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Less Than Zero
Studio Accounting Practices in Hollywood

By Joseph F. Hart, Esq. and Philip J. Hacker, C.P.A.

Joseph F. Hart is a partner in the law offices of Weinstein and Hart, in Beverly Hills, California. His practice includes intellectual property litigation in the motion picture, television and music industries. He has handled numerous profit participation and accounting cases, primarily on behalf of profit participants and royalty recipients.

Philip J. Hacker is a certified public accountant and a senior partner in the accounting firm of Hacker, Douglas & Company in Los Angeles, California. Mr. Hacker's firm has performed profit participation audits and rendered litigation support services to most major motion picture and television profit participants for the past 25 years. The firm's clients include Art Buchwald, Steven Spielberg, Harrison Ford, James Garner, Dustin Hoffman, Aaron Spelling Productions, William Shatner and Leonard Nimoy.


Summary of Article:

This article discusses the issues that typically arise in the process of examining motion picture accountings rendered to net profit participants. The authors explore both the general legal principles involved and the particular accounting practices which are likely to give rise to disputes between profit participants, on one hand, and motion picture studio/distributors on the other.


The seemingly insatiable thirst of the public for news about the motion picture business has now reached even the arcana of Hollywood's studio accounting practices. The Coming To America case, Art Buchwald v. Paramount Pictures Corp.(1), garnered widespread notoriety, as it exposed to public light Paramount's accounting procedures, many of which were considered odd by any normal business standards. The trial court in Buchwald held that certain parts of Paramount's standard contractual net-profit definition, as applied in practice, were unconscionable. Paramount appealed the trial court's decision, but ultimately settled the case. Consequently, there is still not any appellate precedent discussing the intricacies of the studio accounting practices.

Despite the settlement in Buchwald, many issues raised in that case persist. In fact, in a case involving the motion picture Batman and the accounting practices of Warner Bros., another Los Angeles Superior Court judge came to a quite different conclusion, holding that the plaintiffs had failed to prove that the studio's standard-form net-profits contract was unconscionable.(2)

At the heart of these legal disputes is the very meaning of the term net profit. Most accountants and business people would define net profit as revenue less expenses. Beyond this simple statement, the complexities of certain businesses and the unique nature of various industries demand a special language to explain when revenue is recognized and expenses are incurred. These definitions have been codified by the accounting profession in an information database called Generally Accepted Accounting Principles (GAAP).(3)

In addition to GAAP, the accounting profession has developed unique accounting guidelines dealing with standards for particular industries. One such guideline produced for the motion picture industry is entitled Financial Accounting Standards Bulletin 53 (FASB 53). This guideline discusses when income from the exploitation of a motion picture is to be recognized as earned and when the cost of producing and distributing a motion picture is recognized as incurred.

It is somewhat surprising to the layperson, then, to learn that the reports to net-profit participants by studios do not follow GAAP or FASB 53. Instead, these rules are disregarded, and the reported net profit follows a complex document which explains the accounting methodology employed by the studio.

This document generally surfaces as a schedule to the participant's employment agreement containing the studio's Standard Profit Definition (SPD). The SPDs used by the various studios have been refined through the years, often in response to issues of interpretation raised by the legal and accounting representatives of profit participants. While the SPDs of the various studios are not identical, they share many common structures and definitions.

The accounting provisions which are contained in the studios' SPDs make it difficult, if not mathematically impossible in many cases, for net profits ever to be achieved. It may be said in jest, although there is a great deal of truth in the statement, that the studios' SPDs are designed not to achieve net profits, and therefore, not to pay any share to profit participants, even though the motion picture may have achieved an economic net profit according to GAAP.

The fundamental foundation of GAAP is the accrual method of accounting. The accrual method provides that revenue is recognized when it is earned and expenses are recognized when they are incurred. In an SPD, the contract language invariably states that revenue will be recognized when the cash is received and expenses will be recognized when they are incurred. This mismatching of revenue and expenses will delay, possibly forever, the reporting of profits, and will also have a significant impact on the computation of interest, an important element in determining net profit.

