Butterworths Tolley, 1999, P. 728

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1 CHAPTER 3 REVIEW OF THE LITERATURE 3.1 INTRODUCTION The whole question of what intangible assets can and cannot be recognized in accounting terms has been a difficult one for standard setters, and it remains a controversial subject. No one doubts intangibles are of real economic value to business, and in certain industry sectors they are of overwhelming importance to the success of the enterprise. The debate is not on that issue, it is on whether it is within the compass of our present accounting model to capture and convey useful information about such assets. Financial Reporting Standard (FRS) 10 uses this three part approach to set different rules for the various circumstances in which intangible assets can be included in the balance sheet (1) : i) Intangible assets bought separately should be capitalized at cost. This may seem straightforward and obvious, but it has changed previous practice in certain areas. For example, football clubs now capitalize transfer fees, whereas previously they were often expended as incurred. ii) Intangible assets obtained in the course of acquiring a business should be recognized separately from goodwill if their value can be measured reliably on initial recognition. The standard explains that this does not necessarily require there to be a market value, but also allows the use of valuation methods based on 1. Davies, M. and Paterson, R. and Wilson, A. UK GAAP sixth edition, Butterworths Tolley, 1999, P

2 there to be a market value, but also allows the use of valuation methods based on factors such as national royalties on multiples of turnover.the standard also caps the amount that can be attributed to intangible assets by saying that the fair value must be limited to an amount that does not create or increase any negative goodwill that arises on the acquisition. The requirement that acquired intangible must be capable of being measured reliably is not meant to be a major obstacle. The test is often likely to be met by such assets as brands, publishing rights and titles, concessions, patents, licenses, trademarks and similar rights and assets. iii) Internally developed intangible assets should be recognized only if they have a readily ascertainable market value. Here the rule is much more restrictive, because it requires there to be an active market, evidenced by frequent transactions, in that particular assets, it says that the item must belong to a homogenous population of assets that are equivalent in all material respects, such as certain operating licenses, franchises and quotas. This therefore rules out the possibility of recognizing unique intangibles such as brands, publishing titles, and patented inventions if they are homogenous rather than acquired. 3.2 DEFINITIONS AND ENTITY OF INTANGIBLE ASSETS As you know from point of accounting, the fixed assets can be divided in two groups of tangible and intangible. Tangible fixed assets are assets that have physical substance and are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes on a continuing basis in the reporting entity s activities (1).Intangible fixed assets are non-financial fixed assets that do not have physical substance but are identifiable and are controlled by the entity through 1. FRS 15, Para 2 58

3 legal rights. (1) According to this definition, an intangible fixed assets (2) is an item which meets the definition of a fixed assets but has no physical substance. It cannot be touched, seen or heard. The evidence of its existence is the benefit flowing from it. For many years, items such as patents, trademarks and licenses to manufacture products have been bought and sold between companies. The purchase has been recorded as a fixed asset and depreciated over the expected life of the patent, trademark or license. The expected life is decided by law (for patent and trademarks) or by legal contact (for licenses). The depreciation of intangible fixed assets is usually referred to as amortization (in which you may recognize the French word mount meaning death). The intangible fixed asset which has attracted most accounting-related comment in recent years has been the brand name of a company s product (3). When a company works over many years to develop the reputation of its product, that reputation creates an expected future benefit for the company and meets the definition of an asset. However, the generally held view is that it should not be recognized in the balance sheet. The conventional argument is that there is no measurable cost of the reputation joined by the brand name and the value cannot be measured with reliability. That is the generally held view which was challenged in the mid-1980s by a number of leading companies. Some had bought other companies which had 1. FRS 10, Para 2 2. Weetman, P. Financial Accounting An Introduction, Third Edition Printice Hall, 2003, P Ibid 59

4 developed Brand names. The new owners argued that they were buying the other company purely because of the quality of the brand name in the new balance sheet. They had reasonable argument because they had paid a price in the market and could show the cost of the brand name acquired.other companies who had developed their own brand names did not want to be left believed and so paid expert values to calculate a value for their home-grown brands. A new professional specialist of brand valuation gained prominence and the expert claimed they could measure the value of a home-grown brand with reliability. The companies which reported brands names in the balance sheet argued that the brand had a long life and did not require amortization. This argument gave them the advantage of expending the balance sheet without the disadvantage of amortization appearing in the profit and loss account. The Accounting Standard Board has issued a standard, FRS10, which includes accounting for intangible assets. Brand names should appear in a balance sheet only where there is a readily ascertainable market value. Amortization is also requirement. 3.3 AMORTIZATION OF INTANGIBLE ASSETS The accounting treatment of intangible assets is governed by FRS 10. This standard adapts a combination of amortization and impairment review in attempting to ensure that its objective that intangible assets are charged in the profit and loss account in the periods in which they are depleted is achieved. Except for those cases where the useful life of an intangible assets is believed to be indefinite, intangible assets should be amortized over their estimated useful lives. A flowchart which depicts how the combination of amortization and impairment review applies to different circumstances is shown in next page. FRS 10 makes it clear that amortization of intangible assets should be charged to the profit and loss account but it does not explicitly state it should be charged in arriving at operating profit. 60

