DREAMWORKSANIMATIONSKG,INC. NOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued) Revenue from licensing and merchandising is recognized when the associated films have been released and the criteria for revenue recognition have been met. In most instances, this generally results in the recognition of revenue in periods when royalties are reported by licenses or cash is received. For periods prior to October 1, 2004 (the effective date of the Distribution Agreement), we recognized revenue from films net of reserves for returns, rebates and other incentives. Under the Distribution Agreement, the Company is entitled to recognize revenues net of reserves for returns, rebates and other incentives after DreamWorks Studios (i) retains a distribution fee of 8.0% of revenue (without deduction of any distribution and marketing costs or third-party distribution and fulfillment services fees) and (ii) recovers all of its distribution and marketing costs with respect to the Company. As of October 1, 2004, DreamWorks Studios began retaining its 8.0% fee for all revenue recognized by it subsequent to the effective date, regardless of whether the revenue relates to a film released prior to the effective date of the Distribution Agreement and regardless of whether it has recouped the distribution and marketing expenses related to that film that it has incurred. Because DreamWorks Studios is the principal distributor of the Company’s films, in accordance with the SOP, the amount of revenue recognized from films in any given period following the effective date of the Distribution Agreement, depends on the timing, accuracy and sufficiency of the information received from DreamWorks Studios. Although DreamWorks Studios has agreed to provide the Company with the most current information available to enable the Company to recognize its share of revenue, management may make adjustments to that information based on its estimates and judgments. For example, the management may make adjustments to revenue derived from home video units for estimates on return reserves, rebates and other incentives that may differ from those that DreamWorks Studios recommends. The estimates on reserves may be adjusted periodically based on actual rates of returns, inventory levels in the distribution channel, as well as other business and industry information. Company management also reviews expense estimates and may make adjustments to these estimates in order to ensure that revenue and gross margin are accurately reflected in the financial statements. In addition, as is typical in the motion picture industry, the Company’s distributor and its sub-distributors may also make subsequent adjustments to the information that they provide and these adjustments could have a material impact on the operating results in later periods. Costs Inventories are amortized and contingent compensation and residuals are accrued on an individual film basis in the proportion that current revenues bear to total remaining estimated lifetime revenues as required by the SOP. Prior to the effective date of the Distribution Agreement, distribution and marketing costs, including advertising and marketing were expensed as incurred. Theatrical print costs were expensed upon release of the film. During the years ended December 31, 2002, 2003 and 2004, the Company included $212.2 million, $142.0 million and $228.5 million, respectively, of distribution and marketing costs in costs of revenue. Prior to the effective date of the Distribution Agreement, home video manufacturing costs were charged to costs of revenue at the time home video revenues are recognized. Following the effective date of the Distribution Agreement, the Company generally no longer incurs distribution and fulfillment services fees in the markets covered by the Distribution Agreement, including distribution and marketing costs, print costs, and home video manufacturing costs. 76