Case study 2
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Case study 2.2 Agency theory At the beginning of the current reporting period City Retail Ltd launched a new logo and spent $500 000 on new signage for all its premises . The expenditure on signage was originally accounted for as part of property , plant and equipment . It was recognised as a depreciable asset with a useful life of 10 years . Tony has been engaged as the new accountant for City Retail Ltd . Tony believes that the expenditure for signage should be recognised as an expense because it is in the nature of advertising and the signage has no resale value . Eager to impress the senior managers , Tony gave a presentation on how he would 'improve ' the forthcoming ?nancial statements , by expensing signage costs . An extract from his presentation is provided below : Before change % of total $'000 assets Total assets (includes signage with carrying amount of $450 4 200 100 000 ) Total liabilities (includes a long -term debt agreement ) 2 500 60 Shareholders ' equity 1 700 40 Profit (includes depreciation expense of $50 000) 600 14 Tony was puzzled by the senior managers ' response :'You don't understand our business What might look like an improvement for your ?nancial statements , looks like devastating economic consequences for us.' Additional information 0 Managers receive a bonus , subject to profit exceeding 10 % of total assets . o The long term debt agreement restricts borrowing to a maximum of 65 % of total assets . Required For simplicity , assume that the change in accounting treatment has no implications on tax or tax expense 1. Describe and quantify the effects of recognising the signage costs as an expense in City Retail Ltd's ?nancial statement for the year ended 30 June. 2. How would agency theory explain why the managers of City Retail Ltd did not welcome Tony's aceoun ting treatment for the expenditure on signage ? 1. Ignoring tax, if the signage costs were recognised as an expense for The year ended 30 June , profit would decrease by a net amount of $450 000 , comprising an increase in signage expense of $500 000 and a decrease in depreciation expense of $50 000. This would flow through to a reduction in equity of $450 000 . Thus pro?t for the period would be $150 000 and shareholders equity would be $1 250 000 at 30 June . Assets would decrease by $450 000 , being the carrying
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Step-by-step explanation
#1)
If the signage expenditures were recorded as an expense for the fiscal year ended June 30, net profit would decline by a net amount of $450 000, which would be comprised of a $500 000 increase in signing expense and a $50 000 decrease in depreciation expense. This is assuming no tax is paid. In turn, this would result in a $450 000 reduction in the amount invested. Profit for the period would be $150 000, and shareholders' equity would be $1 250 000 as of the end of the fiscal year on June 30. If the signage were expensed, assets would decline by $450 000, which represents the carrying value of the signage, to $3 750 000 at the end of the fiscal year. The way in which the costs of signs are recorded in the accounting records has no impact on liabilities.
#2)
Management incentive plans that tie remuneration to accounting profit, according to agency theory, encourage managers to favor accounting policies that promote profit. The management bonus at City Retail Ltd is linked to the company's profit under the company's incentive plan. Profit is reduced to $150 000, and assets are reduced to $3 750 000, as a result of the change in accounting rules, Profit would amount to only 4 percent of total assets, which is well below the 10 percent threshold for profitability. A bonus would not be awarded to the managers for the present time, as a result of this.
In accordance with agency theory, management of companies that have a high level of leverage, or that operate in close proximity to leverage limitations, is more likely to favor accounting methods that raise reported profit in order to avoid violating restrictive loan covenants. Accounting for signage expenditure as an asset is preferred by management of City Retail Ltd because depreciating it would reduce assets and thus increase the firm's leverage ratio to 67 percent (i.e., $2 500 000/$3 750 000), which exceeds the maximum leverage ratio of 65 percent permitted by the firm's long-term debt contract. A breach of the debt covenant would be avoided at all costs by management, as it could result in the lender requiring full repayment, resulting in a costly refinancing.
