Understanding Financial Accounting 3rd Canadian Edition by Christopher D. Burnley solution manual
b.
Is your net income sufficient to repay a loan?
Is your net income sustainable?
Do you have assets that could be liquidated if your cash flows are insufficient?
Do you have currently existing debt that will make it difficult to repay new loans?
*Other answers may also be accepted.
LO 2 BT: C Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting
UP1-3
The advantages of operating the business as a proprietorship are that it is simple and inexpensive to establish and maintain.
The advantages of operating the business as a corporation are that Taylor’s personal assets would not be at risk in the event the company was unsuccessful. This form of business would also enable the company to raise funds by issuing shares, which is not an option if the business operated as a proprietorship. If the business proves to be success, there can be tax advantages from operating it as a corporation.
Customers would likely prefer that he operates as a corporation. This gives the appearance that the business is more than a single individual.
Creditors would likely prefer that he operate as a proprietorship as they would be able to access any personal assets Taylor might have in the event the business is not successful. They may be able to do this anyway, by requiring personal guarantees from Taylor for any debts of the corporation.
The corporate form of business would be more advantageous if Taylor expects the business to grow rapidly. Rapid growth would require additional financing, and this is easier to obtain as a corporation. As the company grew, Taylor would see a related increase in the value of his shares in the company. Taylor would also have the option of selling some of his shares (for personal gain) or having the company issue additional shares to raise additional capital to fund the company’s growth. There may also be tax advantages associated with organizing the business as a corporation if profits increase as a result of the growth.
LO 3 BT: C Difficulty: M Time: 30 min. AACSB: None CPA: cpa-t001 CM: Reporting
UP1-4 Funds can be raised from several sources, but the two primary sources are from lenders and shareholders.
The advantage of borrowing from a lender is that your friend would retain complete ownership of the business and would not be required to share the decision-making and the profit of the company with anyone else. Bringing in another shareholder may result in a loss of control over the company and would also mean giving up some share of the future profits.
The disadvantage of borrowing from a lender is that loan contracts require repayment of the amount on a set schedule. This increases the risk to the company that it will not be able to make payments on a timely basis. There could be significant consequences for not making payments, including losing ownership of the company. A new shareholder would not have this same type of contractual arrangement and would be at risk in the same way as your friend. However, the new shareholder would probably expect a higher return from her/his investment than would a lender. Your friend would be giving up more potential profit to a new shareholder than lender.
Another disadvantage to borrowing is that interest must be paid on the loan. It is not optional but is tax deductible. Dividends, on the other hand, are optional and would normally only be declared by the company’s board if the company was profitable.
LO 2 BT: C Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting
UP1-5 The board should consider the number of shares outstanding and the proposed dividend per share, which will determine the total cash requirements. They must also consider whether the available cash in the company is sufficient to make the dividend payment without disturbing the overall liquidity of the business in its day-to-day operations. If not, they may have to delay payment of the dividend, or look for ways to generate additional cash.
The dividend declaration will reduce retained earnings, so the retained earnings amount must be larger than the proposed dividend. The board should also consider the company’s future plans. The retained earnings account represents the cumulative profits of the business that are kept within the company to fund future expansion plans. Dividends are declared and paid when the company has no plans to use the accumulated profits to fund future expansion. Thus, the declaration and payment of dividends only makes sense if the company does not need the cash for future expansion plans.