Kartoon Studios, Inc. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide readers of our consolidated financial statements with the perspectives of management. This should allow the readers of this report to obtain a comprehensive understanding of our businesses, strategies, current trends, and future prospects. It should be noted that the MD&A contains forward-looking statements that involve risks and uncertainties. Please refer to the section entitled “Forward-Looking Statements” immediately preceding Part I for important information to consider when evaluating such statements. This section of this Annual Report on Form 10-K generally discusses 2023 and 2022 items and year-to-year comparisons between 2023 and 2022. Discussions of 2021 items and year-to-year comparisons between 2022 and 2021 that are not included in this Annual Report on Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022. Overview Our content distribution business is focused on achieving scale across our networks, including Kartoon Channel! , Frederator, Ameba, and Kartoon Channel! Worldwide. Revenue growth will be driven by the continued focus on licensed content and exploitation of our current content such as Stan Lee, Shaq's Garage , Rainbow Rangers and many more. Continued profit growth will be realized the more we can scale the business across our platforms. In addition, we are looking at artificial intelligence (“AI”) tools to reduce the cost of operating distribution expenses such as dubbing expenses, video resolution upscaling and converting between 2D and 3D. Our production services business is focused on creating high-quality original and for hire content in the most efficient way possible. To achieve this, our Mainframe Studios division, the main driver of this business, is exploring more ways to improve operations by adopting a more flexible and efficient approach. This includes collaborating with outsource partners and utilizing AI technology to streamline processes and drive efficiencies within the organization. Our licensing and royalties business has the most upside and potential for the Company. We are looking to take advantage of our incredible set of Stan Lee assets to drive consumer products - both digitally and physically. We will be focused on utilizing all of our IP assets further in 2024 and beyond. Our media advisory and advertising services business is focused on driving deal flow opportunities and winning annuity business through retainers and projects. The team continues to focus on the toy business, but also expansion into tangential industries such as family and travel. The team has expanded their reach over the past 12-18 months by leveraging their relationships with influencers to promote products and provide bespoke marketing initiatives for the clients. Results of Operations Our summary results for the year ended December 31, 2023 and 2022 are below: Revenue Year Ended December 31, 2023 2022 (1) Change % Change (in thousands, except percentages) Production Services $ 26,799 $ 29,620 $ (2,821) (10) % Content Distribution 11,872 24,747 (12,875) (52) % Licensing & Royalties 475 2,841 (2,366) (83) % Media Advisory & Advertising Services 4,939 5,091 (152) (3) % Total Revenue $ 44,085 $ 62,299 $ (18,214) (29) % (1) Wow and Frederator were acquired on April 1, 2022, resulting in the inclusion of their financials for only the nine months ended December 31, 2022 in the consolidated financials for the previous year. If the variation in results is partly attributable to the difference in time periods, we annualize 2022 financials for comparison purposes. 25 Table of Contents Production services revenue was generated specifically by Wow providing animation production services. Revenue for production services is recognized over time on a percentage of completion basis, therefore, as the projects are still in progress, we recognize revenue based upon the proportion of costs incurred cumulatively to total expected costs. Consequently, less revenue is recognized during the periods in which the projects are near completion or completed. Revenue for the year ended December 31, 2023 was lower than the Wow production services revenue recognized during the nine months ended December 31, 2022. The decrease was primarily due to a lower volume of service production projects and a decrease in the percentage of projects completed during the current year as compared to the prior year period. Revenue related to content distribution on AVOD and SVOD, including advertising sales for the year ended December 31, 2023, decreased by 52% as compared to the year ended December 31, 2022. This was primarily due to a decrease in Wow’s IP production revenue of $6.9 million and Frederator’s IP production revenue of $2.5 million, as there were no IP projects delivered during the current year as compared to the prior year period. In addition, content revenue from Frederator’s multi-channel network on YouTube for the year ended December 31, 2023 was $3.9 million lower as compared to the nine months ended December 31, 2022. The decrease in Frederator’s multi-channel network revenue from YouTube decreased due to less viewership and a decline in RPM advertising rates. The decrease was offset by an increase of $0.2 million in Wow’s distribution revenue. Revenue related to our licensing and royalties for the year ended December 31, 2023 decreased by 83% as compared to the year ended December 31, 2022 primarily due to our license deals related to our Stan Lee Assets generating increased revenue of $2.5 million during the prior year period. Revenue generated by media advisory and advertising services for the year ended December 31, 2023 decreased by 3% as compared to the year ended December 31, 2022 primarily due to lower revenue generated by Beacon Communications during the year ended December 31, 2023, resulting in a decrease of $0.8 million. The decrease is offset by an increase in revenue generated by Beacon Media of $0.7 million primarily due to new customers acquired for digital media services. Expenses Year Ended December 31, 2023 2022 (1) Change % Change (in thousands, except percentages) Marketing and Sales $ 2,651 $ 1,834 $ 817 45 % Direct Operating Costs 40,399 49,360 (8,961) (18) % General and Administrative 35,324 45,851 (10,527) (23) % Impairment of Property and Equipment 134 – 134 100 % Impairment of Intangible Assets 4,413 4,117 296 