Kombar Rex: adventure film producers.

Bell, Janice ; Williams, Melanie Stallings

CASE DESCRIPTION

The primary subject matter of this case concerns the interpretation of contracts and the calculation of revenue. Secondary issues examined include distinguishing cash flow vs. GAAP (Generally Accepted Accounting Principles) income, understanding the timing of revenue recognition and understanding how to budget revenue. The case has a difficulty level of three (appropriate for junior level). The case is designed to be taught in 1-1.5 class hours and is expected to require 3-5 hours of outside preparation by students.

CASE SYNOPSIS

In this case study, students must examine a film distribution agreement to determine its validity, scope and consequences. Adventure Film Producers entered a movie distribution agreement with a large movie theatre chain, Mammoth Theatres, Inc. One of Adventure's "hit" movies was bundled with four "filler" films, each requiring a certain number of screenings. Consideration for the contract was based partly on lump sum payments and partly on the number of screenings. In exchange, the distributor was given exclusive screening rights. After the distributor discovered that the films were being shown in Canada (where Mammoth had no theaters) they alleged that Adventure breached the agreement and demanded a return of all monies paid. Students must examine whether Adventure breached the exclusivity provision of the contract by allowing showings in Canada and must then perform the financial analyses to determine revenues. In order to analyze revenue, students must prepare a budget of expected minimum revenues, apply established revenue recognition criteria, and calculate the reportable revenue using GAAP principles. Students then prepare a schedule showing cash flow and distinguish that number from revenue.

INSTRUCTORS' NOTES

SUGGESTED SOLUTIONS

1. Did Adventure breach the contract? Specifically discuss whether the showing by a competitor movie chain in Toronto constituted a violation of the Adventure/Mammoth agreement.

The discussion should focus on the scope of the distribution agreement. Specifically looking at the Exclusivity paragraph of the contract, what was the geographic limitation of the agreement? If Mammoth was granted an exclusive license to distribute the Kombat Rex films anywhere in the world for the six month period, then Adventure Films' conduct of granting distribution rights of the movies to a theatre in Toronto would be In violation of that agreement. On the other hand, we need to look at what the parties intended. Since Mammoth had theaters located only in the U.S., is it reasonable to interpret the agreement as granting Mammoth exclusive distribution only in the U.S.?

Briefly, there should be a discussion of how, despite the ambiguity about the relevant territory, there is really no question that the parties intended a contract. There should be some reference to DeSantis or Bohman in the library materials to the effect that the parties reasonably intended to be bound (and base their business expectations) on the enforceability of the contract, and a court will enforce the contract with its interpretation of the parties' reasonable expectations.

Mammoth will argue that Adventure Films was barred from allowing the Toronto theater to screen the films. In support of that point, Mammoth can argue that the plain language of the contract contains no geographical limitation. Since an important purpose in entering the contract (and for which Mammoth presumably paid a premium) would be the sole right to screen the film, and since the plain language of the agreement contains no restriction on the geographical region, then Adventure Films breached the agreement by allowing a Canadian theater to screen the films. The Morey case and Witkin (from the Library materials) would be relevant in identifying that the objective manifestations of the parties' intent is to be used to interpret the contract.

Adventure Films would argue that since Mammoth had theaters only in the U.S., and not Canada, their agreement was, by implication, limited to the U.S. Of what business purpose would it be to Mammoth to have an exclusive contract in a country in which they had no theaters? A logical reading of the contract (Adventure would argue) would be that the contract's exclusivity clause applied only to areas in which Mammoth had theaters, i.e. the U.S. Adventure would use Morey for the proposition that not only the objective language of a contract but also the parties' object in the contract should be used in determining its meaning. Surely Mammoth's object must have been to limit competition in areas in which Mammoth theaters were located.

It would frustrate no business purpose of Mammoth to allow a Canadian theater to show the films, since Toronto is not close enough to any American market that would draw viewers who might otherwise see the film in the U.S. The same could not be said, for example, if the theater were in Windsor, Canada (on the border near Detroit); however, Toronto is obviously not a destination to which one would travel just to see a movie. Therefore, it is consistent with a logical interpretation of the agreement's purpose to limit the exclusivity to areas in which Mammoth had legitimate concerns about competition, i.e. the U.S. or immediately adjoining areas. Mammoth would use Levi Strauss to support their argument that the contract means what the parties designate; agreements are not re-made by courts and that therefore the broad language apparently granting Mammoth worldwide filming rights should be enforced. Adventure would counter that Cal Civ. Code [section] 1648 and Rivers show that contracts extend only to those things intended by the parties (no matter how broadly written), which, according to Adventure Films, would be the U.S. theater market.