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6 3.4 USEFUL ECONOMIC LIFE The standard includes a rebuttable presumption that the useful economic lives of purchased intangible assets are limited and do not exceed 20 years (1). This is consistent with the International Accounting Standards Committee (IASC) standard, which is surprising because the two have a quite different philosophy. FRS 10 defines the useful economic life very broadly, as the period over which the value of the underlying business acquired is expected to exceed the values of its identifiable net assets whereas IAS (International Accounting Standard) 22 focuses more conventionally on the benefits that flow from the intangible assets that exists at the time of the acquisition. Even intangible assets have useful economic lives of 20 years or less, the impairment review might still have to be performed. What must we done, in these circumstances, if the intangible assets is not capable of continued measurement? It seems to follow that if continued measurement is not possible them the impairment review cannot be performed. Therefore, in these circumstance, the asset would be subject to an annual amortization change but, apparently, not to an impairment test. Although the useful economic life of intangibles is often uncertain the standard makes it clear that this uncertainty should not be grounds for regarding the useful economic life to be indefinite or for adapting a 20 year period by default RESIDUAL VALUE In amortizing intangible assets, no residual value may be attributed to it, unless such residual value can be measured reliably. FRS 10 suggests that in most cases the residual value of an intangible asset may be insignificant and will be capable of being measured reliably only when: 1. Financial Accounting Standard Board(FASB) says that it do not exceed 40 years. 62

7 a) There is a legal or contractual right to receive a certain sum at the end of the period of the intangible asset ; or b) There is a readily ascertainable market value for the residual asset. 3.5 AMORTIZATION METHODS Having established the original carrying value of intangible asset, its estimated useful economic life and the amount of its residual value (if applicable), the only remaining question as regards amortization is how to spread the difference between the original carrying value and the residual value (if any) over the estimated useful economic life. The standard states that the method of amortization should be chosen to reflect the expected pattern of depletion of the intangible asset. A straight-line method should be chosen unless another method can be demonstrated to be more appropriate. The straight-line basis is an obvious pragmatic response to the need to allocate what is a derived figure over different accounting periods. An example of where an intangible asset can be amortized other than on a straight-line basis would be where a license entitles the holder to produce a finite quantity of a product. The method of amortization could be, in those circumstances, on a unit-of-production basis. For becoming more familiar it is better to introduce some intangible assets as more complete. 3.6 RESEARCH AND DEVELOPMENT COSTS Expenditure on research and development (R & D) should be distinguished from non-r & D expenditure. Research expenditure should be distinguished from development expenditure and must be charged to profit and loss (1).development 1. Sangster, A. Workbook of Accounting Standards 3 rd Edition, Pitman Publishing, 1995,P

8 expenditure may be capitalized and amortized even the period when the benefits arising from the expenditure are expected to be received; otherwise, it must be charged to profit and loss. The Statement of Standard Accounting Practice (SSAP) 13 states that amortization should commence in the period when production starts, and that is should be allocated on a systematic basis to each accounting period over which the product is expected to be sold. When production starts in a different period from that in which sales start, clearly it would be inappropriate to allocate the amortization over periods when there is no income being generated. That would not be matching expenditure to income, any more than would write off the expenditure when it was first incurred. Alternatively, the amortization could be started when production beings but added to the value of the stock being built up, rather than charged to the period s profit and loss. While there will often be nothing wrong with this approach, it could load to the first period of sale being charged with more than its fair share of the development costs. Consequently, when production begins is a different period from sales, amortization would be best delayed until the period in which income is first generated. As a general, fixed assets used to provide facilities for R & D must be capitalized and written-off over their useful lives, the annual depreciation charge should be included in the R & D total for the period, and if relates to development expenditure differed, it should also be differed. The unamortized balance of development expenditure should be examined at the end of each accounting period to ensure it still meets the criteria for deferral, if not it must be written-off. 64

9 3.7 GOODWILL SSAP 22 (1) define goodwill as the difference between the value of the business as a whole and the aggregate of the fair value of its separable net assets. The value of the business as a whole is represented by the present value of the future cash flows expected to be generated by the business. The definition of fair value depends on the nature of the item, i.e. whether it is a non-monetary item, monitory item, a contingency, a provision, a pension scheme or taxation. The fair value of nonmonetary assets should be based on replacement cost unless the assets is to be disposed of or is not wroth replacing, in which case the fair value will be the higher of net realizable value or value in use. The fair value of monitory items will normally be the amount of money involved unless the data of receipt or payment is so distant that it is reasonable to discount the money amount. The separable net assets are these assets (and liabilities), which can be identified and sold (or discharged) separately without necessarily disposing of the business as a whole. They include identifiable intangibles. Goodwill may be positive or negative. It is positive if the agreed value of the business based on future cash flows is greater than the aggregate of the fair value of the separable net assets. It is negative if the agreed value of the business based on future cash flows is lower than the aggregate of the fair value of the separable net assets. Goodwill may also be realized or unrealized. It is realized if it is arrived at as a result of an actual transfer of the business has not occurred but the directors have estimated a value for the business as a whole and the separable net assets. If there has 1. Elliot,B. & Elliot, J. Financial Accounting & Reporting first published, Prentic Hall, 1993, p

