Need help with this case study. It confuses me. Highly expect to get the answer today before 11:00 pm. Please answer Requirement 1 first. That is the most confusing part for me.

Tourist Trap: The New Lease Accounting Standard and Debt Covenants The Case \"There's nothing like a Saturday morning struggling through an FASB standard!\" you lament to the four-footed friend next to you. You received the call yesterday that spoiled your plans of weekend solace. Few people other than your close friends, Corbin and Hailey Newton could cause you to swap a Dan Brown mystery for the FASB's new lease accounting pronouncement. Corbin and H owns Stores named CT.ailey are struggling with an imminent business decision and are relying on your expertise for a Monday morning meeting with their bank. Though times have been challenging for the Newtons, their current business concern may take some tough negotiating and strong background knowledge. You know, of course, that this is exactly why they have called on you. Background on Coastal Trading Corporation Corbin Newton was your best friend in college, and you grew up just a few doors down from Hailey Smith. You were thrilled when, after introducing them at a party your freshman year, they began dating. You participated in their wedding and have remained devoted friends during the ten years since graduation. Corbin majored in management and Hailey was a marketing major. Your degree was in accounting, so naturally Corbin and Hailey exploit your friendship when numbers are involved, as with their new business idea. When they opened their first small souvenir shop, which they named Coastal Trading Corporation (CTC), in 2000 in Myrtle Beach, SC, you were happy to offer your services by keeping their books. Now, the company has grown to encompass 21 stores targeting the sun-seekers and tourists that frequent the southeastern coastline. Your business has thrived, too, and now your local CPA firm offers preparation, review and auditing of hundreds of clients' financial statements as well as preparing income tax returns. Despite that success, you still take a personal interest in assisting your friends and the first clients who hired you. Souvenir Stores Industry Overview Souvenir stores operate in a competitive landscape, with consumer spending, special occasions, and tourist travel driving the demand. The profitability of companies depends on effective merchandising and the ability to generate store traffic. The Newton's expansion of CTC allowed them to gain advantages in purchasing, distribution, and marketing. They also have taken pride in effectively selling specialty products and providing superior service. However, to generate the instore traffic needed to turn a profit, they have situated their retail spaces in high-rent shopping strips across the southeast. By negotiating for 15-year leases in the high-rent areas, CTC have gained tenant improvement allowances and reduced rent. To finance the rapid expansion, CTC was able to secure a private placement of bond debt based in large part to general growth in the industry and the strength of their business plan. Accounting Standards Update No. 2016-02, Leases (Topic 842)1 The call from Corbin and HaileyC and H was initiated by an email from their bank requesting a meeting concerning the passage of a new leasing standard and the impact it may have on CTC loans. GAAP currently categorizes leases as either \"capital leases\" or \"operating leases.\" Though capital leases must be recognized on the balance sheet, operating leases are not reported on the balance sheet. ASC 842: Leases) changes that. It specifies that a lease exists as a contract or part of a contract when a party has a contractual right to control an identified property, plant and/or equipment for a period of time in exchange for consideration. Lessees will classify a lease as either financing (previously capital) or operating leases. The criteria to determine whether a company has a finance lease or an operating lease , the new lease guidance are roughly similar to current practice. However, if an operating lease is indicated the accounting is quite different, and it is this difference that concerns Corbin and Hailey. The new standard compels lessees to recognize operating leases as well as finance leases on the balance sheet. ASC 842 stipulates that both and asset and a liability be reported for nearly every lease except short-term leases with terms of one year or less. The liability is an obligation for future lease payments similar to a debt obligation on the acquisition of a fixed asset. Since the asset is not owned by the company, a right-of-use asset is recorded that is amortized over its useful life. In other words, under ASC 842, operating leases no longer can be used to achieve \"off-balance sheet financing.