Question
COMPANY BACKGROUND CM Corporation (CMC) was founded in 2000 by Eric Conner and Phil Martin. The company designs, installs, and services security systems for high-tech
COMPANY BACKGROUND CM Corporation (CMC) was founded in 2000 by Eric Conner and Phil Martin. The company designs, installs, and services security systems for high-tech companies. The founders, who describe themselves as "entrepreneurial geeks," met in a computer lab when they were teenagers and found they had common interests in working on security systems for critical industries. CMC have released many successful products into the market throughout the past 16 years and they continue to anticipate growth potential for its products, which will require additional funds to finance this growth. As a result, it is planning to go to the market with a new common stock issue at the end of 2017. Conner and Martin have been informed of the different accounting frameworks available to private companies in Canada and have decided to comply with International Financial Reporting Standards (IFRS) due to their plans of going public in the near future. CMC has a December 31 fiscal year-end date. CURRENT SITUATION It is now December 1, 2016 and the company?s December 31, 2016 year-end is fast approaching. Connie and Martin have hired you as an accounting intern to help them analyze certain accounting issues so they can gain a better understanding of the existing accounting standards and make strategic financial decisions before the 2016 fiscal year ends. CMC has equipment with an original cost of $440,000 and is depreciated over an eight-year life. CMC?s accounting policy for this group of assets is amortized cost subject to annual depreciation using the double-declining-balance method. This particular equipment has an estimated a residual value of $50,000. After recording depreciation expense for 2016, the equipment is now fully depreciated to its salvage value of $50,000. Going forward, Conner and Martin are questioning the accounting for depreciation. They argue that they don't think it is necessary to record depreciation expense on the income statement because it does not involve a cash outlay. In addition, they do not see the necessity for reducing the equipment value on the balance sheet. They wonder whether CMC should just stop depreciating its equipment from this point forward. COMPLETE REQUIRED #1 CMC is considering replacing this equipment. Conner and Martin believe that the best time for this equipment replacement is at the end of 2016 (assume December 31, 2016). However, they are concerned about the effects this replacement might have on their financial statements, specifically on key performance ratios such as Quick Ratio (Acid-Test) and Debt-to-Asset Ratio. Conner and Martin tell you that they have thought of five options regarding the replacement of the old equipment. They could (1) construct the new equipment themselves and then sell the old equipment, (2) exchange the old equipment for new equipment that is more efficient, (3) purchase new equipment and sell the old equipment, (4) overhaul the old equipment, or (5) lease new equipment and sell the old equipment. Conner and Martin appear increasingly confident in your analytical skills, and they have asked you to determine the effects of the above alternatives on the 2016 projected financial statements and ultimately recommend a course of action. They have gathered the following information to help with this analysis. Option 1: Construct the new equipment in-house and sell the old equipment for cash at a fair value of $60,000. CMC would liquidate short-term investments (FVNI) to fund construction. The short-term investments have a current fair value of $1 million. Anticipated actual expenditures for constructing the equipment are $650,000. (Note: Construction is assumed to be completed at year-end.) Option 2: Exchange the equipment for a similar piece of equipment with a fair value of $685,000. Conner and Martin have checked the secondary market and have found that the fair value of the old equipment is $60,000. They estimate that CMC can borrow $350,000 on a one-year, 10% note; the balance will be funded with an accounts payable arrangement with the supplier. Option 3: Purchase the new equipment by giving a non-interest-bearing note with five payments of $164,000 at the beginning of each year to the supplier. The prevailing interest rate for obligations of this nature is 10%. The old equipment will also be sold for $60,000 cash. Option 4: Overhaul the existing equipment. The following immediate expenditures are anticipated under this approach: (1) The normal annual cost for lubrication and replacement of minor parts to maintain the integrity of the exterior body would be $27,000. (2) The cost of re-wiring interior components in an overhaul would be $125,000. (3) Replacing old worn components would cost $82,000 with associated labour costs of $210,000 for installation. The overhaul is estimated to extend the useful life of the equipment another four years. The components being replaced had an original cost of $60,000. (The present equipment's original useful life was eight years at the end of 2016, starting January 1, 2009.) The costs will be financed through a one-year loan for $350,000 at 10%, and the balance will be charged on account. Option 5: Tyler Leasing Company would acquire the equipment and lease it to CMC. The lease payments would be $145,661 for five years, paid at the beginning of each lease period. CMC 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 CMC?s borrowing rate. The old equipment be retained under this option and used internally for parts. COMPLETE REQUIRED #2 AND REQUIRED #3 CMC reports goodwill on its balance sheet. Conner and Martin indicate that the goodwill was from the acquisition of small ?garage-type? software development companies purchased a few years ago. CMC purchased the software companies so that it could incorporate their software into the CMC product line as well as to gain the expertise of their employees. Conner and Martin argue that no amortization should be recorded for goodwill because they have heard there is no reliable way to establish a useful life for the goodwill. However, they also know that a number of lawsuits have been filed against companies that have accounted for intangible assets incorrectly. So they want to know if CMC is doing the right accounting in regard to its goodwill. In addition, they have heard that company names often have ?value? similar to a brand. They believe that the CMC name is becoming well-known in the industry and believe that recognizing this