Disney's Real Magic

All copyrights  and content belong to the publisher and Lenore Briloff

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By  Abraham J. Briloff

March 23, 1998 12:01 am ET

Disney's December 1997 Quarter

The Walt Disney Co.'s acquisition of Capital Cities/ABC, by Wall Street's lights, has been a resounding success. Any misgivings about the movie and theme-park giant shelling out $18.9 billion for control of the television network have been dispelled by Disney's ability to continue reporting brisk earnings gains, and investors have responded enthusiastically. Disney's shares, which closed at 58 on July 31, 1995, the day the companies' betrothal was announced, not long ago topped 115. Even Disney's public disclaimer, a couple of weeks ago, of the Street's more exuberant expectations for its earnings had only a slight dampening effect. The shares closed Friday at 107.

A spate of ho-hum movie releases during the second fiscal quarter (ending March) was the official explanation for the caution. Analysts dutifully trimmed a nickel or so a share from their forecasts, bringing the consensus to $3.17 for fiscal 1998, ending September. That still represents a healthy rise from last fiscal year's $2.75, and the stock is trading at better than 35 times earnings. In truth, however, the gains in Disney's reported results over the past five quarters have been significantly enhanced by creative accounting. Indeed, the fact that Disney has now virtually exhausted the source of this stimulus largely explains the anticipated earnings disappointment.

The accounting treatment accorded the merger by Disney, and signed off on by its certified public accountants, Price Waterhouse, allowed the entertainment company to create what amounts to an undisclosed reserve of as much as $2.5 billion to absorb costs and expenses incurred subsequent to the February 9, 1996, close of the merger -- costs that otherwise would have flowed through its income statement and reduced Disney's reported earnings.

In fiscal 1997, the device permitted Disney to show a glitzy 25% earnings gain instead of what would have been a not-quite-10% gain. In its most recent quarter, ended December, the company's merger accounting exertions transformed what otherwise would have been essentially flat earnings into a double-digit increase.

In a letter to this author dated Friday, John J. Garand, Disney's senior vice president for planning and control, strenuously defends the company's accounting treatment of the merger as "appropriate" and says it was mandated by generally accepted accounting principles (or GAAP).

Indeed, when Disney took over Cap Cities/ABC, it did so -- in strict accordance with GAAP for business combinations -- as a "purchase." Which meant that the $18.9 billion Disney paid for the television network ($10.1 billion of it in cash, the remainder in 155 million Disney shares) was accounted for by first allocating the cost to Cap Cities/ABC's identifiable assets and liabilities, based on estimates of the fair value of those tangibles. Then, whatever remained of the purchase price was allocated to the intangible asset known as goodwill.

According to Disney's accountants, goodwill was virtually the only thing Disney got for its $18.9 billion. A footnote in Disney's annual report for the fiscal year ended September 1996 shows that the fair value of the Cap Cities/ABC assets it acquired, at $4.8 billion, was nearly matched by the value of the liabilities it assumed, $4.4 billion -- leaving precious little, obviously, in the way of net tangible assets. In fact, an additional $749 million ABC liability, for deferred income taxes, was booked in the March 1997 quarter, reducing the total value of the net tangible assets that Disney acquired in the Cap Cities/ABC transaction to less than zero.

As a result, more than the $18.9 billion purchase price was ultimately dumped into goodwill. Paying $19 billion for goodwill is essentially equivalent to forking over $30 billion for, say, TV and film properties, because the cost of goodwill is not tax-deductible (in contrast to normal business expenditures), making the after-tax impact of a deductible $30 billion expenditure roughly equal to a $19 billion nondeductible outlay.

Striking, too, is the dramatic divergence between Disney's assessment of the fair value of Cap Cities/ABC's net tangible assets and the balance sheet developed for the network by Ernst & Young, its independent certified public accountants, as of December 31, 1995 -- just 40 days prior to the closing of the merger. Indeed, Disney put Cap Cities/ABC's shareholder equity on the financial equivalent of a miracle diet, making the TV network's $4.5 billion of pre-acquisition shareholders' equity essentially disappear in the translation onto Disney's books.

What happened to those billions? Let's take Cap Cities/ABC's assets first. A $2.8 billion reduction, to $4.8 billion from $7.6 billion, was attributable principally to the elimination -- routine in these circumstances -- of goodwill that had been carried on the network's books. Thus, that $2.1 billion intangible asset presumably was subsumed into the $19 billion of goodwill added to Disney's balance sheet by the transaction.

