Terry Case: EPS

Information:

On January 1st, Terrys Board of Directors issued the management team 192,060 stock options for Terrys $1 par common stock. Terrys stock price on that day was $7.20/share. The Board set the strike price of the options at $10.50/share to encourage the management team to focus on improving the companys stock price. The average stock price during 2020 was $13.70/share. The options will vest 5 years from issuance and, according to the Black Scholes Model, have a fair value of $9.60 each on the date issued. Terrys management was pleased with the decision because this is the first time that the Board has offered them options as a form of compensation, although they were disappointed that the options could only be used to purchase stock, not redeemed for their fair value.

Later in the year, on December 1 when a market change significantly dropped stock prices, Terrys Board voted to repurchase 437,000 shares of common stock. The stock price on the day of the purchase was $5.00/share. Neither the stock options nor this purchase of treasury stock have been recorded.

Terrys management team has also asked you to determine the correct EPS numbers for the year. Up until the issuance of the options, the company had a simple capital structure. Now, though, the company will need to present both basic and diluted EPS on its Income Statement. In addition, they would like to know the effect of the stock options and additional dividend, if any, on the following ratios:

Debt-to-Equity ROA

Assignment:

Calculations

1. Calculate each of the two (2) ratios before you make any adjustments. (Debit to Equity and ROA)

2. Make the appropriate journal entries to correctly record the stock options and repurchase.

3. Make the appropriate journal entry to correctly record the tax effect of the stock options. Please note that for tax purposes, equity options are treated as long-term deferred tax assets (for the future tax breaks that they will provide). In making your tax calculations, assume that Terrys management will exercise the options as soon as they can (at the end of the year when they vest).

4. Make any necessary changes to the financial statements. Please see the hints about the special adjustment to the Statement of Cash Flows.

5. Calculate the two (2) ratios after you make any adjustments. Calculate the new Basic and Diluted EPS values and report them in your Income Statement.

Critical Thinking

6. What do you think Terrys creditors (i.e. bank and bond holder) reaction will be to the purchase of treasury stock? In other words, based on your changes to the financial statements and the change in the ratios, do you think the creditors will be happy with the purchase? Why or why not?

7. After looking back over the companys book, Terrys controller has become concerned that management purposely provided negative financial information to the market in the weeks before the strike price was set on their new options. What options are available to the controller now that she has discovered this information? Provide at least two (2) consequences for each option.

Hints:

1. Terry uses Executive Salaries Expense to record all of the compensation for the management team. Do NOT create a new account for this new compensation.

2. While Terry does keep separate accounts for all of their Additional Paid-in Capital, they combine all of these amounts on the balance sheet, so you should not add a new account to the B/S for the stock option PIC.

3. You will need to change the note under the Common Stock line in the Balance Sheet to include both the 2019 and 2020 end of year shares outstanding.

4. Dont forget to adjust your Statement of Cash Flows for the purchase of the treasury stock.

5. As with pensions, you have to make a special adjustment in the CFO section of the Statement of Cash Flows; you cant just record the change in Additional PIC (since those are equity accounts). In this case, you can record a Stock Option Compensation line that equals the total change in Executive Salary Expense for these stock options.

6. Dont forget to calculate the weighted average common stock shares outstanding before you calculate the new basic EPS. Also, under GAAP (ASC 260-10-45-28A), employee stock options are included in the diluted EPS calculation, even if they havent yet vested. You treat them just like any other outstanding stock option, only weighting them if they were awarded in the middle of the year.

7. Dont forget that Terrys tax rate will change in 2022.

Please number the questions so it is easy to follow the work. Thank you! There are also hints provided to hopefully make it easier.

