Chapter12 - Answer

CHAPTER

12 12-1.

SUBSTANTIVE TESTS OF INTANGIBLE ASSETS

The decision whether a given expenditure on intangible asset to be treated as expense or asset requires judgment. Expenditure giving rise to future benefits will be classified as assets while those expenditure the future benefits from which are uncertain are charged of as expense in the year incurred. The expected benefit from the intangible assets can be assessed in terms of the following: a) Patents: Actual production of the goods covered by the patent b) Goodwill: Review of actual excess income as well as actual income of the investee c) Trademark / Tradename: Continuous production of the product covered by the trademark/tradename.

12-2.

Research and Development Costs vary widely among companies. Many expenditures do have future worth, while others are so highly uncertain as to future value that recording them as assets is clearly improper. The auditor’s interest in auditing Research and Development costs stems from the objective of determining whether they should be deferred or charged against current operations. He shall be guided by GAAP in judging whether the client’s treatment of the Research and Development Costs is justified or not.

12-3.

Menfro, Inc. The rapid amortization of the leasehold for the first twelve (12) years resulted to an understatement of income totaling to P60,000: Correct amortization P450,000 x 12 20 Amortization per client (P27,500 x 12)

P270,000

Over-amortization

P 60,000

330,000

In view of the above, the amount of P60,000 should be added back to Retained Earnings as correction of prior years’ profits. Furthermore, amortization of P22,500 for the 13th year should be recorded. These adjustments would result to a net increase in the Retained Earnings balance which will enable the company to declare dividends without depleting the Retained Earnings balance significantly.

12-2

Solutions Manual to Accompany Applied Auditing, 2006 Edition

12-4.

Requirement (a) The annual depreciation for years 11 to 25 is P1,667. By the end of the 25th year, the building would be fully depreciated. [(50,000 – 25,000) / 15 years) Requirement (b) If the original lease had contained a renewal clause for an additional 20 years, the depreciation rate would still be 5%, which is based on the original term of the lease. The renewal of the lease contract is not certain and therefore will not be considered in the determination of the amortization period.

12-5.

Process Development Company Process Development Company Patents Amortization Schedule 1997 to 2005 Description Patent

P Q R

Less: Adjustment as per BIR requirement As Adjusted

Cost as Recorded P 40,000 120,000 160,000 P320,000 80,000 P240,000

1997 P1,212.12 3,529.41 4,705.88 P9,447.41 (2,361.85) P7,085.56 (a)

Amortization Per Client 1998 to 2005 Total Adjustment P 19,393.94 P 20,606.06 P(5,151.52) 56,470.59 60,000.00 (15,000) 75,294.12 80,000.00 (20,000) P151,158.65 P160,606.06

As Adjusted P 15,454.54 45,000.00 60,000.00

(37,789.67) P113,368.98 (b)

P120,454.54

* Based on 17 years legal life. (a) 1997 Amortization: 30,000 P = 16.5 Q&R =

210,000 17

x 0.5 = P 909.09 x 0.5 =

6,176.47 P7,085.56

(b) 1998 to 2005 Amortization: 30,000 P = x 8 =P 14,545.45 16.5 Q&R =

210,000 17

x 0.5 =

98,823.53 P113,368.98

(40,151.52) P120,454.54

Substantive Tests of Intangible Assets

12-3

Adjusting Journal Entries (1)

(2)

12-6.

Capital in excess of par value Patent P Patent Q Patent R To adjust patent valuation to conform to BIR requirement.

80,000.00

Accumulated amortization – Patent P Accumulated amortization – Patent Q Accumulated amortization – Patent R Retained earnings – Correction of prior years’ profit To adjust amortization provision from 1997 to 2005.

5,151.52 15,000.00 20,000.00

10,000.00 30,000.00 40,000.00

40,151.52

Cartwright Corporation Note to Instructor: For ease of discussion, the adjusting entries in the solution are dated to correspond with the original erroneous journal entries. In actual practice, they would be dated as of the year-end. Jan. 1

10

5

Apr. 1

May 15

Organization Expenses Intangibles To classify incorporation fees.

17,500

Organization Expenses Intangibles To classify legal fees for the organization of the company.

7,500

Advertising Expense Intangibles To expense advertising costs.

15,000

Land Building Intangibles To reclassify land and buildings for R & D activities.

15,000 20,000

Research and Development Expenses Intangibles To expense materials purchased.

