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Norman Corporation (A)
Author(s):
Anthony, Robert N.
Functional Area(s):
   Financial Accounting
Setting(s):
   For Profit
Difficulty Level: Intermediate
Pages: 3
Teaching Note: Available. 
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First Page and the Assignment Questions:

Until 2004, 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 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 2004 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 2005. 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 2004 plant maintenance expenditures were $44,000. Normally, plant maintenance expense was about $60,000 a year, and $60,000 had indeed been budgeted for 2004. Management decided, however, to economize in 2004, 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 non-current liability.
  4. In early January 2004 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 . . .

Assignment

  1. How should each of the previous seven items be reported in the 2004 income statement and balance sheet?
  2. (Optional—requires knowledge of the concept of Present Value.) 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?