7 % Impairment of Goodwill 33,534 4,857 28,677 590 % Total Expenses $ 116,455 $ 106,019 $ 10,436 10 % (1) Wow and Frederator were acquired on April 1, 2022, resulting in the inclusion of their financials for only the nine months ended December 31, 2022 in the consolidated financials for the previous year. If the variation in results is partly attributable to the difference in time periods, we annualize 2022 financials for comparison purposes. The increase in marketing and sales expenses for the year ended December 31, 2023 as compared to the year ended December 31, 2022 was primarily due to recognition of marketing expenses related to Shaq’s Garage of $1.2 million, offset by a decrease due to cost saving efforts during the year ended December 31, 2023. Direct Operating Costs during the year ended December 31, 2023 consisted primarily of salaries and related expenses for the animation production services employees of Wow and Frederator. Channel expenses, licensing and production of content costs, such as participation expenses related to profit sharing obligations with various animation studios, post-production studios, writers, directors, musicians or other creative talent that had rendered services and amortization, including any write-downs of film and television costs, make up the remainder of Direct Operating Costs. The decrease was primarily due to a reduction in film amortization expense recognized during the year ended December 31, 2023 of $5.6 million as compared to the year ended December 31, 2022 as a result of less film and television production during the current year. In addition, Frederator channel costs of its multi-channel network for the year ended 26 Table of Contents December 31, 2023 decreased by $3.7 million compared to the prior year period. The decrease was due to a reduction in payments to our multi-channel network members and aligned with the decline in multi-channel network revenue. The $10.5 million decrease in general and administrative expenses for the year ended December 31, 2023 as compared to the year ended December 31, 2022 was primarily due to a decrease of $8.2 million in stock-based compensation expense and acquisition related costs of $4.5 million incurred during the year ended December 31, 2022. The decrease is offset by the recognition of a full year of costs incurred by Wow and Fred versus nine months of costs incurred during the year ended December 31, 2022 after the acquisition in the second quarter of 2022. During the year ended December 31, 2023, we reassessed our nonfinancial assets, including our definite-lived intangible assets, our indefinite-lived intangible assets and our remaining goodwill for impairment. As a result, we recorded an impairment charge to our property and equipment of $0.1 million, our definite-lived intangible assets of $2.8 million, our indefinite-lived intangible assets of $1.7 million and our goodwill recorded within the Content Production and Distribution reporting unit of $33.5 million in our consolidated statement of operations. 27 Table of Contents Other Income (Expense), net Components of Other Income (Expense), net are summarized as follows Year Ended December 31, 2023 2022 Interest Expense (a) $ (3,126) $ (2,329) Warrant Expense (b) (12,664) – Gain on Revaluation of Warrants (c) 10,373 557 Gain on Revaluation of Equity Investment in YFE (d) 2,314 1,392 Realized Loss on Marketable Securities Investments (e) (4,496) (413) Gain (Loss) on Foreign Exchange (f) 641 (2,161) Interest Income (g) 622 1,015 Loss on Early Lease Termination (h) (258) – Finance Lease Interest Expense (i) (189) (116) Gain on Contingent Consideration Revaluation (j) – 1,345 Other (k) 978 6 Other Income (Expense), net $ (2,679) $ 1,625 (a) Interest Expense during the year ended December 31, 2023 primarily consisted of $1.5 million of interest incurred on the margin loan and $1.5 million of interest incurred on production facilities loans and bank indebtedness. (b) The Warrant Expense is related to the $12.7 million fair value of Exchange Warrants that were issued during the year ended December 31, 2023 to certain existing warrant holders in exchange for previously issued outstanding warrants. (c) The Gain on Revaluation of Warrants during the year ended December 31, 2023 is primarily related to the changes in fair value of the Exchange Warrants of $10.1 million recorded prior to the warrants being reclassified to stockholder’s equity. The decrease in fair value was due to decreases in market price. (d) As accounted for using the fair value option, the Gain on Revaluation of Equity Investment in YFE is a result of the increases or decreases in YFE’s stock price as of the current reporting period when compared to the prior reporting period. This excludes the impact of foreign currency recorded separately. (e) The Realized Loss on Marketable Securities Investments reflects the loss that will not be recovered from the investments due to selling securities and issuers' prepayments of principals on certain mortgage-backed securities. (f) The Gain (Loss) on Foreign Exchange during the year ended December 31, 2023 primarily related to the revaluation of the YFE investment, resulting in a gain of $0.5 million due to the EURO weakening against the USD as compared to the prior reporting period when a loss of $1.4 million was recognized. (g) Interest Income during the year ended December 31, 2023 primarily consisted of interest income of $0.5 million, net of premium amortization expense, recorded for the investments in marketable securities, respectively. (h) The Loss on Early Lease Termination is due to early termination of the Lyndhurst, NJ office lease, effective August 1, 2023. The loss includes fees of $0.2 million and the write-down of assets and liabilities resulting in a net $0.1 million loss. (i) The Finance Lease Interest Expense represents the interest portion of the finance lease obligations for equipment purchased under an equipment lease line. (j) The Gain on Contingent Consideration Revaluation recorded during the year ended December 31, 2022 is related to the write-off of the contingent earn-out liability related to the earn-out arrangement with the sellers of the Beacon entities acquired during 2021 due to cancellation of the arrangement. (k) The Company wrote-off a liability in the amount of $0.9 million that had legally expired during the fourth quarter of 2023 under the statute of limitations on debt collection, resulting in an increase in other income at December 31, 2023. 