Case 6-1 Income Recognition in the Motion Picture Industry

The motion picture industry has undergone significant changes since the 1960s. Originally, companies such as Paramount Pictures
had to rely solely on domestic and foreign screenings of their movies for their revenues. The birth of the television industry in the
1960s resulting in opportunities for broadcastings rights to networks and individual stations. Moreover, the introduction of cable
television in the 1970s opened up substantial new sources of revenue. In addition, the unsaturated demand for new films resulted
in a market for made-for-television films. And the invention of the video recorder opened yet another revenue source for these
companies.

The production of film involves four phases:

1. Acquisition of the story rights

2. Preproduction, including script development, set design, cost selection, costume design, and selection of a filming
location
3. Actual filming
4. Postproduction, including film editing, adding the musical score, and special effects

Warmen Brothers Production Company has just finished the production of Absence of Forethought, a movie that is expected to be
successfully distributed to all available markets

Required:

a. What markets are available to Warmen Brothers for this film?

b. In what order would you suggest Warmen Brothers attempt to enter each market? Why?
c. How should revenue be recognized from each market?
d. How should costs be matched against these revenues?
e. What effect will your decisions have on Warmen Brothers’ income statement for the year’s revenue?

a. There are several markets that would be available to the Warmen Brothers for the release of this film. This includes
the theatrical release of the film both domestically and in foreign markets. This might also include the rental and
purchase markets (domestic and foreign). This would be accomplished with major retailers such as Amazon or Video
on Demand rentals via cable providers and selling DVD copies through major retailers as well once the film has been
released digitally and on DVD for public consumption. Finally, the third market should include broadcasting rights for
such retailers as Netflix, Hulu, and cable providers (domestic and foreign).
b. Warmen Brothers should enter each of these markets in the above order suggested (theatrical release, rental and
purchase release, and broadcasting release in both domestic and foreign markets for all 3). This would enable Warmen
brothers to maximize their revenue in each market. If the movie were to be released directly for rental or purchase
this would result in a significant reduction in the revenue earning capacity of the movie with respect to the movie-going
or theatrical market.
c. Most domestic and foreign screenings are the result of license agreements or contract related agreements. As such
these revenues should be recognized when the terms of the contract have been completed and when there is
reasonable assurance that payment will be received. With respect to the rental and purchase markets once the film
has been released for public consumption that would depend on the arrangement or terms of the contracts with those
retailers. The movie production company would recognize revenue once they had sold these rights or DVD copies to
these retailers unless otherwise outlined in a contract. Finally, the broadcasting market would be similar to the
screening market in that this would be contingent upon meeting contractual obligations. The production entity would
recognize revenues once the contractual obligations had been fulfilled and assuming that payment for these services
was reasonably assured.
d. Warmen Brothers has several options for attempting to match the expenses associated with the production of the
movie with the revenues earned. The revenue for the second and third markets of the film are largely contingent upon
how well the movie is received during the domestic and foreign theatrical release of the film. Thus if the film was
positively received during this market segment its production costs could be expensed in a three tier system using
previous movie history with similar positive trajectories as the reference source. First, the movie company might
expense the largest portion of these costs during the first market release and amortize these expenses over the life of
their contract agreement. Next, the company might expense a portion of these costs on a % basis for the
rental/purchase market depending on the quantity purchased by the major retailers. Finally, in the third broadcasting
market, the remaining capitalized expenses should be amortized over the life of any broadcasting contracts.
e. Depending on at what point during the year the production was completed and when the movie was scheduled to be
theatrically released in both foreign and domestic markets there might be no impact on the current year’s revenue.
For instance, if the movie were scheduled for theatrical release during the next calendar year, no revenue would be
recognized, and all costs would be capitalized until the movie was released. If the movie was released during the
current year, revenue might be recognized from the domestic and foreign theatre screening contracts.
Case 6-3 Income Statement Format

Accountants have advocated two types of income statements based of differing views of the concept of income: the current
operating performance and all-inclusive concepts of income.

