CM Corporation Balance Sheet December 31, 2009 Assets Current assets Cash and cash equivalents Accounts receivable Allowance for doubtful accounts...

Case 1Accounting in Action: CM 2 Knowing that investors and creditors keep a close watch on a company's liabilities in assessing liquidity and financial flexibility, Conner and Martin have been reviewing some of CM 2 's liabilities reported on its balance sheet. Part I: Unearned Revenues Because the company offers service contracts to all of its customers, unearned revenue is a significant element of CM 2 's current liabilities. As indicated in the 2010 forecasted financial statements (see Case 1 Excel file), the projected amount of unearned revenue on the forecasted balance sheet is $105,000. This amount is an increase over the amount of unearned revenue in 2009, which was $70,800. This increase seems reasonable but you wonder whether it should be even higher, given the increased sales expected for CM 2 products. Knepp and Lopez provide the following information about the service contracts expected to be outstanding at the end of 2010 based on recent trends. Customers prepay service contracts regardless of the length of the period of service. Contract Price Service Contract 1, dated October 1, 2010; service for six months $42,000 Service Contract 2, dated November 1, 2010; service for one year 75,000 Service Contract 3, dated December 1, 2010; service for one year 90,000 Instructions • Based on the information provided, determine the amount of unearned revenue that CM 2 should report on the balance sheet at the end of 2010. Assume that the company will provide services evenly over the contract period. • Based on your calculation in (a), prepare the journal entry to record the correct amount of unearned revenue at the end of 2010. • Write a memo explaining to Conner and Martin your analysis and the effect of the journal entry prepared in part (b) on the financial statements. Discuss why your numbers are more indicative of the actual obligation of CM 2. Part II: Contingencies You are informed that CM 2 is facing a patent infringement lawsuit. Connor and Martin claim that the charges are without merit and have yet to contact their lawyers. However, this occurrence has left them with questions about whether this lawsuit would be considered a liability and, if so, how it would be treated for financial reporting purposes.Instructions Prepare a memo to Conner and Martin to address their questions.Part III: Debt vs EquityAfter a long day on the job at CM 2 , you are reflecting on how much you have learned about business decision making through this internship. A good example is CM 2 's 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 CM 2 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 CM 2' s position. They then ask you to help them evaluate the three options they are considering for raising the necessary money for expansion. Amazingly enough, one of the options is to issue debt—you 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. (CM 2 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 to current shareholders and a selected group of new investors (a private issue). The stock would be priced to sell at CM 2' s book value per share at the end of 2010. 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 (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.