CTON Second Street Capital Inc (PK)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2007 AND 2006

1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NATURE OF BUSINESSES

Calton, Inc. ("Calton" or the "Company") was incorporated in the State of New Jersey in 1981. The Company is engaged in constructing single family homes through Homes by Calton, LLC ("Homes by Calton") and the continued development of a loyalty and co-branded credit card program through PrivilegeONE Networks, LLC ("PrivilegeONE"). However, there are currently no revenues or expenses being accrued with respect to PrivilegeONE and, as such, the Company currently operates in just one business segment.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

USE OF ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in the accompanying consolidated financial statements.

REVENUE RECOGNITION

Revenues and related profits from homebuilding on the Company's lots are recognized using the deposit method, as defined in Statements on Financial Accounting (SFAS) No. 66. Revenue is recognized when the earning process of constructing and selling the home has been completed as follows:

o The Company recognizes revenue at the time of closing and title transfer. Prior to closing, the customer performs walkthroughs of the home and any other procedures that they consider necessary to accept the home. The Company attempts to remedy any issues with its customers prior to closing.
o In all instances, the buyer's commitment to repay financing obtained to purchase the property is between the buyer and the buyer's lender. The Company does not provide customer financing and there is no recourse against the Company for non-payment by the buyers.
o The risks and rewards of ownership of the home pass to the customer at closing and the Company has no substantial continuing involvement with the property.

In addition, the Company recognizes revenue from fixed price and modified fixed price construction contracts for homebuilding on customer-owned lots based on the percentage-of-completion method, measured by the percentage of cost incurred to date to estimated total cost for each contract. Contract costs include all direct material and labor costs and those indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs, and depreciation. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined without regard to the percentage of completion. Changes in job performance, job conditions, contract penalty provisions, claims, change orders, and settlements are accounted for as changes in estimates in the current period. Because of the inherent uncertainties in estimating costs, it is at least reasonably possible that the estimates used will change within the near term.

CALTON, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2007 AND 2006

In accordance with SFAS No. 13, Accounting for Leases, the Company defers a portion of its gross profit on the sale-leasebacks of its model homes. The Company will recognize the deferred revenue (the net present value of the lease payments) and deferred cost in equal increments over the term of the lease (deferred gross profit is $58,000 at November 30, 2007 and is included in other current liabilities in the 2007 balance sheet).

CASH AND CASH EQUIVALENTS

Cash equivalents consist of demand deposits and highly liquid money market funds. The Company places its temporary cash investments with high credit quality financial institutions. At times, such investments may be in excess of the FDIC insurance limits. The Company has not experienced any loss to date on these investments.

INVESTMENTS

The Company held certain equity securities which were classified as available-for-sale as defined in SFAS No. 115, and were valued at fair market value. The corresponding unrealized gain on securities held as available-for-sale was recorded as a component of other comprehensive income. During fiscal 2007 all the securities were sold.

INVENTORY

Homebuilding work in process, speculative and model homes and developed land are stated at the lower of cost (including direct construction costs, capitalized interest and real estate taxes) or net realizable value. The capitalized costs are included in cost of homebuilding revenues as homes are sold and customers take title to the home and real estate.

In accordance with SFAS 34, CAPITALIZATION OF INTEREST COSTS, the Company capitalizes interest incurred on lots under development and homes under construction. During the year ended November 30, 2007, approximately $124,000 of interest was capitalized. Capitalization begins when the construction of a home commences, whether it is under contract or being built on a speculative basis. Capitalized interest costs are charged to cost of sales in the period when the revenues from home closings are recognized. Interest costs are expensed on developed, vacant lots and when construction ceases or is completed on speculative homes.

PROPERTY AND EQUIPMENT

Property and equipment are carried at cost. Computer equipment is being depreciated using the straight-line method over a useful life of three years, office furniture is being depreciated using the straight-line method over five years, and leasehold improvements are being depreciated using the straight-line method over the lesser of the asset useful life or the terms of the respective leases, which range from one to five years. Maintenance and repairs are expensed as incurred, while renewals and betterments are capitalized.

IMPAIRMENTS OF LONG-LIVED ASSETS

The Company performs an assessment of the carrying values of property and equipment when indications that the carrying values of such assets may not be recoverable are present. This review consists of a comparison of the carrying value of the assets with expected undiscounted cash flows. If the respective carrying values exceed expected undiscounted cash flows, the impairment is measured using fair value measures to the extent available or discounted cash flows.

