Livent Inc.: Accounting for Pre-Production Costs

University Degree Business and Administrative studies

Executive Summary

This report advises Mr. Phillip Clark, a member of Livent Inc.’s audit committee, on what actions to take regarding recent criticisms the company has experienced concerning their treatment of pre-production costs. Essentially, analysts feel that Livent’s current policy of deferring pre-production costs is too aggressive. The most important users that must be considered when determining what approach to take regarding pre-production expenses are the board of directors, the management, Mr. Clark and the auditing committee, Livent’s shareholders, and the C.C.R.A.. The overriding objective of these users is one of presenting the financial aspects of the company in the most economically realistic way, despite having determine that management’s significant influence on the board might make profit maximization a conflicting objective.

Four alternatives were presented. The first was to continue with the current policy, a policy that some analysts had actually stated was a more conservative approach then what the movie industry uses. The second alternative involved keeping with the current policy but making it more transparent in order for investors to asses how the costs were being evaluated and adjusted. The third alternative called for adopting the policy employed by the movie industry, which forecasts revenues of a production and then amortizes pre-production costs based on a ratio of current revenues to forecasted revenues for the period. The final, and most conservative approach would involve simply expensing all pre-production costs as they are incurred.

The recommendation presented to Mr. Clark was a hybrid of the proposed alternatives and would treat pre-production costs differently based on whether the show being developed was a reproduction, restoration, origination, or a touring production. In this case the current policy would be used for reproductions and restorations, originations would be expensed as incurred, and touring productions would employ the movie industry approach.

Table of Contents

Role

To advise Phillip Clark, a member of the audit committee for Livent Inc., on the best approach to take when accounting for pre-production costs. Advising Mr. Clark will involve discussing what effects each policy will have on the company and how the board will react to the policy suggestions.

Users and Objectives

The board of directors (see Appendix A) are the most important set of users that need to be taken into account when considering a policy change of this magnitude. The board will be the ones that approve or reject any recommendations for significant policy changes from the audit committee, and it is the board that act as agents for the company’s shareholders. It is interesting to note that several executive managers of the company are both on the audit committee and on the board, which could signal a conflict of interest if the policy changes prove to be beneficial to shareholders but not to management. By definition the board of directors should act in the best interest of the organization’s shareholders, and will therefore reject any policy recommendation that fails to represent the true economic situation of the company.

Due to the significant influence within the board, the company’s executive management will be a critical user when considering any significant policy changes. Under the assumption that executive management receive some form of remuneration based on the profitability of the company, the management staff will be most receptive to accounting policies that take a more aggressive approach in order to maximize profits.

Phillip Clark and the remaining members of the organization’s audit committee will be held accountable for the preparation of the company’s financial statements, and in turn must also be considered significant users. The audit committee is appointed by Livent’s board of directors to ensure transparency and accuracy, and to enhance the company's efficiency by building the confidence of its investors. The audit committee will be held responsible for any accounting policies that were put in place in order to deceive shareholders and to manipulate accounting information.

The organization’s shareholders will be significantly impacted by the company’s accounting policies regarding pre-production ...

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The organization’s shareholders will be significantly impacted by the company’s accounting policies regarding pre-production costs. However, the shareholders have appointed the board of directors with the power to make such policy decisions on their behalf in order to achieve the objectives of maximizing their return and presenting the financial reality of the company to them through financial reports.

The Canada Customs and Revenue Agency (C.C.R.A.) would be a user in this case, since these policy changes could have material repercussions on the amount of taxes that Livent will pay. The C.C.R.A.’s objective will be one of ensuring that Livent is representing the true economic reality of the company in their financial statements and, in doing so, paying a fair amount of tax.

In considering the most important users and their respective objectives, it seems obvious that two conflicting objectives have presented themselves. The shareholders and the board of directors they have appointed are concerned with choosing the accounting policy that will show the economic reality of Livent through accuracy and transparency. On the other hand, the company’s management would be interested in maximizing income in order to make the company appear more profitable and raise the stock price. In the end, an accounting policy that represents the economic reality of Livent should be used, although this will prove to be a difficult task due to the conflict of interest present within the board.

Constraints

The only constraints that must be adhered to when deciding on the most appropriate accounting policy for pre-production costs is that it must adhere to Canadian G.A.A.P. and be consistent with Canadian tax laws.

The Issue

Livent’s accounting policies regarding pre-production costs have been recently criticized as being too aggressive. It must be determined whether these allegations have any grounds and whether a reassessment of these accounting policies might be in the company’s best interest.