28 Table of Contents Liquidity and Capital Resources As of December 31, 2023, we had cash of $4.1 million, which decreased by $3.3 million as compared to December 31, 2022. The decrease was primarily due to cash used in financing activities of $60.8 million and cash used in operating activities of $16.1 million, offset by cash provided by investing activities of $73.9 million. The cash used in financing activities was primarily due to repayment of the margin loan, production facilities and bank indebtedness, net proceeds of $63.6 million and payments on finance leases of $2.2 million, offset by cash received from the warrant exchange of $5.3 million. The cash provided by investing activities was due to sales and maturities of marketable securities of $72.1 million. As of December 31, 2023, we held available-for-sale marketable securities with a fair value of $12.0 million, a decrease of $71.8 million as compared to December 31, 2022 due to sales and maturities during the year ended December 31, 2023. The available-for-sale securities consist principally of corporate and government debt securities and are also available as a source of liquidity. As of December 31, 2023 and December 31, 2022, our margin loan balance was $0.8 million and $60.8 million, respectively. During the year ended December 31, 2023, we borrowed an additional $21.2 million from our investment margin account and repaid $81.2 million primarily with cash received from sales and maturities of marketable securities. The borrowed amounts were primarily used for operational costs. The interest rates for the borrowings fluctuate based on the Fed Funds Upper Target plus 0.60%. The weighted average interest rates were 0.98% and 1.66% on average margin loan balances of $27.4 million and $27.1 million as of December 31, 2023 and December 31, 2022, respectively. We incurred interest expense on the loan of $1.5 million and $1.3 million during the years ended December 31, 2023 and December 31, 2022, respectively. The investment margin account borrowings do not mature but are collateralized by the marketable securities held by the same custodian and the custodian can issue a margin call at any time, effecting a payable on demand loan. Due to the call option, the margin loan is recorded as a current liability on our consolidated balance sheets. We are subject to financial and customary affirmative and negative non-financial covenants on the revolving demand facility, revolving equipment lease line and treasury risk management facility that have an aggregate total outstanding balance of USD 4.2 million (CAD 5.5 million). We were in technical violation of two financial covenants requiring a minimum fixed charge ratio and a maximum senior funded debt to EBITDA ratio as of December 31, 2023. We have continued to make regular principal and interest payments in a timely basis since the effective borrowing date. The revolving demand facility and the treasury risk management facility can be called at any time by the lender as per the original terms of the facilities. The risk of the lender demanding repayment can be deemed greater due to the breach of covenants. Subsequent to December 31, 2023, the Company amended the revolving demand facility, equipment lease line, and treasury risk management facility during March 2024. As a result of the amendment, the revolving demand facility allows for draws of up to CAD 1.0 million to be made by way of CAD prime rate loans, CAD overdrafts, USD base rate loans or letters of credit up to a maximum of $200,000 in either CAD or USD and having a term of up to 1 year. The CAD prime borrowings and overdrafts bear interest at a rate equal to bank prime plus 2.00% per annum. The USD base rate borrowings bear interest at a rate equal to bank base rate plus 2.00% per annum. The equipment lease line was amended to set the maximum that can be borrowed under the equipment lease line to CAD 1.6 million. As at December 31, 2023, the Company has drawn down the maximum of CAD 1.6 million under the equipment lease line. The Company has and will continue to make the regular principal and interest payments under the specific financing terms of the existing equipment lease agreements. The amendment removed the treasury risk management facility that allowed for advances of up to CAD 0.5 million. As of December 31, 2023 and the date of the amendment, there were no outstanding amounts drawn under the treasury risk management facility. The amendment also introduced revised financial covenants that are effective as of March 15, 2024. The amendment did not have any impact on the Company’s existing production facilities that are separate from the revolving demand facility and are used for financing specific productions. Working Capital As of December 31, 2023, we had current assets of $57.1 million, including cash of $4.1 million and marketable securities of $12.0 million, and our current liabilities were $45.6 million. We had working capital of $11.5 million as of December 31, 2023 as compared to working capital of $28.6 million as of December 31, 2022. The decrease of $17.1 million was primarily due to a decrease in our cash and marketable security position, offset by the change in net current 29 Table of Contents assets and liabilities as a result of the acquisition of Wow and Ameba and additional short-term borrowings from our margin loan account. During the year ended December 31, 2023, we met our immediate cash requirements through existing cash balances. Additionally, we used equity and equity-linked instruments to pay for services and compensation. We believe that our current cash balances and our investments in available for sale marketable securities are sufficient to support our operations for at least the next twelve months. To meet our short and long-term liquidity needs, we expect to use existing cash and marketable securities balances. Comparison of Cash Flows for the Years Ended December 31, 2023 and December 31, 2022 Our total cash as of December 31, 2023 and December 31, 2022 was $4.1 million and $7.4 million, respectively. Year Ended December 31, 2023 2022 Change (in thousands) Net Cash Used in Operating Activities $ (16,092) $ (25,923) $ 9,831 Net Cash Provided by (Used in) Investing Activities 73,858 (30,937) 104,795 