10 been an actual transfer, then the difference is referred to a purchased goodwill. If there has not been an actual transfer, then the estimated difference is referred to as non-purchased or inherent goodwill. Purchased goodwill is based on a transaction with a third party at arms length, the difference is objective and verifiable. Nonpurchased goodwill has not arisen from a transaction with a third party at arms length; the difference is subjective. For financial reporting purpose, it is normal accounting practice that only purchased goodwill should be recognized in the accounts. For amortizing goodwill, the useful economic life must be determined. In most instances, goodwill will cease to generate economic benefits within twenty years of acquisition. However, Exposure Draft (ED) 4 of SSAP and Accounting Principle Board (APB) 17 states that goodwill is an intangible asset that must be amortized over a period of up to forty years. ED 47 merely states that the amortization charge should be calculated using the straight-line basis or any other systematic basis which is more conservative and considered to give a more realistic allocation. 3.8 BRANDS A brand is defined in a dictionary as a trademark (1). It can therefore be classified using this literal meaning as an intangible fixed asset. The Accounting Standard Committee (ASC) considered that in a commercial sense a brand was actually something more than a trademark and in ED 52 stated that the term brand was generally used with a meaning that was significantly different from, and wider than a trade name. It stated that while every recognized brand had a trade name, the trade name was not synonymous with the brand. Branding cannot a continuous process of 1. Ibid, p

11 assembling, developing and exploiting all the tangible and intangible elements of the products to achieve significant value in commercial operations and to be a major force in modern commercial practice. The fact that they add significant value to commercial operation is apparent if we consider the sort of names that we commonly recognize. Brands actually have foreseen ably finite economic lives. Advocates of systematic amortization contend that this should be done to accord with prudence. Opponents of systematic amortization claim that brands have useful economic lives which are interminately finite, therefore amortization would ignore reality because the amortization period would be arbitrary. Those companies which have capitalized brands have also declined to amortize them because they do not have a foreseeable finite life. 3.9 THE HISTORY OF ACCOUNTING FOR ADVERTISING COSTS The accepted accounting principles, accounting standards and guidelines accounting is created according to accounting society needs and they must be based on researches that have been done by professional researchers. To collect of accounting standards for intangible assets is not except from this case. One of the cases that have been researched by researchers, are about advertising costs THE RESEARCHES OF PALDA Several studies used alternative versions of the distributed lag model, but the results were somewhat inconsistence. Palda (1) (1964) utilized the model in estimating demand- response for the advertising of the Lydia Pinkham Company. Using annual 1. Abdel Khalik, A. Rashad. Advertising effectiveness and Accounting Policy., Accounting Review, Oct 1975, P

12 data for 54 years, his estimated models suggested that advertising is an investment. The decay coefficient ( 0.60) suggested that about 95% of the cost of the asset be amortized over a period of 7 years. But the rate of amortization, if currently estimated, would be applicable only to the product of Lydia Pinkham Company and cannot be amortized to others THE RESEARCHES OF PELES (1) The accounting literature usually considers advertising assets as part of the general category of goodwill, i.e., as an undefined residual. There have been a number of suggestions as to the origin of this intangible asset and how to account for it. A common feature of many of these suggestions is the absence of sound a priori or empirical justifications for the proposed methods of amortization. This article reports the results of an empirical study designed to measure the annual rates of amortization of the intangible asset created by advertising expenditures. These rates may be used to determine which portion of the periodic expenditures for advertising should be deferred as an asset and which portion should be charged to advertising expense. The resulting balance sheet and income statements give a more realistic picture of the firm s present financial condition and its past performances. In particular, the proposed modifications yield more meaningful calculations of the rates of return earned on a firm s assets. At the same time, they help to explain the gap between a firm s book value and its market value. The study was based on a reconstruction of the demand functions for individual firms in the beer, cigarette, and passenger new car industries. These three industries were selected on the basis of their potential for yielding results which could be interpreted 1. Peles, Y. Amortization of Advertising in the Financial Statements, Journal of Accounting Research, Spring 1970, PP