These accounting practices have spawned a number of legal theories by which attorneys representing net profit participants can challenge the studio SPDs. These include straightforward breach of contract theories, based on the position that the studio's accounting practices do not conform to the contract language of the SPD; unconscionability of the SPD in whole or in part, as was asserted in Buchwald; breach of fiduciary duty; and antitrust charges, as has been alleged in a recently filed suit against the major studios. Each of these legal strategies could be invoked by an attorney to challenge one or more of the particular accounting procedures commonly used in SPDs.

The motion picture studios generally provide profit participants with accounting reports which can be divided into three broad categories: (1) receipts, (2) distribution fees and expenses, and (3) production costs. Within those broad categories, profit participants and their representatives will usually find several areas of disagreement with the studio's stated position. In the area of receipts, the disputes commonly concern theatrical gross receipts, home video, television gross receipts, and merchandising and music receipts. Disputes over distribution usually are focused on the areas of advertising, trade show expenses, costs of release prints, taxes, trade dues, and residuals. Production costs are most commonly disputed over the accounting for direct costs, studio overhead charges, overbudget penalties, payments to gross participants, and interest.

Theatrical Gross Receipts. Theatrical gross receipts are least susceptible to reporting manipulation. They are defined simply as the total proceeds paid by theatres to the distributors for the right to exhibit a motion picture in theaters worldwide. The typical agreement between the studio/distributor with the motion picture exhibitor provides that a percentage of the box office receipts be paid to the studio. These proceeds are classified as film rental income and are accumulated as gross receipts in reporting to the profit participants. Generally, the accounting for this income is reasonable and correct. Failure to account properly in this area would render the studio particularly vulnerable to a claim for breach of fiduciary duty.

It should be noted that the film rental income is different from the box office grosses which are reported in the motion picture trade papers and in the popular media. Those commonly reported figures represent monies received by the exhibitors, and not by the studio/distributors. Thus, when a blockbuster motion picture receives widespread publicity for taking in $100 million at the box office, the film rental income actually received by the studio, and reported to the profit participants, is typically $50 million or less.

Home Video. All the major studios have home video distribution affiliates that sell video cassettes to wholesalers and retailers throughout the world. The SPD for all major distributors provides that 20 percent of the sums actually received by such affiliated companies will be included in gross receipts. From the remaining 80 percent the studio pays the expenses of marketing and producing the video cassettes, with the exception of residuals, and keeps the profit.

The rationale for the studios' artificial reporting of home video income is merely an historical accident. When home video was in its infancy, and the studios had not yet established in-house home video departments or subsidiaries, the large, independent, home video distributors paid a flat 20 percent royalty to the studios from home video sales. What was left, after expenses, was the profit earned by the independent company. After the studios established their own home video divisions, they continued the practice of reporting 20 percent of actual receipts to profit participants, as if the profits earned by these subsidiaries were not their own.

The trial court in Buchwald considered this as one of the potential areas of unconscionability in Paramount's SPD, but inexplicably did not make a finding as to whether the SPD was unconscionable in that regard.(4)

Television Gross Receipts. In recent years television gross receipts has grown dramatically as a revenue source. This market includes U.S. network television, pay and cable television, both premium and basic channels, U.S. syndicated television and foreign television. In each of these markets the licensee negotiates for groups of films from a studio. This type of marketing program is generally referred to as group or package selling. Since the packages contain pictures ranging from blockbusters to unknowns, the allocation of the receipts for the package purchase price to the individual pictures in the package should be based upon the relative worth of each picture in the package. This seems, however, not to be the case. The poorer performing pictures generally receive an excessively high allocation of a package sale price, with the better performing pictures receiving an allocation that is lower than their relative worth. This practice transfers income from potentially profitable, better performing picture to "dogs" that are in no danger of earning a profit for the studio. Such allocation of television receipts among films brings up a classic contract conflict-of-interpretation issue. The studio argues that the SPD gives it unfettered discretion to allocate receipts from a television package among films, while the profit participant's position is that any allocation must be reasonable, lest it run afoul of the studio's obligation of good faith and fair dealing, which is implied in every contract in California. To date, there has been no appellate determination on this issue, and so it is likely to remain a matter of contention between studios and profit participants.

