content_image/263839.jpg content_image/263837.jpg
The cost reductions we implemented in 2009 were offset by a total of $9.5 million of operating expense for two separate matters. First, we recorded a $6.1 million operating expense related to adjusting the tax treatment of certain stock options that were originally considered incentive stock options (ISOs). In 1998, 1999, and 2000, we granted ISOs to many employees. Upon exercise, ISOs typically have a favorable tax treatment for the employee relative to the tax treatment for non-qualified stock options (NQSOs). In 2009, we determined that certain ISOs granted to one former and two current executives should have been treated as NQSOs for the executives’ and our income tax purposes. As a result, Morningstar paid these individuals a total of $4.9 million to compensate for the difference in tax treatment. We also recorded $1.2 million, primar- ily for potential penalties related to this matter. This $6.1 million expense is included in our operating expense as a general and administrative expense. 

Second, we recorded an operating expense of $3.4 million for pen- alties related to the timing of deposits for taxes withheld on stock- option exercises. The expense impacted each of our operating expense categories, with approximately half recorded as general and administrative expense. For some companies, including Morningstar, it is common practice for taxes withheld on stock-based compensation to be paid with the company’s regularly scheduled payroll deposit. This approach, however, does not technically com- ply with Internal Revenue Service (IRS) guidelines concerning depos- its of taxes withheld in connection with stock-based compensation, which generally require that if a company’s cumulative deposit liability for all compensation exceeds $100,000, the tax withholding must be deposited by the following business day. Transactions related to stock-based compensation frequently cause companies to exceed this threshold outside of their regularly scheduled payroll cycles, thus triggering the accelerated deposit rules. The subject of tax deposit penalties was part of an IRS audit that began in 2009 and concluded in early 2010. We have concluded the matter with the IRS and have increased the frequency of deposits for taxes withheld on stock-option exercises. 

Operating expense in 2009 also included additional rent expense of $3.2 million to increase a liability related to vacant office space, primarily for the former Ibbotson headquarters. We increased the liability because we anticipated receiving lower sublease income and expected it would take more time than previously estimated to identify a tenant. 

Despite significant reductions to bonus expense, operating expense as a percentage of revenue increased 1.6 percentage points in 2009, mainly driven by the $9.5 million of incremental operating expense described above and other expense increases. 

## Cost of Goods Sold 

<img src='content_image/263839.jpg'>

Cost of goods sold is our largest category of operating expense, accounting for more than one-third of our total operating expense over the past three years. Our business relies heavily on human capital, and cost of goods sold includes the compensation expense for employees who produce our products and services. 

Cost of goods sold rose $28.5 million in 2010 after declining $1.5 million in 2009. Approximately 60% of the increase in 2010 was related to recent acquisitions. Higher salaries, bonus expense, and other compensation-related expense also contributed to the increase. The majority of the decline in 2009 was driven by lower bonus expense and lower fulfillment expense, partially offset by incremen- tal costs from acquisitions. 

Gross margin declined by about 1.4 and 1.0 percentage points in 2010 and 2009, respectively. 

## Development Expense 

<img src='content_image/263837.jpg'>

