Chapter 15

Accounting in Action: CM2

After a long day on the job at CM2, you are reflecting on how much you have
learned about business decision making through this internship. A good example
is CM2s current plan to raise money through a stock issue rather than a debt
issue. You recall from your Intermediate Accounting class that issuing debt
imposes a fixed financial obligation on the company, but does not convey
ownership to the debt holders. However, if CM2 issues stock, it gives up some
ownership and thus some control. You know how protective Conner and Martin
are of the company, and you wonder why they chose to issue stock. You decide
to ask them the next day.
The next day you ask the management team if you could get some
information about the proposed stock issue. You explain that there are trade-offs
between issuing stock and issuing debt, and you wonder why they are planning
to issue stock. Martin has an immediate response: They do not want to take on
any more debt; they would prefer relinquishing some control rather than
assuming more obligations. They argue that companies are like people who have
ready access to multiple credit cards and use them to live on, effectively taking
on more debt than they can easily repay. Having friends in this situation, you
understand CM2s position.
They then ask you to help them evaluate the three options they are
considering for raising the necessary money for expansion. Amazingly enough,

Continuing Case

one of the options is to issue debtyou are glad to see they are at least
considering it. The three options are:
1.

Issue $10,000,000 of 10-year bonds with a coupon rate of 6%, interest

payable semiannually. (CM2 has an A bond rating.) Although the current market
rate is 6%, based on current economic forecasts, Conner and Martin recognize
that market rates might increase to 8% by the time they issue the bonds.
Although they do not like the option of added debt, they feel it is a reasonable
alternative and should be considered.
2.

A second possibility is to issue 2,600,000 shares of common stock ($2 par

value) to current shareholders and a selected group of new investors (a private

issue). The stock would be priced to sell at CM2s book value per share at the end
of 2013.
3.

The third option is to proceed with the initial public offering (IPO). Based

on current and anticipated economic conditions, the resurgence of the IPO

market, and interest in high-tech companies, Conner and Martin think they could
get an IPO price of around $5 per share. At this price, they would need to issue
approximately 2,000,000 shares.
The company does have some shares held in treasury but does not want
to re-issue these shares at this time. Conner and Martin also plan to continue to
pay dividends to current shareholders but at a lower amount, probably $0.05 per
share.
Instructions

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(a)

As a fourth alternative, you suggest that the company borrow the

money from a financial institution instead of issuing either bonds or stock.
Conner and Martin of course turn the question right back to you, and ask
you to summarize the advantages of borrowing in this fashion compared
to issuing bonds. Write a memo describing the advantages and
disadvantages of each method of financing.

(b)

Which alternative would you recommend to Conner and Martin? Be sure

to justify your answer in comparing the merits of raising capital through
bonds, loans, and common stock. Include any pros or cons of utilizing
treasury stock in raising capital. Be specific in your answer, but remember
you are writing to entrepreneurs, not accountants.

Additional Activities: Extend your accounting knowledge

You think that in one of your accounting classes, you covered some
other options that companies had to raise money. You remember something
about preferred stock, special classes of common stock, and convertible bonds.
Prepare a memo suggesting two other ways that CM2 could raise $10,000,000.
Be specific, but again, remember you are writing to entrepreneurs, not
accountants.

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Chapter 16
Accounting in Action: CM2
As part of CM2s plan to obtain financing for its expansion at the end of 2013, you
have already prepared an analysis of the effects on the financial statements of
(1) issuing more common stock to the existing stockholder group; (2) issuing
bonds; (3) going public with a large stock issue; and (4) borrowing money from a
financial institution.
Conner and Martin now have another possible alternative that would
basically permit them to keep control of the company, at least in the short run. To
finance expansion, they are considering the issuance of stock to the existing
stockholder group and the issuance of convertible securities to the general
public. They know that if they eventually do go public, the investment community
will use metrics like EPS to assess the price to pay for the stock. They are quite
concerned about how the companys EPS numbers would compare to those of
their competitors under this new proposal.
Here are the transactions that are under consideration for 2013:
June 1

Issue 6%, $1,000 bonds at a total price of $5 million. Each

$1,000 certificate is convertible into 100 shares of common
stock. The par value and market value of the convertible
bonds are the same.

July 15

Issue 300,000 shares of common stock at $3 per share.

August 1

Issue 20,000 shares of 5% cumulative preferred stock ($150

par), with each share convertible into 19 shares of common

Continuing Case

stock. Dividends are paid on the preferred stock on June 30

and December 31 of each year. The stock would be issued
at par.
October 1

Issue 200,000 shares of common stock for $3 per share.

December 1 Issue 100,000 shares of common stock for $3 per share.

No doubt this is an ambitious plan. Although there are a number of

questions about the assumptions in the plan, Conner and Martin would first like
to know the potential impact on earnings per share.
Instructions
Write a memo to Conner and Martin in which you explain basic and
diluted earnings per share. Compute earnings per share given the new capital
structure following this financing plan. The forecasted net income for 2013 is
$331,500, and the tax rate for CM2 is 35%. Note The net income forecast
includes the interest expense on the bonds that are to be issued June 1.

