (82) 218Total $44,225 $(15,219) $29,006 $24,222 $(13,397) $10,825The Company recorded intangible assets of $23.8 million, associated with the acquisition of Rosetta Stone Ltd. in January 2006, including ourindefinite-live Rosetta Stone trade name.The Company recorded intangible assets of $5.5 million with the acquisition of Livemocha in April 2013, consisting of an online community,enterprise relationships, technology platform and the Livemocha trade name. The estimated useful lives of these intangible assets range from two to five years.The Company recorded intangible assets of $14.5 million with the acquisition of Lexia in August 2013, consisting of enterprise relationships,technology platform and the Lexia trade name. The estimated useful lives of these intangible assets range from five to ten years.Included within the Trade name/ trademark intangible assets is approximately $10.6 million for the Rosetta Stone trade name. This intangible asset isconsidered to have an indefinite useful life and is therefore not amortized, but rather tested for impairment on at least an annual basis.F-24Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)8. INTANGIBLE ASSETS (Continued)The Company computes amortization of intangible assets on a straight-line basis over the estimated useful life. Below are the weighted average remaininguseful lives of the Company's amortizing intangible assets: Weighted Average LifeTrade name / trademark 50 monthsCore technology 67 monthsCustomer relationships 100 monthsPatents 57 monthsThere were no impairment charges for the year ended December 31, 2013 and 2012.Amortization expense consisted of the following (in thousands): Years EndedDecember 31, 2013 2012 2011Included in cost of revenue: Cost of product revenue $— $— $—Cost of subscription and service revenue 244 — —Total included in cost of revenue 244 — —Included in operating expenses: Sales and marketing 1,028 — 45Research & development 550 40 40General and administrative — — —Total included in operating expenses 1,578 40 85Total $1,822 $40 $85The following table summarizes the estimated future amortization expense related to intangible assets as of December 31, 2013 (in thousands): As ofDecember 31, 20132014 $3,1712015 3,0872016 2,6052017 2,4532018 1,839Thereafter 5,244Total $18,3999. OTHER CURRENT LIABILITIESThe following table summarizes other current liabilities (in thousands):F-25Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)9. OTHER CURRENT LIABILITIES (Continued) As ofDecember 31, 2013 2012Accrued marketing expenses $19,885 $16,922Accrued professional and consulting fees 4,570 3,282Sales return reserve 4,834 5,883Sales, withholding, and property taxes payable 3,968 3,451Other 8,935 6,849 $42,192 $36,38710. BORROWING AGREEMENTOn January 16, 2009, the Company entered into a credit agreement with Wells Fargo Bank, N.A. ("Wells Fargo"), which provided the Company with 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 one month LIBOR.On January 17, 2011, the Company allowed its $12.5 million revolving line of credit with Wells Fargo to expire and we had no borrowings outstandingfor any of the periods presented.11. STOCK-BASED COMPENSATION2006 Stock Incentive PlanOn January 4, 2006, the Company established the Rosetta Stone Inc. 2006 Stock Incentive Plan (the "2006 Plan") under which the Company's Board ofDirectors, at its discretion, could grant stock options to employees and certain directors of the Company and affiliated entities. The 2006 Plan initiallyauthorized the grant of stock options for up to 1,942,200 shares of common stock. On May 28, 2008, the Board of Directors authorized the grant ofadditional stock options for up to 195,000 shares of common stock under the plan, resulting in total stock options available for grant under the 2006 Plan of2,137,200 as of December 31, 2008. The stock options granted under the 2006 Plan generally expire at the earlier of a specified period after termination ofservice or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from such grant date. Stock issued as aresult of exercises of stock options will be issued from the Company's authorized available stock.2009 Omnibus Incentive PlanOn 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, Share Awards,Phantom Stock and Cash Incentive Awards. The stock incentive awards and options granted under the 2009 Plan generally expire at the earlier of a specifiedperiod after termination of service or the date specified by the Board or its designated committee at the date of grant, but not more than ten years from suchgrant date. On May 26, 2011 the Board of Directors authorized and the Company's shareholders' approved the allocation of an additional 1,000,000 shares ofcommon stock to the 2009 Plan. On May 23, 2012, the Board of Directors authorized and the Company's shareholders approved the allocation of 1,122,930additional shares of common stock to the 2009 Plan. On May 23, 2013, the Board of Directors authorized and the Company's shareholders approved theallocation of 2,317,000 additional shares of common 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, 2013 there were 2,580,846shares available for future grant under the 2009 Plan.In accordance with ASC 718, the fair value of stock-based awards to employees is calculated as of the date of grant. Compensation expense is thenrecognized on a straight-line basis over the requisite service period of the award. The Company uses the Black-Scholes pricing model to value its stockoptions, which requires the use of estimates, including future stock priceF-26Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)11. STOCK-BASED COMPENSATION (Continued)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: Year Ended December 31, 2013 2012 2011Expected stock price volatility 64%-67% 64%-66% 57%-64%Expected term of options 6 years 6 years 6 yearsExpected dividend yield — — —Risk-free interest rate 0.75%-1.65% 0.60%-0.88% 1.14%-2.59%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 had alimited history of stock option activity, so the Company reviewed a group of comparable industry-related companies to estimate its expected volatility over themost recent period commensurate with the estimated expected term of the awards. In addition to analyzing data from the peer group, the Company alsoconsidered the contractual option term and vesting period when determining the expected option life and forfeiture rate. Subsequent to the initial public offering,the Company continues to review a group of comparable industry-related companies to estimate volatility, but also reviews the volatility of its own stock sincethe initial public offering. The Company considers the volatility of the comparable companies to be the best estimate of future volatility. For the risk-freeinterest rate, the Company uses a