AP 5902 Liabilities

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CPA REVIEW SCHOOL OF THE PHILIPPINES Manila

AUDITING PROBLEMS AUDIT OF LIABILITIES PROBLEM NO. 1 In the audit of the Heats Corporation’s financial statements at December 31, 2005, the chief accountant of the said corporation provided the following information: Notes payable: Arising from purchase of goods Arising from 5 year-bank loans, on which marketable securities valued at P600,000 have been pledged as security, P400,000 due on June 30, 2006; P100,000 due on Dec. 31, 2006 Arising from advances by officers, due June 30, 2006 Reserve for general contingencies Employees’ income tax withheld Advances received from customers on purchase orders Containers’ deposit Accounts payable arising from purchase of goods, net of debit balances of P30,000 Accounts receivable, net of credit balances P40,000 Cash dividends payable Stock dividends payable Dividends in arrears on preferred stock, not yet declared Convertible bonds, due January 31, 2007 First mortgage serial bonds, payable in semi-annual installments of P50,000, due April 1 and October 1 of each year Overdraft with Allied Bank Cash in bank balance with PNB Estimated damages to be paid as a result of unsatisfactory performance on a contract Estimated expenses on meeting guarantee for service requirements on merchandise sold Estimated premiums payable Deferred revenue Accrued interest on bonds payable Common stock warrants outstanding Common stock options outstanding Unused letters of credit Deficiency VAT assessment being contested Notes receivable discounted

304,000 500,000 50,000 400,000 20,000 64,000 50,000 170,000 360,000 80,000 100,000 200,000 1,000,000 2,000,000 90,000 390,000 160,000 120,000 75,000 87,000 360,000 120,000 210,000 400,000 500,000 200,000

On March 1, 2006, the P400,000 note payable was replaced by an 18-month note for the same amount. Heats is considering similar action on the P100,000 note payable due on December 31, 2006. The 2005 financial statements were issued on March 31, 2006. On December 1, 2005, a former employee filed a lawsuit seeking P200,000 for unlawful dismissal. Heats’ attorneys believe that the suit is without merit. No court date has been set. On January 15, 2006, the BIR assessed Heats an additional income tax of P300,000 for the 2003 tax year. Heats’ attorneys and tax accountants have stated that it is likely that the BIR will agree to a P200,000 settlement.

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REQUIRED: Based on the above and the result of your audit, compute for the following as of December 31, 2005: 1. 2. 3.

Total current liabilities a. P2,500,000 b. P2,100,000

c. P2,300,000

d. P2,400,000

Total noncurrent liabilities a. P3,300,000 b. P2,900,000

c. P3,000,000

d. P3,400,000

Total liabilities a. P5,200,000

c. P5,400,000

d. P5,800,000

b. P5,000,000

PROBLEM NO. 2 The following information relates to Sonic Company’s obligations as of December 31, 2005. For each of the numbered items, determine the amount if any, that should be reported as current liability in Sonic’s December 31, 2005 balance sheet. 1. Accounts payable: Accounts payable per general ledger control amounted to P5,440,000, net of P240,000 debit balances in suppliers’ accounts. The unpaid voucher file included the following items that not had been recorded as of December 31, 2005: a) A Company – P224,000 merchandise shipped on December 31, 2005, FOB destination; received on January 10, 2006. b) B, Inc. – P192,000 merchandise shipped on December 26, 2005, FOB shipping point; received on January 16, 2006. c) C Super Services – P144,000 janitorial services for the three-month period ending January 31, 2006. d) MERALCO – P67,200 electric bill covering the period December 16, 2005 to January 15, 2006. On December 28, 2005, a supplier authorized Sonic to return goods billed at P160,000 and shipped on December 20, 2005. The goods were returned by Sonic on December 28, 2005, but the P160,000 credit memo was not received until January 6, 2006. a. P5,923,200 b. P5,712,000 c. P5,601,600 d. P5,841,600 2. Payroll: Items related to Sonic’s payroll as of December 31, 2005 are: Accrued salaries and wages Payroll deductions for: Income taxes withheld SSS contributions Philhealth contributions Advances to employees a. P776,000 b. P992,000

P776,000 56,000 64,000 16,000 80,000 c. P832,000

d. P912,000

3. Litigation: In May, 2005, Sonic became involved in a litigation. The suit is being contested, but Sonic’s lawyer believes it is possible that Sonic may be held liable for damages estimated in the range between P2,000,000 and P3,000,000, and no amount is a better estimate of potential liability than any other amount. a. P0 b. P2,000,000 c. P3,000,000 d. P2,500,000

