Exclusive: How An NBA Team Makes Money Disappear [UPDATE WITH CORRECTION]

We've obtained audited financial data for the New Jersey Nets covering the three fiscal years from June 2003 to June 2006. Though the numbers end five years ago, you can still see the roots of the argument that will have NBA owners, come midnight, again locking out their players. You can also see how a team makes money and how it pretends not to be making any money at all.

The documents are embedded below, but here are the salient parts (click images to enlarge).

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CORRECTION: Portions of the analysis below are wrong. They were based on a misreading of the "Loss on players' contracts" line item, which, it turns out, wasn't an RDA claim after all. (If you look in the audit notes for 2004, No. 8 refers to a "player buy-out and a player injury" — the former of which is almost certainly Dikembe Mutombo — totaling the same $25.1 million listed in the "Loss" line item.) The example is bad, and I apologize for that. I'm leaving the text here for a couple reasons: 1.) The roster depreciation allowance is real, even if we've misidentified it here, and it provides owners with a significant tax shelter based on a baroque logic. 2.) The Nets, like all franchises, do use large paper losses to pad their expenses. Here's what ESPN's experts found using the same set of documents (particularly the 2005-06 financials):

In other words, $41.5 million of the Nets' $49 million operating loss in 2005, and $40.2 million of its $57.4 million in 2006, is there simply to make the books balance. It is part of the purchase price of the team, being expensed each year. This doesn't mean they cooked their books, or that they tried to pull a fast one on the players. It is part of the generally accepted accounting practice to transfer expenses from the acquisition to the profit and loss over a certain time period. However, it's an argument that doesn't hold water in a discussion with Hunter and the players association, who would claim that the Nets didn't really "lose" a combined $106.4 million in those two years, but rather that they lost $7.5 million and $17.2 million, respectively.

We've changed the headline to reflect the error.

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THE NBA'S RESPONSE: From Carol Sawdye, NBA executive vice president and
chief financial officer:

In the three years you addressed, the Nets' cash losses were $20 million in 2004, $27 million in 2005 and $40 million in 2006. Those cash losses have continued since then.

We did not include purchase price amortization in the financial data that we gave to the players and all of the net loss numbers we have used both with the players union and disclosed publicly do not include purchase price amortization. Put simply, none of the Nets losses or the league losses previously disclosed are related to team purchase accounting.

Using the conventional and generally accepted accounting (GAAP) approach, we include in our financial reporting the depreciation of the capital expenditures made by the teams as they're a substantial and necessary cost of doing business. And like every other business, our teams are seeking to make a profit rather than hope that there's some future tax benefit that may or may not be realized.

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Exclusive: How An NBA Team Makes Money Disappear [UPDATE WITH CORRECTION]

The big loss: That $27.6 million net loss looks bad, but, as you'll see, it's an illusion — a trick of accounting, one practiced by every sports franchise with the full blessing of American tax law and one we should keep in mind whenever an owner pleads poverty.

"Anyone who quotes profits of a baseball club is missing the point," Paul Beeston once said (at the time he was a Blue Jays vice president). "Under generally accepted accounting principles, I can turn a $4 million profit into a $2 million loss and I could get every national accounting firm to agree with me." If anything, he was being too modest.

Exclusive: How An NBA Team Makes Money Disappear [UPDATE WITH CORRECTION]

The hustle: The first thing to do is toss out that $25 million loss, says Rodney Fort, a sports economist at the University of Michigan. [See correction above.] That's not a real loss. That's house money. The Nets didn't have to write any checks for $25 million. What that $25 million represents is the amount by which Nets owners reduced their tax obligation under something called a roster depreciation allowance, or RDA.

Bear with me now. The RDA dates back to 1959, and was maybe Bill Veeck's biggest hustle in a long lifetime of hustles. Veeck argued to the IRS that professional athletes, once they've been paid for, "waste away" like livestock. Therefore a sports team's roster, like a farmer's cattle or an office copy machine or a new Volvo, is a depreciable asset.

The underlying logic is specious at best. As Fort points out, a team's roster at any given moment isn't actually depreciating. While some players are fading with age, others are developing and improving. But the Nets don't have to pay more taxes when a player becomes more valuable. And in any case, the cost of depreciation is borne by the athletes themselves, when they pass their primes and lose their personal earning power.

Nevertheless, the IRS not only agreed with Veeck but allowed any owner claiming the write-off to deduct roster expenses twice — first under "player salaries," in the case of the Nets' documents, and then under "loss on players' contracts" — and an enormous tax shelter sprang up within the balance sheets of franchises everywhere. This can't be emphasized enough: Every year, taxpayers hand the plutocrats who own sports franchises a fat pile of money for no other reason than that one of those plutocrats, many years ago, convinced the IRS that his franchise is basically a herd of cattle. Fort calls it "special-interest legislation." "It's not illegal," he says. "It's just weird."

The rules have changed over the years, but the depreciation shelter remains one of the great graces of owning a sports team. In some ways, it's gotten more fanciful. Between 1977 and 2004, owners could write off half the team's purchase price over five years, thanks to the pretend-loss of player value. One consequence, Fort notes, is that teams would change hands every five or six years, once the exemption had dried up. Now, after tax law revisions in 2004, owners can write off 100 percent of their team's purchase price, albeit over a 15-year span. What they're buying, as far as the RDA is concerned, is a set of players — the brand identity, the right to stage games and charge admission, and everything else are throw-ins. (According to Fort's analysis [pdf], the new RDA rules had the twin effect of increasing both tax payments and team values.)

