Anyone in the TV and film industry knows the importance of participation contracts. Especially when a production is successful, there are often many participants who are entitled to a piece of the pie. But to ensure everyone is getting their fair share based on the terms laid out in the contract, an audit may be necessary—and that can open the door to several nuances and challenges that are difficult to navigate.

To get a better handle on the matter, we looked to 8020 Consulting’s Cathy Felch for answers. With more than 25 years of diverse accounting experience, including prior work for clients like MGM Entertainment, HBO and Paramount Pictures, Cathy provided valuable insights on the ins and outs of entertainment and participation accounting.

To begin, can you quickly describe what a participation audit means?

A participation audit (also referred to as a royalty audit) is an audit of financial information based on the language in a contract between a provider and a distributor. In the entertainment industry, the “providers” are the actors, actresses, writers, directors, etc.; and the “distributor” is typically the studio.

Why are participation audits so important in entertainment?

Simply put, the audit is a way to ensure participants in the making of a film or TV show get what’s promised to them according to the contract. For example, how is revenue allocated among participants? How is it allocated across both domestic and global markets? What costs need to be subtracted to arrive at a participant’s net deal? Are there gross deals negotiated for certain individuals (i.e., A-list actors like Meryl Streep) that affect everyone else’s allocations? Terms such as these are all laid out in a contract, of course, and the audit serves to uncover any errors.

How do participants make the decision made to proceed with an audit?

Basically, it’s the responsibility of providers (or their legal team) to look for any deviations from the contract that flag the need for an audit. Here are some key questions they will want to ask:

• Is the presentation of the participation statement consistent with terms of the contract? Providers will want to go through and verify that the details on the participation statement are consistent with the terms of the contract. Along with this, providers should ensure statements are received in a timely matter, as should be outlined in the contract.

• Are the numbers being reported in the statement consistent? Once a film is underway, reports are created to track the progress of everything laid out in the contract. For example, is the provider getting the maximum allowed revenue within a given time period? Have any “surprise” expenses (i.e. overhead fees) been applied? Be on the lookout for such inconsistencies.

• Are the revenues and expenses reported in line with the format and markets where the movie or television show has been released? For example, if a movie is available on home video or Netflix, is the provider collecting revenue from those formats as per the contract? Are expenses being properly applied? Are the correct revenues and expenses being applied to all markets where the production was released?

• How close am I to breaking even? If the production is close to breaking even (and going positive), providers are getting close to pocketing some revenue. That means, if any issues are suspected to have occurred along the way, now’s the time to get ahead of them with an audit.

Is there anything else to be aware of in the contract that might affect an audit?

Yes, a few come to mind right away. Pay attention to the statute of limitations in the contract, which defines how far back in time you can go to perform an audit. Also, know that these audits take a long time. Studios only have so much time and personnel to dedicate to them—and audits are typically handled by the order in which they are received. For that reason, studios will likely grant extensions (called a Tolling Agreement) to allow more time—but it’s up to the provider to issue that request.

Does New Media present many challenges?

Absolutely. Every day, there seems to be a new way to consume content. The game keeps changing; the accounting processes and procedures for New Media revenue reporting put most studios on a perpetual learning curve. That increases the likelihood that the terms of any given contract may be missed.

What are some other exposure areas that may warrant an audit?

There are a few areas where I’ve seen the most problems arise. This includes the allocation of International revenue and output deals (where the buyer commits to taking a production at an agreed-upon price, during a specified time period); off-network sales deals (to ensure the proper allocation of advertising dollars); merchandising, soundtrack and music receipts (i.e., are these items being properly reported properly and allocated?); vertical integration (to ensure participants are getting fair value when self-dealing between related parties); and finally, production costs (to determine if there are any costs related to the corporation versus the actual production film).

Any final takeaways on participation audits in entertainment?

Again, with the rise of New Media, the need for audits is increasingly important. As an L.A.-based company, 8020 Consulting is happy to have this type of expertise on hand. Sometimes our clients simply need guidance or third-party input as they attempt to navigate the intricacies that surround entertainment participation audits. Just like for any industry, contracts are in place for a good reason—and the audits aim to protect everyone’s business and financial interests. Just contact us for more information.

For tips on making your entertainment studio more competitive, you can also download our free operational finance in entertainment ebook. It offers best practices and other advice for better decision making. Just click the button below to get your copy: