Will the SEC require Poly-Medica to change its method of accounting for direct response advertising?
In order to justify capitalizing the direct response advertising costs, the company will have to demonstrate to the SEC that these costs satisfy the requirements of being assets. Understanding of the differences between assets and expenses is central to this issue. Assets are defined as resources with economic value that are owned by the company and are expected to yield future economic benefits. Expenses, on the other hand, are defined as “economic costs incurred by the company to earn revenue”.
Company has been capitalizing the advertising costs in light of AICPA’s statement of purpose (SOP) 93-7. This article states that if the advertising is of such a nature that costumers respond specifically to the ads, then the costs incurred in this regard can be capitalized because these costs help the company to earn in future a probable future economic benefit. As compared to its competitors, the market share and value of the company is very small. The company cannot compete with its competitors directly because of their experience and large scale operations. It is this ability to reach the costumers and attract them through effective advertisement that sets the company apart from its competitors.
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These advertising costs were incurred specifically to increase the costumer base and help the company generate revenue in future. This campaign was successful because in 2003, company succeeded in increasing its costumer base from 17,000 to 545,000. Evidently, profits of the company also increased significantly. The economic benefits of the advertisement costs were materialized in two to four years. This time span was regarded as the useful life of direct response advertising costs. These costs were then amortized based on the useful life.
The maintenance of all records related to the costumers and the enormous impact of these efforts on the customer base show that the company is using funds of advertising solely to derive economic benefits in the future in the form of revenues. So, apparently, the company was true in its understanding of SOP 93-7 and the capitalization of advertisement costs was justifiable. However, one may allege the company of using a very aggressive mode of accounting as far as the treatment of advertisement costs is concerned.
The effectiveness of the advertising campaigns depends on their ability to translate the increase in costumer base to increase in revenue. In order to track this relation between advertisement and sales, the company uses codes, correspondence cards, 800 numbers and all the data relevant to costumers. This data was later on used to deal on behalf of costumers with physicians, to remain in touch with them and provide them consultancy. So, in a way, it can be said that these costs are essentially historical events that help the company to earn probable future economic benefits.
These costumers could not have become a part of the company’s client base unless they were contacted and convinced through proper advertising. Furthermore, the intention of the company behind these ad campaigns was to attract patients who will help augment the revenue of the company in the future. So, in accordance with SOP 93-7, the company can capitalize the advertisement costs and SEC should not object to this practice.
If the company restated its financial statements, what would the impact be on the company’s stock price?
If, SEC forces the company to expense out the advertisement costs, the assets of the company will decline. Net income will fall and hence all the indicators of financial performance will show a negative trend.
The total net direct-response advertising costs are $78,499,000, $91,653,000 and $101,487,000 for years 2005, 2006 and 2007 respectively. The increases in costs for every subsequent year come out to be $13, 546,000, $13,154,000 and $9,834,000. These increases should be subtracted from the income from continuing operations before taxes. The values of incomes from continuing operations before taxes are $24,494,000, $58,374,000 and $53,027,000. After subtracting incremental advertising expenses from these incomes, net income from continuing operations after tax come out to be $7,225,680, $2,984,520 and $28,507,380 for years 2005, 2006 and 2007 respectively. The decrease in the net income from continuing operations after tax comes out to be 55.26%, 20.16% and 15.3385% for years 2005, 2006 and 2007. It can be seen that there is a decreasing trend in the reduction of income over the years. This makes sense because in the long term, effects of expensing out the capitalized costs in financial statements tend to decrease and reported earnings become smooth. If, the company fails to justify the capitalization of advertising costs, the company has to restate the financial statements of previous years. This practice may harm the reputation of the company. The allegation against the company is that it has overstated the earnings in initial years.
The impact of change in accounting policy is as follows.
If, the financial statements of years 2002 and 2003 are restated, it can be seen that earnings per share will decrease from $2.38 to $1.76 for year 2002 and from $3.21 to $2.61. So, effectively, EPS has decreased 26% for 2002 and 195 for year 2003. This is a significant decrease, and it will certainly hurt the share price of the company because shareholders of the company will feel having been cheated on by the company. This will prove to be a serious setback for the growth of the company. The company is in constant need of funds due to enormous growth. The negative reputation resulting from the restatement of the financial statements will make it very difficult for the company to obtain funds both from debt and equity markets. The share price of the company is likely to drop down, and credit rating of the company may deteriorate if the company fails to establish its stance.
