FILMED ENTERTAINMENT Revenue and cost recognition Agenda Revenue

FILMED ENTERTAINMENT Revenue and cost recognition

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

RECAP – LIFE CYCLE OF A FILM OR TV SHOW

Current release windows of a film Licensing and Merchandising Free TV (network & syndicated) Pay TV PPV/VOD Home Entertainment (DVD, Blu-ray) Digital Media Theatrical 3 6 9 12 15 18 21 24 27 30 33 36 (months)

• • • Network Cable Home entertainment Syndicated TV New media Digital Media TV show markets

REVENUE RECOGNITION

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

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

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

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

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)

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

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

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 theatrical market • Overages/royalties based on statements from licensee • Cash vs. accrual basis

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

Revenue recognition – other considerations • Cross collateralization – If cannot allocate, recognized on an “earn out” basis

ULTIMATE REVENUES

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

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

COST AMORTIZATION

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

Amortization calculation • Year 1 Yr. 1 revenues Ultimate costs Costs to amortize Ult costs to go Costs to amortize • Year 2 Yr. 2 revenues Ult revs to go

Amortization calc – Example – Yr 1 Yr. 1 Ultimate Revenues (total) Ultimate Costs (total) Ultimate Gross margin Actual Revenues: Yr. 1 revenues Ultimate revenues 20 60 $ 60 40 20 20 Ultimate costs 40 Costs to amortize 13

Recording amortization – Year 1 Cost of revenues (Amortization expense) $13 Capitalized film costs (Accumulated amort) $13 Record Year 1 amortization expense

Amortization calc – Example – Yr 2 Ultimate Revenues (total) Ultimate Costs (total) Ultimate Gross margin Actual Revenues: Actual Costs Amortized: Yr 1 $ 60 40 20 20 13 Yr. 2 revenues Ult revs to go Ult costs to go 15 40 27 Yr 2 (to go) $ 40 27 13 15 ? Costs to amortize 10

Recording amortization – Year 2 Cost of revenues (Amortization expense) $10 Capitalized film costs (Accumulated amort) $10 Record Year 2 amortization expense

Amortization calc – Example – Yr 2 (revised ultimate) Yr. 1 Ult Yr. 2 Ultimate Revenues Ultimate Costs Ultimate Gr. margin Actual revenues: Actual costs amortized Yr. 2 revenues Ult revs to go 15 35 60 40 20 20 13 Yr. 2 (to go) (revised) 55 40 15 Ult costs to go 27 (revised) 35 27 8 15 ? Costs to amortize 12

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

CASE STUDY PART 2

PARTICIPATIONS

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)

Participations – overview • Agreements typically include: – Revenues to be included (music, merch, etc) – Percentages to be used (2. 5% of net profits) – Producer’s recoupment of direct and indirect production costs – Producer’s recoupment of exploitation costs – Reporting periods and payment terms – Audit rights

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

Sample participation calculation

Participation calculation example

Participations – Example – Yr 1 Yr. 1 Ultimate Revenues (total) Ultimate Participation Costs $ 567, 500 30, 200 Actual Revenues: Yr. 1 revenues Ultimate revenues 362 567. 5 362, 000 Ultimate costs 30. 2 Costs to amortize 19. 3

Recording participations Costs of revenues (Participation exp) $19. 3 Accrued participations $19. 3 Record Year 1 participation expense and related liability

RESIDUALS

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

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

Residual rates – Motion pictures

Residual rates – TV shows

Residuals – Overview • Pro-ration for filming outside the U. S. • Some states are “right-to-work” states (nonunion) • 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

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

Residuals calculation

Residuals – Example – Yr 1 Yr. 1 Ultimate Revenues (total) Ultimate Residuals Costs Actual Revenues: Yr. 1 revenues Ultimate revenues 362 567. 5 $ 567, 500 11, 800 362, 000 Ultimate costs Costs to amortize 11. 8 7. 5

Recording residuals Costs of revenues (Residuals expense) Accrued residuals $ 7. 5 Record Year 1 residuals expense and related liability $ 7. 5

OTHER EXPENSES

Other expenses • DVD inventory – Manufacturing costs – Obsolescence reserves (don’t 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

ULTIMATE COSTS

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

TAX INCENTIVES AND CREDITS

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

IMPAIRED FILMS AND TV SHOWS

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

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

DEVELOPMENT COST WRITE DOWNS

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)?

CASE STUDY PART 3