13 correctly. The required characteristics of the chosen industries were as follows : (1) A reliable published sources of information exist for each. (2) homogenous product (especially in the beer and cigarette industries) is produced by the firms in each industry. (3) Firms in these industries invest considerable sums in advertising, particularly in the beer and cigarette industries; (4) Advertising capital in these industries is the primary component of the firm s intangible assets. This characteristic is necessary to avoid the problem of separating advertising assets from any other intangible assets which do not appear on the firm s records. The beer and cigarette industries produce nondurable goods, whereas the passenger car industry produces durable goods. The durability of the product affects the amortization rate for advertising expenditures. Past sales of a durable product increase the inventory of the product carried over into the current period. This will produce a negative effect on the current demand for the product. For example, current demand for cars is adversely affected by the existing stock of inventory of previous cars sold. Thus, although current advertising increases a firm s sales in the current year, it also increases the stock of inventory, which in turn decreases the demand for cars in the future. Consequently, past advertising may actually have a negative effect on current sales. This suggests that advertising expenditures in passenger cars may have to be fully amortized in the current period. The rate of amortization for advertising expenditures was determined by examining the effect of a firm s advertising expenditure on its current performance. These advertising effects were measured by constructing the demand for the firm s product-or for its brands or divisions-as a function of its advertising expenditures as 69

14 well as other variables expected to influence demand. The variables were adjusted to net out misleading effects, such as changed in prices. Seven models of demand functions were studied. By using the seven models yielded the following results: (1) Advertising expenditures of beer and cigarette firms should be amortized by a declining balance method, with an annual rate of amortization of percent for beer and percent for cigarettes. In the car industry, practically all the current expenditures for advertising should be considered expenses in the year of incurrence. (2) The above rates are annual rates of amortization. In general, the current year in which the expenditures have been made would be charged for a full year of amortization only for those expenditures which were incurred or which existed at the beginning of the year. If the current year s expenditures are spread evenly throughout the year, the average effect-and the amortization-of the current expenditures on the current year s sales will be only half a year. Expenditures made at the end of the year would not be amortized until the following year and thereafter. Hence this timing factor would tend to decrease the amount to be amortized in the first year. However, certain advertising expenditures relating to special sales or prices probably have no effect on future sales. Such expenditures should increase the amount of write-off of the total expenditures made in any year. Because of these two opposing influences, the first year s amortization requires special treatment. It was found that the rate of amortization for the current year in the beer and the cigarette industries was about ¾ of the full year s rate of amortization. For example, if the full rate of amortization was 40 percent, then 30 percent of the current year s expenditure should be amortized in the current year; another 28 percent (40% of 70%) should be amortized in the second year, and so on. 70

15 (3) In addition to the positive asset resulting from the firm s own advertising expenditure, it was also found that competitors advertising expenditures have a negative effect on the firm s sales, thereby creating a type of negative asset. This fact did not raise any special problems. Negative intangible assets can be treated like negative tangible assets such as scrap and air pollution which require expenditures by the firm. Alternatively, the effect of competitors actions on the valuation of the advertising asset can be ignored. This has some precedence in accounting for other assets, for example fixed assets. If a competitor invests in a tangible asset or some new invention, its action will almost certainly reduce the firms future sales and therefore the value of its operating assets. Presently, negative assets of this type do not appear in the firm s financial statement. Note that the above rates of amortization apply to all the advertising expenditures of the firm and not just to that incurred for specific campaigns. Moreover, these rates are averages for the whole industry. The available information was not sufficient to apply these models to the specific expenditure of each firm. Hence, different firms (or brands) may have slightly different patterns of amortization. As one possibility, we might observe higher rates of amortization for the expenditures of small local firms since they are probably affected by higher rates of turnover of population between local communities. A customers move out of local areas, the benefits of previous advertising expenditures will be dissipated. This would raise the rate of amortization for advertising expenditures made by local firms. The possible differences in amortization rates among firms should not detract from the usefulness of accounting for advertising expenditures on the basis of the average figures obtained. The rates of amortization depend on consumers and not on 71

16 producers. Since we are dealing with homogenous products which are sold to the same customers, we would expect a high correlation between the pattern of amortization for all firms in the same industry. The validity of this assumption is supported by high values of the key variables. However, if there is some reason to believe that some firms are different from the average, we can start with the average rates and then adjust them to suit the advertising expenditures of individual firms. In any event, using average rates for advertising capital is not different from using guidelines for the lives of fixed assets when computing depreciation. Amortization of advertising expenditures at a rate lower than the present 100 percent has the same justification in accounting theory as the use of than 100 percent rates of depreciation for tangible assets. Advertising capital should appear on financial statements as concurrent assets, although for tax purposes it may be preferable to treat them as current expenses. As with tangible assets, once it is determine that past appropriation to amortization were not adequate, the proper correction can be made. For example, if the production of a given cigarette brand is stopped while the books still show advertising capital, this asset can be written off according to the accepted rules for accounting for tangible assets. The impact of the corrections suggested here may be illustrated by comparing the balance sheet and profit and loss statements of two firms in the beer and cigarette industries, with and without the corrections, assuming an amortization rate of 40 percent of advertising expenditures. The reported figure are taken directly from the Compustat tapes. The amortization rates reflect the effect of the firm s advertising and not that of competitors advertising. The comparative financial statements are presented in Table 1. The following comments apply to these adjusted statements. 72