\" The resulting addition of operating leases to the balance sheet will increase the lessee's recorded assets and liabilities over the current lease accounting. In fact, nationally, almost three trillion dollars of leases previously off balance sheet now will be reported.2 Though the requirement does not become mandatory for public companies until calendar year 2019 and for nonpublic companies in calendar year 2020, CTC has retail space leases that are locked in for 10 and 15 years. These debt agreements will be in effect for a number of years after ASC 842 becomes effective. Private Placement Debt and Debt Covenants When the Newton's laid out their business plan for expansion for CTC and the funds required to accomplish it to their banker, she recommended a private placement as the best option. The bank acted as the agent, providing guidance and negotiating with the investors. The U.S. Private Placement (USPP) market offered a number of advantages to CTC, namely cost and time-related savings. However, the disadvantages included a higher interest rate, listing PP&E as collateral, and contracted debt covenants. CTC's lease contracts do not provide an exception to any debt covenant default resulting from a GAAP accounting change. 1 FASB Accounting Standards Update, No. 2016-02, February 2016, http://www.fasb.org/jsp/FASB/Document_C/DocumentPage? cid=1176167901010&acceptedDisclaimer=true . This Update created Accounting Standard Codification (ASC) 842. Previous lease guidance was ASC 840. 2 \"Balance Sheets to Swell $2.8 Trillion as Leasing Rules Tighten,\" Jon Glover, Bloomberg.com., January 12, 2016. Debt covenants are agreements between a company and its creditors requiring that the company operate within certain limits as a condition of borrowing. In the case of CTC, the debt could become redeemable if the company is in violation of its covenants, which would likely force the company into bankruptcy. At the very least, the debt would have to be renegotiated on less favorable terms and require that a large waiver fee paid. The current projections show that revenues and profits will grow significantly over the next 5-10 years, but CTC must manage its debt in the meantime to enjoy these future benefits. After reading through the debt contract, you discover that CTC is required to maintain a debt to equity ratio (not including accounts payable) below 2.0, an interest coverage ratio greater than 2.0, a current ratio greater than 1.0, and a tangible net worth greater than $500,000. In addition, the corporation must not increase their debt-service-coverage ratio above the current value of $3,310,0003.31. You recognize immediately that the additional operating lease debt that must be recognized under ASC 842 could cause CTC to violate some or all of its debt covenants. Company Financial Performance CTC began as a small souvenir shop located on the boardwalk in Myrtle Beach, SC. During the first 8 years of operation, CTC grew to comprise 5 stores located in popular tourist cities along the eastern coast. However, the next 5 years were more problematic. The economic downturn of 200809 nearly shattered the company. By 2013, the Newton's knew they had to either expand so they could capture a greater share of the market or get out altogether. You had several meetings with them to help them adequately prepare to meet the logistic challenges, financing concerns, staffing issues, and supply chain management required for successful expansion. You even put them in touch with the banker who assisted with the private placement of the bond sales. CTC issued $6,200,000 of 7% bonds at face amount in January 2015. The bonds mature in 15 years. By the middle of 2015, CT C had expanded to the current 21 stores and one distribution center. The year-end financials for 2015 indicated that the decision was already starting to pay off. Their 15year business projection looked quite promising, especially with the long-term lease advantages and vendor price negotiations. The Newton's prepared income and balance sheet projections through 2029, the last year of their most recent lease contract negotiations (see Appendix A). Case Requirements 1. Examine FASB Accounting Standards Update, Leases, No. 2016-02, February 2016, pages 19 (Summary), to understand the new leasing standard, particularly as it applies to the new right-of-use asset and the related lease liability. a. What is the FASB's definition of a lease under Topic 842? b. Describe the exception in transition for all operating leases at each reporting date. 2. Read through the FASB's \"Background Information and Basis for Conclusion\" report so you can explain to the Newton's why the FASB felt that existing debt covenants were unlikely to be significant impediments (BC14).3 Write a memo explaining in simple terms the FASB's 3 http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176167901087&acceptedDisclaimer=true reasoning as it applies to the Newton's situation. Also include potential concerns with the FASB's reasoning. 