APPLIED AUDITING

CHAPTER 7
AUDIT OF LIABILITIES

Objective
1. Solving Audit of Liabilities Problems
2. Theory of Audit of Liabilities

PROBLEM NO. 1

Atimonan Corporation is selling audio and video appliances. The company’s

fiscal year ends on March 31. The following information relates to the
obligations of the company as of March 31, 2006:

Notes payable
Atimonan has signed several long-term notes with financial institutions. The
maturities of these notes are given below. The total unpaid interest for all of
these notes amounts to P408,000 on March 31, 2006.

Due date Amount

April 31, 2006 P 720,000
July 31, 2006 1,080,000
September 1, 2006 540,000
February 1, 2007 540,000
April 1, 2007 – March 31, 3,240,000
2008
P 6,120,000

Estimated warranties
Atimonan has a one-year product warranty on some selected items. The
estimated warranty liability on sales made during the 2004 – 2005 fiscal year
APPLIED AUDITING

and still outstanding as of March 31, 2005, amounted to P302,400. The

warranty costs on sales made from April 1, 2005 to March 31, 2006, are
estimated at P756,000. The actual warranty costs incurred during 2005 –
2006 fiscal year are as follows:

Warranty claims honored on 2004 – 2005 P 302,400

sales
Warranty claims honored on 2005 – 2006 342,000
sales
Total P 644,400

Trade payables
Accounts payable for supplies, goods, and services purchases on open
account amount to P672,000 as of March 31, 2006.

Dividends
On March 10, 2006, Atimonan’s board of directors declared a cash dividend of
P0.30 per common share and a 10% common stock dividend. Both dividends
were to be distributed on April 5, 2006 to common stockholders on record at
the close of business on March 31, 2006. As of March 31, 2006, Atimonan has
6 million, P2 par value, common shares issued and outstanding.

Bonds payable
Atimonan issued P6,000,000, 12% bonds, on October 1, 2000 at 96. The
bonds will mature on October 1, 2010. Interest is paid semi-annually on
October 1 and April 1. Atimonan uses the straight line method to amortize
bond discount.

QUESTIONS:

Based on the foregoing information, determine the adjusted balances of the

following as of March 31, 2006:

1. Estimated warranty payable

a. P414,000 c. P 302,400
b. P756,000 d. P1,058,400

2. Unamortized bond discount

a. P132,000 c. P240,000
b. P108,000 d. P120,000

3. Bond interest payable

a. P360,000 c. P180,000
b. P300,000 d. P 0

4. Total current liabilities

a. P7,734,000 c. P6,534,000
b. P6,126,000 d. P4,734,000
APPLIED AUDITING

5. Total noncurrent liabilities

a. P9,240,000 c. P9,108,000
b. P9,132,000 d. P9,000,000

Suggested Solution:

Question No. 1

Warranty payable, 3/31/05 P 302,400

Add warranty expense accrued during 756,000
2005-2006
Total 1,058,400
Less payments during 2005-2006 644,400
Warranty payable, 3/31/06 P 414,000

Question No. 2

Bond discount, 10/1/00 (P6,000,000 x .04) P240,000

Discount amortization, 10/1/00 to 3/31/06
(P240,000 x 5.5/10) 132,000
Bond discount, 3/31/06 P 108,000

Question No. 3

Bond interest payable, 10/1/05 to 3/31/06

(P6,000,000 x 12% x 6/12) P 360,000

Question No. 4

Notes payable - current (maturing up to P2,880,000

3/31/07)
Accrued interest payable – Notes payable 408,000
Estimated warranty payable (see no. 1) 414,000
Accounts payable 672,000
Cash dividends payable (6 million shares x 1,800,000
P0.30)
Accrued interest payable – Bonds payable 360,000
Total current liabilities P6,534,000

Question No. 5

Notes payable – noncurrent P 3,240,000

Bonds payable, net of discount of P108,000 5,892,000
Total noncurrent liabilities P 9,132,000

Answers: 1) A; 2) B; 3) A; 4) C, 5) B
APPLIED AUDITING

PROBLEM NO. 2

The following information relates to Candelaria Company’s obligations as of

December 31, 2006. For each of the numbered items, determine the amount if
any, that should be reported as current liability in Candelaria’s December 31,
2006 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,
2006:

a) A Company – P224,000 merchandise shipped on December 31, 2006,

FOB destination; received on January 10, 2007.
b) B, Inc. – P192,000 merchandise shipped on December 26, 2006, FOB
shipping point; received on January 16, 2007.
c) C Super Services – P144,000 janitorial services for the three-month
period ending January 31, 2007.
d) MERALCO – P67,200 electric bill covering the period December 16,
2006 to January 15, 2007.