The remaining $700 million reduction in Cap Cities/ABC's assets represents downward adjustments to the carrying values of its film properties as well as to property, plant and equipment. While a haircut of that size might ordinarily attract critical scrutiny, there are far more daunting issues involved here.

Not least among them is the $1.7 billion increase, to $4.4 billion from $2.7 billion, in the network's liabilities. In fact, it is the key to unraveling the unorthodox purchase-accounting maneuvers that provided Disney with its reserve of as much as $2.5 billion to absorb post-merger costs.

Disney's $700 million writedown of ABC's tangible assets and $2.9 billion increase in its liabilities, at the time of the merger, were merely book entries, and didn't entitle it to a current tax deduction. But as that $3.6 billion ripens into tax-deductible business expenses, the company will derive a $1.2 billion tax benefit. This contemplated entitlement is dubbed a "deferred tax asset" and is netted against Disney's deferred tax liabilities -- and thereby reduces the $2.9 billion gross increase in liabilities to $1.7 billion.

The $2.9 billion of additional liabilities was poured into the "accounts payable and accrued liabilities line" on Disney's balance sheet in connection with the merger and represents loss reserves and other liabilities added in the name of purchase accounting.

John Giesecke who, until leaving last month was Disney's vice president for corporate controllership -- was consulted a number of times, by phone and fax, during the preparation of this analysis. When he was asked whether the entire $2.9 billion addition to Disney's liabilities represented the reserve booked on the Cap Cities/ABC takeover, he indicated that the $2.9 billion figure was on the high side for the "loss reserve." Some of the accruals, he pointed out, were related to the fact that Cap Cities/ABC's package of perquisites had to be sweetened to bring them up to Disney standards.

Giesecke would not commit himself on the actual size of the loss reserve. However, even taking more generous benefits into account, it's a reasonable estimate that these Disney merger-accounting exertions produced a decidedly unmousesized pile of $2.5 billion of accrued liabilities out of which the company could pay post-merger expenses without impacting its bottom line.

Giesecke did not respond to faxes of January 7, February 3 and March 19, which attempted to apprise him of the gist of this analysis and the numbers critical to it. Disney's Garand, as noted, did respond late Friday. His letter took issue with the use of the term "loss reserve" to describe the $2.5 billion of liabilities created by the company's purchase-accounting -- stressing Disney's belief that it followed GAAP -- but he did not dispute the size of the reserve.

How did Disney's accountants justify the creation of that huge reserve -- justify adding some $2.5 billion in liabilities to its balance sheet? Especially liabilities that, 40 days before, hadn't existed on Cap Cities/ABC's balance sheet? Basically, by asserting that Cap Cities/ABC's accountants had ignored the impact of timing on anticipated cash flows from future programming that the network had agreed, at least in part, to finance.

As Disney's Giesecke explained, under the historical cost-accounting rules the network followed before the merger, Cap Cities/ABC wasn't required to record a liability for losses on programming that it was committed to acquire in the future, as long as anticipated revenues were expected to recover the network's cost. After the merger, however, the controller maintains that Disney was required, under the dictates of purchase accounting, to evaluate those same commitments on a fair-value basis. In other words, Disney had to discount the expected future revenues and costs related to the network's programming commitments at an appropriate rate.

Disney engaged Price Waterhouse to carry out those evaluations, Giesecke said, and when the work was completed, "We determined that the fair value of a certain number of these commitments was negative and we recorded a corresponding liability."

"Commitments" is a generic term; all undertakings are commitments. Most are so ordinary, ongoing and of relatively modest proportions that no special attention is given to them by accountants. Where, however, they are long-term and substantial some notice may be given to them, generally in the footnotes to the financial statements. For example, long-term leases, or -- in the case of Cap Cities/ABC -- commitments to purchase future programming. Still, they're only claims that may occur if a contract is performed upon, in the future. The mere signing of a contract doesn't result in a completed transaction -- much less a liability.

That's because "liabilities," in accounting parlance, are recognized obligations to pay money, provide services or transfer specific assets, and are tallied as such in the accounting cycle. They must be fully disclosed in financial statements and are subtracted from a firm's assets to derive its shareholders' equity.

