Accounting for Films (#249)
/In this podcast episode, we discuss the accounting for films. Key points made are noted below.
Film Production Costs
The main issue with films is what happens to the production cost. For example, a studio pays an author for the rights to a book or a screenplay, which it can then adapt into a movie. For example, Amazon recently paid $250 million to the Tolkien estate to bring a Lord of the Rings prequel to television.
The cost of the film rights is capitalized. And so is the cost to adapt the story into a screenplay. And then, the actual cost to produce the film is capitalized. That includes the cost of the actors, the construction crew that builds the sets, the camera crew, and so on.
So, what about a situation where a scene has to be reshot? For a recent example, you might remember the film All the Money in the World, which was about the kidnapping of J. Paul Getty III. Kevin Spacey played the role of J. Paul Getty, but because of sexual misconduct allegations, Christopher Plummer was brought in as a replacement just a month before the film was scheduled for release. The reshoot reportedly cost somewhere between $6 million and $10 million. That cost would have been capitalized.
So let’s say you’ve completed the production work, and you’ve accumulated all of these costs into an asset. Now what? Then the amortization begins, where you charge the asset to expense over a period of time. They use quite a unique method, called the individual film forecast computation method. The calculation of the amortization rate is to divide current period actual revenue by the estimated remaining ultimate revenue as of the beginning of the year.
Ultimate Revenue
So I’ll stop here and go over a few items. First, what is ultimate revenue? Sounds like a video game, but it’s actually the estimated total revenue expected to be generated from a film, from all sources – which includes things like exhibition fees, sales of spin-off products, and foreign licensing. The estimation period usually runs for 10 years from the film release date.
Second item – let’s assume that the ultimate revenue figure is a perfectly accurate estimate. If that’s the case, then the amortization charge essentially matches the revenue that’s been generated in the current period. So, if actual revenues in the period turn out to be 40% of the total amount expected, then you amortize 40% of the production cost of the film. This sounds great, since there’s good matching of revenues to expenses, and the profit percentage should be the same in every period.
There’s just one problem, which is my third point. What if the ultimate revenue figure is wrong? Which usually means that the movie bombed. For example, if you do a search on biggest movie failures, you’ll find that the movie John Carter may have lost as much as $213,000,000, and the loss on the Lone Ranger may have been as high as $200,000,000. Those two are just the largest – there are several dozen movies that have lost at least $100 million – each.
So, let’s say that a movie has gone in and out of the theaters, and a cheap licensing deal with Netflix is the only remaining option. In that case, the ultimate revenue figure is revised downward – a lot. Since most of the revenue has already been earned at this point, the next amortization calculation is pretty much going to require that the rest of the production cost be written off right away. This is essentially the same as an impairment calculation, but the method used to get there is a bit different.
Asset Impairment
Which doesn’t mean that a production company doesn’t have an asset impairment process. They do, though the criteria for judging whether a film asset may be impaired are a bit different. For example, indicators of impairment for a film include things like production delays, a change in the roll out plans to a smaller number of theaters, and not having enough funding to complete a film.
Of course, that’s just to decide whether an actual impairment test should be conducted. The actual impairment test involves making estimates of its discounted cash flows, which are based on some pretty unusual metrics. For example, cash flow projections can be based on the public perception of the underlying story – or, the historical results of the people involved with the film – or, the run time of the film. I assume that a shorter run time is better, but that’s a guess.
In the end, though, no matter how the loss is calculated, a production company has a fairly high risk of taking a bath on each film it produces, so impairment testing is a big deal in the film industry.
A different form of asset write-off occurs when work is begun on a film, but it’s never released. In this case, the production company has three years to either get the project ready for production, or write it off. A good example would be acquiring the film rights to a book, and then deciding that the movie is too difficult to produce. In that case, the studio can sit on the acquisition cost for three years, and then has to write it off. Or, it could sell the film rights to someone else, and use the proceeds to reduce the amount of its write-off.
The Television Series Asset
But that’s just films. What about a television series? The cost of multiple seasons of a television series are rolled up into one big asset, and then amortized by comparing actual revenue to the ultimate revenue figure for all of the produced seasons of the show.
And what if the producer doesn’t directly make any money from airing a particular television series, or film? For example, HBO doesn’t accept advertising, so it can’t tie revenues to specific shows, like Game of Thrones. In this case, they just have to make estimates of how much to amortize as a film or series is exhibited – which is weak, but what else can they do?
Here’s another issue. Let’s say a major actor negotiates compensation that’s a percentage of the gross revenues generated by a movie, which is what Robert Downey Jr. does in his Ironman and Avenger movies. This participation cost is accrued over time, starting with the release of the film, and is charged to expense at the same time as the related revenue is recognized. Again, this means that the film generates a fairly consistent profit percentage.
The Overall Deal
And here’s another accounting issue that’s quite unique to the film industry – the overall deal – which is an arrangement under which a studio pays compensation to a producer in exchange for the use of that person’s creative talents. Under this arrangement, anything developed by the producer stays within the studio. For example, Ryan Murphy just signed an overall deal with Netflix for somewhere between $250 and $300 million dollars over a five-year period.
The main point is how do they account for these payments? If part of the cost can be associated with a specific film project, then it’s accumulated into the capitalized cost of that film. When there’s no way to do that, the remaining cost is charged to expense.
Exploitation Costs
But we’re still not done. Then there’re exploitation costs. This sounds vaguely illegal, but it just means the cost to distribute and promote a film, like advertising and promotions. These items are charged to expense as incurred. Since they’re basically sales and marketing costs, that’s not unexpected.
The Accountant Movie
And a final point, the movie The Accountant was released in 2016. The production budget was $44 million, and its worldwide revenue was $155 million. Which just proves that being an accountant can be profitable. Though, to be fair, the movie was really about a hit man. Which is not what most of us do.