Issues in film industry accounting practices

Movie Accounting

An analysis is done of the accounting methods employed in the world of glitz, glamour, fame and money in other words the movie industry to assess the increasing disparity between the techniques adopted by them to arrive at the financial statement figures as opposed to those stated in the "Generally Accepted Accounting Practices."

The standards and regulations of the accounting world have been twisted to give them an entirely different meaning in the light of movie accounting. This is majorly done by distributors and studios in order to show the failure of a particular project and their by deprive the profit participants of their lawful share as per the contractual agreement.

Applications to real life scenarios have been quoted to demonstrate how movie accounting is incorporated within the financial statements. It can be concluded that this form of accounting is not only illegal but also unethical. However studios and distributors will continue to adopt these practices as the power resides in a handful of parties who have the major say in negotiating contracts.

Introduction

It is rather surprising to hear that a movie that has done so well commercially could face a loss. However in recent times this is becoming the norm of the movie industry. Movie accounting is the process of adopting creative accounting practices for reporting profits in a manner such that expenditures are inflated and revenues are reduced their by decreasing the reported NET PROFIT and ultimately reducing the royalty and profit sharing payments.

Movie Accounting refers to accounting practices of studio/distributors that ranges from adoption of dishonest practices to making up fictitious companies that are used to transfer profits in the name of "service charges." As rightly said by John D. MacDonald's in his novel Free Fall in Crimson (1981) above movie accounting:

"Darling! This is the Industry! The really creative people are the accountants. A big studio got over half the profit, after setting breakeven at about three times the cost, taking twenty-five percent of income as an overhead charge, and taking thirty percent of income as a distribution charge, plus rental fees, and prime interest on what they advanced."

How Movie Accounting works?

Movie accounting can take various forms for example the most popular one is the formation of a special purpose subsidiary whereby the parent company transfers revenue from the subsidiary by charging service fees for various activities undertaken. Or fictitious entities are created whereby instead of showing the total revenues earned from DVDs and home rentals a transfer of revenues in form of "royalty payments" is made from one entity to another resulting in lower net profits for the profit participants.

Studios that have various production and distribution channels can manipulate the license fee among their associated entities so that profit participants receive a lesser share than the fair market value.

These schemes can range from being simplistic to complex but many of them revolve around the concept of overhead. An estimation of the studios general overheads is required in operating a studio. This amount is then charged off as an expense of the film or Television show. The studios calculate 15% of total production costs as production overheads followed by 30% of gross rentals as distribution overheads and finally 10% of advertising costs are assumed to be marketing overheads. All these are deducted from gross receipts to arrive at the final net profit figure.

All these calculations are made on an arbitrary basis and do not adequately trace overhead costs to actual activities undertaken. The extreme overestimation of overheads mean that it does not come as a surprise when only 5% of movies officially show net profit while major block buster's report losses.

The wide usage of such a method is further stressed by the fact that many actors demand to have a percentage of gross revenue as opposed to having a percentage of net revenue because there is virtually no net profit remaining once the studio and the movie makers take out their shares.

All in all, studios get millions while conveying to the profit takers that the film is a money "loser" as far as accounting is concerned.

Contrasting GAAP and Movie Accounting

The financial information presented to the users of account must adhere to certain standards and guidelines and should be a free of biasness or any inconsistency. The guidelines are stated in General Accepted Accounting Principles and every entity must adhere to them when issuing financial statements.

These include the principle of regularity or consistency, principle of non-compensation, principle of prudence, principle of continuity, principle of periodicity, representation in good faith and comparability over time and with other entities. However, movie accounting is seen to be far from the principles of GAAP and sways the numbers towards the studio and distributor.

The movie industry denies the incorporation of GAAP in studio accounting. Movie accounting is based on the negotiations that take place between different parties and are not hampered or limited by GAAP. The movie accounting is contractual based, whereby contracts have their own definitions of profit participations, gross and contingent proceeds which are very different from those defined as per GAAP.

These movie accounting practices have helped a few handful entities to gain dominance in the market. It is these practices that ultimately determine whether the producers, directors, actors, investors will get a share in the profit generated by the motion pictures.

Accounting concepts and practices applied to Movie accounting

All financial statements must be made in accordance to the guidelines issued by various accounting bodies. Each guideline includes various conditions that need to be satisfied before the accounting practice is adopted. Below is a description of how the rules of accounting have little or no value within the movie world and how movie accounting is different from our day-to-day accounting.

