Effects of Capitalizing versus Expensing: Liberator Medical Holdings, Inc. Liberator Medical Holdings, Inc. (OTCBB: LBMH), based in Stuart, Florida with 319 employees, is a national direct-to-consumer provider of medical supplies to Medicare-eligible seniors. LBMH has four main product lines: diabetes, urological, ostomy and mastectomy. As of September 30, 2014, the Company distributed products from over 200 manufacturers, including all of the United States suppliers. LBMH markets its products directly-to-consumers, primarily through targeted media, direct-response television, print, and Internet advertising, throughout the United States. LBMH follows the accounting edict of the American Institute of Certified Public Accountants Statement of Position 93-7, "Reporting on Advertising Costs" which provides guidance concerning the financial reporting for the cost of activities such as advertising. In general, according to 93-7, the costs of advertising should be expensed either as incurred or the first time the advertising takes place. However, one exception is direct-response advertising: (1) whose primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising, and (2) that results in probable future economic benefits. Expenditures for direct-response advertising should be capitalized if both of the conditions are met. The future benefits to be received are the future revenues arising from the advertising. The firm is required to provide persuasive evidence that there is a linkage between the direct-response advertising and these future benefits. These costs are then amortized over the period in which the future benefits are to be received. Business Model LBMH employs an advertising driven business model. The Company attracts new customers through targeted advertising across television, the Internet, and print media. The advertising driven model requires significant investment. In fiscal year 2014 , LBMH invested $14 million in advertising (19% of revenue) compared to $9 million in fiscal year 2008 (13% of revenue). Management estimates that each dollar invested in advertising results in $10 in revenue over the short term and more than $20 over the long term. LBMH believes that it has developed a high quality method of capturing initial and recurring sales through the use of local, regional, and national ad placements and maximizing the "drag" of each ad. As advertising expenditures are expected to yield revenue over several years LBMH amortizes these costs over a four-year period. Customers can order product by phone, nail or over the Internet. LBMH's sales representatives establish contact with the customer and check if the customer is eligible for Medicare reimbursement. After verifying eligibility, orders are shipped and Medicare or third-party insurers are billed, as appropriate. LBMH continuously adds new customers and sales leads to its database and sales representatives consistently evaluate it to identify potential leads and to generate repeat orders. According to management LBMH's clients have an average customer life of four years. Management believes its proactive sales efforts and targeted advertising help assure predictable and recurring revenue. LBMH continues to focus on making the buying process more convenient by reducing the paper work for the Medicare beneficiary and by taking initiatives to ensure reimbursement from Medicare.LBMH bills Medicare/insurers on the day products are shipped. According to the Company, Medicare normally reimburses 80% of the amount billed and the balance is collected from private insurance companies, if applicable. LBMH's takes about 60 to 65 days to collect from Medicare and other insurers. On the procurement front most of LBMH's suppliers are within one day's shipping distance and they are primarily in the U.S. The Company generally uses ground shipping and orders inventory on a quarterly basis. Proximity to its suppliers allows LBMH to keep its inventory lean but urgent requirements can usually be replenished within a day's notice. Questions. - LBMH's Balance Sheet, Income Statement and Operating Section of its Cash Flow Statement are presented in Exhibits 4, 5 and 6. You should only consider the direct financial statement effects with respect to changes in accounting for LBMH's advertising costs and not consider any other possible "side effects". LBMH's Common Size Balance Sheet, Common Size Income Statement, and Ratios and presented In Exhibits 7, 8 and 9. a. For the years ended September 30, 2010, 2011, 2012, 2013 and 2014, what would LBMH's Income (Loss) before Income Taxes have been if it expensed its advertising costs instead ofcapitalizing them? b. How do you think LBMH is accounting for its advertising costs for tax purposes. On what do you base your answer? c. Would there be any effect on LBMH's cash flow if it expenses its advertising costs instead of capitalizing them? Why or why not?