At the beginning of the current reporting period City Retail Ltd launched a new logo and spent \(\$ 500000\) 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 financial statements, by expensing signage costs. An extract from his presentation is provided below:

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.

- The profit of \(\$ 600000\) includes a depreciation expense of \(\$ 50000\) for the signage.
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?

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Total assets (includes signage with carrying amount of $450 000) Total liabilities (includes a long-term debt agreement) Shareholders' equity Profit Before change % of total $'000 assets 4 200 100 2 500 60 1 700 40 600 14