U.S. Treasury Bond rate consistent with the estimated expected term of the option award.Stock Options—The following table summarizes the Company's stock option activity from January 1, 2013 to December 31, 2013: OptionsOutstanding WeightedAverageExercisePrice WeightedAverageContractualLife (years) AggregateIntrinsicValueOptions Outstanding, January 1, 2013 2,470,347 $12.57 6.98 $6,760,327Options granted 636,656 14.82 Options exercised (549,722) 5.95 Options cancelled (629,729) 17.42 Options Outstanding, December 31, 2013 1,927,552 13.61 7.54 2,829,380Vested and expected to vest at December 31, 2013 1,787,571 13.63 7.43 2,734,041Exercisable at December 31, 2013 817,870 $13.94 6.08 $1,746,647During the second quarter of 2013, the Company allowed a former executive to net exercise 213,564 vested stock options with an exercise price of$3.85. In the net exercise, the Company repurchased 123,367 shares from the former employee based on the Company's stock price on the exercise date of$15.09 for $1.0 million.As of December 31, 2013 and 2012, there was approximately $6.8 million and $6.8 million of unrecognized stock-based compensation expense relatedto non-vested stock option awards that is expected to be recognized over a weighted average period of 2.53 and 2.52 years, respectively.Stock options are granted at the discretion of the Board of Directors or the Compensation Committee (or its authorized member(s) and expire 10 yearsfrom the date of the grant. Options generally vest over a four-year period based upon required service conditions. No options have performance or marketconditions. The Company calculates the pool of additional paid-in capital associated with excess tax benefits using the "simplified method" in accordance withASC 718.The weighted average remaining contractual term and the aggregate intrinsic value for options outstanding at December 31, 2013 was 7.54 years and$2.8 million, respectively. The weighted average remaining contractual term and the aggregate intrinsic value for options exercisable at December 31, 2012 was6.98 years and $6.8 million, respectively. As ofF-27Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)11. STOCK-BASED COMPENSATION (Continued)December 31, 2013, options that were vested and exercisable totaled 817,870 shares of common stock with a weighted average exercise price per share of$13.94.The weighted average grant-date fair value per share of stock options granted was $8.88 and $5.94 for the years ended December 31, 2013 and 2012,respectively.The aggregate intrinsic value disclosed above represents the total intrinsic value (the difference between the fair market value of the Company's commonstock as of December 31, 2013, and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holdershad all option holders exercised their options on December 31, 2013. This amount is subject to change based on changes to the fair market value of theCompany's common stock.The following table summarizes the Company's restricted stock activity for the years ended December 31, 2013 and 2012, respectively: NonvestedOutstanding WeightedAverageGrant DateFair Value AggregateIntrinsicValueNonvested Awards, January 1, 2012 323,010 $18.22 $5,885,242Awards granted 651,978 8.88 Awards vested (133,831) 16.85 Awards canceled (83,054) 12.68 Nonvested Awards, December 31, 2012 758,103 11.00 8,339,133Awards granted 352,985 14.83 Awards vested (304,560) 11.72 Awards canceled (172,497) 12.88 Nonvested Awards, December 31, 2013 634,031 12.28 7,785,901During 2013 and 2012, 352,985 and 651,978 shares of restricted stock were granted, respectively. The aggregate grant date fair value of the awards in2013 and 2012 was $5.2 million and $5.8 million, respectively, which will be recognized as expense on a straight-line basis over the requisite service periodof the awards, which is also the vesting period. The Company's restricted stock grants are accounted for as equity awards. The grant date fair value is basedon the market price of the Company's common stock at the date of grant. The Company did not grant any restricted stock prior to April 2009.During 2013, 172,497 shares of restricted stock were forfeited. As of December 31, 2013, future compensation cost related to the nonvested portion ofthe restricted stock awards not yet recognized in the statement of operations was $5.7 million and is expected to be recognized over a period of 2.78 years.Restricted stock awards are considered outstanding at the time of grant as the stock holders are entitled to voting rights and to receive any dividendsdeclared subject to the loss of the right to receive accumulated dividends if the award is forfeited prior to vesting. Unvested restricted stock awards are notconsidered outstanding in the computation of basic earnings per share.Restricted Stock Units—During 2013 and 2012, 24,779 and 44,241 restricted stock units were granted, respectively. The aggregate grant date fairvalue of the awards in 2013 and 2012 was $0.4 million and $0.6 million, respectively, which was recognized as expense on the grant date, as the awards wereimmediately vested. The Company's restricted stock units are accounted for as equity awards. The grant date fair value is based on the market price of theCompany'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 February 21, 2013, the Company’s board of directors approved the 2013 Rosetta Stone Inc. Long Term IncentiveProgram (“2013 LTIP”). The 2013 LTIP is administered under the Rosetta Stone Inc. 2009 Omnibus Incentive Plan (the “Plan”) and the shares awarded underthe 2013 LTIP will be taken from the shares reserved under the Plan. The purpose of the 2013 LTIP is to: motivate senior management and other executives toachieve key financial and strategic business objectives of the Company; offer eligible executives of the Company a competitive total compensation package;reward executives in the success of the Company; provide ownership in the Company; and retain key talent. The 2013 LTIP is effective from January 1, 2013until December 31, 2014.F-28Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)11. STOCK-BASED COMPENSATION (Continued)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 cash paymentto be made under the 2013 LTIP, the Company must meet the minimum threshold requirements for a performance goal for the 2014 fiscal year in addition tothe cumulative performance goals for the two year period ended December 31, 2014. Each performance goal is mutually exclusive. Each performance goal hasa 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 512,400 and the maximum cash payout is$2.7 million, althoughexecutives hired after the approval of the 2013 LTIP may be allowed to participate at the discretion of the board of directors, which could raise the overall shareawards and cash payouts. The minimum