Accounting Changes for the Film Industry

By Marc H. Levine and Joel G. Siegel

In Brief

Refined Rules for Reporting and Disclosure

The AICPA’s effort to provide more comprehensive accounting guidelines for films resulted in Statement of Position (SOP) 00-2, Accounting by Producers or Distributors of Films. SOP 00-2 presents new accounting, reporting, and disclosure requirements for the motion picture industry, aimed at codifying the practice of timing revenue recognition, classifying film costs, and estimating future performance. In June 2000, FASB issued SFAS 139, which rescinded SFAS 53, Financial Reporting by Producers and Distributors of Motion Picture Films, and amended several other statements in order to incorporate the guidance in SOP 00-2. SFAS 139 became effective on December 15, 2000. The authors detail the statement’s requirements for revenue recognition, cost and expense reporting, and disclosures.

An entity may license films to customers such as distributors, theaters, exhibitors, or other licensees on either an exclusive or nonexclusive basis in a particular market or territory. The license fee may be fixed (flat fee) or may be based on a percentage of a revenue (variable fee). A variable fee arrangement may include a nonrefundable guarantee paid in advance or over the license period.

Revenue Recognition

Revenue from the sale or licensing of a film should be recognized only when all five of the following conditions are met:

• Persuasive evidence of a sale or licensing arrangement with a customer exists.
• The film is complete and has been delivered or is available for immediate and unconditional delivery (in accordance with the terms of the arrangement).
• The license period has begun and the customer can begin its exploitation, exhibition, or sale.
• The fee is fixed or determinable.
• Collection of the fee is reasonably assured.

If a receivable is recognized on the accounting records of an entity for advances presently due or cash payments are received prior to revenue recognition, the entity should also recognize an equivalent liability for deferred revenue until it can be recognized. If that receivable is transferred to a third party, the liability for deferred revenue should not be reduced and the revenue should not be recognized until all five conditions are met.

Persuasive evidence of an arrangement. Persuasive evidence of an arrangement is generally provided only by a contract or other enforceable document that indicates the license period, the film or films, the rights to be transferred, and the consideration to be exchanged. If these factors raise doubts as to the obligation or ability of either party to fulfill the arrangement, revenue should not be recognized. The persuasive evidence (e.g., a written contract, purchase order, online authorization) should document the contract arrangements and clearly show that there is a mutual agreement between the entity and the customer or that the customer’s actions are in accordance with such an agreement.

Delivery. Physical delivery is required in order to recognize revenue, unless the licensing agreement contains terms to the contrary. Some licensing agreements do not require the delivery of the film to the customer. In such a case, if the arrangement gives the customer immediate and unconditional access to the film or authorization to make the film immediately and unconditionally available for the customer’s use, the delivery condition is considered met. If the licensing agreement requires that the entity make significant changes to a film after its initial availability, the delivery condition is not deemed to be met. Significant changes are those considered to be additions of new or additional content to the film, such as reshooting a scene or adding special effects. These costs should be added to the film costs and charged to expense when the entity recognizes the related revenue. Insignificant changes include the insertion of preexisting film footage, addition of subtitles to existing footage, removal of offensive language, reformatting of the film, and adjustments to allow for the insertions of commercials. These changes should be accrued and expensed if the entity begins to recognize revenue from the agreement before incurring such costs.

Availability. Some arrangements in a given contract will restrict a customer from initiating its exploitation, exhibition, or sale of given film until some future point in time. Revenue should not be recognized until such restrictions lapse or expire.

Fixed or determinable fee. If a single-film arrangement provides that an entity will receive a flat fee, then that entire fee (considered fixed and determinable) should be recognized as revenue. If a multiple-film arrangement exists (including films not yet produced or completed), then the entity should allocate the fixed or determinable fee to each individual film by market or territory based on the relative fair value of the rights to exploit each film under the licensing arrangement. Allocations to a film or films not yet produced or completed should be based on the amounts refundable to the customer if the entity does not ultimately complete and deliver the films. The remaining flat fee should be allocated to the completed films based on their relative fair values.

Once an allocation is made, it should not be adjusted later. If relative fair values cannot be ascertained, then the fee is not fixed or determinable and the entity should not recognize revenue until such a determination can be made. In determining the fair value of the rights to exploit an individual film within a multiple film arrangement, an entity should use the best information available with the objective of determining the amount it would have received had it entered into a license agreement for the same rights to the individual film alone.