Net Cash Provided by (Used in) Financing Activities (60,802) 54,444 (115,246) Effect of Exchange Rate Changes on Cash (301) (212) (89) Decrease in Cash $ (3,337) $ (2,628) $ (709) Net Noncash Expenses Items necessary to reconcile from net loss to cash used in operating activities included net noncash expenses of $59.3 million for the year ended December 31, 2023 as compared to net noncash expenses of $37.8 million for the year ended December 31, 2022. The majority of the increase of $21.5 million was primarily due to the recognition of $12.7 million as the fair value of Exchange Warrants classified as liabilities issued in June 2023 and impairment expenses of our long-lived assets, intangible assets and goodwill of $29.1 million recorded during the year ended December 31, 2023. In addition, the realized loss on marketable securities increased by $4.1 million due to the increased sales of our marketable securities prior to their maturity date. The increase is offset by a gain of $9.8 million from the revaluation of liability classified warrants, primarily the new Exchange Warrants, a decrease in our stock-based compensation of $8.2 million due to the absence of incurring a modification expense in the current year for the CEO’s restricted stock that occurred in the prior year, a decrease in the amortization of film and television costs of $5.6 million due to decreased project deliveries during the current year and a gain of $0.5 million related to the foreign currency revaluation of the equity investment in YFE versus a loss of $1.4 million in the prior year period. Change in Operating Activities The net change in operating asset and liability activities from cash used of $19.2 million as of December 31, 2022 to cash provided by operating activities of $1.8 million as of December 31, 2023 was primarily due to an increase in net receipts of tax credits during the current year of $10.0 million as credits were received for production completed in the prior year and the decrease in film and television costs of $7.0 million and accrued production costs of $2.6 million due to less production activity during the current year. Change in Investing Activities The change in cash investing activities of $104.8 million from cash used in investing of $30.9 million at December 31, 2022 to cash provided by investing of $73.9 million at December 31, 2023 was primarily due to an increase in proceeds from the sales and maturities of marketable securities of $50.6 million during the year ended December 31, 2023 and the decrease in cash used of $50.7 million for investments and acquisitions in the prior year that did not occur in the current period. 30 Table of Contents Change in Financing Activities The change in cash financing activities of $115.2 million from cash provided by financing of $54.4 million at December 31, 2022 to cash used in financing of $60.8 million at December 31, 2023 was primarily due to paying down the margin loan during the year ended December 31, 2023 compared to additional borrowings during the year ended December 31, 2022. Material Cash Requirements We have entered into arrangements that contractually obligate us to make payments that will affect our liquidity and cash flows in future periods. Our material cash requirements from known contractual and other obligations primarily relate to our debt and lease obligations and our employment and consulting contracts. The aggregate amount of future minimum purchase obligations under these agreements over the period of next five years is approximately $34.2 million as of December 31, 2023, of which about $26.3 million could be owed within one year if the margin loan and interim production facilities are called. We plan to utilize our liquidity (as described above) to fund our material cash requirements. As of December 31, 2023, we had $2.2 million in commitments for capital expenditures, related to equipment leases. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles, or GAAP. This requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures. The following accounting policies involve critical accounting estimates because they are particularly dependent on estimates and assumptions made by management. We also have other significant accounting policies that are relevant to understanding our results. For additional information about these policies, see Note 2 of the Notes to Consolidated Financial Statements in Item 8 of this report. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information available at the time. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. Business Combinations We account for transactions that are classified as business combinations in accordance with the Financial Accounting Standards Board's (“FASB”) Accounting Standards Codification (“ASC”) 805, Business Combinations (“ASC 805”). Once a business is acquired, we allocate the fair value of the purchase consideration of a business acquisition to the tangible assets, liabilities, and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. The valuation of acquired assets and assumed liabilities requires significant judgment and estimates, especially with respect to intangible assets. The valuation of intangible assets requires that management use valuation techniques such as the income approach. The income approach includes the use of a discounted cash flow model, which includes discounted cash flow scenarios and requires significant estimates such as future expected revenue, expenses, capital expenditures and other costs, and discount rates. We estimate the fair value based upon assumptions management believes to be reasonable, but are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Estimates associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed. Acquisition-related expenses and any related restructuring costs are recognized separately from the business combination and are expensed as incurred. Variable Interest Entities We hold an interest in Stan Lee University (“SLU”), an entity that is considered a variable interest entity (“VIE”). The variable interest relates to 50% ownership in the entity that is comprised of the Stan Lee Assets and that requires additional financial support from us to continue operations. We are considered the primary beneficiary and are required to consolidate the VIE. 31 Table of Contents In evaluating whether we have the power to direct the