Question

5. Del and ring of the current reporting period City Retail Lid launched a new logo and spent $500.000 AP CASE STUDY 2.2 AGENCY THEORY At the beginning of the current repor oe was originally accounted for as part of on new signage for all its premises. The expenditure on signage property, plant and equipment. It was recognised as a depreciable as a depreciable asset with a useful life of 10 years. Tony has been engaged as the new acountant for City Retail Lid. Tony believes that the expenditure for signape 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 om presentation on how he would 'improve he forthcoming annual financial statements, by expensing signage costs. An extract from his presentation is provided below. BA 2.1 Before change $'000 4200 2500 1 700 600 % of total assets 100 60 40 14 Total assets includes signage with carrying amount of $450 000) Total liabilities includes a long-term debt agreement) Shareholders' equity Profit (includes depreciation expense of $50 000) Tony was puzzled by the senior managers' response: 'You don't understand our business. What might look like an improvement for your financial statements, looks like devastating economic consequences for us." Additional information • Managers receive a bonus, subject to profit exceeding 10% of total assets. • The long-term debt agreement restricts borrowing to a maximum of 65% of total assets Required implicity assume that the change in accounting treatment has no implications on tax or tax expense. 1. Describe and quantify the effects of recognisin e and quantify the effects of recognising the signage costs as an expense in City Retail Ltd's financial statements for the year ended 30 June cency theory explain why the managers of City Retail Lid did not welcome Tony's accounting treatment for the expenditure on signage?

Answer 1

(1): First of all profits will fall. The impact will be 600,000 + 50,000 (depreciation will be added back) – 500,000 = 150,000. Thus profits will fall to $150 (in ‘000s). Total assets will be = 4,200 – 450 (as carrying value of the signage will be deducted). This will be equal to 3,750 (in ‘000s). Thus the new financials will be:

	$000	% of total assets
Total assets	3,750	100%
Total liabilities	2,500	67%
Shareholder's equity	1,250	33%
Profit	150	4%

Thus the profit (as a % of total assets) will fall to just 4% and liabilities will rise to 67% of total assets.

(2): Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. In this case the managers of City Retail Ltd. are agents of the company and the owners of the company are the principal. Now agents will have certain different priorities than principals. For example in this case the priority of the agents is to generate a profit of a minimum of 10% of total assets so that they are able to earn bonus. Tony's accounting treatment would cause the profits to fall to 4% and hence the managers will not be able to earn a bonus. This is not a desirable situation or outcome for them.