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Chapter 17
Accounting in Action: CM2
CM2 purchased some shares of one of its suppliers, Infrared Co., as an
investment. CM2 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 CM 2 to buy
shares on the open market.
Conner and Martin mention that they might go so far as to buy 1015% 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 critical pieces in the CM 2 system.
They want you to help them understand whether it makes a difference if they buy
just 1015% or if they buy 30% of these suppliers shares. Both these suppliers
have been around for some time 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.
Instructions
(a)

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

Continuing Case

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:
1. CM2s investment represents 10% of Infrared shares.
2. CM2s investment represents 30% of Infrared shares.
Indicate the differential effect on income between the accounting for the
conditions under assumptions 1 and 2.
(b)

Conner and Martin have heard that as long as they do not hold
more than 20% of the shares of one of these suppliers, they are able to
recognize the unrealized gains on these equity investments in income.
Prepare a memorandum to Conner and Martin with references to the
authoritative literature on the accounting for equity investments of less
than 20% ownership. Discuss other factors beyond the percentage of
shares owned that should be considered in determining the accounting for
investments if they hold at least 20% but less than or equal to 50% of the
stock of another company.

Continuing Case

Chapter 18
Accounting in Action: CM2
This morning before going to work, you read in the paper about a company that
the SEC is investigating for improper revenue recognition. It is not clear from the
article what industry this company is in, but you start to wonder about the specific
recognition policies at CM2. You know that CM2 sells a product and a service, and
you are aware that its service contracts extend over variable lengths of time, but
you are unsure whether it includes upgrades in the sale price of its products.
When you arrive, you find Conner and Martin and ask how CM 2
recognizes revenue. They indicate that there is only one way to record revenue
for a product and that is when the company ships the product. For an individual
service call, CM2 recognizes revenue when the service technician leaves the
company premises to provide the service to the customer. They are not quite
sure how the revenue from service contracts is recognized.
Instructions
(a)

Prepare a brief memo describing the various revenue recognition

methods acceptable for CM2. Recall that it sells products (with possible
upgrades included in the sale price), provides service on demand for
customers, and has service contracts that guarantee customers service
over a specified period of time. Also recall the product contains both
software and hardware and that each may be sold separately or as a
package. Access the FASB Accounting Standards Codification to provide

Continuing Case

authoritative support for the position articulated in your memo for each of
these categories.
(b)

Access the 2012 10-K for Microsoft, Inc. within the SEC website
(www.sec.gov). Examine Microsofts Significant Accounting Policies
(usually found in footnote 1). Write a memo to Conner and Martin
describing Microsofts revenue recognition policies, so that they will have a
better understanding of the issues faced by a firm in the software industry.

Continuing Case

Chapter 19
Accounting in Action: CM2
When you arrive at CM2 for the afternoon, Conner and Martin are arguing with
Lopez and Knepp about, of all things, the corporate income taxes. As you walk
in, you hear Conner saying, "The corporate rate is always 35%." For some
reason, Knepp is talking about something called SFAS No. 109 that has to do
with how taxes are reported in financial statements (deferred taxes). This
discussion is not clear to you since you have not yet had a tax course, so you
figure you will learn a lot this afternoon. (You had no idea at this point how much
you would learn.)
Instructions
Access File 4a to perform the following analysis (Excel File). This file contains the
balance sheet and income statement reflecting forecasts for 2013. Review the
income statement and verify that the tax is indeed 35% of income before tax for
both 2012 and 2013.
(a)

Since Knepp has raised the issue of SFAS No. 109, access the
FASB Codification and read the information describing the framework now
used in accounting for income taxes. Write a memo that you can take to
Conner and Martin describing the change in focus from the income
statement to the balance sheet. Describe the concepts of permanent and
temporary differences. Give two examples of each and how they reflect
the new focus.

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10

(b)

During the meeting in the afternoon, you ask Knepp and Lopez if
there were permanent or temporary differences in 2012 and whether they
will continue into 2013. They responded that they were not aware of any
differences for either 2012 or 2013. However, in 2013 Conner and Martin
were given life insurance policies. The insurance premium on these
policies amounted to $80,000 per year. CM2 also anticipates investing in
local county bonds which should earn about $7,000 investment income in
2013. Both of these items are reported on the forecasted income
statement. In addition, Knepp tells you that depreciation expense recorded
for tax will be $30,000 higher than that recorded for the books. That is, the
book value of the fixed assets for GAAP will be $30,000 higher compared
to their book value reported on the tax return.
Knepp then mentions that CM2 will begin offering a six-month
warranty on its RFID product. The forecasted income statement includes
estimated warranty expense accrual of $100,000; one-fourth of this
amount will be settled in 2013 through actual claims being filed. You
remember from your Intermediate Accounting class that for tax purposes,
only the cash expense incurred in doing the work is deductible.
The forecasted income statement reports a tax expense of
$178,500. Prepare a memo to Conner and Martin in which you explain the
adjusting entry to reflect the income tax expense that should be reported.

