Merck & Co., Inc. and Johnson & Johnson are two leading producers of healthcare products. Each has considerable assets, and each expends considerable funds each year toward the development of new products. The development of a new healthcare product is often very expensive, and risky. New products frequently must undergo considerable testing before approval for distribution to the public. For example, it took Johnson & Johnson 4 years and $200 million to develop its 1-DAY ACUVUE contact lenses. Below are some basic data compiled from the financial statements of these two companies.

$$\begin{array}{lcc} \text{{(all dollars in millions)}}&\text{\underline{Johnson \& Johnson}}&\text{\underline{Merck}}\\ \text{Total assets}&\text{\$\hspace{5pt}53,317}&\text{\$\hspace{5pt}42,573}\\ \text{Total revenue}&\text{\hspace{10pt}47,348}&\text{\hspace{10pt}22,939}\\ \text{Net income}&\text{\hspace{14pt}8,509}&\text{\hspace{14pt}5,813}\\ \text{Research and development expense}&\text{\hspace{14pt}5,203}&\text{\hspace{14pt}4,010}\\ \text{Intangible assets}&\text{\hspace{9pt}11,842}&\text{\hspace{14pt}2,765}\\ \end{array}$$

Instructions

• a. What kinds of intangible assets might a healthcare products company have? Does the composition of these intangibles matter to investors—that is, would it be perceived differently if all of Merck’s intangibles were goodwill than if all of its intangibles were patents?
• b. Suppose the president of Merck has come to you for advice. He has noted that by eliminating research and development expenditures the company could have reported $4 billion more in net income. He is frustrated because much of the research never results in a product, or the products take years to develop. He says shareholders are eager for higher returns, so he is considering eliminating research and development expenditures for at least a couple of years. What would you advise?
• c. The notes to Merck’s financial statements note that Merck has goodwill of$1.1 billion. Where does recorded goodwill come from? Is it necessarily a good thing to have a lot of goodwill on a company’s books?

The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ complete annual reports, including the notes to the financial statements, are available online.

Instructions Use the companies’ financial information to answer the following questions.

• a. (1) What amounts for intangible assets were reported in their respective balance sheets by Coca-Cola and PepsiCo at year-end 2014? (2) What percentage of total assets is each of these reported amounts at year-end 2014? (3) What was the change in the amount of intangibles from 2013 to 2014 for Coca-Cola and PepsiCo?
• b. (1) On what basis and over what periods of time did Coca-Cola and PepsiCo amortize their intangible assets? (2) What were the amounts of accumulated amortization reported by Coca-Cola and PepsiCo at the end of 2013 and 2014? (3) What was the composition of the identifiable and unidentifiable intangible assets reported by Coca-Cola and PepsiCo at the end of 2014?

On January 2, 2017, Raconteur Corp. reported the following intangible assets: (1) copyright with a carrying value of $15,000, and (2) a trade name with a carrying value of$8,500. The trade name has a remaining life of 5 years and can be renewed at nominal cost indefinitely. The copyright has a remaining life of 10 years.

At December 31, 2017, Raconteur assessed the intangible assets for possible impairment and developed the following information.

$$\begin{array}{lcc} &\text{Estimated Undiscounted}\\ &\text{\underline{Expected Future Cash Flows}}&\text{\underline{Estimated Fair Value}}\\ \text{Copyright}&\text{\$\hspace{5pt}20,000}&\text{\$\hspace{5pt}16,000}\\ \text{Trade name}&\text{\hspace{10pt}10,000}&\text{\hspace{14pt}5,000}\\ \end{array}$$

Accounting Prepare any journal entries required for Raconteur’s intangible assets at December 31, 2017.

Analysis Many stock analysts indicate a preference for less-volatile operating income measures. Such measures make it easier to predict future income and cash flows, using reported income measures. How does accounting for impairments of intangible assets affect the volatility of operating income?