number of shares to be issued as performance stock awards is zero, and the minimum cash payout is zero. Ifperformance stock awards are granted, the shares will be 100% vested as of the date of grant. There will be no subsequent holding period requirement.Before any granting of performance stock awards or payment of cash pursuant to an award granted under the 2013 LTIP can be made, the materialterms of the performance goals must be disclosed to, and subsequently approved by, the stockholders, in accordance with Treasury Regulation Section 1.162-27(e)(4).The Company’s stockholders approved the material terms of the performance goals on May 23, 2013, the grant date for the performance stock awards. The amount of share-based compensation expense recognized related to the 2013 LTIP was $1.4 million for the year ended December 31, 2013. $0.6 million ofexpense was recognized related to the cash-based portion of the 2013 LTIP for the year ended December 31, 2013.On January 4, 2011, the Company's board of directors approved the Rosetta Stone Inc. Long Term Incentive Program ("LTIP"), a long-term incentiveplan for certain of the Company's executives. The LTIP was administered under the Rosetta Stone Inc. 2009 Omnibus Incentive Plan (the "Plan"), and the1,000,000 shares allocated to the LTIP were taken from the shares reserved under the Plan. The purpose of the LTIP was to: advance the best interests of theCompany; 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. Executives designated bythe Board of Directors were eligible to receive a minimum number of shares of restricted common stock for each milestone level of total market capitalizationachieved, as specified in individual award agreements. The shares received would be restricted in that after issuance of the shares, they would be subject tovesting over a two-year period. For each milestone level of market capitalization reached above the base market capitalization as of October 1, 2010, thecompensation committee of the Board of Directors would allocate the pre-defined share incentive pool for that milestone reached amongst the participatingexecutives with the minimum number of shares specified in individual award agreements. Although minimum participation percentages were communicated tocertain plan participants, all share grants under the LTIP were contingent upon achievement of the market capitalization thresholds.In accordance with the agreements communicated to the executives after the approval of the plan by the Board of Directors, the LTIP participants weregranted minimum participation percentages of each tranche of shares issued at each milestone level reached. Throughout the year ended December 31, 2011,the target market capitalization required to trigger the first issuance of shares was below the minimum threshold, and no shares were issued. The minimumparticipation percentages given to plan participants were considered grants in accordance with the provisions of ASC 718. The grant date fair value of theminimum awards was $6.1 million, which was derived using a Monte Carlo valuation model. This value would have been amortized as stock-basedcompensation 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 canceled the LTIP. Asa result of the cancellation, the company recognized $4.9 million in stock-based compensation expense equal to the total unamortized value of the 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, there was nounrecognized stock-based compensation expense related to awards under the LTIP.The following table presents the stock-based compensation expense for stock options and restricted stock included in the related financial statement lineitems (in thousands):F-29Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)11. STOCK-BASED COMPENSATION (Continued) Years Ended December 31, 2013 2012 2011Included in cost of revenue: Cost of product revenue $109 $110 $30Cost of subscription and service revenue 66 178 25Total included in cost of revenue 175 288 55Included in operating expenses: Sales and marketing 1,840 1,185 1,932Research & development 1,460 1,547 2,448General and administrative 5,766 4,989 7,918Total included in operating expenses 9,066 7,721 12,298Total $9,241 $8,009 $12,35312. STOCKHOLDERS' EQUITYAt December 31, 2013, the Company's Board of Directors had the authority to issue 200,000,000 shares of stock, of which 190,000,000 were designatedas Common Stock, with a par value of $0.00005 per share, and 10,000,000 were designated as Preferred Stock, with a par value of $0.001 per share. AtDecember 31, 2013 and 2012, the Company had shares of Common Stock issued of 22,588,484 and 21,950,671, respectively, and shares of CommonStock outstanding of 21,588,484 and 21,950,671, respectively.On May 8, 2013, the Company filed a universal shelf registration statement which became effective on May 30, 2013. The registration statementpermitted certain holders of the Company’s stock to offer the shares of common stock held by them. On June 11, 2013 the selling shareholders, ABS CapitalPartners IV Trust and Norwest Equity Partners VIII, LP, sold a combined total of 3,490,000 shares at an offering price of $16.00. During November andDecember 2013, ABS Capital Partners IV Trust sold the remainder of its common stock holdings in the Company. As of December 31, 2013, NorwestEquity Partners VIII, LP continues to hold only a nominal number of shares of common stock. The shelf also provides the Company with the flexibility tooffer an amount of equity or issue debt in the amount of $150.0 million. The Company issued and sold an additional 10,000 shares at a per share price of$16.00 in the offering.On August 22, 2013, the Company’s Board of Directors approved a share repurchase program under which the Company is authorized to repurchaseup to $25 million of its outstanding common stock from time to time in the open market or in privately negotiated transactions depending on marketconditions, other corporate considerations, and applicable legal requirements. The Company expects to fund the repurchases through existing cash balancesand cash generated from operations. For the year ended December 31, 2013, the Company paid $11.4 million to repurchase 1.0 million sharesat a weighted average price of $11.44 per share as part of this program. Shares repurchased under the program were recorded as treasury stock on theCompany’s consolidated balance sheet. The shares repurchased under this program during the year ended December 31, 2013 were not the result of anaccelerated share repurchase agreement. Management has not made a decision on whether shares purchased under this program will be retired or reissued.F-30Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)13. EMPLOYEE BENEFIT PLANThe Company maintains a defined contribution 401(k) Plan (the "Plan"). The