Cap Cities/ABC programming commitments totaled $4.1 billion at year-end 1995. The network's final audited financials (submitted to the SEC in a Disney 8K report dated March '96) disclosed that these consisted of contracts to purchase "broadcast rights for various feature films, sports and other programming" during the next five years. There was nary a hint in ABC's financials, however, of anxiety on the part of ABC management or its auditors regarding the economics of those programs or projects. To the contrary, all were deemed to have been undertaken in the normal course of ABC's business -- there was nothing contingent about them.

Indeed, the plain truth that Disney ignored in applying a discounting factor to future revenues anticipated on programming Cap Cities/ABC was committed to purchase (and in thereby creating those $2.5 billion of "liabilities") was that there was nothing novel about those contracts. Over its half-century of existence, the network's ordinary operating cycle had always encompassed both commitments to purchase future programming and current income representing the "ripening," or coming to fruition, of past programming outlays. In short, the network's programming commitments were simply a consequence of the ordinary operating cycle of a going concern.

In fact, in this author's view, Disney's booking of those $2.5 billion or so of additional liabilities related to the network's future programming commitments as part of accounting for the merger as a purchase was simply not permissible under GAAP. Only liabilities which are identifiable as such for the acquired enterprise, or contingencies that may have "ripened" into liabilities as of the acquisition date, should properly have been booked as liabilities by Disney.

This interpretation of the accounting rules is fully supported by an October 13, 1997, letter from the Financial Accounting Standards Board, which (in part) reasserted the board's long-held position that the same rules should apply to "recognition and measurement provisions arising from a business combination" and to "those incurred in the normal course of business." FASB's position is unambiguous: If, pursuant to its Statement 5 (which deals with contingencies), no such undiscounted/discounted liability reserve is permitted, one cannot be created in the process of accounting for a merger.

And there's no way Disney's $2.5 billion reserve for the discounted value of the network's programming commitments would qualify as a liability under FASB Statement 5. That litmus test is whether "a liability had been incurred at the date of the financial statements." If that test could have been met as of December 31, 1995, Cap Cities/ABC's accountants would have been constrained to reflect a $2.5 billion liability in the network's final financial statement. But there was no such liability then -- neither did one come into existence during the succeeding 40 days while the merger was being closed.

Disney and its auditors clearly interpreted GAAP far more aggressively in transmuting some of those $4.1 billion of commitments, per ABC's final annual report, into a $2.5 billion undisclosed liabilities reserve. Under the circumstances, investors might reasonably have expected, at the very least, a clear explanation of the purchase-accounting adjustments to Cap Cities/ABC's programming commitments in Disney's financial statements. Yet none is to be found.

Yet the reason Disney went out on a limb to create its undisclosed reserve is clear enough: flexibility. It meant that as its new television arm ran up various programming costs after the merger, Disney had the option of merely writing those amounts off against those accrued liabilities instead of running them through its income statement -- where they would have crimped reported profits.

In the immediate aftermath of the February '96 merger, and, in fact, all the way through the quarter ended December 1996, Disney had no call to draw on its big reserve. The comparative year-earlier figures included in its financial reports throughout that stretch incorporated the operations of Cap Cities/ABC on an entirely pro forma basis. Midway through its March 1997 quarter, which marked the first anniversary of the acquisition, that changed: Disney was now going head-to-head with real numbers generated by the network while within its ambit -- and those were less than ebullient.

A couple of unheralded adjustments that Disney made to its books for that quarter first signaled that Disney was dipping into its $2.5 billion reserve to cushion earnings. Without a whit of explanation, the March '97 balance sheet showed a fiscal '96 year-end value for the asset dubbed "TV and Film Costs" that had been retroactively decreased by $653 million from the amounts listed in Disney's fiscal '96 annual report -- and a corresponding decrease on the liabilities side of the ledger.

When queried, Disney's Giesecke indicated that the balance sheet was adjusted because a previously recorded valuation allowance for film and TV costs had been reclassified. He also commented that the reclassification had "no income-statement impact." In his Friday letter, Disney's Garand reiterated that the balance-sheet reclassification, a final purchase-accounting adjustment related to the merger, affected only Disney's balance sheet.

Which is true, in the sense that the reclassification didn't involve any changes to the income statement for fiscal '96. But they laid the groundwork for enhancing earnings in the future. The $653 million represented production costs the Disney broadcasting unit had run up during fiscal 1996, costs Disney initially had treated conventionally: They'd been added to the "TV and Film Cost Assets" line on Disney's balance sheet, and fiscal '96 operating net had been reduced by some $200 million in amortization of that asset.

