Question

What will be the impact on Netflix’s net income of the lower content amortization under the new streaming strategy?

Answer 1

Answer:

As per the purchase model of Netflix, for streaming agreements, the company typically acquires 3-5 years agreement.

Being a company whose revenue is based on current trends and tastes of its customers, the company should use accelerated method of amortization. The reason to do so is that when a new content is acquired, the same will generate more income in initial years than in later years as it is new and will grab more attention of the company's consumers. Hence, higher amortization costs will be in proportion to the income earned from such streaming content. In later years, as the content will become old and lose the attention, the income from such content will also decline, the proportionate amortization expense too will be less and would not have a substantial and negative effect on the income.

On the contrary, if company uses SLM method for amortization, the expense will be less in proportion to the income earned from the content in initial years and more in later years, which wont give a true picture of the accounts. Hence, SLM method should be avoided.

With the same logic as mentioned in Ans.1, that due to fluctuating trends, the content will generate more income in initial years than in later years, the best suited method for amortization of the asset should be "Sum of the year's digits" method. The same is recommended, as it considers the period for which such streaming agreements are acquired and also charges higher amount of amortization in initial years and lesser in later years, which therefore helps in striking a balance between the income earned from the content and expense against the same.

Also, the same was earlier used by the company for DVDs and it proved to be an effective and reliable method. Hence, the same can be used even for streaming content.

As per the general accounting norms, any tangible or intangible property acquired or created by a company that generates income for the company should be considered as an asset.

The streaming content acquired by paying upfront costs, will help in generating revenue for the company. Hence, the fact that it is acquired and not created does not stop it from being considered as an asset, as long as it helps the company earn.

Currently, the costs are equally amortized over the period of the streaming agreement. But, due the fluctuating nature of trends in entertainment business, the content will logically generate more income in initial years because its new, than in later years. The lower rate of content amortization under the streaming strategy (as the costs are equally amortized over the period of the asset), will lead to lower levels of expenses as a percentage of higher income earned from the content in initial years and higher levels of expenses as a percentage of lower income earned in later years which will show disparity in income levels of the company over the years.

Hence, the lower rate of amortization in streaming strategy versus DVD strategy is definitely a cause of concern.

As clearly stated and clarified above, with the current method of lower rate of amortization, the net income in initial years of content life will be huge as the expenses against the income are not in the same proportion. Whereas in later years of the content, the income will reduce but the rate of amortization being constant, will lead to sudden decline in net income. This will cause disparity in income level over the life of the asset and wont show true picture of income earned over the period of the streaming content.