All copyrights and content belong to the publisher and Lenore Briloff
________________________________________
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.
