Question 4

Celebrity Monthly is a glossy monthly magazine that has been on the market for nearly 2 years. It currently has a circulation across several countries of 1.6 million copies per month. Currently, negotiations are under way for the company, to obtain a loan from a bank in order to upgrade production facilities. The company is currently producing close to capacity and expects to grow at an average of 15% over the next 3 years.

After reviewing the financial statements of the company, the bank loan officer, Joe Teller, has indicated that a loan could be made if the company is able to improve its debtequity ratio (non-current liabilities divided by equity) and current ratio (current assets divided by current liabilities) to a specified level.

The companys marketing manager, Jess Smith, has devised a plan to meet these requirements. Smith indicates that an advertising campaign can be initiated immediately to increase the companys circulation. The campaign would include:

• an offer to subscribe to Celebrity Monthly at 75% of the normal price for 1 year
• an unconditional guarantee that any subscriber will receive a full refund if dissatisfied with the magazine.

Although the offer for a full refund is risky, Smith claims that very few people ask for a refund after receiving half of their subscription issues. Smith also claims that other magazine companies have tried this sales campaign and have had great success, with an average cancellation rate of only 25%. Overall, these other companies increased their initial circulation threefold, and in the long run increased circulation to twice that which existed before the promotion. Smith feels confident that the increased subscriptions from the campaign will increase the current ratio and reduce the debtequity ratio to the required levels. The managing director agrees.

Required:

You are the accountant for the company, and are required to give your opinion of the accounting treatment for the proposed campaign.

Referring to the Conceptual Framework, explain:

• how you would treat the costs of the advertising campaign
• when revenue should be recognised from the new subscriptions
• how you would treat sales returns stemming from the unconditional guarantee