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This is the suggested solution set for a Financial Accounting pset on Johnson and Johnson....

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The University of Chicago Booth School of Business

Financial Accounting 30000

Johnson & Johnson Accounting for Income Taxes Johnson & Johnson is a holding company engaged in research and development, manufacture, and sale of a broad range of products in the health care. The business of Johnson & Johnson is conducted by more than 275 operating companies located in 60 countries, including the United States, which sell products in virtually all countries throughout the world. The company was founded in 1886 by three brothers: Robert Wood Johnson, James Wood Johnson, and Edward Mead Johnson in New Brunswick, New Jersey. In 1944, Johnson & Johnson went public with a listing on the New York Stock Exchange. Answer the following questions using the excerpts from Johnson & Johnson’s annual report for the year ended December 31, 2017: 1. What was Johnson & Johnson’s income tax expense for 2017? Answer: Provision for income taxes: 16,373 million (Income Statement or Note 8) 2. How much of Johnson & Johnson’s income tax expense for 2017 is due on its Tax Return for 2017? Answer: Current component: $13,967 million (Note 8) Currently payable taxes include U.S. taxes and international taxes 3. How much cash did Johnson & Johnson actually pay for income taxes during 2017? Answer: Johnson & Johnson paid $3,312 million for income taxes in 2017 (Statement of cash flows) 4. What was Johnson & Johnson’s effective tax rate for 2017? Answer: Johnson & Johnson’s effective tax rate is 92.6% (Note 8) (or Provision / Earnings Before Income Taxes, i.e. 16,373/17,673 = 92.6%) 5. What explains the difference between the U.S. federal statutory tax rate and Johnson & Johnson’s effective tax rate for 2017? Answer: Enactment of the Tax Cuts and Jobs Act, international operations, research tax credits, U.S. state and local taxes, U.S. manufacturing deductions.

6. By how much would Johnson & Johnson’s provision for income taxes have been higher or lower than recognized in its 2017 financial statements had the tax rate on international operations for 2017 been identical to the U.S. statutory tax rate? Answer: The reduction in effective tax rate due to international operations is 12.8%. If international operations were subject to the U.S. statutory tax rate, the provision for income taxes would be higher by 17,673*12.8% = 2,262.14. 7. These questions pertain to the effect of share-based compensation expense on Johnson & Johnson’s income taxes. When answering these questions, use the enacted statutory tax rate of 21%.

(a) Was the cumulative share-based compensation expense that Johnson & Johnson reported on its financial statements higher or lower than what they reported on their tax return at the end of the fiscal year 2017? By how much? Answer: Johnson & Johnson has deferred tax asset related to share-based compensation expense. The ending balance of this asset is 507 at the end of fiscal year 2017. Hence, stock-based compensation expense for financial reporting purposes must have been higher than for tax purposes. The cumulative share-based compensation expense on financial statements have been higher by 507/21% = $2,414.3 million. (b) Was the share-based compensation expense that Johnson & Johnson reported on its financial statements higher or lower than what they reported on their tax return during 2017? By how much? Note that the enacted statutory tax rate is 35% in 2016; while the enacted statutory tax rate is 21% in 2017. Answer: Deferred tax asset related to share-based compensation changed, which can happen because the difference in expenses has changed or because the enacted statutory tax rate has changed. The share-based compensation expense that Johnson & Johnson recognized in its financial statements during 2017 was different than what they reported on their tax return by (507/21% - 749/35%) = $274.2 million. The stockbased compensation expense reported on tax return was lower than on financial statements by $274.2 million in 2017.

8. Suppose Johnson & Johnson purchased an asset at the end of fiscal year 2017. The difference between Modified Accelerated Cost Recovery System (MACRS) depreciation, which is used for tax purposes, and straight line depreciation, which is typically the method used for financial statements, will give rise to a deferred tax liability (DTL). Following is the data for the asset (in millions): Asset value: 600 Salvage value: 0 Useful life: 6 years MACRS Asset Category: 5 years, i.e., asset is depreciated over 6 years for tax purposes Income before taxes and depreciation for new asset: 10,000 each year 1 – 6 The MACRS depreciation schedule for the asset in the 5-year category is as follows: Year 1 2 3 4 5 6

Percentage depreciated 20.0% 32.0% 19.2% 11.52% 11.52% 5.76%

What would be the annual depreciation expense for tax purposes and for financial reporting? What would be the difference between income before taxes (for financial reporting) and taxable income (on tax return)? How would the ending balance of DTL related to this asset change from year 1 to year 6? You may assume the 21% tax rate for years 1 – 6. Answer: Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

10,000.00 (100.00) 9,900.00 2,079

10,000.00 (100.00) 9,900.00 2,079

10,000.00 (100.00) 9,900.00 2,079

10,000.00 (100.00) 9,900.00 2,079

10,000.00 (100.00) 9,900.00 2,079

10,000.00 (100.00) 9,900.00 2,079

10,000.00 (120.00) 9,880.00

10,000.00 (192.00) 9,808.00

10,000.00 (115.20) 9,884.80

10,000.00 10,000.00 (69.12) (69.12) 9,930.88 9,930.88

10,000.00 (34.56) 9,965.44

Taxes due (at 21%) Income tax provision - Taxes due

2074.8 4.2

2059.68 19.32

2075.81 3.19

2085.48 (6.48)

2085.48 (6.48)

2092.74 (13.74)

EB of DTL (equals 0 in Year 0)

4.2

23.52

26.71

20.23

13.75

0

Financial statements Income before taxes and depreciation for new asset Depreciation for financial reporting Income before taxes Income tax provision (at 21%) Tax return Income before taxes and depreciation for new asset Depreciation for tax purposes (use MACRS) Taxable income...