Finley and Associates is a consulting firm that spends $60,000 per year advertising the company’s brand names and trademarks. Gross margin on sales after taxes is up $66,000 each year because of these advertising expenditures. For the purposes of this problem, assume that the firm makes all advertising expenditures on the first day of each year and that the $66,000 extra after-tax gross margin on sales occurs on the first day of the next year. Excluding any advertising assets or profits, Finley has $200,000 of other assets that have produced an after-tax income of $20,000 per year. Finley follows a policy of declaring dividends each year equal to net income, and it has a cost of capital of 10 percent per year.
a. Is the advertising policy a sensible one? Explain.
b. How should accounting report the expenditures for advertising in Finley’s financial statements to reflect accurately the managerial decision of advertising at the rate of $60,000 per year? In other words, how can the firm account for the advertising expenditures in such a way that the accounting rate of return for the advertising project and the rate of return on assets for the firm reflect the 10-percent return from advertising?