Company matches employee contributions to the Plan up to 4% of theircompensation that vest immediately. The Company recorded expenses for the Plan totaling $1.9 million, $1.6 million, and $1.4 million for the years endedDecember 31, 2013, 2012 and 2011, respectively.14. COMMITMENTS AND CONTINGENCIESOperating LeasesThe Company leases copiers, parking spaces, buildings, a warehouse and office space under operating lease and site license arrangements, some ofwhich contain renewal options. Building, warehouse and office space leases range from 12 months to 89 months. Certain leases also include lease renewaloptions.The following table summarizes future minimum operating lease payments as of December 31, 2013 and the years thereafter (in thousands): As ofDecember 31,2013Periods Ending December 31, 2014 $6,3422015 5,0492016 4,4392017 4,1402018 3,926 $23,896Total expenses under operating leases were $7.1 million, $9.5 million and $13.5 million during the years ended December 31, 2013, 2012 and 2011respectively.The Company accounts for its leases under the provisions of ASC topic 840, Accounting for Leases ("ASC 840"), and subsequent amendments,which require that leases be evaluated and classified as operating leases or capital leases for financial reporting purposes. Certain operating leases contain rentescalation clauses, which are recorded on a straight-line basis over the initial term of the lease with the difference between the rent paid and the straight-line rentrecorded as either a deferred rent asset or liability depending on the calculation. Lease incentives received from landlords are recorded as deferred rent liabilitiesand are amortized on a straight-line basis over the lease term as a reduction to rent expense.Royalty AgreementOn 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 and developmentcosts during 2006 because the products into which the licensed software were to be incorporated had not yet reached technological feasibility. In addition, theagreement specifies that, in the event the software is incorporated into specified Company software products, royalties will be due at a rate of 20% of sales forthose products up to an additional amount totaling $0.4 million. There were no additional royalty payments made under this agreement in 2013, 2012 or 2011.Employment AgreementsThe Company has agreements with certain of its executives and key employees which provide guaranteed severance payments upon termination of theiremployment without cause.LitigationIn April 2010, a purported class action lawsuit was filed against the Company 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,F-31Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)14. COMMITMENTS AND CONTINGENCIES (Continued)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 personssimilarly situated who are or were employed as salaried managers by the Company in its retail locations in California are due unpaid wages and other relief forthe Company’s violations of state wage and hour laws. Plaintiffs moved to amend their complaint to include a nationwide class in January 2011. In March2011, the case was removed to the United States District Court for the Northern District of California. In November 2011, the parties agreed to the mediator’sproposed settlement terms, and as a result, as of September 30, 2011, the Company reserved $0.6 million for the proposed settlement amount. The Companydisputed the plaintiffs’ claims and it has not admitted any wrongdoing with respect to the case. In September 2013, the court entered a final order directingpayment of the $0.6 million settlement amount and in October 2013 the Company paid this amount in final settlement of the lawsuit.In June 2011, Rosetta Stone GmbH was served with a writ filed by Langenscheidt KG (“Langenscheidt”) in the District Court of Cologne, Germanyalleging trademark infringement due to Rosetta Stone GmbH’s use of the color yellow on its packaging of its language-learning software and the advertisingthereof in Germany. In January 2012, the District Court of Cologne ordered an injunction of Rosetta Stone GmbH’s use of the color yellow in packaging, on itswebsite and in television commercials and declared Rosetta Stone liable for damages, attorneys’ fees and costs to Langenscheidt. No dollar amounts have beenspecified yet for the award of damages by the District Court of Cologne. In its decision, the District Court of Cologne also ordered the destruction of RosettaStone GmbH’s product and packaging which utilized the color yellow and which was deemed to have infringed Langenscheidt’s trademark. The Court ofAppeals in Cologne affirmed the District Court's decision. Langenscheidt has not posted the necessary bond to immediately enforce that decision. TheCompany commenced a separate proceeding for the cancellation of Langenscheidt’s German trademark registration of yellow as an abstract color mark. InJune 2012, the German Patent and Trademark Office rendered a decision in the cancellation proceeding denying Rosetta Stone’s request to cancelLangenscheidt’s German trademark registration. The Company has filed appeals of the decisions in both cases to the German Federal Supreme Court on thegrounds of law. The Company cannot predict the timing and ultimate outcome of this matter, however, the Company believes the range of possible loss isimmaterial to the consolidated financial statements. Even if the plaintiff is unsuccessful in its claims against the Company, the Company will incur legal feesand other costs in the defense of these claims and appeals.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 a materialimpact on its business, financial condition or results of operations.F-32Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. INCOME TAXESThe following table summarizes the significant components of the Company's deferred tax assets and liabilities as of December 31, 2013 and 2012 (inthousands): As ofDecember 31, 2013 2012Deferred tax assets: Inventory $731 $873Amortization and depreciation 1,450 7,273Net operating loss carryforwards 13,461 3,107Deferred revenue 3,153 2,548Accrued liabilities 10,308 10,189Stock-based compensation 5,009 5,613Bad debt reserve 374 441Foreign currency translation 341 286Foreign and other tax credits 1,221 445Gross deferred tax assets 36,048 30,775Valuation allowance (33,866) (29,671)Net deferred tax assets 2,182 1,104Deferred tax liabilities: Goodwill and indefinite lived intangibles (9,687) (8,400)Prepaid expenses (2,100) (759)Other (5) (6)Gross deferred tax liabilities (11,792) (9,165)Net deferred tax liabilities $(9,610) $(8,061)On April 1, 2013 and August 1, 2013, the Company acquired all of the outstanding shares of Livemocha and Lexia, respectively. For tax purposes, theacquisitions will be treated as a non-taxable stock purchase and all of