CALTON, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2007 AND 2006

DEFERRED FINANCE CHARGES

Deferred finance charges are associated with the Company's current revolving credit agreement (Note 5). Deferred finance charges are amortized over the term of the line of credit. Amortization is reflected as a component of interest expense.

INCOME TAXES

The Company records deferred taxes based on temporary differences between the tax bases of the Company's assets and liabilities and their financial reporting bases. A valuation allowance is established when it is more likely than not that some or all of the deferred tax assets will not be realized. Income tax expense is the tax payable for the period and the change during the period in deferred tax assets and liabilities.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company's financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and other liabilities and notes payable. At November 30, 2007, the fair value of these instruments approximated their carrying value.

ADVERTISING EXPENSE

The costs of advertising are expensed as incurred. Included in selling, general and administrative expenses are advertising costs of approximately $306,000 and $430,000 for the years ended November 30, 2007 and 2006, respectively.

 2007 2006
 ----------- -----------

Net loss - [numerator] $(1,043,000) $(1,406,000)
 =========== ===========

Basic and diluted:
 Weighted average shares outstanding
 [denominator] 9,667,000 9,528,000
 =========== ===========

Net loss per common share $ (0.11) $ (0.15)
 ==========================

The effects of 827,000 and 717,000 stock options outstanding at November 30, 2007 and 2006, respectively, were not included in the calculation of diluted loss per share for each of those years, as they were anti-dilutive pursuant to the treasury stock method.

CALTON, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2007 AND 2006

STOCK-BASED COMPENSATION

In December 2005, the Company adopted the accounting provisions of Statement of Financial Accounting Standards No. 123R - Share-based Payments (FAS 123R) which required the use of the fair-value based method to determine compensation for all arrangements under which employees and others received shares of stock or equity instruments (warrants and options). The adoption of this standard had a minimal impact on the Company's results of operations for the fiscal year ended November 30, 2007.

The Company uses the Black-Scholes option-pricing model to determine the fair value of each option grant as of the date of grant for expense incurred. In applying the Black-Scholes option-pricing model during fiscal 2007, the following assumptions were made: dividend yield - none, volatility ranging from 114% to 183%, risk-free interest rate ranging from 4.60% to 4.64%, share prices of $0.21, option exercise prices of $0.21 and $0.23, and an expected life ranging from 3.0 to 6.5 years (based upon the simplified method).

The Company recorded stock-based compensation expense of $17,000 in the year ended November 30, 2007, related to employee and director stock options. The Company recorded stock-based compensation expense of $7,000 in the year ended November 30, 2006, related to director stock options.

RECENT ACCOUNTING PRONOUNCEMENTS

FASB STATEMENT NO. 159, THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND
FINANCIAL LIABILITIES, INCLUDING AN AMENDMENT OF FASB STATEMENT NO. 115

In February 2007, the FASB issued statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115" ("FAS 159"). FAS 159 permits entities to choose to measure many financial instruments and certain other items as fair value that are not currently required to be measured at fair value. FAS 159 is effective for fiscal years beginning after November 15, 2007. Management does not expect the adoption of FAS 159 to have a material effect on the Company's financial position or results of operations.

2. LIQUIDITY AND MANAGEMENT'S PLANS

The Company's consolidated financial statements are prepared on a going concern basis, which assumes that the Company will realize its assets and discharge its liabilities in the normal course of business. As reflected in the financial statements, the Company has incurred net losses in each of the last two years. Additionally, the Company has significant completed and work-in-process inventories of approximately $2.5 million and developed lots of approximately $0.8 million which are collateral for the credit facility with a $2.2 million balance at November 30, 2007. The Company's $6.5 million credit facility expired on May 31, 2007. On July 16, 2007, the bank extended the facility through December 31, 2007, and on December 7, 2007, extended it through June 30, 2008, each time reducing borrowing availability under the facility. The facility was reduced to $4.8 million in July and further reduced to $2.8 million in December, 2007. In connection with the extensions, the terms of the facility were revised to limit future funding to the completion of existing speculative homes under construction for which a sales contract providing for at least a 10% customer deposit has been signed. Maximum available borrowings are reduced as each of these homes is sold. Amounts outstanding under the credit facility in June 2008 will be due on that date. These conditions raise doubt as to the ability of the Company to continue its normal business operations as a going concern.

