How did Harry Potter movies manage to make losses?

In this article, we look at Hollywood Accounting - a set of creative accounting methods used by television, film and entertainment industry to budget and record profits.

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This article isn’t really about Harry Potter. It’s about accounting. We are about to dive into how, despite having some of the highest box office grosses in Hollywood history, some of the Harry Potter films technically lost money.

Let’s start with some simple economics: most people like having money, and most people don’t like giving money to other people. So now, let’s get into the accounting. A while back, movie stars decided that they wanted to be beautiful and famous and very rich. They figured that the way to get very rich was to negotiate into their contract not only a salary, but also a share of the movie’s net profits. That way, if the movie made a lot of money, the actor would get some of it, and for a while, this worked—but then the studios realized that instead of giving the actors the money they wanted, they could just use clever accounting tricks to screw them out of it.

Here’s what those accountants did. They set things up so that each movie would technically be made by its own little company, created specifically for that movie. So, when Warner Brothers made Harry Potter and the Order of the Phoenix, they had their accountants create a shell company called Harry Potter and the Order of the Phoenix, Inc, Phoenix, Inc. for short.

Phoenix Inc. is who technically makes the movie Harry Potter and the Order of the Phoenix, and if Phoenix Inc. were to make a net profit, then anyone who is owed a portion of the film’s net profit would get paid. So, if Daniel Radcliffe had negotiated to earn 1% of net profits, and Phoenix Inc. made $100 million in net profits, Daniel Radcliffe would earn $1 million. But the thing is, no matter how much money the actual movie makes, Daniel Radcliffe will never get a cut of the profits, because Phoenix Inc. will never make a net profit, because it is designed specifically to lose money.

Now of course, the company doesn’t actually lose the money. The net profits just go to the very

studio that created them, Warner Brothers. To make sure it doesn’t make a profit, Phoenix Inc. will pay Warner Brothers exorbitant fees for distributing and advertising the film—a number far higher than the actual market value of those services. Here’s the income statement from Harry Potter and the Order of the Phoenix.

The movie grossed nearly $1 billion dollars—at the time, it was the 6th highest grossing movie ever—but according to the income statement, it lost $167 million dollars. So, where did that $1 billion go? Some of it went to the movie theaters, some of it went to the cost of actually making the film, but the key to Hollywood accounting lies here, in the costs of advertising, distribution, and interest. Phoenix Inc. paid the studio, Warner Brothers, $212 million dollars to distribute the film, $130 million for advertising and publicity, and another $57 million in interest.

But remember, Warner Brothers created Phoenix, Inc. and they own complete ownership in the company, so they’re paying all that money to themselves. By doing it this way, they ensure that Phoenix Inc. overpays way above the fair value, and thus makes no profit, and thus, anyone who would have shared in Phoenix Inc’s net profits gets nothing either. It’s not just Harry Potter films that have used creative accounting tricks to make their profits disappear. Nearly every movie ever released has, on paper, lost money.

In an interview in 2011, David Prowse—the man who played Darth Vader in Star Wars: Return of the Jedi—said that he still gets letters claiming he can’t be paid any residuals because the film hasn’t turned a profit, despite the movie grossing $475 million on a $32 million budget.

Hollywood accounting has not only affected writers and actors, but also production companies, producers and investors. A number of cases of creative accounting have been successfully pursued in court and have resulted in hundreds of millions of dollars in awarded damages. But what can be a long term solution for this problem? Taking a cut of gross revenues rather than net profits? Introducing transfer pricing?

Only time will tell.