On December 28, 2006, a supplier authorized Candelaria to return goods

billed at P160,000 and shipped on December 20, 2006. The goods were
returned by Candelaria on December 28, 2006, but the P160,000 credit
memo was not received until January 6, 2007.

a. P5,923,200 c. P5,712,000
b. P5,601,600 d. P5,841,600

2. Payroll:

Items related to Candelaria’s payroll as of December 31, 2006 are:

Accrued salaries and wages P776,000

Payroll deductions for:
Income taxes withheld 56,000
SSS contributions 64,000
Philhealth contributions 16,000
Advances to employees 80,000

a. P776,000 c. P992,000
b. P832,000 d. P912,000

3. Litigation:

In May, 2006, Candelaria became involved in a litigation. The suit being

contested, but Candelaria’s lawyer believes there is probable that
APPLIED AUDITING

Candelaria 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. P 0 c. P2,000,000
b. P3,000,000 d. P2,500,000

4. Bonus obligation:

Candelaria 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 c. P395,000
b. 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, 2006. The note is dated October 1, 2005,
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,
2006.

a. P800,000 c. P908,000
b. P 72,000 d. P872,000

6. Purchase commitment:

During 2006, Candelaria entered in a noncancellable commitment to

purchase 320,000 units of inventory at fixed price of P5 per unit, delivery to
be made in 2007. On December 31, 2006, 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, 2007.

a. P0 c. P1,600,000
b. P1,408,000 d. P 192,000

7. Deferred taxes:

On December 31, 2006, Candelaria’s deferred income tax account has a

2006 ending credit balance of P772,800, consisting of the following items:

Caused by temporary differences in Deferred tax

accounting
For gross profit on installment sales P376,000 Cr
For depreciation on property and 576,000 Cr
equipment
For product warranty expense 179,200 Dr
APPLIED AUDITING

P772,800 Cr

a. P772,800 c. P952,000
b. P196,800 d. P 0

8. Product warranty:

Candelaria has a one year product warranty on selected items in its

product line. The estimated warranty liability on sales made during 2005,
which was outstanding as of December 31, 2005, amounted to P416,000.
The warranty costs on sales made in 2006 are estimated at P1,504,000.
Actual warranty costs incurred during the current 2006 fiscal year are as
follows:

Warranty claims honored on 2005 P 416,000

sales
Warranty claims honored on 2006 992,000
sales
Total warranty claims honored P1,408,000

a. P 0 c. P1,504,000
b. P96,000 d. P 512,000

9. Premiums:

To increase sales, Candelaria Company inaugurated a promotional

campaign on June 30, 2006. Candelaria 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. Candelaria estimated
that only 60% of the coupons issued will be redeemed. For the six months
ended December 31, 2006, the following is available:

Packages of product sold 160,000

Premiums purchased 16,000
Coupons redeemed 64,000

a. P1,728,000 c. P1,152,000
b. P1,600,000 d. P 576,000

10. Due to Five Six Finance company:

Candelaria’s accounting records show that as of December 31, 2006,

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. P 0 c. P1,600,000
b. P320,000 d. P1,280,000
APPLIED AUDITING

Suggested Solution:

Question No. 1

Accounts payable per general ledger P5,440,000

Debit balances in suppliers' accounts 240,000
Goods in transit on 12/31/06, FOB shipping 192,000
point
Unrecorded purchase return (160,000)
Accounts payable, as adjusted 5,712,000
Accrued janitorial expenses (P144,000 x 96,000
2/3)
Accrued utilities (P67,200 x 15/30) 33,600
Total P5,841,600

Question No. 2

Accrued salaries and wages P776,000

Income taxes withheld 56,000
SSS contributions payable 64,000
Philhealth contributions 16,000
Total P912,000

Question No. 3

Midpoint of the range [(P2,000,000 + P3,000,000)/2] P2,500,000

PAS 37 par. 36 states that the amount recognized as a provision should be

the best estimate of the expenditure required to settle the present
obligation at the balance sheet date. Par. 39 further states that where there
is a continuous range of possible outcomes, and each point in that range is
a likely as any other, the mid-point of the range is used.

Question No. 4

B = 10% (P9,600,000 - B - T)
T = 30% (P9,600,000 - B)
T = P2,880,000 - .3B

B = 10% [P9,600,000 - B - (P2,880,000 - .3B)]

B = 10% (P9,600,000 - B - P2,880,000 + .3B)
B = 10% (P6,720,000 - .7B)
B = P672,000 - .07B
1.07B = P672,000
B = P628,000 (rounded off)

Question No. 5
APPLIED AUDITING

Principal amount due, 10/1/07 P800,000

Accrued interest payable (P1,600,000 x 18% 72,000
x 3/12)
Total P872,000

Question No. 6

Estimated liability for purchase commitment

[320,000 x (P5 - P4.40)] P192,000

Question No. 7

PAS 1 par. 70 states that when an entity presents current and non-current
assets, and current and non-current liabilities, as separate classifications
on the face of the balance sheet, it shall not classify deferred tax assets
(liabilities) as current assets (liabilities).