Bad Debt

In the accounting world, an accounts receivable that is unlikely to be recovered is generally written off in the profit and loss statement, however this is only done when there is high probability of the debtor not paying and inflow of cash is unlikely (principle of prudence). However in movie accounting the distributors themselves decide that certain amounts are uncollectible based on some objective criteria in the distribution agreement and writes them off against the revenue earned by the film thus lowering down the profit share for producers and other profit participants.

Audit

An audit is generally done of the entities financial statements in order to ensure accuracy and completeness of the records. It is can either be an internal audit or an independent audit of the firm's activities with full access given to the auditor to analyze the business activities. The auditor examines the system of internal control and the details of the books of account, including subsidiary records and supporting documents, while reviewing legality, mathematical accuracy, accountability and the application of accepted accounting principles.

However in movie accounting the audit rights are typically negotiated by the dominant bargaining partied in the distribution agreement curtailing the right of auditors to undertake a complete assessment of the studios activities. Distributors naturally want to limit audit rights by restricting when the audit may be started and conducted, limiting the purpose of the audit, restricting who may conduct the audit, requiring that copies of all reports completed by the producer's accountant be delivered to the distributor at the same point as the producer, placing restrictions on the amount of time an audit can take, permitting entity's records to be audited once, limiting the time during which objections may be made, providing that all statements by the distributor are requisite unless objected to in script within a certain period of time, forever excluding the producer or other profit participants from instituting any lawsuit unless well-timed objection is made and only allowing review of the books of the subject picture even when the picture is marketed with other pictures as a package. Distributors will also insert language which permits them to keep records in their own unique way.

Breakeven

In everyday accounting terminology breakeven is the point at which the costs of the firm are equivalent to the firm's revenue resulting in no profit or loss situation. If revenue exceeds the cost the firm shows a profit and vice versa. When applied to the movie industry this would have meant the point when the revue from the movie equals the cost of production and distribution. However it is estimated that less than 5% of the films in Hollywood breakeven. This is not because the industry faces high levels of cost or has inefficient operations but rather is due to the application of creative accounting whereby the overheads are escalated, accounts receivables are set off against profits and revenue from rentals are vastly understated. The accounting concept of breakeven holds little or no value in the world of movie accounting.

Contractually Defined Profits

In the accounting dictionary the term "profit," "gross profit" and "net profit" have statutory defined meanings and every entity must adhere to these when making up their financial statement or drawing up contracts. However, movie accounting disregards these terms to have any standard definition as an individual or a single organization does not have enough power to define such a term when negotiating contract. The definition would be determined by the contracting parties or in other words by the dominant party.

Contractual Overhead

In order for any organization to correctly analyze the cost of an activity it is now becoming increasingly necessary to apportion overheads in a manner such that cost drivers are identified for each specific activity and cost are then allocated thus avoiding arbitrary allocation of overheads. But the movie accounting seems to have no such regard for the concept and those distributor's general operating expenses that cannot be directly allocated to a specific motion picture distributed are deducted from gross receipts as distribution expenses for a specific film by authority of a provision in the distribution agreement which permits such deductions. This gives distributors an incentive to gross up their overheads to the maximum possible extent.

Direct Distribution Expense

A firm should classify only those expenses as direct expenses that are entirely contingent on the activity taking place. In other words if the activity would not have been undertaken these expenses would not have been incurred. The contribution is then calculated by deducting theses expenses from the revenue earned.

Although movie accounting does not deny this concept they continue to manipulate the direct expenses incurred in the distribution process by classifying indirect expenses as direct expenses. In most cases theses indirect expenses are not even related to a single film but rather to a number of films. Even if it is held that some of these expenses were incurred as a direct result of distributing the film it should be based on concrete information and accounting methods such as absorption on a general overhead rate. Movie accounting is seen remote from incorporating this method.

Dividend

A public entity should distribute the corporate profits or earnings to the corporations

Shareholders prorated by class of security and paid in the form of money, stock or Company products or property. The amount is decided by the board of directors and is paid quarterly or semi-annually.

Movie accountings once again is seen distant from this notion of providing adequate returns to the shareholders for providing finance and rather view the entity as a financing vehicle or as a means to use other people's money by taking the major chunk of revenues that generate from the films leaving less than a fair share to the shareholders.