15,000*

* Alternatively, unused materials and supplies, if material, may be set up as

17,500

7,500

15,000

35,000

15,000

12-4

Solutions Manual to Accompany Applied Auditing, 2006 Edition June 30

July 1

Dec. 10

31

31

31

prepaid expenses. Patent Intangibles To reclassify the patent.

10,000 10,000

Income Summary / Retained Earnings Intangibles To record operating loss.

12,000

Research and Development Expenses Intangibles To record acquisition of equipment.

12,000

Research and Development Expenses Intangibles To expense R & D costs.

30,000

12,000

12,000

30,000

Research and Development Expenses Accumulated Depreciation: Building To record ¾ year depreciation on R & D building (20-year life) from April 1 entry.

750

Amortization Expense Patent To record ½ year amortization (20year life) on June 30 patent.

250

750

250

PAS 38 prohibits capitalization of start-up expenses such as organization costs. No amortization should therefore be recorded. 12-7.

Harper, Inc. Calculation of Goodwill Average year-end net assets: (P2,400,000  5) Average annual earnings (P400,000  5) Less: Normal return on average year-end assets (10% x P480,000) Excess annual earnings Excess annual earnings capitalized at 20% or Goodwill P32,000  12%

P 480,000

P 80,000 48,000 P 32,000 = P160,000

Substantive Tests of Intangible Assets 12-8.

12-5

Bayer, Inc.

Net tangible assets per records, Nov. 1, 2006 Add: Agreed increase in value of equipment Net adjusted tangible assets Add: Value of Goodwill (Schedules 1 & 2) Total amount to be paid for net tangible assets and goodwill

Bayer, Inc. P328,500 40,000

Lead, Inc. P298,500

P368,500 74,900

P298,500 12,900

P443,400

P311,400

Supporting Computations: Schedule 1: Goodwill of Bayer, Inc. Average pre-tax earnings 11.1.01 to 11.1.06 Less: Additional annual depreciation equipment taken over at P40,000 in excess of book value (P40,000 / 5) Adjusted pre-tax earnings Less: Required earnings on net tangible assets (15% x P368,500)

P82,000

Excess annual pre-tax earnings

P18,725

Goodwill (excess earnings capitalized at 25%)

P74,900

8,000 P74,000 55,275

Schedule 2: Goodwill of Lead, Inc.

12-9.

Average pre-tax earnings 11.1.01 to 11.1.06 Less: Adjustment for effect of organization cost written off in 2005 (P20,000 / 5) Adjusted pre-tax earnings Less: Required earnings on net tangible assets (15% x P298,500)

P44,000

Excess annual pre-tax earnings

P 3,225

Goodwill (excess earnings capitalized at 25%)

P12,900

4,000 P48,000 44,775

Phoenix Supply Company Requirement (a) Allocation of the P137,500 cost to the individual assets in the group of assets acquired is based on the relative fair value of the individual assets.

12-6

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Asset Patent A Patent B Equipment Land

Appraisal Value

Portion of Total Value

P 30,000 40,000 19,700 62,000

30/151.7 40/151.7 19.7/151.7 62/151.7

Total Cost x x x x

P137,500 137,500 137,500 137,500

P151,700

Allocated Cost = = = =

P 27,192 36,256 17,856 56,196 P137,500

Journal entries for 2004, 2005 and 2006, relative to intangible assets, are as follows: 2004 Apr. 27 Patent A Patent B Equipment Land Cash To record the acquisition of assets.

27,192 36,256 17,856 56,196

Oct. 31 Amortization of Patents Patent A (27,192 / 5 x 6/12) Patent B (36,256 / 12 x 6/12) To record amortization of patents for 2004.

4,230

137,500

2,719 1,511

2005 Mar. 7 Legal Expenses 17,600 Cash To record legal fees related to defense of patents. Mar. 7 Amortization of Patents Patent A To record amortization on Patent A to date of write-off (Nov. 2004 to Feb. 2005).

17,600

1,813

Mar. 7 Loss on Patent A 22,660 Patent A To record write-off of Patent A after

1,813

22,660

Substantive Tests of Intangible Assets

12-7

unsuccessful defense. Oct. 31 Amortization of Patents 3,021 Patent B To record amortization of Patent B for 2005.