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4. Bonus obligation: Sonic Company’s president gets an annual bonus of 10% of net income after bonus and income tax. Assume the tax rate of 30% and the correct income before bonus and tax is P9,600,000. (Ignore the effects of other given items on net income.) a. P722,600 b. P395,000 c. P2,240,000 d. P628,000 5. Note payable: A note payable to the Bank of the Philippine Islands for P2,400,000 is outstanding on December 31, 2005. The note is dated October 1, 2004, bears interest at 18%, and is payable in three equal annual installment of P800,000. The first interest and principal payment was made on October 1, 2005. a. P800,000 b. P908,000 c. P72,000 d. P872,000 6. Purchase commitment: During 2005, Sonic entered in a noncancellable commitment to purchase 320,000 units of inventory at fixed price of P5 per unit, delivery to be made in 2006. On December 31, 2005, the purchase price of this inventory item had fallen to P4.40 per unit. The goods covered by the purchase contract were delivered on January 28, 2006. a. P0 b. P1,600,000 c. P1,408,000 d. P192,000 7. Deferred taxes: On December 31, 2005, Sonic’s deferred income tax account has a 2005 ending credit balance of P772,800, consisting of the following items: Caused by temporary differences in accounting For gross profit on installment sales For depreciation on property and equipment For product warranty expense a. P772,800

b. P952,000

Deferred tax P376,000 Cr. 576,000 Cr 179,200 Dr P772,800 Cr. c. P196,800 d. P0

8. Product warranty: Sonic has a one year product warranty on selected items in its product line. The estimated warranty liability on sales made during 2004, which was outstanding as of December 31, 2004, amounted to P416,000. The warranty costs on sales made in 2005 are estimated at P1,504,000. Actual warranty costs incurred during the current 2005 fiscal year are as follows: Warranty claims honored on 2004 sales Warranty claims honored on 2005 sales Total warranty claims honored a. P0 b. P1,504,000

c. P96,000

P 416,000 992,000 P1,408,000 d. P512,000

9. Premiums: To increase sales, Sonic Company inaugurated a promotional campaign on June 30, 2005. Sonic placed a coupon redeemable for a premium in each package of product sold. Each premium costs P100. A premium is offered to customers who send in 5 coupons and a remittance of P30. The distribution cost per premium is P20. Sonic estimated that only 60% of the coupons issued will be redeemed. For the six months ended December 31, 2005, the following is available: Packages of product sold Premiums purchased Coupons redeemed a. P1,728,000 b. P1,152,000

160,000 16,000 64,000 c. P1,600,000 d. P576,000

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10. Due to Five Six Finance company: Sonic’s accounting records show that as of December 31, 2005, P1,280,000 was due to Five Six Finance Company for advances made against P1,600,000 of trade accounts receivable assigned to the finance company with recourse. a. P0 b. P1,600,000 c. P320,000 d. P1,280,000 PROBLEM NO. 3 In conjunction with your firm’s examination of the financial statements of Pistons Company as of December 31, 2005, you obtained from the voucher register the information shown in the working paper below. Item No. 1

Entry Date 12.18.05

Voucher Ref. 12-202

2

12.18.05

12-204

3

12.21.05

12-206

4

12.21.05

12-214

5

12.21.05

12-219

6

12.26.05

12-221

7

12.28.05 12.28.05

12-230 12-234

8

9

12.28.05

12-243

10

01.02.06

01-001

11

01.02.06

01-002

12

13

14

15

01.05.06

01.10.06

01.10.06

01.12.06

01-003

01-004

01-005

01-006

Description Supplies, purchased FOB destination, 12.15.05; received, 12.17.05 Auto insurance, 12.15.05 to 12.15.06 Repair services; received 12.20.05 Merchandise shipped FOB shipping point, 11.20.05; received, 12.4.05 Payroll, 12.6.05 to 12.20.05 (12 working days) Subscription to tax reporting service for 2006 Utilities for December 2005 Merchandise shipped FOB destination, 12.24.05; received, 1.2.06 Merchandise shipped FOB destination, 12.26.05; received, 12.29.05 Legal services, received 12.28.05 Medical services for employees for December 2005 Merchandise shipped FOB shipping point, 12.29.05; received, 1.4.06 Payroll, 12.21.05 to 01.05.06 (12 working days in total, 4 working days in Jan.) Merchandise shipped FOB shipping point, 1.2.06; received, 1.5.06 Manufacturing royalties, Dec. 2005

Amount

Account Charged

Supplies on 20,000 hand Prepaid 24,000 insurance Repairs and 24,000 maintenance

17,000 Inventory Salaries and 69,000 wages Dues and 5,000 subscription expense 29,000 Utilities expense

