Chapter 8-1 Group Report - Norman

FINANCIAL ACCOUNTING CASE 8-1 Norman Corporation (A) Case Analysis I.

TITLE OF THE CASE: Norman Nor man Corporation (A)

II.

BACKGROUND OF THE CASE Until 2010, 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. r eturns. Because it was considering borrowing on a longterm note and the lender surely would require audited statements. Norman decided to have its 2010 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 statements shown in Exhibit Ex hibit 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 2010 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 2011. No provision for this loss had been made in the financial statements. 2.

The company had a second lawsuit outstanding. It invo lved 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 customer’s attorney, Norman’s attorney believed that the suit probably could be settled for $50,000. There was no guarantee for 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 2010 plant maintenance expenditures were $44,000. Normally, plant maintenance expense was about $60,000 a year, and $60,000 had indeed been budgeted for 2010. Management decided, however, to economize in 2010, 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 noncurrent liability.

4.

In early January 2010 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 non current 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 2010, and Ms. Warshaw calculated that this was the correct amount of amortization. However, the $784 was included as an item of  non-operating 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 cost were included in non-operating expense 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, 2010, 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 2014. The $13,581 lease payment for 2010 was included in operating expenses in the income statement. Although Mr. Burrows recognized that some o f 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.

Exhibit 1 Norman Corporation Proposed income statement (condensed) For the Year 2010

Net Sales Cost of Sales

$1,658,130 $1,071,690

Gross Margin Operating Expenses

$586,440 $329,100

Operating Income Nonoperating income and expense (net)

$257,340 $9,360

Pretax income Provision for income taxes

$247,980 $99,300

Net income

$148,680 Proposed Balance Sheet (condensed) As of December 31, 2013 Assets

Current Assets: Cash and short term investments Accounts recievable, gross Less: Allowance for doubtful accounts

$107,026 $262,904 $5,250

$257,654

Inventories Prepaid Expenses

$376,006 $10,814

Total Current assets Plant and equipment, at cost Less: accumulated depreciation

$751,500 $310,996 $139,830

Goodwill Development costs Other deferred Charges Total Assets

$171,166 $101,084 $124,648 $166,878 $1,315,276

Liabilities and Shareholder's Equity

Current Liabilites Non current liabilities

$421,770 $228,704

Total Liabilities Common stock (100,00 shares) Capital Surplus Retained Earnings Reserve for contingencies

$650,474 $100,000 $82,500 $432,302 $50,000

Total Liabilities and shareholder's equity III.

$1,315,276

STATEMENT OF THE PROBLEM 1.

To know how we should consider each 7 events mentioned above in the 2010 income statement and balance sheet.

2.

Assuming that the $5,000 annual interest payment is made in a lump sum at year-end and the bond described in item 4 has a 15-year maturity date. Identify 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 account?

3.

IV.

Give the effective interest rate if t he lease in item 7 is determined t o be a capital lease.

ANALYSIS 1.a No provision for loss had been made in financial statements since the amount of loss is not reasonably estimated. But when surety, for liability occurs then in keeping with the conservatism principle a provision for full $250,000 contingency should be created.

1.b A loss contingency is recognized as a liability since item 2 satisfies both conditions; A. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred.

B. The amount of loss can be reasonably estimated. The discussion with the claimant lawyer, has brought down to the probable liability to $50,000. Hence in keeping with the conservatism principle, Norman is creating a reserve for the claim amount. 1.c The reserve of $16,000 is a non current liability so P&M expenditure of subsequent periods will first be recognized from this reserve and then from the budgeted reserve from that year. As a result we perceive we are reducing the risk by creating the buffer to absorb the extra expenditure over the budgeted amount. 1.d $20,000 is treated as deferred asset, where the company issued $100,000 bond in return for $80,000 received from shareholder (rate of interest is 5%). This is because bonds are

usually issued for less than the bond’s par value at a discount. This is done to account for changes in the rate of return between the time the bond’s coupon rate is decided upon when the bond is actually available to the public. This $20,000 fictitious asset has to be amortized. 1.e Amortization of discount is treated as non-operating charge. Bond issue is not a routine task for Norman Corporation so any cost associated with them should not be treated as operating expense. 1.f

As stated on item 1.e any cost issue associated with bond issue should not be treated as an operating expense and bond charges are recorded as a deferred charge, which is an asset analogous to prepaid expenses. If this accounting method will be followed, it is understating this year profit and overstating next year profit. The net profit for the period will go up, the value of asset will increase and amortization expenditure for subsequent periods will increase.

1.g The company cannot charge the lease payments as operating expense since from the income tax point of view, the lessor can claim tax benefits on the lease payments of the lease asset only if it an operating lease.

2. Yield rate comes with the formula; =Rate(nper,pmt,pv,fv,type,guess) Given are: Nper = 15 years Pmt = -5,000 Pv = 80,000 Fv = -100,000 Type = 0 Yield rate = 7% Amortization; Interest expense = 80,000*.07 = 5,600

Nominal interest = .05* 100,000 = 5,000 Amortization = 5600 – 5000 = 600 Therefore $784 discount amortization cited on item 5 is not the correct first – year amount.

3.

Effective interest Rate: Cost of Car = 35,000 Annual payment = 13,581 =35,000/40,743*100 = 8%

V.

ALTERNATIVE COURSES OF ACTION

VI.

RECOMMENDATION

VII.

CONCLUSION