3,021

2006 Oct. 31 Amortization of Patents 3,021 Patent B To record amortization on Patent B for 2006.

3,021

Computations Amortization for 2006: Patent A: (P27,192 / 5 years) (6 / 12) Patent B: (P36,256 / 12 years) (6 / 12) Amortization on Patent A, 10/31/2004 – 3/7/2005: (P27,192 / 5 years) (4/12) Book value of Patent A to 3/7/2005: Cost Amortization recognized P2,719 1,813 Amortization for 2005 and 2006: Patent B: (P36,256/12 years)

P 2,719 1,511 P 4,230 P 1,813 P27,192 4,532 P22,660 P 3,021

The cost basis of patent B is P36,256 - P1,511 + P8,800 - P3,546). 2005, a full year’s amortization is taken by dividing the unamortized cost by the remaining useful life. In 2006 this is P39,999/10 ½ years or P3,809. Requirement (b) The legal costs of a court defense should be charged to expense whether the suit is won or lost because it does not meet the recognition criteria. Also, the unsuccessful defense implies that Patent A is of no further value to the company and leads to the write-off of the remaining unamortized cost of that patent.

12-8

Solutions Manual to Accompany Applied Auditing, 2006 Edition

12-10.

Balagtas Enterprises Requirement (a) Patents 1. Balance before adjustment, 12/31/06 P550,000 Correction: Deduct unamortized balance of P75,000 expenditures incorrectly debited to account on 1/1/03: P75,000 x (7 years/10 years) (52,500) [AJE (1)] Corrected balance before 2006 amortization P497,500 2.

2006 Amortization Patent having two years remaining life Unamortized cost: P210,000 x (7 years/14 years) = P105,000 Amortization: P105,000/2 Remaining Patents Unamortized cost: P497,500 - P105,000 = P392,500 Amortization: P392,500/7

Franchise Agreement 1. Balance before adjustment, 12/31/06 Correction: Deduct periodic payment charged to account Corrected balance before 2006 amortization 2.

2006 Amortization: P50,000 / 5 years

Organization Costs 1. Balance before adjustment, 12/31/06 Correction: Legal fees incorrectly charged to Goodwill account in 1998 Amortization of above costs, 1998 - 2004 (P45,000 / 40) (7 years) 2.

P 52,500 56,071 P108,571 [AJE (2)] P 95,000 (45,000) [AJE (3)] P 50,000 P 10,000 [AJE (4)] P102,000

P45,000

[AJE (5)]

7,875

37,125 [AJE (6)] P139,125 [AJE (7)]

No amortization need be taken up in 2006. With the effectivity of PAS 38 which does not allow deferment or capitalization of organization costs, the entire balance of this account, should have been charged off against income in 2004. Adjusting entry in 2006 will be: Retained earnings – Prior period

Substantive Tests of Intangible Assets adjustment Organization costs

139,125 139,125

Goodwill 1. Balance before adjustment, 12/31/06 Correction: Reclassification of legal fees to Organization Costs Reclassification of advertising fee to Advertising Expense Amortization on Goodwill for 2004 (P200,000 / 40 years) Balance 12.31.04 2.

12-9

P345,000 ( 45,000) (100,000) ( 5,000) P195,000

Effective January 2005, Revised PAS 36 prohibits amortization of intangibles with indefinite life - Goodwill being one of them. Hence, no amortization would be taken up starting 2005. Assessment for possible impairment should be done annually or whenever there is an indication that the asset may be impaired.

Adjusting Journal Entries: Patents AJE (1) Retained Earnings Patents

52,500

AJE (2) Cost of Goods Sold Patents

108,571

52,500 108,571

Franchise Agreement AJE (3) Selling and Administrative Franchise Expense Franchise Agreement

45,000

AJE (4) Selling and Administrative Expense Franchise Agreement

10,000

45,000

10,000

Organization Cost AJE (5) Organization Costs Goodwill AJE (6) Retained Earnings Organization Costs AJE (7) Retained Earnings

45,000 45,000 7,875 7,875 139,125

12-10

Solutions Manual to Accompany Applied Auditing, 2006 Edition Organization Costs

139,125

Goodwill AJE (8) Selling and Administrative – Advertising Expense Goodwill

100,000 100,000

AJE (9) Retained Earnings Goodwill

5,000 5,000

Requirement (b) (1) Retained Earnings Selling and Administrative – Franchise Expense Selling and Administrative – Advertising Expense Organization Costs Franchise Agreement Goodwill Patents

204,500 45,000 100,000 102,000 45,000 150,000 52,500

Summary: Retained Earnings AJE (1) (7) (9) (6)

(Dr.) Cr. (52,500) (139,125) 5,000 7,875 (204,500)

Organization Costs AJE (5) (6) (7)

Dr. (Cr.) 45,000 (7,875) (139,125) (102,000)

Goodwill AJE

Dr. (Cr.) 45,000 100,000 5,000 150,000

(5) (8) (9)

(2) Cost of Goods Sold

108,571

Substantive Tests of Intangible Assets

12-11.

