Classifying Expenditures as Assets or Expenses
As of December 31, 2008, W. W. Cole Company’s total assets were $325 million and total liabilities were $180 million. Net income for 2008 was $38 million. During 2008, W. W. Cole’s chief executive officer had put extreme pressure on employees to meet the profitability goal the CEO had set for them. The goal was to achieve a return on stockholders’ equity in 2008 of 25% (net income/stockholders’ equity). The rumor among Cole’s employees is that to meet this goal, the accounting for some items may have been overly “aggressive.” The following items are of concern:
(a) Research and development costs totaling $18 million were capitalized. None of these costs related to items with alternative uses. The capitalized R&D was assigned a useful life of six years; $3 million was written off during 2008.
(b) During the year, a building was acquired in exchange for 5 million shares of Cole common stock. The building was assigned a value of $27 million by the board of directors. At the time of the exchange, Cole common stock was trading on the New York Stock Exchange for $3 per share.
(c) On December 31, equipment was purchased for $1 million in cash and an agreement to pay $3 million per year for the next eight years, the first payment to be made in one year. The cost of the equipment was recorded at $25 million. The interest rate implicit in the contract was 12%.
(d) Interest of $7 million was capitalized during the year. The only items produced during the year by Cole were routine inventory items.
Instructions:
1. Ignoring any concerns raised by items (a) through (d), did W. W. Cole Company meet its profitability goal for the year?
2. After making any adjustments suggested by items (a) through (d), did W. W. Cole meet its profitability goal? (Ignore income taxes.)
3. What should prevent accounting abuses like those described above?