Clarence Company is a building contractor. Like all companies in
the construction industry, there are some doubts about the
collectability of its accounts receivable.
Fiscal year. Clarence Company’s fiscal year end is December 31
(12/31). The accounting year just ended for Clarence Company is
the fiscal year ending December 31, 2008 (12/31/08).
Retained earnings, pretax financial income, tax rates.
Clarence’s retained earnings on January 1, 2008 was $4,000,000
and its tax rate for all past fiscal years, including 2008, is 30%. The
tax laws have changed and Clarence’s tax rate for all years after
2008 will be 40%. Clarence’s pretax financial income (i.e.,
accounting income before tax) is $2.2 million for fiscal 2008.
Prior to 2008, Clarence never had any temporary or permanent
differences between pretax financial income and taxable income
(in other words, pretax financial income and taxable income
always were the same prior to 2008).
Investments. Clarence’s Chief Financial Officer loves to invest, so
he uses Clarence’s money to invest in shares of other companies’
stock. On 1/1/2007, Clarence purchased 1,000 shares of Llama
Corporation. During fiscal 2008, Clarence purchased 1,000 shares
of Goat Corporation. The Llama shares were purchased for $10.50
per share and the Goat shares were purchased for $7.20 per share.
At the end of fiscal 2007, the fair market value of Llama was
$10.90/share. At the end of fiscal 2008, the shares of Llama and
Goat were worth $10.50 and $7.20 per share, respectively. Llama
Corporation declared and paid cash dividends of $0.75 per share in
both 2007 and 2008; Goat Corporation declared and paid a cash
dividend of $0.50 per share in fiscal 2008.
Clarence’s share of Llama’s stockholders’ equity at the date of
purchase was 10,000, with the entire difference between cost and
book value attributable to equipment with a remaining useful life
of five years (Llama uses straight-line for all depreciation and
amortization). Llama’s total net income was $3,000 in 2007 and
$3,500 in 2008.
6% Bonds. On July 1, 2007, Clarence issued 800 bonds. The
bonds are 6% stated (face, coupon) rate, 10-year, non-convertible,
callable bonds (each bond has a face value of $1,000 and they were
issued at 107.7214). The bonds pay interest annually on July 1.
The bond issue price was based on an effective interest rate of 5%.
The bonds are callable anytime at 96 plus accrued interest.
5.5% Convertible bonds. In 2005, Clarence issued, at face value,
$1,000,000 of 5.5%, 8-year, convertible, non-callable bonds (that
is, it issued 1,000 bonds that each have a face value of $1,000).
Each bond can be converted anytime by the bondholder into 24
shares of common stock. The bonds were issued on January 1,
2005 and pay interest annually on January 1.
The effective interest method is used to amortize all bond
discount or premium.
Common Stock. On 1/1/08, there were 900,000 shares of $1 par
value common stock authorized and 360,000 shares issued and
outstanding. The 360,000 shares were originally issued on August
12, 2001 for $32 per share. Consequently, the balance in the paidin capital from common stock account on 1/1/08 totals
$11,160,000. The market price of Clarence’s stock typically
fluctuates quite a bit. The next page contains detailed information
about Clarence’s common stock price.
8% Convertible, cumulative, non-participating, Preferred
Stock. There are 850 shares of $1,000 par, 8% preferred stock
issued and outstanding. The preferred stock is cumulative and nonparticipating. Each share of preferred stock is convertible into four
(4) shares of common stock. The preferred stock was issued at par
in 1995. Preferred stock dividends were last declared and paid in
Treasury Stock. Clarence purchased 40,000 shares of treasury
stock on 4/1/08 for $32 per share and reissued 20,000 of these
shares on 9/1/08 for $37 per share. Clarence uses the cost method
to account for treasury stock transactions.
Cookies or peanuts? Clarence’s CFO was on an airplane last
week visiting the PCAOB and the flight attendants were asking if
the passengers would like cookies or peanuts. Not one person
asked “what kind of cookies?” People need to be more curious.
Stock options as compensation. On November 1, 2007, Clarence
announced that it planned to implement a compensatory stock
option plan—the company would distribute 40,000 options, each
of which allows the holder to purchase a share of stock for $40.
Only employees in management would be eligible.
On December 1, 2007, the company distributed the 40,000 options
as planned. The employees eligible for the plan must work for the
company until December 1, 2010, at which time the options can be
exercised—all eligible employees are expected to remain with the
company until they earn the options. As of December 1, 2007, the
company forecasts that the market price per share will be $64 on
December 1, 2010. The options expire on June 30, 2011.
Using an option pricing model, the company estimates that each
option was worth $19 on November 1, 2007, $21 on December 1,
2007, and $23 on December 31, 2008. See below for the price of
the common stock on each of those dates.
Stock dividend. On October 1, 2008, Clarence declared a 15%
stock dividend. The dividend was distributed on November 1,
Cash dividend. On December 15, 2008, Clarence declared a total
cash dividend of $500,000 payable to preferred and common
stockholders of record as of December 20, 2008. It will be paid on
December 30, 2008.
Inventory error. The company counted inventory incorrectly as of
12/31/08. As a result, ending inventory for the year ended 12/31/08
was overstated by $4,000.
Accrued wages errors. Clarence forgot to accrue $3,400 of wages
payable as of 12/31/07. All of these wages were paid and expensed
early in fiscal 2008.
Market value per share of common stock at the end
of fiscal 2007, throughout Fiscal 2008, and for
January 1, 2009:
Nov 1 2007 $33
Dec 1 2007 $34
Dec 31, 2007
Jan 1 2008 $35
Feb 1 2008 $37
Mar 1 2008 $42
April 1 2008 $32
May 1 2008 $34
June 1 2008 $45
July 1 2008 $40
Aug 1 2008 $41
Sept 1 2008 $39
Oct 1 2008 $29
Nov 1 2008 $31
Dec 1 2008 $37
Dec 31 2008 $55
Average for fiscal 2008 $41
Jan 1 2009 $55
10. HW5 – 6 pointsAssume that the two treasury stock transactions
that occurred in the year ended
12/31/08 are the only treasury stock transactions that Clarence has
What is the effect of the two treasury stock transactions on total
stockholders’ equity? You must indicate increase, decrease, or no
effect and, if increase or decrease, provide a dollar amount.
What is the balance in the paid-in capital-treasury stock account as
i. How would your answer to part b differ if, in addition to the
other two treasury stock transactions, 10,000 treasury shares were
reissued on 7/2/08 for $29 per share? You must indicate higher,
lower, or no difference and, if higher or lower, provide a dollar
c. What is the net effect of the two treasury stock transactions on
cash flows for the year ended 12/31/08 (ignore the hypothetical
transaction in part b(i)). Provide a dollar amount and, if the amount
is not zero, indicate whether it is a cash inflow or outflow and
whether it would appear as an operating, investing, or financing
activity in the cash flow statement?
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Restricted Stock: quickly replacing options as share-based compensation
method of choice