Accounting in Action: CM2

Chapter 15

Accounting in Action: CM2 After a long day on the job at CM2, you are reflecting on how much you have learned about business decision making through this internship. A good example is CM2s current plan to raise money through a stock issue rather than a debt issue. You recall from your Intermediate Accounting class that issuing debt imposes a fixed financial obligation on the company, but does not convey ownership to the debt holders. However, if CM2 issues stock, it gives up some ownership and thus some control. You know how protective Conner and Martin are of the company, and you wonder why they chose to issue stock. You decide to ask them the next day.

The next day you ask the management team if you could get some information about the proposed stock issue. You explain that there are trade-offs between issuing stock and issuing debt, and you wonder why they are planning to issue stock. Martin has an immediate response: They do not want to take on any more debt; they would prefer relinquishing some control rather than assuming more obligations. They argue that companies are like people who have ready access to multiple credit cards and use them to live on, effectively taking on more debt than they can easily repay. Having friends in this situation, you understand CM2s position.

They then ask you to help them evaluate the three options they are considering for raising the necessary money for expansion. Amazingly enough, one of the options is to issue debtyou are glad to see they are at least considering it. The three options are:

1.Issue $10,000,000 of 10-year bonds with a coupon rate of 6%, interest payable semiannually. (CM2 has an A bond rating.) Although the current market rate is 6%, based on current economic forecasts, Conner and Martin recognize that market rates might increase to 8% by the time they issue the bonds. Although they do not like the option of added debt, they feel it is a reasonable alternative and should be considered.

2.A second possibility is to issue 2,600,000 shares of common stock ($2 par value) to current shareholders and a selected group of new investors (a private issue). The stock would be priced to sell at CM2s book value per share at the end of 2013.

3.The third option is to proceed with the initial public offering (IPO). Based on current and anticipated economic conditions, the resurgence of the IPO market, and interest in high-tech companies, Conner and Martin think they could get an IPO price of around $5 per share. At this price, they would need to issue approximately 2,000,000 shares. The company does have some shares held in treasury but does not want to re-issue these shares at this time. Conner and Martin also plan to continue to pay dividends to current shareholders but at a lower amount, probably $0.05 per share.

Instructions

(a) As a fourth alternative, you suggest that the company borrow the money from a financial institution instead of issuing either bonds or stock. Conner and Martin of course turn the question right back to you, and ask you to summarize the advantages of borrowing in this fashion compared to issuing bonds. Write a memo describing the advantages and disadvantages of each method of financing.

(b) Which alternative would you recommend to Conner and Martin? Be sure to justify your answer in comparing the merits of raising capital through bonds, loans, and common stock. Include any pros or cons of utilizing treasury stock in raising capital. Be specific in your answer, but remember you are writing to entrepreneurs, not accountants.

Additional Activities: Extend your accounting knowledge

You think that in one of your accounting classes, you covered some other options that companies had to raise money. You remember something about preferred stock, special classes of common stock, and convertible bonds. Prepare a memo suggesting two other ways that CM2 could raise $10,000,000. Be specific, but again, remember you are writing to entrepreneurs, not accountants.

Chapter 16

Accounting in Action: CM2As part of CM2s plan to obtain financing for its expansion at the end of 2013, you have already prepared an analysis of the effects on the financial statements of (1) issuing more common stock to the existing stockholder group; (2) issuing bonds; (3) going public with a large stock issue; and (4) borrowing money from a financial institution.

Conner and Martin now have another possible alternative that would basically permit them to keep control of the company, at least in the short run. To finance expansion, they are considering the issuance of stock to the existing stockholder group and the issuance of convertible securities to the general public. They know that if they eventually do go public, the investment community will use metrics like EPS to assess the price to pay for the stock. They are quite concerned about how the companys EPS numbers would compare to those of their competitors under this new proposal.

Here are the transactions that are under consideration for 2013:June 1Issue 6%, $1,000 bonds at a total price of $5 million. Each $1,000 certificate is convertible into 100 shares of common stock. The par value and market value of the convertible bonds are the same.

July 15Issue 300,000 shares of common stock at $3 per share.

August 1Issue 20,000 shares of 5% cumulative preferred stock ($150 par), with each share convertible into 19 shares of common stock. Dividends are paid on the preferred stock on June 30 and December 31 of each year. The stock would be issued at par.

