How Hollywood cooks the books

Disney (NYSE:DIS) will make a fortune from the new Star Wars film. But that's no guarantee anyone else will.

Star Wars: Return of the Jedi, Forrest Gump and Harry Potter and the order of the Phoenix were very popular films. But according to Hollywood accounting practices, none of them made a profit.

The release of the new Star Wars Movie on Thursday night may well become one of the top three grossing movies of all time. It may also turn out to be just as 'unprofitable' as Return of the Jedi. How so?

Because Hollywood accountants are just as creative as those hired to act, direct or design the special effects. They don't subscribe to the common accounting rule that profit is revenue minus costs, instead finding a way to actually take their profit before any expenses are deducted. Neat eh?

The wizardry is a trick created by the 'distribution fee', usually around 32-35% of the studio's share of the gross box office proceeds.  Yes, the studio effectively pays itself to make the movie. It is only after the studios take their cut that expenses relating to the making of the film are deducted. The overall effect is to make movies look like a loss making venture.

Why the pretence? Well, the lower the 'reported' profits the less the studios have to pay in royalties to actors and directors. Because their contracts are linked to net proceeds, extracting the distribution fee first reduces the royalties paid.

Dick Smith (ASX:DSH) is another example of the ease with which apparent profitability can mislead rather than inform. In the retailer's case profit margins were fairly consistent. Indeed, the company's net margin increased in the lead up to its recent trading update (and subsequent share price crash).

And yet clues existed, just as they do in Hollywood accounting, that all was not well. In 2013, inventory stood at $171m. Two years later it has ballooned to $293m, a sure sign that the retailer was struggling to sell its product range. In 2015 the company also had negative cash flow from operations. A year previously it was positive $52m. Both were signs of a business with problems – problems not apparent were one to look solely at profitability.

And the lesson? There is no single metric or ratio that paints an accurate position of a business. Rather, there are disparate pieces of a jigsaw that your analysis needs to assemble before the big picture reveals itself. Movie investors have learnt this lesson the hard way, as have Dick Smith shareholders.

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