BOOKLET 2-ready.docx

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AUDIT OF LIABILITIES EXERCISE 1 On January 1, 2014, CRC-ACE Corporation issued bonds with a face value of P1,000,000 and a maturity date of December 31, 2023. The bonds have a stated interest rate of 10%, payable on January 1and July 1. They were sold for P915,300. CRC-ACE Corporation paid P30,000 to issue the bonds. Required: 1. What is the effective interest rate on this bond? a. 9% b. 10% c. 11% d. 12% 2. The total bond interest expense for the year 2014 is a. 92,426 b. 106,423 c. 104,673 d. 93,577 3. Carrying amount of bonds payable as of December 31, 2015 a. 891,723 b. 1,000,000 c. 895,226 d. 898,939 4. The unamortized bond discount on December 31, 2016 is a. 92,953 b. 114,700 c. 101,061 d. 104,774 5. Assuming that the bonds were required on January 1, 2015 at 90, how much is the gain or loss that should be recognized in the Income Statement? a. 8,277gain b. 8,277 loss c. 1,061 gain d. 100,000 gain Solution: Carrying amount FV Loss:

P891,723 (900,000) P 8,277

Answer: 1. D

3. D

2. B

4. A

5. B

EXERCISE 2 On January 1, 2014, Sea Air Company issued its 8%, 5-year convertible debt instrument with a face amount of P8,000,000 to P7,700,000. Interest is payable every December 31 of each year. The debt instrument is convertible into 50,000 ordinary shares with a par value of P100. When the debt instruments were issued, the prevailing market rate of interest for similar debt without conversion option is 10%. PV of 10% for an ordinary annuity of P1 after 5 periods 3.791 PV of 10% after 5 interest periods .621 On December 31, 2016, all the convertible debt instruments were retired for P8,000,000. The prevailing rate of interest on a similar debt instrument as of December 31, 2013 is 9% without the conversion option. PV of 9% for an ordinary annuity of P1 after 2 periods 1.795 PV of 9%^ after 2 interest periods

.842

Required: On the date of issue, what amount of the proceeds represents the equity components? Solution:

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PV of 1 (800T x .621) PV of I (640T x 3.791)

P4,968,000 2,426,620

Answer: P305,760 1. What is the carrying value of the debt instruments as of December 31, 2016? Answer: P305,760 2. On the date of retirement, what amount of the proceeds represents the equity component? Answer: P7,723,333 3. How much is the gain or loss that should be reported in the profit or loss on the retirement of the convertible debt instruments? Answer: P138,240 4. How much is the gain on cancellation of the equity component to be reported in the shareholders equity? Answer: P167,520 EXERCISE 4 REAL Company compensates its employees for certain absences for vacation and sickness. Employees are entitled to one day vacation plus one day sick leave for each month work during the year. Unused vacation days may be carried forward, but unused sick leave does not accumulate. Employees are compensated according to their pay in effect at the time of the leave. The following data were taken from the records for the year 2014. Date of Initial Employee Mr. A Mr. B Mr. C Mr. D Required:

Unused Vacation Vacation taken in Employment 1/1/2014 01/10/2012 18 07/28/2013 5 09/01/2014 0 08/01/2014 0

Sick leave taken in 2014 8 4 2 3

Rate 2014 5 10 6 5

per day P1,000 800 600 400

1. Compute the balance of the account Liability for Compensated Absences at December 31, 2013. Answer: P22,000 Solution: Employee Liabilities Expense VCT Mr. A P18,000 P17,000 P4,000 Mr. B 4000 17,600 6,400 Mr. C 0 4,800 1,200

