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APPLIED AUDITING PROBLEMS

AP.05 - Audit of Intangible Assets SMC

SUBSTANTIVE AUDIT OF INTANGIBLE ASSETS

Existence: Recorded intangible assets exist Valuation and allocation: Intangible assets are valued in
accordance with GAAP
1. Obtain an analysis of ledger accounts for intangible
assets. 6. Vouch additions to or acquisitions during the year.

2. Examine documentation supporting intangible assets. 7. Evaluate dispositions and write offs during the year.

8. Evaluate amortization policy and verify computation of


Completeness: All intangible assets are recorded amortization.

3. Vouch additions to or acquisitions during the year.


Presentation and disclosure: Intangible assets are classified
4. Evaluate dispositions and write offs during the year. and disclosed in accordance with GAAP

9. Review financial statements and perform analytical


Rights and obligations: Intangible assets are owned by the procedures to determine whether accounts are classified
entity and disclosed in the financial statements in accordance
with GAAP.
5. Examine documentation supporting intangible assets.

INTERNAL CONTROL MEASURES

1. Acquisitions, dispositions and write offs of intangible assets should be properly authorized.

2. Adequacy and consistency of accounting policies governing intangible assets should be reviewed periodically.

3. General ledger account should be supported by adequate detailed records and they should be periodically reconciled.

4. Schedules of intangibles showing their cost and basis of amortization should be prepared periodically and reviewed by a
responsible official.

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PROBLEM NO. 1 Apr.1 Patented a newly developed process with costs as


follows:
The accountant of the newly organized Zerg Corporation
provided to you the details the companys Intangible Assets Legal fees to obtain patent P429,000
account as follows: Patent application and licensing fees 61,000
Total P490,000
Intangible Assets
Date Description Amount It is estimated that in 5 years other companies will
01/02 Organization costs P 233,000 have developed improved processes, making the
01/15 Goodwill 15,000 Zerg Corporation process obsolete.
04/01 Patent 490,000
05/01 License and trademark 300,000 May1 Acquired both a license to use a special type of
07/01 R & D laboratory 1,310,000 container and a distinctive trademark to be printed
12/31 Product development costs 1,750,000 on the container in exchange for 6,000, no-par,
P4,098,000 ordinary shares of Zerg selling for P50 per share.
The license is worth twice as much as the
Transactions during 2012 included the following: trademark, both of which may be used for 5 years.

Jan.2 Paid legal fees of P150,000 and stock certificate Jul. 1 Constructed a shed for P1,310,000 to house
costs of P83,000 to complete organization of the prototypes of experimental models to be developed
corporation. in future research projects.

15 Hired a clown to stand in front of the corporate office Dec. Paid salaries for an engineer and chemist involved
for 2 weeks and hand out pamphlets and candy to 31 in research and development totaling P1,750,000 in
create goodwill for the new enterprise. Clown cost, 2012.
P10,000; pamphlets and candy, P5,000.
It is the companys policy to take full year amortization in the
year of acquisition.

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4. Carrying amount of other intangible assets on December
REQUIRED 31, 2012
a. P690,000 c. P980,000
1. Prepare the necessary adjusting journal entries as of b. P640,000 d. P706,667
December 31, 2012.
PROBLEM NO. 3
2. Compute the carrying amount of the Intangible assets as
of December 31, 2012. You noted the following items relative to the companys
Intangible assets in connection with your audit of the Five
3. Compute the total amount resulting from the foregoing Corporations financial statements for the year 2012.
transactions that should be expensed when incurred.
Franchise
PROBLEM NO. 2
On January 1, 2012, Five signed an agreement to operate as
The Terran Company acquired several small companies at franchisee of Clear Copy Service, Inc. for an initial franchise
the end of 2011 and, based on the acquisitions, reported the of P680,000. Of this amount, P200,000 was paid when the
following intangibles in its December 31, 2011 statement of agreement was signed and the balance was payable in four
financial position: annual payments of P120,000 each, beginning January 1,
2013. The agreement provides that the down payment is not
Patent P200,000 refundable and no future services are required of the
Copyright 400,000 franchisor. The implicit rate for loan of this type is 14%. The
Tradename 350,000 agreement also provides the 5% of the revenue from the
Computer software 100,000 franchise must be paid to the franchisor annually. Fives
Goodwill 900,000 revenue from the franchise for 2012 was P8,000,000. Five
estimates the useful life of the franchise to be ten years.
The company's accountant determines the patent has an
expected life of 10 years and no expected residual value, and Patent
that it will generate approximately equal benefits each year.
The company expects to use the copyright and tradename for On July 1, 2012, Five purchased a patent from the inventor,
the foreseeable future. The accountant knows that the who asked P1,100,000 for it. Five paid for the patent as
computer software is used in the company's 120 sales offices. follows: cash, P400,000; issuance of 10,000 shares of its own
The company has replaced the software in 60 offices in 2012, ordinary shares, par P10 (market value, P20 per share); and
and expects to replace the software in 40 more offices in 2013 a note payable due at the end of three years, face amount,
and the remainder in 2014. P500,000, noninterest-bearing. The current interest rate for
this type of financing is 12 percent. Five estimates the useful
On December 31, 2012, there are no indications of life of the patent to be ten years.
impairment of patent and computer software. The following
information relate to the other intangible assets: Trademark

