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F ILMED E NTERTAINMENT Revenue and cost recognition Slide 2 Agenda Revenue recognition Ultimate revenues Cost amortization Participations and residual expense Other expenses Impaired films and TV shows Development cost write downs Tax incentives/credits Slide 3 R ECAP L IFE CYCLE OF A FILM OR TV SHOW Slide 4 (months)618123036 Theatrical Home Entertainment (DVD, Blu-ray) Free TV (network & syndicated) PPV/VOD 243915212733 Pay TV Current release windows of a film Licensing and Merchandising Digital Media Slide 5 TV show markets Network Cable Home entertainment Syndicated TV New media Digital Media Slide 6 R EVENUE RECOGNITION Slide 7 Revenue recognition Guidance: ASC 926 (SOP 00-2) and ASC 605 (SAB 104, FAS 48) Five revenue recognition criteria, as defined in ASC 926: Persuasive evidence of sale or licensing agreement with customer Film or TV show completed and available for delivery (not necessarily physical delivery) License period has begun and customer can begin exploitation, exhibition or sale Fee is fixed or determinable Collection of fee reasonably assured If an entity does not meet any one of the preceding conditions, the entity should defer recognizing revenue until all of the conditions are met Slide 8 Revenue recognition - theatrical Revenues recognized over the exhibition period If MG or advance received before exhibition date, defer and recognize in accordance with ASC 926 Settlement rates and film rentals International markets Slide 9 Revenue recognition home entertainment Revenue not recognized until street date All criteria of ASC 926 must be met Shipping considerations (FOB shipping point / destination) Reserves (contra-revenue) must be recorded and inventory must be adjusted Slide 10 Revenue home entertainment reserves Returns reserves (must have ability to estimate) New release Catalog Inventory adjustment component Price protection Slotting fees Charge backs Co-op advertising Slide 11 Revenue recognition PPV / VOD All criteria of ASC 926 must be met Recognized as subscribers access (buy) film from cable / satellite company May require reporting from provider for revenue recognition (estimable license fee) Slide 12 Revenue recognition Pay TV All criteria of ASC 926 must be met Recognized as film becomes available Output deals contain terms, including revenue (generally based on box office) Allocation of license fee multiple windows Slide 13 Revenue recognition Free TV All criteria of ASC 926 must be met Generally recognized when film is available to the network Terms included in agreement output or one off May require allocation to multiple windows Slide 14 Revenue recognition Licensing & merchandising All criteria of ASC 926 must be met Usually subject to advances and/or MGs MG generally recognized when film is available in the theatrical market Overages/royalties based on statements from licensee Cash vs. accrual basis Slide 15 Revenue recognition TV shows Same criteria as for films License fee on a per-episode basis Revenue generally recognized as each episode is delivered License fees paid over more than one year must be discounted Slide 16 Revenue recognition other considerations Cross collateralization If cannot allocate, recognized on an earn out basis Slide 17 U LTIMATE REVENUES Slide 18 Ultimate revenues - Film Markets include revenues from: Theatrical (U.S. and Non-U.S.) PPV / VOD SVOD Home entertainment Pay TV Free TV (network & syndication) Includes revenue estimates up to 10 yrs from initial theatrical release Should not include revenues from unproven territories or markets Discounting not allowed except in certain situations Slide 19 Ultimate revenues Episodic TV Markets include revenues from: TV license fees Home entertainment SVOD Includes revenue estimates up to the later of: 10 yrs from date of delivery of first episode or, If still in production, 5 yrs from date of delivery of most recent episode Include estimates of secondary market sales only if company can demonstrate history of success Slide 20 C OST AMORTIZATION Slide 21 Cost amortization basics Individual film forecast (IFF) method, as stipulated in ASC 926 (SOP 00-2) Cost amortization is based on estimated gross margin for the life of the film Estimated gross margin may change throughout life, which may affect cost amortization in period change occurs Slide 22 Amortization calculation Year 1 Year 2 Ultimate costs Costs to amortize Yr. 1 revenues Ultimate revenues Ult costs to go Costs to amortize Yr. 2 revenues Ult revs to go Slide 23 Yr. 1 Ultimate Revenues (total)$ 60 Ultimate Costs (total)40 Ultimate Gross margin20 Actual Revenues:20 Ultimate costs Costs to amortize Yr. 1 revenues Ultimate revenues 20 60 40 13 Amortization calc Example Yr 1 Slide 24 Recording amortization Year 1 Cost of revenues (Amortization expense) $13 Capitalized film costs(Accumulated amort) $13 Record Year 1 amortization expense Slide 25 Yr 1 Yr 2 (to go) Ultimate Revenues (total) $ 60 $ 40 Ultimate Costs (total)4027 Ultimate Gross margin20 13 Actual Revenues:20 15 Actual Costs Amortized:13 ? Ult costs to go Costs to amortize Yr. 2 revenues Ult revs to go 15 40 27 10 Amortization calc Example Yr 2 Slide 26 Recording amortization Year 2 Cost of revenues (Amortization expense) $10 Capitalized film costs(Accumulated amort) $10 Record Year 2 amortization expense Slide 27 Ult costs to go Costs to amortize Yr. 2 revenues Ult revs to go 15 35 27 12 Amortization calc Example Yr 2 (revised ultimate) Yr. 1 UltYr. 2 UltYr. 