Question No. 8

Warranty payable, 12/31/05 P 416,000

Add warranty expense accrued during 2006 1,504,000
Total 1,920,000
Less payments during 2006 1,408,000
Warranty payable, 12/31/06 P 512,000

Question No. 9

Estimated coupons to be redeemed (160,000 96,000

x 60%)
Less coupons redeemed 64,000
Coupons outstanding 32,000
Divide by exchange rate 5
Premiums to be issued 6,400
Multiply by net premium cost P90
(P100+P20-P30)
Estimated liability for coupons, 12/31/06 P576,000

Question No. 10

This transaction involves assignment of accounts receivable, wherein the

company obtained a loan using the receivables as security. Accounts
receivable – assigned will be included in trade and other receivables, while
the related loan will be reported under current liabilities.

Answers: 1) D; 2) D; 3) D; 4) D, 5) D; 6) D; 7) D; 8) D; 9) D; 10) D
APPLIED AUDITING

PROBLEM NO. 3

In your initial audit of Infanta Finance Co., you find the following ledger account
balances.

Debit Credit
12%, 25-year Bonds Payable, 2002
issue
01/01/2002 P6,400,000

Treasury Bonds
10/01/2006 P864,000

Bond Premium
01/01/2002 320,000

Bond Interest Expense

01/01/2006 P384,000
07/01/2006 384,000

The bonds were redeemed for permanent cancellation on October 1, 2006 at

105 plus accrued interest.

QUESTIONS:

Based on the above and the result of your audit, determine the following: (Use
straight line method to amortize premium or discount)

1. The adjusted balance of bonds payable as of December 31, 2006 is

a. P5,536,000 c. P5,600,000
b. P6,400,000 d. P4,000,000

2. The unamortized bond premium on December 31, 2006 is

a. P320,000 c. P256,000
b. P224,000 d. P235,200

3. The total bond interest expense for the year 2006 is

a. P756,400 c. P731,600
b. P755,200 d. P731,200

4. The gain or loss on partial bond redemption is

a. P 7,600 loss c. P 7,600 gain
b. P72,400 loss d. P72,400 gain

Suggested Solution:

Question No. 1
APPLIED AUDITING

Total bonds issued P6,400,000

Face value of bonds retired
{P864,000/[1.05 + (.12 x 3/12)]} 800,000
Adjusted balance of bonds payable, P5,600,000
12/31/06

Question No. 2

Unamortized bond premium, 12/31/06

(P320,000 x 8/64 x 20/25) P224,000

Question No. 3

Nominal interest:
Remaining bonds (P5,600,000 x P672,000
12%)
Bonds retired (P800,000 x 12% x 72,000 P744,000
9/12)
Less premium amortization:
Remaining bonds (P320,000/25 x 11,200
14/16)
Bonds retired (P320,000/25 x 2/16 1,200 12,400
x 9/12)
Bond interest expense P731,600

Question No. 4

Retirement price (P800,000 x 1.05) P840,000

Carrying amount of bonds retired:
Face value P800,000
Unamortized bond premium
(P320,000 x 8/64 x 20.25/25) 32,400 832,400
Loss on bond redemption P 7,600

Answers: 1) C; 2) B; 3) C; 4) A

PROBLEM NO. 4

In connection with the audit of the company’s financial statements for the year
ended December 31, 2006 the Lucban Corporation presented to you their
records. This is the first time the company has been audited. The company
issued serial bonds on April 1, 2003. Your audit showed the following details
of the issue and the accounts as of December 31, 2006:

Total face value P2,000,000

Date of bond March 1, 2002
Total proceeds P2,656,000
Interest rate 12% per annum
Interest payment date March 1
APPLIED AUDITING

Maturity dates and amount:

Date of maturity Amount

March 1, 2006 P 500,000
March 1, 2007 500,000
March 1, 2008 500,000
March 1, 2009 500,000
P2,000,000

Since the corporation had excess cash, bonds of P500,000 scheduled to be

retired on March 1, 2008 were retired on April 1, 2006. The total amount paid
was charged to serial bonds payable account.