Selling and Administrative Expense Patents Franchise Agreement Balagtas Company

12-11

10,000 108,571 10,000

Requirement (a) The deficiencies listed below are apparent from the balance sheet and the explanations given. The assumption is made that costs incurred have been properly classified by Mr. Balagtas. The correct treatment of each item is presented in the column on the right. Deficiency

Correct Treatment

1.

Capitalization of expenses: Research and development Marketing research Personnel recruitment and training Legal fees relative to organization of the corporation Operating expenses

Treat all the items as expenses in 2006 income statement.

2.

No depreciation was taken on machinery.

Expense appropriate amounts in the 2006 income statement.

3.

Ordinary shares account does not reflect the par value of the outstanding shares (11,000).

Increase ordinary shares by par value of 1,000 shares.

4.

No statement of shareholders’ equity and explanation of shares issued is presented.

The statement should be provided, including dates and numbers of shares issued, peso amounts assigned, and the bases for assigning peso values in noncash transactions. Also, land given by Mario should be recorded at fair value; services by Pedro should be recognized as an expense at fair value. Additional paid-in capital may be recognized as the result of the above.

5.

No accumulated deficit presented.

“Deficit accumulated during development stage” should be included in the shareholders’ equity section. The amount results from corrections made in items 1 and 2

12-12

Solutions Manual to Accompany Applied Auditing, 2006 Edition above. Requirement (b) Additional items which should be included are:

12-12.

1.

Income statement, including amounts of revenue and expenses recognized since the inception of the enterprise in 2006.

2.

Statement of cash flows, including cumulative amounts of sources and uses of cash since the inception of the enterprise.

3.

Additional disclosures: identification of the company as a development-stage enterprise, and description of significant development-stage activities.

Nikko Corporation Requirement (a) In a purchase transaction, assets are recorded at their acquisition price, which becomes the cost basis to the acquiring corporation. The book values of the assets for Rain Company are irrelevant. Requirement (b) When a price is paid for a group of assets, the total price must be allocated to the individual assets. Because we know neither the total fair value of the tangible and other intangible assets acquired from Rain Company nor the price to be paid by the Nikko Corporation, we cannot determine whether Nikko Corporation has any goodwill to record. The total price to be paid by the Nikko Corporation is indefinite but it may be estimated by discounting the expected receipts (1% of net sales) at the end of each of the next 5 years and adding the initial P450,000 cash payment. If the estimated purchase price exceeds the sum of the estimated fair values of the tangible and other assets purchased, then the excess may be recorded as goodwill.

12-13.

Golden Springs Shopping Center, Inc. Interest on mortgage bonds: An amount equal to the interest cost incurred in 2004 (P60,000) is clearly a cost that can be associated with the normal construction period and can be regarded as a normal element of the capitalized cost of the physical assets of the shopping center because the construction period would have ended at the end of the year if the typhoon had not occurred. The decision to use debt capital to finance the shopping center was made with full knowledge that interest would accrue during the construction period and add to the total cost of

