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Case 8-1 Norman Corporation (A)* Until 2010, Norman Corporation, a young manufac- turer of specialty consumer products, had not had its fi- nancial statements audited. It had, however, relied on the auditing firm of Kline & Burrows to prepare its in- come tax returns. Because it was considering borrow- ing on a long-term 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 direc- tion of Allen Burrows. Norman's financial vice presi- dent 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 2010 a group of female employees sued the com- pany, asserting that their salaries were unjustifiably lower than salaries of men doing comparable work. They asked for back pay of $250,000. A large num- ber of similar suits had been filed in other compa- nies, but results were extremely varied. Norman's outside counsel thought that the company probably would win the suit but pointed out that the deci- sions 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 provi- sion for this loss had been made in the financial statements. 2. The company had a second lawsuit outstanding. It in- volved a customer who was injured by one of the com- pany'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 re- ported $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 main- tenance expense, with an offsetting credit of $16,000 to a reserve account included as a 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 inter- est rate at the time; the stockholder thought that this arrangement provided a personal income tax advan- tage 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 ques- tioned about this treatment, the financial vice presi- dent 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 S784 in 2010, 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 amount- ing to $500. These costs were included in nonoper- ating 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, 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 Copyright Professor Robert N. Anthony. Case 8-1 Norman Corporation (A)* Until 2010, Norman Corporation, a young manufac- turer of specialty consumer products, had not had its fi- nancial statements audited. It had, however, relied on the auditing firm of Kline & Burrows to prepare its in- come tax returns. Because it was considering borrow- ing on a long-term 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 direc- tion of Allen Burrows. Norman's financial vice presi- dent 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 2010 a group of female employees sued the com- pany, asserting that their salaries were unjustifiably lower than salaries of men doing comparable work. They asked for back pay of $250,000. A large num- ber of similar suits had been filed in other compa- nies, but results were extremely varied. Norman's outside counsel thought that the company probably would win the suit but pointed out that the deci- sions 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 provi- sion for this loss had been made in the financial statements. 2. The company had a second lawsuit outstanding. It in- volved a customer who was injured by one of the com- pany'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 re- ported $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 main- tenance expense, with an offsetting credit of $16,000 to a reserve account included as a 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 inter- est rate at the time; the stockholder thought that this arrangement provided a personal income tax advan- tage 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 ques- tioned about this treatment, the financial vice presi- dent 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 S784 in 2010, 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 amount- ing to $500. These costs were included in nonoper- ating 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, 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 Copyright Professor Robert N. Anthony