Moreover, when banks lend loans they might place covenants restricting the corporation's ability to pay off dividends. The studios are seen to use the loan agreement as an excuse for not paying dividends and also using this as way to avoid an IRS tax impose on the unreasonable accumulation of retained earnings while raking in cash themselves.

Anticipated Expenses

The accounting standards emphasize the matching concept whereby the revenues in this term should match the expenses incurred and no provision for contingent expenses is to be made unless and until there is high probability of such an expenses, reasonable forecast present accompanied by the chance of outflow of cash.

This concept is often adopted by the distributors as they set aside a certain amount that will be incurred in future in connection with the picture being distributed. This is correct until the point that the provision meets the requirements. But more often than not distributors are merely interested in overstating the anticipated expenses and deducting them from the gross receipts.

Foreign Receipts

For entities that have operations abroad as well or sell items abroad are likely to deal in foreign currency. However the revenue recognition rules in the accounting books do not change as a result. Revenue is to be recognized when sale is made and if the amount remains unpaid that is to be shown in the statement of financial position under "accounts receivable"

Movie accounting twists this concept and doesn't include foreign receipts from sales of films outside the home country in the calculation of net profit unless and until they have been remitted back to the home country.

Year End Adjustments

The accounting standards have set a very strict criterion for post balance sheet date events and their adjustments. Such adjustments can only be done if at the time of drafting the balance sheets there was an existence of the happening of such an event. An event would merely be disclosed if there was no existence at the balance sheet date

However, distributors do not observe this standard and although they are only allowed to make adjustments in relation to net profit computations distributors have been noted to make whatever adjustments, as and when they please.

Corporate Governance

A term that is gaining significant importance in the today's world is corporate governance which highlights the manner in which corporations should run so that they can satisfy their stakeholders or more specifically the shareholders of the organization. The shareholders appoint the Board of Directors, who then corporate and operational decisions on shareholders behalf. It is expected that the BOD will undertake those decisions that are in the best interest of the shareholders.

The studios are mostly publicly held corporations and thus accountable to the general public. However rather than employing best practices these formerly family owned entities that have evolved into corporations have entered the market merely for the purpose of obtaining finance and employ tactics and strategies that will enable them to maintain ownership and their by control.

Fiduciary Duty

This can be defined as a person or entity having a legal duty, created by his, her or its

Undertaking, to act primarily for the benefit of another in matters connected with an Undertaking, (i.e., a person in a position of trust and confidence). As a rule of thumb fiduciary duty is created by the express terms of a written agreement. When a distributor takes certain duties of the behalf of produces the distributor is under the fiduciary duty to act in the best interest of the producer. However, cases in movie industry (also illustrated below) indicate that distributors dismiss this concept entirely.

Covenant of Good Faith and Fair Dealing

This is widely used term in corporate law pertaining to contracts whereby a contractual agreement between two parties automatically binds them to deal with each other in good faith and honesty, to observe reasonable commercial standards of fair dealing in trade and not to deny the reality of contractual terms. Breach of this covenant by either party can result in other party demanding lawsuit.

Breach of this particular covenant is common in the movie industry but lawsuits for such a breech remain uncommon due to fear of economic reprisal. However in recent times many parties that have been unfairly treated are heading towards the courts and not surprisingly the jury sympathizes with these parties granting them damages.

Application of Movie accounting in real life

The above mentioned techniques and how they apply in the movie industry is illustrated below in various examples. Whatever the techniques maybe, the result is the same that is to convert a profitable film into a loss making one.

An example of movie accounting is seen in "Harry Potter and the Order of the Phoenix" however $167. This is rather mind blogging to not only the general public but also the jury to which the case was taken to. An analysis would reveal how movie accounting was incorporated into the entity's financial statement.

In the above financial statement three points (as highlighted) are of considerable importance. The distribution fee of $212 million dollars and advertising fee of $130 million is Warner Bros paying itself or paying its own properties while the $57 million in interest payments is also a payment to the entity only for financing the film. While some of these expenses might actually have been incurred it is pretty difficult to accept that all of them reflect factual expenses. This could mean only one thing, the company uses the over exaggerated expenses to deflate the profit figure resulting in the company showing huge losses despite the movie being a commercial success.