Creative accounting can hamper your investment returns.
James Cameron's film Avatar is breaking box office records as audiences around the world flock to see its revolutionary special effects. But there's a big question that's yet to be answered; after the accountants have finished with it, will Avatar make a profit?
In recent years the improvements in computer-generated imagery have enabled filmmakers to create some truly memorable scenes; veritable "movie magic." But some of the greatest magic in the movie business is performed by the studios' accountants who use "Hollywood accounting" to ensure that a profitable film doesn't make an accounting profit. This is done in order to prevent anyone who is entitled to a share of the net profits from getting anything and it's the reason why only the really big stars and major league directors ever get a percentage of the gross.
Sometimes you can find examples of equally dodgy accounting in other companies' accounts where the firm attempts to overinflate or, very occasionally, depress its profits. Investors beware!
Profit, What Profit?
It cost roughly $100 million to produce all 110 episodes of the science-fiction TV show Babylon 5. Today, it is still being shown in numerous countries, is known to have grossed more than a $1 billion, including DVD sales. Yet the show's creator J. Michael Straczynski has never received a single cent of his entitlement to net profits. As he put it; "by the terms of my contract, if a set on a WB movie burns down in Botswana, they can charge it against B5's profits."
Another example is the 1994 hit movie Forrest Gump which, even though it grossed more than ten times its production cost, somehow didn't manage to break even. The result was that Winston Groom, the author of the book, didn't get any share of the net profits. If you're wondering why the sequel has yet to be made, the story goes that Groom said that in good conscience he couldn't allow money to be wasted on a failure!
Surprise, surprise! The phenomenally successful Lord of the Rings films also failed to make a profit; or at least that's what the studio tried to claim. A few months ago, the Tolkien estate came to an out-of-court settlement with New Line Studios concerning its share of the profits. Good news for fans is that this has removed the major roadblock which was preventing The Hobbit from being turned into a film. Gollum and Smaug couldn't stop Bilbo Baggins but Hollywood Accounting almost did!
Businesses' Hollywood Accounting
There are numerous ways in which companies "adjust" their accounts to flatter their profitability. Sometimes a company classifies some of its regular costs as "exceptional items" in order to make its ongoing businesses appear to be more profitable. Or there's the trick where reductions in asset values are put through the balance sheet instead of the profit & loss account but any increase in asset values are appear in the profit and loss account. In theory a company could write down an asset in one year, add it back the next year and claim that this is a real profit!
Then there's the potential for misusing the restructuring provisions which firms can make after a merger. Make some extremely large "provisions" to generate a big one-off loss then gradually write back these provisions over several years to boost your profits or use them to smooth out any fluctuations in profits so as to meet your profit targets for those juicy bonuses!
Manchester United, currently in the process of rescheduling the loans which the Glazer family needed to buy the club, booked roughly half of its new four-year sponsorship deal with the insurer AON in last year's accounts even though the AON logo won't appear on the shirts until next season. The suspicion is that this was done to flatter last year's accounts because prudent accounting practices require that revenues are booked in the years when they are earned.
Another variation on Hollywood Accounting is transfer pricing, where a multinational business sells goods and services between its subsidiaries in two countries at vastly different prices, effectively transferring the profits from a high-tax country to a low-tax country in order to reduce its tax bill. Good news for shareholders but bad news for the taxman which is why stories about "unfair tax competition" emerge from time to time from our government in Brussels.
Investors should beware of companies adopting Hollywood accounting to create fantasies in their accounts.
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