Johnson & Co: Year-end Audit Engagement

Tom Jones is the quality review partner on the Johnson & Co. engagement. He was reviewing the workpapers prior to the December 31, 2015, annual audit when he came across transactions that caused him a great deal of concern. He wondered if the firms auditors had handled them properly. The following information appeared in a memo to the file that prompted his concern.

Memo to File: Supplier Credits for Returned Product

For the last three quarters of the year, Johnson has engaged in last-minute transactions that are questionable. The facts are, according to the client, that Johnson received credits from a cellular phone supplier and promised to repay the supplier by purchasing cellular telephone and repair services at inflated prices in the subsequent quarter. The client has been unable to produce any supporting documents with respect to the promised purchases, and we have not been able to trace any such payments to cash disbursements.

The client has produced credit memos in the amount of $10 million, $7 million, and $4 million for December 31, 2015, September 30, 2015, and June 30, 2015, respectively, which is about 16 percent of the reported net income for 2015. The memos are marked to indicate that the credit was being provided in connection with defective telephone components. However, we could not identify any shipping documents to confirm that the components were returned to the supplier. The following table shows selected income and equity data by quarter and in aggregate for 2015. The table also indicates what the net income would have been without the credits.

Johnson & Co. Selected Income/Equity Information (figures are in million USD, except shares outstanding)
	Mar. 31	Jun. 30	Sep. 30	Dec. 31	YR 2015
Reported revenues	$170.00	$150.00	$160.00	$170.00	$650.00
Reported expenses	$134.00	$118.00	$127.00	$136.00	$515.00
Reported net income	$ 36.00	$ 32.00	$ 33.00	$ 34.00	$135.00
Net income w/o credits	$ 36.00	$ 28.00	$ 26.00	$ 24.00	$114.00
$ difference	$ 0.00	$ 4.00	$ 7.00	$ 10.00	$ 21.00
% difference	% 0.00	% 12.50	% 21.21	% 29.41	% 15.56
Preferred dividends	$ 1.05	$ 1.10	$ 1.15	$ 1.20	$ 4.50
Common stockholders equity	$650.00	$680.90	$712.75	$745.55	$745.55
Common stock shares outstanding	65.00	65.00	65.00	65.00	65.00

We have filed 10-Q quarterly reports to the SEC based on the reported net income. We recommend, however, the firm conduct due diligence prior to publishing the 10-K annual report.

The client assures us that the promised purchases will be made and the only reason for not doing so is a cash flow problem. We are relying on managements representations in that regard. Johnson is currently negotiating a loan for $20 million.

Required Quantitative Skills

1. 2. Calculate the Return on Equity (ROE) and Earnings per Share (EPS) ratios using the year-end amounts at December 31, 2015 - with and without the questionable credit memo transactions. Briefly describe ROE and EPS ratios, and explain how these year-end ratios might influence a potential investors decision on whether to purchase shares in Johnson & Co.