2 (to go) (revised) (revised) Ultimate Revenues605535 Ultimate Costs404027 Ultimate Gr. margin2015 8 Actual revenues:2015 Actual costs amortized13 ? Slide 28 Recording amortization Year 2 (revised ultimate) Cost of revenues (Amortization expense) $12 Capitalized film costs(Accumulated amort) $12 Record Year 2 amortization expense revised ultimate Slide 29 C ASE S TUDY PART 2 Slide 30 P ARTICIPATIONS Slide 31 Participations overview Contingent compensation for creative talent (actors, writers, directors, producers) Expensed using IFF method (based on ultimates) Amounts paid, if any, are based on contractually agreed-upon formulas and cash received (not revenue recognized) Formulas vary depending on star power of talent (gross deal vs net deal) Slide 32 Participations overview Agreements typically include: Revenues to be included (music, merch, etc) Percentages to be used (2.5% of net profits) Producers recoupment of direct and indirect production costs Producers recoupment of exploitation costs Reporting periods and payment terms Audit rights Slide 33 Participations common terms Gross receipts Distribution fees Production costs and production interest P&A, marketing and distribution costs (exploitation costs) Adjusted gross receipts Net receipts Break even (first, second, rolling) Bonuses and deferments Slide 34 Sample participation calculation Slide 35 Participation calculation example Slide 36 Yr. 1 Ultimate Revenues (total)$ 567,500 Ultimate Participation Costs 30,200 Actual Revenues:362,000 Ultimate costs Costs to amortize Yr. 1 revenues Ultimate revenues 362 567.5 30.2 19.3 Participations Example Yr 1 Slide 37 Recording participations Costs of revenues (Participation exp)$19.3 Accrued participations$19.3 Record Year 1 participation expense and related liability Slide 38 R ESIDUALS Slide 39 Residuals Overview Additional compensation for ancillary markets (DVD, pay TV, cable, network TV, etc) Residuals based on percentage of gross revenues received by a distributor from ancillary markets Residuals for TV shows based on original salary paid during the production and are not paid on the initial airing of the show (only on re-runs) Union or guild specific Payments made to individuals or to the guilds on behalf of members Slide 40 Residuals Overview Guilds in TV and film: Screen Actors Guild (SAG*) represents motion picture actors American Federation of Television and Radio Artists (AFTRA*) represents television actors and radio personalities Directors Guild of America (DGA) represents directors Writers Guild of America (WGA) represents writers American Federation of Musicians (AFM) represents musicians International Alliance of Theater and Stage Employees (IATSE) represents production crew and administrative staff * SAG and AFTRA recently merged Slide 41 Residual rates Motion pictures Slide 42 Residual rates TV shows Slide 43 Residuals Overview Pro-ration for filming outside the U.S. Some states are right-to-work states (non- union) SAG/AFTRA applies no matter where actor works Range from 12.5% - 20% of revenues generated in ancillary markets Fringe benefits (payroll tax, pension, health & welfare benefits) can add another 25% surcharge to residual payments Slide 44 Residuals Guild audits Guilds conduct periodic audits of film and TV producers Specialized firms do most audits Industry-wide litigation regarding various practices employed by film producers when calculating residuals Percentage of home entertainment revenues subject to residual payments Allocation of minimum guarantees Slide 45 Residuals calculation Slide 46 Yr. 1 Ultimate Revenues (total)$ 567,500 Ultimate Residuals Costs 11,800 Actual Revenues:362,000 Ultimate costs Costs to amortize Yr. 1 revenues Ultimate revenues 362 567.5 11.8 7.5 Residuals Example Yr 1 Slide 47 Recording residuals Costs of revenues (Residuals expense)$ 7.5 Accrued residuals$ 7.5 Record Year 1 residuals expense and related liability Slide 48 O THER EXPENSES Slide 49 Other expenses DVD inventory Manufacturing costs Obsolescence reserves (dont forget about units added back as part of returns reserve calculation) Prints capitalize and amortize vs. expense Advertising ASC 720-35 (SOP 93-7) Expense as incurred or Upon first airing Slide 50 U LTIMATE COSTS Slide 51 Ultimate costs Film and episodic TV Estimated total costs directly associated with generation of ultimate revenues Production (or acquisition) costs Negative costs Capitalized overhead Capitalized interest Participations and residuals Other considerations Slide 52 T AX INCENTIVES AND C REDITS Slide 53 Tax incentives and credits Offered by various cities, states and countries to entice filming in their locale Treated as a reduction to film costs Timing of recording Slide 54 I MPAIRED FILMS AND TV S HOWS Slide 55 Impaired film / TV show costs Pre-release write down Impairment after release of film Certain events or changes in circumstances may indicate company should assess whether product is impaired (fair value less than unamortized film costs): Film performance Costs in excess of budget Delays in completion or release schedules Insufficient funding or resources to complete film and market it effectively Slide 56 Impaired film / TV show costs If there is indication product is impaired, must determine fair value of film and write off amount by which unamortized capitalized costs exceed fair value If film already released, calculate and record IFF amortization first, then calculate impairment Discounted cash flow analysis Slide 57 D EVELOPMENT COST WRITE DOWNS Slide 58 Development cost write downs Presumption that if a film has not been set for production within 3 years of first capitalized cost, it will be disposed of Write off required (assumes fair value of $0) What about films with a longer production period (e.g. CG animation)? Slide 59 C ASE S TUDY P ART 3