111,500 Inventory

84,000 Inventory Legal and 46,000 professional expense

25,000 Medical expense

55,000 Inventory

72,000

Salaries and wages

64,000 Inventory Manufacturing 39,000 costs

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Item No. 16

Entry Date 01.12.06

Voucher Ref. 01-007

17

01.13.06

01-008

18

01.14.06

01-009

19

01.15.06

01-010

20

01.15.06

01-011

Description Merchandise shipped FOB destination, 1.3.06; received, 1.10.06 Maintenance services, received 1.9.06 Interest on bank loan, 10.12.05 to 1.10.06 Manufacturing equipment, installed on 12.29.05 Dividends declared, 12.15.05

Amount

Account Charged

38,000 Inventory 9,000 Repairs and maintenance 30,000 Interest expense Machinery and 254,000 equipment Dividends 160,000 payable

Accrued liabilities as of December 31, 2005 were as follows: Accrued payroll Accrued interest payable Dividends payable Accrued royalties payable

48,000 26,667 160,000 39,000

The Accrued payroll, Accrued interest payable, and Accrued royalties payable accounts were reversed on January 1, 2006. REQUIRED: Prepare adjusting entries as of December 31, 2005 based on your review of the data given above. PROBLEM NO. 4 During your regular annual audit of Rockets Company for the year ended December 31, 2005, you obtain the following evidence and data relative to your examination of the bonds payable and related accounts. From your permanent file working papers: Client is authorized to issue 20,000 bonds with par value of P1,000 each. Bonds are dated May 1, 2002 and are due May 1, 2012. Interest at 12% per annum is due semiannually every May 1 and November 1. The December 31, 2004 balance of P9,500,000 represents proceeds from issuance of 10,000 bonds on November 2, 2003. From the client’s ledger: 12%, 10-year Bonds Payable 12/31/2004 Balance 07/01/2005 CR

05/01/2005 11/01/2005

CV-120 CV-531

Interest Expense P600,000 07/01/2005 720,000

CR

P9,500,000 2,100,000

P40,000

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From supporting documents: CR

Cash receipts entry for issuance of 2,000 bonds for a total of P2,100,000 on July 1, 2005. Trustee’s remittance statement attached. Entry recorded Cash Bonds Payable Interest expense

P2,140,000 P2,100,000 40,000

CV-120

Cash payment to trustee for November 1, 2004 through April 30, 2005 interest. Paid check to trustee attached.

CV-531

Cash payment to trustee for May 1, 2005 through October 31, 2005 interest. Paid check to trustee attached.

REQUIRED: 1.

Adjusting journal entries as of December 31, 2005. Use the straight line method to amortize bond discount and premium, if any.

2.

Compute for the adjusted balances of the following as of December 31, 2005: a. Bonds payable d. Accrued interest b.

Bond discount

c.

Bond premium

e. Interest expense

PROBLEM NO. 5 Wizards Company presented to you their records in connection with the audit of the company’s financial statements for the year ended December 31, 2005. This is the first time the company has been audited. The company floated a serial bond issue in 2003. Your audit showed the following details of the issue and the accounts as of December 31, 2005: Total amount Date of issue Proceeds from issue Interest rate Interest payment date Maturity date 10/02/2005

VR

P5,000,000 October 2, 2003 P4,900,000 5% per annum October 1 P1,000,000 annually, starting October 1, 2005 5% Serial Bonds Payable P1,000,000 10/02/2003

CR

P4,900,000

Accrued Interest Payable 01/02/05

P62,500

REQUIRED: 1.

Adjusting journal entries as of December 31, 2005. method to amortize bond discount and premium, if any.

Use the bond outstanding

2.

Compute for the adjusted balances of the following as of December 31, 2005: a. Bonds payable b. Bond discount c. Accrued interest payable d. Bond interest expense

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PROBLEM NO. 6 On January 2, 2004, the Suns, Inc. issued P2,000,000 of 8% convertible bonds at par. The bonds will mature on January 1, 2008 and interest is payable annually every January 1. The bond contract entitles the bondholders to receive 6 shares of P100 par value common stock in exchange for each P1,000 bond. On the date of issue, the prevailing market interest rate for similar debt without the conversion option is 10%. On December 31, 2005, the holders of the bonds with total face value of P1,000,000 exercised their conversion privilege. In addition, the company reacquired at 110, bonds with a face value of P500,000. The balances in the capital accounts as of December 31, 2004 were: Common stock, P100 par, authorized 50,000 shares, issued and outstanding, 30,000 shares Premium on common stock

P3,000,000 500,000

Market value of the common stock and bonds were as follows: Date December 31, 2004 December 31, 2005