Serial Bonds Payable

3/01/2006 VR P500,000 4/01/2003 CR P2,656,000
4/01/2006 VR P495,000

Accrued Interest Payable

01/01/2006 GJ P200,000

Interest Expense
3/01/2006 VR P240,000

QUESTIONS:

Based on the information presented above and the result of your audit, answer
the following: (Use bond outstanding method to amortize premium or discount)

1. The adjusted balance of the bonds payable account as of December 31,

2006 is
a. P2,000,000 c. P1,500,000
b. P1,084,000 d. P1,000,000

2. The unamortized bond premium as of December 31, 2006 should be

a. P66,642 c. P 84,000
b. P82,444 d. P104,000

3. The accrued interest payable as of December 31, 2006 is

a. P150,000 c. P100,000
b. P120,000 d. P200,000

4. The bond interest expense that should be reported by the corporation for
the year 2006 is
a. P55,264 c. P63,801
b. P58,000 d. P59,611
APPLIED AUDITING

5. The gain on early retirement of bonds is

a. P79,000 c. P81,170
b. P77,722 d. P 0

Suggested Solution:

Question No. 1

Total bonds issued P2,000,000

Bonds retired, 3/1/06 (500,000)
Bonds retired, 4/1/06 (500,000)
Adjusted balance of bonds payable, P1,000,000
12/31/06

Question No. 2

Total proceeds P2,656,000

Less accrued interest payable
(P2,000,000 x 12% x 1/12) 20,000
Issue price 2,636,000
Less face value 2,000,000
Total bond premium 636,000
Less:
Amortization:
Prior years (2003 to 2005) P396,000
Current year (2006):
Bonds retired on
maturity (P500,000 P6,000
x .006 x 2 mos.)
Bonds retired prior to
maturity (P500,000 9,000
x .006 x 3 mos.)
Remaining bonds
(P1,000,000 x .006 x 72,000 87,000 483,000
12 mos.)
Unamortized premium
cancelled on bonds retired
prior to maturity
(P500,000 x .006 x 23 69,000
mos.)
Unamortized bond premium, 12/31/06 P 84,000

Computation of amortization rate:

Bond Premium
Yea Period covered outstandin Mos Peso months amort.*
r g .
APPLIED AUDITING

Bond Premium
Yea Period covered outstandin Mos Peso months amort.*
r g .
2003 04/01-12/31 P2,000,000 9 P 18,000,000 P108,000
2004 01/01/-12/31 2,000,000 12 24,000,000 144,000
2005 01/01-12/31 2,000,000 12 24,000,000 144,000
2006 01/01-02/28 2,000,000 2 4,000,000 24,000
03/01-12/31 1,500,000 10 15,000,000 90,000
2007 01/01-02/28 1,500,000 2 3,000,000 18,000
03/01-12/31 1,000,000 10 10,000,000 60,000
2008 01/01-02/28 1,000,000 2 2,000,000 12,000
03/01-12/31 500,000 10 5,000,000 30,000
2009 01/01-02/28 500,000 2 1,000,000 6,000
P106,000,000 P636,000

Amortization rate = P636,000/P106,000,000 = .006

* Peso months x .006

Question No. 3

Accrued interest payable, 12/31/06

(P1,000,000 x 12% x 10/12) P100,000

Question No. 4

Nominal interest:
Remaining bonds (P1,000,000 x 12%) P120,000
Bonds retired on maturity (P500,000 x 12% x 10,000
2/12)
Bonds retired prior to maturity (P500,000 x 15,000
12% x 3/12)
145,000
Less premium amortization for 2006 (see no. 2) 87,000
Interest expense in 2006 P 58,000

Question No. 5

Retirement price (P500,000 x .98) P490,000

Carrying amount of bonds retired:
Face value P500,000
Add unamortized bond premium,
(P500,000 x .006 x 23 mos.) 69,000 569,000
Gain on early retirement of bonds P 79,000

Answers: 1) D; 2) C; 3) C; 4) B, 5) A
APPLIED AUDITING

PROBLEM NO. 5

On January 2, 2005, the Mauban, Inc. issued P2,000,000 of 8% convertible

bonds at par. The bonds will mature on January 1, 2009 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, 2006, 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, 2005 were:

Common stock, P100 par, authorized 50,000

shares, issued and outstanding, 30,000 P3,000,000
shares
Premium on common stock 500,000

Market value of the common stock and bonds were as follows:

Date Bonds Common

stock
January 1, 2006 118 40
December 31, 110 42
2006

QUESTIONS:

Based on the above and the result of your audit, answer the following: (Round
off present value factors to 4 decimal places)

1. How much of the proceeds from the issuance of convertible bonds should
be allocated to equity?
a. P634,000 c. P126,816
b. P221,664 d. P 0

2. How much is the carrying value of the bonds payable as of December 31,
2005?
a. P2,000,000 c. P1,389,400
b. P1,796,170 d. P1,900,502

3. How much is the interest expense for the year 2006?

a. P160,000 c. P138,940
b. P179,617 d. P190,050

4. The conversion of the bonds on December 31, 2006 will increase equity by
a. P365,276 c. P400,000
b. P307,893 d. P 0
APPLIED AUDITING