the acquired assets and assumed liabilities will retain their historical carryover tax bases.Therefore, the Company recognized deferred taxes related to all book/tax basis differences in the acquired assets and liabilities.In connection with the Livemocha purchase accounting, the Company recognized net deferred tax liabilities of $1.2 million associated with the book/taxdifferences on acquired intangible assets and deferred revenue, offset by deferred tax assets associated with acquired net operating loss ("NOL")carryforwards. The effect of this on the tax provision for the Company resulted in a release of its valuation allowance equal to the amount of the net deferredtax liability recognized at the time of the Livemocha Merger. Thus, a tax benefit of $1.2 million was recorded during the three months ended June 30, 2013.During the fourth quarter of 2013, the Company elected to treat the acquisition as an asset acquisition for tax purposes. Accordingly, the Company wrote offnet deferred tax liabilities of $0.9 million against the original net deferred tax liabilities recognized during the three months ended June 30, 2013. In connection with the Lexia purchase accounting, the Company recognized net deferred tax liabilities of $4.2 million associated with the book/taxdifferences on acquired intangible assets and deferred revenue, offset by deferred tax assets associated with acquired net operating loss carryforwards. Theeffect of this on the tax provision for the Company resulted in a release of its valuation allowance equal to the amount of the net deferred tax liability recognizedat the time of the Lexia Merger. Thus, a tax benefit of $4.2 million was recorded during the three months ended September 30, 2013.F-33Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. INCOME TAXES (Continued)For the year ended December 31, 2013, the Company’s recorded income tax benefit of $1.9 million is primarily attributable to a partial valuationallowance release of $5.4 million related to the net deferred tax liabilities acquired with the Livemocha and Lexia acquisitions, offset by income related tocurrent year profits of operations in Canada, Germany, and the U.K., foreign withholding taxes, the tax impact related to amortization of indefinite livedintangibles, and an inability to recognize tax benefits associated with current year losses associated with operations in Brazil, Korea, Japan, and the U.S.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 the deferred taxassets 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 allowance isrequired. As of December 31, 2012, a full valuation allowance was provided for domestic and certain foreign deferred tax assets in those jurisdictions wherethe Company has determined the deferred tax assets will more likely than not be realized.As of December 31, 2013, the Company had federal tax NOL carryforwards in the amount of $20.0 million in the U.S. that if not utilized, would beginto expire in 2031. During the year ended December 31, 2013 the Company utilized $0.8 million of state NOL’s acquired by Lexia. As of December 31, 2013,the Company had state tax NOL carryforwards in the amount of $20.0 million in the U.S. that if not utilized, would begin to expire in 2017. Additionally, theCompany has foreign tax credit carryforwards of $0.6 million, which if not utilized, would expire in 2022.As of December 31, 2013, the Company had foreign net operating loss carryforwards related to operations in Japan of $7.3 million which expire in2020, Brazil of $4.0 million which have an unlimited carryforward, and Korea of $6.2 million which expire in 2024.If future events change the outcome of the Company's projected return to profitability, a valuation allowance may not be required to reduce the deferredtax assets. The Company will continue to assess the need for a valuation allowance.The components of income (loss) before income taxes and the provision for taxes on income consists of the following (in thousands): Year Ended December 31, 2013 2012 2011United States $(14,360) $(933) $(32,708)Foreign (3,658) (4,143) 5,289Loss before income taxes $(18,018) $(5,076) $(27,419)Current: Federal $155 $288 $(8,758)State 123 333 (582)Foreign 1,709 2,150 3,458Total current $1,987 $2,771 $(5,882)Deferred: Federal $(3,972) $20,075 $(498)State (112) 3,278 (857)Foreign 213 2,785 (532)Total deferred (3,871) 26,138 (1,887)Provision (benefit) for income taxes $(1,884) $28,909 $(7,769)Reconciliation of income tax provision (benefit) computed at the U.S. federal statutory rate to income tax expense is as follows (in thousands):F-34Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. INCOME TAXES (Continued) Year Ended December 31, 2013 2012 2011Income tax expense at statutory federal rate $(6,306) $(2,024) $(9,600)State income tax expense, net of federal income tax effect 7 216 (844)Domestic production activities deduction — (81) 580Nondeductible LTIP expense — — 2,062Nondeductible intercompany interest — — 29Acquired intangibles (859) — —Other nondeductible expenses 1,105 504 698Tax rate differential on foreign operations (264) (346) (209)Increase in valuation allowance 4,263 28,679 —Tax Audit Settlements — 281 —Change in prior year estimates (17) 1,608 —Other tax credits — — (619)Other 187 72 134Income tax expense (benefit) $(1,884) $28,909 $(7,769)The Company accounts for uncertainty in income taxes under ASC topic 740-10-25, Income Taxes: Overall: Recognition, ("ASC 740-10-25"). ASC740-10-25 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. ASC 740-10-25 also provides guidance on de-recognition, classification, interest and penalties, accounting in interimperiods, 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, 2013 and2012, the Company had $16,000 and $9,000 accrued for interest and penalties, respectively, in "Other Long Term Liabilities". During the year endedDecember 31, 2013, the Company accrued $7,000 of interest expense. During the year ended December 31, 2012, the Company accrued $42,000 of interestexpense 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): Year EndedDecember 31, 2013 2012Balance at January 1, $143 $165Increases for tax positions taken during prior period — —Increases for tax positions taken during current period — 239Settlements — (261)Balance at December 31, $143 $143During the year ended December 31, 2013, the Company did not recognize additional unrecognized tax benefits. During the year ended December 31,2012, the Company recognized $239,000 for unrecognized tax benefits and paid $261,000 as settlement of its Japan audit for the tax years 2008, 2009, and2010. These liabilities for unrecognized tax benefits are included in "Other Long Term Liabilities." As of December 31, 2013 and 2012, the Company had$143,000 of unrecognized tax benefits, respectively, which if