3. Perform analytical calculations in Excel to examine the company's financial performance as well as management's projections through 2029 for the following debt covenant values attached to the debt contract: debt to equity ratio, interest coverage ratio, current ratio, tangible net worth, and debt-service-coverage ratio. a. First prepare the calculations assuming current GAAP. b. Repeat the calculations beginning with 2016, reflecting the impact of the new standard. Additional relevant considerations: i. Be sure to add a line for the new \"Right-of-use asset\" prior to \"Other assets\" and the related lease liability prior to \"Current portion of long-term debt.\" ii. The company is committed to a $189,500 per month lease payment for the 21 stores and the distribution center. Remember that, beginning with 2016, the lease payments must be reported on the balance sheet at the present value of the future payments. The first payment of $2,274,000 was due January 1st, 2016. iii. The rate implicit in the lease is not readily determinable. However, CTS's incremental borrowing rate is 7.0 percent, which reflects the fixed rate at which CTC could borrow a similar amount in the same currency, for the same term, and with similar collateral as in the lease at the commencement date. iv. Though not stipulated in the debt covenant, the Right-of-use asset might be considered by the bank to be an intangible asset. Calculate the Net Tangible Worth with and without the Right-of-use asset included as an intangible asset. v. The current annual debt service is a $178,478 annual note on a $700,000 note payable. The note will be repaid in December 2019. However, the lease liability will need to be included in the annual debt service for the purpose of calculating the debt service coverage ratio. c. Prepare a summary of the two analyses to include with the spreadsheets you create. Indicate any debt covenant violations that may occur when Topic 842 is implemented. 4. To be proactive in helping avoid future covenant violations, you are recommending that the Newton's work with the bank to amend current agreements. What clauses should be added that would allow the covenants to be calculated as they are at current GAAP? Identify several options that you might suggest to the Newton's in their negotiations. 5. Prior to the release of Topic 842, one reason to lease rather than buy was to take advantage of \"off-balance sheet financing.\" Now that GAAP requires lessees to report assets and liabilities for all but very short-term leases, is there still an advantage to long-term leases for the Newton's? Identify and discuss any advantages or disadvantages to continuing to lease. What recommendation will you make to the Newton's concerning continuing the long term retail leases? APPENDIX A Financial Statements Panel A: Balance Sheet Coastal Trading Corporation Balance Sheet December 31st, (in thousands) ASSETS CURRENT ASSETS Cash and cash equivalents Merchandise inventories Prepaid expenses and other assets Audited FY 2015 265 5,171 325 $ FY 2029 280 5,326 328 $ 2,280 5,486 380 $ $ 5,761 $ 6,078 390 6 $ 5,934 $ 6,478 364 7 $ 8,146 $ 8,478 260 20 $ 7,723 $10,400 10 40 TOTAL ASSETS $12,235 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 1,070 Interest Payable 387 Current maturities of long-term debt 178 $12,783 $16,904 $18,173 $ 1,505 371 178 $ 1,200 360 178 $ 2,500 340 0 TOTAL CURRENT LIABILITIES Bonds payable Notes payable $ 1,635 $ 6,200 700 $ 2,054 $ 6,200 576 $ 1,738 $ 6,200 0 $ 2,840 0 0 TOTAL LIABILITIES STOCKHOLDERS' EQUITY $ 8,535 $ 8,830 $ 7,938 $ 2,840 TOTAL CURRENT ASSETS PROPERTY, PLANT, AND EQUIPMENT - net INTANGIBLE ASSETS OTHER ASSETS $ FY 2016 Projections FY 2019 690 6,583 450 Common stock, $1 par, 300,000 shares authorized, 100,000 shares outstanding Paid in capital Retained earnings TOTAL EQUITY TOTAL LIABILITIES AND EQUITY $ 100 $ 100 $ 100 $ 100 3,200 400 $ 3,700 3,200 653 $ 3,953 3,200 5,666 $8,966 3,200 12,033 $15,333 $12,235 $12,783 $16,904 $18,173 APPENDIX A (continued) Panel B: Statements of Income Coastal Trading Corporation Income Statement Year ended December 31, (In thousands) NET OPERATING REVENUES Cost of goods sold GROSS PROFIT Selling, general, and administrative expenses Other Operating Expenses OPERATING INCOME Interest income Interest expense INCOME BEFORE INCOME TAXES Income taxes NET INCOME Audited FY 2015 $28,500 22,260 $ 6,240 3,948 63 $ 2,229 12 405 $ 1,836 734 $ 1,102 FY 2016 $36,412 24,370 $12,042 8,355 62 $ 3,625 15 412 $ 3,228 1,291 $ 1,937 Projections FY 2019 $37,504 25,080 $12,425 8,598 64 $ 3,762 15 390 $ 3,388 1,355 $ 2,033 FY 2029 $41,349 27,525 $13,823 9,107 68 $ 4,649 16 298 $ 4,368 1,747 $ 2,621 REFERENCES Mendel, R. 2013. Private placement debt: Diversification, yield potential in a complementary IG asset, Hartford Investment Management Company. Available at: http://conferences.pionline.com/uploads/conference_admin/HIMCO_Private_Placement.pdf