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, 2015. 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.”

Question:

In a 300-500 word, double-spaced paper, evaluate this ethical dilemma. Include what you would do in this dilemma.Also explain your reasons.

Explanation / Answer

The above mentioned scenario highlights the significance of matching principle which states that expenses should be recorded in the period in which the related earnings are made and not in the period in which the cash is spent.

The matching principle is one of the basic underlying guidelines in accounting. The matching principle directs a company to report an expense on its income statement in the same period as the related revenues.

Example

To illustrate the matching principle, let's assume that all of a company's sales are made through sales representatives (reps) who earn a 10% commission. The commissions for each calendar month's sales are paid to the reps on the 15th day of the following month. For example, if the company has $60,000 of sales in December, the company will pay commissions of $6,000 on January 15. The matching principle requires that $6,000 of commission expense be reported on the December income statement along with the related December sales of $60,000. This is likely to be carried out through an adjusting entry on December 31 that debits Commission Expense and credits Commissions Payable for $6,000.

The matching principle is associated with the accrual method of accounting and adjusting entries. Without the matching principle, the company might report the $6,000 of commission expense in January (when it is paid) instead of December (when the expense and the liability are incurred).

A retailer's or a manufacturer's cost of goods sold is another example of an expense that is matched with sales through a cause and effect relationship. However, not all costs and expenses have a cause and effect relationship with sales or revenues. Hence, the matching principle may require a systematic allocation of a cost to the accounting periods in which the cost is used up. For example, if a company purchases an elaborate office system for $252,000 that will be useful for 84 months, the company will match $3,000 of expense each month to its monthly income statement.

In the above mentioned case, since it is clearly forecasted that the expenditure on TV and radio will produce results till the month of July ,hence the entire expenditure should not charged as expense in the months in which cash is spent rather it should be systematically allocated to various periods according to the related revenue allocation.

The management will have to process an adjusting entry whereby the expenditure incurred on radio and TV campaign will be reversed as an expense and shown as an asset (Prepaid Expense).

This will help the management in confirming to the matching principle which is the basic principle of accountancy.

It will also show true picture of profit and loss instead of loss by allocating the expense to various periods.

Hence,recording advertisement expense as prepaid asset will be the effective solution to bring expenses and related revenues matched up against each other .

This is the basic principle of accountancy.

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