Unless otherwise specified, the numbers in the financial statements are all in millions.
Please type your answer below each question using this Word document. Please show all calculations.
Please start each question on a separate page.
NOTE:
Some of the exam’s questions evolve around the annual report (the 10-K) of Johnson & Johnson (J&J) for fiscal year 2020. The relevant items from the 10-K are included in this exam.
QUESTIONS
Q1
Write a short memo on describing the main purpose(s) of financial accounting, the five categories of accounts; the four financial statements (and the objective of each); the relative importance of SEC and FASB in determining accounting standards; and the purpose and effect of auditing financial statements (between 500 and 750 words).
Q2
J&J explains its accounting for sales returns in a Note to the financial statements, excerpted here:
Revenue Recognition:
The Company recognizes revenue from product sales when obligations under the terms of a contract with the customer are satisfied; generally, this occurs with the transfer of control of the goods to customers. The Company's global payment terms are typically between 30 to 90 days. Provisions for certain rebates, sales incentives, trade promotions, coupons, product returns and discounts to customers are accounted for as variable consideration and recorded as a reduction in sales.
Sales returns are estimated and recorded based on historical sales and returns information. Products that exhibit unusual sales or return patterns due to dating, competition or other marketing matters are specifically investigated and analyzed as part of the accounting for sales return accruals.
Sales returns allowances represent a reserve for products that may be returned due to expiration, destruction in the field, or in specific areas, product recall. The sales returns reserve is based on historical return trends by product and by market as a percent to gross sales. In accordance with the Company’s accounting policies, the Company generally issues credit to customers for returned goods. The Company’s sales returns reserves are accounted for in accordance with the U.S. GAAP guidance for revenue recognition when right of return exists. Sales returns reserves are recorded at full sales value. Sales returns in the Consumer Health and Pharmaceutical segments are almost exclusively not resalable. Sales returns for certain franchises in the Medical Devices segment are typically resalable but are not material. The Company infrequently exchanges products from inventory for returned products. The sales returns reserve for the total Company has been approximately 1.0% of annual net trade sales during the fiscal years 2020 and 2019.
Assume the following:
(1) The Company estimates each year the sales returns to be 1% of that sales year;
(2) The actual sales for the year amounted to $82,584; $82,059 and $81,581 in 2020, 2019, and 2018, respectively;
(3) Actual sales returns amounted to $920, $750 and $718 in 2020, 2019, and 2018, respectively, and
(4) The balance of the Allowance for Sales Returns at the beginning of 2018 was $550.
Q
a. Derive the estimated allowance for sales returns recorded in 2019.
. Based on the experience with sales returns in the last three years, was J&J’s management accurate in its estimation of the extent of sales returns? Explain.
Q3
The Accounts Receivables amounted to $13,576 and $14,481 in 2020 and 2019 respectively. These values reflected the subtraction of the allowance for doubtful accounts, estimated at $293 & $226 for 2020 and 2019 respectively. The actual sales for the year amounted to $82,584; and $82,059 in 2020, and 2019 respectively; How much did J&J collect from customers in 2020?
Q4
J&J is using FIFO to evaluate its inventories. Analysts estimate that if the Company used LIFO, its inventory balances at any time would be lower by 20% than the balances cu
ently reported under FIFO.
a. What could be the reasons that J&J does not use LIFO, a method that is usually beneficial for taxpayers?
. By how much would J&J’s earnings before tax for 2020 have increased or decreased, according to the analysts’ estimate above, if J&J had been using LIFO all along?
c. “I know from my own long years as a product manager with J&J that we don’t strictly use a FIFO regime when we handle the physical inventory,” commented Mr. Adams and continued to say that “I, therefore, I do not understand why we do not simply use the “Specific Identification” method instead of FIFO or LIFO. This would result in greater accuracy and reliability when measuring the true COGS and our inventory. The move to specific identification would be inexpensive: Almost all of our products are already bar-coded.” Do you agree with Mr. Adams’ assessment of the advantages of the switch to specific identification? Explain.
For questions Q5 & Q6 you may find it useful to refer the excerpted note #4 below Q5 from the J&J 10-K.
Q5
J&J reports in its income statement interest expense “net of portion capitalized.”
a. What could be the accounting justification for capitalizing interest cost?