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18 (1) The adjustment in the balance sheet represents the net increment in the advertising asset for each firm. For the cigarette firm, the net investment of $11 million is equal to the annual advertising expenditures of $71 million minus the amortization of $60 million. The corresponding figure for the beer firm is $3.2 million or the difference between annual advertising expenditures of $34.2 million and annual amortization of advertising capital of $31 million. (2) As long as the net investment in advertising asset is positive, the dollar value of the profits after the adjustment will be higher than before. The behavior of the adjusted rate of return on assets depends on the ratio of net investment to total investment in advertising capital and the rate of return to total assets before the adjustment. This can be demonstrated as follows : I un = income uncorrected A = stock of advertising asset DA = net investment in advertising asset S un = total assets uncorrected S c = total assets corrected = S un + A r un = rate of return uncorrected = I un /S un r c = rate of return corrected. The adjusted rate of return equal : I un + DA S un DA S un r c = = r un S un A S c A S c In words : The adjusted rate of return will be the weighted average of the unadjusted rate of return and of the rate of investment in advertising capital. The weights are based on the ratio of adjusted assets to unadjusted assets. Note that 74

19 as long as the rate of investment in advertising capital is higher than the unadjusted rate of return, the suggested adjustment will raise the accounting rate of return; that is, it will raise the measured rate of return if DA/A >r un. In the specific example presented in Table 1, the adjusted rate of return to net worth for the beer firm was 19 percent higher than the unadjusted rate and 9 percent higher for the cigarette firm. (3) The suggested adjustment may smooth the income stream in the financial statements. For example, introducing a 40 percent rate of amortizing of advertising expenditures into the financial statements of Anheuser-Busch reduced the variance of the operating income around its trend line up to 30 percent of its former unadjusted level. For American Tobacco, the variance of operating income for the same period was reduced to 75 percent of its unadjusted level. Of course, smoothing is desirable only if it results in an elimination of the distorting effects caused by inappropriate accounting methods. The proposed adjustment is believed to satisfy this constraint. Conclusion: This report has outline the major results of an attempt to measure advertising capital for three industries. Conceivably, the models use could be applied to other industries if the required data on expenditures and sales are available in detail. The significance of these adjustments will vary from firm to firm, depending on such things as the ratio of advertising expenditures to expenditures on current and noncurrent tangible assets. Also the effect of adjustment for advertising capital on the current year s income statement will be less significant than the cumulative effect on the firm s balance sheet. In any event, an objective method for amortizing advertising capital will lead to more uniformity to treatment than presently exist and should discourage indiscriminate switching from one accounting method to another. 75

20 In addition, this method may be appropriate for accounting for other intangible such as R & D THE RESEARCHES OF BASS AND CLARKE (1) Time series marketing models often involve some notion of distributed lag, specially in studies of the relationship between sales and advertising. The estimation method employed has not always been the most appropriate method and the models have seldom been tested against plausible alternatives. The availability of sales and advertising data for a dietary weight control product afforded them an excellent opportunity to apply different methods of estimation and predictive tests in a study of alternative distributed lag theories of the effects of advertising. The data used in this study consisted of a three -year history of sales and advertising for a Dietary Weight Control (DWC) product, aggregated by month. Sales history was measured in multiples of equivalent serving units (to account for the different sizes in which the product was distributed) and the advertising history was given in dollar expenditures. Advertising expenditure was recognized in the month in which the advertising occurred, rather than month in which it was billed to the company. During the period under study, the product was a heavily advertised competitor in an active market characterized by large monthly fluctuations in both sales and advertising. These conditions made the DWC market an excellent candidate for a study of the short run effect of advertising on sales. The Theory and the General Model - Advertising has been the dominant 1. Bass, F. M. and Clark, D. G. Testing Distributed Lag Models of Advertising effect, journal of marketing research, August 1972,PP

21 marketing decision variable for sales of DWC products, since sales are closely related to advertising s success in increasing and directing the consumer s desire to be slimmer. Consumer of the DWC product under study fell into two general classes: (1) those who used the product to help control their weight by consuming it as one of their daily meals and (2) those on a diet who consumed practically nothing else but the product. Consumers in the second group would seem to be the most sensitive to current advertising appeals. Unfortunately, there was no way to distinguish according to these groups purchases, and advertising may well have affected the two groups differently. Because of extreme fluctuations in advertising expenditures (Figure 1), They expected that multicolinearity of the lagged values of advertising would be less than expected for advertising data or time series data generally. They thus developed a rationale for assuming nonmonotonic, lagged response to advertising. Letting a r be the probability of making a first purchase r periods after exposure and b s be probability of a second purchase, s periods after first purchase, the 77

