Steve Morgan, controller for Newton Industries, was reviewing production cost reports for the year. One amount in these reports continued to bother him - advertising. During the year, the company instituted an expensive advertising campaign to sell some of its slower moving products. It is still too early to tell whether the advertising campaign was successful.

There had been much internal debate as to how to report advertising costs. The vice president of finance argued that advertising costs should be reported as a cost of production, just like direct materials and direct labour. He therefore recommended that this cost be identified as manufacturing overhead and reported as part of inventory cost until sold. Others disagree. Morgan believed that this cost should be reported as an expense of the current period, so as not to overstate net income. Others argue that it should be reported as prepaid advertising and reported as a current asset, to be expensed as the advertising results in increased sales.

The president finally had to decide on the issue. He argued that these costs should be reported as inventory. His arguments were practical ones. He noted that the company was experiencing financial difficulty and expensing this amount in the current period might jeopardise a planned bond offering. Also, by reporting the advertising costs as inventory rather than as prepaid advertising, less attention would be directed to it by the financial community.

Required

a) What are the ethical issues involved in this situation? (6 marks)

b) What is the effect of treating advertising as either product cost or period cost on the company's equity? (6 marks)

c) What would you do if you were Steve Morgan? (3 marks)