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Business Readings
By Ross Bengei and Bruce Ikawa Reprinted with permission of the Institute of Management Accountants, from Management Accounting, December 1997; permission conveyed through Copyright Clearance Center, Inc. What do Rain Man, Batman, and Who Framed Roger Rabbit? have in common? At the box office, all three are among the 40 most successful films of all time, but each as remained in the red for those performers, writers, and other filmmakers whose contracts provide a share in the film’s net profits. And these three films are not unique in this respect. Fewer than 5% of released films show a profit for net profit participation purposes.1 Accounting for net profit participations achieved notoriety in Buchwald v. Paramount Pictures Corp. This case disclosed that the movie Coming to America, which grossed more than $350 million, showed an $18 million loss for participation contracts. More recently, Winston Groom, author of the novel Forrest Gump, sued Paramount. Groom’s contract called for him to receive 3% of net profits, but Paramount claims that Gump, with the third-highest gross in film history, has yet to show any profits.2 What’s going on? Film industry profit participations began with a 1950 agreement between Jimmy Stewart and the financially strapped Universal Studios during the making of Winchester 73. In that arrangement, Stewart gave up his customary $250,000 up-front fee for a share of the film’s profits. Because Stewart would receive nothing for an unsuccessful film, he shared the film’s risk. Although contingent compensation became quite common in Hollywood, subsequent contracts evolved away from this sort of pure risk-sharing arrangement. Creative talent has preferred more of its compensation up front, and studios have, by altering accounting provisions, reduced the contingent payment’s value. Private contracts do not have to follow generally accepted accounting principles or any other prescribed accounting rules. In many ways, the accounting issues involved in computing a film’s profit for participation purposes parallel the issues management accountants face in evaluating divisional or segment performance. Participation contracts, however, resolve these issues quite differently. While today’s contracts vary according to studio and participant, the accounting provisions defining net profit show a great deal of consistency.3 Defining Net Profit Generally, net profit for participation purposes is defined as the film’s gross receipts less distribution fees, certain distribution expenses, film production cost called negative cost, interest on unrecovered negative cost, and payouts to any gross profit participants. (See Figure 1.) Gross receipts represent the film’s total revenues. Sources include theater and other film rentals; television rentals including pay-per-view, cable, network, and syndication sales; videocassette sales; and miscellaneous revenues as, for example, those from merchandising and music. Theater film rentals are not the well-publicized "box office receipts" regularly reported by the media. They are, rather, the studio’s share of these receipts, approximately 45% of gross box office.4 There are four major areas of controversy in defining gross receipts for participation purposes:
Advances. The studio often receives from theaters advance payments that are not credited to the participation statement until the film is exhibited, even if the advances are nonreturnable. This deferral, although consistent with accrual basis accounting, results in higher interest charges to the participant because it delays recoupment of the film’s unrecovered cost, on which interest is calculated. At the same time, the studio has use of the advances and any earnings the advances generate. Allocations. When the studio sells more than one film as a package, such as to a television network, the package price must be allocated among the individual films. Similar problems may exist for revenues from double features. In conventional accounting, the cost of such a "basket purchase" might be allocated based on the relative fair market values of the assets sold. Studios have an incentive to allocate a greater share to those films without net profit participations. In addition, participation contracts sometimes entitle the studio to allocate a small portion of foreign gross receipts to "trailers," which are one- to three-minute advertisements previewing upcoming films. Videocassette sales. Videocassettes account for an important share of a film’s total revenues. Usually they are sold by a studio subsidiary to video outlets or other retailers. Participation statements handle these sales in one of two ways. The method that favors the participant includes videocassette sales in gross receipts and treats the cost of goods sold as a distribution expense. More often, however, gross receipts include only a royalty, commonly 20% of gross receipts. The remaining 80% of sales revenue is excluded from gross receipts, and the cost of producing the tape is not charged to participant expenses. In this way, participation profit can exclude a substantial portion of gross profit from videocassette sales. (See "Accounting for Videocassette Sales," p. #.) Because the videocassette distributor normally is the studio’s subsidiary, the royalty method may allow the studio to reduce participant income through other than arm’s-length pricing. Distribution Fees After a film is produced, it is distributed. To compute a film’s net profit for participation purposes, the studio charges a fee for its distribution overhead, calculated by applying a percentage to gross receipts after certain adjustments. For instance, fees on domestic film distribution usually are 30% of gross rentals. If a film grosses $100 million at the box office and the studio collects $45 million from theaters, the net profit participation statement would include $45 million in gross receipts and a variable distribution fee expense of $13.5 million ($45 million 3 30%). Distribution fees are charged on all sources of revenue including film rentals, television rentals, videocassette sales, and ancillary rights. The percentage varies by market and the type of revenue involved. Foreign film distribution fees range from 30% to 40%. Fees may be 25%–35% for U.S. network television sales and 30%–35% for syndicated television sales. Foreign television distribution fees usually are 30–40%.5 Distribution fees for some ancillary rights, such as merchandising, may be as high as 50%. Distribution fees may be the most controversial aspect of participation contracts. As noted earlier, the