For showbiz, the fiscal heat is getting more intense. With no company above suspicion these days, Hollywood and its accounting practices will almost certainly be swept up in the imbroglio over corporate hanky-panky.
Politicians are nervous and the Securities & Exchange Commission is looking for perps. Just last week, the SEC began a fact-finding inquiry into AOL Time Warner’s books after revelations about irregular advertising deals and revenue reporting.
Investors in Vivendi Universal, meanwhile, filed a lawsuit against ousted Viv U chairman Jean-Marie Messier for allegedly misleading shareholders about the overall health of the conglom and the true extent of its debts.
And perhaps most dramatically, the Justice Dept. handcuffed the already disgraced Rigas family, charging them with defrauding Adelphia Cable and its shareholders. And showbiz fears that the Adelphia case, though unusual, could ignite an accounting witchhunt.
Or, all this could simply accelerate the rush to self-regulation.
It’s not just the Feds who will demand crystal-clear accounts. The prospect of a breakup of congloms like Viv U or even AOL TW will require real numbers with which to make accurate valuations, particularly when it comes to deciphering the mysterious branches of showbiz.
“We are living through a time when merely complying with (generally accepted accounting principles) may not be enough,” AOL TW CEO Richard Parsons acknowledged to analysts and investors July 24 during a conference call about the company’s second-quarter earnings.
The humbled conglom is in the eye of the SEC storm at the moment, as auditors review the veracity of the company’s disclosures, revenue recognition and handling of the AOL TW merger in 2000.
Parsons said AOL TW is simplifying corporate structure and disclosing more financial detail than legally required because “the state of the market calls for it.”
However, David Londoner, longtime Wall Street media analyst and adviser to numerous exec suites, worries that overzealous auditing could do investors more harm than good.
“Wall Street has come to expect certainty in earnings and it doesn’t exist in the business world and especially not in the movie business,” Londoner tells Variety. “The pressure to meet Wall Street’s expectations is enormous: in a bull market it’s intolerable; in a bear market it’s death.”
Variety has surveyed bankers and bookkeepers to come up with key issues about which media companies may be wise to come clean — not because they’re necessarily doing anything illegal, but because, in the absence of info, investors are assuming the worst.
Consider these problem areas:
- Company reporting
The hue and cry on Wall Street and in the investor heartland demands greater transparency among publicly traded corporations. But the trend among consolidating entertainment industry is to disclose less.
This is all perfectly legit since a studio’s earnings at, say 10% of total corporate income, is considered of marginal impact to the parent.
Still, “these things muddy the waters and go against the tenor of the times, which demands greater clarity in company finances,” says veteran media analyst and current fund manager Hal Vogel.
He is particularly dismayed by Viacom’s decision to lump together theme parks, publishing, movie theaters and filmed entertainment into a single line item on the income statement.
“If you’re not trying to hide something, break it out,” pleads the former Merrill Lynch media analyst, who also authored the industry bible on showbiz accounting and finance, “Entertainment Industry Economics” (now in its fifth edition).
“The lack of access to real numbers in this industry is astounding and it’s getting worse all the time. We have no way to judge Hollywood’s actual return on equity nor can we accurately assess the year-to-year health of the film business.”
- Hidden liabilities
Viv U brought to light the dangers of burying important info that can inflate earnings while hiding liabilities — such as its practice of consolidating 100% of the revenues of telecom unit Cegetel, in which it owns only minority stakes.
Even more questionable was Viv U’s understating of its debt liabilities by as much as $8 billion over the past year. What may have been kosher under French accounting rules didn’t reassure investors who later found a host of contingent liabilities and sales guarantees that recently sparked a cash crisis.
Other financial constructs, such as put clauses and earn-outs on acquisitions are potentially more problematic than accounting issues, and are only visible in the fine print of SEC filings.
With insufficient controls, deals that barely raise eyebrows in boom times become time bombs when the market sours.