October 1Issue 200,000 shares of common stock for $3 per share.

December 1Issue 100,000 shares of common stock for $3 per share.

No doubt this is an ambitious plan. Although there are a number of questions about the assumptions in the plan, Conner and Martin would first like to know the potential impact on earnings per share.

Instructions

Write a memo to Conner and Martin in which you explain basic and diluted earnings per share. Compute earnings per share given the new capital structure following this financing plan. The forecasted net income for 2013 is $331,500, and the tax rate for CM2 is 35%. Note The net income forecast includes the interest expense on the bonds that are to be issued June 1.Chapter 17

Accounting in Action: CM2 CM2 purchased some shares of one of its suppliers, Infrared Co., as an investment. CM2 paid $140,186 for the shares. Although management plans to hold this investment for the long-term, the company may need to sell it in the future for liquidity purposes. Conner and Martin also think that making investments in some of their other suppliers can be a good way to ensure quality and consistency in the components they buy from these suppliers. Because many of its suppliers are public companies, it should be fairly easy for CM2 to buy shares on the open market. Conner and Martin mention that they might go so far as to buy 1015% of the common stock of one of their main suppliers and up to 30% of the common stock of another supplier of routers, which are critical pieces in the CM2 system. They want you to help them understand whether it makes a difference if they buy just 1015% or if they buy 30% of these suppliers shares. Both these suppliers have been around for some time and, with very few exceptions, the parts ordered from them have been of high quality and delivered on time; Conner and Martin tell you that if they do buy these stocks, they anticipate holding them for a long time. Instructions

(a) Use the investment in Infrared Co. to illustrate the accounting and financial reporting implications of an equity investment in a supplier. While the growth prospects for Infrared are quite good, in the current year it reported a net loss of $120,000 and paid cash dividends of $24,000. The fair value of the Infrared shares is $150,000 at year-end. Prepare journal entries for the Infrared investment, assuming:

1. CM2s investment represents 10% of Infrared shares.

2. CM2s investment represents 30% of Infrared shares.

Indicate the differential effect on income between the accounting for the conditions under assumptions 1 and 2.

(b) Conner and Martin have heard that as long as they do not hold more than 20% of the shares of one of these suppliers, they are able to recognize the unrealized gains on these equity investments in income. Prepare a memorandum to Conner and Martin with references to the authoritative literature on the accounting for equity investments of less than 20% ownership. Discuss other factors beyond the percentage of shares owned that should be considered in determining the accounting for investments if they hold at least 20% but less than or equal to 50% of the stock of another company.

Chapter 18

Accounting in Action: CM2This morning before going to work, you read in the paper about a company that the SEC is investigating for improper revenue recognition. It is not clear from the article what industry this company is in, but you start to wonder about the specific recognition policies at CM2. You know that CM2 sells a product and a service, and you are aware that its service contracts extend over variable lengths of time, but you are unsure whether it includes upgrades in the sale price of its products. When you arrive, you find Conner and Martin and ask how CM2 recognizes revenue. They indicate that there is only one way to record revenue for a product and that is when the company ships the product. For an individual service call, CM2 recognizes revenue when the service technician leaves the company premises to provide the service to the customer. They are not quite sure how the revenue from service contracts is recognized. Instructions(a) Prepare a brief memo describing the various revenue recognition methods acceptable for CM2. Recall that it sells products (with possible upgrades included in the sale price), provides service on demand for customers, and has service contracts that guarantee customers service over a specified period of time. Also recall the product contains both software and hardware and that each may be sold separately or as a package. Access the FASB Accounting Standards Codification to provide authoritative support for the position articulated in your memo for each of these categories. (b) Access the 2012 10-K for Microsoft, Inc. within the SEC website (www.sec.gov). Examine Microsofts Significant Accounting Policies (usually found in footnote 1). Write a memo to Conner and Martin describing Microsofts revenue recognition policies, so that they will have a better understanding of the issues faced by a firm in the software industry.