Variable fee. If the entity’s fee arrangement is predicated on a percentage or share of customer’s revenue from the exhibition or other exploitation of a film, then revenue recognition should be based on meeting the conditions of revenue recognition previously noted as the customer exhibits or exploits the film.

Nonrefundable minimum guarantees. In licensing arrangements that have a variable fee structure, a customer may guarantee to pay an entity a nonrefundable minimum amount that is to be applied against variable fees on a non-cross-collateralized group of films. In this case, the nonrefundable minimum guarantee satisfies the fixed and determinable criteria and should be recognized as revenue.

On the other hand, if the nonrefundable minimum amount is applied against variable fees from a group of films on a cross-collateralized basis, the amount of the minimum guarantee applicable to each film cannot be objectively determined, and revenue recognition during the license period should be recognized only when all revenue recognition conditions are satisfied. If at the end of the license period, a portion of the nonrefundable minimum guarantee remains unearned, an entity should recognize it as revenue by allocating it to each film based on the film’s relative performance.

Barter revenue. If a licensing agreement with a television station provides programming in exchange for advertising, the transaction is treated as nonmonetary. The transaction should be accounted for in accordance with APB 29, Accounting for Nonmonetary Exchanges, as interpreted by EITF 93-11, Accounting for Barter Transactions Involving Barter Credits.

Returns and price concessions. If the contract arrangement between the customer and the entity includes a right-of-return provision or if the entity’s past practices allow for such a procedure, then revenue must meet all the conditions of SFAS 48, Revenue Recognition when Right of Return Exists, in order to be recognized. For example, in the home video business, customers are frequently granted price protection on previously purchased and unsold products if the entity reduces its wholesale prices. At the date of revenue recognition, the entity is required to account for the possibility of price reductions. If future price concessions cannot be reasonably and reliably estimated, the revenue is not considered fixed and determinable. The entity should not recognize revenue until it can make reasonable and reliable estimates of future price changes.

Licensing of film-related products. An entity should only recognize revenue from licensing arrangements of film-related products after the film’s release.

Present value. The amount of revenue recognized under a licensing agreement should equal the present value of the licensing fee as of the date that the entity first recognizes the revenue (as required by APB 21, Interest on Receivables and Payables).

Costs and Expenses

The costs of producing a film and bringing it to market are categorized as: participation costs, exploitation costs, and manufacturing costs.

Capitalization of film costs. Film costs include all direct costs incurred in the physical production of a film, such as the costs of story and scenario (film rights to books, stage plays, or original screenplays); compensation of cast, directors, producers, and extras; costs of set construction, operations, and wardrobe; costs of sound synchronization; costs of rental facilities on location; and postproduction costs (music, special effects, and editing). They also include allocations of production overhead and capitalized interest costs (under SFAS 34, Capitalization of Interest Cost).

Production overhead consists of the costs of the individuals and departments that have a significant (or exclusive) responsibility for the production of the film. These costs should not include administrative and general expenses and the costs of certain “overall deals.” In overall deals, a producer is compensated for creative services. If the costs of overall deals cannot be associated with specific projects, then they should be expensed as incurred. In general, an entity should record a reasonable proportion of costs of overall deals as specific project film costs to the extent that these costs are directly related to their acquisition, adaptation, or development.

The cost of adaptation or development should also be added to the cost of a particular property. The entity should periodically review properties in development. If it is determined that a property in development will be disposed of, the entity should recognize a loss on these costs by charging them to the current period income statement. There is a presumption of disposal if the property has not been scheduled for production within three years of the first capitalized transaction. The loss is calculated as the excess of the carrying amount of the project over its realizable value. Amounts that have been written off should not be recapitalized. The costs of producing a film and bringing it to market should be reported as separate assets on the entity’s balance sheet.

Revenue for a television series generally includes estimates from initial and secondary markets. The initial market is the first market of exploitation in each territory, such as a broadcast network, cable television, or first-run syndication. Until an entity can establish estimates of secondary market revenue, the capitalized costs for each episode should not exceed the revenue contracted for that episode. Any costs incurred that exceed this limitation on an episode-by-episode basis should be expensed, not capitalized. As an entity recognizes revenue for each television episode, the related capitalized costs of production (including the costs of sets) should be expensed. Once an entity can estimate its secondary market revenue, however, it should capitalize all subsequent film costs. These capitalized expenditures should be amortized and periodically evaluated for impairment.