It's not hard to see the benefits. Owners who've set themselves up as a partnership or a Subchapter S corporation can pass their "losses" onto their personal income tax forms. Let's assume that's what the Nets owners did, and let's put them in the 33 percent tax bracket. (The audit here covers the last year that Lewis Katz and Ray Chambers owned the team, the fiscal year ending in June 2004. In August 2004, six years after buying the Nets, they sold the franchise for $300 million to real estate developer Bruce Ratner. In 2009, Ratner sold an 80 percent share to a Rocky and Bullwinkle character named Mikhail Prokhorov for $293 million in equity.) That $27.6 million loss would mean tax savings of $9.1 million ($27.6 x .33).

If we're trying to arrive at some idea of how much money the Nets really made in 2004, we'll need to do a little crude math. Knock out the $25.1 million RDA — a paper loss, remember — and add the $9.1 million in tax savings. Suddenly, that $27.6 million loss becomes a $6.6 million profit.

Exclusive: How An NBA Team Makes Money Disappear [UPDATE WITH CORRECTION]

A typical profit: In the 2003-04 season, the Nets went 47-35, won the Atlantic Division, and lost in seven games to the eventual champions — the Pistons — in the Eastern Conference semifinals. (This was the last of the Kidd-Jefferson-Martin Nets.) That playoff run brought in an extra $4.8 million in revenue, a decent haul that few owners can count on every year. So let's pretend the playoffs didn't happen. Take away that $4.8 million, and the $1.4 million in expenses, and the $27.6 million net loss is now $31 million. Run the earlier calculation again and you would have a $4.4 million profit in a non-playoff season.

Exclusive: How An NBA Team Makes Money Disappear [UPDATE WITH CORRECTION]

The sale: Bruce Ratner's ownership group took over in fall 2004, and the Nets became a small piece of Forest City's $12 billion portfolio. This includes the Atlantic Yards land grab in Brooklyn, the future home of the Nets and the best explanation for why a buccaneering real estate developer like Ratner might buy a middling franchise like the Nets in the first place. As Neil deMause, co-author of Field of Schemes, explains: "If Ratner had gone to Brooklyn politicians and said, 'Hey, I want to build offices and residential buildings on public land,' they'd have hung up on him. But when he says, 'I'm going to bring professional sports back to Brooklyn,' suddenly here's [Brooklyn Borough President] Marty Markowitz holding press conferences and sobbing about the Dodgers. [Buying the Nets] helped him get a foot in the door with Brooklyn politicians."

This means you have to think about the Nets under Ratner as a single node on a vast network — "an element in a billionaire's wealth-generating portfolio," as Rodney Fort says. The real value of the team to Forest City will likely show up in small type on the balance sheets of another subsidiary, lying just beyond our view.

Exclusive: How An NBA Team Makes Money Disappear [UPDATE WITH CORRECTION]

A real loss: "Something interesting happens in 2005," Fort says. "The team really did lose $30 million," even after you remove the phantom losses for player depreciation. (The adjustments aren't insignificant. The next year, in 2006, the team lost something south of $40 million, not the $70 million you see on the balance sheet.) Under previous ownership, the team had been a $4 million a year operation, give or take. What happened?

Exclusive: How An NBA Team Makes Money Disappear [UPDATE WITH CORRECTION]

The motor plant: Operating income was down in 2005, dropping from $95.7 million to $77.4 million, and expenses rose, particularly in those line items representing what we'll loosely call the team's self-presentation: ticket sales, marketing, broadcast, etc. Fort's guess is that the Nets were "presenting the team to Brooklyn" and spending a good deal of money in the process. (The accounting also changed — among other things, we now have line items for both "loss on players' contracts" and "depreciation and amortization.") Still, that doesn't quite account for the swing from a mild profit to a seemingly large loss. "One of two things must be true," Fort says. "Either they haven't found all the values [of owning a team], or they're not losing money."

We can't know for sure, though, since we're seeing only a sliver of Forest City's portfolio. The mistake is in thinking of a sports team as a self-contained unit. Fort says a team is more like the motor plant at Ford. If you were to look at the motor division's revenue, he says, "I'd promise you it's negative." He continues: "But if you said, 'Look, Ford is losing money!' that'd be ridiculous." The motor plant is selling motors at a price that enables Ford to turn a profit when it sells completed motor vehicles. It creates value, Fort says, "every time a Ford goes out of the assembly line."

For anyone who wants to extrapolate these numbers to the rest of the league, caveats apply. These are six-year-old financials for a single team in the NBA, where market size is destiny and where, for instance, New York's books won't look anything like Milwaukee's. What's more, this is about as close a look as you'll get at the financial workings of a sports franchise, and even then the balance sheets are hopelessly opaque. But that's partly the point. In the modern era, franchises are owned by businessmen who approach their teams as one of many interconnected wealth-generating mechanisms. As in Fort's example above, the real value of one asset (the Nets) can't be known without looking at the numbers for another (the Barclays Center) and another (the rest of the Atlantic Yards development), and so on. There's nothing illegal or even wrong with that, but in such a system you can see very quickly why incentives for owners often fall irreparably out of plumb with the wishes of their fans — owners want to maximize revenue (which is their right), and fans want to win (which is their nature), and both Wayne Huizenga and the folks in the grandstand at PNC Park will tell you that these goals aren't necessarily compatible.

The other lesson to draw is that there are certain baked-in advantages to owning a team. You have both the relevant labor law and the tax code firmly on your side. You are making money you didn't exactly earn from the moment you sign the paperwork, and you are making more money for your other businesses — your shopping mall across the street from the arena, your legal practice, your broadcast holdings — and then, come tax time, you are allowed by law, and even encouraged, to pretend you are not making any money at all. Remember this the next time David Stern says the NBA's economic system is broken. "The bottom line about the bottom line," Fort says, "is that even if it looks like they're losing money, it doesn't mean they're losing money."

RELATED: Is the NBA really losing money? [ESPN]

2004 [Download as PDF]

2005-06 [Download as PDF]