Page 1 out of 12 Question 1 (120 Points) 1. In a separate file named Amazon10K2019.pdf (available on Canvas in the Sample Exams folder – make sure it is the 2019 statement, for December 31, 2019), you are given Amazon’s 2019 Annual Report. 2. The use of the terms “during 2019,” “in 2019,” or “fiscal 2019,” means during the fiscal year 2019, that ends on December 31, 2019. The same applies for other years. 3. Items a-v are each worth 5 points (22 * 5 = 110). Item w is worth 10 points. 4. You have one “life-line” for this question. Full credit for one item: Just print LIFE LINE Required: a. Describe in no more than three lines Amazon’s business. Name three different types of constituencies Amazon serves. b. What company audits the financial statements of Amazon? What issue did the auditors consider as a critical audit matter? What did they do to address the issue? c. Based on the income statement: By how much did Amazon’s revenue grow between 2018 and 2019 (in dollars and percentages)? What source (type) of revenue grew the most? Please speculate why. d. What is Amazon’s largest source of operating expense? e. Removed – was a specific question to the actual students who took the exam. f. What are Amazon’s operating segments? Which segment generates the largest portion of sales in 2019? Does this segment also generate the largest portion of operating income in 2019? Which service/product generated the most sales in 2019? Page 2 out of 12 g. What was Amazon’s operating margin (operating income/revenue) in 2018 and 2019? What was Amazon’s turnover (net sales/net operating assets) in the same years? Instructions: (i) assume net operating assets = total assets – cash and cash equivalents – marketable securities – current liabilities – long-term lease liabilities – other long-term liabilities; (ii) ignore taxes. Assume that the median profit margin for public firms is 7.5%, while the median asset turnover ratio is 1.30. Relative to this benchmark, what drives Amazon’s overall operating profit, volume or price? h. Which income statement and/or balance sheet items increase or decrease when a customer buys a gift card? What was the total balance of the outstanding gift cards that Amazon expects to be redeemed in the future, as of December 31, 2019? How does Amazon determine a gift card is not going to be redeemed? i. Describe a key difference between the way Amazon recognizes revenue for sales related to products in their physical and online stores, and third-party related sales. j. How does Amazon recognize sales related to its prime membership? Record a hypothetical transaction for the purchase of an Amazon Prime Membership by a customer, for $119, on January 1, 2020. k. What percentage of service revenue is attributable to Amazon Web services (AWS) in 2019? l. Estimate the probability of product returns on sales made in 2019. m. Is cash flow from operations higher or lower than net income in 2018? In 2019? By how much? Can you identify what drives this difference? n. Does Amazon have more PP&E, or intangible assets, as a percentage of total assets in 2019? What are the percentages? Do you think this make sense? o. What is your best guess for the amount of amortization Amazon will recognize for their customer-related intangible assets in 2020, if no intangible assets are purchased or sold in 2020? As per Amazon’s disclosure, you can assume that amortization is computed using the straight- line method for this asset. Page 3 out of 12 p. Does Amazon record inventory using the LIFO or FIFO approach? If prices of inputs are rising, how does their cost flow assumptions affect the amount of Cost of Goods Sold and Inventory in 2019, relative to the alternative approach? q. How much money did Amazon invest in (spend purchasing) marketable securities in 2019? r. How many bonus points are required to have the picture of your most favorite accounting professor as your wallpaper on all your electronic devices? s. Consider the 2.50%, $1,250 note due November 2022. Assume no transactions beyond coupon payments were made during fiscal 2019. What is the interest expense on the bond in 2019? t. What was Amazon’s income tax expense for 2019? What were Amazon’s net cash tax payments for 2019? Provide