activities of a VIE that most significantly impact its economic performance, we consider the purpose for which the VIE was created, the importance of each of the activities in which it is engaged and our decision-making role, if any, in those activities that significantly determine the entity’s economic performance as compared to other economic interest holders. This evaluation requires consideration of all facts and circumstances relevant to decision-making that affects the entity’s future performance and the exercise of professional judgment in deciding which decision-making rights are most important. In determining whether we have the right to receive benefits or the obligation to absorb losses that could potentially be significant to the VIE, we evaluate all of our economic interests in the entity, regardless of form (debt, equity, management and servicing fees, and other contractual arrangements). This evaluation considers all relevant factors of the entity’s design, including the entity’s capital structure, contractual rights to earnings (losses), subordination of our interests relative to those of other investors, contingent payments, as well as other contractual arrangements that have the potential to be economically significant. The evaluation of each of these factors in reaching a conclusion about the potential significance of our economic interests is a matter that requires the exercise of professional judgment. We continuously assess whether we are the primary beneficiary of a variable interest entity as changes to existing relationships or future transactions may result in us consolidating its collaborators or partners. Foreign Currency Forward Contracts Our wholly-owned subsidiary, Wow, is exposed to fluctuations in various foreign currencies against its functional currency, the Canadian dollar. Wow uses foreign currency derivatives, specifically foreign currency forward contracts ("FX forwards"), to manage its exposure to fluctuations in the CAD-USD exchange rates. FX forwards involve fixing the foreign currency exchange rate for delivery of a specified amount of foreign currency on a specified date. The FX forwards are typically settled in CAD for their fair value at or close to their settlement date. We do not currently designate any of the FX forwards under hedge accounting and therefore reflect changes in fair value as unrealized gains or losses immediately in earnings as part of the revenue generated from the transactions hedged. We do not hold or use these instruments for speculative or trading purposes. Per FASB ASC 815-10-45, Derivatives and Hedging , we have elected an accounting policy to offset the fair value amounts recognized for eligible forward contract derivative instruments. Therefore, we present the asset or liability position of the FX Forwards that are with the same counterparty net as either an asset or liability in our consolidated balance sheets. Tax Credits Receivable The Canadian federal government and certain provincial governments in Canada provide programs that are designed to assist film and television production in the form of refundable tax credits or other incentives. Estimated amounts receivable in respect of refundable tax credits are recorded as an offset to the related production operating cost, or to investment in film and television costs when the conditions for eligibility of production assistance based on the government’s criteria are met, the qualifying expenditures are made and there is reasonable assurance of realization. Determination of when and if the conditions of eligibility have been met is based on management’s judgment, and the amount recognized is based on management’s estimates of qualifying expenditures. The ultimate collection of previously recorded estimates is subject to ordinary course audits from the Canada Revenue Agency (“CRA”) and provincial agencies. Changes in administrative policies by the CRA or subsequent review of eligibility documentation may impact the collectability of these estimates. We continuously review the results of these audits to determine if any circumstances arise that in management’s judgment would result in a previously recognized amount to be considered no longer collectible. We classify the tax credits receivable as current based on their normal operating cycle. Government assistance, in the form of refundable tax credits, is relied upon as a key component of production financing. These amounts are claimed from the CRA through the submission of income tax returns and can take up to 18 to 24 months from the date of the first tax credit dollar being earned to being received. As this financing is fundamental to our ability to produce animated productions and generate revenue in the normal course of business, the normal operating cycle for such assets is considered to be a 12-to-24-month period, or the time it takes for the CRA to assess and refund the tax credits earned. Film and Television Costs We capitalize production costs for episodic series produced in accordance with FASB ASC 926-20, Entertainment-Films - Other Assets - Film Costs . Accordingly, production costs are capitalized at actual cost and amortized 32 Table of Contents using the individual-film-forecast method, whereby these costs are amortized, and participations costs are accrued based on the ratio of the current period’s revenues to management’s estimate of ultimate revenue expected to be recognized from each production. There are usually three stages for production projects with different costs incurred at each stage: Productions in Development Development costs include the costs of acquiring film rights to books, scripts or original screenplays and the third-party costs to adapt such projects, including visual development and design. Advances or contributions received from third parties to assist in development are deducted from these costs. Productions in Progress Capitalized development costs are reclassified to productions in progress once the project is approved and physical production of the film or television program commences. Capitalized costs include all direct production and financing costs incurred during production that are expected to provide future economic benefit to the Company. Borrowing costs and depreciation are capitalized to the cost of a film or television program until substantially all of the activities necessary to