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Mr. D

0 P22,000

4,000 P43,400

800 P12,400

2. Compute the amount of Employees benefit expense for sick leave and vacation leave for the year 2014. Answer: 43,400 Solution: Employee Benefit Expense Mr. A P17,000 Mr. B 17,600 Mr. C 4,800 Mr. D 4,000 Total P43,400 3. Compute the balance of liability for compensated absences at December 31, 2014. Answer: P34,400 Solution: Liability Compensated= P22,000 + P12,400 = P34,400 (see solution 1 also) EXERCISE 5 HOPE Company adopted the policy of leasing as the primary method of selling its products. The entity’s main product is a small helicopter that is very popular among politicians and entity managers. HOPE Company constructed such a helicopter for SOLO Company at a cost of P8,500,000. Financing the construction was at a 14% rate. The terms of the lease provided for annual advance payment of P2,500,000 to be paid over 10 years with the ownership transferring to the lessee at the end of the lease period. It is estimated that the helicopter will have an economic life of 20 years and a residual value of P1,600,000 at that date. The lease payments began January 1, 2014. HOPE Company incurred initial direct cost of P500,000 in financing the lease agreement with SOLO. The present value of an annuity due of 1 at 14% for 10 periods is 5.95. 1. What is the gross profit on sale that should be recognized by HOPE company? a. P5,875,000 b. P6,375,000 c. P4,275,000 d. P4,775,000 Answer: a Solution: Advance payment P2,500,000 X PV of annuity 5.95

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Total Less: Opex Gross profit

P14,875,000 9,000,000 P5,875,000

2. What is the unearned interest income on January 1, 2014? a. P10,125,000 b. P11,725,000 c. P9,625,000

d. P8,525,000 Answer: a

Solution: Advance payment X Total Less: Interest income

P2,500,000 10 years P25,000,000 14,875,000 P10,125,000

3. What is the interest income for 2014? a. P2,082,500 b. P1,732,500

c. P2,306,500

d. P1,956,500 Answer: b 4. What is the cost of the helicopter that should be recognized by SOLO? a. P25,000,000 b. P6,900,000 c. P8,500,000 d. P14,875,000 Answer: d Solution: Advance payment P2,500,000 X PV of annuity 5.95 Total Cost P14,875,000 5. What is the depreciation expense that should be recognized by SOLO in 2014? a. P743,750 b. P663,750 c. P1,327,500 d. P345,000 Answer: b Solution: Total cost P14,875,000 Residual value (1,600,000) Total 13,275,000 Over 20 years Dep’n expense P663,750 EXERCISE 6 Irene Co., a lessor of office equipment, purchased a new equipment for P1,000,000 on December 31, 2013. The equipment was delivered on the dame day to Gabby Co., the lessee. The following information relates to the lease transaction:

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1. The leased asset has an estimated economic life of seven years, which is also at the lease term. 2. At the expiration of the lease, the equipment will revert to Irene, at which time it is expected to have a residual value of P120,000 (none of which is guaranteed) 3. Irene implicit interest rate is 12% which is known by Gabby 4. Gabby’s incremental borrowing rate is 14% at December 31, 2013 5. Lease rentals consist of seven equal payments, the first of which was paid on December 31, 2013. 6. Irene properly accounts for this lease a direct financing lease and as a finance lease by Gabby. Both lessor and lessee are calendar year corporations and depreciate all property, plant, and equipment on the straight line basis. The present value tables show the following present value factors: Present value of 1 for seven periods at 12% 0.4523 Present value of 1 for seven periods at 14% 0.3996 Present value of annuity due for seven periods at 12% 5.1114 Present value of annuity due for seven periods at 14% 4.8387 1. How much is the annual lease payment? a. P135,103.43 b. P142,857.14 c. P185,022.50 d.P195,641.12 Answer: c Solution: Annual lease payment= P945,724/5.1114 = P185,022.50 2. How much unearned interest income should be recognized by Irene at the inception of the lease? a. P0 b. P65,724 c. P120,000 d. P415, 157.50 Answer: d Solution: ALP P185,022 X 7 years Total P,295,154 Add: RV 120,000 P1,415,154 Less: (999,9996.5) UnE Int. Inc P415,157.50 3. What is the amount of depreciation expense that Gabby should record for 2014? a. P0 b. P135,103.43 c. P142,857.14 d. P185,022.50 Answer: b Solution: Dep’n Expense= P945,724/ 7years = P 135,103.