the journal entry that summarizes Amazon’s income tax expense for 2019. u. What is the amount of deferred tax liabilities related to the depreciation and amortization of PP&E in 2018 and 2019? Explain in a few sentences why Amazon might have these deferred tax liabilities. v. How much did Amazon purchase Whole Foods Market for? Assume that all the goodwill and intangible assets related to the acquisitions made in 2017 result from the purchase of Whole Food Markets. What portion of this purchase was attributed to intangible assets (including goodwill)? Does that make sense? w. A Judgment Question. (Only a short answer is required here - up to 10 lines.) You talk with your friend, who did not attend our accounting course, at a cocktail party about Amazon’s performance. Your friend heard that Amazon’s operating income and net income tripled in 2018, relative to 2017 (and increased another, about, 15% in 2019). You friend then says “Wow, I didn’t realize selling stuff (products, music, videos) on the internet could be so profitable.” Would you agree with this statement? Why or why not? What would you say? Page 4 out of 12 Question 2 (80 Points) Following are comparative Balance Sheets, an Income Statement for 2020, and supplementary notes of A. Fauci Inc. A. Fauci Inc. Balance Sheets as of December 31 (in millions) 2019 2020 Assets: Cash $ 25,700 $ 31,500 Accounts Receivable (gross) 120,000 130,000 Allowance for Uncollectibles (2,400) (3,200) Inventory 175,000 210,000 Property Plant and Equipment (at cost) 247,300 290,200 Accumulated Depreciation (78,000) (95,000) Patents 75,000 Accumulated Amortization (15,000) $ 487,600 $ 623,500 Liabilities and Shareholders’ Equity: Accounts Payable $ 55,000 $ 72,000 Dividend Payable 5,000 10,000 Long-term Debt 100,000 110,000 Common Stock 100,000 173,900 Retained Earnings 227,600 257,600 $ 487,600 $ 623,500 Income Statement For the Year Ended December 31, 2020 (in millions) Net Sales $ 1,000,000 Gain on Sale of Patent 113,000 Gain on Bond retirement 12,000 1,125,000 Cost of Goods Sold 750,000 Selling and Administrative 185,000 Bad Debt Expense 20,000 Interest Expense 8,000 Depreciation Expense 39,000 Amortization Expense 15,000 Impairment of Equipment 10,000 Loss on sale of Equipment 8,000 Income Tax Expense 30,000 Net income $ 60,000 See Notes on the following page. Page 5 out of 12 Notes: 1. During 2020, A. Fauci acquired property, plant and equipment as follows: For cash $62,900 and, in addition, by issuing Common Stock $30,000. 2. During 2020, A. Fauci sold a patent on a device developed internally by its research staff for $113,000 and purchased a patent for cash totaling $75,000. 3. A bond with book value of $50,000 was retired during the year. Required: Prepare the 2020 Statement of Cash Flows for A. Fauci Inc. Include all relevant Supplemental Schedules. Page 6 out of 12 Question 3 (40 Points) The following information is taken from the 2018 financial report of a company I am not revealing its name, a software development company headquartered in Luxembourg. Founded in Buenos Aires, this company has its central operating locations in Latin America and mainly serves commercial clients from the United Kingdom and the United States. The next page shows footnote information about the company’s accounts receivable. Clarifying information: 1. Trade receivables is another name for Accounts receivable. 2. The allowance table only includes receivables that are past due. Therefore, the <30 category represents receivables that are between 1 and 30 days past due. Receivables that are current and not past due are not included in the table. 3. Lifetime ECL is an acronym for excepted credit losses, or allowances for doubtful accounts (i.e., receivables the firm does not expect to collect). 