brand name in the financial statements makes sense for a fair presentation. They believe that the name is worth at least $125,000. They wonder, though, what effect the recording of this intangible will have on net income. Every year CMC invests significantly in applied research and development, which in many cases lead to successful technological advancements in the security equipment they offer customers. Both shareholders? aspire to provide their clientele with the most effective security devices available to the market. They truly believe that the expected total research anddevelopment investment in 2016 of $200,000 will help them achieve this goal. COMPLETE REQUIRED #4 CMC purchased some shares of one of its suppliers, Infrared Co., as an investment. CMC 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 CMC to buy shares on the open market. Conner and Martin mention that they might go so far as to buy 10?15% 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 a critical piece in the CMC system. They want you to help them understand whether it makes a difference if they buy just 10?15% or if they buy 30% of these suppliers' shares. Both these suppliers have been around for awhile, 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. COMPLETE REQUIRED #5 INSTRUCTIONS: THIS PRACTICE SET IS DUE BY 10:30 AM ON WEDNESDAY, APRIL 12TH, 2017 Students are required to submit a printed AND electronic version of the group report which will include the main report and related exhibits (all spreadsheets from ?Required #1 (b)? and ?Required #2?). There is no minimum or maximum length required for this assignment. Main report must be 1.5 spacing, 12 point font size. All late-submitted reports or incomplete components will receive a grade reduction of 10% per day. Complete the following required in order they appear within the main case study. Please be sure to carefully read the required, incorporate case facts and use your textbook as a point of reference to complete this practice set. Required #1 (10 marks) (a) Determine the following concerning depreciation: (1) What is the general concept underlying depreciation? (2) How does depreciating an asset portray a more realistic picture of both the performance of the company and its financial position? (3) What is the effect on CMC's financial statements if Conner and Martin decide not to depreciate the equipment? (b) Use an Excel spreadsheet to prepare a depreciation schedule for the old equipment over its eight-year life, using the double-declining-balance method. Also within this spreadsheet, record the journal entry for depreciation that would be made in the third year of the equipment's useful life. (Save this under the file name ?Required 1 ? Depreciation Schedule?) (c) Please explain the merits of an accelerated depreciation method, such as double-declining-balance. In your answer address the following issues: Does the type of company or industry have anything to do with the choice of depreciation method selected? What effect does matching have on the decision to use double-declining-balance depreciation versus straight-line depreciation? Required #2 (45 marks) Access the Excel files provided to your group and complete the following steps for EACH option to replace or upgrade the equipment: In Spreadsheets (provided by instructor): (30 marks) 1) Record all necessary journal entries in the ?General Journal? tab. Label each entry with a reference number such as ?JE#1, JE#2?. 2) Transfer the adjustments made in (1) above, and reference numbers, to the ?proposed adjustment? column in the ?Trial Balance? tab to establish an ?adjusted trial balance?. 3) Complete the 2016 projected financial statements (all other tabs) per the ?adjusted trial balance? in (2) above. Careful review should be made prior to submitting the practice set to ensure specific statements balances properly tie-in with other statements. For example, ensure cash balance on the statement of financial position agrees to the ending cash balance on the statement of cash flows. In Report (produced by students): (15 marks) 4) Perform pros/cons analysis of each option, including qualitative and quantitative factors such as the impact on financial statements areas, key ratios, investor decisions, etc. Please reference your spreadsheets as exhibits to your main report when discussing data pertaining to these spreadsheets. For further information on key ratios (quick ratio and debt-to-assets ratio), please visit: www.investopedia.com 5) Recommend an option for CMC to pursue that is supported by the analysis performed in (4) above. Be Advised: You are required to work with and submit five separate spreadsheet files for the five options. You may adjust the structure of the trial balance and individual statements by adding accounts and line items as you see fit. Make sure that all new items created are properly flowing to all interrelated schedules of the financial statements. Please ensure that all spreadsheet formulas used (if any) are properly formatted as marks are based on the numbers provided and not formulas. Required #3 (6 marks) At the next management team meeting, Conner and Martin express some concern that any new equipment acquired to replace the old equipment may become obsolete within the next two to five years. A number of popular-press articles have recently discussed the increasing number of asset impairments occurring in their industry. Conner and Martin therefore want to know how the accounting rules for impairments would apply to any new equipment. Refer to your text to determine the guidance for on impairments including the timing and calculation of the amount under both accounting models (ASPE and IFRS) and recommend which should be used at CMC. Recall that Conner and Martin think that expenses that do not involve cash outflow should not be recorded, so be sure you describe the reasons for recording impairments. Required #4 (5 marks) Provide some guidance to CMC management about the proper treatment of goodwill and company names or brands. Also provide some clarification relating to the treatment of the company?s $200,000 investment in R&D activities which have historically been expensed. Remember to write for nonaccountants so they know that you know what you are talking about. Required #5 (4 marks) 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: (a) CMC's investment represents 10% of Infrared shares. (b) CMC's investment represents 30% of Infrared shares. Indicate the differential effect on income between the accounting for the conditions under assumptions (a) and (b).
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