Terry Co. Multi-Step Income Statement For the Year Ended December 31, Year 3 $73,245,600 Sales Revenue Sales Revenue Less: Sales Discounts Sales Returns Net Sales Revenue $799,700 $6,361,250 $7,160,950 $66,084,650 Cost of Goods Sold Cost of Goods Sold Gross Profit $40,338,221 $25,746,429 $1,423, 125 $617,950 $354,413 $999,625 $3,635,000 $595,231 $7.625,344 Operating Activities Selling Expenses Advertising Expense Bad Debt Expense Miscellaneous Selling Expenses Sales Force Salaries Expense Selling Commissions Expense Shipping Expense Total Selling Expenses Administrative Expenses Executive Salaries Expense Depreciation & Amortization Expense Insurance Expense Miscellaneous Admin. Expenses Office Supplies Expense R&D Expense Utilities Expense Total Administrative Expenses Income from Operations $3,180,625 $2,181,000 $275,538 $35,896 $281,713 $1,090,500 $545,250 $7,590,522 $15,215,866 $10,530,563 $227,188 $0 ($503,989) ($276,801) $10,542,563 Other Gains and Losses Rent Revenue Net Pension Cost Interest Expense Income from Continuing Operations before Taxes Income Tax Expense Current Taxes Deferred Tax Income Tax Expense Net Income ($2,302,261) ($229,227) ($2,531,487) $7,734,275 EPS Weighted Average # of common shares outstanding $2.66 2,910,000 Year 2 Terry Co. Balance Sheet As of 12/31/Year 3 Year 3 Assets Current Assets Cash $7 281,740 AR $8,543.000 Allowance for Bad Debts ($383,500) Inventory $8.288,000 Prepaid Insurance $545 250 Prepaid Uslities $908.750 Total Current Assets $23,181.240 Long-term Investments Loans to other businesses $2,908 000 Total Long-term Investments $2,908,000 PPE Land $7.997 000 Building $5,816,000 Equipment $20,356,000 Accumulated Depreciation ($9.451,000) Total PPE $24.718,000 Intangible Assets Patents, net $1,090,500 Total Assets $51.897.740 $3,635,000 $8,179,500 ($1.817,500) $10,178,000 $1.090.500 $727,000 $19,992,500 $2,908,000 $2.900.000 $5.089.000 $5,816,000 $9.451,000 (S7270,000) $13,088,000 $1.090,500 $37,077,000 $4.362.000 so $0 $727,000 $0 $1.090,500 $908,750 $383,500 $7.451,750 Liabilities and Stockholders' Equity Current Liabilities Accounts Payable $3,723,134 Dividends Payable $0 Estimated Liab for Coupons $80,000 Income Tax Payable $2,277,089 Interest Payable $43,313 Unearned Revenue $1,301,300 Wages Payable $799,700 Current Portion of Loan Payable $383,500 Total Current Liabilities $8.568,036 Long-term Debt Loan Payable $3,998,500 Deferred Taxes $229 227 Bonds Payable, Net $1.942 453 Notes Payable $10,178,000 Total Long-term Debt $16,348,180 Total Liabilities $24,916.216 Stockholders' Equity Common stock $2,910,000 ($1 par, 5,100,000 authorized, 2,910,000 outstanding) Additional Paid-in capital $2,181,000 Treasury Slock $0 Retained Earnings $28,179,591 Accumulated OCI (54.289,088) Total Stockholders' Equity $28,981,525 Total Liabilities and Stockholder's Equity $51 897 741 $4,382,000 $0 $0 $5.816.000 $10,178,000 $17.629,750 $2,910,000 $2,181,000 $0 $18.645,316 (84289,088) $19.447 250 $37077.000 $7,734 275 Terry Co. Statement of Cash Flows For Year Ended 12/31/Year 3 Cash Flow from Operations Net Income Adjustments: Change in AR ($1.817,500) Change in Inventory $1,912,000 Change in Prepaid Insurance $545 250 Change in Prepaid Rent ($181,750) Depreciation & Amortization $2,181,000 Change in AP ($838,888) Net Pension Contributions $0 Deferred Taxes $229,227 Amortization of Bond Premium ($2,787) Change in Est. Coupon Lib. $80,000 Change in Income Tax Payable $1,550,089 Change in Interest Payable $43,313 Change in Unnarned Revenue $210,800 Change in Wages Payable ($109,050) Net Cash Flow from Operations Cash Flow from Investments Purchase of Land ($2,908,000) Purchase of Equipment ($10.905.000) Net Cash Flow from Investments Cash Flow from Financing Repayment of Loans ($333,500) Issuance of Bonds Payable $1.945,240 Issuance of Notes Payable $4,382,000 Payments of Dividends ($200,000) Net Cash Flow from Financing Net Increase (Decrease) in Cash Cash, January 1, Year 3 Cash, December 31, Year 3 $3,981,726 $11,716,001 ($13,813,000) $5,743,740 $3,646,741 $3,635,000 $7 281.741 