4. Estimated total gross carrying amount is another way to say the gross amount of trade receivables (before any allowance). Required: a. Record the company’s bad debt expense and write-offs in 2018. Identify the income statement impact of each entry. b. Complete the aging table as of December 31, 2018. c. What percentage of the total trade receivables is past due on December 31, 2018? What percentage of the total trade receivables is the allowance for doubtful accounts on December 31, 2017 and on December 31, 2018? Comment, briefly, on your answers to this item. Page 7 out of 12 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS As of December 31, 2018, and 2017 and for the three years in the period ended December 31, 2018 (amounts are expressed in thousands of U.S. dollars) NOTE 11 – TRADE RECEIVABLES As of December 31, 2018 2017 Trade Receivables 114,855 80,687 Less: Allowance for doubtful accounts (3,957) (609) TOTAL 110,898 80,078 . Allowance for doubtful accounts The following tables detail the risk profile of trade receivables based on the Company's provision matrix as of December 31, 2018 and 2017. December 31, 2018 Trade receivables - days past due < 30 31 - 60 61 - 90 91-120 > 120 Total Expected credit loss rate % 1.90 % 4.40 % 11.90 % 85.90 % Estimated total gross carrying amount 17,815 6,843 2,778 3,801 34,051 Lifetime ECL 107 331 3,957 December 31, 2017 Trade receivables - days past due < 30 31 - 60 61 - 90 91-120 > 120 Total Expected credit loss rate 0.19 % 0.84 % 2.74 % 8.58 % 100.00 % Estimated total gross carrying amount 18,513 4,140 878 902 438 24,871 Lifetime ECL 35 35 24 77 438 609 The following table shows the movement in ECL that has been recognized for trade receivables: As of December 31, 2018 2017 2016 Balance at beginning of year (609) (617) (438) Additions, net of recoveries (3,421) 5 (928) Write-off of receivables 73 3 749 Balance at end of year (3,957) (609) (617) Page 8 out of 12 Question 4 (40 Points) In 2018, Tesla produced a total of 245,240 cars: 145,846 of Model 3; 48,453 of Model S; and 50,941 of Model X. Tesla sells the cars at the following prices (per car): Model 3@$36,200, Model S@$81,190 and Model X@$86,190. The car production requires raw materials (e.g., steel and lithium), labor (factory workers), R&D, machinery, and factories. The total costs by input factor for the entire year 2018 are summarized below: Input Factor Amount (in $ million) Raw Materials 3,878 Labor (Wage) 4,863 R&D 1,271 Machinery (Depreciation) 2,720 Factories 1,395 When Tesla uses the Activity Based Costing (ABC) method to allocate the total cost per input factor to the respective models, cost drivers utilization by model are: Input Factor (cost driver) Model 3 Model S Model X Raw Materials (tons per car) 1.0 1.5 1.6 Labor (labor hours per car) 3 4 4 R&D (computerized components per model) 40 80 120 Machinery (Depreciation) 2.5 3.0 3.0 Factories (number of assembly lines) 2 1 1 Required: a. Assume Tesla is allocating all overhead using labor hours. Calculate the cost per car for each of the three models. Which of the models has the highest profit margin percentage? b. Assume Tesla is allocating overhead using ABC. Calculate the cost per car for each of the three models. Which of the models has the highest profit margin percentage? c. Given implementing ABC is expansive, should Tesla invest in this system? d. Tesla claims it make sense to offer Model 3 (the low price, mass market car) at a price below total cost. Provide a few arguments to support such a claim. Page 9 out of 12 Question 5 (40 Points) In the accompanying table there are four independent cases. All assets purchases were made on January 1. Asset 1 Asset 2 Asset 3 Asset 4 Depreciation Method Double Straight Straight Units Declining Line Line Produced Balance Year purchased 2017 2016 2018 2018 Original cost $14,000 $17,300 G K Estimated salvage $2,000 D H $5,000 Book value, January 1, 2020 A F $9,400 $33,750 Useful life (years) B 7 - 8 Useful life (units) - - 100,000 - Production, 2020 (units) - - I - Production, preceding years (units) - - 60,000 - Depreciation 2020 C $2,200 $2,600 J Accumulate depreciation, January 1, 2020 $4,500 E $12,000 $26,250 Required: a. Find the missing amounts. b. Assume Asset 1 was sold on December 31, 2020 for $8,500. Provide the journal entry. c. What accounting concept is behind the recording of depreciation expense? d. Over the life of Asset 4, what would be the impact of using the sum-of-the-years-digits depreciation methods on the Owners’ Equity account? Would your answer change if Asset 4 was sold during 2021? Page 10 out of 12 Question 6 (40 Points) Progressive Corporation (a property and casualty insurance company) reported the following in the debt footnote of the 2016 annual report. They account for their bonds using the amortized cost approach (which is the method we studied in class). 