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4. The amount of interest expense that should be recorded by Gabby for 2014 is a. P76,070.15 b. P91,284.18 c. P100,000 d. P113,487 Answer: b Solution: Cost P945,724 Less: ALP (185,022) Total: P760,702 X 12% Int. Expense P91,284.18 EXERCISE 7 WALMART Corporation is in the business of leasing new sophisticated computer systems. As a lessor of computers, WALMART purchased a new system on December 31, 2014. The system was delivered the same day (by prior system arrangement) to General Investment Company, a lessee. The corporation accountant revealed the following information relating to the lease transactions: Cost of system to WALMART Estimated useful life and lease term Expected residual value (unguaranteed) WALMART implicit rate of interest General’s incremental borrowing rate Date of first lease payment Additional information is as follows:

P550,000 8 years P40,000 12% 14% Dec. 31, 2014

(a) At the end of the lease, the system will revert to WALMART. (b) General is aware of Walmart rate of implicit interest. (c) The lease rental consists of equal annual payments. Questions: Based on the above and the results of your audit, answer the following: 1. The annual lease payment under the lease is a. P110,717 b. P95,950 c. P102,665

d. 91,664 Answer: b

2. The total financial revenue to be earned by the lessor over the lease term is a. P257,600 b. P183,312 c. P271,320 d. P335,736 Answer: a Solution: APL P95,950 X 8 years *Cost of system P550,000

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Total P767,600 less: RS Less:TCoS (510,000)* TCS Revenue P257,600 3. The interest income to be recognized by the lessor in 2015 is a. P53,680 b. P52,714 c. P54,486

(40,000) P510,000

d. P52,547 Answer: c

Solution: Interest income = P454,050 x 12% = P54,486 4. The total expenses related to the lease that will be recognized by the lessee in 2015 is a. P121,464 b. P130,792 c. P112,630 d. P119,278 Answer: d Solution: Depreciation Add: interest Total

P66,731 52,547 P119,278

5. The amount to be reported under current liabilities as liability under finance lease as of December 31, 2015 is a. P60,239 b. P48,611 c. P35,715 d. P64,963 Answer: b Solution: Cost P437,894 X 1.12 Total P490,441 Less: ALP (95,950) P394,491 Less: (345,880) Total P48,611

EXERCISE 8 In connection with the audit of financial statements of BLAKE Company, you were able to obtain the following information regarding a non-cancellable lease agreement that BLAKE entered into on January 1, 2014.

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The lease term is for a three year period beginning January 1, 2014. Under the terms of the operating lease, lease payments will be as follows: Year 1 P1,000,000 2 1,200,000 3 1,300,000 In addition, BLAKE paid a refundable rental deposit of P1,200,000. However, as an inducement to enter the lease, the lessor granted BLAKE Company the first six months of the lease, rent free. Assume that BLAKE’s incremental borrowing rate is 10%. 1. What is the rent expense that should be recognized in 2014? a. 1,000,000 b. 1,100,000 c. 1,166,667

d. 1,266,667 Answer: b

Solution: Y1 (1000/2) Y2 Y3 Total ÷ Total: Add: Total rent exp.

P 500 1,200 1,300 P3,000 3 years P1,000 100* P1,100

*1000 x 10% = P100

2. What is the interest income that should be recognized in 2015? a. 99,000 b. 90,000 c. 120,000

d. 0 Answer: a

Solution: Interest Income = P990 x 10% = P99,000

EXERCISE 9 You were engaged to audit the financial statements of FELIX Company for the year ended December 31, 2014. During the course of the audit, you obtained the following information about the company’s liabilities outstanding at December 31, 2014: 1. At December 31, 2014, FELIX has an obligation to its suppliers for the purchase of raw materials amounting to P128,500. 2. At the end of 2014, the company was in breach of a loan covenant in respect of a P600,000 long term loan from a bank that is otherwise repayable three years after. A review of subsequent events disclosed that before the financial statements were

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approved for issue, the bank formally agreed not to demand early repayment of the loan. 3. On January 1, 2014, FELIX issued 1,000 of its P1,000 bonds for P1,000,000 in a private transaction. On 1 January each year interest at the fixed rate of 5 percent per year is payable on outstanding capital amount of the bonds. On 31 December each year, the entity has a contractual obligation to redeem 100 of the bonds at P1,000 per bond. 4. At December 31, 2014, the carrying amount of the entity’s unfunded obligation for long-service leave was P100,000, P40,000 of which employees are entitled to take as leave in twelve months following the end of the reporting period. The balance of P60,000 is in respect of leave that employees are entitled to take only after the end of the next annual reporting period. The entity anticipates that only 75 per cent of its employees will take the leave due during the next annual reporting period. Required: 1. Compute the amount of the current liability as of December 31, 2014. a. P313,500 b. P903,500 c. P908,500 d. P303,500 Answer: c Solution: Payment of RM Bonds issued Bonds redeem Recovered Total

