Problem
Big Lots Stores Limited (Big Lots) is a chain of retail stores across Canada. Big Lots sells a wide range of kitchen and hardware items, cleaning supplies and seasonal items that it obtains from major manufacturers and wholesalers. Big Lots' strategy has long been to deliver value and help shoppers save time by offering everyday products with low prices and good value in convenient neighborhood location. The company is wholly owned by Sanjay and Priyanka Chowdry, who founded it many years ago. In recent years, the Chowdrys have not been involved in managing the company but have hired professional managers. The Chowdrys currently live in Bermuda and rely on the cash flow generated by Big Lots to live on.
A year ago, the Chowdrys hired Joseph Wan as the chief executive officer of the company to help turn the company around after a number of unprofitable years. At the time Joseph was hired, the Chowdrys were worried that Big Lots would go bankrupt and they would lose their main source of income. Joseph was well known as an excellent manager, and the Chowdrys were prepared to pay for someone who could reverse the current financial status of their business. The Chowdrys agreed to pay Joseph a salary plus a bonus of 25 percent of net income (in accordance with ASPE) in each year of a three-year contract. Big Lots' tax rate is 40%.
In his first year with Big Lots, Joseph made significant improvements in the strategic direction of the business. In addition to adding online shopping and corporate clients, Big Lots new business strategy is to provide customers with a consistent value add shopping experience, offering a broad assortment of national brand-named merchandise, consumables and seasonal items. Products are available in individual or multiple units at low, fixed price points. This allowed Big Lots to compete with large retail chain stores.
Joseph estimated that the bonus this year could reach to $45,000. After hiring Joseph, the Chowdrys feel confident about the viability of Big Lots.
Joseph has just presented the financial statement for the current year to the Chowdrys for their approval. The Chowdrys are pleased about Big Lots' profitability, but they are concerned about some accounting treatments that appear to have contributed to the significant increase in net income. Here are the items noted below:
Joseph launched an extensive national advertising campaign amounting to $300,000 to improve the image and reputation of Big Lots and to attract new customers. According to Joseph, the re-branding campaign has been a success and as a result Big Lots has been able to increase its profit margins and has increased the flow of customers through all stores. Joseph capitalized 50 percent of the advertising costs as goodwill since the reputation of Big Lots has improved tremendously from before. Joseph directed the accountant to amortize the goodwill over five years, arguing that the increase in Big Lots' reputation in the market will benefit the company over a number of years. A full year amortization was expensed this year.
a) What should be the correct net income? (Write down the journal entries)
b) What is the impact of this error other than net income? (For example, what is the impact on Joseph's bonus)
c) What can we do to reverse this error?