Accounting for pre-contract costs
Amey is a UK-based support services group. It provides a range of services - from IT support to prop- erty maintenance - for public sector and private sector organisations that have decided to outsource these activities. According to the chief executive, 2001 was a good year. Group revenues increased 19% to £786 million. The company had an 80% bid success rate, winning contracts with a total value of £1,890 million that year. However, 2002 saw it competing for major London Underground mod- ernisation contracts and there were doubts whether it could maintain this bid success rate.
The company changed the way it accounted for pre-contract costs in its 2001 accounts. Until then, it had capitalised as an asset (under ‘deferred charges') the costs incurred in bidding for new con- tracts where it was reasonably certain it would recover the costs. (Evidence of ‘reasonable certainty' was a cost indemnity or the company's appointment as preferred bidder.) Capitalised costs were amortised against income arising on the related contracts. The new policy is to expense immediately all pre-contract costs unless reimbursement is assured.
The effect of the change in policy on the group's 2001 accounts was significant. Profit before tax was reduced by £28.5 million. Together with other accounting changes introduced at the same time, this turned a £15 million profit into a loss (before tax) of £18.2 million.
Amey's management justified the change in policy on the grounds that it was consistent with pro- posed UK accounting guidelines on the topic. However, the draft rules only required companies to expense immediately pre-contract costs that did not meet specified cost recovery tests. Moreover, Amey's competitors did not change their accounting policies in 2001 and continued to capitalise cer- tain pre-contract costs. An analyst commented at the time:
‘Amey has interpreted [the draft rules] very prudently indeed, more so than any other company has con- templated before.'
Required
(a) Under what circumstances should pre-contract costs be recorded as an asset in your view?
(b) Why do you think Amey changed its accounting policy on pre-contract costs in 2001?