Question

Slappey Communications is a technology firm in Birmingham, Alabama, specializing in telecommunications, computer, and network security. Its owner, Bill Slappey, invested nearly $770,000 in property, plant, and equipment for the business in 2014 (See “Small Firms Poised to Spend More on Plants, Equipment,” A. Loten and V. Monga, Wall Street Journal, September 3, 2014.)

Slappey spent about $100,000 to build a 1,000-square-foot “cloud storage” room, or a warehouse for network servers. Slappey also spent about $670,000 on computers, servers, and other hardware.

Funding for the 2014 investment in the warehouse and computer hardware came from two sources. According to the September 3, 2014, Wall Street Journal article, Slappey borrowed about $385,000 and “….used its earnings to fund the rest.”

Questions 1. Assume that Slappey borrowed the funds for the cloud storage room by signing a long-term note. What impact, if any, would this investment have on Slappey’s assets, liabilities, and equity? 2. Will the $100,000 investment in the cloud storage room impact Slappey’s 2014 income statement (again assume that Slappey borrowed the funds)? If so, what account(s) would be impacted? 3. When the Wall Street Journal article states that Slappey “…used its earnings to fund the rest,” what does this statement mean? Where did the funding come from? 4. Now assume that Slappey purchased computer hardware for $300,000 by using “…its earnings to fund the rest.” What impact will that transaction have on Slappey’s balance sheet? On its income statement for 2014? What accounts would be affected?

This investment will have following inpact on Slappey’s assets, liabilities, and equity.

First of all let’s see the information provided in the question;

Slappey spent about $100,000 to build a 1,000-square-foot “cloud storage” room or a warehouse for network servers.

Slappey also spent about $670,000 on computers, servers, and other hardware.

Thus total investment is ($100000 + $670000) = $770000

He arranged this amount as follow;

Long-term note …..$385000

Retained earnings….($770000 - $385000) = $385000

So impact on the Slappey’s assets, liabilities, and equity is as follow;

$770000 will be shown as non-current assets under assets side.

$385000 will be shown as long-tern note payable under non-current liabilities in liability side.

Equity will be reduced by $385000.

We can also understand it with the help of following table;

Shareholders’ Funds	Non-current Liability	Non-current Assets
($385000)	$385000	$770000

Answer 1

Answer 1: is given in the question.

Answer 2:

Assuming $100,000 investment in the cloud storage room is financed from borrowings:

Impact Slappey’s 2014 income statement:

i. Depreciation expense: Based on depreciation method followed, depreciation expense on $100,000 need to be provided. Since the same is tax deductible, net effect on net income = Depreciation * (1 - Tax rate)

ii. Interests Expense: As the fund of $100,000 is borrowed, Interest expense has to be accrued/paid. This will impact net income by 'Interest expense * (1 - Tax rate)'

The accounts impacted are Depreciation Expense, Interest Expense and Tax.

Answer 3:

The statement means that the rest amount of $385,000 will be funded from Retained Earnings. The fund comes from accumulated retentions from Net income.

Answer 4:

Assuming that Slappey purchased computer hardware for $300,000 by using its earnings:

Impact on balance sheet:

The retention amount of net income increases the Equity (as retained earnings) on "Liabilities and Equity" and on the "Asset" side it will increase non-current (Fixed) Asset.

The accounts impacted will be " Retained Earnings" and "Non-Current Assets"

Impact on Income Statement:

Purchased computer hardware for $300,000, will increase the Depreciation Expense by amount of '$300,000 * Depreciation rate'. Since Depreciation is tax deductible, net income will be impacted by an amount of 'Depreciation Expense * (1 - Tax Rate)'.

The accounts impacted will be 'Depreciation Expense" and 'Tax"