22 probability of a first or second purchase r periods after exposure is: a r + a r b 0 + a r-1 b a 0 b r a r b 0 = a r {1-b 0 } + a r b 0 + a r-1 b a 0 b r. Credit for the second purchase should be assign to the expenditure which induced initial trial, and bumps in current sales in fact may be the result of repeat purchase resulting from a prior bump in initial purchase. After the first repurchase, the effect of further repeat buying are damped; hence they considered only first and second purchases in the argument above. Since light users (consuming the product only one meal a day) constituted the bulk of the buyers, and since an equivalent serving unit consisted of 24 servings, the modal time to repeat purchase for an average consumer was three weeks or more. Heavy users, on the other hand, tended to respond more quickly to advertising and repurchased the product weekly. The modal total response after exposure obviously depended on the mix of these two groups in the market. Because they used monthly data and because of a modal response time of three weeks, they did not rule out the possibility of the greatest response to advertising occurring in the month following exposure. (1) S t = a + (P o A t +P 1 A t ) + U t Where: St = sales at time t, At = advertising at time t, Pi = probability of purchase t period (months) after exposure, and = marginal effect of one dollar of advertising in period t. They might find p 1 > p o. Thus the Koyck model (1) is not the only reasonable 1. It is the famous distributed lags model in econometrics. 78

23 possibility under the circumstances. Estimation of parameters with the Koyck model when this model is inappropriate can lead to serious misinterpretation of the effects of advertising and hence to advertising policies which are not efficient. Reasonable Distributed Lag Functions- They examine here six possible models within the distributed lag class, and they shall show the transformed version of each and the implications of each in terms of parameter values of the equivalent untransformed lag model. These implied parameter restrictions will then serve as a basis for predictive tests of the models. Model I. The first model they shall consider is the Koyck model. Thus, the transformed equation to be estimated is: (2) S t = a (1- ) + S t-1 + (1 - ) X t + µ t - µ t-1 Where the condition that 0 < <1, 0< <1 must be satisfied if the data are consistent with the theory and where P i = (1 - ), i = 0, 1, 2, Model II. A possible alternative to the Koyck model is one in which the geometric decay in the effect of advertising does not begin with the initial period but is delayed say until period two. The equivalent transformed equation is : (3) S t = a (1 - ) + S t-1 + a o x t + a 1 x t-1 + µ t + µ t-1. In this case: a o P o = (1 - ), a o + a 1 (1 - ) P 1 = (a o + a 1 ), (a o + a 1 ) 79

24 P t = P t 1, i = 2,3,. The restrictions implied by the theory are 0 1, 0 p o 1, 0 p 1 1. In order for Model II to differ substantially from Model I, p 1 p o, implying that : (1- ) (a 1 /a o ). Model III. The next model is the extension of the Koyck model to a second-order lag function. The appropriate equation is : (4) S t = a( ) + 1 S t S t-2 + a o x t + µ t - 1 µ t-1-2 µ t-2. For this model : P o = P 1 = 1 P o P i = 1 P i P i 2, i = 2,3 In order for (4) to imply a nonnegative lag distribution for x, the following condition must hold : 0 1 2, , , , ( a 0 ) 0. Model IV. A natural extension of the second-order lag function in Model III is one in which x is lagged by one period in addition to the lag in the dependent variable. This gives the equation: (5) S t = a( ) + 1 S t S t-2 + a o x t + a o x t-1 + µ t - 1 µ t-1-2 µ t-2.. For this model: a o P o = ( ), a o + a 1 a o P 1 = ( ) + 1 P 0, a o + a 1 P j = 1 P j P j 2, j = 2,3,. 80

25 In order for (5) to imply a nonnegative lag distribution for x, the following conditions must hold : 0 1 2, , , , a 0 ) 0, ( a 1 ) 0. A nonmonotonic lag function would imply (a a o /a o ) 1, Model V. The third order lag function gives the equation : (6) S t = a( ) + 1 S t S t S t-3 + a o x t + µ t - 1 µ t-1-2 µ t-2-3ut-3. For this model: P 0 = ( ), P 1 = 1 P 0, P 2 = ( )P 0, P j = 1 P j P j 2, 3 P j 3, j 3. Model VI. The third-order lag function with a period lag in x is the last model considered. The equation which follows from this function is: (7) S t = a( ) + 1 S t S t S t-3 + a o x t + a o x t-1 + u t - 1 u t-1 For this model : - 2 u t-2-3ut-3. a o P o = ( ), a o + a 1 a o + 1 a o P 1 = ( ), a o + a 1 1 (a a o ) + 2 a o P 1 = ( ), a o + a 1 P j = 1 P j P j 2, 3 P j 3, j 3. 81

26 Parameter Estimates for model I-VI. Model I-VIi pretty well exhaust the range of distributed lag models which it is responsible or practical to consider. The ordinary least squares regression estimates for Models I through VI are shown in Table1. 82

