Capitalizing versus expensing advertising costs: effects on financial statements and rate of return. Consumer Products Company has $300,000 of total assets. The company has historically earned $45,000 per year and generated

$45,000 per year of cash flow from operations. Each year Consumer Products Company distributes its earnings by paying $45,000 cash to owners. Management believes that a new advertising campaign now will lead to increased sales over the next four years. The company anticipates incremental net cash flows of the campaign as follows:

Assume that the company undertakes the advertising campaign, that cash flows occur as forecast, and that Consumer Products Company makes payments to owners of $45,000 at the end of the first year and $47,000 at the end of each of the next three years. Assume that there are no interest expenses in any year. Ignore any income tax effects.

a. Compute net income and the rate of return on assets (= net income/assets) of Consumer Products Company for each of the four years, assuming that the company expenses advertising expenditures as they occur. Use the year-end balance of total assets in the denominator of the rate-of-return calculation.

b. Compute net income and the rate of return on assets of Consumer Products Company for each year of the project, assuming that the company capitalizes advertising costs and then amortizes them on a straight-line basis over the last three years.
Use the year-end balance of total assets in the denominator of the rate of return on assets.

c. How well has the management of Consumer Products Company carried out its responsibility to its owners? On what basis do you make this judgment? Which method of accounting seems to reflect performance more adequately?

Transcribed Image Text:

Beginning of Year 1 2, 3, and 4 Net Cash Inflow (Outflow) ($24,000) 10,000 each year