Alternatives

Do Not Change Policy

The simplest thing for Mr. Clark to do would be to not suggest any changes in Livent’s pre-production accounting policy. In this case the company will continue to capitalize all pre-production costs associated with each production and then amortize the costs after the opening day of each show. The amount to be amortized each year is essentially the annual operating profit of the individual production, this will continue until the pre-production costs are fully amortized. In the current year, Livent also implemented an additional policy limiting the amortization to a maximum of five years. If it was recognized that a production would not be able to recover the pre-production costs, the remaining cost would be written down.

The current policy has the distinctive advantage of not being based on any sort of accounting estimates that are prone to manipulation by management. This policy only recognizes revenue for a production once the full value of the pre-production costs have been recovered. The determinants of whether development costs should be deferred to future periods as seen in 3450.21 of the CICA Hand Book (Appendix B) are easily satisfied and therefore it is suggested that these development costs be capitalized. This method also conforms, in part, to the matching principle prescribed under G.A.A.P. by matching expenses to revenues.

Unfortunately the current policy also faces several pitfalls, which has garnered growing criticism among analysts. A major concern regarding this strategy is that management has significant leeway in terms of distributing and adjusting these pre-production costs. This leeway is achieved through the aggregation of pre-production costs as a current asset, and no disaggregate information for analysts or shareholders to review. Management could theoretically move a cost from one pre-production asset pool into another in order to defer it indefinitely and keep it off the income statement. For Livent, the longer a pre-production cost is deferred, the higher the level of assets reported, which in turn leads to an inflated current ratio. This would have the dual benefit of lowering expenses for the company and furthering the management’s objective of increased book profitability. Another pitfall of continuing with the current policy is that it ignores the useful life of some tangible items in the pre-production account, such as costumes and props. These items may not depreciate in the same time-span during which the pre-production costs are amortized. This would therefore invalidate the matching principle as items such as costumes, that may be used to produce future revenue, would not be amortized in the period that the revenue is generated.

More Transparent Policy

This alternative would consist of Livent continuing with its current policy regarding pre-production costs, while attempting to alleviate the criticism of analysts by being more transparent in their disclosure of pre-production costs. Essentially, Livent would provide shareholders with a greater degree of detail regarding the composition of the pre-production account and an increased level of disclosure on their procedure for amortizing these costs. This approach would allow the company to be more forthright with their procedures and policies and would ease the minds of shareholders and analysts. Investors would be able to closely scrutinize the strategy and more accurately determine whether the company is attempting to manipulate the financial data. Having to disclose the strategy would clearly limit the company’s ability to manoeuvre costs between productions, thereby forcing them to more accurately represent the true economic position of the organization.

The major issue with this alternative is whether the disclosure of the additional information would seriously harm the company’s competitiveness. Being publically traded, competing private production companies would have the ability to analyze the financial statements and identify any weaknesses within Livent’s strategy. However, Livent is the lone production company in North America that is publically traded, indicating that there would be no companies that would gain a competitive advantage in the stock market. Another concern is that the disclosure of the additional information would in fact breed more controversy and scrutiny. It is believed that analysts may begin to question why write-offs of a slumping show have yet to occur if the show was not an immediate success. If management believed that sales would recover at a later time then they may choose to not write-off any additional amount of the pre-production costs, and continue with the current amortization schedule.

Adopt Film Industry’s Policy

Another alternative for Livent would be to account for pre-production costs in the same way as the movie industry. This method would involve estimating expected gross revenues and then amortizing using the ratio of actual current revenues to the forecasted revenues. Unlike their current policy, the company would be able to recognize net income from a production before the pre-production costs have been fully recovered. Therefore better matching of expenses to revenues would be achieved. When compared directly to their current approach, and assuming that their estimates held true, the company would experience a higher income using this method in the short term but at the cost of a lower net income in the future. This would have the effect of smoothing income over the duration of a production.

Unfortunately, some analysts may consider this an even more aggressive approach than Livent’s current policy. It is also a policy that would be very dependant on the estimates of management, which would mean that it would be prone to manipulation. An incorrect estimate of future revenues could lead to profits being recognized too soon, followed by a large loss in future periods if the estimates do not hold true. However, assuming that the company found a way to make accurate estimates, perhaps based on verifiable past data, then this alternative would most fully satisfy the overriding objective of a policy that most accurately represents the company’s economic reality.

Expense All Pre-production Costs

This strategy would be the most simplistic and conservative of all the alternatives. Essentially, Livent would expense any pre-production costs as soon as they were incurred. Under this strategy there would be no leeway for the manipulation of the pre-production costs considering the haste at which they would be expensed. This strategy would undoubtedly silence analysts who felt Livent employed an accounting policy that was too aggressive.

