A producer's cut: CPAs can play critical role in resolving royalty disputes.

It's common to hear of the disappointments and disputes of authors, writers and producers in the motion picture industry who receive very little in royalty or salary compensation for their contributions to a film.

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During these disputes, a CPA is often hired to perform a forensic analysis of the books to resolve the matter by determining economic damages. In some cases, the outcome may be surprising because compensation structures can vary significantly in the entertainment industry.

FACTORS TO CONSIDER

There are many factors that can impact the amount of royalties paid to various contributors to a film. One is whether the royalties are based on net profits or first-dollar-gross.

Net profits typically are comprised of the studio's share of revenue, less distribution fees and costs associated with production, prints, promotion and advertising. Salaries and royalties from the film's stars also are deducted to arrive at net profit.

First-dollar-gross represents the gross box-office revenues before the deduction of any expenses.

Net profit participants are often a film's writer, "B-level" talent, the composer and in some cases, the cinematographer. First-dollar-gross participants are typically directors and stars such as Tom Hanks, Cameron Diaz, Brad Pitt and the like.

The Motion Picture Association of America reports that Hollywood spent an average of $96 million in 2005 to make and market a film. As a result of such high production and marketing costs, net-profit participants carry a much higher risk than first-dollar-gross participants because they may have contributed to a box office hit and may not see a return for many years, if at all. This is because such high marketing and production costs significantly reduce the net profit, which is the basis used to compute royalties paid to net profit participants

The distribution method, which is typically selected by the studio, also can impact a film's profitability and royalties. Often, disputes will arise on films that did not make widescreen distribution and, as a result, were distributed to a very limited number of screens or went straight to DVD.

A widescreen distribution is critical to a film's profitability because it launches "word-of-mouth" marketing. It is common for studios to see a film experience a loss in the initial domestic theatrical release. The expectation, though, is that a good film will receive a significant amount of momentum through word-of-mouth marketing and critic reviews and will turn a profit either during the international theatrical phase or in the subsequent channels of distribution, such as DVD or cable or network television.

CASE STUDY

An ongoing legal dispute is Wingnut Films, Ltd. v. Katja Motion Pictures Corp., New Line Cinema Corp., and New Line Productions, Inc.

Wingnut provided the writing, producing and directing services for the hugely successful film The Lord of the Rings: The Fellowship of the Ring. In the complaint, Wingnut alleges, among other things, that Katja, New Line Cinema and New Line Productions failed to properly account for and pay to Wingnut its share of profits.

Wingnut was to be paid a fixed compensation and receive a share of the first-dollar-gross receipts of The Lord of the Rings trilogy, in addition to other contingent compensation for revenues derived from other media, such as DVD sales and merchandise gross receipts received from promotional partners.

The following are selected excerpts of the allegations in the complaint, which would alert the CPA that the license fee arrangement is a complex one requiring an in-depth forensic analysis:

"* Defendants have improperly deducted certain costs related to home video other than the enumerated costs set forth in the agreement;

"* Defendants have accounted and paid for the sale of DVD units at an incorrect royalty rate;

"* In instances in which Defendants have used affiliated entities as the subdistributor of the Film, Defendants have permitted the imposition of subdistribu-tion fees that are in excess of the subdistribution fees charged by unrelated third party subdistributors;

"* Defendants have failed in good faith to include in Gross Receipts a reasonable sum as the license fee allocable to the Film for the exploitation of pay television rights;

"* Defendants have failed to audit the books and records of subdistributors of the Film, including entities affiliated with Defendants;

"* Defendants have failed to include in Gross Receipts unreported and/or mis-characterized receipts related to the film;

"* Defendants have refused to include in Gross Receipts a significant portion of revenue derived from the sale of soundtrack albums of the Film in which Wingnut is entitled to share;

"* Defendants have improperly deducted arbitrarily accrued costs not permitted in calculating Gross Receipts;

"* Defendants have failed to license, market and exploit the Film subject to reasonable business judgment exercised in good faith as required under the Agreement."