recognized, would affect income tax expense. The Company does not expect that the amounts ofunrecognized tax benefits will change 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 2009, 2010, 2011 and 2012 aresubject to examination by the tax authorities. As of December 31, 2013, the Company has a federal tax examination ongoing for income tax years 2009, 2010and 2011.F-35Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)15. INCOME TAXES (Continued)No provision was made in 2013 for U.S. income taxes on undistributed earnings of the foreign subsidiaries as it is the Company's intention to utilizethose 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 $3.3 million, $4.0 million, and $1.7 million in 2013, 2012 and 2011, respectively.16. SEGMENT INFORMATIONDuring 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 Global Enterprise & Education. These segments also represent the Company'sreportable segments. Concurrent with the change in reportable segments, the Company reviewed the expenses included in segment contribution. The Companyidentified additional expenses including certain customer care, coaching, finance and sales and marketing costs that directly benefit individual reportablesegments and 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, customer careand coaching costs, and sales and marketing expenses. The Company does not allocate expenses beneficial to all segments, which include certain general andadministrative expenses, facilities and communication expenses, purchasing expenses and manufacturing support and logistic expenses. These expenses areincluded in the unallocated expenses section of the table presented below. Revenue from transactions between the Company's operating segments is not material.With the exception of goodwill, the Company does not identify or allocate its assets by operating segment. Consequently, the Company does not presentassets or liabilities by operating segment.Operating results by segment for the twelve months ended December 31, 2013, 2012, and 2011 were as follows (in thousands): Years Ended December 31, 2013 2012 2011Revenue: North America consumer $174,016 $172,826 $157,561Rest of world consumer 30,420 40,248 50,465Global Enterprise & Education 60,209 60,167 60,423Total revenue $264,645 $273,241 $268,449Segment contribution: North America consumer $72,511 $70,767 $54,985Rest of world consumer (1,627) (3,536) (5,317)Global Enterprise & Education 20,965 26,621 34,819Total segment contribution 91,849 93,852 84,487Unallocated expenses, net: Unallocated cost of sales 4,586 6,104 7,042Unallocated sales and marketing 16,447 16,633 22,581Unallocated research and development 33,993 23,455 24,145Unallocated general and administrative 54,423 52,926 58,577Unallocated non-operating income/(expense) (424) (190) (439)Unallocated lease abandonment 842 — —Total unallocated expenses, net 109,867 98,928 111,906Income (loss) before income taxes $(18,018) $(5,076) $(27,419)F-36Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)16. SEGMENT INFORMATION (Continued)Geographic InformationRevenue 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 of endcustomers.The information below summarizes revenue from customers by geographic area for the years ended December 31, 2013, 2012 and 2011, respectively (inthousands): Years Ended December 31, 2013 2012 2011United States $223,404 $223,747 $212,122International 41,241 49,494 56,327Total Revenue $264,645 $273,241 $268,449The information below summarizes long-lived assets by geographic area for the years ended December 31, 2013, 2012 and 2011, respectively (inthousands): As of December 31, 2013 2012 2011United States $17,205 $15,986 $18,417International 561 1,227 2,452Total $17,766 $17,213 $20,86917. RELATED PARTIESAs of December 31, 2013 and 2012, the Company had outstanding receivables from stockholders of $0, and outstanding receivables from employees inthe amount of $55,000 and $60,000, respectively.18. VALUATION AND QUALIFYING ACCOUNTSThe following table includes the Company's valuation and qualifying accounts for the respective periods (in thousands): Year Ended December 31, 2013 2012 2011Allowance for doubtful accounts: Beginning balance $1,297 $1,951 $1,761Charged to costs and expenses 1,420 1,820 1,228Deductions—accounts written off (1,717) (2,474) (1,038)Ending balance $1,000 $1,297 $1,951Sales return reserve: Beginning balance $5,883 $9,931 $8,391Charged against revenue 14,258 11,148 24,922Deductions—reserves utilized (15,307) (15,196) (23,382)Ending balance $4,834 $5,883 9,931Deferred income tax asset valuation allowance: Beginning balance $29,671 — —Charged to costs and expenses 9,566 29,671 —Deductions (5,371) — —Ending balance $33,866 $29,671 $—F-37Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)19. SUPPLEMENTAL QUARTERLY FINANCIAL INFORMATION (Unaudited)Summarized quarterly supplemental consolidated financial information for 2013 and 2012 are as follows (in thousands, except per share amounts): Three Months Ended March 31, June 30, September 30, December 31,2013 Revenue $63,924 $62,139 $60,872 $77,710Gross profit $53,660 $51,915 $50,128 $63,228Net loss $(4,904) $(3,213) $(4,169) $(3,848)Basic loss per share $(0.23) $(0.15) $(0.19) $(0.18)Shares used in basic per share computation 21,360 21,569 21,827 21,353Diluted loss per share $(0.23) $(0.15) $(0.19) $(0.18)Shares used in diluted per share computation 21,360 21,569 21,827 21,3532012 Revenue $69,449 $60,812 $64,279 $78,701Gross profit $55,975 $49,492 $53,094 $65,770Net income (loss) $(2,003) $(4,554) $(32,063) $4,635Basic loss per share $(0.10) $(0.22) $(1.52) $0.22Shares used in basic per share computation 20,942 20,995 21,073 21,166Diluted loss per share $(0.10) $(0.22) $(1.52) $0.21Shares used in diluted per share computation 20,942 20,995 21,073 21,828The summarized quarterly supplemental financial information above has been adjusted for the retrospective change in accounting principle for salescommissions, as disclosed in the Company's financial statements for the quarter ended September 30, 2013.20. SUBSEQUENT EVENTSOn December 19, 2013, the Company executed a Share Purchase Agreement (the “Agreement”) pursuant to which Rosetta Stone Canada Inc., a wholly-owned, indirect subsidiary of the Company, agreed to purchase all of the outstanding shares of Vivity Labs Inc., a company organized under the laws ofCanada, from its shareholders for $12.0 million in cash. The Agreement contains customary representations, warranties, covenants, indemnificationobligations and closing conditions. The acquisition of Vivity Labs Inc. was completed on January 2, 2014. Based upon the timing of the acquisitionsubsequent to the end of the year, the initial accounting for the acquisition is incomplete at this time as the Company is in the process of determining the fairvalues of the