Substantive Tests of Intangible Assets

12-13

building the center and bringing it to the point at which it would produce revenue. The future income to be generated by the shopping center must have been estimated to be more than sufficient to recover all of the expected costs of building the center and preparing it for occupancy, including interest during the construction period. Instead of treating interest during construction as an element of the cost of the physical assets, it can be argued that it represents an element of the general cost of bringing the business to the point of revenue production and should therefore be treated as an organization cost. This view regards interest during construction as just another of the many expenditures that are necessary to acquire and organize the physical assets of a new business but do not attach to any specific assets. Treated as an organization cost, interest during construction would be expensed as a start-up cost. Another alternative to capitalizing an amount equal to the 2004 interest cost is to treat it as interest expense. This treatment is inappropriate because it assumes that the decision to use debt capital to finance construction is a decision deliberately to incur an expense for the interest that accrues during the expected construction period. The extension of the construction period to October 2005 because of the typhoon was externally imposed and so the interest capitalization period continues until final construction is complete. That is, the additional interest cost is capitalized and not expensed as a loss from the typhoon. Cost of obtaining tenants: Both the 2004 and 2005 costs of obtaining tenants should be capitalized and amortized over the life of the leases. The fact that all of the tenants who were signed when the typhoon occurred accepted the October occupancy date indicates that the total cost of obtaining tenants was not affected by the delay. The cost of obtaining tenants has a direct and easily identifiable relationship to the rental income to be earned over the terms of the leases. Under these circumstances, the problem of reliably measuring periodic net income is best solved by matching costs with the revenues to which they are directly related. Promotional advertising: The 2004 cost of promotional advertising should be written off as a start-up cost. The 2005 cost of promotional advertising should also be expensed. The initial expense treatment of the 2004 advertising cost is appropriate because it is a start-up cost. The 2005 advertising cost may also be considered as a start-up cost or simply expensed as advertising cost incurred.

12-14

Solutions Manual to Accompany Applied Auditing, 2006 Edition

12-16 12-14.

Solutions Manual to Accompany Applied Auditing, 2006 Edition Lee Manufacturing Corporation

General Ledger Accounts Cash Accounts receivable Allowance for doubtful accounts Inventories Machinery Equipment Accumulated depreciation Patents Leasehold improvements Prepaid expenses Organization costs Goodwill Licensing agreement no. 1 Licensing agreement no. 2 Accounts payable Unearned revenue Capital stock Retained earnings, Jan. 1, 2006 Sales Cost of goods sold

Trial Balance Debit Credit P 61,000 92,500 P 500 38,500 75,000 29,000 10,000 85,000 26,000 10,500 29,000 24,000 50,000 49,000

27,000 454,000

Selling and general expenses Start-up expenses

173,000

Interest expense Extraordinary losses Accumulated amortization: patents Accumulated amortization: leasehold improvements Accumulated amortization: licensing agreements Prior period adjustment – licensing agreement no. 1 Prior period adjustment – amortization of leasehold improvements Net income for 2006

3,500 12,000

Totals *

P1,239,000

147,500 12,500 300,000 768,500

P1,239,000

Lee Manufacturing Corporation Financial Statement Worksheet For the Year Ended December 31, 2006 Adjustments Debit Credit (8)

P 2,500

(1) (8)

17,000 8,500

Income Statement Debit Credit P

(1) P 17,000 (8) 11,000

(3)

(2) (6) (10) (7) (7) (9)

1,000

(9) (7) (4) (5)

29,000 24,000 1,250 29,250

(3)

1,000

3,400 5,500 1,500 8,000 16,000 29,000

(4) (5)

1,250 29,250

(10)

1,500 P124,400

Balance Sheet Debit Credit 61,000 95,000 (500) 38,500 92,000 37,500 (10,000) 68,000 15,000 10,500 19,500 50,000

P

464,400

P

P

768,500

147,500 13,500 300,000 (27,000)

181,000 45,000 3,500 12,000 (2)

3,400

(3,400)

(10)

3,000

(3,000)

(6)

5,500

(5,500)

(30,500) *

(1,500) * 62,600

62,600 P124,400

P

768,500

P

768,500

P

470,600

P

470,600

Generally, adjustments in the current period that could have been determined by management in a prior period should enter into the determination of net income in the current period. However, because the 2006 financial statements were not prepared in conformity with generally accepted accounting principles, these retroactive adjustments are considered to be errors and treated as prior period adjustments and, therefore, should be applied against beginning retained earnings.

Substantive Tests of Intangible Assets 12-14.

12-17

Lee Manufacturing Corporation (continued . . . ) Adjusting entries (shown on worksheet): (1)

(2)

(3)

(4)

Machinery Patents To transfer cost of improving machinery to the fixed asset account.

17,000 17,000

Cost of Goods Sold Accumulated Amortization: Patents To record 2006 patent amortization (1/20 x P68,000).

3,400

Licensing Agreement No. 2 Unearned Revenue To classify revenue received in advance on licensing agreement as unearned revenue.

