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Case 8-1: Norman Corporation (A)* Note: This case has been updated from the Twelfth Edition.

Norman Corporation (A) allows students to practice dealing with various types of liabilities. If students have had little previous experience identifying when future, possible obligations are and are not accounting liabilities, you may wish to begin with a general discussion of the criteria for recording accounting liabilities. Following this, each of the items in Norman Corporation (A) can be discussed. Students should be encouraged to identify what accounting choice they made, to explain why they made this choice including explaining, where appropriate, how the item met or failed to meet the criteria for a liability, and to state the impact of their choice on the financial statements. Answers to Question 1 1. In order to recognize an expense related to this contingency, it must be feasible to make an estimate of at least the minimum amount of loss. In this case, no such estimate is available, so no amount should be recorded. In fact, some will argue that it is not clear that a liability has been incurred. The existence of the suit should be disclosed in a note to the financial statements, however. 2. This lawsuit differs from the one above in that the lawyers are able to make an estimate of the loss. The $50,000 should be shown as an expense (rather than a debit directly to Retained Earnings), with a resulting $20,000 (40 percent) decrease in income taxes. (This may raise the question of the treatment of deferred taxes since this item would not be a tax-deductible expense in 2010; it is for this reason that students are asked not to consider detailed income tax consequences, nor to adjust the balance sheet.) In any event, showing this as a Reserve for Contingencies in the owners equity section of the balance sheet is no longer considered an acceptable practice; the credit should be to Contingent Liabilities or, better, Estimated Loss from Lawsuit. 3. Future maintenance costs are no more a liability than are, say, future salaries or materials purchases. Normans treatment of maintenance is an example of income smoothing, which is not in accordance with generally accepted accounting principles, and which is particularly frowned on by the Financial Accounting Standards Board. The expense charge should be $44,000, increasing net income and Retained Earnings by $16,000 and reducing noncurrent liabilities by the same amount. The bond discount should be subtracted from the related liability, rather than being shown as an asset. The company has, in effect, borrowed only $80,000, but at an effective interest rate that is higher than 5 percent. Not enough information is given to calculate the effective rate; this is part of the optional question if students have been required to read the Appendix. It will not owe the $100,000 until the issue matures, at which time the bond discount will have been amortized, and the liability amount will be $100,000. The method of recording does make a difference because it affects total assets and total liabilities amounts and the debt/equity ratio. It does not affect income. (The stockholders motive for having the transaction arranged in this way probably was the belief that the $20,000 would be taxed at the lower capital gains rate when the issue matured; this belief probably was incorrect.) 4. This transaction was handled correctly. The amortization of bond discount is, in effect, a part of the true interest expense and is shown as an expense on the income statement. The statement about Retained Earnings is a red herring. Most statement users would prefer to have interest expense shown as a separate income statement line item rather than lumped into a broader category. 5. There are two issues here: whether the $500 should have been capitalized as a deferred charge rather than expensed; and, if expensed, whether included as a nonoperating item. While the deferred charge approach in general is the correct one, in this case an exception could probably be made on the ground that the difference between the correct approach and immediate expensing is immaterial. Although at one time the nonoperating income and expenses caption was used to aggregate such things as dividend income and interest expenses, this is no longer the case. APB-9 and APB-30 (discussed in Chapter 10) essentially equate nonoperating items to extraordinary items, for which specific criteria exist. This does not, however, preclude a company from reporting the net amount of financial revenues (e.g., dividend income) and expenses (interest, bank fees) as a line item in the calculation of pretax income from continuing operations. In the condensed income statement given in Exhibit 1, then, if this $500 is expensed, it should be included in the total for operating expenses. 6. From Chapter 8, we know clearly that this is a capital lease, since one criterion that requires capital lease treatment is transfer of title to the lessee at the end of the lease. Thus, the $35,000 value of the car should have been capitalized as an asset on January 2, 2010, and a $35,000 credit for capital lease obligations made. Assuming
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This teaching note was prepared Robert N. Anthony. Copyright Robert N. Anthony.

straight-line depreciation, one-fifth of the asset amount ($7,000) should be charged as depreciation expense in 2010. Note that the depreciation charge is based on useful life, not the lease term or ACRS schedules. If the student has been required to cover the appendix, enough information is given to calculate the interest rate of the lease, which is 8 percent (see below). Thus the $13,581 first-year payment is divided between $2,800 interest expense (.08 * $35,000) and $10,781 reduction of capital lease obligations. Answer to Optional Question 2 We are told to assume that the $100,000 (par value) bond with a 5 percent coupon rate in item 4 of Question 1 involves 15 year-end annual interest payments of $5,000 ($100,000 * 0.05). (The payments are assumed to be annual, at year-end, rather than the more realistic semiannual, so that students not having PV calculators can use the texts appendix tables.) Tables A and B and a rate of 8 percent results in a present value of $5,000 * 8.559 = $42,795 for interest payments plus $100,000 * 0.315 = $31,500, or a total of $74,295; since the investor paid $80,000, the yield rate is less than 8 percent. Trying 6 percent, we get PV = ($5,000 * 9.712) + ($100,000 * 0.417) = $90,260; so we know the yield is between 6 and 8 percent. Using 7 percent and linear interpolation in Tables A and B. we have PV = ($5,000 * 9.135) + ($100,000 * .366) = $82,275. (The mathematically inclined student will realize that linear interpolation for 7.0 percent will result in the average of the two PVs we found for 6 and 8 percent, except for rounding.) I accept 7 percent as a perfectly adequate answer. Those with calculators will come up with 7.23. As for the correctness of the $784 first-year bond discount amortization, the calculation is as follows: Since the bond proceeds were $80,000 and the true yield was 7.23 percent, then Year 1 net interest should be $80,000 * 0.0723 = $5,784. But the stated (cash) interest payment is $5,000; thus the remaining $784 of interest expense is amortization of bond discount. Ms. Fullers calculation was correct. Answer to Optional Question 3 The interest rate is determined by finding the value in Table B equal to $35,000 divided by the annual payments of $13,581 for a period of 3 years ($35,000 divided by $13,581 = 2.577). The interest rate is 8 percent. The amortization schedule: Principal Reduction $10,781 11,643 12,575

Year 1 2 3

Beg. Bal. $35,000 24,219 2,576

Payment $13,581 13,581 13,581 ($1 rounding error)

Interest $2,800 1,938 1,006

I use this schedule to generate journal entries for the lease payment and then show the asset depreciation entries, which are based on the useful life of five years.