Chapter 21

Accounting in Action: CM2

Earlier, 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 2013. They do not want to guarantee the residual Continuing Case 9 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 company?s 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 company?s 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.

Chapter 21 Accounting in Action: CM2 Earlier, 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 2013. They do not want to guarantee the residual Continuing Case 9 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 company's 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 company's 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. CM Corporation Balance Sheet December 31, 2011 Assets Current assets Cash and cash equivalents Accounts receivable Allowance for doubtful accounts Inventory Prepaid expenses Other current assets Total current assets Property, plant and equipment Accumulated depreciation Net fixed assets Other Assets Investments Goodwill Other intangible assets % $120,670 576,454 (84,975) 847,460 18,841 4,612 1,483,062 0.65 508,140 0.22 296,590 0.13 $2,287,792 1.00 845,198 0.37 278,525 0.12 1,100,105 (591,965) 100,150 87,740 108,700 Total assets Liabilities and Stockholders' Equity Current liabilities Accounts payable Dividends payable Unearned revenue Accrued liabilities Total current liabilities $315,395 48,000 73,500 408,303 Long-term liabilities Stockholders' equity Contributed capital Common stock, $2 par value (4,000,000 shares authorized),460,000 shares issued of which 440,000 shares are outstanding 920,000 Paid-in capital common stock 105,000 Total contributed capital 1,025,000 Accumulated other comprehensive income Retained earnings Less common stock in treasury, at cost Total stockholders' equity 0 539,069 (400,000) Total liabilities and stockholders' equity 1,164,069 0.51 $2,287,792 1.00 CM Corporation Income Statement For the Years Ended 2011 Revenue Net product sales revenue Service revenue Total revenue Cost of goods sold Products Services Total cost of goods sold Gross profit Operating expenses Advertising Bad debt expense Depreciation and amortization Dues and subscriptions Equipment expenses Insurance Legal and accounting fees Miscellaneous Office expense Payroll taxes Property taxes Repair and maintenance Research and development Telephone Travel and entertainment Utilities Wages - Employees Wages - Officers Total operating expenses $8,984,852 975,860 9,960,712 1.00 5,801,655 4,159,057 0.42 3,030,626 0.30 1,128,431 0.11 5,356,018 445,637 123,869 28,640 125,500 19,730 64,781 90,144 87,650 12,010 214,138 131,170 93,400 37,543 278,000 21,085 60,402 37,876 954,688 650,000 Income (loss) from operations Other income and (expense) Interest expense Gain (loss) on disposal of assets Investment income % (27,800) (26,950) 9,230 Total other income (expense) Income (loss) before income taxes Income tax (expense) benefit Net income (loss) (45,520) 1,082,911 (379,019) 0.11 $703,892 0.07 CM Corporation Statement of Cash Flows ( Indirect Method ) For the Years Ended 2011 Cash flows from operating activities Net income (loss) Adjustments to reconcile net income to Net cash provided from operating activities Depreciation and amortization Net (gain) loss on assets (Increase) decrease in accounts receivable Increase (decrease) in allowance for doubtful accounts (Increase) decrease in inventory (Increase) decrease in prepaid expenses (Increase) decrease in other current assets Increase (decrease) in accounts payable Increase (decrease) in unearned revenue Increase (decrease) in interest payable Increase (decrease) in wages and payroll taxes payable Increase (decrease) in income taxes payable $703,892 125,500 26,950 (188,643) (7,564) (125,360) (14,650) 4,612 263,400 46,820 3,456 (5,478) (278,950) Total adjustments Net cash provided by operating activities (149,907) 553,985 Cash flows from investing activities (Purchase) of fixed assets (Purchase) of intangibles (Purchase) of investments Net cash used by investing activities (274,300) 0 (12,650) (286,950) Cash flows from financing activities Dividends paid Net cash used by financing activities (32,000) (32,000) Net increase (decrease) in cash and cash equivalents 235,035 Cash and cash equivalents at beginning of period (114,365) Cash and cash equivalents at end of period $120,670 General Ledger Account Names Balance Sheet Accounts Cash and cash equivalents Accounts Receivable Balance 12/31/12 Debit Credit 72,337 782,080 Allowance for doubtful accounts Inventory Prepaid expenses Other Current Assets Property, Plant and Equipment 2013 Projections Debit # Credit 170,000 133,195 102,470 1,340,902 404,683 16,063 1,560,192 365,000 739,085 Investments 140,186 Goodwill 397,740 Other intangible assets 253,900 205,500 Proposed ajes Debit JE# Credit Forcasted Trial Bal 12/31/13 Debit Credit 242,337 915,275 16,530 17,174 Accum Depr Proposed Trial Balance 2013 Debit Credit 242,337 119,000 1,745,585 1,745,585 17,174 17,174 16,063 16,063 1,195,192 1,195,192 132,500 5,000 915,275 119,000 666,085 666,085 140,186 140,186 397,740 397,740 248,900 248,900 Accounts Payable 1,169,343 30,657 1,200,000 1,200,000 Dividends payable 110,000 5,000 115,000 115,000 Accrued liabilities 340,759 187,991 528,750 528,750 Unearned revenue 102,860 34,200 137,060 137,060 Long term liabilities 588,500 508,500 508,500 Common Stock 920,000 920,000 920,000 Paid-in capital common stock 105,000 105,000 105,000 Treasury Stock 80,000 400,000 Retained Earnings 400,000 802,557 Dividends 115,000 Net Income 