Accounting Issues - Assignment Example

Retained earnings are the accumulated wealth of earnings not paid as dividends that the company obtained over the years. The cash balance of the company as of December 31, 2012 was $2,800,000. In terms of retained earnings the company had a balance of $31,400,000. Based on the asset distribution of the company it seems as if the company invested its retained earnings in the past in property, plant, and equipment. Common stocks, preferred stocks, and bonds payable are three distinct financial instruments that corporations can utilize to raise money.

A common stock can be defined as an equity security that has last claim on residual assets and earnings of a corporation (Tewales, Bradley, Tewales). Common stocks are traded in the open market and its price fluctuates daily. A common stock gives its owner a participation stake in the ownership of a company. Common stocks have voting rights. At the end of the fiscal year shareholders are eligible to receive dividends if the board of directors declares them. A preferred stock is a special type of stock that has a claim on a corporation’s earnings, dividends, and assets ahead of common stock, but behind debt (Tewales, et al.). Corporations are mandated to pay dividends to preferred stock holders.

If dividends are not paid they become cumulative and must be paid in the next accounting period. Preferred stocks do not have voting rights. A bond is a long term note that corporations sell to the general public. A bond has the obligation of paying its holders an interest payment to be paid on a quarterly, semiannual, or annual basis. The interest rate paid on a bond is known as the coupon rate. The principal of the bond must be repaid to the investor in full upon maturity date. The use of preferred stock is ideal for the company for a variety of reasons.

First of all the use of preferred stocks does not dilute the power of the current owners of the company because preferred stocks do not have voting rights. Most importantly preferred stocks are accounted for as an equity option. The debt on the balance sheet of the company will not increase by selling preferred stocks. The use of preferred stocks does have a cost as the company will be obligated to pay dividends to the owners of preferred stocks. The capital structure of the company did not include any preferred stocks at the end of 2012.

The company has a covenant on its previous debt that requires the firm to maintain a debt ratio below 60%. The total liabilities of the company in 2012 were $48.6 million, while its total assets amounted to $90 million. The debt ratio of the company is 0.54. This ratio is an indicator of the solvency of the company. If the company were to acquire an additional $10 million in debt its debt ratio would increase to 0.65 violating the existing covenant on its debt. The firm would also not quality for a $20 million loan since doing so would increase its debt ratio to 0.76. The use of capital leases is a viable financing arrangement that the company can use to acquire equipment and machinery.

The debt analysis performed on the company showed that additional debt is a limiting option due to a covenant on its existing debt that requires the firm to maintain a debt ratio below 60%. The use of a capital lease is a very attractive option because the debt on the lease is not reflected on the balance sheet liabilities section, but the asset being leased is considered an asset in the accounting books of the company. The use of a capital lease affects both the income statement and balance sheet of the firm.

The balance sheet is affected because the leased equipment must be included in the asset section of the balance sheet under the