Principles Many accounting issues involve a trade-off between the primary characteristics of relevant and representationally faithful information. How does the accounting for intangible asset impairments reflect this trade-off?

Edington Electronics Inc. produces and sells two models of pocket calculators, XQ-103 and XQ-104. The calculators sell for $15 and$25, respectively. Because of the intense competition Edington faces, management budgets sales semiannually. Its projections for the fi rst 2 quarters of 2017 are as follows.

No changes in selling prices are anticipated.

Instructions Prepare a sales budget for the 2 quarters ending June 30, 2017. List the products and show for each quarter and for the 6 months, units, selling price, and total sales by product and in total.

For Gundy Company, units to be produced are 5,000 in quarter 1 and 7,000 in quarter 2. It takes 1.6 hours to make a finished unit, and the expected hourly wage rate is $15 per hour. Prepare a direct labor budget by quarters for the 6 months ending June 30, 2017

Taylor Swift Corporation purchases a patent from Salmon Company on January 1, 2017, for $54,000. The patent has a remaining legal life of 16 years. Taylor Swift feels the patent will be useful for 10 years. Prepare Taylor Swift’s journal entries to record the purchase of the patent and 2017 amortization.

On January 1, 2017, Blair Corporation purchased for $500,000 a tract of land (site number 101) with a building. Blair paid a real estate broker’s commission of$36,000, legal fees of $6,000, and title guarantee insurance of$18,000. The closing statement indicated that the land value was $500,000 and the building value was$100,000. Shortly after the acquisition, the building was razed at a cost of $54,000.

Blair entered into a$3,000,000 fixed-price contract with Slatkin Builders, Inc. on March 1, 2017, for the construction of an office building on land site number 101. The building was completed and occupied on September 30, 2018. Additional construction costs were incurred as follows.

$$\begin{array}{lrr} \text{Plans, specifications, and blueprints}&\text{\$\hspace{5pt}21,000}\\ \text{Architects’ fees for design and supervision}&\text{82,000}\\ \end{array}$$

The building is estimated to have a 40-year life from date of completion and will be depreciated using the 150% declining-balance method.

To finance construction costs, Blair borrowed $3,000,000 on March 1, 2017. The loan is payable in 10 annual installments of$300,000 starting on March 1, 2018, plus interest at the rate of 10%. Blair’s weighted-average amounts of accumulated building construction expenditures were as follows.

$$\begin{array}{lrr} \text{For the period March 1 to December 31, 2017}&\text{\$\hspace{5pt}1,300,000}\\ \text{For the period January 1 to September 30, 2018}&\text{1,900,000}\\ \end{array}$$

Instructions

• a. Prepare a schedule that discloses the individual costs making up the balance in the land account in respect of land site number 101 as of September 30, 2018.
• b. Prepare a schedule that discloses the individual costs that should be capitalized in the office building account as of September 30, 2018. Show supporting computations in good form.

At December 31, 2019, certain accounts included in the property, plant, and equipment section of Reagan Company's balance sheet had the following balances.

$$\begin{array} {lrrrrr} \text{Land}& \hspace{10pt}\text{\$\hspace{10pt}230,000}&\\ \text{Buildings}& \hspace{10pt}\text{890,000}&\\ \text{Leasehold improvements}& \text{660,000}&\\ \text{Equipment}& \hspace{10pt}\text{875,000}&\\ \end{array}$$

During 2020, the following transactions occurred.

1. Land site number 621 was acquired for $850,000. In addition, to acquire the land Reagan paid a$51,000 commission to a real estate agent. Costs of $35,000 were incurred to clear the land. During the course of clearing the land, timber and gravel were recovered and sold for$13,000.