Bonds 118 110

Common stock 40 42

QUESTIONS: Based on the above and the result of your audit, answer the following: 1. How much of the proceeds from the issuance of convertible bonds should be allocated to equity? a. P634,000 b. P126,816 c. P221,664 d. P0 2. How much is the carrying value of the bonds payable as of December 31, 2004? a. P2,000,000 b. P1,389,400 c. P1,796,170 d. P1,900,502 3. How much is the interest expense for the year 2005? a. P160,000 b. P138,940 c. P179,617

d. P190,050

4. The entry to record the conversion on December 31, 2005 will include a credit to APIC of a. P365,276 b. P400,000 c. P307,893 d. P0 5. How much is the loss on bond reacquisition on December 31, 2005? a. P50,000 b. P96,053 c. P67,362 d. P0 PROBLEM NO. 7 In connection with your audit of Ginebra Corporation’s financial statements for the year 2005, you noted the following liability account balances as of December 31, 2004: Note payable, bank Liability under finance lease Deferred income taxes

P 5,600,000 430,000 700,000

Transactions during 2005 and other information relating to Ginebra’s liabilities were as follows: a.

The principal amount of the note payable is P5,600,000 and bears interest at 12%. The note is dated April 1, 2004 and is payable in four equal annual installments of P1,400,000 beginning April 1, 2005. The first principal and interest payment was made on April 1, 2005.

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b.

The capitalized lease is for a ten-year period beginning December 31, 2002. Equal annual payments of P100,000 are due on December 31 of each year, and the 14% interest rate implicit in the lease known by Ginebra. The present value at December 31, 2004 of the seven remaining lease payments (due December 31, 2005 through December 31, 2011) discounted at 14% was P430,000.

c.

Deferred income taxes are provided in recognition of timing differences between financial and income tax reporting of depreciation. For the year ended December 31, 2005, depreciation per tax return exceeded book depreciation by P312,500. Ginebra’s effective income tax rate for 2004 was 32%.

d.

On July 1, 2005, Ginebra issued for P1,774,000, P2,000,000 face amount of its 10%, P1,000 bonds. The Bonds were issued to yield 12%. The bonds are dated July 1, 2004 and will mature on July 1, 2014. Interest is payable annually on July 1. Ginebra uses the interest method to amortize bond discount.

QUESTIONS: Based on the above and the result of your audit, determine the following: 1. Liability under finance lease as of December 31, 2005 a. P381,600 b. P390,200 c. P344,828

d. P330,000

2. Total noncurrent liabilities as of December 31, 2005 a. P5,610,440 b. P5,770,640 c. P5,931,328

d. P5,725,268

3. Current portion of long-term liabilities as of December 31, 2005 a. P1,445,372 b. P1,400,000 c. P1,500,000 d. P1,446,576 4. Accrued interest payable as of December 31, 2005 a. P484,440 b. P432,628 c. P532,628

d. P478,000

5. Total interest expense for the year 2005 a. P652,440 b. P707,068

d. P699,760

c. P712,640

PROBLEM NO. 8 Select the best answer for each of the following: 1.

In auditing accounts payable, an auditor’s procedures most likely will focus primarily on management’s assertion of a. Existence or occurrence c. Completeness b. Presentation and disclosure d. Valuation or allocation

2.

An auditor performs a test to determine whether all merchandise for which the client was billed was received. The population for this test consists of all a. Merchandise received c. Canceled checks b. Vendors’ invoices d. Receiving reports

3.

The primary audit test to determine if accounts payable are valued properly is a. Confirmation of accounts payable b. Vouching accounts payable to supporting documentation c. An analytical procedure d. Verification that accounts payable was reported as a current liability in the balance sheet.

4.

Which of the following procedures is least likely to be performed before the balance sheet date? a. Observation of inventory c. Search for unrecorded liabilities b. Testing of internal control over cash d. Confirmation of receivables

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5.

An audit assistant found a purchase order for a regular supplier in the amount of P5,500. The purchase order was dated after receipt of goods. The purchasing agent had forgotten to issue purchase order. Also a disbursement of P450 for materials did not have a receiving report. The assistant wanted to select additional purchase orders for investigation but was unconcerned about lack of receiving report. The audit director should a. Agree with the assistant because the amount of the purchase order exception was considerably larger than the receiving report exception b. Agree with the assistant because the cash disbursement clerk had been assured by the receiving clerk that the failure to fill out a report didn’t happen very often. c. Disagree with the assistant because two problems have an equal risk of loss associated with them. d. Disagree with the assistant because the lack of a receiving report has a greater risk of loss associated with it.

6.

