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Norman Corporation

Group J
Introduction
Norman Corp is a young manufacturer of
specialty consumer products
Until 2006, the financial statements were
never audited
Company was considering to borrow a long-
term note
Hence it decided to have it’s 2006 financial
statements audited by Kline & Burrows
Some questions came up during the
preparation of preliminary financial
statements
Case Analysis
Group of female employees sued the
company alleging injustice in payment
They demanded a back pay of $250,000
Company was again sued by an employee
who was injured by a product of company.
He demanded $500,000 as compensation.
But the company thinks that it can be
settled at $50,000 and they can win this if
this goes on for trial.
They decided to report $50,000 as reserve
for contingencies corresponding debit to
retained earning.
In 2004 plant maintenance expenditure was
$44000.
Normally plant maintenance was about
$60,000 a yr.
$60,000 had indeed been budgeted for
2006.
Income statement of company contains this
$60,000for plant maintenance expenses
with an offsetting credit to reserve account
as a noncurrent liability.

In January 2006 company issued $100000
bond in return of $80,000 to one of its
stakeholder.
Discount of 20000 arose because 5%
interest rate was below the ongoing rate.

Analysis of fact one ..
Only if the company is reasonably certain of
loosing lawsuit and the loss amount can be
reasonably estimated is a liability
recognized. and when a liability is
recognized a provision is created.
According to paragraph 8.4 of AS 4:
 “Events occurring after the balance sheet
date which do not affect the figures stated
in the financial statements would not
normally require disclosure in the financial
statements although they be of such
significance that they may require a
disclosure in the report of the approving
authority to enable users of financial
External is pretty certain that Norman might
win the trial.
Also there is no surety that the trial will take
place 2007, whenever the trial takes place
in the worst case scenario we can make a
reasonable estimate of the loss. Hence
Norman should not create a provision for
this contingency in financial statement of
2006.
But when surety, for liability occurs then in
keeping with the conservatism principle a
provision for full $250,000 contingency
should be created.
For 2006, they have to provide a disclosure
so the same effect in the financial
Analysis of fact 2
The company has no product liability
insurance. This is because they are
reasonably certain of the quality of their
product and if am insurance fund is not
used for a long time and still premium is
paid, it is a sunk cost.
Question is since Norman is reasonably
certain of winning the trial, why should
they go in for creating a reserve.
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
Analysis fact 3
 The company has a budget of $60000 for P&M
maintenance.
 After economizing  Expenditure is 44000 and
16000 is credited to non current liability.
 Two questions
Why is the company economizing?
Why are they creating the reserve?
 As we have one year B/S so we cannot find out the
reason behind economizing.
 The reserve of $16000 is a non current liability so P
& M expenditure of subsequent periods will first be
recognized be 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.
Analysis of fact 4
 The company issued $100,000 bond (debt) in
return for $80,000 received from shareholder.
The rate of interest is 5% (which is lower than
the market rate) for which $20,000 discount
has been given
 $20,000 is treated as deferred asset. The
company is giving this discount because:
1.It does not have enough cash to pay market rate
of interest
2.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 and when the bond is actually
From stockholder point of view, this is more
beneficial because he can get tax benefit
on entire $100,000 instead of $80,000
This $20,000 fictitious asset has to be
amortized
Analysis of fact 5
The discount of $20,000 is amortized in the
first year by $784
Bond issue is not a routine task for Norman
Corp. so any costs associated with them
should not be treated as operating
expenses.
Premium and discount represent adjustment
over nominal interest rate ( of bonds ).
Amortization of discount is treated as non-
operating charge.

Analysis of fact 6
Bond issue is not a routine task for Norman
Corp. so any costs associated with them
should not be treated as operating
expenses.
The bond issuance charges are recorded as
a deferred charge, which is an asset
analogous to prepaid expenses
If this accounting method is followed, the
net profit for the period will go up, the
value of asset will increase and
amortization expenditure for subsequent
periods will increase
If this accounting method is followed, it is
understating this year profit and
overstating next year profit
Analysis of fact 7
The company has leased car valued $35,000
Annual year end lease payment of $13,581,
at the end of 3 years title of the car would
pass to Norman, so the lease is Capital
lease
From the Income Tax point of view, the
lessor can claim tax benefits on the lease
payments of the lease asset only if it a
operating lease.
So the company cannot charge the lease
payments as operating expenses.

Question 2
 Maturity date is 15 years.
 Calculation of yield to maturity ( effective interest rate ):
 Rate(nper,pmt,pv,[fv],[type],[guess])
 Nper = 15 years ( Maturity years )
 Pmt = -5000
 Pv = 80000
 Fv = -1,00,000 ( principal )
 Type = 0
 Rate = 7%
 Calculation of amortization:
 Interest expense = 80,000 ( market price of bond ) * 7 %
 = 5600
 Nominal interest = 5% * 1,00,000 = 5000
 Amortization = 5600 – 5000 = 600
 Therefore the amortization amount ( 784 ) calculated is not the
current first year amount.
Financial Lease
The company takes the car on financial
lease.
The effective rate of interest is calculated
based on the Internal Rate of Return

Cost of the Car $35,000


Annual payment $13,581
Rate of interest(IRR) 8%
Analysis of Financial
Statement
 Debt/Equity Ratio = Total Liabilities/Shareholders
equity
 = 650474/532302
 = 1.22

A high debt/equity ratio generally means that a


company has been aggressive in financing its


growth with debt. This can result in volatile
earnings as a result of the additional interest
expense.
 In income statement, non-operating expense
should not gain tax benefit. It should be
deducted from retained earnings.

Thankyou.