Question

Problem IV: (21%) Ethics Case John Franklin, controller for Kepler Industries, was reviewing production cost reports for the year. One amount in these reports continued to bother him-advertising. During the year, the company had instituted an expensive advertising campaign to sell some of its slower-moving products. It was still too early to tell whether the advertising campaign was successful. There had been much internal debate as how to report advertising cost. The vice president of finance argued that advertising costs should be reported as a cost of production, just like direct materials and direct labor. He therefore recommended that this cost be identified as manufacturing overhead and reported as part of inventory cost unit sold. Other disagreed. Franklin believed that this cost should be reported as an expense of the current period, so as not to overstate net income. Others argued that it should be reported as prepaid advertising and reported as current asset. The president finally had to decide the issue. He argued that these costs should be reported as inventory. His arguments were practical ones. He noted that the company was experiencing financial difficulty and expensing this amount in the current period might jeopardize a planned bond offering. Also, by reporting the advertising costs as inventory rather than as prepaid advertising, less attention would be directed to it by financial community. Instructions (a) Who are the stakeholders in this situation? (b) What are the ethical issues involved in this situation? (What would you do if you were John Franklin?

Answer 1

a) In the situation, the affecting stakeholders are

1) Shareholders : The advertising expense taken as period cost can reduce earning for the shareholders, the owner.

2) Investors : The reduction in the net income of the year of expense will hamper the market price of the company’s stock and the investors expectations.

3) Creditors and Bankers : The treatment of advertising expense as period cost can reduce the interest coverage ratio.

b) The ethical issues involved in the situation are:

A) Treatment : Treating the advertising expense as direct cost, indirect cost, period cost or asset.

B) Benefits spread: The advertising expense does not appreciate the current year’s sales but also for future years. The expense spread issue will be there.

c) If I being the John Franklin, the controller for Kepler Industries, we will treat the advertising costs are Pre-paid expense ( current assets) and spread the expense for the period to which the benefits of advertising expense goes. This will not put pressure on the net income of the expense incurred year. This treatment is ethically perfect as per GAAP.