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Case: Comdisco, Inc. (B)




103
Part 4 Additional Cases




Comdisco who offered short-term leases. This was likely to provide additional business
opportunities which would offset any loss of long-term lease business to IBM.
While equipment leasing to computer users was Comdisco™s primary activity, the
company also offered tax-oriented leases to investors who were primarily interested in
the tax bene¬ts associated with leasing. In recent years, the ¬nancial services income
from the tax advantaged transactions accounted for a growing portion of the company™s
revenues.


TAX ADVANTAGED TRANSACTIONS
In addition to leasing equipment to computer users, Comdisco undertook leasing trans-
actions with investors who were interested in tax shelters. While the speci¬c terms and




Comdisco (B)
conditions of these tax advantaged transactions varied, a typical transaction was as fol-
lows:
1. After the inception of the initial user lease and independent of it, Comdisco sold
all the leased equipment to a third party investor. This sale usually occurred three
to nine months after the commencement of the initial user lease. The sales price
equaled the then current fair market value of the equipment. The payment from
the investor to Comdisco consisted of: (a) cash and a negotiable interest-bearing
promissory note due within two years for 10“22 percent of the sales price (the
“equity payment”) and (b) an installment note for the balance payable over an 84-
month period.
2. Simultaneously with the sale, Comdisco leased the equipment back from the in-
vestors for 84 months. The lease payments under the leaseback obligation were
equal to the installment payments receivable by Comdisco from the investor (1.b).
3. As part of the leaseback arrangement, during the 61st through 84th months of the
leaseback period, the investor shared in the re-lease proceeds that the company re-
ceived from subleasing the equipment to a user. Upon the expiration of the lease-
back period, the investor had the exclusive right to the equipment.
The net result of the above transaction was that Comdisco gave up the depreciation
tax bene¬t, a portion of the rental revenues for months 61“84, and 100 percent of the
equipment value after the 84th month. In return, the company received the nonrefund-
able equity payment (1.a).
If the equipment sold to the investor was originally under an operating lease, the eq-
uity payment was recorded by Comdisco as ¬nancial services revenue in the period in
which the tax advantaged transaction occurred. From the fourth quarter of 1983, the
company began to allocate as cost of ¬nancial services a portion of the net book value
of the equipment at lease termination. For sales-type and direct ¬nancing leases, the eq-
uity payment was ¬rst applied to reduce a portion of the residual value of the equipment
shown in the balance sheet (as investment in sales-type and direct ¬nancing leases). This
is because the company™s ability to recover the residual value was decreased due to the
834 Case: Comdisco, Inc. (B)




104 Part 4 Additional Cases




rental sharing under the tax advantaged transaction. The excess of the equity payment
over the residual value reduction was recorded as ¬nancial services revenue in the period
in which the tax advantaged transaction occurred.


THE BARRON™S ARTICLE
The October 10, 1983 issue of Barron™s, a widely circulated ¬nancial weekly, carried an
article on Comdisco, “Something Doesn™t Compute: A Hard Look at Comdisco™s Ac-
counting.” The article, excerpts from which are given in Exhibit 2, focused on four areas:
the company™s accounting, competition from IBM Credit Corporation, the company™s
tax advantaged leasing program, and the sale of company stock by insiders.
The article attracted considerable attention on Wall Street, leading to hectic trading
Comdisco (B)




of the company™s stock. The company™s stock price dropped from $38.250 to $22.875
by the end of the week, representing a loss of about $453.5 million in the market value
of the company (see Exhibit 1 for data on Comdisco™s stock price).
In response to these events, Kenneth Pontikes, president of Comdisco, issued a letter
to shareholders on October 12, 1983. The letter addressed the issues raised in the Bar-
ron™s article and attempted to rebut the charges (see Exhibit 3). Pontikes concluded:
[Finally,] it is important for you, our stockholders, to understand completely that
Comdisco is stronger ¬nancially than it has ever been; that we have greater op-
portunities before us than at any time in our history; and that management is ded-
icated to retaining stockholder con¬dence and enhancing stockholder wealth.
Shortly after the above developments, Comdisco released its annual report for ¬scal
1983 (Exhibit 4).