2016 2015 Net Book Fair Net Book Fair (millions) Value Value Value Value 3.75% Senior Notes due 2021 (face value: $500.0, issued: August 2011) $ 498.4 $528.8 $498.1 $528.7 2.45% Senior Notes due 2027 (face value: $500.0, issued: August 2016) 495.8 464.6 0 0 6 5/8% Senior Notes due 2029 (face value: $300.0, issued: March 1999) 295.9 380.1 295.7 376.0 6.25% Senior Notes due 2032 (face value: $400.0, issued: November 2002) 395.2 499.0 395.0 490.6 4.35% Senior Notes due 2044 (face value: $350.0, issued: April 2014) 346.4 362.3 346.4 352.8 3.70% Senior Notes due 2045 (face value: $400.0, issued: January 2015) 395.1 372.5 395.0 362.0 6.70% Fixed-to-Floating Rate Junior Subordinated Debentures due 2067 (face value: $1,000.0, issued: June 2007; outstanding: $594.6 and $614.4) 594.1 581.2 612.8 612.8 Other debt instruments 127.3 127.3 164.9 164.9 Total $ $3,148.2 $3,315.8 $2,707.9 $2,887.8 Aggregate principal payments on debt outstanding at December 31, 2016, is as follows: (in millions) Year Payments 2017 $25.0 2018 25.0 2019 11.3 2020 0.8 2021 500.0 Thereafter 2,609.8 Total $3,171.9 Page 11 out of 12 Required: a. What amount does Progressive report for long-term debt on its balance sheet at December 31, 2016? b. How much of the principal of its long-term debt does Progressive expect to become due (to pay) in each of 2017, 2018, and 2019? c. Why is there a difference between the fair value and the net book value of Progressive’s long- term debt? d. Assume that none of the 3.75% Senior Notes were issued or retired during 2015 or 2016. Were the 3.75% Senior Notes originally issued at par, at a discount or at a premium? How do you know? e. What is the amount of the unamortized discount on the 6.25% Senior Notes as of December 31, 2016? f. Assume that Progressive repurchased all its 6.25% Senior Notes using cash on January 1, 2017 at their fair value. Record the transaction. How is the income statement affected by this transaction? Is there any impact on the statement of cash flows (using the indirect method)? Page 12 out of 12 Question 7 (40 Points) JK Bakery is expanding, following the successful promotion of its new gluten-free, sugar-free cupcakes. The bakery recently invested in a new top-of-the-line commercial oven on January 1, 2020 for $40,000. The oven has an estimated service life of four years and a salvage value of zero. JK Bakery is now able to generate $50,000 of profit before taxes and depreciation on this new oven each year. The IRS is allowing JK Bakery to accelerate the depreciation of the machine for tax purposes. The depreciation rates, as a percentage of purchase price, used by the IRS are 33 percent in the first year, 44 percent in the second year, 15 percent in the third year and 8 percent in the fourth year. Additional Information: Oven depreciation is the only difference between JK Bakery’s taxable income and financial income. The oven is depreciated using the straight-line method for financial reporting. JK Bakery’s tax rate is 25%. Required: a. Write the journal entry used to record JK Bakery’s income tax expense in 2020 and 2021. What is JK Bakery’s effective tax rate each year? b. The Mayor of New York City is trying to help the city recover from the COVID-19 crisis (and also promote healthy lifestyles). Accordingly, businesses that sell healthy foods earn a tax credit that allows them to pay no taxes on $15,000 of profit. JK Bakery received a letter notifying them that they qualify for this tax break. Therefore, JK Bakery will never have to pay tax on this $15,000. Please answer part a again, only for 2020, using this new information. c. Ignore the information in part b for this requirement. The government, in order to finance the huge deficit resulting from the stimulus package, decided to implement new tax practices common in Eastern Europe. As a result, the new 2020 tax rule states that depreciation is no longer deductible for tax purposes. JK Bakery will never be able to deduct any depreciation for tax purposes. Please answer part a again, only for 2020, using this new information.