Chapter 19

Accounting in Action: CM2When you arrive at CM2 for the afternoon, Conner and Martin are arguing with Lopez and Knepp about, of all things, the corporate income taxes. As you walk in, you hear Conner saying, "The corporate rate is always 35%." For some reason, Knepp is talking about something called SFAS No. 109 that has to do with how taxes are reported in financial statements (deferred taxes). This discussion is not clear to you since you have not yet had a tax course, so you figure you will learn a lot this afternoon. (You had no idea at this point how much you would learn.)InstructionsAccess File 4a to perform the following analysis (Excel File). This file contains the balance sheet and income statement reflecting forecasts for 2013. Review the income statement and verify that the tax is indeed 35% of income before tax for both 2012 and 2013. (a) Since Knepp has raised the issue of SFAS No. 109, access the FASB Codification and read the information describing the framework now used in accounting for income taxes. Write a memo that you can take to Conner and Martin describing the change in focus from the income statement to the balance sheet. Describe the concepts of permanent and temporary differences. Give two examples of each and how they reflect the new focus.

(b) During the meeting in the afternoon, you ask Knepp and Lopez if there were permanent or temporary differences in 2012 and whether they will continue into 2013. They responded that they were not aware of any differences for either 2012 or 2013. However, in 2013 Conner and Martin were given life insurance policies. The insurance premium on these policies amounted to $80,000 per year. CM2 also anticipates investing in local county bonds which should earn about $7,000 investment income in 2013. Both of these items are reported on the forecasted income statement. In addition, Knepp tells you that depreciation expense recorded for tax will be $30,000 higher than that recorded for the books. That is, the book value of the fixed assets for GAAP will be $30,000 higher compared to their book value reported on the tax return.

Knepp then mentions that CM2 will begin offering a six-month warranty on its RFID product. The forecasted income statement includes estimated warranty expense accrual of $100,000; one-fourth of this amount will be settled in 2013 through actual claims being filed. You remember from your Intermediate Accounting class that for tax purposes, only the cash expense incurred in doing the work is deductible.

The forecasted income statement reports a tax expense of $178,500. Prepare a memo to Conner and Martin in which you explain the adjusting entry to reflect the income tax expense that should be reported. Additional Activities: Extend your accounting knowledgeSince the discussion about tax expense you had yesterday, Conner and Martin have read about something called "deferred taxes." They ask you just what is involved in the concept of deferred taxes. (a) Prepare a memo for Conner and Martin describing when deferred tax assets are recorded and what provisions, if any, have to be accounted for if Conner and Martin believe that the future benefits from the deferred tax asset probably will not be realized. Use the FASB Codification to provide support for your response from the authoritative literature.

(b) Write a memo to Conner and Martin describing the potential for earnings management that exists when recording valuation allowances for deferred tax assets.

(c)From what you have read about taxes, you realize that there is substantial judgment in the determination of tax expense for book purposes. Check the FASB Codification for the guidance on taxes; in particular, check for footnote disclosures required.Chapter 20

Accounting in Action: CM2CM2 has not offered retirement benefits to its employees but is looking for information on pension retirement plans. Naturally, when you show up for work, Conner and Martin suggest that you gather information and fill them in on possible benefit plans and their accounting consequences. Instructions

(a) Research the authoritative literature (using the FASB Codification) for information about two types of retirement pension plans that might be adopteddefined-contribution plans and defined-benefit plans. Write a memo explaining these plans and describing their costs and benefits.

(b) After you present the memo and explain the concept of pension retirement plans, Conner and Martin chime in and say they have read in the news that many companies are singing the blues because they have severely underfunded pension plans and face huge shortfalls in covering their looming pension obligations. However, they are also quite confused because years ago, these same companies were on top of the world when their pension plans were overfunded. How, they wonder, can this happen in a relatively short period of time? Explain to Conner and Martin how this can happen for defined-benefit pension plans. In your discussion, address the following:

(1) Five components of pension expense. (2) The concept of smoothing in terms of gains/losses (delayed recognition).

Chapter 21

Accounting in Action: CM2Earlier, Conner and Martin asked you to analyze four proposals for acquiring a very expensive, very large piece of equipment (refer to Accounting in Action, Chapter 10). None of the proposals they asked you to review involved leasing the new equipment. In light of concerns expressed about the potentially short period of time before new technology makes a machine obsolete, you are surprised that leasing was not considered. From what you remember, leasing provides some real benefits. Recall that the fair value of the new equipment is approximately $685,000 and is expected to have an economic life of eight years. When the possibility of leasing equipment is discussed, both Conner and Martin express much interest. They have had prior business dealings with Tyler Leasing Company, and the results have been satisfactory. You call Buzz Tyler and ask him about leasing the new equipment; the next day, he sends you the following proposal:

Tyler Leasing Company would acquire the equipment and lease it to CM2. The lease payments would be $145,661 for five years, paid at the beginning of each period. CM2 would guarantee the residual value of $125,000 at the end of the lease period. The fair market value of similar equipment is $685,000.

