Your conversation with Mr. Gerrard, which took place in February 2011 (see Case 6.28), continued as follows:

Mr. Gerrard: I’ve been talking with my accountant about our capital expansion needs, which will be considerable during the next couple of years. To stay in a strong competitive position, we’re constantly buying new pieces of earthmoving equipment and replacing machinery that has become obsolete. What it all comes down to is financing, and it’s not easy to raise $10 million to $20 million all at once. There are a number of options, including dealer financing, but the interest rates offered by banks are usually lower.

Your reply: From reviewing your balance sheet, I can see that you’ve got a lot of notes payable already. How is your relationship with your bank? Mr. Gerrard: Actually we use several banks and we have an excellent credit history, so getting the money is not a major problem. The problem is that we already owe more than $40 million on all of those notes and I don’t want to get overextended.

Your reply: Have you considered long-term leases?

Mr. Gerrard: Yes. This is essentially how dealer financing works. Usually it is arranged as a lease with an option to buy the equipment after a number of years. We’ve been actively looking into this with our Cat dealer for a couple of scrapers that we need to put on a big job immediately. I can show you one of the contracts involved.

Your reply: OK, I’ll have a look at the contract, but this sounds like a long-term capital lease.

Mr. Gerrard: Yes, I think that’s what my accountant called it. What matters most to me is that we get the equipment in place ASAP; but if you could explain what the accounting implications would be of entering into these types of arrangements, that might put me at ease about it.

Your reply: No problem; will do. It would impact both your balance sheet and income statement, but in most respects a long-term capital lease is treated very much like a long-term note payable with a bank. I’ll give you a memo about it. But what about looking into other sources of equity financing? Have you considered any of these options?

Mr. Gerrard: We’re a family business and want to keep it that way. Our shares are publicly traded, but we’re owned mostly by family members and employees. We’ve got a lot of retained earnings, but that’s not the same thing as cash, you know. Should we be issuing bonds?

Your reply: Issuing bonds is possible, but I was thinking more on the lines of preferred stock. Are you familiar with this option?

Mr. Gerrard: Oh sure. That’s the cologne I wear! But other than that, I don’t know much about it. Isn’t preferred stock a lot like bonds payable?

Your reply: Maybe this is something else I should include in my memo: an explanation of the differences between common stock, preferred stock, and bonds payable.

Mr. Gerrard: Yes, please do.

Required:

a. When discussing capital leases with Mr. Gerrard, you commented, “It would impact both your balance sheet and income statement, but in most respects a long-term capital lease is treated very much like a long-term note payable with a bank.” Explain the accounting treatment of capital leases as compared to the accounting treatment of notes payable in terms that a nonaccountant could easily understand. Include in your answer both the balance sheet and income statement effects of capital leases.

b. Assume you have reviewed the contract Mr. Gerrard provided concerning the dealer financing agreement for the purchase of two new scrapers. You have determined that the lease agreement would qualify as a capital lease. The present value of the lease payments would be $2 million. Use the horizontal model, or write the journal entry, to show Mr. Gerrard how this lease would affect the financial statements of Gerrard Construction Co.

c. Explain what Mr. Gerrard meant by his statement “We’ve got a lot of retained earnings, but that’s not the same thing as cash, you know.” Review the balance sheet at December 31, 2010, provided in Case 4.26. In which assets are most of the company’s retained earnings invested?

d. Explain to Mr. Gerrard what the similarities and differences are between bonds payable, preferred stock, and common stock.

e. Why would you recommend to Mr. Gerrard that his company consider issuing $10 million to $20 million of preferred stock rather than bonds payable?