QUESTIONS
1. Evaluate Barron™s criticism of Comdisco™s accounting and the company™s response.
Do you agree with the company or Barron™s?
2. Compare the level of disclosure in Comdisco™s annual reports in the (A) and (B) cases.
Do you think the company™s poor disclosure prior to 1983 made it vulnerable to the
attack by Barron™s? Would the market reaction to the Barron™s article have been dif-
ferent if the company had a better disclosure policy?
3. Do you think Comdisco™s stock in November 1983 was a “buy”?
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Case: Comdisco, Inc. (B)




105
Part 4 Additional Cases




EXHIBIT 1
Movement of Comdisco™s Stock Price and S&P 500 Index, January 1982“November
1983

450


400


350


300




Comdisco (B)
250


200


150


100


50
Jan.
Jan. Nov.
1983
1982 1983


Comdisco's Stock S&P 500 Index
836 Case: Comdisco, Inc. (B)




106 Part 4 Additional Cases




EXHIBIT 2
“Something Doesn™t Compute”A Hard Look at Comdisco Accounting Practices”3

Rhonda Brammer, Barron™s, October 10, 1983

Twenty years ago, Ken Pontikes sold computer First, sources close to the IRS say that computer-leas-
tapes and tab cards for IBM. He was paid $5,000 a ing tax shelters are the object of wrathful scrutiny
year. When he lit out on his own ¬ve years later” these days. The very guidelines around which Com-
starting up a one-man brokerage business in com- disco structures deals are being rewritten.
puters”his whole idea, he says “was to make a nice Second, IBM is moving into territory where
living.” That start-up operation today is Chicago- Comdisco had been undisputed king. The IBM
based Comdisco, the biggest computer leasing Credit Corp. is pushing its way into third-party leas-
company in the country. And yes, the 43-year-old ing with partners none other than Merrill Lynch and
Comdisco (B)




Pontikes is making a living. His compensation was Metropolitan Life Insurance. By next year, say indus-
$2.4 million last year. So far this year, he™s reported try observers, the Armonk giant will rank No. 1. And
stock sales of $2.6 million. And his stake in the com- with its enormous supplies of cheap capital, IBM
pany, at the current market price, is worth $200 mil- already is offering surprisingly aggressive rates. This
lion plus. ominous trend threatens to put an increasing
His company could now be ranked an old-timer squeeze on the pro¬t margins of computer leasing
in the volatile computer leasing business, but its out¬ts like Comdisco. To compete they may well
meteoric stock market rise is a recent phenomenon. have no choice but to take calculated”and danger-
In 1977, for example, shares could be had for a ous”¬nancial risks.
fraction of a dollar. As late as 1982, investors could Finally, there™s some controversial accounting.
have bought the stock under 7. Those same shares Comdisco™s method of accounting for “fees” from
now sell at 38, just four points shy of their all-time tax-advantaged leases is a matter unresolved by the
high. accounting profession”and a potentially explosive
The spectacular rise in the stock re¬‚ects the issue. Right now, Comdisco has signi¬cant latitude
transformation of the company itself, from a com- in the level of pro¬ts it reports and the amount of
puter brokerage business”one that basically residual values it carries on the balance sheet. The
matched up computer buyers and sellers for a fee” details are complex, but essentially Comdisco often
into a complex ¬nancial service operation. Today, records what it calls “fees” from tax-advantaged
Comdisco not only buys and leases computers, but transactions as straight pro¬t”without offsetting
also re-sells the leased equipment in intricately such “fees” against the company™s investment in the
structured tax shelters. The marketing men of a equipment. It thereby keeps on its books a signi¬-
decade ago have been joined by a cadre of lawyers cant investment, recorded in “leased computer
and accountants”tough, shrewd professionals, equipment” or “net investment in sales and direct
paid handsomely to keep one step ahead of the IRS. ¬nancing leases””an investment it hopes to recoup
It™s a new emphasis that has done wonders for the from the residual value when the equipment is re-
bottom line. Since 1980, sales have almost dou- leased.
bled, hitting $472 million in the 1982 ¬scal year And if there are no residual values when the
ended September. More important”thanks to the equipment comes off lease? Well, based on infor-
tax shelters”over the like stretch earnings expanded mation supplied by the company™s ¬nancial depart-
more than fourfold, to $29 million. ment, if all equipment was considered to have zero
But past is not necessarily prologue. And Com- residual value, Comdisco™s entire net worth, as of
disco may be running into trouble on several fronts. the end of ¬scal 1982, would vanish.
..................................................................................................................................................
3. Reprinted by permission of Barron™s . Copyright © by Dow Jones & Company, Inc. All rights reserved. (Abridged by case writer.)
837
Case: Comdisco, Inc. (B)




