Effect of Advertising on the Sales Revenue and Net Profit

Effect of Advertising on the Sales Revenue and Net Profit

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Chapter one on Effect of Advertising on the Sales Revenue and Net Profit

INTRODUCTION

BACKGROUND TO THE STUDY

In recent years, much attention has been paid to whether certain expenditures generate intangible assets, and how these expenditures should be accounted for in financial statements (see, for example, Lev, 2001; Hand & Lev, 2003). However, relatively little attention has been given to advertising activities as possible creators of intangible assets (Shah, Stark & Akbar, 2009). Advertising expenditure is found to be effective in creating awareness, enhancing consumer knowledge, and influencing both short-term and long-term consumer preferences and loyalty, thereby generating additional revenue. As a consequence, advertising is believed to have an indirect impact on firm value through an increase in sales and profits, as well as a direct effect by virtue of building brand-related intangible asset (see e.g., Graham & Frankenberger, 2000). Despite the significant economic importance of advertising expenditures in building brand equity and its potential impact on future cash flows, significant considerations have not been given to treating advertising expenditure as an intangible asset. Advertising expenditure in Nigeria as a case study, according to the International Accounting Standard, IAS 38, requires expenditure on advertising to be written off as incurred by companies. This study in essence, aims at investigating the relationship between advertising cost and relevant variables such as sales and profit of selected listed firms in Nigeria to conclude on its value relevance which further serves as a basis for determining its accounting treatment – to expense or to capitalize.

STATEMENT OF THE PROBLEM

There has been a controversy as to the treatment of advertising expenditure. While some studies are of the view that advertising should be capitalized, other studies suggest otherwise. These equivocal views have therefore called for a need for more research to be made on advertisement treatment. For instance some researchers believe that advertising cost should be capitalized (e.g. Qureshi, 2007; Shah et al., 2009). In their view, since investment in advertising would benefit current as well as future periods, the cost should be recorded as an intangible asset and amortized against current and future revenues. On the other hand, the dominant accounting practice is to charge advertising expenditure to current expenses, producing an implicit rate of amortization of 100%. This practice has its advantages such as tax benefit considerations, conservatism, and a lack of other acceptable and nonarbitrary systems of amortization. In addition to the the controversy of capitalizing or expensing, companies willing to capitalize face the major challenge of their inability to accurately estimate all costs associated with advertising as well as the future benefits accrued from it.

They therefore prefer to write off the cost incurred against the current profit for that period which is more certain rather than risking amortising it against future profits which might be unable absorb it. However, inappropriate recognition of advertising cost goes against the International Accounting Standard regulation which requires that the purpose of financial accounting is to provide users of financial statement with information that is useful for efficient decision making. Financial statements should therefore provide accurate and reliable information to assist potential and present investors, creditors, and other users in making rational investment, credit and similar decisions. It is therefore of great importance to conclude whether advertising benefits spread across multiple periods. If so, it would be therefore appropriate to capitalize it. This research therefore seeks to examine and conclude on the best possible treatment of advertisement cost based on its value relevance. The general question here is, is advertising expenditure value relevant?

RESEARCH QUESTIONS

The following are the specific research questions:

1) Is there a relationship between advertising expenditure and companies sales?

2) Is there a relationship between advertising expenditure and companies profits?

JUSTIFICATION FOR THE STUDY

Results of previous studies about the value relevance of advertising expenditure are contradictory. Even though most studies find that advertising expenditures are positively related to market value (e.g., Graham & Frankenberger, 2000; Qureshi, 2007; Shah et al., 2009), a number of studies indicate that advertising expenditures do not have an impact or has a negative impact on market value (e.g., Core et al., 2003; Han & Manry, 2004; Heimonen & Uusitalo, 2009). The inconsistency in the results of the above studies is one tangible reason for this one. To add to, few researches on the value relevance of advertising cost have been carried out in Nigeria and also a detailed method of treatment of advertising cost as an intangible method is nonexistent in previous studies. Furthermore, the results of this study may be of interest to firms accounting policy makers. Since one of their key purposes is to ensure that the financial statement is accurate and reliable, based on this study, they may wish to re-evaluate their disclosure policy on advertisement cost.

OBJECTIVES OF THE STUDY

The main objective of the study is to ascertain if advertising expenditure is value relevant.

However, the specific objectives are to:

a) Determine if advertising expenditure incurred in a year affect sales revenue beyond that year.

b) Assess if advertising expenditure incurred in a year affect profitability beyond that year.

HYPOTHESES OF THE STUDY

The following hypotheses are formulated and stated in the null form for the purpose of this study.

Ho1: Advertisement cost does not affect sales beyond the year in which it is incurred.

Ho2: Advertisement cost does not affect profitability beyond the year in which it is incurred.

SCOPE OF THE STUDY

This study shall be concerned with the effect of advertising on the sales revenue and net profit of the selected listed companies in Nigeria. A period of five years would be adopted for the study ranging from the year 2011 to 2015 both years inclusive. The choice of the period is based on the relevance of the data involved as these are the years in which the adoption of the International Accounting Standards in the preparation of financial statements are most encouraged and practised.

DEFINITION OF TERMS

Advertising expenditure: The total amount of money spent by a firm on product announcements and promotion, usually per year.

Capitalization: The treatment of a cost as a non current asset instead of an expense, therefore exposed to depreciation or amortization annually in the statement of financial position.

Expensing: The treatment of a cost as an operating cost rather than a capital investment therefore offset against the income in the comprehensive income statement.

 Plan of the Study

Chapter one of the study gave an overview to a reader what the whole research is all about. Chapter two shall be about various observations from past studies as well as underlying concept related to the study. Chapter three shall discuss basically, the research methodology while chapter four shall analyse and present the data and finally, the research shall be rounded up with chapter five which summarizes, concludes and gives recommendations regarding the study.

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