You have recently been employed by a large retail chain that sells sporting goods. One of your tasks is to help prepare financial statements for external distribution. The chain's largest creditor, National Savings & Loan, requires that financial statements be prepared according to generally accepted accounting principles (GAAP). During the months of November and December 2012, the company spent $1 million on a major TV advertising campaign. The $1 million included the costs of producing the commercials as well as the broadcast time purchased to run them. Because the advertising will be aired in 2012 only, you decide to charge all the costs to advertising expense in 2012, in accordance with requirements of GAAP.
The company's chief financial officer (CFO), who hired you, asks you for a favor. Instead of charging the costs to advertising expense, he asks you to set up an asset called prepaid advertising and to wait until 2013 to record any expense. The CFO explains, “This ad campaign has produced significant sales in 2012; but I think it will continue to bring in customers throughout 2013. By recording the ad costs as an asset, we can match the cost of the advertising with the additional sales in 2013. Besides, if we expense the advertising in 2012, we will show an operating loss in our income statement. The bank requires that we continue to show profits in order to maintain our loan in good standing. Failure to remain in good standing could mean we'd have to fire some of our recent hires.” What should you do?
12121
As an employee responsible for preparing financial statements according to GAAP, it is important to adhere to the principles and guidelines set by the accounting standards. In this case, the chief financial officer (CFO) is requesting that you set up an asset called prepaid advertising and delay recording the expenses until 2013 to maintain profits on the income statement. However, it is essential to consider the following factors to make an informed decision:
1. Matching Principle: The matching principle in accounting states that expenses should be recorded in the same accounting period as the revenue they help generate. In this case, the advertising costs are incurred in November and December 2012 and are expected to bring in additional sales in 2013. Therefore, according to GAAP, it would be appropriate to record the advertising expenses in the same period (2012) since they are related to the revenue generated during that time.
2. Materiality: Assess the materiality of the advertising costs on the overall financial statements. If the $1 million spent on the advertising campaign is not significant compared to the company's total revenue or expenses, the impact on the income statement may not be substantial. However, if the amount is material, it becomes even more important to follow GAAP guidelines accurately.
3. Disclosure and transparency: It is essential to provide accurate and transparent financial statements to external stakeholders, such as National Savings & Loan, the largest creditor. By recording the expenses related to the advertising campaign in the appropriate period, the financial statements will reflect the company's actual financial performance, ensuring the integrity of the information presented.
Based on these considerations, it is recommended to follow GAAP and record the advertising expenses in the year they were incurred (2012). This decision ensures alignment with accounting principles, accuracy in financial reporting, and transparency for external stakeholders. It is crucial to communicate these reasons to the CFO, emphasizing the importance of adhering to GAAP guidelines for consistent and reliable financial reporting.