Management's plan to sustain the Company's operations includes targeted marketing for new home sales, incentive pricing for current inventory homes, renegotiating pricing with subcontractors, curtailing expenses to the extent

CALTON, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2007 AND 2006

appropriate, seeking further extensions of the terms of the credit facility, and raising additional debt or equity capital from external sources. There can be no assurance that the Company will be successful in achieving these plans.

Land $2,404,000
Homes under construction 1,586,000
Speculative and model homes 871,000
 ----------
 $4,861,000
 ==========

During the year ended November 30, 2006, the company recorded a $677,000 inventory impairment charge. No impairment charges have been recognized during the year ended November 30, 2007. However, negative market conditions in the homebuilding industry, possible fluctuations in interest rates, and the Company's plans to offer sales incentives in order to liquidate inventory could result in further impairment charges during the year ending November 30, 2008, and/or thereafter.

The Company capitalizes interest on loans directly associated with the real estate development projects. During the years ended November 30, 2007 and 2006, the Company capitalized $124,000 and $108,000, respectively.

 Computer equipment and furniture $ 208,000
 Leasehold improvements 5,000
 Other 75,000
 ---------
 288,000
 Less: Accumulated Depreciation (152,000)
 ---------
 $ 136,000
 =========

5. NOTES PAYABLE

As of November 30, 2007, notes payable includes borrowings under a demand line of credit with National City Bank (formerly Harbor Federal Savings Bank) with future funding limited to the completion of existing speculative homes under construction for which a sales contract providing for at least a 10% customer deposit has been signed. On December 7, 2007, the bank reduced available borrowings to $2.8 million and extended the credit facility with the same terms through June 30, 2008. As of November 30, 2007, $2.2 million of advances under the line of credit was outstanding. The credit facility is secured by inventories and related homebuilding assets. Notes payable also includes a $1 million mortgage note due September 1, 2008, that is payable to National City Bank. The mortgage note is secured by the land purchased in the Magnolia Plantation subdivision. The annual interest rate on both the revolving credit line and mortgage note is the bank's prime rate plus 1% (8.5% at November 30, 2007).

CALTON, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2007 AND 2006

6. SHAREHOLDERS' EQUITY ACTIVITY

The Company's Certificate of Incorporation, as amended, provides for 25,000,000 authorized shares of Common Stock (par value $.05 per share), 520,000 shares of Redeemable Convertible Preferred Stock (par value $.10 per share) and 2,000,000 shares of Class A Preferred Stock (par value $.10 per share), 1,000,000 shares of which have been designated as Class A Series One Preferred Stock. None of the Preferred Stock is issued or outstanding.

 2007 2006
 -------------------- --------------------
 Weighted Weighted
 Average Average
 Exercise Exercise
 Options Price Options Price
 -------------------- --------------------

Outstanding
 Beginning of year 717,000 $ 0.45 758,200 $ 0.70
 Granted at market price 305,000 0.22 50,000 0.45
 Expired or cancelled (195,000) 0.53 (91,200) 2.51
 -------------------- --------------------
Outstanding end of year 827,000 $ 0.35 717,000 $ 0.45
 ==================== ====================

 -------------------- --------------------
Exercisable as of November 30 522,000 $ 0.43 667,000 $ 0.45
 ==================== ====================

The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model that uses assumptions for expected volatility, expected dividends, expected term and the risk-free interest rate. Expected volatilities are based on implied volatilities from traded options on the Company's stock, historical volatility of the Company's stock and other factors estimated over the expected term of the options. The expected term of options granted is derived using the "simplified method" which computes expected term as the average of the sum of the vesting term plus contract term. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the period of the expected term.

The weighted average grant date fair value of the options granted during the year ended November 30, 2007 was $0.18. The range of exercise prices for exercisable options and the weighted average remaining lives are reflected in the following table:

 Options Outstanding Exercisable
------------------------------------------------------------------ ----------------------------------------------------
 Weighted Weighted Aggregate Weighted Weighted Aggregate
 Range of Average Average Intrinsic Average Average Intrinsic
 Prices Number Remaining Life Exercise Price Value Number Remaining Life Exercise Price Value
------------- -------- -------------- -------------- -------- ------- -------------- -------------- ---------
$ 0.16 - 0.83 827,000 4.62 yrs. $ 0.35 $ - 522,000 3.28 yrs. $ 0.43 $ -

 Weighted Average
 Grant Date
Nonvested Stock Options Shares Fair Value
----------------------- ---------- ----------

 Nonvested at November 30, 2006 50,000 $ 0.29
 Granted 305,000 0.22
 Vested (50,000) (0.29)
 Forfeited -- --
 ---------- ----------
 Nonvested at November 30, 2007 305,000 $ 0.22
 ========== ==========

As of November 30, 2007 there was approximately $46,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of approximately 45 months.