The implicit interest rate in this offer is 10%, which is also CM2 s borrowing rate.

Conner and Martin like the proposal and want to know more about the benefits of leasing versus owning. Remember that their focus is to go to the bond or equity market at the end of 2010. They do not want to guarantee the residual value. They are also excited about the possibility of reporting only the rental expense on the income statement. In addition, they understand that they may not have to report a liability on the balance sheet, which makes them even happier.

Instructions

(a) Analyze the Tyler Leasing Company proposal. Show Conner and Martin (and also Lopez and Knepp, since they appear to be slightly skeptical of this idea) the effect of the proposal on the companys balance sheet. Explain to the four the effect on the relationship between debt and equity at the present time. (b) Access file 4a on the website (Excel File) for information about the companys current debt and equity positions. Explain the debt and equity relationships assuming the leasing proposal results in an operating lease versus a capital lease. For illustrative purposes, ignore income taxes. Also help Conner and Martin understand why Tyler wants CM2 to guarantee the residual amount.

Additional Activities: Extend your accounting knowledge Assuming the leasing alternative is selected, and given your analysis, Conner and Martin are concerned about the residual value guarantee, given the changing technology in this market. They indicate they will agree to this lease only if they do not have to guarantee the residual value. They place a conference call with Buzz Tyler. He expresses his companys concern that they stand to lose a considerable amount if the equipment is run down when it is returned to them. Explain the concept of third-party guarantees and how this might be the solution for all concerned.

Chapter 22

Accounting in Action: CM2Conner and Martin have appreciated your involvement in all aspects of the companys operations throughout the year. They now want you to take the accounting records over these past three years and give them advice on any errors and/or corrections you may find. You tell them this may take a while, and you ask if they can give you a few days to conduct your review. They agree. Access File 4a on the website (Excel File) containing CM2 s financial statements for 2011, 2012, and the forecasted trial balance and financials for 2013. After carefully examining three years of information, you come up with the following:

(1)Ending inventory in 2011 was overstated by $32,000 as a result of errors in the inventory count-sheet footings.

(2)Prepaid rent of $9,500 for 2013 was expensed at the end of 20012.

(3)Depreciation was understated in 2011, 2012, and 2013. This was due to a piece of equipment costing $110,000 which was purchased in 2011 and was expected to have a five-year life and no residual value. Instead of using straight-line depreciation for the expense in 2011, the whole $110,000 was expensed.

(4)Employee wages of $26,000, earned at the end of 2011, were not accrued but were expensed in 2012 when they were paid. Instructions

Prepare a worksheet in a similar format to the one in Illustration 22-24 of the text. Ignore income taxes. Chapter 23

Accounting in Action: CM2You were looking forward to going to CM2 today since it was your last working day as an intern. Tomorrow the group is planning to take you to lunch to celebrate the end of your internship. You figured today would be easy just wrapping up loose ends.

It was not to be. You walked in and found people with expectant faces, holding sheets of paper, and you could tell that another issue had arisen. Conner and Martin started right off: they saw no reason at all for a statement of cash flows. They felt that CM2s cash flows were nobodys business but the banks. Lopez and Knepp clearly were trying to explain that investors like to see where the cash flow was coming from and how the cash was being used. So once again, you were on the spot. By now, Conner and Martin have learned to put their questions in writing so they were ready with a paper on which they had written:

1. What is the point of the statement of cash flows?

2. Why are there three categories of cash flow information?

3. What can the reader learn from the Cash flow from investing section?

4. What can the reader learn from the Cash flow from financing section? 5. What is the difference between the direct and indirect methods for preparing the Cash flow from operations?

6. We have a copy of a statement of cash flows for another firm. Why is this firm adding back depreciation? 7. Someone told us that you could learn a lot from looking at the accounts receivable adjustment to net income on this statement. We dont understand this at all. Whats to be learned?Instructions

Prepare responses to their questions.

Continuing Case

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