prepare the film or television program for its use intended by management are complete. Completed Productions Completed productions are carried at the cost of proprietary film and television programs which have been produced by the Company or to which the Company has acquired distribution rights, less accumulated amortization and accumulated impairment losses. Due to the inherent uncertainties involved in making such estimates of ultimate revenues and expenses, these estimates have differed in the past from actual results and are likely to differ to some extent in the future from actual results. In addition, in the normal course of business, some titles are more successful or less successful than anticipated. Management reviews the ultimate revenue and cost estimates on a title-by-title basis, when an event or change in circumstances indicates that the fair value of the production may be less than its unamortized cost. This may result in a change in the rate of amortization of film costs and participations and/or a write-down of all or a portion of the unamortized costs of the film or television production to its estimated fair value. An impairment charge is recorded in the amount by which the unamortized costs exceed the estimated fair value. These write-downs are included in amortization expense within Direct Operating Expenses on the consolidated statements of operations. All capitalized costs that exceed the initial market firm commitment revenue are expensed in the period of delivery of the episodes. Additionally, for episodic series, from time to time, the Company develops additional content, improved animation and bonus songs/features for its existing content. After the initial release of the episodic series, the costs of significant improvement to existing products are capitalized while routine and periodic alterations to existing products are expensed as incurred. Goodwill and Intangible Assets Goodwill represents the excess of purchase price over the estimated fair value of net assets acquired in business combinations accounted for by the acquisition method. In accordance with FASB ASC 350, Intangibles Goodwill and Other, goodwill and certain intangible assets are presumed to have indefinite useful lives and are thus not amortized, but subject to an impairment test annually or more frequently if indicators of impairment arise. We complete the annual goodwill and indefinite-lived intangible asset impairment tests at the end of each fiscal year. To test for goodwill impairment, we may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit, of which we have two, is less than its carrying value. If impairment is indicated in the qualitative assessment, or, if management elects to initially perform a quantitative assessment of goodwill, the impairment test uses a one-step approach. The fair value of a reporting unit is compared with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. If the carrying amount of a reporting unit exceeds its fair value, an impairment charge would be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value, not to exceed the total amount of goodwill allocated to that reporting unit. Changes in future results, assumptions, and estimates after the measurement date may lead to an outcome where additional impairment charges would be required in future periods. Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions. Further, continued adverse 33 Table of Contents market conditions could result in the recognition of additional impairment if the Company determines that the fair values of its reporting units have fallen below their carrying values. Intangible assets have been acquired, either individually or with a group of other assets, and were initially recognized and measured based on fair value. Annual amortization of these intangible assets is computed based on the straight-line method over the remaining economic life of the asset. Debt and Attached Equity-Linked Instruments We measure issued debt on an amortized cost basis, net of debt premium/discount and debt issuance costs amortized using the effective interest rate method or the straight-line method when the latter does not lead to materially different results. We analyze freestanding equity-linked instruments including warrants attached to debt to conclude whether the instrument meets the definition of the derivative and whether it is considered indexed to our own stock. If the instrument is not considered indexed to our stock, it is classified as an asset or liability recorded at fair value. If the instrument is considered indexed to our stock, we analyze additional equity classification requirements per ASC 815-40, Contracts in Entity’s Own Equity . When the requirements are met, the instrument is recorded as part of our equity, initially measured based on its relative fair value with no subsequent re-measurement. When the equity classification requirements are not met, the instrument is recorded as an asset or liability and is measured at fair value with subsequent changes in fair value recorded in earnings. When required, we also consider the bifurcation guidance for embedded derivatives per ASC 815-15, Embedded Derivatives . Revenue Recognition We account for revenue according to standard FASB ASC 606, Revenue from Contracts with Customers (“ASC 606”). Revenue is measured based on the consideration specified in a contract with a customer. Revenue is recognized when a customer obtains control of the products or services in a contract. Judgment is required in determining the timing of whether the transfer of control occurs at a point in time or over time and is discussed below. We evaluate each contract to identify separate performance obligations as a contract with a customer may have one or more performance obligations. Consideration in a contract with multiple performance obligations is allocated to the separate performance obligations based on their stand-alone selling prices. If a stand-alone selling price is not determinable, we estimate the stand-alone selling price using an adjusted market assessment approach. Our main sources of revenue are derived from animation production services provided to third parties, the sale of licenses for the distribution of films and television programs, advertising revenues, and merchandising and licensing sales. We have identified the following material and distinct performance