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Deferring or Expensing Costs in the First Year of Operation

Wendell Systems, Inc: Case C10-12

Deferring versus Expensing Costs in the First Year of Operations
Wendell Systems, Inc. was incorporated on February 2, 20X1. It was organized by 10 shareholders who contributed a total of $250,000 in exchange for common stock. Two of the shareholders, Marty Mahoney and Cecila Shriberg, will be actively involved in the business. Wendell Systems plans to distribute and install high-end home audio and video entertainment systems. Wendell anticipates obtaining future financing from a second placement of stock to venture capitalists in 20X2.

In anticipation of seeking financing from venture capitalists, Marty Mahoney and Cecila Shriberg are concerned about first-year operating results. Marty Mahoney states that the higher the reported earnings, the better their chances are of obtaining financing on favorable terms. Cecila Shriberg is not certain that she totally agrees with Marty. However, she indicates that some 20X1 expenditures could be capitalized instead of expensed to increase 20X1 earnings. Cecila thinks that the costs of organizing Wendell Systems and starting up its operations could either be capitalized or expensed. She indicates that if these costs are capitalized and subsequently amortized, Wendell would achieve certain tax benefits and 20X1 operating results would improve.

After investigating the issue further, Cecila informs Marty that for tax purposes Wendell Systems can elect to capitalize and amortize over a period of 60 months or more start-up expenditures and organizational expenditures. She states that these provisions are contained in Internal Revenue Code Sections 195 and 248, respectively. If Wendell Systems does not make these elections, then for tax purposes the expenditures are permanently capitalized. She also informs Marty that according to her understanding there is limited authoritative guidance on the financial accounting for organization costs and start-up costs. Thus, she concludes that Wendell Systems would be justified in following tax law, capitalizing both organizational, start-up expenditures, and amortizing them over the minimum period of 60 months. Marty Mahoney and Cecila Shriberg then compile the following list of 20X1 expenditures:

Newspaper and radio advertising prior to commencing operations $ 60,000
Training of installation technicians 27,000
Legal fees for incorporation 6,000
Accounting fees for incorporation 2,000
Accounting fees for business and tax consulting 20,000

Promotion and commission fees paid for the sale of stock 15,000
Market research surveys prior to commencing operations 50,000
Fees paid to executive search firm to hire a marketing director 20,000
They plan on capitalizing these expenditures as organization costs and start-up costs and amortizing them over 60 months.
In addition, Cecila Shriberg notes that Wendell Systems incurred $100,000 for direct-response advertising costs in 20X1. These costs were incurred because of the results of the market research surveys prior to commencing operations. The costs relate to print advertisements in trade publications with an 800 number included. Cecila informs Marty that direct-response advertising costs can be capitalized. She recommends that Wendell Systems capitalize these costs and amortize them over 60 months to be consistent with the amortization of the organizational and start-up costs. Marty agrees that this sounds like a reasonable plan.

1. What are organization and start-up costs? Give examples of each.
2. In the absence of authoritative sources of accounting guidance, is it appropriate to base financial accounting on federal tax law?
3. Is Wendell Systems' proposed accounting treatment of the organizational and start-up expenditures and direct-response advertising costs in accordance with generally accepted accounting principles? Be specific in your response and identify how you are treating all the expenditures in the case. Cite any literature that you base your decision on.
4. Discuss whether Wendell Systems' proposed accounting, reporting for organizational, start-up expenditures, and direct-response advertising costs will likely influence the decision of future investors.

Solution Preview

1. The distinction between organizational costs and startup costs are that organizational costs are those which relate to setting up the entity before beginning business. Startup costs are costs that would normally be operating costs except that they are incurred prior to the time when revenue would be earned. Legal and accounting fees for incorporation are organizational. Newspaper advertising and market research are startup costs.

2. In the absence of other ...

Solution Summary

Wendell Systems, Inc: Case C10-12 includes discussions about start up costs and organizational costs for a new company. The 285 word solution provides detailed information about the proper method of amortizing up-front costs including the effect to investors.