Adventurous Computer Games, Inc.
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Part 1. Accounting for the Cost of Software Programs at AdCom Games Adcom games should allocate all costs from the Product Development Support Center, as well as the project team labor, to the games that are developed. I believe that all costs from the Product Development Support Center (PDSC) should be allocated in order to properly match expenses with revenues. Costs should be allocated on the basis of lines of code written. For example, 16% of all code written pertained to “Secret Agent”. Because 16% of work product went towards this game, 16% of all costs incurred by the PDSC should be allocated to this game as well. Labor costs pertaining to this game should be added to the allocated PDSC costs in order to find the total cost of the product. The total product costs for Secret Agent, The Wild West, and World Search are: $235,520; $485,920; $629,560 – respectively. These estimates were developed using the methodology explained above (based on lines of code). The tables below will better illustrate how the estimates were made.
I would recommend that labor hours be tracked to specific jobs so that costs can be more accurately allocated. While lines of code is a good measure, hours would most likely be better. Even if a game has fewer lines of code than another, it doesn’t necessarily mean that code was written in less time. Some code, while short, can still be complex and could have required large amounts of time to get working. For this reason, I feel that hours would be a better measure than lines of code. I would also recommend depreciating PDSC equipment using activity-based depreciation. Capitalizing the depreciation expense, and then re-capitalizing the cost to the inventory, accomplishes the same purpose.
However, it would make more sense to depreciate equipment using the activity-based method, and not have to re-capitalize the depreciation expense (only to re-expense it later). Part 2. Estimating what the Final Financial Reports for AdCom Games for 2003 will Show If all costs incurred after technological feasibility is established are capitalized, the total capitalized amount would be $837,532. This is done by multiply the original percentage of allocation for costs, and then multiplying that by the costs incurred after technological feasibility has been established. The chart below shows a break-down of the capitalization of individual costs.
The total amount of the costs which should be matched with Revenues for 2003 is $71,129. This is done by taking the capitalization amount shown above (217,520), dividing it by the 200,000 unit estimate, and multiplying it by the units that were sold in 2003. The calculation is shown below.
This accounting policy will improve the preliminary financial statements drastically. Net income will be substantially higher; rather than expensing everything right away, we are matching the expenses with revenues. This better represents the earnings of the company. Additionally, the balance sheet will be show a higher amount of assets due to the capitalization of expenses. This will increase asset-to-debt ratios and improve the attractiveness of the company to investors. If it can be reasonably claimed that technological feasibility was established one quarter earlier, I believe we should make this claim. If we establish technological feasibility earlier, we will be able to capitalize more costs. If we capitalize more costs, our net income will increase and our balance sheet will show more assets. Overall, this would make the company much more attractive.
If we were to establish technological feasibility one period later, the opposite effect would happen; net income would decrease, and the balance sheet would show less assets. If either method of establish technological feasibility is acceptable, recognizing it earlier rather than later would prove to be more beneficial. As far as the Statement of Cash Flows is concerned, there will not be much of a change. The Statement of Cash Flows will show all of the same inflows and outflows, and will have the same beginning and ending balances of cash. However, the adjustments will be different. For example, a lesser amount of depreciation will be added back to cash, yet more cash will be shown as going to inventory (because depreciation was capitalized). While the adjustments on the Statement of Cash Flows will be different, the net amounts of inflows and outflows will be exactly the same – cash is cash. The ending balance of cash will be the same. Accounting policies will not affect the cash balances of a company. Part 3. Overall Evaluation and Conclusions
I believe the greatest thing that will be gained from capitalizing expenditures will be that internal managers, company executives, investors, and creditors will be able to better see how much money the company is making on its software. Expensing all costs upfront before revenues are earned will make the software company appear as though they are losing money in the first couple years. This isn’t necessarily the case; the company is simply investing in its product.
Additionally, once the company starts selling, there will be almost no expenses once the software starts selling – which will make the company look like it is making more money than it actually is (all its costs were upfront). By capitalizing the costs, expenses will be better matched with revenues. The net income recognized at the end of the year will be a better representation of the company’s performance and earnings. Additionally, net income will be more stable (rather than showing years of significant earnings and years of significant losses). This information will be more valuable to management and investors because they will have a better idea of the financial status of the company.