Required:

a. Discuss the general nature of these two concepts of income.

b. How would the following items be handled under each concept?
i. Cost of goods sold
ii. Selling expenses
iii. Extraordinary items
iv. Prior period adjustments

a. Current operating performance concept and the all-inclusive concept of income are defined in the below table:

Current operating This concept implies that normal and recurring items, termed sustainable income, should
performance concept constitute the principal measure of enterprise performance. That is, net income should
reflect the day-to-day profit-directed activities of the enterprise, and the inclusion of other
items of profit or loss distorts the meaning of the term net income.
All-inclusive concept of This concept holds that net income should reflect all items that affected the net increase or
income decrease in stockholders’ equity during the period, with the exception of capital
transactions. This group believes that the total net income for the life of an enterprise
should be determinable by summing the periodic net income figures.
(Schroeder, Clark, and Cathey, 2014)
b. The following items are handled similarly and divergently in some cases under both concepts. This is expressed in
greater detail in the following summary.

i. Cost of goods sold are handled similarly under both the current operating performance concept and the all-
inclusive concept of income. These costs would all be expensed.
ii. Selling expenses are also handled the same as they would be expensed under both concepts.
iii. In the case of extraordinary items these would be recorded as revenues and expenses under the all-inclusive
concept of income. Conversely, these extraordinary items would be considered gains or losses under the
current operating performance concept.
iv. Prior period adjustments would also be considered revenues or expenses under the all-inclusive concept.
With respect to the current operating performance concept and prior period adjustments theses would be
considered gains or losses.
Case 6-4 Accounting Changes

It is important in accounting theory to be able to distinguish the types of accounting changes.

Required:

a. If a public company desires to change from the sum-of-year’s-digits depreciation method to the straight-line method for
its fixed assets, what type of accounting change will this be? How would it be treated? Discuss the permissibility of this
change.
b. If a public company obtained additional information about the service lives of some of its fixed assets that showed that
the service lives previously used should be shortened, what type of accounting change should be reported in the income
statement of the year of the change and what disclosures should be made in the financial statements or notes.
c. Changing specific subsidiaries comprising the group of companies for which consolidated financial statements are
presented is an example of what type of accounting changed? What effect does it have on the consolidated income
statements?

a. “For example, if a company changed from straight-line to sum-of-year’s-digit depreciation, the cumulative effect of this
change on all years prior to the change was calculated and disclosed (net of tax) as a separate figure between
extraordinary items and net income. The cumulative effect (net of tax) was then disclosed as a separate figure
between extraordinary items and net income.” (Schroeder, Clark, and Cathey, 2014) Thus, if a company were doing the
inverse (changing from sum-of-year’s-digit depreciation method to straight-line) it would also be considered an
extraordinary item and calculated and disclosed (net of tax) between extraordinary items and net income.
b. “For example, assume a company originally estimated that an asset would have a useful service life of ten years, and
after three years of service the total service life of the asset was estimated to be only eight years. The remaining book
value of the asset would be depreciated over the remaining useful life of five years.” (Schroeder, Clark, and Cathey,
2014) According to the text, Financial Accounting Theory and Analysis: Text and Cases, this type of situation is handled
prospectively. “They require no adjustments to previously issued financial statements. These changes are accounted
for in the period of the change, or if more than period is affected, in both the period of the change and in the future.
The effects of changes in estimates on operating income, extraordinary items, and the related per-share amounts must
be disclosed in the year they occur.” (Schroeder, Clark, and Cathey, 2014)
c. This type of change would be considered a change in reporting entities. “Changes in reporting entities must be
disclosed retroactively by restating all financial statements presented as if the new reporting unit had been in existence
at the time the statements were first prepared.” (Schroeder, Clark, and Cathey, 2014)
Case 6-9 Comprehensive Income

Earnings as defined in SFAC No. 5 are consistent with the current operating performance concept of income. Comprehensive
income is consistent with the all-inclusive concept of income.