a) Because of the rampant piracy, the copyright is expected Five purchased for P1,200,000 a trademark for a very
to generate cash flows of just P8,000 per year. successful soft drink it markets under the name POWER!.
The trademark was determined to have an indefinite life. A
b) The tradename is expected to generate cash flows of competitor recently introduced a product that is in direct
P15,000 per year. competition with the POWER! product, thus suggesting the
need for an impairment test. Data gathered by the entity
c) The goodwill is associated with Terrans SCV suggests that the useful life of the trademark is still indefinite,
Manufacturing reporting unit. The cash flows expected to but the cash flows expected to be generated by the trademark
be generated by the SCV Manufacturing reporting unit is have been reduced either to P40,000 per year (with a
P200,000 per year for the next 25 years. The reporting probability of 70%) or to P80,000 per year (with 30%
unit has a carrying amount of P2,100,000. probability). The appropriate risk-free interest rate is 5%. The
appropriate risk-adjusted interest rate is 10%.
QUESTIONS:
QUESTIONS:
Based on the above and the result of your audit, determine
the following: (Assume that the appropriate discount rate for Based on the above and the result of your audit, determine
all items is 5%) the following: (Round off present value factors to 4 decimal
places)
1. Total amortization of intangible assets in 2012
a. P 70,000 c. P88,750 1. Total expenses related to franchise in 2012
b. P107,500 d. P20,000 a. P503,914 c. P448,950
b. P535,200 d. P454,964
2. Total loss on impairment in 2012
a. P452,470 c. P471,220 2. Carrying amount of franchise as of December 31, 2012
b. P530,280 d. P433,720 a. P549,644 c. P538,733
b. P494,680 d. P612,000
3. Carrying amount of goodwill on December 31, 2012
a. P900,000 c. P855,000 3. Carrying amount of patent as of December 31, 2012
b. P718,780 d. P659,720 a. P1,045,000 c. P860,310
b. P 955,900 d. P908,105