What Disney in March '97 determined, however, was that those $653 million of costs should have been written off against its $2.5 billion reserve. That way, its operating income in future periods wouldn't be burdened with the amortization of the network costs. Hence, its retrospective balance-sheet adjustments.

What Disney didn't do, though, was restate its already-reported fiscal '96 earnings to reflect the benefit of the lower amortization charges produced by this accounting device.

Disney's Garand insists in his letter that "it would be inappropriate to consider restating" the company's fiscal 1996 income because the retrospective changes it made affected only its balance sheet on the one hand, and, on the other, were merely offsetting adjustments to a couple of lines in its statement of cash flows. However, in fact, the company's reported fiscal 1996 income had been reduced by amortization of those $653 million of costs that Disney subsequently reclassified. And a logical inference is that the company's earnings weren't restated because the object of these accounting exertions was to enhance future earnings comparisons.

Another retrospective change Disney made to its financial statements for the year ended September '96 provides a clue to quantifying how much the company used the reserve to absorb costs in succeeding periods. Specifically, Disney's fiscal '97 10K listed a decline in the deferred-tax asset, as of September 30, '96, of $241 million from the total it had reported a year earlier. Which was how much Disney was able to reduce its deferred taxes by retrospectively charging the $653 million of costs against its reserve.

In fiscal '97, Disney's deferred-tax asset was further reduced by $493 million, to $1.129 billion. Assuming, again, a 35% corporate tax rate, that implies that during that year, about $1.4 billion, previously stashed away in Disney's accrued liabilities reserve, was spent -- without impacting the company's operating statement. Outlays of $1.4 billion would entitle the company to apply $493 million of the related tax asset to reduce its current tax provision.

Disney's Garand, in his Friday letter, insists that this $1.4 billion estimate is incorrect; that the amount of costs absorbed can't be calculated based on the change in the company's deferred-tax asset, which "resulted primarily from unrelated factors."

Nonetheless, its most recent quarterly report indicates that the company ran through virtually all of the remaining $450 million or so in its liabilities reserve during the quarter. Which strongly suggests that the reserve absorbed around $1.4 billion of costs during fiscal 1997. And, to reiterate, that's what likely prompted Disney's caution to analysts to rein in their full-year earnings estimates.

Indeed, Disney pretty much admits that it has used up its purchase accounting benefits in the "Management's Discussion & Analysis" section of its recent 10Q, noting that an 11% increase in its broadcasting unit's costs and expenses "reflected higher program amortization at the TV network , due primarily to changes in the program mix in response to lower ratings and a reduction in benefits arising from the ABC acquisition ." (Emphasis added.)

How much did Disney's treatment of those TV production costs, totaling $653 million, $1.4 billion and $450 million, respectively, boost its bottom line during fiscal '96, '97 and the first quarter of '98?

According to Disney's 1997 statement of cash flows, it had charged $204 million of amortization against those $653 million of TV & Film Cost Assets during the 7 1/2 months of fiscal '96 that the network had been in its fold. Which means that a full year's amortization of those assets would have amounted to roughly $320 million, or about $80 million a quarter.

The accompanying tables use the same amortization rate to quantify the amortization charges Disney avoided in fiscal '97 and in the December quarter by writing off that total of $2.5 billion of television production costs against its undisclosed reserve. They also give Disney the benefit of some accounting charges it would have avoided had it not employed that accounting device, most notably a reduction in its amortization of goodwill. While, by necessity, they're only estimates based on the publicly available data, the calculations demonstrate that by calling on the reserve, Disney supercharged its recent earnings comparisons. More specifically, it avoided some $840 million in charges against its fiscal '97 operating income, and around $290 million of such costs in the December quarter.

Clearly, had Disney not been able to use its reserve to shield its bottom line from major chunks of costs related to its foray into television network ownership, its recent results would have had considerably less luster. Indeed, the 25% earnings surge Disney reported in fiscal '97 would have come to 10%, without benefit of the accounting device. And, far from an 18% earnings increase in the December quarter, net would have been flat.

Disney, through the agency of accounting, has adeptly masked the negative impact of its Cap Cities/ABC acquisition on its earnings over the past two years. But even accounting magic has its limits: From here on, the true picture will become very much clearer.

ABRAHAM J. BRILOFF, a CPA and a frequent contributor to Barron's over the past 30 years, is the Emanuel Saxe Distinguished Professor Emeritus at Bernard M. Baruch College and Presidential Professor of Ethics and Accounting at Binghamton University, SUNY.