obligations: • Providing animation production services • Licensing rights to exploit Functional Intellectual Property (“functional IP” is defined as intellectual property that has significant standalone functionality, such as the ability to be played or aired. Functional IP derives a substantial portion of its utility from its significant standalone functionality) • Licensing rights to exploit Symbolic Intellectual Property (“symbolic IP” is intellectual property that is not functional as it does not have significant standalone use and substantially all of the utility of symbolic IP is derived from its association with the entity’s past or ongoing activities, including its ordinary business activities, such as the Company’s licensing and merchandising programs associated with its animated content) • Providing media and advertising services to clients • Fixed and variable fee advertising and subscription-based revenue generated from the Kartoon Studios Kartoon Channel!, the Frederator owned and operated YouTube channels and revenues generated from the operation of its multi-channel network, Channel Frederator Network, on YouTube • Options to renew or extend a contract at fixed terms (while this performance obligation is not significant for the Company’s current contracts, it could become significant in the future) 34 Table of Contents • Options on future seasons of content at fixed terms (while this performance obligation is not significant for the Company’s current contracts, it could become significant in the future) Production Services Animation Production Services For revenue from animation production services, the customer controls the output throughout the production process. Each production is made to an individual customer’s specifications and if the contract is terminated by the customer, the Company is entitled to be reimbursed for any costs incurred to date, and for any prepaid commitments made, plus the agreed contractual mark-up. Revenue and the associated costs of such contracts are recognized over time on a percentage of completion basis - i.e., as the project is being produced, prior to it being delivered to the customer. The percentage-of-completion is calculated based upon the proportion of costs incurred cumulatively to total expected costs. Changes in revenue recognized as a result of adjustments to total expected costs are recognized in profit or loss on a prospective basis. Invoices related to these projects are issued based on the achievement of milestones during the project or other contractual terms. The difference between contractual payments received and revenue recognized is recorded as deferred revenue when receipts exceed revenue. When revenue exceeds milestone billings, we recognize this difference as unbilled accounts receivable within Other Receivable on our consolidated balance sheet. Unbilled accounts receivables are transferred to accounts receivable when we have an unconditional right to consideration. When the outcome of an arrangement cannot be estimated reliably, revenue is recognized only to the extent of the expenses incurred that are recoverable. Content Distribution Film and Television Licensing We recognize revenue related to licensed rights to exploit functional IP in two ways; for minimum guarantees, we recognize fixed revenue upon delivery of content and the start of the license period and for functional IP contracts with a variable component, we estimate revenue such that it is probable there will not be a material reversal of revenue in future periods. We recognize revenue related to licensed rights to exploit symbolic IP substantially similarly to functional IP. Although it has a different recognition pattern from functional IP, the valuation method is substantially the same, depending on the nature of the license. Invoices related to these projects are issued based on the achievement of milestones during the project or other contractual terms. The difference between contractual payments received and revenue recognized is recorded as deferred revenue when receipts exceed revenue. When revenue exceeds milestone billings, we recognize this difference as unbilled accounts receivable within Other Receivable on our consolidated balance sheets. Unbilled accounts receivables are transferred to accounts receivable when we have an unconditional right to consideration. Advertising revenues We sell advertising and subscriptions on our wholly-owned AVOD service, Kartoon Channel! , and our SVOD distribution outlets, Kartoon Channel! Kidaverse and Ameba TV . Advertising sales are generated in the form of either flat rate promotions or advertising impressions served. For flat rate promotions with a fixed term, revenue is recognized when all five revenue recognition criteria under ASC 606 are met. For impressions served, we deliver a certain minimum number of impressions on the channel to the advertiser for which the advertiser pays a contractual cost per 1000 (mille) impressions (“CPM”). Impressions served are reported on a monthly basis, and revenue is reported in the month the impressions are served. For subscription-based revenue, revenue is recognized when a customer downloads the mobile device application and their credit card is charged. Upon the acquisition of Wow, we generate advertising revenue from Frederator’s owned and operated YouTube channels as well as revenues generated from the operation of its multi-channel network, Channel Frederator Network, on YouTube. Revenue is recognized when services are provided in accordance with our agreement with YouTube, the price is fixed or determinable, and collection of the related receivable is probable. Receivables are usually collectable within 30 days. Licensing & Royalties Merchandising and licensing 35 Table of Contents We enter into merchandising and licensing agreements that allow licensees to produce merchandise utilizing certain of our intellectual property. For minimum guaranteed amounts that make up a contract, revenue is recognized over time, over the term of the license period commencing on the date at which the licensees can use and benefit from the licensed content. Variable consideration in excess of non-refundable guaranteed amounts, such as royalties and other contractual payments are recognized as revenue when the amounts are known and become due provided collectability is reasonably assured. Invoices