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11

Additional Activities: Extend your accounting knowledge

Since the discussion about tax expense you had yesterday, Conner and Martin
have read about something called "deferred taxes." They ask you just what is
involved in the concept of deferred taxes.
(a)

Prepare a memo for Conner and Martin describing when deferred

tax assets are recorded and what provisions, if any, have to be accounted
for if Conner and Martin believe that the future benefits from the deferred
tax asset probably will not be realized. Use the FASB Codification to
provide support for your response from the authoritative literature.

(b)

Write a memo to Conner and Martin describing the potential for

earnings management that exists when recording valuation allowances for
deferred tax assets.

(c)

From what you have read about taxes, you realize that there is substantial
judgment in the determination of tax expense for book purposes. Check
the FASB Codification for the guidance on taxes; in particular, check for
footnote disclosures required.

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12

Chapter 20
Accounting in Action: CM2
CM2 has not offered retirement benefits to its employees but is looking for
information on pension retirement plans. Naturally, when you show up for work,
Conner and Martin suggest that you gather information and fill them in on
possible benefit plans and their accounting consequences.
Instructions
(a)

Research the authoritative literature (using the FASB Codification)

for information about two types of retirement pension plans that might be
adopteddefined-contribution plans and defined-benefit plans. Write a
memo explaining these plans and describing their costs and benefits.

(b)

After you present the memo and explain the concept of pension
retirement plans, Conner and Martin chime in and say they have read in
the news that many companies are singing the blues because they have
severely underfunded pension plans and face huge shortfalls in covering
their looming pension obligations.
However, they are also quite confused because years ago, these
same companies were on top of the world when their pension plans were
overfunded. How, they wonder, can this happen in a relatively short period
of time? Explain to Conner and Martin how this can happen for definedbenefit pension plans. In your discussion, address the following:

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13

(1) Five components of pension expense.

(2) The concept of smoothing in terms of gains/losses (delayed
recognition).

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14

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 CM 2 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 2010. They do not want to guarantee the residual

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15

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 companys 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
companys 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 CM 2 to guarantee the
residual amount.

Additional Activities: Extend your accounting knowledge

Assuming the leasing alternative is selected, and given your analysis,
Conner and Martin are concerned about the residual value guarantee, given the
changing technology in this market. They indicate they will agree to this lease
only if they do not have to guarantee the residual value.
They place a conference call with Buzz Tyler. He expresses his companys
concern that they stand to lose a considerable amount if the equipment is run

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16

down when it is returned to them. Explain the concept of third-party guarantees

and how this might be the solution for all concerned.

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17

Chapter 22
Accounting in Action: CM2
Conner and Martin have appreciated your involvement in all aspects of the
companys operations throughout the year. They now want you to take the
accounting records over these past three years and give them advice on any
errors and/or corrections you may find. You tell them this may take a while, and
you ask if they can give you a few days to conduct your review. They agree.
Access File 4a on the website (Excel File) containing CM2 s financial
statements for 2011, 2012, and the forecasted trial balance and financials for
2013. After carefully examining three years of information, you come up with the
following:
(1)

Ending inventory in 2011 was overstated by $32,000 as a result of

errors in the inventory count-sheet footings.

(2)

Prepaid rent of $9,500 for 2013 was expensed at the end of 20012.

(3)

Depreciation was understated in 2011, 2012, and 2013. This was

due to a piece of equipment costing $110,000 which was
purchased in 2011 and was expected to have a five-year life and no
residual value. Instead of using straight-line depreciation for the
expense in 2011, the whole $110,000 was expensed.

(4)

Employee wages of $26,000, earned at the end of 2011, were not

accrued but were expensed in 2012 when they were paid.

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18

Instructions
Prepare a worksheet in a similar format to the one in Illustration 22-24 of the text.
Ignore income taxes.

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19

Chapter 23
Accounting in Action: CM2
You were looking forward to going to CM2 today since it was your last working
day as an intern. Tomorrow the group is planning to take you to lunch to
celebrate the end of your internship. You figured today would be easy just
wrapping up loose ends.
It was not to be. You walked in and found people with expectant faces,
holding sheets of paper, and you could tell that another issue had arisen.
Conner and Martin started right off: they saw no reason at all for a statement of
cash flows. They felt that CM2s cash flows were nobodys business but the
banks. Lopez and Knepp clearly were trying to explain that investors like to see
where the cash flow was coming from and how the cash was being used.
So once again, you were on the spot. By now, Conner and Martin have
learned to put their questions in writing so they were ready with a paper on which
they had written:
1.

What is the point of the statement of cash flows?

2.

Why are there three categories of cash flow information?

3.

What can the reader learn from the Cash flow from investing
section?

4.

What can the reader learn from the Cash flow from financing
section?

5.

What is the difference between the direct and indirect methods

for preparing the Cash flow from operations?

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20

6.

We have a copy of a statement of cash flows for another firm.

Why is this firm adding back depreciation?

7.

Someone told us that you could learn a lot from looking at the
accounts receivable adjustment to net income on this statement.
We dont understand this at all. Whats to be learned?

Instructions
Prepare responses to their questions.

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21