As of November 30, 2007, there were 646,520 shares of Common Stock reserved for possible future issuances under the Company's stock option plans.

During 2007 and 2006, 306,000 and 96,000 shares, respectively, of treasury stock were issued to directors of the Company in lieu of receiving cash fees. The Company records stock-based compensation associated with the issuance of common stock to directors based upon the fair market value of the shares on the date issued. Compensation expense amounted to $50,000 for each of the years ended November 30, 2007 and 2006, under this method. Treasury stock was relieved using the first-in first-out method of accounting with the difference being recorded as a reduction of paid-in capital. Treasury stock is carried at cost at acquisition date, and at November 30, 2007, there were approximately 800,000 shares of treasury stock with an average cost of $4.47 per share remaining.

PREFERRED STOCK RIGHTS AGREEMENTS

In February 1999, the Company's Board of Directors adopted a shareholder rights plan (the "Rights Plan") and declared a dividend of one preferred stock purchase right (a "Right") for each outstanding share of Common Stock. Under the Rights Plan, each Right represents the right to purchase from the Company one one-hundredth (1/100th) of a share of Class A Preferred Stock Series One (the "Preferred Stock") at a price of $5.50 per one one-hundredth (1/100th) of a share. Each one one-hundredth (1/100th) of a share of Preferred Stock has economic and voting terms equivalent to those of one share of the Company's Common Stock.

The Rights will not become exercisable unless and until, among other things, a person or group acquires or commences a tender offer for 15% or more of the Company's outstanding Common Stock. In the event that a person or group, without Board approval, acquires 15% or more of the outstanding Common Stock, each Right would entitle its holder (other than the person or group) to purchase shares of Preferred Stock having a value equal to twice the exercise price. Also, if the Company is involved in a merger or sells more than 50% of its assets or earning power, each Right will entitle its holder (other than the acquiring person or group) to purchase shares of common stock of the acquiring company having a market value equal to twice the exercise price. If any person or group acquires at least 15%, but less than 50%, of the Company's Common Stock, the Board may, at its option, exchange one share of Common Stock for each Right (other than Rights held by such person or group). The Rights Plan may cause substantial dilution to a person or group that, without prior Board approval, acquires 15% or more of the Company's Common Stock unless the Rights are first redeemed by the Board. The Rights expire on February 1, 2009 and may be

CALTON, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2007 AND 2006

redeemed by the Company at a price of $0.01 per Right. The Company had 9,497,491 preferred stock rights outstanding as of November 30, 2007.

OTHER COMPREHENSIVE INCOME:

Under Statements of Financial Accounting Standards No. 130 (SFAS 130), Reporting Comprehensive Income, the Company is required to display comprehensive income and its components as part of its full set of financial statements. Comprehensive income comprises net income and other comprehensive income items. Other comprehensive income during the years ended November 30, 2007 and 2006 represents the changes in unrealized gains (losses) on available-for-sale equity securities. These securities were all sold in fiscal 2007. The following table reflects comprehensive income for the years ended November 30, 2007 and 2006:

 2007 2006
 ----------- -----------

 Net loss $(1,043,000) $(1,406,000)
 Unrealized gain on investments 38,000 61,000
 Realized gain on sale of investments (154,000) --
 ----------- -----------
 Comprehensive loss $(1,159,000) $(1,345,000)
 =========== ===========

7. INCOME TAXES

The federal net operating loss carryforward for tax purposes is approximately $34,808,000 and $33,411,000 at November 30, 2007 and 2006, respectively. The Company's ability to utilize its deferred tax assets, including the federal net operating loss carryforwards created prior to November 21, 1995 to offset future income, is limited to approximately $1,000,000 per year under Section 382 of the Internal Revenue Code as a result of the change in control of the Company in November 1995. These federal carryforwards will expire between 2007 and 2027.

