CASE 8–1 Norman Corporation (A)*

Until 1998, Norman Corporation, a young manufacturer of specialty consumer products, had not
had its financial statements audited. It had, however, relied on the auditing firm of Kline &
Burrows to prepare its income tax returns. Because it was considering borrowing on a long-term
note and the lender surely would require audited statements, Norman decided to have its 1998
financial statements attested by Kline & Burrows. Kline & Burrows assigned Jennifer Warshaw
to do preliminary work on the engagement, under the direction of Allen Burrows. Norman’s
financial vice president had prepared the preliminary financial statements shown in Exhibit 1. In
examining the information on which these financial statements were based, Ms. Warshaw
discovered the facts listed below. She referred these to Mr. Burrows.

1. In 1998 a group of female employees sued the company, asserting that their salaries were
unjustifiably lower than salaries of men doing comparable work. They asked for back pay
of $250,000. A large number of similar suits had been filed in other companies, but
results were extremely varied. Norman’s outside counsel thought that the company
probably would win the suit but pointed out that the decisions thus far were divided, and
it was difficult to forecast the outcome. In any event, it was unlikely that the suit would
come to trial in 1999. No provision for this loss had been made in the financial
statements.

2. The company had a second lawsuit outstanding. It involved a customer who was injured
by one of the company’s products. The customer asked for $500,000 damages. Based on
discussions with the customer’s attorney, Norman’s attorney believed that the suit
probably could be settled for $50,000. There was no guarantee of this, of course. On the
other hand, if the suit went to trial, Norman might win it. Norman did not carry product
liability insurance. Norman reported $50,000 as a Reserve for Contingencies, with a
corresponding debit to Retained Earnings.

3. In 1998 plant maintenance expenditures were $44,000. Normally, plant maintenance

expense was about $60,000 a year, and $60,000 had indeed been budgeted for 1998.
Management decided, however, to economize in 1998, even though it was recognized
that the amount would probably have to be made up in future years. In view of this, the
estimated income statement included an item of $60,000 for plant maintenance expense,
with an offsetting credit of $16,000 to a reserve account included as a noncurrent
liability.

4. In early January 1998 the company issued a 5 percent $100,000 bond to one of its
stockholders in return for $80,000 cash. The discount of $20,000 arose because the 5
percent interest rate was below the going interest rate at the time; the stockholder thought
that this arrangement provided a personal income tax advantage as compared with an
$80,000 bond at the market rate of interest. The company included the $20,000 discount
as one of the components of the asset “other deferred charges” on the balance sheet and
included the $100,000 as a noncurrent liability. When questioned about this treatment,
the financial vice president said, “I know that other companies may record such a
 transaction differently, but after all we do owe $100,000. And anyway, what does it
matter where the discount appears?”

5. The $20,000 bond discount was reduced by $784 in 1998, and Ms. Warshaw calculated
that this was the correct amount of amortization. However, the $784 was included as an
item of nonoperating expense on the income statement, rather than being charged directly
to Retained Earnings.

6. In connection with the issuance of the $100,000 bond, the company had incurred legal
fees amounting to $500. These costs were included in nonoperating expenses in the
income statement because, according to the financial vice president, “issuing bonds is an
unusual financial transaction for us, not a routine operating transaction.”

7. On January 2, 1998, the company had leased a new Lincoln Town Car, valued at
$35,000, to be used for various official company purposes. After three years of $13,581
annual year-end lease payments, title to the car would pass to Norman, which expected to
use the car through at least year-end 2002. The $13,581 lease payment for 1998 was
included in operating expenses in the income statement.

Although Mr. Burrows recognized that some of these transactions might affect the
provision for income taxes, he decided not to consider the possible tax implications until
after he had thought through the appropriate financial accounting treatment.

Questions

1. How should each of the above seven items be reported in the 1998 income statement
and balance sheet?

2. (Optional—requires knowledge of Appendix material.) The bond described in item 4

above has a 15-year maturity date. What is the yield rate to the investor who paid
$80,000 for this bond? Is the $784 discount amortization cited in item 5 indeed the
correct first-year amount? (Assume that the $5,000 annual interest payment is made
in a lump sum at year-end.)

3. (Optional) If the lease in item 7 is determined to be a capital lease, what is its

effective interest rate?
Answers

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 estimate is available,
so no amount should be recorded. The existence of the suit should be disclosed in a note
to financial statement.

2. The lawsuit differs from the one above in that the lawyers are able to make an estimated
loss. The 50,000 should be shown as an expense (rather than debit directly to Retained
Earnings), with a resulting 20,000 (from 40%) decrease in income taxes. In any event,
showing “Reserve for Contingencies” in the owner’s equity section of the balance sheet
is no longer acceptable practice; the credit should be to Estimated Loss from Lawsuit
or Estimated Lawsuit Payable.

3. Future maintenance are no more a liability than are , future salaries or materials
purchases. Norman’s treatment of maintenance is an example of “income smoothing”,
which is not in accordance with generally accepted accounting principles. The expense
charge should be 44,000, increasing Net income and Reserve for Contingencies by
16,000 and reducing non current liabilities by same amount.

4. 20,000 is treated as deferred asset, where the company issued 100,000 bondi in return for
80,000 received from shareholder because bonds are usually issued for less than the
bonds par value at a discount.

5. The $784 should be as non operating expense.

6. There are 2 issues, whether the 500 will be capitalized as deferred charge rather than
expensed, if expensed, whether included as non-operating. Legal cost are recorded as non
operating expense in the income statement worth $500, because of the company policy,
“Issuance of bonds is not a primary purpose”

If the 500 is expensed, it should be in the total for operating assets.

7. This is a capital lease. The $35,000 capital value of the car should have been capitalized
as an asset on January 2, 2010 and 35,000 credit for capital lease obligations. Assuming
7,000 should be charged as depreciation expense in 2010. If the student is been required
to cover the appendix, enough information is given to calculate the interest rate of the
lease which is 8%. Thus, the $13,581 first year payment is divided between $2,800
interest expense. (.08*35,000) and $10,781 reduction of capital lease obligation.