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4. Total expenses related to the intangible assets in 2012 Item 6:
a. P662,759 c. P733,063 The Leasehold Improvement account includes (a) the
b. P711,709 d. P802,212 P15,000 cost of improvements with a total estimated useful
life of 12 years, which Summer, as tenant made to leased
PROBLEM NO. 4 premises in January 2013; (b) movable assembly line
equipment costing P8,500, which was installed in the leased
Summer Manufacturing Corporation was incorporated on premises in December 2014; and (c) real estate taxes of
January 3. 2013. The corporations financial statements for its P2,500 paid by Summer, which under the terms of the lease,
first years operations were not examined by a CPA. You have should have been paid by the landlord. Summer paid its rent
been engaged to audit the financial statements for the year in full during 2014. A 10-year nonrenewable lease was signed
ended December 31, 2014, and your work is substantially January 3,2013, for the leased building that Summer used in
completed. A partial trial balance of the companys accounts manufacturing operations.
follows:
Item 7:
Account Title Debit Credit The balance in the Organization Expenses account includes
Cash P11,000 pre-operating costs incurred during the organizational period.
Accounts Receivable 42,500
Allowance for doubtful accounts P500 Questions:
Inventories 38,500
Machinery 75,000 1. Patents will have an audited balance as of December
Equipment 29,000 31,2014 of
Accumulated depreciation 10,000 a. P85,000 c. P66,000
Patent (Item 1) 85,000 b. P64,000 d. P46,000
Leasehold improvement (Item 6) 26,000
Prepaid expenses 10,500 2. The adjusted balance of Licensing Agreement A as of
Organization expenses (Item 7) 29,000 December 31, 2014 is
Goodwill (Item 5) 24,000 a. P20,000 c. P10,000
Licensing Agreement A* b. P0 d. P50,000
(Item 2 & 3) 50,000
Licensing Agreement B* 3. The adjusted balance of Licensing Agreement B as of
(Item 2 & 4) 49,000 December 31, 2014
a. P66,000 c. P45,000
The following information relate to accounts that may yet b. P85,000 d. P64,000
require adjustment:
4. Leasehold improvements, net of amortization, audited
Item 1: balance as of December 31,2014 is
Patents for Summers manufacturing process were purchased a. P26,000 c. P13,200
January 2, 2014, at a cost of P68,000. An additional P17,000 b. P15,000 d. P12,000
was spent in December 2014 to improve machinery covered
by the patents and charged to the Patents account. The 5. The net adjustment to Retained earnings to reflect all the
patents had a remaining legal term of 17 years. necessary corrections from Item 1 to 7 will amount to
a. P84,500 debit c. P83,000 debit
Item 2: b. P84,500 credit d. P55,400 debit
On January 3, 2013, Summer purchased two licensing
agreements; at that time they were believed to have unlimited PROBLEM NO. 5
useful lives. The balance in the Licensing Agreement A
account included its purchase price of P48,000 and P2,000 in Select the best answer for each of the following:
acquisition expenses. Licensing Agreement B also was
purchased on January 3, 2013, for P50,000 but it has been 1. The most effective means for the auditor to determine
reduced by credit of P1,000 for the advance collection of whether a recorded intangible asset possesses the
revenue from the agreement. characteristics of an asset is to
a. Vouch the purchase by reference to underlying
Item 3: documentation.
In December 2013, an explosion caused a permanent 60 b. Inquire as to the status of patent applications.
percent reduction in the expected revenue-producing value of c. Evaluate the future revenue-producing capacity of the
Licensing Agreement A, and in January 2015 a flood caused intangible asset.
additional damage, which rendered the agreement worthless. d. Analyze research and development expenditures to
determine that only those expenditures possessing
Item 4: future economic benefit have been capitalized.
A study of Licensing Agreement B made by Summer in
January 2014 revealed that its estimated remaining life 2. In auditing intangible assets, an auditor most likely would
expectancy was only 10 years as of January 1, 2014. review or recompute amortization and determine whether
the amortization period is reasonable in support of
Item 5: managements financial statement assertion of
The balance in the Goodwill account includes P24,000 paid a. Valuation.
December 30,2013, for an advertising program, which it is b. Completeness.
estimated will assist in increasing Summers sales over a c. Existence or occurrence.
period of four years following the disbursement. d. Rights and obligations.

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3. Assuming TLL Co. has capitalized all research and a. False; True.
development costs associated with patent. You, CPA, b. True; False.
who is examining this account, will probably c. False; False.
a. Confer with management regarding transfer of the d. True; True.
amount from the balance sheet to the income
statement. 5. Which of the following comparisons would be the most
b. Confirm that the patent is registered and on file with appropriate audit test for the amount of recorded
the intellectual property office. goodwill?
c. Confer with management regarding a change in the a. The purchase price and the book value of assets
title of the account to "goodwill." purchased.
d. Confer with management regarding ownership of the b. The purchase price and the fair value of assets
patent. purchased.
c. The figure for goodwill specified in the contract for
4. There is goodwill involved in the acquisition of a business purchase.
if the purchase price paid is in excess of the proprietorship d. Earnings in excess of 5% of net assets for the past
of the business acquired. five years.