1,000

Prior Period Adjustment – Licensing Agreement No. 1 Licensing Agreement No. 1 To take up 2005 amortization (40 year life). (Note 1)

3,400

1,000

1,250 1,250

Note 1: Under the revised PAS 38 made effective January 1, 2005, intangible assets with indefinite useful lives need not be amortized but periodically assessed for possible impairment. This problem may also be solved by disregarding the 40-year amortization period for Licensing Agreement #1. The flood that rendered Licensing Agreement #1 worthless in January 2007 should be fully disclosed in the December 31, 2006 statements. (5)

Prior Period Adjustment – Licensing Agreement No. 1 Licensing Agreement No. 1 To write off the permanent 60% reduction in the expected revenueproducing value of licensing agreement no. 1 caused by the December 2005 explosion (60% x P48,750).

29,250 29,250

Substantive Tests of Intangible Assets (6)

(7)

(8)

(9)

Cost of Goods Sold Accumulated Amortization: Licensing Agreements To record 2006 amortization of licensing agreement no. 1 [(P50,000 – P1,250 – P29,250)  39] and no. 2 (P50,000  10).

5,500 5,500

Selling and General Expenses Start-up Expenses Goodwill To transfer items improperly charged to Goodwill.

8,000 16,000

Start-up Expenses Organization Costs To expense other organization costs.

29,000

Equipment Accounts Receivable – Lessor Leasehold Improvements To charge the Equipment account with movable equipment and to record a receivable from the landlord for the real estate taxes erroneously paid by Lee.

(10) Cost of Goods Sold Prior Period Adjustment – Amortization of Leasehold Improvements Accumulated Amortization: Leasehold Improvements To record 2005 and 2006 amortization of leasehold improvements based on 10-year life of lease (2 x 10% x P15,000).

12-18

24,000

29,000 8,500 2,500 11,000

1,500 1,500 3,000

Substantive Tests of Intangible Assets 12-15.

12-19

Broadway Corporation Requirement (1) Broadway Corporation Intangibles Section of Balance Sheet December 31, 2006 Franchise from IE Copy Service, Inc., net of accumulated amortization of P6,870 (Schedule 1) Patent, net of accumulated amortization of P2,050 (Schedule 2) Trademark, net of accumulated amortization of P7,294 (Schedule 3) Total intangibles

P 61,830 14,350 42,706 P118,886

Schedule 1: Computation of Franchise from IE Copy Service, Inc. Cost of franchise at January 1, 2006 Down payment Present value of installments Initial amount capitalized Amortization of franchise for 2006 (P68,700  10 years) Franchise balance, December 31, 2006

P25,000 43,700 P68,700 (6,870) P61,830

Schedule 2: Computation of Patent Capitalized cost of patent at January 2, 2006 – legal fees and other costs associated with registration Amortization of patent for 2006 (P16,400  8 years) Patent balance, December 31, 2006

P16,400 (2,050) P14,350

12-20

Solutions Manual to Accompany Applied Auditing, 2006 Edition Schedule 3: Computation of Trademark Cost Cost of trademark at July 1, 2003 Amortization through December 31, 2006 (P40,000  20 years = P2,000 x 3 ½ years)

P40,000

Balance, December 31, 2006 Deduct accumulated amortization Trademark balance, December 31, 2006

P40,000 (7,000) P33,000

Accumulate d Amortizatio n P7,000 P7,000

Cost of successful litigation in defense of trademark should be charged to expense. Requirement (2) Broadway Corporation Expenses Resulting from Intangibles Transactions For the Year Ended December 31, 2006 Franchise from IE Copy Service, Inc. Amortization of franchise (Schedule 1) Franchise fee on revenues from operations (P900,000 x 5%) Imputed interest expense on unpaid balance of initial franchise fee (P43,700 x 14%) Amortization of patent (Schedule 2) Litigation expense – Trademark Amortization of trademark Total expenses 12-16.

Precious Opal Corporation (a) 2006 amortization: P16,000  10 = P1,600. 12/31/06 book value: P16,000 – P1,600 = P14,400. 2007 amortization: (P16,000  10) = P1,600. 12/31/07 book value: (P16,000 – P3,200) = P12,800. (b) 2007 amortization: (P12,800)  4 = P3,200. 12/31/07 book value: P12,800 – P3,200 = P9,600.