5,433,452 Income Statement Accounts Product sales revenue Service revenue Products cost of goods sold Service cost of goods sold Bad debt expense Depreciation and amortization 331,500 5,433,452 9,100,000 9,100,000 975,000 975,000 5,433,452 975,000 500,000 500,000 5,400,000 5,400,000 5,400,000 450,000 450,000 450,000 20,000 20,000 20,000 137,500 137,500 137,500 10,000 10,000 10,000 178,500 178,500 178,500 Insurance 80,000 80,000 80,000 Interest expense 48,000 48,000 Investment income 10,500 Other operating expenses 900,000 Research and development Wages- employees Wages - Officers Net (Income) Loss 0 48,000 10,500 10,500 900,000 900,000 200,000 200,000 200,000 1,050,000 1,050,000 1,050,000 800,000 800,000 0 800,000 (331,500) 0 9,764,000 10,872,378 10,872,378 0 5,433,452 9,100,000 500,000 Gain/loss on disposal Income tax expense 115,000 331,500 4,980,574 Product sales returns & discounts 802,557 115,000 0 4,980,574 400,000 802,557 9,764,000 (331,500) 0 0 9,764,000 9,764,000 CM Corporation Balance Sheet Remember the 2013 column is management's projection December 31, 2013 December 31, 2012 Assets Current assets Cash and cash equivalents Accounts receivable Allowance for doubtful accounts Inventory Prepaid expenses Other current assets Total current assets Property, plant and equipment Accumulated depreciation Net fixed assets Other Assets Investments Goodwill Other intangible assets $242,337 915,275 (119,000) 1,745,585 17,174 16,063 $72,337 782,080 (102,470) 1,340,902 17,174 16,063 2,817,434 0.68 1,195,192 (666,085) 1,560,192 (739,085) 529,107 0.13 140,186 397,740 248,900 Total assets 2,126,086 0.57 821,107 0.22 140,186 397,740 253,900 786,826 0.19 791,826 0.21 $4,133,367 1.00 $3,739,019 1.00 Liabilities and Stockholders' Equity Current liabilities Accounts payable Dividends payable Unearned revenue Accrued liabilities Total current liabilities $1,200,000 115,000 137,060 528,750 Long-term liabilities $1,169,343 110,000 102,860 340,759 1,980,810 0.48 1,722,962 0.46 508,500 0.12 588,500 0.16 Stockholders' equity Contributed capital Common stock, $2 par value (4,000,000 shares authorized),460,000 shares issued of which 440,000 shares are outstanding 920,000 Paid-in capital common stock 105,000 Total contributed capital 1,025,000 Accumulated other comprehensive income Retained earnings Less common stock in treasury, at cost Total stockholders' equity 920,000 105,000 1,025,000 0 1,019,057 0 802,557 (400,000) Total liabilities and stockholders' equity (400,000) 1,644,057 0.40 1,427,557 0.38 $4,133,367 1.00 $3,739,019 1.00 Remember the 2013 column is management's projection CM Corporation Income Statement For the Years Ended December 31, 2013 Revenue Net product sales revenue Service revenue Total revenue Cost of goods sold Products Services Total cost of goods sold Gross profit Operating expenses Bad debt expense Depreciation and amortization Insurance Other operating expenses Research and development Wages - Employees Wages - Officers Total operating expenses $8,600,000 975,000 $9,575,000 5,400,000 450,000 5,850,000 3,725,000 Income (loss) before income taxes Income tax (expense) benefit Net income (loss) 0.90 0.10 1.00 $8,732,684 1,261,645 0.56 0.05 5,315,848 570,811 $9,994,329 0.91 0.13 1.04 0.56 0.06 5,886,659 4,107,670 0.39 20,000 137,500 80,000 900,000 200,000 1,050,000 800,000 Income (loss) from operations Other income and (expense) Interest expense Gain (loss) on disposal of assets Investment income Total other income (expense) December 31, 2012 0.41 17,508 147,120 85,744 1,063,741 470,680 998,545 710,000 NOTE: some of the operating expenses detailed in Chapter 3 Excel files have been combined herein as "other operating expenses" 3,187,500 0.33 3,493,338 0.35 537,500 0.06 614,332 0.06 (48,000) 10,000 10,500 (52,965) 0 13,230 (27,500) (39,735) 510,000 (178,500) 574,597 (201,109) $331,500 0.03 $373,488 0.04 CM Corporation Statement of Retained Earnings For the Years Ended December 31, 2013 December 31, 2012 Beginning balance $802,557 $539,069 Net income (loss) 331,500 373,488 (115,000) (110,000) $1,019,057 $802,557 Dividends Ending balance Remember the 2013 column is management's projection CM Corporation Statement of Cash Flows ( Indirect Method ) For the Years Ended December 31, 2013 Cash flows from operating activities Net income (loss) Adjustments to reconcile net income to Net cash provided from operating activities Depreciation and amortization Net (gain) loss on assets (Increase) decrease in accounts receivable Increase (decrease) in allowance for doubtful accounts (Increase) decrease in inventory (Increase) decrease in prepaid expenses (Increase) decrease in other current assets Increase (decrease) in accounts payable Increase (decrease) in unearned revenue Increase (decrease) in accrued liabilities Total adjustments Net cash provided by operating activities Cash flows from investing activities Proceeds from sale (purchase) of fixed assets (Purchase) of intangibles (Purchase) of investments Net cash used by investing activities Cash flows from financing activities Proceeds from (payment on) long-term liabilities Dividends paid Net cash used by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period December 31, 2012 $331,500 $373,488 137,500 (10,000) (133,195) 16,530 (404,683) 0 0 30,657 34,200 187,991 147,120 0 (205,626) 17,495 (493,442) 1,667 (11,451) 853,948 29,360 (67,544) (141,000) 271,527 190,500 645,015 169,500 169,500 (460,087) (455,200) (40,036) (955,323) (80,000) (110,000) (190,000) 309,975 (48,000) 261,975 170,000 (48,333) 72,337 120,670 $242,337 $72,337