Goodwill might be viewed as the enjoyment of a profit by


a company in excess of the normal or usual return for the - now do the DIY drill -
industry as a whole but such goodwill is not recorded if it
has not been purchased or paid for.

DO-IT-YOURSELF (DIY) DRILL

PROBLEM NO. 1 1. Total amortization for the year 2012


a. P 73,333 c. P141,515
On December 31, 2011, Probe Corporation acquired the b. P116,190 d. P 86,857
following three intangible assets: 2. Impairment loss for the year 2012
a. P 90,476 c. P179,584
A trademark for P300,000. The trademark has 7 years b. P133,333 d. P 0
remaining legal life. It is anticipated that the trademark 3. Carrying amount of Trademark as of December 31, 2012
will be renewed in the future, indefinitely, without problem. a. P300,000 c. P166,667
Goodwill for P1,500,000. The goodwill is associated with b. P257,143 d. P120,416
Probes Nexus Manufacturing reporting unit. 4. Carrying amount of Goodwill as of December 31, 2012
A customer list for P220,000. By contract, Probe has a. P1,500,000 c. P1,431,818
exclusive use of the list for 5 years. Because of market b. P1,425,000 d. P1,462,500
conditions, it is expected that the list will have economic 5. Carrying amount of Customer list as of December 31,
value for just 3 years. 2012
a. P220,000 c. P176,000
On December 31, 2012, before any adjusting entries for the b. P146,667 d. P 0
year were made, the following information was assembled
about each of the intangible assets: PROBLEM NO. 2

d) Because of a decline in the economy, the trademark is On November 15, 2012, Rodeo Corporation acquired Rapids,
now expected to generate cash flows of just P10,000 per a company that operates a scenic railway along the coast of
year. The useful life of trademark still extends beyond the a popular tourist area. The summarized statement of financial
foreseeable horizon. position at fair values of Rapids on July 1, 2012, reflecting the
e) The cash flows expected to be generated by the Nexus terms of acquisition was:
Manufacturing reporting unit is P250,000 per year for the
next 22 years. Book values and fair values of the assets Goodwill P 200,000
and liabilities of the Nexus Manufacturing reporting unit Operating license 1,200,000
are as follows: Property-train stations and land 300,000
Book values Fair values Rail track and coaches 300,000
Identifiable assets P2,700,000 P3,000,000 Steam engines (2) 1,000,000
Goodwill 1,500,000 ? Purchase consideration P3,000,000
Liabilities 1,800,000 1,800,000
The operating license is for ten years. It has recently been
f) The cash flows expected to be generated by the customer renewed by the transport authority and is stated at the cost of
list are P120,000 in 2013 and P80,000 in 2014. its renewal. The carrying amounts of the property and rail
track and coaches are based on their estimated replacement
REQUIRED: cost. The engines are valued at their net selling price.
Based on the above and the result of your audit, determine
the following: (Assume that the appropriate discount rate for On December 1, 2012, the boiler of one of the steam engines
all items is 6%): exploded, completely destroying the whole engine.
Fortunately no one was injured, but the engine was beyond

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repair. Due to its age, a replacement could not be obtained. 6. Goodwill
Because of the reduced passenger capacity, the estimated a. P120,000 c. P200,000
value in use of the business after the accident was assessed b. P166,667 d. P 0
at P2 million.
7. Operating license
Passenger numbers after the accident were below a. P900,000 c. P771,429
expectations even after allowing for the reduced capacity. A b. P866,667 d. P720,000
market research report concluded that tourists were not using
the railway because of the fear of a similar accident occurring 8. Property train stations and land
to the remaining engine. In the light of this, the value in use a. P200,000 c. P216,667
of the business was re-assessed on December 31, 2012 at b. P192,857 d. P168,750
P1.8 million. On this date Rodeo received an offer of
P900,000 in respect of the transferable operating license. 9. Rail track and coaches
a. P200,000 c. P168,750
QUESTIONS: b. P216,667 d. P192,857

Based on the above and the result of your audit, compute the 10. Steam engines
carrying amount of the following as of December 31, 2012 a. P562,500 c. P500,000
after recognizing the impairment loss, if any: b. P642,857 d. P600,000

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