Current Liabilities P128,500 1,000,000 (150,000) ( 70,000) P908,500

2. Compute the amount of non-current liability as of December 31, 2014. a. P1,470,000 b. P1,460,000 c. P870,000 d. P860,000 Answer: c Solution: Long term loan Long service leave Leave 12 mos. Balance to be paid Long term payable Total

Non- Current Liabilities P600,000 100,000 40,000 60,000 70,000 P870,000

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EXERCISE 10 Included in MORGAN Corporation’s liability account balances at December 31, 2014 were the following: Note payable, bank P2,800,000 Liability Under Finance Lease 430,000 Deferred income taxes 360,000 Transactions during 2015 and other information relating to MORGAN’s liabilities were as follows: 1. The principal amount of the note payable is P2,800,000 and bears interest at 15%. The note is dated April 1, 2014 and is payable in four equal installments of P700,000 beginning April 1, 2015. The first principal and interest payment was made on April 1, 2015. 2. The capitalized lease is for ten-year period beginning December 31, 2012. Equal annual payments of P100,000 are due December 31 of each year, and the 14% interest rate implicit in the lease is known by MORGAN. The present value at December 31, 2014, of the seven remaining lease payments (due December 31, 2015, through December 31, 2017) discounted at 14% was P430,000. 3. Deferred income taxes are provided in recognition of timing differences between financial statement and income tax reporting of depreciation. For the year ended December 31, 2015 depreciation per tax return exceeded book depreciation by P90,000. MORGAN’s effective income rate for 2015 was 40%. 4. On July 1, 2015, MORGAN 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 1,2015 and mature on July 1, 2020. Interest is payable annually on July 1. MORGAN uses the interest method to amortize bond discount. Compute for the following as of December 31, 2015: A 1. Long-term liabilities 2. Current Portion of LongTerm Liabilities 3. Accrued Interest payable 4. Interest Expense Answers: 1. A 2. C 3. B EXERCISE 12

4.D

B

C

D

3,921,268 1,081,622

3,525,268 754,372

3,885,268 745,372

3,966,640 700,000

100,000 401,450

336,250 547,690

286,250 543,890

436,250 507,890

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COMPANY ALY starts operations at the beginning of 2014. The company has elected the revaluation model under IAS 16 for PPE as its accounting policy: During 2014, COMPANY ALY invests in shares of publicly traded companies. Part of them, purchased for 3 million, are classified/ designated as “at fair value through profit or loss” (FVPL) and the other ones, with a purchased cost of 25 million, are classified as available-for-sale (AFS). The market value of the FVPL securities at the end of the year is 4.2 million. In respect of AFS securities the company has recognized an impairment loss of 1.5 million. As a result of revaluation of PPE acquired during the year, the company has recognized both a positive revaluation of 10 million and a negative revaluation of 26 million on different PPE assets. Tax regulation in the country of the company’s incorporation is as follows:    

No capital gain and losses Tax rate is 30% Tax depreciation is based on historical cost. Gains and losses on financial assets are taxable/deductible when realized.

Required: 1. What is the deferred tax asset at the end of the year? Answer: P600,000 Solution: Purchased cost Less: nega. Revaluation Total cost X Deferred Tax Asset

P 2,500,000 (500,000) P2,000,000 30% P600,000

2. What is the deferred tax liability at the end of the year? Answer: P1,860,000 Solution: FVPL Add: total cost Total X Deferred tax liab.