net assets acquired and goodwill resulting from the acquisition.On December 11, 2013, Rosetta Stone Inc. the Company executed a Stock Purchase Agreement (the “Agreement”) pursuant to which Rosetta Stone Ltd.,a wholly-owned subsidiary of the Company, agreed to purchase all of the outstanding shares of Tell Me More S.A., a company organized under the laws ofFrance, from its shareholders for approximately €20.75 million ($28.0 million), including assumed net debt. The Agreement contains customaryrepresentations, warranties, covenants, indemnification obligations and closing conditions. The acquisition of Tell Me More S.A. was completed on January8, 2014. Based upon the timing of the acquisition subsequent to the end of the year, the initial accounting for the acquisition is incomplete at this time as theCompany is in the process of determining the fair values of the net assets acquired and goodwill resulting from the acquisition.On January 10, 2014, Rosetta Stone announced the restructuring of its Asian operations. During the first quarter of 2014, the Company will close itsoffice in Japan and streamline its operations in South Korea. As a result of these restructuring efforts, Rosetta Stone will reduce its work force byapproximately 70 employees. The Company will maintain its web-based presence in both countries and focus its efforts in South Korea more directly onfurther scaling the Proctor Assisted LearningF-38Table of ContentsROSETTA STONE INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)20. SUBSEQUENT EVENTS (Continued)(“PAL”) channel. The Company expects to incur a charge in the first quarter for the actions in Asia of $3.5 million to $4.0 million, predominantly forseverance expenses, lease termination costs and inventory writedowns. All final decisions with respect to the reduction of operations in Japan and Korea weremade on January 10, 2014. With respect to employee severance decisions, all communications to affected employees were made on that same date. All leasedspace to be abandoned will not occur until sometime in 2014. Inventory consists of software products and as the restructuring strategy is to eliminate the salesof products and move to a third party hosted model, such inventory will be destroyed in 2014 based on the date of the final decisions. The Company also announced in the press release an effort to reduce general and administrative expenses through a planned space consolidation,primarily at its Arlington, Virginia headquarters location, resulting in a charge of $2.5 million to $3.5 million in the first quarter of 2014. All leased space wasabandoned and ceased to be used by the Company on January 31, 2014.F-39Table of ContentsEXHIBIT INDEX Index to exhibits3.1(1) Second Amended and Restated Certificate of Incorporation3.2(1) Second Amended and Restated Bylaws4.1(1) Specimen certificate evidencing shares of common stock4.2(1) Registration Rights Agreement dated as of January 4, 2006 among Rosetta Stone Inc. and the InvestorShareholders and other Shareholders listed on Exhibit A Thereto10.1+(1) 2006 Incentive Option Plan10.2+(1) 2009 Omnibus Incentive Plan10.3+(1) Director Form of Option Award Agreement under the 2006 Plan10.4+(1) Executive Form of Option Award Agreement under the 2006 Plan10.5+(1) Standard Form of Option Award Agreement under the 2006 Plan10.6+(1) Form of Option Award Agreement under the 2009 Plan10.7(1) Form of Indemnification Agreement entered into with each director and executive officer10.8(1) Lease Agreement dated as of February 26, 2006, by and between Premier Flex Condos, LLC and FairfieldLanguage Technologies, Inc., as amended10.9(1) Sublease Agreement dated as of October 6, 2008, by and between The Corporate Executive Board Company andRosetta 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 Plan10.12+(1) Executive Employment Agreement between Rosetta Stone Ltd. and Michael Wu dated February 20, 200910.13+(2) Executive Employment Agreement between Rosetta Stone Ltd. and Stephen Swad effective as of November 9,201010.14+(3) Executive Employment Agreement between Rosetta Stone Ltd. and Judy Verses effective as of October 5, 201110.15+(3) Executive Employment Agreement between Rosetta Stone Ltd. and Pragnesh Shah effective as of November 14,201110.16+(3) Amendment to Executive Employment Agreement between Rosetta Stone Ltd. and Michael Wu effective as ofDecember 22, 201110.17+(3) Amendment to Executive Employment Agreement between Rosetta Stone Ltd. and Stephen Swad effective as ofDecember 22, 201110.18+(3) Second Amendment to Executive Employment Agreement between Rosetta Stone Ltd. and Stephen Swad effectiveas of February 22, 201210.19+(3) Amended Executive Form of Option Award Agreement under 2009 Plan effective for awards after October 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 after March 1,2012.10.22+(3) Amended Employee Form of Restricted Stock Award Agreement under 2009 Plan effective for awards afterMarch 1, 2012.10.23(4) First Amendment to Sublease Agreement with The Corporate Executive Board, dated as of November 1, 2012.10.24(5) Agreement and Plan of Merger among Rosetta Stone Ltd., Liberty Merger Sub Inc., LiveMocha, Inc., andShareholder Representative Services LLC., dated April 1, 2013.21.1 Rosetta Stone Inc. Subsidiaries23.1 Consent of Deloitte & Touche LLP, independent registered public accounting firm24.1 The Power of Attorney with Board of Directors' Signatures31.1 Certifications of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Table of Contents Index to exhibits31.2 Certifications of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1 Certifications of Principal Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2 Certifications of Principal Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002101++ 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 or prospectus for purposesof Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and 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), as amended.(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.(4)Incorporated by reference to exhibit filed with Rosetta Stone Form 10-K for the fiscal year ended December 31, 2012.