2. Assuming the contract is valid, prepare the following financial analyses:

a. Prepare a budget of expected minimum revenues from the set of five films over the term of the contract.

Expected Minimum Revenue

Film/Fee # of # of showings Total contracted
 Theatres per contract showings

Kombat Rex 475 42 19,950
KR II 475 18 8,550
KR III 475 18 8,550
KR IV 475 18 8,550
KR V 475 18 8,550
Contract Fee

Total Budgeted 54,150
Revenue

Film/Fee Revenue per Budgeted
 showing Revenue

Kombat Rex $500 $9,975,000
KR II $500 $4,275,000
KR III $500 $4,275,000
KR IV $500 $4,275,000
KR V $500 $4,275,000
Contract Fee $5,000,000

Total Budgeted $32,075,000
Revenue

b. What are the general revenue recognition criteria established under Generally Accepted Accounting Principles (GAAP)?

Per GAAP, for revenue to be recognized, it must be realized or realizable and earned

Realized or realizable means that the amounts being recognized as revenue have been received in cash or your company has a claim to cash through a receivable. The receivable must be from a company with a good credit rating; that is, the receivable must be collectible.

Earned means that your company has performed the most important tasks to be entitled to the revenue. Usually this means that you have delivered merchandise or rendered a service to a customer and title has legally passed for the merchandise to the buyer or the buyer is legally obligated to pay for the service received.

c. How would you apply the GAAP criteria for revenue recognition to account for the revenues under this contract? Explain your logic for both realizable and earned.

It is difficult to apply the GAAP criteria to this contract for several reasons.

First, the contract isn't exactly clear what the $5,000,000 fee is for. Presumably, it relates to providing Mammoth the exclusive right to show the set of films in its theatres. If so, then although all of the $5,000,000 is realized by 12/31/3, it isn't earned until Mammoth gains exclusive use for a full six months. Given that logic, you might divide the $5,000,000 by six months and recognize it evenly with the passage of time over the six-month period. Others might argue that the $5,000,000 was simply an inducement for signing the contract; they will want to recognize it all as revenue when it is received in cash. Some students may want to postpone recognition until the entire 6-month period is over and Adventure has fulfilled its part of the contract.

Industry rules written by the American institute of Certified Public Accountants (not available to students, but you might want to mention these at the end of the presentation and discussion) suggest that the amount can be recognized:

1. with the passage of time (divide by 6 months and recognize $833,333 per month)

2. or with the showing of the films (for example, 10,925 at year end divided by 54,150 minimum showings expected under the contract times $5,000,000 or $1,008,772 would be recognized by 12/31.)

The other difficulty with the revenues under this contract is the number of times that Mammoth reports showing the films at 12/31/03. They have only shown 10,925 movies of the 54,150 total showings expected. It seems that they may not be meeting the contract terms to show each KRII-V 18 times per 42 showings of Kombat Rex. In the four months, Kombat Rex has been shown 8,550 times. That is approximately 42.8% of the total showings allowed (19,950). That means that approximately 14,638 showings of KRII-V should have occurred (34,200 in total times 42.8%.) This creates a dilemma. Adventure needs a report that shows if each theatre has lived up to the contract terms to show each of the lesser films 18 times while showing Kombat Rex 42 times. If they haven't (and they don't intend to do so), then Adventure may be owed more money than they were paid in January or perhaps Mammoth has breached the contract.

Regardless of how the audit of the number of showings comes out, the $5,462,500 shown on the 12/31/03 summary is a receivable at year-end. In fact, it was paid in January 2004, so the receivable did exist. These facts mean that this amount meets the realizable test for revenue recognition. In addition, that amount was also earned, since Adventure provided Mammoth with the films for showing and Mammoth showed the films.

d. Using the logic you developed in part c, calculate the revenue that Adventure Films should report for the set of five films for the year ended 12/31/2003.

Assuming that the $5,000,000 will be recognized evenly over 6 months and that Mammoth does have a plan at 12/31/03 to show each film the required minimum times in the remaining months of the contract, I would recognize:

Revenue Calculation Total

Fee $5,000,000/6 * 4 $3,333,333

Film Showings Given in Mammoth's table 5,462,500

Total revenue from 8,795,833
contract at 12/31/03

Notice that Adventure cannot anticipate additional revenues until they audit a theatre-by-theatre schedule of movies shown and scheduled. Accountants want to be conservative when they recognize revenues.

e. For the year ended 12/31/2003, prepare a schedule that shows the cash flows received from Mammoth for the contract.