. How does the capitalization of interest costs affect net income in the year(s) during which the interest cost is actually incu
ed and how does it affect net income in future years?
Q6
J&J is using straight-line depreciation for its PP&E. Estimate the average age of J&J’s property, plant and equipment? Why is it important to learn about the average age of the PPE?
NOTE 4
Property, Plant and Equipment, At the end of fiscal years 2020 and 2019, property, plant and equipment at cost and accumulated depreciation were:
Dollars in Millions
2020
2019
Land and land improvements
$882
854
Buildings and building equipment
12,502
11,877
Machinery and equipment
29,104
26,964
Construction in progress
4,316
3,637
=Total property, plant and equipment, gross
$46,804
43,332
Less accumulated depreciation
28,038
25,674
==Total property, plant and equipment, net footnote(1)
$18,766
17,658
footnote(1) See Note 18 to the Consolidated Financial Statements for details on assets held for sale and the related divestitures for the fiscal year ended December 29, 2019. There were no assets held for sale at January 3, 2021
The Company capitalizes interest expense as part of the cost of construction of facilities and equipment. Interest expense capitalized in fiscal years 2020, 2019 and 2018 was $63 million, $70 million and $86 million, respectively.
Depreciation expense, including the amortization of capitalized interest in fiscal years 2020, 2019 and 2018 was $2.6 billion, $2.5 billion and $2.6 billion, respectively.
Upon retirement or other disposal of property, plant and equipment, the costs and related amounts of accumulated depreciation or amortization are eliminated from the asset and accumulated depreciation accounts, respectively. The difference, if any, between the net asset value and the proceeds are recorded in earnings.
Q7
J&J reports among its assets for the end of 2020 a balance of $36,393 million of Goodwill.
a. What does this balance represent?
. The balance of Goodwill on J&J books increased in 2020 by almost $3 billion. In general, could this balance decrease? What could increase this balance? What could decrease it? Explain.
c. As a potential investor in the Company, what concerns might you have with respect to this large balance?
Q8
One banker commented: “I don’t understand why the rule of Lowest-of-Cost-or-Market (LCM) is not applied to the valuation on the balance sheet of Property, Plant and Equipment. Not applying this rule results in an overestimation of the value of PPE.” Do you agree? Explain.
Q9
A company reports in a note to its financial statements for 2020 that it finally settled an old lawsuit against the Company that had been
ought in 2015 by employees. The company indicated in the annual report for fiscal 2018, that it had established in that year an allowance for the estimated loss from this lawsuit.
a. What was the journal entry that the company must have recorded in fiscal 2018 to reflect the creation of the above-mentioned reserve (omit the dollar values)?
. What could be the reasons that the company has established an allowance only in 2018 (even though the lawsuit was filed in 2015)?
c. Show the journal entry to record the eventual payment of the settlement amount (omit the dollar values)?
d. Did the settlement of the lawsuit in fiscal year 2020 affect the net income for that year? Explain.
Q10
A Company reports a balance of “Common Stock Held in Treasury” of $38,490 million at the end of 2020.
a. In your own words, what does this balance represent?
. What could be the reason(s) that this balance increases from its level at the end of 2019? Could this balance decrease? Explain.
*THE REMAINING TWO QUESTIONS ARE BONUS QUESTIONS (FOR EXTRA POINTS)
Q11
Following is information on the PPE account of a company:
Items
XXXXXXXXXX
XXXXXXXXXX
PPE, Cost
100
101
PPE, Accumulated Depreciation
14
19
During 2020 the company there was a single sale of PPE for a price of $33. At the time of sale, the cost of the sold PPE was 40 and the accumulated depreciation on it was 11.
a. What was the gain on the sale of PPE?
. What was the depreciation expense for 2020?
c. What was the cost of the new PPE added during 2020?
Q12. Please fill the following table:
The effect of an overstatement in the numerical estimate on the following accounts:
Items
Income for the period
Total assets at the end of the period
Total liabilities at the end of the period
Numerical estimates (indicated by the underlined parameter) that companies may make in preparing the financial statements
Example: The percentage of bad debt out of credit sales
Understated
Understated
No effect
The length (in years) of the useful life of PPE
Wa
anty cost ($ amount per units sold)
Pension obligation (total $ amount)
Merchandize returns (% of total sales)
GOOD LUCK