P 6,870 45,000 6,118 P57,988 2,050 10,000 2,000 P72,038

Substantive Tests of Intangible Assets

12-21

Legal fees in successfully defending the trade name should be charged to expense. (c) Carrying amount (P19,733) > Fair Value (P15,000); thus the tradename fails the recoverability test. The new carrying value is P15,000. The fair value is considered the recoverable amount. The estimated total future flows from the trade name of P16,000 need to be discounted and the resulting present value would in most probability be a lower amount than P15,000. 2008 amortization (after recording impairment loss): P15,000 ÷ 8 = P1,875. 12/31/08 book value: P15,000 – P1,875 = P13,125 12-17.

Miguel Alfonso Corporation Requirement (a) Attorney’s fees in connection with organization of the corporation Costs of meetings of incorporators to discuss organizational activities State filing fees to incorporate Total organization costs

P15,000 7,000 1,000 P23,000

Drafting and design equipment, P10,000, should be classified as part of fixed assets, rather than as organization costs. Requirement (b) Organization Expense............................................................................................................ 23,000 Cash (Payables)....................................................................................................... 23,000 12-18.

Jo Tan Company Requirement (a) Jo Tan Company INTANGIBLES SECTION OF BALANCE SHEET December 31, 2007

Patent from Francis Argante Company, net of accumulated amortization of P560,000 (Schedule 1) Franchise from JC Company, net of accumulated amortization of P48,000 (Schedule 2) Total intangibles

P1,440,000 432,000 P1,872,000

12-22

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Schedule 1 Computation of Patent from Francis Argante Company Cost of patent at date of purchase Amortization of patent for 2006 (P2,000,000  10 years) Amortization of patent for 2007 (P1,800,000  5 years) Patent balance

P2,000,000 (200,000) 1,800,000 (360,000) P1,440,000

Schedule 2 Computation of Franchise from JC Company Cost of franchise at date of purchase Amortization of franchise for 2004 (P480,000  10) Franchise balance

P 480,000 (48,000) P 432,000

Requirement (b) Jo Tan Company Income Statement Effect For the year ended December 31, 2007 Patent from Francis Argante Company: Amortization of patent for 2007 (P1,800,000  5 years) Franchise from JC Company: Amortization of franchise for 2007 (P480,000  10) Payment to Reagan Company (P2,500,000 X 5%) Research and development costs Total charged against income 12-19.

P360,000

P 48,000 125,000

173,000 433,000 P966,000

Twinkle Industries Requirement (a) Patent X Life in years Life in months (12 X 17) Amortization per month Number of months amortized to date Year 2004 2005

Month 10 12

17 204 P150

Substantive Tests of Intangible Assets 2006 2007

12-23

12 12 46

Book value 12/31/07 P23,700: (P30,600 – [46 X P150]) Patent Y Life in years Life in months (12 X 10) Amortization per month Number of months amortized to date Year 2005 2006 2007

10 120 P125

Month 6 12 12 30

Book value 12/31/07 P11,250: (P15,000 – [P125 X 30]) Patent Z Life in years Life in months (12 X 4) Amortization per month Number of months amortized to date Year 2006 2007

4 48 P300

Month 4 12 16

Book value 12/31/07 P9,600: (P14,400 – [P300 X 16]) At December 31, 2007 Patent X Patent Y Patent Z Total

P23,700 11,250 9,600 P44,550

Requirement (b) Analysis of 2008 transactions 1.

The P245,700 incurred for research and development should be expensed.

12-24

Solutions Manual to Accompany Applied Auditing, 2006 Edition 2.

The book value of Patent Y is P11,250 and its estimated future cash flows are P6,000: (3 X P2,000) therefore Patent Y is impaired. The impairment loss is imputed as follows:

Book value Less: Present value of future cash flows 2,000 X 2.57710 Loss recognized Patent Y carrying amount (12/31/08) P5,154

P11,250 5,154 P 6,096

At December 31, 2008 Patent X Patent Y Patent Z Patent AA Total

P21,900 5,164 6,000 34,560 P67,624

(P23,700 – [12 X P150]) (Present value of future cash flows) (P9,600 – [12 X P300]) (P36,480 – P1,920*)

Patent AA amortization Life in years Life in months Amortization per month P320 X 6 = P1,920

9 1/2 114 P320

Patent Y: Value in Use 2,000 2,000 2,000

x x x

0.9259 = 0.8573 = 0.7983 =

P1,852 1,715 1,597 P5,164

or 2,000 12-20.