5. How much is the loss on bond reacquisition on December 31, 2006?

a. P50,000 c. P96,053
b. P67,362 d. P 0

Suggested Solution:

Question No. 1

Total proceeds P2,000,000

Less liability component:
Present value of the principal
(P2,000,000 x 0.6830) P1,366,00
0
Present value of the interest
[(P2,000,000 x 8% x 507,184 1,873,184
3.1699)
Equity component P 126,816

PAS 32 par. 29 states that an entity recognizes separately the components

of a financial instrument that (a) creates a financial liability of the entity and
(b) grants an option to the holder of the instrument to convert it into an
equity instrument of the entity. Par. 31 further states that equity
instruments are instruments that evidence a residual interest in the assets
of an entity after deducting all of its liabilities. Therefore, when an initial
carrying amount of a compound financial instrument is allocated to its
equity and liability components, the equity component is assigned the
residual amount after deducting from the fair value of the instrument as a
whole the amount separately determined for the liability component.

Question No. 2

Carrying value, 1/2/05 (see no. 1) P1,873,184

Add discount amortization for
2005:
Effective interest (P1,873,184 x P187,318
10%)
Nominal interest (P2,000,000 x 160,000 27,318
8%)
Carrying value, 12/31/05 P1,900,502

Question No. 3

Effective interest (P1,900,502 x 10%) P190,050

Question No. 4

Journal entry to record the conversion

APPLIED AUDITING

Bonds Payable P1,000,000

Discount on bonds payable
(P1,000,000 - P965,276) P 34,724
Common stock 600,000
APIC 365,276

Carrying amount of bonds converted (P1,930,552* P965,276

x 1/2)
Less par value of common stock received
(P1,000,000/P1,000 x 6 x P100) 600,000
Amount to be credited to APIC P365,276

Carrying value, 1/1/06 (see no. 2) P1,900,502

Add discount amortization for
2006:
Effective interest (P1,900,502 x P190,050
10%)
Nominal interest (P2,000,000 x 160,000 30,050
8%)
Carrying value, 12/31/06 P1,930,552*

Question No. 5

Reacquisiton price (P500,000 x 110%) P550,000

Carrying value of bonds reacquired (P1,930,552 482,638
x 1/4)
Loss on early retirement of bonds P 67,362

Answers: 1) C; 2) D; 3) D; 4) A, 5) B

PROBLEM NO. 6

The noncurrent liabilities of Pitogo Company at December 31, 2005 included

the following:

Note payable, bank P3,600,000

Liability under finance lease 2,623,200
Note payable, supplier 1,500,000

Transactions during 2006 and other information relating to Pitogo’s liabilities

were as follows:

a) The note payable to the bank bears interest at 20% and is dated May, 1,
2005. The principal amount of P3,600,000 is payable in four equal annual
APPLIED AUDITING

installments of P900,000 beginning May 1, 2006. The first principal and

interest payment was made on May 1, 2006.

b) The finance lease is for a ten-year period. Equal annual payments of

P750,000 are due on December 31, of each year. The interest rate implicit
in the lease is 18%. The amount of P2,623,200 represents the present
value of the six remaining lease payments (due December 31, 2006
through December 31, 2011) discounted at P18%.

c) The note payable to supplier bears interest at 19% and matures on

September 30, 2007. On February 25, 2007, after the December 31, 2006
balance sheet date, but before the 2006 statements were authorized for
issue, Pitogo Company consummated a noncancelable agreement with a
lender to refinance the 19%, P1,500,000 on a long-term basis, on readily
determinable terms that have not yet been implemented. Both parties are
financially capable of honoring the agreement, and there have been no
violations of the agreement’s provisions.

d) On April 1, 2006, Pitogo issued for P7,005,675, P6,000,000 face amount of

its 20%, P100,000 bonds. The bonds were issued to yield 15%. The bonds
are dated April 1, 2006 and mature on April 1, 2011. Interest is payable
annually on April 1.

