Read the following excerpt from an article in Fortune magazine and answer the questions that appear below.
Forget about fraud. Companies don't need to lie, cheat, and steal to fool investors. Clever managers have always had, and continue to have, access to perfectly legal tricks to help make their balance sheets and income statements look better than they really are-tricks that even today won't jeopardize their ability to swear to the SEC that their books are on the up and up . . . One of the most controversial of all number games-the one that got WorldCom in trouble-is to capitalize expenses. That can have a tremendous impact on the bottom line.
1. When a company incurs a cost, its accountants have to decide whether to record the cost as an asset or expense. When costs are recorded as an asset, they are said to be capitalized. This builds on ideas first presented in Chapter 2, where you learned that it was appropriate to record costs as assets, provided that they possess certain characteristics. What are those characteristics?
2. The author of the article argues that even with clear rules like those referenced in question 1 above, accounting still allows managers to use "tricks" like capitalizing expenses. What do you suppose the author means by the expression capitalizing expenses?
3. Suppose that, in the current year, a company inappropriately records a cost as an asset when it should be recorded as an expense. What is the effect of this accounting decision on the current year's net income? What is the effect of this accounting decision on the following year's net income?
4. Later in the article (not shown) the author says that the videogame industry is one where companies frequently capitalize software development costs as assets. These costs include wages paid to programmers, fees paid to graphic designers, and amounts paid to game testers. Evaluate whether software development costs are likely to possess the main characteristics possessed by all assets. Can you think of a situation where software development costs might not possess these main characteristics?
5. Do you think it is always easy and straightforward to determine whether costs should be capitalized or expensed? Do you think it is always easy and straightforward to determine whether a manager is acting ethically or unethically? Give examples to illustrate your views.