27 The Ordinary Least Squares (OLS) estimates of models I-VI were not consistent without a very strong assumption about the form of the disturbance term. Maximum likelihood estimation requires finding solutions to systems of nonlinear equations. The maximum likelihood estimates are shown in Table 2. Notice that the OLS estimates for the coefficient of current advertising was less in every case that the corresponding maximum likelihood estimates; OLS estimates in general were based upwards for lag effects and biased downwards for current effects. The R 2 statistics were only slightly lower under maximum likelihood estimation than under OLS estimation. 83

28 General Implications of Estimates. As indicated in tables 1 and 2, the estimates of 1 and 2 for Models III and IV did not satisfy the stability conditions requirements. Of course, these suspicious estimates may have arisen because of chance.the estimates of the distributed lag weight estimated by OLS for Models I-IV are displayed in Figure 2. Figure 2 The estimates for models II, IV, and VI suggested nonmonotonic lag functions, while those for Models I, III, and V indicated monotonic decay in advertising effectiveness. The weights shown in Table 2 as derived from maximum likelihood 84

29 estimates were similar to those based on OLS for models I-IV, but differed substantially for Models V and VI, in all cases and with both sets of estimates, the weights got close to zero after a lag of three periods. A Predictive Test of the Autoregressive Alternative. A simple and plausible to Model II is the first order autoregressive model: (8) S t = a o + aa t + u t, u t = ρu t - t + e t in testing Model II against this alternative, if (8) reflects the real world, then: (9) S t = a o + aa t + pu t-1 + e t = a o + aa t + ρ (S t - 1 a o aa t-1 ) + e t = (a o ρa 0 ) + aa t + ρs t-1 ρaa t-1 +e t Equation (9) implies that the lag effect was due entirely to auto correlated disturbances. Also, (9) has the same form as Model II, although its interpretation is very different, and if the autoregressive model were appropriate, when the parameter of Model II are estimated they would observe that the product of the estimated coefficient of advertising and lagged sales were approximately equal to the negative of the coefficient of lagged advertising. From the estimates in Table I we can compare (.07708) with (.11259) (.46799) =.052. These two values differ by more than the estimated standard deviation of any of the involved variables, and if each of the estimated in the product is reduced by three standard deviation the product will still not cover the negative value implied by the autoregressive model. The results are similar if data from Table 2 are used. Thus it seemed reasonable to reject the autoregressive model as representing a complete explanation of the data. Predictive Testing of Models I-VI: Parameter Estimate Comparison. The confidence interval basis for discriminating between the different types of lag functions represented in the various regions of the parameter space is conditional upon a given model being and adequate representation of the way nature has 85

30 generated the data. An alternative test can be developed where the data are such that estimate of one model suggest that another model is inconsistent with the evidence. The nesting of models in the configuration of models they considered permits a test of one model on the basis of the parameter estimates of another. For example, if Model I is true, they would expect that when model III is estimated the parameter estimate of the coefficient for sales lagged twice would be sufficiently close to zero that the difference could be attributed to chance. If this is not case, then Model I will be discredited. Therefore, the predictive test for Model I would be that 2 lies within the acceptance region for a test of the hypothesis H 0 : 2 = 0. From Table 1 and 2, we see that in Model III was about two standard deviations away from zero. Thus H o was rejected and, along with it, Model I. Similarly, if model III is an adequate representation of reality, when model V is estimated, they would expect to find that the estimated coefficient for sales lagged three times is close enough to zero that it is easily attributable to chance, to the extent that it differs from zero. Since 3 in Model V was close enough to zero measured in standard deviation units, Model III was not contradicted by the estimates of parameters in Model V. Moreover, the maximum likelihood estimates for the coefficient of lagged advertising and sales lagged three times in Model VI were not large enough relative to their standard deviations to reject Model III. Thus in the nesting of Models I, III, and V in Model VI, Model I was, by conventional standards, rejected and Model III was not strongly contradicted by the evidence. The remaining contenders can be tested for consistency with the evidence by a similar approach. If Model II is an adequate representation of the way the data were generated, then 2 = 0 in Model IV. The estimates of these parameters and their standard deviations for Model IV in Table 1 and 2 show that by conventional 86

31 standards the estimates probably (we did not know the exact distributions) did not full in the critical regions for the tests. Model II, then, was not contradicted by the evidence. Table 3 summarizes the testing of nested models. The predictive testing led to the rejection of the only model which necessarily implied monotonic response to advertising. This results was, of course, far from conclusive with respect to the shape of the lag distribution, but the evidence against the Koyck model and geometric decay was rather strong. Predictive Testing of Nested Models I-VI: Analysis of Residual Variance. In addition to the absence of knowledge about the exact distribution of parameter estimates, the procedure for discriminating between models discussed in the previous section suffers from the limitation that only one parameter at a time is considered. If is the set of assumptions associated with a regression model with r independent variables; and if is the set of assumptions associated with a nest regression model such that differs from only by the fact that under, q of the 87