QUESTIONS:

Based on the above and the result of your audit, determine the following:

1. Liability under finance lease as of December 31, 2006

a. P1,873,200 c. P2,017,544
b. P2,345,376 d. P1,123,200

2. Carrying amount of bonds payable as of December 31, 2006

a. P6,893,813 c. P6,856,527
b. P7,417,536 d. P7,117,536

3. Total noncurrent liabilities as of December 31, 2006

a. P12,211,357 c. P10,711,357
b. P10,154,190 d. P9,817,014

4. Current portion of long-term liabilities as of December 31, 2006

a. P3,150,000 c. P2,727,832
b. P2,812,824 d. P2,169,864

5. Total interest expense for the year 2006

a. P2,145,314 c. P1,673,139
b. P2,408,028 d. P1,673,139

Suggested Solution:
APPLIED AUDITING

Question No. 1

Liability under finance lease, 1/1/06 P2,623,200

Less principal payment on
12/31/06:
Total payment P750,000
Less applicable to interest
(P2,623,200 x 18%) 472,176 277,824
Liability under finance lease, P2,345,376
12/31/06

Question No. 2

Carrying amount, 4/1/06 P7,005,675

Less premium amortization:
Nominal interest
(P6,000,000 x 20% x 9/12) P900,000
Effective interest
(P7,005,675 x 15% x 9/12) 788,138 111,862
Carrying amount, 12/31/06 P6,893,813

Question No. 3

20% Note payable, bank

Balance, 12/31/06 P2,700,000
(P3,600,000 -
P900,000)
Less installment due, 900,000 P1,800,000
4/1/07
Liability under finance
lease:
Balance, 12/31/06 (see 2,345,376
no. 1)
Less principal payment
due on 12/31/07:
Total payment P750,000
Less applicable to
interest 422,168 327,832 2,017,544
(P2,345,376 x
18%)
20% bonds payable due
4/1/11 (see no. 2) 6,893,813
Total noncurrent
liabilities, 12/31/06 P10,711,357

Question No. 4
APPLIED AUDITING

20% Note payable, bank - due 4/1/07 P 900,000

Finance lease liability - principal payment 327,832
due on 12/31/07 (see no. 3)
19% Note payable, bank - due 9/30/07 1,500,000
Current portion of long-term liabilities, P2,727,832
12/31/06

The Note payable to supplier was classified as current liability since it is

due within 12 months after balance sheet date and the entity does not have
an unconditional right to defer settlement of the liability for at least 12
months after the BS date (even if an agreement to refinance on a long term
basis is completed after the BS date and before the FS are authorized for
issue – such an agreement would qualify for disclosure as a non-adjusting
event after the BS date in accordance with PAS 10).

Question No. 5

20% Note payable, bank

1/1 to 4/30 (P3,600,000 x 20% x P240,00
4/12) 0
5/1 to 12/31(P2,700,000 x 20% x P 600,000
8/12) 360,000
Liability under finance lease (see no. 1) 472,176
20% bonds payable see no. 2) 788,138
19% Note payable, bank (P1,500,000 x 285,000
19%)
Total interest expense in 2006 P2,145,314

Answers: 1) B; 2) A; 3) C; 4) C, 5) A

PROBLEM NO. 7

Real Inc. leases equipment to its customers under noncancelable leases. On

January 1, 2006, Real leased equipment costing P4,000,000 to Quezon Co.,
for nine years. The rental cost was P440,000 payable in advance
semiannually (January 1 and July 1), plus P20,000 semiannually for executory
costs. The equipment had an estimated life of 15 years and sold for
P5,330,250 with an estimated unguaranteed residual value of P800,000. The
implicit interest rate is 12 percent.

QUESTIONS:

1. How much is the total interest income from lease that will be earned by
Real, Inc.?
a. P2,869,988 c. P3,675,616
b. P3,389,748 d. P 0

2. Real, Inc. should report profit on the sale at

APPLIED AUDITING

a. P1,330,252 c. P1,050,012
b. P1,044,384 d. P1,338,492

3. How much should be reported by Quezon Co. as liability under finance

lease as of December 31, 2006?
a. P4,143,593 c. P4,273,410
b. P4,446,613 d. P 0

4. How much should be reported by Quezon Co. under current liabilities as

liability under finance lease as of December 31, 2006?
a. P356,798 c. P394,252
b. P378,207 d. P 0

5. How much interest expense should be reported by Quezon Co. in relation

to the lease for the year ended December 31, 2006?
a. P508,064 c. P543,398
b. P501,793 d. P 0

Suggested Solution:

Question No. 1

Gross investment in the lease:

Minimum lease payments P7,920,00
(P440,000 x 18)
Unguaranteed residual value 800,000 P8,720,000
Net investment in the lease:
PV of minimum lease payments
(P440,000 x 11.4773) 5,050,012
PV of unguaranteed residual
value 280,240 5,330,252
(P800,000 x 0.3503)
Total unearned interest income P3,389,748

Question No. 2

Sales (present value of MLP) P5,050,012

Less cost of sales (P4,000,000 - P280,240) 3,719,760
Profit on sale P1,330,252

Question No. 3

Finance lease liability (P440,000 x 11.4773) P5,050,012

Less lease payment, 1/1/06 440,000
Balance, 1/1/06 4,610,012
Less principal payment on 7/1/06:
Total payment P440,000
Applicable to interest
APPLIED AUDITING

(P4,610,012 x 12% x 6/12) 276,601 163,399

Balance, 12/31/06 P4,446,613

The lease will be accounted for as finance lease because the present value
of the minimum lease payments amount to substantially all of the fair value
of the leased asset at the inception of the lease. (P5,050,012/P5,330,250 =
95%).

