The Company That Capitalised Its Own Advertising
Ridgeway Ltd is a small private company. Its draft income statement for the year shows revenue $640,000, cost of sales $410,000, and administrative expenses $96,000, giving an operating profit of $134,000. The draft statement of financial position shows intangible assets of $48,000 described as 'brand development'.
On enquiry you find the $48,000 consists of:
- $31,000 spent on a television advertising campaign during the year
- $17,000 paid to a design agency for a new logo and packaging
No amortisation has been charged. The company also has an outstanding lawsuit from a former supplier claiming $75,000; the directors' solicitor advises that the claim is 'possible but not probable'.
The bank covenant requires operating profit of at least $100,000.
1. Assess whether the $48,000 should be treated as an asset, and restate the operating profit.
Read the worked answer
Internally generated brands, advertising and logos cannot be recognised as intangible assets. The relevant test is whether the expenditure creates a probable future economic benefit that can be reliably measured and is controlled by the entity. Advertising and design costs fail this: the benefit is uncertain, cannot be separated from the business as a whole, and cannot be measured reliably. They are revenue expenditure and must be written off as incurred.
Restated operating profit:
| $ | |
|---|---|
| Draft operating profit | 134,000 |
| Less advertising written off | (31,000) |
| Less logo/packaging written off | (17,000) |
| Restated operating profit | 86,000 |
The intangible asset of $48,000 is removed from the statement of financial position; there is no amortisation to charge because the asset should never have existed.
2. Explain how the lawsuit should be treated and state the effect on the covenant.
Read the worked answer
The lawsuit is a contingent liability. Because the solicitor advises the outcome is 'possible but not probable', no provision is recognised - a provision requires a present obligation arising from a past event that is probable and can be reliably estimated. It is disclosed in the notes to the financial statements, with an estimate of the possible outflow ($75,000) and the uncertainty.
Covenant effect: the covenant requires operating profit ≥ $100,000. Restated profit is $86,000, a shortfall of $14,000. Ridgeway is in breach. The contingent liability does not itself affect profit, but it must be disclosed, and a lender reading the notes will see both the breach and the potential $75,000 claim.
3. Explain why the directors might have preferred the draft treatment, and why accounting standards prevent it.
Read the worked answer
The draft treatment boosted profit by $48,000 and created an asset, keeping the company inside its $100,000 covenant. It also flattered the statement of financial position and any return-on-capital ratios. Directors of a company close to a covenant threshold have a clear incentive to capitalise costs.
The standards prevent this because they prioritise faithful representation and prudence over optimism. Capitalising advertising would overstate assets and profit, misleading the bank and any shareholder. The accruals concept requires costs to be matched to the period whose revenue they helped generate - advertising run this year produced this year's sales, so it belongs in this year's expenses. Allowing directors to choose would make profits uncomparable between companies and between years.