are issued based on the contractual terms of an agreement and are usually payable within 30-45 days. Product Sales We recognize revenue related to product sales (e.g., apparel and collectibles) when the Company completes its performance obligation, which is when the goods are transferred to the buyer. Media Advisory & Advertising Services Media and Advertising Services We provide media and advertising consulting services to clients. Revenue is recognized when the services are performed or as paid through the monthly retainer. When we purchase advertising for clients on linear and across digital and streaming platforms and receives a commission, the commissions are recognized as revenue in the month the advertising is displayed. Gross Versus Net Revenue Presentation We evaluate individual arrangements with third parties to determine whether we act as principal or agent under the terms. To the extent that we act as the principal in an arrangement, revenues are reported on a gross basis, resulting in revenues and expenses being classified in their respective financial statement line items. To the extent that we act as the agent in an arrangement, revenues are reported on a net basis, resulting in revenues being presented net of any expenses incurred in providing agency services. Determining whether we act as principal or agent is based on an evaluation of which party has substantial risks and rewards of ownership under the terms of an arrangement. The most significant factors that we consider include identification of the primary obligor, as well as which party has credit risk, general and inventory risk and the latitude or ability in establishing prices. Share-Based Compensation We issue stock-based awards to employees and non-employees that are generally in the form of stock options or restricted stock units (“RSUs”). Share-based compensation cost is recorded for all options and awards of non-vested stock based on the grant-date fair value of the award. The fair value of stock options is estimated at the date of grant using the Black-Scholes option pricing model, which requires management to make assumptions with respect to the fair value on the grant date. The assumptions are as follows: (i) the expected term assumption of the award is based on our historical exercise and post-vesting behavior (ii) the expected volatility assumption is based on historical and implied volatilities of our common stock calculated based on a period of time generally commensurate with the expected term of the award; (iii) the risk-free interest rates are based on the implied yield available on U.S. treasury zero-coupon issues with an equivalent expected term; (iv) and the expected dividend yields of our stock are based on history and expectations of future dividends payable. In the case of RSUs the fair value is calculated based on our underlying common stock on the date of grant. We recognize compensation expense over the requisite service period ratably, using the graded attribution method, which is in-substance, recognizing multiple awards based on the vesting schedule. We have elected to account for forfeitures when they occur. We issue authorized shares available for issuance under our 2020 Incentive Plan upon employees’ exercise of their stock options. Income Taxes Deferred income tax assets and liabilities are recognized based on differences between the financial statement and tax basis of assets and liabilities using presently enacted tax rates. At each balance sheet date, we evaluate the available evidence about future taxable income and other possible sources of realization of deferred tax assets and record a valuation allowance that reduces the deferred tax assets to an amount that represents management’s best estimate of the amount of such deferred tax assets that more likely than not will be realized. 36 Table of Contents Fair value of Financial Instruments Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). These tiers include: • Level 1 - Observable inputs such as quoted prices for identical instruments in active markets • Level 2 - Inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active • Level 3 - Unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable The carrying amounts of cash, restricted cash, receivables, payables, accrued liabilities, bank indebtedness and the margin loan approximate fair value due to the short-term nature of the instruments. We use the fair values of the liability-classified derivative warrants revalued at the end of each reporting period determined using the BSM option pricing model (Level 2) with standard valuation inputs. Refer to Note 16 for additional details. The investment in YFE is also revalued at the end of each reporting period based on the trading price of YFE (Level 1). Refer to Note 4 for additional details. Upon the acquisition of Wow, foreign currency forward contracts that are not traded in active markets were assumed. These are fair valued using observable forward exchange rates at the measurement dates and interest rates corresponding to the maturity of the contracts (Level 2). The fair values of the AFS securities are generally based on quoted market prices, where available. These fair values are obtained primarily from third-party pricing services, which generally use Level 1 or Level 2 inputs for the determination of fair value to facilitate fair value measurements and disclosures. Level 2 securities primarily include corporate securities, securities from states, municipalities and political subdivisions, mortgage-backed securities, United States Government securities, foreign government securities, and certain other asset-backed securities. For securities not actively traded, the pricing services may use quoted market prices of comparable instruments or a variety of valuation techniques, incorporating inputs that are currently observable in the markets for similar securities. Recent Accounting Pronouncements For a description of recent accounting pronouncements and the potential impact of these pronouncements on our consolidated financial statements, see Note 2 to the financial statements in Item 8 of this Annual Report. Off Balance Sheet Arrangements We have no off-balance sheet arrangements. Item 7A. Quantitative and Qualitative Disclosures about Market Risk As a “smaller reporting company,” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this Item.