Question No. 4

Principal payment due, 1/1/07:

Total payment P440,000
Applicable to interest
(P4,446,613 x 12% x 6/12) 266,797 P173,203
Principal payment due, 7/1/07:
Total payment P440,000
Applicable to interest
[(P4,446,613 - P173,203) x 12% x 256,405 183,595
6/12]
Current portion of finance lease
liability, 12/31/06 P356,798

Question No. 5

1/1/06 to 6/30/06 (P4,610,012 x 12% x 6/12) P276,601

7/1/06 to 12/31/06 (P4,446,613 x 12% x 6/12) 266,797
Total interest expense P543,398

Answers: 1) B; 2) A; 3) B; 4) A, 5) C

PROBLEM NO. 8

The following information relates to the defined benefit pension plan of the
Tiaong Company as of January 1, 2005:

Projected benefit obligation (PBO) P16,150,000

Fair value of plan assets 15,135,000
Unrecognized prior service cost 1,050,000
Unrecognized net pension gain or 0
loss

Pension data for the years 2005 and 2006 follows:

2005 2006
Current service cost P 870,000 P1,150,000
Contributions to the plan 1,200,000 1,250,000
APPLIED AUDITING

Benefits paid to retirees 1,320,000 1,400,000

Actual return on plan assets 263,500 1,800,000
Amortization of past service cost 210,000 186,667
Actuarial change increasing PBO 800,000 -
Settlement interest rate 11% 11%
Long-term expected rate of return
on plan assets 10% 10%

As of January 1, 2006, the remaining expected service life of employees was 5

years.

QUESTIONS:

Based on the above and the result of your audit, answer the following.

1. What is the 2005 net benefit expense?

a. P2,593,000 c. P1,200,000
b. P4,370,000 d. P1,343,000

2. The projected benefit obligation as of December 31, 2005 is

a. P18,276,500 c. P17,476,500
b. P16,973,000 d. P16,173,000

3. The prepaid/accrued benefit cost on December 31, 2005 is

a. P1,358,000 c. P108,000
b. P3,135,000 d. P 0

4. What is the 2006 net benefit expense?

a. P1,863,702 c. P1,547,082
b. P1,250,000 d. P1,819,232

5. The prepaid/accrued benefit cost on December 31, 2006 is

a. P 0 c. P1,655,082
b. P3,143,302 d. P 721,702

Suggested Solution:

Question No. 1

Current service cost P 870,000

Interest cost (P16,150,000 x 11%) 1,776,500
Expected return on plan assets (1,513,500)
(P15,135,000 x 10%)
Amortization of past service cost 210,000
Net benefit expense for 2005 P1,343,000

Question No. 2

Projected benefit obligation, 1/1/05 P16,150,000

Current service cost 870,000
APPLIED AUDITING

Interest cost (P16,150,000 x 11%) 1,776,500

Actuarial change increasing PBO 800,000
Benefits paid to retirees (1,320,000)
Projected benefit obligation, 12/31/05 P18,276,500

Question No. 3

Debits
Fair value of plan assets, 12/31/05
Fair value of plan assets, 1/1/05 P15,135,000
Contributions to the plan 1,200,000
Actual return on plan assets 263,500
Benefits paid to retirees (1,320,000) P15,278,500
Unrecognized prior service cost,
12/31/05 (P1,050,000 - P210,000) 840,000
Unrecognized net pension loss,
12/31/05
Difference between expected and
actual return on plan assets
(P1,513,500 - P263,500) 1,250,000
Actuarial change increasing PBO 800,000 2,050,000
18,168,500
Credit
Projected benefit obligation, 12/31/05 (see no. 2) 18,276,500

Prepaid (Accrued) pension cost, (P108,000)

12/31/05

Alternative computation:

Debits
Fair value of plan assets, 1/1/05 P15,135,000
Unrecognized prior service cost, 1,050,000
1/1/05
16,185,000
Credit
Projected benefit obligation, 1/1/05 16,150,000

Prepaid (Accrued) pension cost, P 35,000

1/1/05

Prepaid (Accrued) pension cost, P 35,000

1/1/05
Underfunding in 2005:
Contributions to the plan P1,200,000
Net benefit expense (see no. 1) 1,343,000 (143,000)
Prepaid (Accrued) pension cost, (P108,000)
12/31/05
APPLIED AUDITING