KNOW THE HISTORY

Litigation matters similar to Wingnut most likely would include a first-dollar-gross analysis, in addition to a net-profit analysis, which would involve a detailed review of the costs.

The following are some procedures CPAs may consider during a forensic analysis involving litigation disputes similar to Wingnut:

Understand distribution arrangements. The agreements will provide the CPA with the royalty rate, any applicable advances and the types of expenses deducted prior to computing the royalty amount, along with other information. It is important to note that the accounting for profit participation and royalties is often contractually driven and often deviates from GAAP accounting.

Understand the film's history. If the film, such as The Lord of the Rings, is based on a book, it may be pertinent to understand the popularity of that book. Additionally, since The Lord of the Rings is based on a trilogy, it may be pertinent for the CPA to consider analyzing the performance of related releases. This may be pertinent in matters similar to issues raised in Wingnut, where there is an allegation that the defendants failed to adequately market and exploit the film. An analysis of the popularity of the book or related movie releases may provide further support regarding the expected performance of the film.

Become familiar with the genre. The CPA may consider researching the performance of other films in the same genre as the film in question, since the popularity of the genre may vary depending on the geographic location of the release. An analysis of similar films within the same genre may provide further support regarding the film's expected performance.

Analyze film reviews. Film reviews may be helpful in comparing the financial performance of the film with the performance of other films in the same genre with similar reviews. In matters similar to Wingnut, comparing the film's financial performance to the performance of films in the same genre with similar reviews can be used as a revenue reasonableness test for reported revenues. Additionally, this type of analysis can help substantiate or dispute the allegation that the film was not adequately promoted. Reviews can be obtained from various websites, including www.about.com and www.IMDB.com.

Review subdistributor reports and settlement statements. The studios will contract with subdistributors worldwide to distribute the picture to theaters. Sub-distributors are required to provide the studio with settlement statements, which summarize the film's box office performance and detail the final fee arrangements with the theatres. In forensic investigations in which reported revenue for films is in question, the subdistributor reports and settlement statements can be very pertinent to the analysis.

Review internal audit reports and workpapers. The major studios typically have an internal audit division that will audit subdistributors and other licensees. These audits often will result in significant adjustments to amounts reported to the studios in the form of film revenue or royalties on merchandise related to the film. One of the allegations in Wingnut is that the books and records of the subdistributors were not audited. The CPA would address this type of allegation in similar matters by requesting audit reports related to the film and/or film merchandise.

Since there are allegations that gross receipts were underreported in the theatrical and other channels of distribution. Wingnut likely will require revenue projections for various distribution channels. The CPA may consider obtaining historical revenues for films that are in the same genre with similar reviews.

Since the remaining two Lord of the Rings films were released prior to the filing of the complaint, the CPA may consider reviewing the performance of those releases as a basis for the revenue analysis. Historical revenues for films can be obtained from www.Baseline.com, which has an extensive database of revenues for films in the various distribution channels such as theatrical, video, DVD and television.

Additionally, Wingnut includes allegations that costs were incorrectly deducted from the revenues to arrive at the net profit amount. In similar matters, the CPA may need to analyze the costs of the picture in addition to analyzing film revenues. The historical costs of the picture can be obtained directly from the client or studio if it is a matter in which historical data can be relied upon.

However, if the matter requires the projection of distribution and marketing expenses without the benefit of historical data, www.Baseline.com provides cost estimate reports by film. The CPA may consider using these reports for comparable films as part of the analysis.

THAT'S A WRAP

Behind the scenes in Hollywood are very complex business deals, which often result in legal disputes requiring the expertise of a CPA.

There are many factors that can impact the outcome of a theatrical royalty dispute and a thorough analysis performed by the CPA may yield surprising results.

Frances Franco-Valdez, CPA is a manager in the litigation and forensic consulting group at Hemming Morse Inc. in Los Angeles. You can reach her at [e-mail].

BY FRANCES FRANCO-VALDEZ, CPA