When using confirmation to provide evidence about completeness assertion for accounts payable, the appropriate population most likely is a. Vendors with whom the entity has previously done business. b. Amounts recorded in the accounts payable subsidiary ledger. c. Payees of checks drawn in the month after the year end. d. Invoices filed in the entity’s open invoice file.

7.

Which of the following is a substantive test that an auditor is most likely to perform to verify the existence and valuation of recorded accounts payable? a. Investigating the open purchase order file to ascertain that pre-numbered purchase orders are used and accounted for. b. Receiving the client’s mail, unopened, for a reasonable period of time after year end to search for unrecorded vendor’s invoices. c. Vouching selected entries in the accounts payable subsidiary ledger to purchase orders and receiving reports. d. Confirming accounts payable balances with known suppliers who have zero balances.

8.

Only one of the following four statements, which compare confirmation of accounts payable with suppliers and confirmation of accounts receivable with debtors is false. The false statement is that a. Confirmation of accounts receivable with debtors is a more widely accepted auditing procedures than is confirmation of accounts payable with suppliers. b. Statistical sampling techniques are more widely accepted in the confirmation of accounts payable than in the confirmation of accounts receivable. c. As compared with the confirmation of accounts receivable, the confirmation of accounts payable will tend to emphasize accounts with zero balances at the balance sheet date. d. It is less likely that the confirmation request sent to the supplier will show the amount owed than that request sent to the debtor will show the amount due.

9.

When title to merchandise in transit has passed to the audit client the auditor engaged in the performance of a purchase cut-off will encounter the greatest difficulty in gaining assurance with respect to the a. Quantity b. Quality c. Price d. Terms

10. Which of the following audit procedures is least likely to detect an unrecorded liability? a. Analysis and recomputation of interest expense. b. Analysis and recomputation of depreciation expense. c. Mailing of standard bank confirmation forms. d. Reading of the minutes of meetings of the board directors. 11.

Unrecorded liabilities are most likely to be found during the review of which of the following documents? a. Unpaid bills c. Bills of lading b. Shipping records d. Unmatched sales invoices

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12. Which of the following audit procedures is best for identifying unrecorded trade accounts payable? a. Reviewing cash disbursements recorded subsequent to the balance sheet date to determine whether the related payables apply to the prior period. b. Investigating payables recorded just prior to and just subsequent to the balance sheet date to determine whether they are supported by receiving reports. c. Examining unusual relationships between monthly accounts payable balances and recorded cash payments. d. Reconciling vendors’ statement to the file of receiving reports to identify items received just prior to the balance sheet date. 13. In verifying debits to perpetual inventory records of a nonmanufacturing firm, the auditor is most interested in examining the purchase a. Journal b. Requisitions c. Orders d. Invoices 14. Which of the following procedures relating to the examination of accounts payable could the auditor delegate entirely to the client’s employees? a. Test footings in the accounts payable ledger b. Reconcile unpaid invoices to vendors statements c. Prepare a schedule of accounts payable d. Mail confirmations for selected account balances 15. An auditor’s purpose in reviewing the renewal of a note payable shortly after the balance sheet date most likely is to obtain evidence concerning management’s assertions about a. Existence or occurrence c. Completeness b. Presentation and disclosure d. Valuation or allocation. 16. An auditor’s program to audit long term debt should include steps that require a. Examining bond trust indentures b. Inspecting the accounts payable subsidiary ledger. c. Investigating credits to the bond interest income account. d. Verifying the existence of the bondholders. 17. In an audit of bonds payable, an auditor expects the trust indenture to include the a. Auditee’s debt-to-equity ratio at the time of issuance. b. Effective yield of the bonds issued. c. Subscription list. d. Description of the collateral 18. In auditing long-term bonds payable, an auditor most likely will a. Perform analytical procedures on the bond premium and discount accounts. b. Examine documentation of assets purchased with bond proceeds or liens c. Compare interest with the bond payable amount for reasonableness. d. Confirm the existence of individual bondholders at year-end. 19. The audit procedures used to verify accrued liabilities differ from those employed for the verification of accounts payable because a. Accrued liabilities usually pertain to services of a continuing nature while accounts payable are the result of completed transactions b. Accrued liability balances are less material than accounts payable balances. c. Evidence supporting accrued liabilities in nonexistence while evidence supporting accounts payable is readily available. d. Accrued liabilities at year-end will become accounts payable during the following year. 20. The auditor is most likely to verify accrued commissions payable in conjunction with the a. Sales cutoff test b. Verification of contingent liabilities c. Review of post balance sheet date disbursements d. Examination of trade accounts payable – End of AP-5902 –

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