Question No. 4

Current service cost P1,150,000

Interest cost (P18,276,500 x 11%) 2,010,415
Expected return on plan assets
(P15,278,500 x 10%) (1,527,850)
Amortization of past service cost 186,667
Amortization of unrecognized net
pension loss:
Unrecognized net pension loss, P2,050,000
1/1/06
Less corridor (P18,276,500 x 1,827,650
10%)
Excess 222,350
Divide by remaining service life 5 44,470
Net benefit expense for 2006 P1,863,702

Question No. 5

Prepaid (Accrued) pension cost, (P108,000)

1/1/06
Underfunding in 2006:
Contributions to the plan P1,250,000
Net benefit expense (see no. 4) 1,863,702 (613,702)
Prepaid (Accrued) pension cost, (P721,702)
12/31/06

Answers: 1) D; 2) A; 3) C; 4) A, 5) D

PROBLEM NO. 9

Select the best answer for each of the following:

1. A client's purchasing system ends with the assumption of a liability and the
eventual payment of the liability. Which of the following best describes the
auditor's primary concern with respect to liabilities resulting from the
purchasing system?
A. Commitments for all purchases are made only after established
competitive bidding procedures are followed.
B. Accounts payable are not materially understated.
C. Authority to incur liabilities is restricted to one designated person.
D. Acquisition of materials is not made from one vendor or one group of
vendors.

2. Which of the following functions is not appropriate for the accounts payable
department?
a. Prepare purchase orders.
b. Prepare voucher and daily summary.
c. File voucher package by due date.
APPLIED AUDITING

d. Compare purchase requisitions, purchase orders, receiving reports, and

vendors' invoices.

3. In a properly designed accounts payable system, a voucher is prepared

after the invoice, purchase order, requisition, and receiving report are verified.
The next step in the system is to
A. Post the voucher amount to the expense ledger.
B. Cancel the supporting documents.
C. Enter the check amount in the check register.
D. Approve the voucher for payment.

4. Which of the following would be the best procedure to determine whether

purchases were properly authorized?
A. Discuss authorization procedures with personnel in the controller's and
purchasing functions.
B. Review and evaluate a flowchart of purchasing procedures.
C. Determine whether a sample of entries in the purchase journal is supported
by properly executed purchase orders.
D. Vouch payments for selected purchases to supporting receiving reports.

5. In conducting a search for unrecorded liabilities, the auditor should do all

but the following:
a. Examine prior year's audit workpapers to ascertain that adjustments for
unrecorded liabilities have not been overlooked.
b. Examine invoices paid a few days prior to the balance sheet date.
c. Examine paid invoices for a short period following the balance sheet date
and trace to client's year-end adjustment for unrecorded liabilities.
d. Examine unpaid invoices for a short period following the balance sheet
date and trace to client's year-end adjustment for unrecorded liabilities.

6.An audit procedure applicable to testing the year-end cutoff of liabilities is

a. Reviewing the general journal for unusual entries recorded immediately
after year-end.
b. Examining vendor invoices received subsequent to year-end for shipment
date and terms of shipment.
c. Tracing recorded liabilities to supporting documents.
d. Preparing an aging schedule for accounts payable.

7. An auditor usually examines receiving reports to support entries in the

a. Sales journal and sales returns journal.
b. Check register and sales journal.
c. Voucher register and sales journal.
d. Voucher register and sales returns journal.

8. Which of the following is not used to test overstatements and

understatements of accounts payable?
a. Unmatched receiving reports.
b. Canceled voucher packages.
c. Cash receipts records.
d. Cash disbursement records.
APPLIED AUDITING

9. During the course of an audit, an auditor observes that the recorded interest
expense seems excessive in relation to the balance in long-term debt.
This observation could lead the auditor to suspect that
a. Long-term debt is overstated.
b. Long-term debt is understated.
c. Premium on bonds payable is understated.
d. Discount on bonds payable is overstated.

10. An auditor's program to examine long-term debt most likely would include
steps that require
a. Correlating interest expense recorded for the period with outstanding debt.
b. Inspecting the accounts payable subsidiary ledger for unrecorded
long-term debt.
c. Comparing the carrying amount of the debt to its year-end market value.
d. Verifying the existence of the holders of the debt by direct confirmation.

Answers: 1) B; 2) A; 3) D; 4) C, 5) B; 6) B; 7) D; 8) C; 9) B; 10) A

 To have an information about Introduction of Audit of Liabilities.

https://youtu.be/xevGBLbnz1M

 This Video is all about Solving Current Liabilities

https://youtu.be/4deZo4lg7VU

 This video is all about Non-Current Liabilities

https://youtu.be/RMTGXxUocT0

Reference:
Compilation of lecture notes by
Dean Rene Boy R. Bacay , CPA, CrFA, CMC, MBA, FRIAcc