Epstein Engineering Inc. began operations on January 5, 2014, with the issuance of
500,000 shares of $80 par common stock. The sole stockholders of Epstein Engineering Inc. are Barb Abrams and Dr. Amber Epstein, who organized Epstein Engineering Inc. with the objective of developing a new flu vaccine. Dr. Epstein claims that the flu vaccine, which is nearing the final development stage, will protect individuals against 90% of the flu types that have been medically identified. To complete the project, Epstein Engineering Inc. needs $25,000,000 of additional funds. The local banks have been unwilling to loan the funds because of the lack of sufficient collateral and the riskiness of the business.
The following is a conversation between Barb Abrams, the chief executive officer of Epstein Engineering Inc., and Amber Epstein, the leading researcher.
Barb: What are we going to do The banks won't loan us any more money, and we've got to have $25 million to complete the project. We are so close! It would be a disaster to quit now. The only thing I can think of is to issue additional stock. Do you have any suggestions
Amber: I guess you're right. But if the banks won't loan us any more money, how do you think we can find any investors to buy stock
Barb: I've been thinking about that. What if we promise the investors that we will pay them 5% of net sales until they have received an amount equal to what they paid for the stock
Amber: What happens when we pay back the $25 million Do the investors get to keep the stock If they do, it'll dilute our ownership.
Barb: How about, if after we pay back the $25 million, we make them turn in their stock for $120 per share That's one and one-half times what they paid for it, plus they would have already gotten all their money back. That's a $120 profit per share for the investors.
Amber: It could work. We get our money, but don't have to pay any interest, dividends, or the $80 per share until we start generating net sales. At the same time, the investors could get their money back plus $120 per share profit.
Barb: We'll need current financial statements for the new investors. I'll get our accountant working on them and contact our attorney to draw up a legally binding contract for the new investors. Yes, this could work.
In late 2014, the attorney and the various regulatory authorities approved the new stock offering, and 312,500 shares of common stock were privately sold to new investors at the stock's par of $80.
In preparing financial statements for 2014, Barb Abrams and Dan Fisher, the controller for Epstein Engineering Inc., have the following conversation:
Dan: Barb, I've got a problem.
Barb: What's that, Dan
Dan: Issuing common stock to raise that additional $25 million was a great idea. But…
Barb: But what
Dan: I've got to prepare the 2014 annual financial statements, and I am not sure how to classify the common stock. Barb: What do you mean It's common stock.
Dan: I'm not so sure. I called the auditor and explained how we are contractually obligated to pay the new stockholders 5% of net sales until $80 per share is paid. Then, we may be obligated to pay them $120 per share.
Dan: So the auditor thinks that we should classify the additional issuance of $25 million as debt, not stock! And, if we put the $25 million on the balance sheet as debt, we will violate our other loan agreements with the banks. And, if these agreements are violated, the banks may call in all our debt immediately. If they do that, we are in deep trouble. We'll probably have to file for bankruptcy. We just don't have the cash to pay off the banks.
1. Discuss the arguments for and against classifying the issuance of the $25 million of stock as debt.
2. What do you think might be a practical solution to this classification problem