P Co. is looking for some additional financing in order to renovate one of the company€™s manufacturing plants. It is having difficulty getting new debt financing because its debt-to-equity ratio is higher than the 3:1 limit stated in its bank covenant. It is unable to attract an equity partner because the sole owner of P Co. has set equity partner conditions that make it practically impossible to find a new equity investor.
Part of the problem results from the use of historical cost accounting. If the company€™s assets were recorded at fair value, the debt-to-equity ratio would be much lower. In order to get around the requirements for historical cost accounting, the CFO for P Co. came up with the following plan.
The existing and pro forma balance sheets (in 000s) and debt-to-equity ratios for P Co. and SPE are presented below in condensed form:

The CFO would like you to prepare a memo in which you discuss the accounting issues related to these proposed transactions.
Required:
Prepare the memo requested by the CFO. Ignore income taxes.

Transcribed Image Text:

P Co P Co. Jan. 1/6 P Co. SPE Dec. 31/5 Sep. 1/5 Dec. 31/5 S 900 Note receivable from SPE Manufacturing facility Other assets $150 1,350 $1,500 $1,560 1,350 $2,910 $1,500 0 $1,500 $900 1,350 S 2,250 Note payable to P Co Other liabilities Common shares Retained earnings 1,200 15 285 1,500 1,200 $1,860 15 1,035 $2,910 1.77:1 600 0 $1,500 1.5:1 15 1,035 2,250 1.14:1 Debt-to-equity ratio