Required:

a. Discuss the current operating performance concept of income.

b. Explain how current earnings, as defined in SFAC No. 5 are consistent with the current operating performance concept of
income.
c. Discuss the all-inclusive concept of income.
d. Explain how comprehensive income is consistent with the all-inclusive concept of income.
e. Explain how comprehensive income is consistent with the financial capital maintenance concept.
f. What additional changes in reporting practices would have to occur for financial reporting to be consistent with the
physical capital maintenance concept? Have some similar changes already occurred? Give an example.

a. The current operating performance concept of income is outlined in the following table:

Current operating This concept implies that normal and recurring items, termed sustainable income, should
performance concept constitute the principal measure of enterprise performance. That is, net income should
reflect the day-to-day profit-directed activities of the enterprise, and the inclusion of other
items of profit or loss distorts the meaning of the term net income.
(Schroeder, Clark, and Cathey, 2014)

b. According to SFAC No. 5, earnings are defined as, “a measure of entity performance during a period. It measures the
extent to which asset inflows (revenues and gains) associated with cash-to-cash cycles substantially completed during
the period exceed asset outflows (expenses and losses) associated, directly or indirectly, with the same cycles.”
(FASB.org, 2008) This is consistent with the definition of current operating performance of income as previously
outlined given that they are both referencing the operating revenue during a given period.
c. The all-inclusive concept of income is outlined in the following table:

All-inclusive concept of This concept holds that net income should reflect all items that affected the net increase or
income decrease in stockholders’ equity during the period, with the exception of capital
transactions. This group believes that the total net income for the life of an enterprise
should be determinable by summing the periodic net income figures.
(Schroeder, Clark, and Cathey, 2014)
d. “Comprehensive income is a broad measure of the effects of transactions and other events on an entity, comprising all
recognized changes in equity (net assets) of the entity during a period from transactions and other events and
circumstances except those resulting from investments by owners and distributions to owners.” (FASB.org, 2008) This
definition of comprehensive income is consistent with the all-inclusive concept of income in that it includes everything
except transactions resulting from investments from or distributions to the owners.
e. The term, financial capital maintenance, is defined in the following table:

Financial capital Occurs when the financial (money) amount of enterprise net assets at the end of the period
maintenance exceeds the financial amount of net assets at the beginning of the period, excluding
transactions with owners. This view is transactions-based. It is the traditional view of capital
maintenance employed by financial accountants.
(Schroeder, Clark, and Cathey, 2014)

"The definition of comprehensive income coincides with this definition of financial capital maintenance due to the fact that
they both encompass changes in the net assets of an organization during a period excluding any capital transactions.

f. The term, physical capital maintenance, is defined in the below table:

 Physical capital Implies that a return on capital (income) occurs when the physical productive capacity of the
maintenance enterprise at the end of the period exceeds its physical productive capacity at the beginning
of the period, excluding transactions with owners. This concept implies that income is
recognized only after providing for the physical replacement of operating assets. Physical
productive capacity at a point in time is equal to the current value of the net assets
employed to generate earnings. Current value embodies expectations regarding the future
earning power of the net assets.
(Schroeder, Clark, and Cathey, 2014)

“When productive capacity is measured using replacement costs, assets are stated at the cost to replace them with similar assets
in similar condition. To maintain the entity’s physical productive capacity, it must generate enough cash flows to provide for the
physical replacement of operating assets. To determine income under this approach, revenues are matched against the current
cost of replacing these items. Consequently, income can be distributed to the owners without impair the physical capacity to
continue operating in the future.” (Schroeder, Clark, and Cathey, 2014) Currently there are some reporting methods which are
consistent with the physical capital maintenance concept. This includes discounted present value which is the, “measurement of
net asset value of the future cash flows expected to be received from an asset (or liability) that should be disclosed in the balance
sheet. Under this method, income is equal to the difference between the present value of net assets at the end of the period
and their present value at the beginning of the period, excluding the effects of investments by owners and distributions to
owners.” (Schroeder, Clark, and Cathey, 2014) The discounted present value technique is a useful balance sheet measurement,
“to the extent that these estimates approximate reality.” (Schroeder, Clark, and Cathey, 2014)
Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2014). Financial Accounting Theory and Analysis: Text and Cases. Hoboken: John
Wiley & Sons.

Statement of Financial Accounting Concepts No. 5 Recognition and Measurement in Financial Statements of Business Enterprises.
(2008). Retrieved October 8, 2017, from
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