The major issue regarding this strategy would be the timing of revenues and expenses. This strategy would clearly violate the matching principle under G.A.A.P. By expensing pre-production costs immediately Livent would stand to suffer severe short term losses while experiencing unrealistic inflated profits in future periods. Since Livent spent a significant amount of time and resources in order to determine the viability of future projects, they have appeased the requirements of section 3450.21 in the CICA Hand Book found in Appendix B. Moreover, this alternative would fail to meet the overriding objective of using the financial statements as a means to represent the true economic position of the organization.

Recommendations

The company incurs pre-production costs in one of two ways. The first of which is from putting on a new production, where costs such as publicity, set design, costumes, props, and advertising are incurred in order for the production to open. The second way involves pre-production costs incurred as a result of touring a production by moving to a new location. Livent uses three techniques in producing and acquiring rights to live theatre performances: reproductions, restorations, and originations. Reproductions and restorations are relatively low risk endeavours that involve staging a production that has been a past success or is an important historical work. Originations, on the other hand, involve developing an all new musical production and therefore pose a higher degree of risk. The creation of an all new production also has the possibility of providing substantial returns for the company in the future.

In order to satisfy the overriding objective of the board and shareholders, to please the criticisms of the analysts, and to do what is in the best interests of the company, a hybrid approach of the alternatives should be adopted. A touring production that incurs the pre-production costs of moving to a new location, will have past income data from which accurate estimates can be formed to forecast future revenues in the new city. This would alleviate the concerns faced with adopting the film industry’s policy on pre-production costs, allowing Livent to use this strategy for their touring pre-production costs. These estimates will be based on past data and will therefore not be prone to management manipulation to the same degree that a new production’s estimates would be. This will also satisfy the requirements under 3450.21 of the CICA Hand Book, since the feasibility of the process will have been established in the past markets.

Regarding productions that involve the reproduction or restoration of a previously successful work, Livent should continue to employ their current policy for pre-production costs. This is because these works have proven to be successful, satisfying 3450.21, and therefore making it a more conservative accounting approach to defer these costs since they will most likely be recoverable. Although the film strategy may most accurately match expenses to revenues, it is a more aggressive approach that requires precise estimates and a greater certainty of success. When Livent moves a successful production from New York to Chicago it is much easier to forecast future revenues considering the similarities between the two markets. However, in the case of the restorations and reproductions it is more difficult to establish precise estimates, therefore making the film industry’s strategy too aggressive for an accounting policy. A market’s response to a production during the 1950’s may be substantially different from the reaction of consumers in the present.

A work that is an origination has the greatest degree of risk associated with it and therefore employing even the current policy on it may be viewed as too aggressive of an approach. It would be difficult to justify 3450.21’s criteria of a future market being clearly defined since Livent would be venturing into an unknown work. When one considers that Broadway’s failure rate sits at approximately 80 to 90 percent (Weatherford Review Journal), it is very difficult for Livent to justify capitalizing 100% of a new show’s pre-production costs. Hence they should use the more conservative approach of expensing pre-production costs.

Therefore it would be in Mr. Clark’s and the company’s best interests to recommend this hybrid solution to the board. This recommendation would be more conservative as it identifies the degree of risk facing productions and treats them accordingly. With this approach, the company would profit from less bad publicity arising from criticisms of their policy being viewed as too aggressive. The company will also benefit from more accurate treatment of pre-production costs which would lead to less write-downs that could severely impact the income statement in the future. The board’s reaction to this recommendation will undoubtedly be mixed based on the significant influence the management exerts over the board due to the presence of several key executives. However, even though this approach is beneficial to shareholders, any dissenting board members that are on the management team should see that the conservative treatment of origination productions would lead to very profitable future periods if these productions prove to be a success. Adhering to this recommendation would require that the company apply this policy change retroactively.

Appendix A: Board of Directors

Appendix B: CICA Hand Book 3450.21

.21 Development costs should be deferred to future periods if all of the following criteria are satisfied:

(a) the product or process is clearly defined and the costs attributable thereto can be identified;

(b the technical feasibility of the product or process has been established;

(d) the future market for the product or process is clearly defined or, if it is to be used internally rather than sold, its usefulness to the enterprise has been established; and

(e) adequate resources exist, or are expected to be available, to complete the project. [AUG. 1978]

Works Cited

Weatherford Review Journal. Giving Regards to Broadway. 29 January 2006. 11 March 2007 <http://www.reviewjournal.com/lvrj_home/2006/Jan-29-Sun-2006/news/5244628.html>.