The following schedule reconciles the income tax benefit at the federal statutory rate (35%) to the effective rate:

 2007 2006
 -------------------------

Tax benefit using statutory rate $ (368,000) $ (489,000)
Change in valuation allowance 368,000 489,000
 -------------------------
 $ -- $ --
 =========================

Net operating losses $ 13,626,000
Asset impairment charges 177,000
Capital loss carryforwards --
Investment impairment charges 263,000
Unamortized start up costs --
Bad debt and other allowances 7,000
Other 54,000
 -------------------
 Deferred tax assets 14,127,000
Less: Valuation allowances (14,127,000)
 -------------------
Net deferred taxes $ --
 ===================

In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48 ("FIN 48"), ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES, AN INTERPRETATION OF FASB STATEMENT NO. 109. FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 applies to all tax positions related to income taxes subject to SFAS 109, ACCOUNTING FOR INCOME TAXES. Differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption should be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. FIN 48 is effective for fiscal years beginning after December 15, 2006 and was required to be adopted by the Company on December 1, 2007. The Company does not believe the adoption of FIN 48 will have a material impact on its financial statements.

8. RELATED PARTY TRANSACTIONS

In November 2007, Homes by Calton entered into a contract and completed the sale of two homes in its Pointe West development to AFP Enterprises, Inc. ("AFP"), a company owned by the Caldarone family, including two corporate officers of the Company, Anthony J. Caldarone and Maria F. Caldarone. The contract prices for the homes were $617,000 and $629,000, respectively. Costs for the homes totaled $562,000 and $584,000, respectively. All funds have been paid to the Company in full as of November 30, 2007. Homes by Calton has also entered into a sale-leaseback agreement with AFP for one of these homes to be used as a sales model on a month-to-month basis, at a cost of $2,000 per month. The transactions between Homes by Calton and AFP were reviewed and approved by the Company's Board of Directors and the Audit Committee of the Board of Directors.

9. DISCONTINUED OPERATIONS

On July 31, 2006, the Company completed the sale of substantially all of the assets of eCalton.com, Inc. to Bray Web Development, Inc. for $250,000 less purchase price adjustments of approximately $41,000.

 Net revenues $ 509,000
 Cost of goods sold 277,000
 ------------
 Gross profit 232,000

 Operating expense (307,000)
 Non-operating expense, net (9,000)
 ------------
 Loss from discontinued operations (84,000)
 Gain on sale of assets 229,000
 ------------
 Income from discontinued operations $ 145,000
 ============

10. COMMITMENTS AND CONTINGENT LIABILITIES

 WARRANTY COMMITMENTS ON HOMES BY CALTON

The Company provides a basic limited warranty on workmanship and materials for all homes for a period of one year. The Company estimates the costs that may be incurred under its basic limited warranty and records a liability in the amount of such costs at the time the product revenue is recognized. Factors that affect the Company's warranty liability include the number of homes sold, historical and anticipated rates of warranty claims and average cost per claim. Estimated future warranty costs are charged to cost of sales in the period when the revenues from home closings are recognized. Such estimated warranty costs are 0.5% of the total sales price of the home. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amount as necessary.

Following is the Company's warranty reserve activity for the years ended November 30, 2007 and 2006:

 2007 2006
 -------- --------
Balance at beginning of period $ 33,000 $ 59,000
Reserves 26,000 39,000
Payments and other adjustments (37,000) (65,000)
 -------- --------
Balance at end of period $ 22,000 $ 33,000
 ======== ========

Warranty reserves are included in accrued expenses in the accompanying consolidated balance sheet.

2008 $ 110,000
2009 46,000
 -------------
Total $ 156,000
 ==============

CALTON, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED NOVEMBER 30, 2007 AND 2006

Rent expense for continuing operations for the years ended November 30, 2007 and 2006 amounted to $100,000 and $70,000, respectively.

PROFIT SHARING ARRANGEMENT

The Company has entered into an arrangement with John G. Yates and Thomas C. Corley, who are the President and Chief Financial Officer of PrivilegeONE, respectively, pursuant to which Mr. Yates and Mr. Corley have agreed to serve as unpaid officers of PrivilegeONE and pursue business opportunities on behalf of PrivilegeONE in consideration of the Company's agreement to pay them 25% of the net profit attributable to business arrangements with parties introduced by either of them to PrivilegeONE. There were no revenues derived from PrivilegeONE in fiscal years 2007 and 2006.

LITIGATION

The Company is involved from time to time in litigation arising in the ordinary course of business, none of which is expected to have a material adverse effect on the Company's financial position or results of operations.

There were no litigation settlements recorded for the year ended November 30, 2007. The Company paid $15,000 in litigation settlements as a result of the resolution of certain matters in the year ended November 30, 2006.

CALTON, INC. AND SUBSIDIARIES