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.