problems in determining the profits of an individual film, are, in some ways, analogous to those management accountants face in trying to determine divisional results for performance evaluation. Most management accountants (and tax authorities) would argue that, in the ideal situation, interdepartmental transactions (such as the distribution fee) should be transfer-priced at market, which, in the absence of arm’s-length prices, could be approximated by cost-plus. In the film industry, participants in net profits argue that the distribution fee is both arbitrary and excessive in its relation to cost. From a cost recovery standpoint, the distribution fee covers the studio’s overhead associated with distributing the film because direct distribution expenses are recovered separately. As it is unlikely that this overhead increases in direct proportion to increases in a film’s gross receipts, successful films are likely to be "overcharged," while unsuccessful films may be "undercharged." Certainly the overhead allocations obtained through this arbitrary percentage are much different from the ones that would be produced by activity-based costing or by other methods more directly relating overhead allocated to actual overhead incurrence. Participants also complain that the implied profit on distribution is excessive because the total of the distribution fees charged to individual films far exceeds a studio’s actual overhead. For example, plaintiffs in Buchwald argued that the distribution fee charged Coming to America "more than covered the cost of Paramount’s worldwide distribution network for an entire year and made the $63 million in distribution fees the studios collected on its other 1987 releases pure profit.6 There are other controversies. Distribution fees also are charged when a studio uses a subdistributor, such as for foreign markets. The studio includes the amount received from the subdistributor in gross receipts and may subject it to the distribution fee. Participants view this procedure as double billing because, in effect, both the subdistributor and the studio are charging a distribution fee. The distribution fee also may apply to royalties from a subsidiary selling videocassettes, further reducing videocassettes revenue to the participant. (See "Videocassette Sales and Distribution Fee," page #.) Direct Distribution Expenses Direct distribution expenses include a variety of costs associated with preparing a film for distribution and then distributing it. The largest expense usually is advertising. Some of the other distribution expenses include costs incurred in preparing copies of the film for individual theaters, dubbing, subtitling and re-editing foreign versions, shipping, copyrighting, insurance, litigation, trade association fees, guild payments, royalties, verifying the accuracy of box office receipts, collection, and taxes. Participants question the advertising expense because it usually carries a 10% overhead charge assessed on the amount of advertising dollars spent. Theoretically, its purpose is to recoup the overhead incurred by the studio’s advertising and publicity departments. As with the distribution fee, the assumption is that the studio’s overhead expenses increase in direct proportion to increases in advertising. But they usually don’t, and the advertising overhead charge can be considerably more than actual expenses. Studios usually don’t pass along volume and quantity discounts to the participants. For example, in accounting for print costs, the studio may charge a higher amount for prints than what it actually paid. The studio reasons that the volume discount results from total amount of business done with the vendor—not simply because of one film.7 In addition, foreign taxes may be treated as a distribution expense even though the studio gets a foreign tax credit for these taxes on its federal income tax return. Negative Cost Negative cost refers to the cost of producing the film up to the creation of the film’s final negative. It includes the cost of personnel (in front of and behind the camera), film stock, equipment rental, costumes, and other production expenses. Costs incurred after the final negative usually are considered distribution expenses. In addition to the direct cost of producing the film, negative cost includes another studio assessment. Typically, a studio will charge the participant 15% of production costs. Like other studio overhead fees, the production charge may have little relation to the studio’s actual expense. Not all services provided by the studio are covered by the overhead fee, which allows the studio to charge separately for certain services and facilities. The line between negative costs and distribution costs is not always clear. If classification is debatable, the studio would prefer to treat the cost as a negative cost, allowing imposition of the 15% production overhead charge. Negative costs also are subject to interest charges, which distribution expenses avoid. Interest Interest generates considerable controversy. The interest expense charged to participants does not necessarily relate to the cost of outside financing. Rather, it is an amount imputed by the studio by multiplying a rate, often 125% of commercial prime, times unrecovered negative cost. (See Figure 2.) In determining unrecovered negative cost, gross receipts are not offset against the negative cost until all other expenses, including distribution fees, distribution expenses, and the interest itself, are recovered. Thus, interest usually continues to accrue on total production cost until the film breaks even for participation purposes. Interest usually begins accruing when expenses are incurred, not when paid. Receipts are not offset against negative cost until the end of the period in which interest is both earned and received. In other words, the studio accelerates the start of interest calculation using accrual accounting, but it delays the stopping point beyond cash collection until the end of the accounting period. Gross Participations Big name stars, producers, directors, and other participants with greater bargaining power sometimes can negotiate gross participation arrangements. They, like net profit participations, are a form of contingent compensation. The gross participant’s share of profits usually is based on gross revenues less certain adjustments. Because gross participations represent an additional expense, they delay the arrival of net profits for net profit participants. In addition, gross participations are treated as negative costs, accruing interest and overhead charges. The different types of gross participation