Source Explanation Amount

Fee Received on contract signature $5,000,000
 and September 1

Films Received by Adventure 0
 in January 2004

Total cash received 5,000,000

f. Why do cash flows and revenues recognized differ, if they differ under your calculations?

Cash flow measures the amount of cash that Adventure had available from the contract through 12/31/03. Cash is real; it is a balance sheet asset. It is used to pay operating bills, finance expansion, or invest. It is important to understand the timing of expected cash flows so a cash budget can be prepared. If we plan excess cash, we can plan to invest it. If we budget a cash shortage, then the company can arrange to borrow either temporarily or long term to meet upcoming obligations.

Revenue, on the other hand, is a measure of the amount of work that the company performed during the period whether or not cash was received (as long as the company has a claim to cash.) Revenues go on the income statement. The income statement provides investors and creditors with information about the results of the earnings activity during a time period. It is a measure of the company's effectiveness (revenues show that people buy our products/services) and efficiency (the amount of expenses the company incurs to earn those revenues.)

Since the purpose of information about cash flow and revenues differs, the amounts should not be the same under normal circumstances.

STATEMENT OF FINANCIAL ACCOUNTING CONCEPTS

Statement 5. Recognition and Measurement in Financial Statements of Business Enterprises Financial Accounting Standards Board

GUIDANCE IN APPLYING CRITERIA TO COMPONENTS OF EARNINGS

CON5, Par. 78

CON5, Par. 78

78. This section discusses the need for and provides further guidance in applying the fundamental criteria in recognizing components of earnings. Changes in net assets are recognized as components of earnings if they qualify under the guidance in paragraphs 83-87. Certain changes in net assets (discussed in paragraphs 42-44 and 49-51) that meet the four fundamental recognition criteria just described may qualify for recognition in comprehensive income even though they do not qualify for recognition as components of earnings based on that guidance.

CON5, Par. 79

79. Further guidance in applying the recognition criteria to components of earnings is necessary because of the widely acknowledged importance of information about earnings and its components as a primary measure of performance for a period. The performance measured is that of the entity, not necessarily that of its management, and includes the recognized effects upon the entity of events and circumstances both within and beyond the control of the entity and its management. 48 The widely acknowledged importance of earnings information leads to guidance intended in part to provide more stringent requirements for recognizing components of earnings than for recognizing other changes in assets or liabilities.

CON5, Par. 80

80. As noted in paragraph 36, earnings measures the extent to which asset inflows (revenues and gains) associated with substantially completed cash-to-cash cycles exceed asset outflows (expenses and losses) associated, directly or indirectly, with the same cycles. Guidance for recognizing components of earnings is concerned with identifying which cycles are substantially complete and with associating particular revenues, gains, expenses, and losses with those cycles.

CON5, Par. 81

81. In assessing the prospect that as yet uncompleted transactions will be concluded successfully, a degree of skepticism is often warranted. 49 Moreover, as a reaction to uncertainty, more stringent requirements historically have been imposed for recognizing revenues and gains than for recognizing expenses and losses, and those conservative reactions influence the guidance for applying the recognition criteria to components of earnings.

CON5, Par. 82

82. The guidance stated here is intended to summarize key considerations in a form useful for guidance for future standard setting--guidance which also is consistent with the vast bulk of current practice. The following paragraphs provide guidance separately for recognition of revenues and gains and for expenses and losses as components of earnings.

Revenues and Gains

CON5, Par. 83

CON5, Par. 83

83. Further guidance for recognition of revenues and gains is intended to provide an acceptable level of assurance of the existence and amounts of revenues and gains before they are recognized. Revenues and gains of an enterprise during a period are generally measured by the exchange values of the assets (goods or services) or liabilities involved, and recognition involves consideration of two factors (a) being realized or realizable and (b) being earned, with sometimes one and sometimes the other being the more important consideration.

84.a. Realized or realizable. Revenues and gains generally are not recognized until realized or realizable. 50 Revenues and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. Revenues and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. Readily convertible assets have (i) interchangeable (fungible) units and (ii) quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.

b. Earned. Revenues are not recognized until earned. An entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, 51 and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. Gains commonly result from transactions and other events that involve no "earning process," and for recognizing gains, being earned is generally less significant than being realized or realizable.

CON5, Par. 84

Janice Bell, California State University, Northridge

Melanie Stallings Williams, California State University, Northridge