32 variables under have zero regression coefficients, they can test H o : against H 1 : on the basis of : T= n r q S -S S o where n is the number of observation, S is the residual sum of squares under, and S is the residual sum of squares under. They reject H o only if T F a,q,n-r..the result of the tests are shown in Table 4. It appears that the additional variable in Model II contributed enough to explained variance to reject Model I, while the additional variables in the other comparisons contributed only negligibly to explained variance. Direct Estimation of the Original Model. Thus far they have used predictive testing in an attempt to eliminate candidate theories for explaining sales behavior. Rejection of the autoregressive disturbance model led them to believe that advertising did indeed have carryover effects. Rejection of the Koyck monotonic decay model suggests that the process is more general than allowed by the highly restrictive assumptions associated with this frequently employed model. While 88

33 precise statements about the true shape of the lag distribution are not warranted, at least they can have some confidence in the statement that it is not the Koyck distribution. One of the reasons for the difficulty in discriminating the shape of the lag distribution is that the parameters of the original model (y t = 0 x t + 1 x t x t t ) are nonlinear functions of the parameters of the transformed models. If it were possible to estimate a truncated version of (1) directly where the effects of the truncation were negligible, there would be distinct advantages to this estimation. OLS estimates would be normally distributed, unbiased, and consistent for large samples. Unfortunately, they do not know of a rigorous test for negligibility of omitted variables. Nevertheless, as a matter of interest, they estimated the parameters of truncated versions of (1) for zero through five-period lags (Table 5). The results were not unlike those for earlier estimates. The estimates of weights after a lag of three periods were small and not significant. Four of the six equations shown suggested a nonmonotonic response function. Looking at the three-period lag equation from Table 5, if is taken as the sum of the coefficients, the equation can be rewritten as: (10) S t = (0.353A t A t A t A t-3 ) 89

34 The weight estimates in (10) compare very favorably with those of Model II in Table 2:P o =0.366, P 1 =0.380, P 2 =0.152, P 3 = All things considered, there appear to be good grounds for adopting a distributed lag model of the class of models associated with Model II as an explanation of the sales of the DWC product. Finally by using a variety of estimation and testing procedures on different distributed lag models of sales and advertising data for a dietary weight control product, they demonstrated that statistical models of the dynamics of sales and advertising need not be limited to the highly restrictive Koyck model. Nonmonotonic lag distributions, particularly for monthly data, have strong theoretical appeal and, as they have shown, appeared in this case to be more consistent with the evidence than the Koyck model. Marketing studies which posit distributed lag effects would be more appropriately estimated by maximum likelihood methods than by OLS. When multicollinearity is not great, direct estimation of truncated versions of the lag models is probably meaningful with respect to the shape of the lag function, although there is no theoretical guidance to indicate where the truncation should take place THE RESEARCHES OF A. RASHAD ABDEL-KHALIK (1) This paper reported on findings suggesting different accounting treatments and different amortization rates of promotional costs for firms in different industries. Based on the results reported here and on the results of some prior studies, a recommendation is made to consider adopting different accounting treatments for firms in different industries on the basis of the measured effectiveness of advertising and promotion efforts. 1. Abdel-Khalik, A. Rashad, Advertising Effectiveness and Accounting Policy, Accounting Review, Oct 1975, PP

35 From a pragmatic viewpoint, the accounting treatment of advertising costs does not appear to be as controversial as the treatment or research and development costs because few firms choose to capitalize advertising costs. In 1973, for example, over 400 of the firms filing the 10-k report have deferred research and development costs, while only 5 firms have deferred advertising costs. On this basis alone, it could be argued that an accounting standard which accords advertising costs the same treatment as research and development, namely, expense as incurred would not be unsatisfactory to many executives. Nevertheless, unless practice follows a conceptually valid method, adopting what is followed in practice may be supported only on the grounds of expediency. A standard, by its nature, is not a mere codification of practice. Furthermore, others have shown that capitalization and amortization, instead of expensing as incurred, creates an intangible asset. Also, alternative accounting treatments could have significant impact on reported earnings per share. An issue at hand, therefore, is to establish whether or not the practice of expensing as incurred suffers from conceptual or methodological shortcomings. In principle, if promotional costs have long-term effect on generated revenues, them, with due considerations paid to materiality, expensing as incurred would be conceptually inconsistent with the traditional accounting model. Additionally, prior to selecting the appropriate accounting treatment, the objective of advertising should be identified. The objective is to generate additional sales. Moreover, according to the present accounting model, if the response of demand to advertising is delayed beyond the current period, advertising expenditures, which are incurred currently, would be expected to generate revenues in the future and should therefore be deferred until such time when the stimulated revenues are deemed realized. Implicit in this goal orientation is the possibility of achieving an increase in market share with no additional revenues because of substantial price cuts. Thus, if 91