2. A second tract of land (site number 622) with a building was acquired for $420,000. The closing statement indicated that the land value was$300,000 and the building value was $120,000. Shortly after acquisition, the building was demolished at a cost of$41,000. A new building was constructed for $330,000 plus the following costs.

$$\begin{array} {lrrrrr} \text{Excavation fees}& \hspace{10pt}\text{\$\hspace{10pt}38,000}&\\ \text{Architectural design fees}& \hspace{10pt}\text{11,000}&\\ \text{Building permit fee}& \text{2,500}&\\ \text{Imputed interest on funds used}\\ \hspace{10pt}\text{during construction (stock financing)}& \hspace{10pt}\text{8,500}&\\ \end{array}$$

The building was completed and occupied on September 30, 2020.

3. A third tract of land (site number 623) was acquired for $650,000 and was put on the market for resale.

4. During December 2020, costs of$89,000 were incurred to improve leased office space. The related lease will terminate on December 31, 2022, and is not expected to be renewed. (Hint: Leasehold improvements should be handled in the same manner as land improvements.)

5. A group of new machines was purchased under a royalty agreement that provides for payment of royalties based on units of production for the machines. The invoice price of the machines was $87,000, freight costs were$3,300, installation costs were $2,400, and royalty payments for 2020 were$17,500.

Instructions

a. Prepare a detailed analysis of the changes in each of the following balance sheet accounts for 2020.

$$\begin{array} {lll} \text{Land }& \hspace{10pt}\text{Leasehold Improvements}&\\ \text{Buildings }& \hspace{10pt}\text{Equipment}&\\ \end{array}$$

Disregard the related accumulated depreciation accounts.

b. List the items in the situation that were not used to determine the answer to (a) above, and indicate where, or if, these items should be included in Reagan's financial statements.

Robots, Inc. reported the following information regarding 2019-2020 inventory.

Robots, Inc.

$$\begin{array} {lrrr} &\underline{\hspace{15pt}\text{2020}\hspace{15pt}}&\underline{\hspace{15pt}\text{2019}\hspace{15pt}}\\ \text{Current Assets}\\ \hspace{10pt}\text{Cash}\hspace{5pt} \ &\ \text{\$153,010}&\text{\$538,489}\\ \hspace{10pt}\text{Accounts receivable, net of allowance for doubtful accounts}\\ \hspace{10pt}\text{of \$46,000 in 2020 and \$160,000 in 2019}\hspace{5pt}& \text{1,627,980}&\text{2,596,291}\\ \hspace{10pt}\text{Inventories (Note 2)}\hspace{5pt} \ &\ \text{1,340,494}&\text{1,734,873}\\ \hspace{10pt}\text{Other current assets}\hspace{5pt} \ &\ \text{123,388}&\text{90,592}\\ \hspace{10pt}\text{Assets of discontinued operations}\hspace{5pt} & \text{\underline{\hspace{35pt}{---}}}&\text{\underline{\hspace{15pt}{32,815}}}\\ \hspace{20pt}\text{Total current assets}\hspace{5pt} \ &\ \text{3,244,872}&\text{4,993,060}\\ \end{array}$$

Notes to Consolidated Financial Statements

Note 1 (in part): Nature of Business and Significant Accounting Policies

Inventories--Inventories are stated at the lower-of-cost-or-market. Cost is determined by the last-in, first-out (LIFO) method.

Note 2: Inventories

Inventories consist of the following.

$$\begin{array} {lrrr} &\underline{\hspace{15pt}\text{2020}\hspace{15pt}}&\underline{\hspace{15pt}\text{2019}\hspace{15pt}}\\ \text{Raw materials}\hspace{5pt} \ &\ \text{\$1,264,646}&\text{\$2,321,178}\\ \text{Work in process}\hspace{5pt}& \text{240,988}&\text{171,222}\\ \text{Finished goods and display units}\hspace{5pt} & \text{\underline{\hspace{15pt}{129,406}}}&\text{\underline{\hspace{15pt}{711,252}}}\\ \hspace{10pt}\text{Total inventories}\hspace{5pt} & \text{{\hspace{6pt}{1,635,040}}}&\text{{\hspace{6pt}{3,203,652}}}\\ \text{Less: Amount classified as long-term}\hspace{5pt}& \text{\underline{\hspace{15pt}{294,546}}}&\text{\underline{\hspace{8pt}{1,468,779}}}\\ \hspace{10pt}\text{Current portion}\hspace{5pt}& \underline{\underline{\$\hspace{3pt}\text{1,340,494}}}&\underline{\underline{\$\hspace{3pt}\text{1,734,873}}}\\\\ \end{array}$$

