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On December 30th, Terrys management completed negotiations with one of their suppliers to cover Terrys $28,000 account with shares of Terrys common stock. Rather than issue additional shares (and deal with the requirements of the SEC), Terry issued the supplier 7,200 shares of the treasury stock originally purchased on November 15, Year 3.

As a relatively new public corporation, Terry still has several large investors that hold seats on its Board and have significant control over the companys decisions. These investors have expressed concern with the companys new Indirect Method Statement of Cash Flows and have asked the management team to switch to a Direct Method Statement with the required Schedule to Reconcile Net Income to Cash Provided from Operations. Because of the influence of these investors, Terrys management team has no choice but to agree with their request (although, they arent thrilled with the extra work this change will cause). They have asked you to convert the current Statement of Cash Flows into a Direct Method version. The management team has decided to condense the line items used in the CFO section to include only seven (7) lines: Customers, Inventory, Selling Expenses, Administrative Expenses, Rent, Interest, and Taxes.

In addition, they would like to know the effect of their contract with the supplier, if any, on the following ratios:

Debt to Equity Current Ratio ROE

Assignment:

Calculations

1. Calculate each of the three (3) ratios before you make any adjustments.

2. Make the appropriate journal entries to correctly record the payment on A/P with treasury stock.

3. Make the appropriate journal entry, if any, to correctly record the tax effect of the payment on account.

4. Make any necessary changes to the Income Statement and Balance Sheet, then create a new Direct Method Statement of Cash Flows for Terry. Don't forget the reconciliation required in the footnotes!

5. Calculate the three (3) ratios after you make any adjustments. Acct 331 - Page 12

Critical Thinking

6. What do you think Terrys creditors (i.e. bank and bond holder) reaction will be to using treasury stock to settle A/P? 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 decision? Why or why not?

7. The CFO is concerned with the CEOs decision to issue stock to repay this debt. He feels it is inappropriate to dilute the control of their current owners by issuing stock without giving them any opportunity to retain their control (i.e. by buying up a percentage of the newly reissued shares). Provide two (2) arguments that the CFO could use to convince the CEO that they should repay the debt with cash instead of stock.

Hints:

1. Remember that Terry keeps separate accounts for all of its Additional Paid in Capital, but that it combines all of those accounts for reporting purposes. In other words, you should have a specific Add PIC account in your journal entry, but not add a new line to the Balance Sheet.

2. Think carefully about the tax effects of this adjustment. Remember that in most cases taxes only change if net income changes.

3. As you start preparing the new Statement Cash Flows, keep in mind that not only will the Cash Flows from Investing and Cash Flows from Financing section stay exactly the same as they were in the last Terry, but you already have all of the necessary adjustments calculated for the Cash Flows from Operating Activities section. Remember, it balances using the numbers from the last Terry! All you need to do is match those adjustments up with the accrual numbers to get the cash flows numbers, using the worksheet for CFO we studied in Step 3 of creating the Statement of Cash Flows. Remember, use ALL of the adjustments listed in the last Terry with their EXACT numbers and your new Direct Method Statement of Cash Flows will balance perfectly!

4. Cash Paid for Selling Expenses should be the sum of the cash flows for advertising, miscellaneous selling expenses, sales for salaries, selling commissions, and shipping. Cash Paid for Administrative Expenses should be the sum of the cash flows for executive salaries, pensions, insurance, miscellaneous administrative expenses, office supplies, R&D, and utilities.

5. You only need to recognize one (1) non-cash transaction, and that is the entry that you made for this Terry.

6. Note that you will NOT have to change Terrys EPS calculations, just the number of shares outstanding at the end of the year.

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