Merchandising And Music Gross Receipts. All major studios have merchandise-licensing and music-publishing affiliates. The SPD provides for the inclusion of gross receipts from these sources only after the exclusion of up to 50 percent of the gross receipts. Since merchandising and music publishing are becoming increasingly more important as a source of revenue, it is evident that the practice of excluding such a large portion of the gross receipts when accounting to participants has a dramatic impact on the amount of reported profits.

From the participant's perspective, the most likely available legal challenge to the SPD's treatment of merchandising and music income would be based on a theory of unconscionability. In most SPDs, the treatment of music and merchandising income is explicitly stated, and so the likelihood of a claim based upon different interpretations of the agreement is minimal. However, given the apparent lack of any economic justification for reporting less than the full amount of income received from music and merchandising, the clause may well be unconscionable.

Distribution Fees. The SPD provides for a deduction for distribution fees, ranging from 15 percent to 50 percent, from each type of media receipt. Although classified as distribution fees, this is in effect an extra profit allocation to the studio. The studios' actual distribution overhead -- an average of approximately 12 percent of gross receipts -- is far less than the percentage amounts provided for in the SPD. Deducting such a large percentage off-the-top contributes mightily to making it unlikely that a release will ever achieve a net profit according to the SPD definition.

Given the long history of distribution fees, and their inclusion in all SPDs, it appears doubtful that a profit participant would mount a legal challenge to the appropriateness of such charges as a general proposition. There are, however, issues that commonly appear with respect to the classification of income, and the appropriateness of the particular distribution fee being charged, which the attorney and auditor for the participant should be careful to analyze.

Distribution Expenses. The SPD provides for deductions, as distribution expenses, for such items as advertising, release prints, foreign versions, shipping, taxes, trade dues, and checking. Most of these sums charged are bonafide out-of-pocket distribution expenses properly deductible in the determination of net profit. However, many of the charges classified as distribution expenses are not bonafide direct charges.

Advertising. The SPD provides for a percentage (generally 10 percent) to be applied against the direct advertising expenses, ostensibly to cover the studio's advertising "overhead." In the past, studios have had large advertising departments whose primary purpose was to develop and design advertising campaigns. Modern practice generally assigns the development of advertising campaigns to independent contractors, and studio advertising support staffs and overhead have been reduced as a result. Since direct advertising expenditures are growing dramatically (the advertising expenditures for a major release generally exceeds $20,000,000), the practice of adding 10 percent of the direct cost for advertising overhead can reduce the reported net profit by $2 million, or more. This surcharge on advertising expenses was one of the practices that the Buchwald trial court found to be unconscionable. The court stated that it "was able to discern no justification for this flat charge and Paramount has offered none."(5)

Trade Show Expenses. Most studios charge the cost of attending sales conventions as an advertising expense. In reality, these are selling expenses and should be covered by the substantial distribution fees provided for in the SPD. (This issue was not addressed in the Buchwald case.) In practice, the amount of money represented by this particular item is generally too small to impel a claim on its own, but it can become part of the give-and-take negotiations between profit participants and the studios.

Release Prints. All studios have contracts with major laboratories to produce release prints that are used by the theaters to exhibit the picture. A release print costs approximately $1,500, and a national release generally requires 2,000 prints, for a total charge of $3,000,000. While the contracts with the laboratories provide for discounts when certain volume levels are reached, studios do not generally pass these discounts on to the participants in their net profit accountings. This is another item which becomes a subject in settlement negotiations.

Taxes. Taxes charged to a motion picture primarily consist of payments to foreign governments for the right to do business in a particular country. Such taxes can be credited on a one-to-one basis against the studios' United States income tax liabilities, so the studios suffer no net out-of-pocket expense as a result of paying these foreign taxes. Studios insist that the taxes can be legitimately charged against a film, and their inclusion as a distribution expense can reduce net profits by several million dollars. The Buchwald trial court, without any discussion, did not find this practice to be unconscionable.