x

2.582 =

P5,164

Depp Corporation Requirement (a) Cash............................................................................................................. 50,000 Receivables.................................................................................................. 90,000 Inventory...................................................................................................... 125,000 Land............................................................................................................. 60,000 Buildings...................................................................................................... 75,000 Equipment.................................................................................................... 70,000 Trademarks.................................................................................................. 15,000 Goodwill...................................................................................................... 65,000

Substantive Tests of Intangible Assets

12-25

Accounts Payable............................................................................ 200,000 Notes Payable.................................................................................. 100,000 Cash................................................................................................. 250,000 Note that the building and equipment would be recorded at the 7/1/06 cost to Brigham; accumulated depreciation accounts would not be recorded. Requirement (b) 1. Amortization Expense (Trademarks)................................................................................ 1,500 Trademarks ([P15,000 – P3,000] 1/4 X 6/12)......................................................... 1,500 2. Goodwill will not be amortized. 12-21.

Bill Santos Company Requirement (a) December 31, 2006 Loss on Impairment....................................................................................... 1,100,000* Copyrights....................................................................................... 1,100,000 *Carrying amount Fair value Loss on impairment

P4,300,000 3,200,000 P1,100,000

Requirement (b) Copyright Amortization Expense................................................................... 320,000* Copyrights........................................................................................320,000 *New carrying amount Useful life Amortization per year

CV 12.31.06 Amortization, 2007 CV 12.31.07

Historical Cost P4,300,000 430,000 P3,870,000

P3,200,000  10 years P 320,000

Recovery Requirement (c)

Fair Value 12.31.07

Fair Value P3,200,000 320,000 P2,880,000

P3,400,000 520,000

12-26

Solutions Manual to Accompany Applied Auditing, 2006 Edition Copyrights...................................................................................................... 520,000 Copyright Amortization Expense or Gain on Recovery of Previously Recognized Impairment................................................................520,000

12-22.

Español Co. Franchises.................................................................................................................... 42,000 Prepaid Rent....................................................................................................................... 28,000 Retained Earnings (Organization Costs of P6,000 in 2006).............................................................................................................................. 6,000 Retained Earnings (P16,000 – P6,000).............................................................................. 10,000 Patents................................................................................................................................ 74,000 Legal fees........................................................................................................................... 12,650 Research and Development Expense.................................................................................. (P75,000 + P160,000)...................................................................................................... 235,000 Goodwill............................................................................................................................. 278,400 Intangible Assets.................................................................................................. 686,050 5,250 Franchise Amortization Expense (P42,000  8)................................................................. 2,625 Retained Earnings (P42,000  8 X 6/12)............................................................................ Franchises............................................................................................................. 7,875 14,000 Rent Expense (P28,000  2)............................................................................................... 3,500 Retained Earnings (P28,000  2 X 3/12)............................................................................ Prepaid Rent......................................................................................................... 17,500 Patent Amortization Expense............................................................................................. 7,400 Patents.................................................................................................................. 7,400 (P74,000  10) Note—No amortization of goodwill; goodwill should be tested for impairment on at least an annual basis in future periods.

12-23.

Sim Laboratories Requirement (a) Costs to obtain patent Jan. 1999 1996 amortization (P62,050  17) Carrying value, 12/31/99

P62,050 (3,650) P58,400

Substantive Tests of Intangible Assets

12-27

All costs incurred prior to January 1999 are related to research and development activities and were expensed as incurred.

Requirement (b) 1/1/00 carrying value of patent 2000 amortization (P62,050  17) 2001 amortization Legal fees to defend patent 12/01 Carrying value, 12/31/01 2002 amortization (P86,800  14) 2003 amortization Carrying value, 12/31/03

P58,400 P3,650 3,650

6,200 6,200

(7,300) 51,100 35,700 86,800 (12,400) P74,400

The costs incurred in 2000 and 2002 are related to research and development activities and are expensed as incurred. Legal fees in successful defense of the patent in 2001 could be capitalized and considered GAAP. Requirement (c) 1/1/04 carrying value 2004 amortization (P74,400  5) 2005 amortization 2006 amortization Carrying value, 12/31/06

P74,400 P14,880 14,880 14,880

(44,640) P29,760

The legal costs in 2006 were expensed because the suit was unsuccessful. Even if the lawsuit was successful, the legal fees would be likewise charged to expense. This is in accordance with PAS 38, Intangibles which was made effective in 2004.