II. GLASS BOTTLE COMPANY

Glass Bottle Company has perfected a new process of manufacturing small plastic bottles at half the cost of any comparable product. Glass has been actively promoting its new process and the response has been enthusiastic.

A Glass potential customers, International Drugs, could use so many plastic bottles that Glass would need to build a plant specifically to fill its orders. Glass does not have much capital and wants International to finance the construction. International refuses to put up cash, but wants the bottles and is agreeable to almost any financing plan.

Glass initially offered to create a new subsidiary, Plastics, to build the plant, finance it with a 100 percent bank loan, and lease it to International for 30 years. Lease payments would be substantially equal to the payments on the bank loan, which would be collateralized by the plant and by the lease agreement. Glass would have a 30-year management contract to operate the plant, for a fee. The plan looked good and convenient. The bottle plant was to be built next to International's main manufacturing facility and a conveyor belt was to carry the bottles into International's packing room.

But a snag soon appeared. International's auditors said that under Financial Accounting Standards Board Statement No. 13 on leases, the plastics lease would require capitalization and the related additional "debt" would put International into default on its debt/equity requirement. Their conclusion was based on the fact that the proposed lease provided for minimum lease payments with a present value in excess of 90 percent of the fair value of the leased property. And so, International asked Glass to try again.

Now Glass has a new plan. Once again a new subsidiary (Plastics) would construct and finance the plant. This time, however, International would not be required to sign a lease but would simply be required to sign a purchase agreement. Under the purchase agreement, International would express its intention to buy all of its bottles from Plastics, paying a unit price which at normal capacity would cover labor, material and overhead, the Glass operating fee, and the debt service requirement on the plant. That expected unit price is substantially lower than current market. Also, under the agreement, if International takes less than the normal production in any one year, and if the excess bottles are not sold at a high enough price on the open market, International is to make up any cash shortfall so that Plastics can make the payments on its debt and retain a profit to the extent of the management fee. The bank will be willing to loan the money for the plant, taking the plant and the purchase agreement as collateral.

Glass likes the new plan. It will have the management fee from operating the plant and a guaranteed source of funds sufficient to service the obligation for the plant. International has an assured source of supply, without incurring any obligation. The bank has its loan and feels secure. Glass's only concern is that International's auditor might object to this deal. Glass's controller explains, "They were going to make International capitalize that lease but surely they can't make International capitalize a purchase agreement. But just to be on the safe side, please study this deal and tell me if I can tell International that our auditors agree that this contract need not be recognized as an asset, or as a debt."

DISCUSS OF GLASS'S NEW PLAN, AND DOES INTERNATIONAL HAVE AN ASSET AND A DEBT TO RECORD?