AGENCY THEORY At the beginning of the current reporting period City Retail Ltd launched a new logo and spent $1 000 000 on new signage for all its premises. The expenditure on signage was originally accounted for as part of property, plant and equipment. It was recognised as a depreciable asset with a useful life of 10 years. Tony has been engaged as the new accountant for City Retail Ltd. Tony believes that the expenditure for signage 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 on how he would ‘improve’ the forthcoming annual financial statements, by expensing signage costs. An extract from his presentation is provided below. Before change $’000 % of total assets Total assets (includes signage with carrying amount of $900 000) 8 400 100 Total liabilities (including a long term debt agreement) 5 000 60 Shareholders’ equity 3 400 40 Profit (includes depreciation expense of $100 000) 1 200 14 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 For simplicity, assume that the change in accounting treatment has no implications on tax or tax expense. 1. Describe and quantify the effects of recognising the signage costs as an expense in City Retail Ltd’s financial statement for the year ended 30 June. 2. How would agency theory explain why the managers of City Retail Ltd did not welcome Tony’s accounting treatment for the expenditure on signage? CASE STUDY