(5)Incorporated by reference to exhibit filed with Rosetta Stone's Current Report on Form 8-K dated April 2, 2013.Exhibit 21.1ROSETTA STONE INC. SUBSIDIARIESAs of March 3, 2014 EntityJurisdiction of IncorporationRosetta Stone Holdings Inc. DelawareRosetta Stone Brazil Holding, LLCDelawareRosetta Stone Ltd. (Formerly Fairfield & Sons Ltd., d/b/a Fairfield Language Technologies)VirginiaRosetta Stone International Inc. DelawareRosetta Stone (UK) Limited (Formerly Fairfield & Sons Limited)England and WalesRosetta Stone Japan Inc. (Formerly Rosetta World K.K.)JapanRosetta Stone GmbHGermanyRosetta Stone Korea Ltd. Republic of KoreaRosetta Stone Canada Inc. CanadaRosetta Stone Hong Kong LimitedHong KongRosetta Stone Ensino de Linguas Ltda. BrazilRosetta Stone France SASFranceLivemocha LLCDelawareLexia Learning Systems LLCDelawareTell Me More SAFranceAuralog Studios SARLFranceAuralog Inc.DelawareTell Me More GmbHGermanyAuralog SLSpainAuralog SA de CVMexicoAuralog Software Development (Beijing) Company Ltd.ChinaExhibit 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe consent to the incorporation by reference in Registration Statement Nos. 333-183148, 333-180483, 333-158828, and 333-190528 on Form S-8 andRegistration Statement No. 333-188444 on Form S-3 of our reports, dated March 3, 2014, relating to the consolidated financial statements of Rosetta Stone Inc.and subsidiaries (which report expresses an unqualified opinion and includes an explanatory paragraph regarding the Company’s change in its accountingpolicy for sales commissions related to non-cancellable Software-as-a-Service contracts), and the effectiveness of Rosetta Stone Inc. and subsidiaries' internalcontrol over financial reporting, appearing in this Annual Report on Form 10-K of Rosetta Stone Inc. and subsidiaries for the year ended December 31, 2013./s/ Deloitte & Touche LLPMcLean, VirginiaMarch 3, 2014Exhibit 24.1ROSETTA STONE INC.POWER OF ATTORNEYEach person whose signature appears below hereby constitutes and appoints Stephen M. Swad and Bruce C. Ghrist, or either of them, each with powerto 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 andstead, in any and all capacities, to sign the Annual Report on Form 10-K of Rosetta Stone Inc. (the "Company") and any or all subsequent amendments andsupplements 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 other documents inconnection therewith, with the Securities and Exchange Commission, granting unto each said attorney-in-fact and agent full power to do and perform each andevery act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, herebyqualifying and confirming all that said attorney-in-fact and agent or his substitute or substitutes may lawfully do or cause to 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 in writingspecifying 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 powerof attorney shall be revoked automatically with respect to any person whose signature appears below effective on the date he or she ceases to be a member of theBoard of Directors or an officer of the Company. Any revocation hereof shall not void or otherwise affect any acts performed by any attorney-in-fact and agentnamed herein pursuant to this power of attorney prior to the effective date of such revocation.Dated: March 3, 2014SignatureTitle /s/ STEPHEN M. SWADChief Executive Officer and DirectorStephen M. Swad(Principal Executive Officer) /s/ THOMAS M. PIERNOChief Financial OfficerThomas M. Pierno(Principal Financial Officer and Principal Accounting Officer) /s/ PATRICK W. GROSS Patrick W. GrossDirector /s/ JAMES P. BANKOFF James P. BankoffDirector /s/ JOHN T. COLEMAN John T. ColemanDirector /s/ LAURENCE FRANKLIN Laurence FranklinDirector /s/ PHILLIP A. CLOUGH Phillip A. CloughDirector /s/ MARGUERITE W. KONDRACKE Marguerite W. KondrackeDirector /s/ LAURA L. WITT Laura L. WittDirectorExhibit 31.1CERTIFICATION 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 this report;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)) andinternal 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 our supervision, toensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others 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 for external purposes inaccordance 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; andd. disclosed in this report any change in the Registrant's internal control over financial reporting that occurred during the Registrant's most recentfiscal quarter (the Registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, theRegistrant's internal control over financial reporting; and5. I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the audit committee of theRegistrant'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 are reasonablylikely to adversely affect the Registrant's ability to record, process, summarize and report financial information; andb. any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controlover financial reporting. By: /s/ STEPHEN M. SWAD Stephen M. Swad(Principal Executive Officer)Date: March 3, 2014Exhibit 31.2CERTIFICATION 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 this report;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)) andinternal 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 our supervision, toensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others 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 for external purposes inaccordance 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; andd. disclosed in this report any change in the Registrant's internal control over financial reporting that occurred during the Registrant's most recentfiscal quarter (the Registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, theRegistrant's internal control over financial reporting; and5. I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the audit committee of theRegistrant'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 are reasonablylikely to adversely affect the Registrant's ability to record, process, summarize and report financial information; andb. any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controlover financial reporting. By: /s/ THOMAS M. PIERNO Thomas M. Pierno(Principal Financial Officer)Date: March 3, 2014Exhibit 32.1CERTIFICATION OFPRINCIPAL EXECUTIVE OFFICEROF ROSETTA STONE INC.PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTEDPURSUANT TO SECTION 906 OF THESARBANES-OXLEY ACT OF 2002In connection with the accompanying Annual Report on Form 10-K for the calendar year ended December 31, 2013 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"), hereby certify,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; and2. the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company./s/ STEPHEN M. SWAD Stephen M. Swad (Principal Executive Officer)Date: March 3, 2014Exhibit 32.2CERTIFICATION OFPRINCIPAL FINANCIAL OFFICEROF ROSETTA STONE INC.PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTEDPURSUANT TO SECTION 906 OF THESARBANES-OXLEY ACT OF 2002In connection with the accompanying Annual Report on Form 10-K for the calendar year ended December 31, 2013 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"), hereby certify,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; and2. the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company./s/ THOMAS M. PIERNO Thomas M. Pierno (Principal Financial Officer)Date: March 3, 2014

Continue reading text version or see original annual report in PDF format above