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Part 4 Additional Cases




Obviously, the way residual values are treated Comdisco ¬nds a user who wants to lease a
affects earnings, too. When Comdisco reasons that computer for say, ¬ve years, and buys a machine for
it will recoup its net investment after the equipment $100. Comdisco then takes the lease to the bank,
is released, it books the “fee” from the sale of the and borrows the discounted value of the payments.
tax shelter as pure pro¬t. If, instead, it subtracted its A typical present value for the lease payments might
investment in equipment from this fee”recovered be $85.
the investment and took it off the balance sheet” This borrowing from the bank appears on
earnings would be a mere fraction of the substantial Comdisco™s balance sheet as “discounted lease
sums currently reported. rentals,” but the contract is so structured that the risk
This method of accounting is thus disturbing on is essentially transferred to the bank. “These are
several scores. First, it™s possible the residual values hell-or-high water agreements,” insists one Com-
simply aren™t there. Comdisco insists its assumptions disco executive. If anything goes wrong”if the user
are conservative”and they may well be”but all fails to make his payments”all the bank can do is
leasing companies have made such assertions, even con¬scate the equipment. It has no recourse to




Comdisco (B)
the defunct ones. If there™s a miscalculation, and the Comdisco. So at this point, Comdisco™s investment
equipment should come off lease and suddenly be has effectively been reduced from $100 to $15.
worthless, that means Comdisco would face a write- Then comes the “tax advantaged” part of the
off. deal. Comdisco sells the computer to an investor
Not to be overlooked, either, is the matter of who is looking for a tax shelter. And here things start
when pro¬ts are recognized by Comdisco. Why to get tricky.
should a company be allowed to report earnings Comdisco collects, say, $17 in cash, from the
today when it won™t see the cash for four or ¬ve investor and then agrees to take a seven-year note
years, if ever? And ¬nally, at the very least, ¬nancial for the remaining $83 of the purchase price of the
statements might reasonably be expected to disclose equipment. At the same time, it signs a seven-year
net investment and assumed residual values, as well leaseback with the investor, so the rental payments
as detailed descriptions of how “fees” are booked. the investor gets are spread over seven years. It™s
None of this, however, is to say that Comdisco™s neatly arranged so the rental payments of this lease-
accounting breaks the rules. Quite the contrary. back are precisely enough to cover the payments on
“The accounting profession hasn™t addressed the the seven-year note. Put another way, Comdisco
issue on this type of transaction,” John Vosicky, pays the investor rent, and the investor turns right
Comdisco™s vice president of accounting and ¬nan- around and pays this rent back to Comdisco as
cial controls, correctly points out. “One could argue interest and principal on the note. It™s a wash”a
that you could take the entire fee into income right paper transaction. It™s a nifty tax deal that has no
away”on everything. Another could argue you effect on the actual user of the equipment, who con-

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