deals vary in two significant ways. First, many bases are used to calculate the gross participant’s share. Nearly all arrangements reduce gross receipts by certain enumerated expenses. The fewer these expenses, the better the deal for the participant. Second, gross participation arrangements also may differ as to when the participant begins to share in profits. For example, that point may be defined as a certain multiple of negative cost or a separately defined break-even point. As an artist becomes more successful, he or she may move from no participation to net profit participation to a succession of improving gross profit participation arrangements. Illustrations At one Academy Awards ceremony, Billy Crystal jibed participation contracts by asking why Warner Brothers was preparing a Batman sequel when the original didn’t make any money. Many management accountants have faced similar questions in different settings. Costs and revenues relevant to one purpose may not apply to another. For example, the relevant costs of a product used to determine whether to produce it can differ significantly from the full absorption cost required for inventory valuation under GAAP. Because of these differences, it is interesting to compare a film’s profit computed under a participation agreement to its profit based on its incremental contribution to the studio. Consider the profit participation statement for Warner’s 1987 Police Academy 4 summarized in Table 1. The film appears to be a failure. Certainly, there seems little reason to produce a Police Academy 5, let alone a Police Academy 6 or a Police Academy 7. Management accountants evaluating this decision might, however, modify these figures to isolate relevant costs, which would be those costs incremental to the film. Allocated corporate costs, such as the distribution fee and overhead charges for production and advertising, should not be included. While these charges may cover certain expenses traceable directly to Police Academy 4, they are, for the most part, allocated costs. Although there may have been incremental interest associated with making the film, the interest charged represents an imputed cost. Finally, accounts receivable are, under accrual basis accounting, considered earned. Adding back these items we have:
Police Academy 4 now appears to be an economic success, justifying Police Academy 5 in 1988, Police Academy 6 in 1989, and Police Academy 7 in 1994. That these two concepts of "income" differ, in no way indicates that either is inappropriate. Nonetheless, it should be clear why accounting in profit participation statements can lead to misunderstandings. Buchwald v. Paramount and Recent Cases Buchwald was the first court case to deal substantively with net profit participation accounting. The case dealt with columnist Art Buchwald and producer Alain Bernheim’s contract with Paramount Studios. The court determined that Buchwald’s story idea eventually was developed into the hit film Coming to America. As a result, Buchwald was entitled to a share of the profits. Accounting issues became relevant when Paramount claimed that the film lost $18 million for participation purposes even though the film generated more than $235 million in gross receipts to the studio. The court found that the net profit participation contract Buchwald had signed was a contract of adhesion and that some of the accounting provisions were unconscionable. The court struck the overhead charges of 15% on negative cost and 10% on advertising as not proportional to cost. The court did not address the most significant overhead charge—the studio distribution fee. In addition, the court found unconscionable some aspects of calculating interest, including: the practice of first offsetting gross receipts against the distribution fee instead of negative cost, the inclusion of accrued gross participations in negative cost, and the use of an inflated interest rate. The trial court decision in Buchwald was appealed, but the case was settled before the appellate court rendered a decision. The trial court decision has not precedential value. The Buchwald decision is controversial. Legal experts question whether the courts should "rewrite" a negotiated contract. At least one court agrees. In a subsequent case brought by the executive producers of Batman, the trial court upheld a similar net profit participation contract. In a recent suit, attorneys for the estate of former New Orleans District Attorney Jim Garrison have sued Warner Brothers, producers of the movie JFK, which was based on Garrison’s book On the Trail of the Assassins. The suit, brought in federal court, charges that because the studios have virtually identical, nonnegotiable net profit participation contracts, they have committed antitrust violations. A Missed Opportunity? In recent years, businesses increasingly have turned to variable pay plans that tie a portion of an employee’s compensation to the success of the enterprise. These plans include performance, productivity, and incentive bonuses; gainsharing; and other types of profit sharing. During this same period, the role of net profit participations in Hollywood compensation arrangements has decreased. Artistic personnel blame studio attorneys and accountants for "creative accounting" that expands a film’s expenses while reducing revenues. Studio representatives charge that current net profit participation schemes result from pressure by creative personnel and their agents to obtain greater up-front compensation. They argue that with little or no risk sharing there should be little or no revenue sharing. Regardless of who is to blame, both studios and participants might benefit from more meaningful participation arrangements. Incentive concepts have become a key element in designing compensation packages. These arrangements can improve performance, especially on short-term projects like film production. Incentives are most effective when an employee risks a significant portion of customary compensation for the possibility of a greater performance related reward. Employees must, however, understand the plan and perceive it as fair. In net profit participations, these objectives might be overcome by using more commonly accepted accounting practices. There may be no industry that spends more money than the film industry negotiating incentive provisions and auditing for compliance with those provisions. At the same time, there probably is no other industry where profit-sharing participants are so dissatisfied with the results and so distrustful of industry accountants. Discussion Questions
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