You have recently been employed by a large retail chain that sells sporting good

Question

You have recently been employed by a large retail chain that sells sporting goods. One of your tasks is to help prepare periodic financial statements for external distribution. The chain’s largest creditor, National Savings & Loan, requires quarterly financial statements, and you are currently working on the statements for the three-month period ending June 30, 2006. During the months of May and June, the company spent $1,200,000 on a large radio and TV advertising campaign. The $1,200,000 included the costs of producing the commercials as well as the radio and TV time purchased to run the commercials. All of the costs were charged to advertising expense. The company’s chief financial officer (CFO) has asked you to prepare a June 30 adjusting entry to remove the costs from advertising expense and to set up an asset called prepaid advertising that will be expensed in July. The CFO explained that “This advertising campaign has produced significant sales in May and June and I think it will continue to bring in customers through the month of July. By recording the ad costs as an asset, we can match the cost of the advertising with the additional July sales. Besides, if we expense the advertising in May and June, we will show an operating loss on our income statement for the quarter. The bank requires that we continue to show quarterly profits in order to maintain our loan in good standing.”

Would you make the 'adjustment' and record the advertising expense as an asset?

***Please note that this situation says you have just recently been employed here. Since your job is to prepare financials that go to the outside world, you are obviously in the finance/accounting department and report up to the CFO--very possibly with supervisors in between you and the CFO. CFOs can make their own entries, but each entry needs an approval, so it is common practice to ask an underling to make the entry and then the CFO approves it. One of these lines of logic might be OK and one might be wrong as a driver in determining what to do.***

Explanation / Answer

Step 1—The Facts:

One of your tasks as an employee of a large sporting goods chain is to prepare financial statements for external use. You are currently preparing quarterly statements for the quarter ending June 30, 2005, that will be given to the chain's largest creditor, National Savings & Loan. The CFO has asked you to capitalize (charge to a prepaid asset) the $1,200,000 cost for an advertising campaign conducted in May and June of 2005. The capitalization of advertising will prevent an operating loss for the quarter and maintain the company's good standing with the creditor. The CFO believes that the commercials improved sales in May and June and expects the advertising effect to continue in July. The matching principle states that expenses are recognized in the same period as the related revenue. In some situations it is impossible to determine in which periods revenues will be earned from expenses such as advertising. Because of the difficulty in estimating the effect of advertising expenditures, accounting principles dictate that advertising should be recognized as an expense in the period incurred.

Step 2—The Ethical Issue and the Stakeholders:

The ethical issue or dilemma is whether your obligation to challenge the CFO's request for capitalization of the advertising expense is stronger than your obligation to your employer's financial interests.

Stakeholders include you, the accountant, the CFO, other corporate managers, company employees, the bank and other creditors, and current and future investors.

Step 3—Values:

Values include competence, honesty, integrity, objectivity, loyalty to your employer, and responsibility to users of financial statements.

Step 4—Alternatives:

1.   Follow the suggestion of the CFO to record the advertising costs as a prepaid asset.

2. Record the advertising costs as an expense in the quarter ending June 30, 2005.

3.   Report the CFO's request to a higher level of management, the audit committee, or the auditors.

4.   Resign from the company and seek employment elsewhere.

Step 5—Evaluation of Alternatives in Terms of Values:

1.   Alternative 1 illustrates loyalty to the employer.

2.   Alternative 2 exhibits the values of competence, honesty, integrity, objectivity, and responsibility to users of the financial statements.

3.   Alternative 3 illustrates loyalty to the employer at a level higher than that of the CFO, but also includes the values of honesty, integrity, and objectivity on the part of the accountant.

4.   Alternative 4 supports the values of honesty and integrity, but does not reflect competence or responsibility to financial statement users.

Step 6—Consequences:

Alternative 1

Positive consequences: You would keep your job and please the CFO. The company would remain in good standing with the bank.

Negative consequences: Users of the financial statements would be misinformed. Users of financial statements may sue the company upon learning the truth if the amount of advertising is material and affects their financial decisions. You may lose your self-respect and the respect of co-workers.

Alternative 2

Positive consequences: Users of financial statements would receive more conservative information concerning advertising costs. You would maintain your integrity.

Negative consequences: You may incur disfavor with the CFO and other top management, resulting in a loss of future promotions or your job.   You also may lose the trust of other employees.

Alternative 3

Positive consequences: You would maintain your integrity. Users may receive more conservative information concerning advertising costs if upper management levels or the audit committee compel fair presentation in the financial statements.

Negative consequences: You may incur disfavor with the CFO and other top management, resulting in a loss of future promotions or your job.   You also may lose the trust of other employees. Whistle blowers often are not rewarded.

Alternative 4

Positive consequences: You maintain your integrity and avoid conflict with management and other employees.

Negative consequences: You have no job and you may have difficulty getting references for a new job. Users of financial statements still do not receive correct information regarding advertising costs.

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