Prepare the memo requested by the CFO. Ignore income taxes.

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.

On September 2, Year 5, P Co. will sell its manufacturing facility to SPE for $1,350,000 in the form of a non-interest-bearing note receivable. SPE will be set up for the sole purpose of renovating the manufacturing facility. No other activities may be carried out by SPE without the approval of P Co. Mr. Renovator, an unrelated party, will invest $900,000 in cash to cover the estimated cost of the renovation and will be the sole owner of SPE. On January 1, Year 6, after the renovation is complete and one day after P Co.'s year-end, SPE will sell the manufacturing facility back to P Co.  at $2,340,000 and will be wound up. P will finance the repurchase with a $990,000 bank loan and by offsetting the remaining $1,350,000 against the note receivable from SPE from the original sale of the manufacturing facility to SPE. By selling the unrenovated facility and repurchasing the renovated facility, P Co. hopes to reflect the facility at its fair value, borrow the money to finance the renovation, and improve its debt-to-equity position.

The existing and pro forma balance sheets (in OOOs) 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.

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P Co. Sep. 1/5 P Co. Dec. 31/5 $ 1,350 P Co. SPE Jan. 1/6 Dec. 31/5 Note receivable from SPE Manufacturing facility Other assets $2,340 225 2,025 $2,250 2,025 $ 3,375 2,025 $4,365 $ 2,250 $2,250 $1,350 Note payable to P Co. Other liabilities Common shares Retained earnings $ 1,800 $ 1,800 $2,790 30 30 30 900 420 1,545 1,545 $ 2,250 $ 3,375 $4,365 $2,250 Debt-to-equity ratio 4:1 1.14:1 1.77:1 1.5:1