Trade Dues And Checking Costs. Distributors pay dues to certain trade organizations such as the Motion Picture Association of America (MPAA). They also engage outside agencies to check on the box office grosses at selected theaters throughout the world. The costs incurred in these activities are allocated to each picture based on the relative film rental income earned. Such allocation of the MPAA dues is especially egregious since it is an industry trade association which promotes the general interest of the motion picture industry. This system is inherently unfair to the more successful pictures since the costs incurred do not relate directly to the amount of revenue generated by each picture. A successful film can receive an expense allocation for trade dues and expenses in excess of $500,000. As in package sales, this is a method for the studios to allocate greater expenses to or reduce the income of the more successful films.

Residuals. Residuals are payments made to talent (actors, directors, writers and musicians) and the technical staff (film crew) for additional uses of the motion picture beyond its initial theatrical use. This expenditure is measured as a percentage of the gross receipts derived from the secondary sources of revenue (television and video). Residuals are payable to the talent as payroll subject to payroll taxes. The studios increase the residual charge by a percentage factor to cover these payroll taxes, but this factor is frequently in excess of the actual payroll tax expense. The studio justification for the artificial payroll tax charge for residuals has traditionally been that the accounting necessary to arrive at a precise figure is too complex an operation for the studio to undertake. Given the increased sophistication of computer-based accounting systems, studios can and should make more precise calculations.

Direct Costs of Production. The SPD contains language that permits the studio to deduct the cost of production determined in the customary manner producer accounts for production cost at the time the picture is produced. (6) A substantial portion of the direct cost of a film produced on a studio lot is charges for the use of the studio's facilities, including the sound stages, vehicles, equipment, etc. Although the studio incurs no out-of-pocket expense for providing these facilities, it insists that the charges are proper because they comply with the SPD language defining production cost. The charges made for using these facilities are substantially in excess of the actual costs. In addition, the studio adds a percentage of the direct labor costs incurred to cover fringe benefits for such items as payroll taxes and union benefits. The percentage applied significantly exceeds the actual fringe benefit expense incurred by the studio. For example, a studio will charge a motion picture for the use of a vehicle at a rental rate based upon the rental rate being charged by the leading rental-car companies, typically $45 per day or more. This charge, which includes a profit rate equivalent to the rental companies' profit rate, will be made even if the vehicle has long ago been purchased by the studio, and even if the cost of the vehicle has been charged against other films. It appears that the Buchwald trial court considered this issue, but did not make a finding regarding its unconscionability.(7)

Studio Overhead. The SPD normally provides for a charge of 15 percent of direct production costs to cover studio overhead. Since actual studio overhead is substantially less than the amount permitted to be charged in the SPD, profits are reduced beyond economic reality. The Buchwald trial court found Paramount's 15 percent overhead charge to be unconscionable, observing "Paramount's charge of a flat 15 percent for overhead yields huge profits, even though the overhead charges do not even remotely correspond to the actual costs incurred by Paramount."(8) This overhead charge is typically one of the larger items of dispute in any audit of a studio's reporting to its profit participants.

Overbudget Penalty. Most standard profit definitions provide for an additional amount to be added to production cost equal to the amount by which the picture exceeds the original budget estimate. This represents, in effect, a 100 percent penalty charge on any amount spent over the original budget. This practice is especially onerous since the majority of the profit participants do not exercise any control over the decisions that determine whether a picture exceeds its original budget.

As an economic matter, the calculation of whether or not a film has earned profits is completely independent from whether or not the cost of the film exceeded the original budget. A film which costs $25 million to make will be profitable once that $25 million has been earned, and the fact that the original budget was $20 million does not change the fact that the film will begin to earn profits after $25 million has been recouped.

Gross Participations. A few members of an elite club, known as "A-Talent", are able to negotiate profit participations determined solely by the gross receipts earned by the picture. The SPD provides that gross participation payments made before a picture breaks even shall be included as a cost of production, and will therefore be subject to the standard overhead fees and interest charges. What this means is that the production cost (and attendant overhead and interest charges) spiral ever upward as a film becomes more and more successful, ultimately adding millions of dollars to production costs. In many cases this makes the achievement of net profit a virtual impossibility.

