The only constraints that must be adhered to when deciding on the most appropriate accounting policy for pre-production costs is that it must adhere to Canadian G. A. A. P. and be consistent with Canadian tax laws. The Issue Livent’s accounting policies regarding pre-production costs have been recently criticized as being too aggressive. It must be determined whether these allegations have any grounds and whether a reassessment of these accounting policies might be in the company’s best interest. Alternatives Do Not Change Policy The simplest thing for Mr.
Clark to do would be to not suggest any changes in Livent’s pre-production accounting policy. In this case the company will continue to capitalize all pre-production costs associated with each production and then amortize the costs after the opening day of each show. The amount to be amortized each year is essentially the annual operating profit of the individual production, this will continue until the pre-production costs are fully amortized. In the current year, Livent also implemented an additional policy limiting the amortization to a maximum of five years.
If it was recognized that a production would not be able to recover the pre-production costs, the remaining cost would be written down. The current policy has the distinctive advantage of not being based on any sort of accounting estimates that are prone to manipulation by management. This policy only recognizes revenue for a production once the full value of the pre-production costs have been recovered. The determinants of whether development costs should be deferred to future periods as seen in 3450.
21 of the CICA Hand Book (Appendix B) are easily satisfied and therefore it is suggested that these development costs be capitalized. This method also conforms, in part, to the matching principle prescribed under G. A. A. P. by matching expenses to revenues. Unfortunately the current policy also faces several pitfalls, which has garnered growing criticism among analysts. A major concern regarding this strategy is that management has significant leeway in terms of distributing and adjusting these pre-production costs.
This leeway is achieved through the aggregation of pre-production costs as a current asset, and no disaggregate information for analysts or shareholders to review. Management could theoretically move a cost from one pre-production asset pool into another in order to defer it indefinitely and keep it off the income statement. For Livent, the longer a pre-production cost is deferred, the higher the level of assets reported, which in turn leads to an inflated current ratio. This would have the dual benefit of lowering expenses for the company and furthering the management’s objective of increased book profitability.
Another pitfall of continuing with the current policy is that it ignores the useful life of some tangible items in the pre-production account, such as costumes and props. These items may not depreciate in the same time-span during which the pre-production costs are amortized. This would therefore invalidate the matching principle as items such as costumes, that may be used to produce future revenue, would not be amortized in the period that the revenue is generated. More Transparent Policy
This alternative would consist of Livent continuing with its current policy regarding pre-production costs, while attempting to alleviate the criticism of analysts by being more transparent in their disclosure of pre-production costs. Essentially, Livent would provide shareholders with a greater degree of detail regarding the composition of the pre-production account and an increased level of disclosure on their procedure for amortizing these costs. This approach would allow the company to be more forthright with their procedures and policies and would ease the minds of shareholders and analysts.
Investors would be able to closely scrutinize the strategy and more accurately determine whether the company is attempting to manipulate the financial data. Having to disclose the strategy would clearly limit the company’s ability to manoeuvre costs between productions, thereby forcing them to more accurately represent the true economic position of the organization. The major issue with this alternative is whether the disclosure of the additional information would seriously harm the company’s competitiveness.
Being publically traded, competing private production companies would have the ability to analyze the financial statements and identify any weaknesses within Livent’s strategy. However, Livent is the lone production company in North America that is publically traded, indicating that there would be no companies that would gain a competitive advantage in the stock market. Another concern is that the disclosure of the additional information would in fact breed more controversy and scrutiny. It is believed that analysts may begin to question why write-offs of a slumping show have yet to occur if the show was not an immediate success.
If management believed that sales would recover at a later time then they may choose to not write-off any additional amount of the pre-production costs, and continue with the current amortization schedule. Adopt Film Industry’s Policy Another alternative for Livent would be to account for pre-production costs in the same way as the movie industry. This method would involve estimating expected gross revenues and then amortizing using the ratio of actual current revenues to the forecasted revenues.
Unlike their current policy, the company would be able to recognize net income from a production before the pre-production costs have been fully recovered. Therefore better matching of expenses to revenues would be achieved. When compared directly to their current approach, and assuming that their estimates held true, the company would experience a higher income using this method in the short term but at the cost of a lower net income in the future. This would have the effect of smoothing income over the duration of a production. Unfortunately, some analysts may consider this an even more aggressive approach than Livent’s current policy.
It is also a policy that would be very dependant on the estimates of management, which would mean that it would be prone to manipulation. An incorrect estimate of future revenues could lead to profits being recognized too soon, followed by a large loss in future periods if the estimates do not hold true. However, assuming that the company found a way to make accurate estimates, perhaps based on verifiable past data, then this alternative would most fully satisfy the overriding objective of a policy that most accurately represents the company’s economic reality. Expense All Pre-production Costs
This strategy would be the most simplistic and conservative of all the alternatives. Essentially, Livent would expense any pre-production costs as soon as they were incurred. Under this strategy there would be no leeway for the manipulation of the pre-production costs considering the haste at which they would be expensed. This strategy would undoubtedly silence analysts who felt Livent employed an accounting policy that was too aggressive. The major issue regarding this strategy would be the timing of revenues and expenses. This strategy would clearly violate the matching principle under G.
A. A. P. By expensing pre-production costs immediately Livent would stand to suffer severe short term losses while experiencing unrealistic inflated profits in future periods. Since Livent spent a significant amount of time and resources in order to determine the viability of future projects, they have appeased the requirements of section 3450. 21 in the CICA Hand Book found in Appendix B. Moreover, this alternative would fail to meet the overriding objective of using the financial statements as a means to represent the true economic position of the organization.