Put options, such as those exercised by News Corp.-backed BSkyB in demanding payment for its stake in ailing German paybox Premiere, for example, helped push Kirch into bankruptcy.
- Accounting issues
Over the past few years, the introduction of several accounting rules has had an impact on media balance sheets.
Earlier this year Financial Accounting Standards Board (FASB) 42 required all companies to regularly test and write off excessive goodwill, leading to gigantic write-downs by AOL TW and Viv U, reflecting the serious loss in corporate value after expensive acquisitions sprees.
Before that, FASB 139 tightened up reporting requirements for film and TV producers and distributors, which requires all marketing costs to be expensed as incurred, as opposed to being capitalized and amortized over the entire distribution lifetime of the movie or TV show.
The rule alleviated some of the gross excesses of the past, but it does not fully resolve the complicated issue of just how long a program’s useful life is.
- Film amortization
Accounting has always been nebulous where film and TV companies are concerned, for a number of reasons. For example, revenues on a production are earned over many years, long after costs have been recognized.
Problems can arise when studios increase production expenditures faster than they were amortizing them historically.
“This just increases the likelihood of unpleasantness later,” explains Vogel.
One former studio exec says the whole system is constructed around residuals and the guilds.
“It’s like trying to trace the path of a phone call — revenues mysteriously come in and just as mysteriously go out,” he said. “Only a few individuals (such as big-ticket talent) can afford to do an audit to verify the income they’re due, and in most cases, the audit will invariably find something amiss.”
But shareholders and production participants are two very distinct constituencies for Hollywood bookkeepers, and the goals of serving the former (show them the biggest possible numbers) tends to conflict with those of the latter (minimize movie profits to contain residual payments).
- Forecasting revenues
One former CFO at a major media firm says the real challenge is trying to forecast future revenue streams from TV and movies over 10 years. In a five-year TV syndication deal, for instance, the producer can record upfront the full value of the deal, even before all costs are incurred. This makes earnings lumpy from year to year and easy to manipulate to smooth earnings or quickly repair a poor quarter.
Londoner, who advised FASB on the amortization rule changes, defends the limitations of the guidelines. “It’s not the accounting practices of media companies that’s so obscure,” he says. “It’s the flexibility that it enables. Estimating film grosses is totally a judgment call.”
- Off-balance-sheet financing
Enron revealed all too painfully the dangers of parking too much debt in special-purpose financial vehicles that don’t appear on the balance sheet but for which the company still is liable for losses. Such “off-balance sheet” practices are thought to be common among large media groups, particularly for financing TV and film products.
Showbiz is much more above board than Enron in this area. But the terms of these esoteric agreements are well-guarded secrets and every deal is constructed differently.
Essentially, off-balance sheet deals “securitize” certain programming assets (series or a package of films). This is in contrast to the multi-billion dollars in unsecured loans that investment banks like JP Morgan Chase lent to Enron.
The fund fronts the money for production, keeps the copyright for a fixed number of years and pays the participating studio a distribution fee. While this minimizes the risk in film production, it limits the potential upside and distorts the true costs and returns of production businesses.
But whom you choose to borrow from (remember Eli Samaha and Franchise Pictures?) and how, may ultimately be more compromising than the perfectly legitimate financial and reporting arrangements of the deal.
- Dubious terms
Some corporations have put the emphasis on EBITDA (earnings before interest, taxes, depreciation and amortization) or cash flow. But the bottom line (after all those nasty charges) is what counts.
By and large, entertainment companies play fair, meeting the letter, if not exactly the intent, of the law. But in an environment where a good accountant is defined as one who can “put lipstick on a dog,” the pressure to obfuscate is strong.
Ultimately, says one exec, dubious accounting won’t bankrupt a company; only running out of money can do that. But investors (if not Wall Street equity analysts) have lost their innocence, and the golden days of “don’t ask, don’t tell” may be over.
Full Disclosure is in, and better now than when under the SEC’s microscope.