The impact of gross profit participations upon net profit participants is particularly troubling in a situation when the gross profit participant is signed after the net profit participant has already made a deal with the studio. The gross participation can make be the difference between the net profit participant realizing a share of profits or casting the production into a limbo where profitability can never be reached. In such cases, the net profit participant may be able to base a claim on the implied covenant of good faith and fair dealing, arguing that the studio has an obligation not to do anything that is likely to prevent the profit participant from receiving the anticipated benefits under their agreement.(9)

The Buchwald trial court was presented with variations of this issue, and made a mixed ruling. The court found that Paramount's practice of charging 15 percent overhead on a "special productions operational allowance" for Eddie Murphy Productions was unconscionable, and it also found that the practice of charging interest on monies paid to gross profit participants was unconscionable, but it made no finding of unconscionability on the general question of whether charging overhead on gross profit participations was unconscionable.(10)

Interest. The SPD provides for the computation of an imputed interest charge based on the unrecouped production cost. The studios apply many factors that cause this interest charge to be inflated beyond the actual interest expense incurred in producing the picture, including: (1) the interest rate charged by the distributor is generally substantially greater than its actual borrowing rate; (2) production costs reported by the studio contain many charges for which the studio does not incur out-of-pocket expenses, and therefore represent no advance of funds; (3) the net receipts applied to recover the production cost contain substantial charges for distribution fees that are not out-of-pocket expenses; (4) gross participation expenses prior to breakeven are included in production cost even though they are only paid after the distributor has obtained gross proceeds from distribution; and (5) distributor first applies the proceeds from distribution to accumulated interest and only after the accumulated interest is satisfied is the balance applied to reduce the unrecovered production cost.

The Buchwald trial court found that many of Paramount's practices in charging interest were unconscionable. Specifically, it found that Paramount acted unconscionably in charging interest on the negative cost balance without credit for distribution fees, in charging interest on distribution fees and overhead charges, charging interest on profit participation payments, and charging interest rates not proportional to the actual cost of funds.(11)

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ENDNOTES

(1) Art Buchwald v. Paramount Pictures Corp., Los Angeles Superior Court Case No. C706083.

(2) Batfilm Productions, Inc., et al. v. Warner Bros, Inc., et al., Los Angeles Superior Court consolidated Cases Nos. BC051653 and BC051654.

(3) GAAP contains the standards, conventions, and rules accountants follow in recording and summarizing transactions leading to the preparation of financial statements. GAAP has been developed to standardize the preparation of financial statements so that economic net profit is reported reasonably and consistently.

(4) The trial court in Buchwald did not discuss the reasons for its lack of a finding on certain issues raised by the plaintiffs. P. O'Donnell and D. McDougal, Fatal Subtraction, Appendix B (1992) (hereinafter, "Fatal Subtraction"). Fatal Subtraction, a first-person account of the Buchwald case which was co-authored by Buchwald's lead counsel, Pierce O'Donnell, reproduces various findings of the trial court as appendices.

(5) Buchwald, L.A.Sup.Ct. Case No. C706083, Tentative Decision (Second Phase) reproduced in Fatal Subtraction, supra, Appendix B, at 550.

(6) The ability of the studios to unilaterally change their manner of accounting for production costs, and thereby modify the accounting to profit participants is subject to the implied covenant of good faith and fair dealing; the studio must act reasonably in making any changes. Automatic Vending Co. v. Wisdom (3d Dist. 1960) 182 Cal.App.2d 354, 357-58, 6 Cal.Rptr. 31.

(7) In its Tentative Decision, the Buchwald court mentioned that plaintiffs had challenged "charges for services and facilities in excess of actual costs", but made no further mention of the issue, while finding that certain other practices of Paramount were unconscionable. See Fatal Subtraction, supra, Appendix B at 550.

(8) Id.

(9) See Foley v. U.S. Paving Co. (1968) 262 Cal.App.2d 499, 68 Cal.Rptr. 780 (owners of a company violated the covenant of good faith and fair dealing by increasing their salaries, thereby decreasing company profits, when an employee was entitled by contract to receive a percentage of profits).

(10) Fatal Subtraction, supra, Appendix B at 550-51.

(11) Id

Copyright 1996, Philip J. Hacker and Joseph F. Hart

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