Terry Co. Multi-Step Income Statement For the Year Ended December 31, Year 3 $73,245,600 Sales Revenue Sales Revenue Less: Sales Discounts Sales Returns Net Sales Revenue $799,700 $6,361,250 $7,160,950 $66,084,650 Cost of Goods Sold Cost of Goods Sold Gross Profit $40,338,221 $25,746,429 $1,423, 125 $617,950 $354,413 $999,625 $3,635,000 $595,231 $7.625,344 Operating Activities Selling Expenses Advertising Expense Bad Debt Expense Miscellaneous Selling Expenses Sales Force Salaries Expense Selling Commissions Expense Shipping Expense Total Selling Expenses Administrative Expenses Executive Salaries Expense Depreciation & Amortization Expense Insurance Expense Miscellaneous Admin. Expenses Office Supplies Expense R&D Expense Utilities Expense Total Administrative Expenses Income from Operations $3,180,625 $2,181,000 $275,538 $35,896 $281,713 $1,090,500 $545,250 $7,590,522 $15,215,866 $10,530,563 $227,188 $0 ($503,989) ($276,801) $10,542,563 Other Gains and Losses Rent Revenue Net Pension Cost Interest Expense Income from Continuing Operations before Taxes Income Tax Expense Current Taxes Deferred Tax Income Tax Expense Net Income ($2,302,261) ($229,227) ($2,531,487) $7,734,275 EPS Weighted Average # of common shares outstanding $2.66 2,910,000 Year 2 Terry Co. Balance Sheet As of 12/31/Year 3 Year 3 Assets Current Assets Cash $7 281,740 AR $8,543.000 Allowance for Bad Debts ($383,500) Inventory $8.288,000 Prepaid Insurance $545 250 Prepaid Uslities $908.750 Total Current Assets $23,181.240 Long-term Investments Loans to other businesses $2,908 000 Total Long-term Investments $2,908,000 PPE Land $7.997 000 Building $5,816,000 Equipment $20,356,000 Accumulated Depreciation ($9.451,000) Total PPE $24.718,000 Intangible Assets Patents, net $1,090,500 Total Assets $51.897.740 $3,635,000 $8,179,500 ($1.817,500) $10,178,000 $1.090.500 $727,000 $19,992,500 $2,908,000 $2.900.000 $5.089.000 $5,816,000 $9.451,000 (S7270,000) $13,088,000 $1.090,500 $37,077,000 $4.362.000 so $0 $727,000 $0 $1.090,500 $908,750 $383,500 $7.451,750 Liabilities and Stockholders' Equity Current Liabilities Accounts Payable $3,723,134 Dividends Payable $0 Estimated Liab for Coupons $80,000 Income Tax Payable $2,277,089 Interest Payable $43,313 Unearned Revenue $1,301,300 Wages Payable $799,700 Current Portion of Loan Payable $383,500 Total Current Liabilities $8.568,036 Long-term Debt Loan Payable $3,998,500 Deferred Taxes $229 227 Bonds Payable, Net $1.942 453 Notes Payable $10,178,000 Total Long-term Debt $16,348,180 Total Liabilities $24,916.216 Stockholders' Equity Common stock $2,910,000 ($1 par, 5,100,000 authorized, 2,910,000 outstanding) Additional Paid-in capital $2,181,000 Treasury Slock $0 Retained Earnings $28,179,591 Accumulated OCI (54.289,088) Total Stockholders' Equity $28,981,525 Total Liabilities and Stockholder's Equity $51 897 741 $4,382,000 $0 $0 $5.816.000 $10,178,000 $17.629,750 $2,910,000 $2,181,000 $0 $18.645,316 (84289,088) $19.447 250 $37077.000 $7,734 275 Terry Co. Statement of Cash Flows For Year Ended 12/31/Year 3 Cash Flow from Operations Net Income Adjustments: Change in AR ($1.817,500) Change in Inventory $1,912,000 Change in Prepaid Insurance $545 250 Change in Prepaid Rent ($181,750) Depreciation & Amortization $2,181,000 Change in AP ($838,888) Net Pension Contributions $0 Deferred Taxes $229,227 Amortization of Bond Premium ($2,787) Change in Est. Coupon Lib. $80,000 Change in Income Tax Payable $1,550,089 Change in Interest Payable $43,313 Change in Unnarned Revenue $210,800 Change in Wages Payable ($109,050) Net Cash Flow from Operations Cash Flow from Investments Purchase of Land ($2,908,000) Purchase of Equipment ($10.905.000) Net Cash Flow from Investments Cash Flow from Financing Repayment of Loans ($333,500) Issuance of Bonds Payable $1.945,240 Issuance of Notes Payable $4,382,000 Payments of Dividends ($200,000) Net Cash Flow from Financing Net Increase (Decrease) in Cash Cash, January 1, Year 3 Cash, December 31, Year 3 $3,981,726 $11,716,001 ($13,813,000) $5,743,740 $3,646,741 $3,635,000 $7 281.741