Diviney Company wants to raise $50 million cash but for various reasons does not want to do so in a way that results in a newly recorded liability. The firm is sufficiently solvent and profitable, so its bank is willing to lend up to $50 million at the prime interest rate. Diviney's financial executives have devised six different plans, described in the following sections.
Diviney will transfer to Condon Company its long-term accounts receivable, which call for payments over the next two years. Condon will pay an amount equal to the present value of the receivables, minus an allowance for un-collectibles, as well as a discount, because it is paying now but will collect cash later. Diviney must repurchase from Condon at face value any receivables that become uncollectible in excess of the allowance. In addition, Diviney may repurchase any of the receivables not yet due at face value minus a discount specified by formula and based on the prime rate at the time of the initial transfer. (This option permits Diviney to benefit if an unexpected drop in interest rates occurs after the transfer.) The accounting issue is whether the transfer is a sale (in which Diviney increases Cash, reduces Accounts Receivable, and recognizes expense or loss on transfer) or merely a loan collateralized by the receivables (in which Diviney increases Cash and increases Notes Payable at the time of transfer).
Diviney will transfer inventory to Condon, which will store the inventory in a public warehouse. Condon may use the inventory as collateral for its own borrowings, the proceeds from which will be used to pay Diviney. Diviney will pay storage costs and will repurchase the entire inventory within the next four years at contractually fixed prices plus interest accrued for the time elapsed between the transfer and later repurchase. The accounting issue is whether the inventory is sold to Condon, with later repurchases treated as new acquisitions for Diviney's inventory, or whether the transaction is merely a loan, with the inventory remaining on Diviney's balance sheet.
Diviney wants a branch line of a railroad built from the main rail line to carry raw material directly to its plant. It could, of course, borrow the funds and build the branch line itself. Instead, it will sign an agreement with the railroad to ship specified amounts of material each month for ten years. Even if Diviney does not ship the specified amounts of material, it will pay the agreed shipping costs. The railroad will take the contract to its bank and, using it as collateral, borrow the funds to build the branch line. The accounting issue is whether Diviney should increase an asset for future rail services and increase a liability for payments to the railroad. The alternative is to make no accounting entry except when Diviney makes payments to the railroad.
Diviney and Mission Company will jointly build a plant to manufacture chemicals that both need in their production processes. Each will contribute $5 million to the project, called Chemical. Chemical will borrow another $40 million from a bank, with Diviney being the only guarantor of the debt. Diviney and Mission are each to contribute equally to future operating expenses and debt service payments of Chemical, but in return for its guaranteeing the debt, Diviney will have an option to purchase Mission's interest for $20 million four years hence. The accounting issue is whether Diviney should recognize a liability for the funds borrowed by Chemical. Because of the debt guarantee, debt service payments ultimately will be Diviney's responsibility. Alternatively, the debt guarantee would be treated as a commitment merely to be disclosed in the notes to Diviney's financial statements.
Diviney will contribute a laboratory and preliminary findings about a potentially profitable gene-splicing discovery to a partnership, called Venture. Venture will raise funds by selling the remaining interest in the partnership to outside investors for $2 million and borrowing $48 million from a bank, with Diviney guaranteeing the debt. Although Venture will operate under Diviney's management, it will be free to sell the results of its further discoveries and development efforts to anyone, including Diviney. Diviney is not obligated to purchase any of Venture's output. The accounting issue is whether Diviney would recognize the liability.
Diviney owns and operates a profitable hotel. It could use the hotel as collateral for a conventional mortgage loan. Instead, it considers selling the hotel to a partnership for $50 million cash. The partnership will sell ownership interests to outside investors for $5 million and borrow $45 million from a bank on a conventional mortgage loan, using the hotel as collateral. Diviney guarantees the debt. The accounting issue is whether Diviney would record the liability for the guaranteed debt of the partnership.
Required
Discuss the appropriate treatment of each proposed arrangement from the viewpoint of the auditor, who must apply U.S. GAAP in deciding whether the transaction will result in a liability to be recorded or whether note disclosure will suffice. Does U.S. GAAP reporting result in an accurate portrayal of the economics of the arrangement in each case? Explain.