Film costs amortization and participation costs accrual. An entity is required to amortize film costs and to accrue participation costs using the individual-film-forecast method. The method amortizes or accrues film costs as the ratio of current period actual revenue to estimated remaining unrecognized ultimate revenue (as of the beginning of the current fiscal year).

To calculate the amount of film costs that should be amortized for the period, the individual-film-forecast fraction above is multiplied by the unamortized film costs (as of the beginning of the current fiscal year). Unaccrued ultimate participation costs (see definition below) that have to be recorded for the period are expensed by multiplying the individual-film-forecast fraction by the unaccrued ultimate participation costs at the beginning of the current fiscal year. This technique, illustrated in Exhibit 1, ensures that, given constant estimates, film costs are amortized and participation costs are accrued in a manner that, over the ultimate period, generates a constant rate of periodic profit before exploitation costs (marketing, advertising, publicity, promotion, and other distribution expenses, manufacturing costs, and other period costs).

Participation costs are contingent payments to parties involved in the production of a film (participants) based on contractual formulas (participations) and by contingent amounts determined by collective bargaining agreements (residuals). Participants generally include creative talent such as actors, writers, or licensors. In general, an entity should accrue a liability for participation costs only if it is probable that assets will be sacrificed to settle its obligation under the terms of a participation agreement.

Actual results will of course vary from estimates. At each reporting date, the entity should update estimates of ultimate revenue and participation costs, as illustrated in Exhibit 2. If estimates are revised, the entity should determine a new denominator for the individual-film-forecast fraction that includes only ultimate revenue from the beginning of the fiscal year of the change (the ultimate revenue changes are treated prospectively as of the beginning of the fiscal year of change). The entity should apply the revised fraction to the net carrying amount of unamortized film costs and to the film’s unaccrued ultimate participation costs as of the beginning of the fiscal year. The difference between expenses as determined using revised estimates and any amounts already expensed should be charged or credited to the income statement in the fiscal year of the revision.

Ultimate revenue. Ultimate revenue consists of estimates of revenue from the exploitation, exhibition, and sale of a film in all markets and territories over the entire revenue time horizon. The following constraints apply to ultimate revenue:

• For films other than episodic television series, ultimate revenue should include estimates over a period not to exceed 10 years after the film’s release.
• For an episodic television series, ultimate revenue should include estimates of revenue over a period not to exceed 10 years from delivery of the first episode.
• For an episodic television series still in production, ultimate revenue should include estimates of revenue over a period not to exceed five years from delivery of the most recent episode (if later than delivery of the first episode).
• Ultimate revenue for an episodic television series should include estimates of all secondary market revenue only if the entity can show that it will be able to successfully license those episodes already produced and those committed to be produced.
• For previously released films acquired as part of a film library, ultimate revenue should include estimates for a period not to exceed 20 years from acquisition. For purposes of this guidance, a film library consists of films initially released at least three years prior to acquisition.
• If persuasive evidence exists that revenue can be generated from a market or territory, then this revenue should be included in estimates of ultimate revenue. Estimates of revenue from newly developing territories should only be used if an existing arrangement provides convincing evidence that the entity will realize such amounts.
• If convincing evidence exists that revenue can be generated from third-party licensing arrangements to market film-related products (e.g., a contract with a nonrefundable minimum guarantee or advance), then estimates of such revenue should be included in ultimate revenue.
• Ultimate revenue should include estimates of wholesale or retail revenue from an entity’s sale of peripheral items (such items as toys and apparel) attributable to exploitation of the film only if the entity can demonstrate a history of such revenue generation.
• Estimates of revenue from unproven or undeveloped technologies should not be included in ultimate revenue.
• Estimates of wholesale promotion or advertising reimbursement from third parties should not be included in ultimate revenue, but rather should be offset against exploitation costs.
• Estimates of sales of film rights for the following periods should not be included in ultimate revenue:
• For films other than episodic television series, estimates exceeding 10 years after the film’s initial release.
• For episodic television series, estimates exceeding 10 years from delivery of the first episode or, if still in production, a period exceeding five years from delivery of the most recent episode, if later.
• Ultimate revenue should be discounted to its present value. All foreign currency estimates of future revenues should be based on current spot rates. In addition, ultimate revenue should not include projections for current inflation.