If, the company capitalizes costs of advertising and amortizes these costs in upcoming years, company will be able to report smooth income statement over the years. However, if advertising costs are expensed immediately, then the income of the company will show a lot of variation over the years. Since the company has recently initiated large scale advertising campaign, the income of the company will suddenly drop down due to very high expenses incurred. However, increased revenue caused by the advertising costs incurred currently will compensate for this loss of income. The calculations show that net income decreases from $32,434,000 to $23,507,000 for 2005, $60,398,000 to $52,361,000 for 2006 and $33,672,000 to $23,376,000 for year 2007.
Since, net income will drop down initially, retained earnings. So, initially expensing advertising costs will result in lower stockholder’s equity. However, if the company continues advertising campaign at the same scale, stockholder’s equity will become smooth.
Cash Flow from Operations
Since Poly-Medica was capitalizing its costs, it reported higher income in initial years and hence paid higher taxes. In the long term, tax effect on the cash flow will even out. However, the place of cash outflow due to advertising costs depends on company’s choice of expensing or capitalizing costs. If the company capitalizes these costs, the cash flow is included in investing activities. Whereas, if the company expenses these costs, the cash flow will be included in cash flow from operations.
If, the company is forced to expense advertising costs by SEC, total assets value will certainly decrease by the amount of expense.
Almost all of financial ratios depend on the income of the company. If the company is forced to expense the capitalized portion of advertising costs, it will report lower income for a few years until the pattern of advertising costs is established. Since the company has suddenly augmented the scale of business by starting the advertising campaign, it will take a few years before the revenues and costs could be matched properly. For example, net income per weighted average share has decreased from 1.47 to 1.24 for 2007, 2.43 to 2.12 for 2006 and 1.19 to 0.85 for 2005. So, EPS of the company will also fall for initial few years. Return on assets will be lower in case of expensing because of the combined effect of decrease in income and assets. ROE will also show the same trend. A summary of the impact of change in accounting treatment of advertising costs is as follows.
EBITDA will remain the same for both the scenarios. This is primarily because it is only the depreciation expense that matters whereas for computing EBITDA, depreciation is ignored. Interest and taxes remain the same for both cases.
Total Asset Turnover
This ratio is calculated by dividing sales by total assets. This ratio will be higher if the company expenses the advertising costs. This is because the numerator, sales, remains the same for both the scenarios but the asset base in the denominator decreases if the company expenses the costs that were earlier on capitalized.
ROA is the ratio of net income to total assets. Return of assets will decrease if the company chooses to expense the advertising costs. This is because net income value in the numerator decreases. Although asset base in the also denominator also decreases but this decrease is not enough to compensate for the decrease of Net income in numerator.
Return of equity is the ratio of net income to equity. This ratio will also decrease if the company restates the financial statements by expensing advertising costs rather than capitalizing. The reasons are the same as that for ROA.
Fixed Asset Turnover
Fixed asset turnover is the ratio of net sales to fixed assets. This ratio will increase for the expensing scenario because the sales in the numerator will remain the same while fixed asset value in the denominator decreases because advertising costs are now no longer capitalized.
This is the ratio of net sales and stock holder’s equity. This ratio will increase if the company expenses advertising costs because sales in the numerator will remain the same while equity in the denominator decreases. Equity decreases because the retained earnings are dependent upon Net income that suffers directly from the decision of expensing out advertising costs.
Debt to Equity Ratio
The solvency ratios of the company increase if capitalization costs are treated as expenses. Debt to equity ratio increases for the expense scenario because debt in the numerator remains the same while equity in the denominator decreases.
Times Interest Earned Ratio
This is the ratio of Net income to interest expense. Since net income decreases initially if advertising costs are expensed out, times interest earned ratio decreases. It means that the firm is more risky from the creditor’s point of view.
So, we can see that for initial few years, solvency ratios increase while the profitability ratios decrease. This is harmful for the reputation of the company, and the share price of the company is likely to decrease. The company may not be able to give dividends to the shareholders because it may report losses for initial years. So, if the company is forced to restate the financial statements, reputation of the company will suffer. Although all indicators of financial performance indicators show a negative trend initially, the impact of this trend should not be over emphasized. Financial ratios will increase in the upcoming years as the impact of change in accounting policy diminishes. So, James should not let himself be carried away by these figures.
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