Net Profits
AFP via Getty Images Some people assume that there is one monolithic standard for calculating “net profits” for all purposes. When they hear that a film company has reported a certain amount of net profits for one purpose, they assume that the reported net profits apply for all purposes. This assumption is the genesis of many misconceptions, such as that film companies must be lying or “cooking the books” when they report inconsistent numbers for different purposes. The truth is that film companies are permitted or required to calculate net profits differently for different purposes. This article briefly summarizes the major differences in the calculations for each purpose.
Accounting Reports. Accounting reports are for purposes of showing lenders and shareholders the supposed financial condition of the company, usually applying „generally accepted accounting principles“ („GAAP“). I write „supposed“ because the rules are highly artificial and easy to manipulate. The goal of film companies in applying GAAP is to report net profits as high as possible to impress shareholders and lenders. This is achieved in several ways. First, and most importantly, many items are “capitalized,” which means that the costs are not immediately deducted but are, instead, added to the cost of films. Capitalizing costs has two salutary benefits: First, it decreases current deductions, thereby increasing reported earnings. Second, it increases film costs reported as an asset on the balance sheet. GAAP rules for film companies permit the capitalization of development costs, production costs, interest on production costs, payments of participations to third parties, and a portion of the company’s overhead.
Another way to maximize reported earnings is to accelerate the date that income is reported. This is achieved by permitting film companies to report the present value of all payments to be made under a license as income as soon as the “availability date” has occurred, which is the date that the licensee can exploit the first showing or broadcast of the film under the license. This allows film companies to report income years before it is received. For example, if a film company enters into a ten-year license that provides for payments of $1 million per year, the film company will report the present value of the total payments of $10 million as current income upon entering into the license. This is contrary to the rule applicable to most industries; if the same transaction had involved the lease of real property, the annual payments would be reported as income each year, instead of being all reported as income in the first year.
Another key to maximizing reported earnings is to deduct film costs as slowly as possible. This is achieved by deducting film costs based on estimated future income during the first ten years from release of the film (or during the first twenty years from the date of acquisition, in the case of the acquisition of an existing film library). By maximizing the estimate of future income, film companies can defer writing off film costs as long as possible because they are required to match the deduction of film costs with the receipt of income. The estimate of future income is made by management, who are under an irresistible impulse to make the estimate as high as possible in order to defer deductions as long as possible.
Tax. For tax purposes, the goal is to report net profits as low as possible. For tax purposes, film companies do not follow the GAAP rule of recognizing all the future income under a license on the “availability date.” Rather, for tax purposes the income is reported each year when it is payable. Further, while the goal under GAAP is to defer the deduction of film costs by over-estimating future income, the goal for tax purposes is to under-estimate future income, as this will accelerate deductions, and there is no requirement that the two estimates match. To prevent film companies from under-estimating future income for tax purposes, they are required to include in their estimates all income for the first 11 years from the date the films are released, with a retroactive interest charge added to the film company’s tax liability if the estimates prove too low in practice.
Participations. As with calculating net profits for tax purposes, the goal of calculating net profits for purposes of paying profit participants is to report net profits as low as possible. The calculation of net profits for purposes of paying profit participants is entirely a contractual animal, although these contracts tend to follow a standard industry pattern.
With respect to gross receipts, the goal is to report as little and as late as possible. This might be achieved by contractual definitions permitting generous reserves, exclusions, and allocations. For example, a film company may receive a large cash advance from a television network for the right to show a film several times over a three-year period to commence in two years. The advance might not be reported until the end of the two-year waiting period, and even then, it might be reported over the term of the three year license. It is common to sell or license films in packages, and it is common to allocate gross receipts away from the winning films to the turkey films, for which no participations will be payable. Further, certain sources of income, such as theme parks, are simply excluded entirely from being included in gross receipts.
The goal with respect to distribution expenses is to report as early and as much as possible. This might be achieved by several means, including high internal fees, early accrual of expenses, payments to affiliates, overhead allocations, and deemed interest. Film companies also take a huge slice of gross receipts off the top as their distribution fee.
Dividends. The final calculation of net profits relates to how much cash is distributed to equity holders, such as shareholders, in the form of dividends or similar distributions. This calculation is more complex than the others because it is a function of three variables.
The first variable is the amount of actual cash on hand (net of reserves for expenses, debts, and the like), as most distributions are made in cash.
The next variable is contractual—namely, the provisions of the governing corporate documents, such as the articles and bylaws for a corporation and the operating agreement for a limited liability company. These governing documents will usually have provisions dealing with distributions, ranging all the way from requiring a minimum specified level of distributions each year all the way to granting management unbridled discretion to reinvest net profits in other businesses.
The third variable is statutory: Most states have statutes that prohibit distributions while an entity is “insolvent” (defined differently by various states.) These statutes serve as a ceiling on the amount of any permissible distributions.
Conclusion. The consequence of all this is that, as Humpty Dumpty said in Through the Looking Glass by Lewis Carroll, “When I use a word, it means just what I say it means.” When the words “net profits” are bantered about, ask for what purpose it is being calculated. By knowing the purpose, you will know the biases inherent in the calculation and can take the proffered number with the appropriate grain of salt.