Inventories are stated at the lower of cost determined by the LIFO method or market for Robots, Inc. If the FIFO method had been used for the entire consolidated group, inventories after an adjustment to the lower-of-cost-or-market would have been approximately $2,000,000 and$3,800,000 at October 31, 2020 and 2019, respectively.

Inventory has been written down to estimated net realizable value, and results of operations for 2020, 2019, and 2018 include a corresponding charge of approximately $868,000,$960,000, and $273,000, respectively, which represents the excess of LIFO cost over market.

Inventory of$294,546 and $1,468,779 at October 31, 2020 and 2019, respectively, shown on the balance sheet as a noncurrent asset represents that portion of the inventory that is not expected to be sold currently.

Reduction in inventory quantities during the years ended October 31, 2020, 2019, and 2018 resulted in liquidation of LIFO inventory quantities carried at a lower cost prevailing in prior years as compared with the cost of fiscal 2017 purchases. The effect of these reductions was to decrease the net loss by approximately$24,000, $157,000, and$90,000 at October 31, 2020, 2019, and 2018, respectively.

Instructions

a. Comment on why Robots, Inc., might disclose how its LIFO inventories would be valued under FIFO.

b. Why does the LIFO liquidation reduce operating costs?

c. Comment on whether Robots, Inc. would report more or less income if it had been on a FIFO basis for all its inventory.

Kelly Clarkson Corporation operates a retail computer store. To improve delivery services to customers, the company purchases four new trucks on April 1, 2020. The terms of acquisition for each truck are described below.

1. Truck #1 has a list price of $15,000 and is acquired for a cash payment of$13,900.

2. Truck #2 has a list price of $16,000 and is acquired for a down payment of$2,000 cash and a zero- interest-bearing note with a face amount of $14,000. The note is due April 1, 2021. Clarkson would normally have to pay interest at a rate of 10% for such a borrowing, and the dealership has an incremental borrowing rate of 8%.

3. Truck #3 has a list price of$16,000. It is acquired in exchange for a computer system that Clarkson carries in inventory. The computer system cost $12,000 and is normally sold by Clarkson for$15,200. Clarkson uses a perpetual inventory system.

4. Truck #4 has a list price of $14,000. It is acquired in exchange for 1,000 shares of common stock in Clarkson Corporation. The stock has a par value per share of$10 and a market price of $13 per share.

Prepare the appropriate journal entries for the above transactions for Clarkson Corporation.

Gruden Company produces golf discs which it normally sells to retailers for $7 each. The cost of manufacturing 20,000 golf discs is:

Gruden also incurs 5% sales commission ($0.35) on each disc sold. McGee Corporation offers Gruden $4.80 per disc for 5,000 discs. McGee would sell the discs under its own brand name in foreign markets not yet served by Gruden. If Gruden accepts the offer, its fixed overhead will increase from$40,000 to $46,000 due to the purchase of a new imprinting machine. No sales commission will result from the special order.

Instructions (c) What assumptions underlie the decision made in part (b)?