P4,200,000 2,000,000 P6,200,000 30% P1,860,000

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3. What is the total tax expense, assuming taxable income is P10M? Answer: P2,760,000 Solution: Taxable income = P10,000,000 x 30% - 240,000 =

P2,760,000

EXERCISE 13 JENNINGS Co. gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale, JENNINGS Co. undertakes to make good, by repair or replacement, manufacturing defects that become apparent within one year from the date of sale. On the basis of experience, it is probable (ie more likely than not) that there will be some claims under warranties. At 31 December 2013 JENNINGS Co., appropriately recognized P50,000 warranty provision. JENNINGS Co., incurred and charged P140,000 against the warranty provision in 2014. P80,000 of this related to warranties for sales made in 2014. The increase during 2014 in the discounted amount recognized as a provision at 31 December 2014 arising from the passage of time is P2,000. At 31 December 2013 JENNINGS Co., estimated that it would incur expenditures in 2015 to meet its warranty obligations at 31 December 2014, as follows:    

5 per cent of probability of P400,000 20 per cent of probability of P200,000 50 per cent of probability of P80,000 25 per cent of probability of P20,000

Assume for simplicity that the 2015 cash flows for warranty repairs and replacements take place, on average, on 30 June 2015. An appropriate discount rate is 10 per cent per year. An appropriate rate adjustment factor to reflect the uncertainties in the cash flow estimates is in increment of 6 per cent to the probability-weighted expected cash flows. JENNINGS Co., is the defendant in a breach of patent lawsuit. Its lawyers believe there is 70 per cent chance that JENNINGS Co., will successfully defend the case. However, the court rules in favor of the claimant, the lawyers believe that there is 60 per cent chance that the entity will be required to pay damages of P2 million (the amount sought by the claimant) and 40 per cent chance that the entity will be required to pay damages of P1 million (the amount that recently awarded by the same judge in a similar case). Other amounts of damages are unlikely. The court is expected to rule in late December 2015. There is no indication that the claimant will settle out of court.

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A 7 per cent risk adjustment factor to the cash flows is considered appropriate to reflect the uncertainties in the cash flow estimates. An appropriate discount rate is 10 per cent per year. 1. What is the interest expense in 2014? a. P0 b. P1,000 c. P2,000

d. P3,000 Answer: P2,000

2. The provision for warranty at December 31, 2014 is a. P105,000 b. P111,300 c. P100,000

d. P106,000 Answer: P111,300

Solution: P400,000 x 5% 200,000 x 20% 80,000 x 50% 20,000 x 25% Total X Prov. For warranty 3. The warranty expense in 2014 is a. P196,000 b. P186,000

P20,000 40,000 40,000 5,000 P105,000 1.06 P111,300 c. P114,000

d. P194,000 Answer: d

Solution: Warranty expense = P106,000 + 140,000 – 50,000 = P194,000 4. How much provision should be recognized from lawsuit? a. P1,500,000 b. P1,600,000 c. P2,000,000 d. P0 Answer: 0 EXERCISE 14 You are the continuing auditor of CRESCENT Company. The comparative balance sheet of CRESCENT Company for 2013 and 2014 follows: December 31 Assets

2014

2013

Cash

200,000

115,000

Installment accounts receivable

420,000

310,000

Inventory

180,000

125,000

Equipment-net of accumulated depreciation 360,000

480,000

240

Liabilities and Stockholders’ Equity Accounts payable

150,000

200,000

Unearned Rent

70,000

40,000

Estimated Warranties Obligation

120,000

60,000

Other liabilities (including Deferred tax liability)150,000

145,000

Stockholders’ Equity

585,000

670,000

You have satisfied yourself as to the accuracy of the balances shown above. In addition, the following information was obtained:  

  

The company’s installment sales are taxable when cash are collected. CRESCENT Company uses the straight-line method of depreciation for financial reporting purposes and sum of the years digit method for tax purposes. The equipment was acquired in January 2013 and was estimated to have 5 year life. Rental income is taxable when cash is received. Warranty expense is deductible only when actual expenditure is made. CRESCENT Company reported a taxable income of P1,000,000 for 2014.

Required: 1. The amount of net deferred tax liability at January 1, 2014 is a. P101,500 b. P135,000 c. P87,000 d. P30,000 2. The amount of net deferred tax liability as at December 31,2014 is a. P57,000 b. P48,000 c. P105,000 d. P162,000 Answer: c Solution: Deferred Tax Liability P162,000 Less: Deferred Tax Asset 57,000 Total P105,000 3. Income tax expense-current for 2014 is a. P270,000 b. P360,000 4. Total income tax expense for 2014 is a. P318,000 b. P300,000 Answer: 1. C

2. C

3. D

4. A

c. P330,000

d. P300,000

c. P371,000

d. P282,000