Ultimate participation costs. Estimates of unaccrued ultimate participation costs are used in the individual-film-forecast method to arrive at current period participation cost expenses. As noted above, such costs are based on estimates of film costs, exploitation costs, and ultimate revenue. If, at any balance sheet date, a film’s recognized participation cost liabilities exceed the estimated unpaid ultimate participation costs, the excess liability should be reduced with an offsetting credit to unamortized film costs (see Exhibit 3). To the extent that an excess liability exceeds the film’s unamortized costs, it should be credited to income. If a film continues to generate revenue after its film costs are fully amortized, the entity should accrue associated participation costs as the additional revenue is recognized.

Film costs valuation. The following circumstances require an entity to assess the possibility that the fair value of a film, regardless of its completion, is less than its amortized costs:

• There is an adverse change in the expected performance of the film prior to its release.
• The actual costs substantially exceed budgeted costs.
• There are significant delays in the film’s completion or release schedule.
• There is a reduction in the initial release pattern or change in other release patterns.
• There are insufficient funds to complete the film and market it effectively.
• Actual performance subsequent to release does not meet prior expectations.

If one or more of these indications imply that the fair value of a film is less than its unamortized costs, a determination of fair value, based on estimated future exploitation costs, should be made. The entity should then write off on the income statement the amount by which the unamortized capitalized costs of the film exceed its fair value. After writing down a film to fair value, the costs that have been written off should never be restored.

It is common to use a discounted cash flow model to estimate fair value. The following factors should be considered when estimating the future cash flows for a given film:

• The public’s perception of the film’s story, director, producer, and cast
• Historical results of similar films
• Prior performance of the director, producer, or cast
• Performance in prior markets (if previously released)
• The film’s running time
• The degree of cash outflows necessary to generate the film’s cash inflows. The entity should incorporate estimates of future costs to complete the film, future exploitation and participation costs, and other necessary cash outflows in determining fair value.

When determining the fair value of a film using a traditional discounted cash flow approach, additional guidelines should be followed:

• The discount rate should not be an entity’s incremental borrow rate, liability settlement rate, or weighted average cost of capital. These rates do not consider the risks associated with a film asset.
• The discount rate should consider the time value of money and expectations about possible variations in the amount or timing of likely cash flows. This rate should also be adjusted to incorporate the uncertainty inherent in a film asset, including illiquidity and market imperfections.

Subsequent evidence leading to a write-down of unamortized film costs. If a film is released around the entity’s balance sheet date and evidence exists that a write-down of the film’s unamortized costs is required, then, if the entity has not issued its financial statements, it should adjust them for the effect of any changes in estimates resulting from the use of subsequent evidence. The entity is not required to take such action during the subsequent period if it can be shown that the conditions leading to the write-off did not exist at the balance sheet date.

Accounting for film advertising costs. Advertising costs incurred by an entity should be accounted for in accordance with SOP 93-7, Reporting on Advertising Costs. Marketing costs and all other exploitation costs should be expensed as incurred.

Manufacturing costs. The costs of products for sale, such as videocassettes and DVDs, should be expensed on a unit-specific basis, charged to manufacturing or duplication of products for sale when the related product revenue is recognized. At the balance sheet date, the entity should evaluate its inventory of these products to determine if adjustments are required when considering their net realizable value and exposure to obsolescence. In addition, the costs of theatrical film prints should be expensed over the period of expected benefit.

Presentation and Disclosure

If the entity presents a classified balance sheet, film costs should be reported as noncurrent assets. In any case, the portion of unamortized costs of an entity’s completed films that will be written off during the upcoming operating cycle should be disclosed in the financial statements or notes. In addition, the components of film costs should be shown separately under theatrical-release films or direct-to-television products. These film costs (within each of the two categories) should be further classified as: released; completed and not released; in production; or in development or preproduction.

An entity should disclose the percentage of unamortized film costs for released films (excluding acquired film libraries) that it plans to amortize within three years from the entity’s balance sheet date. If the percentage is less than 80%, then the entity must disclose the period required to attain that amortization level. For acquired film libraries, an entity must disclose the amount of unamortized cost that remains, the method of amortization, and the amortization period being used.

The following miscellaneous disclosure guidelines should also be followed:

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