The Kroger Company reported the following data in its annual report (in millions).

$$\begin{array}{lcccccccc} &&{\hspace{10pt}\text{January 28,}\hspace{10pt}}&\hspace{10pt}&{\hspace{10pt}\text{January 30,}\hspace{10pt}}&&{\hspace{10pt}\text{January 31,}\hspace{10pt}}&\hspace{10pt}\\ &&\underline{\hspace{15pt}\text{2017}\hspace{15pt}}&\hspace{10pt}&\underline{\hspace{15pt}\text{2016}\hspace{15pt}}&&\underline{\hspace{15pt}\text{2015}\hspace{15pt}}&\hspace{10pt}\\ \text{Net sales}&&\$115,337&\hspace{10pt}&\text{\$109,830}&&\$108,465\\ \text{Cost of sales (using LIFO)}&&89,502&&\text{85,496}&&85,512\\ \text{Year-end inventories using FIFO}&&7,852&&\text{7,440}&&6,933\\ \text{Year-end inventories using LIFO}&&6,561&&\text{6,168}&&8,178\\ \end{array}$$

Instructions

a. Compute Kroger's inventory turnovers for fiscal years ending January 28, 2017, and January 30, 2016, using:

1. Cost of sales and LIFO inventory.

2. Cost of sales and FIFO inventory.

b. Some firms calculate inventory turnover using sales rather than cost of goods sold in the numerator. Calculate Kroger's fiscal years ending January 28, 2017, and January 30, 2016, turnover, using:

1. Sales and LIFO inventory.

2. Sales and FIFO inventory.

c. State which method you would choose to evaluate Kroger's performance. Justify your choice.

One of the more closely watched ratios by investors is the price/earnings (P/E) ratio. By dividing price per share by earnings per share, analysts get insight into the value the market attaches to a company’s earnings. More specifically, a high P/E ratio (in comparison to companies in the same industry) may suggest the stock is overpriced. Also, there is some evidence that companies with low P/E ratios are underpriced and tend to outperform the market. However, the ratio can be misleading.

P/E ratios are sometimes misleading because the E (earnings) is subject to a number of assumptions and estimates that could result in overstated earnings and a lower P/E. Some analysts conduct “revenue analysis” to evaluate the quality of an earnings number. Revenues are less subject to management estimates and all earnings must begin with revenues. These analysts also compute the price-to-sales ratio (PSR = price per share / sales per share) to assess whether a company is performing well compared to similar companies. If a company has a price-to-sales ratio significantly higher than its competitors, investors may be betting on a stock that has yet to prove itself. [Source: Janice Revell, “Beyond P/E,” Fortune (May 28, 2001), p. 174.]

Instructions

• a. Identify some of the estimates or assumptions that could result in overstated earnings.
• b. Compute the P/E ratio and the PSR for Tootsie Roll and Hershey for 2014.
• c. Use these data to compare the quality of each company’s earnings.

Manilow Corporation operates in an industry that has a high rate of bad debts. Before any year-end adjustments, the balance in Manilow's Accounts Receivable account was $555,000 and Allowance for Doubtful Accounts had a credit balance of$40,000. The year-end balance reported in the balance sheet for Allowance for Doubtful Accounts will be based on the aging schedule shown below.

$$\begin{array}{lccc} \text{}&\text{}&\text{Probability of}\\ \underline{\text{Days Account Outstanding}}&\underline{\hspace{10pt}\text{Amount}\hspace{10pt}}&\underline{\hspace{10pt}\text{Collection}\hspace{10pt}}\\ \text{Less than 16 days}\hspace{5pt}&\$\hspace{5pt}300,000&.98\\ \text{Between 16 and 30 days}&\hspace{10pt}100,000&.90\\ \text{Between 31 and 45 days}&\hspace{15pt}80,000&.85\\ \text{Between 46 and 60 days}&\hspace{15pt}40,000&.80\\ \text{Between 61 and 75 days}&\hspace{15pt}20,000&.55\\ \text{Over 75 days (to be written off)}&\hspace{15pt}15,000&.00\\ \end{array}$$

Instructions

a. What is the appropriate balance for Allowance for Doubtful Accounts at year-end?

b. Show how accounts receivable would be presented on the balance sheet.

c. What is the dollar effect of the year-end bad debt adjustment on the before-tax income?