UNIVERSITY OF SOUTHERN MINDANAO

ACC 413 (Auditing and Assurance Services II)

Audit of Intangible Assets & Prepayments

Instruction: Answer the requirement(s) and show solutions in good form for problem-related items.
Place all answers on a worksheet. Box your final answer.

PART I. PROBLEMS.

Problem 1
Art Manufacturing Corporation was incorporated on January 3, 2012. The corporation’s financial
statements for its year’s operations were not examined by a CPA. You have been engaged to
examine the financial statements for the year ended December 31, 2013, and your examination is
substantially completed. The corporation’s adjusted trial balance appears as follows:
ART MANUFACTURING COMPANY
Adjusted Trial Balance
December 31, 2013
Debit Credit
Cash P110,000
Accounts receivable 685,000
Allowance for doubtful accounts P5,000
Inventories 385,000
Machinery 750,000
Equipment 290,000
Accumulated depreciation 100,000
Patents 1,020,000
Prepaid expenses 105,000
Organization costs 290,000
Goodwill 240,000
Licensing agreement 1 500,000
Licensing agreement 2 590,000
Accounts payable 1,475,000
Unearned revenue 125,000
Share capital 3,170,000
Accumulated profits, 1/1/2013 170,000
Sales revenue 6,685,000
Cost of goods sold 4,540,000
Selling and general expenses 1,730,000
Interest expense 35,000
Loss on typhoon 120,000
Totals P11,560,000 P11,560,000

The following information relates to accounts that may still require adjustment:
a. Patents for Art’s manufacturing process were acquired January 2, 2013 for P680,000. An
additional P340,000 was spent in December 2013 to improve machinery covered by the
patents and was debited to the patents account. Depreciation on operational assets has
been properly recorded for 2013 in accordance with Art’s practice, which provides a full
year’s depreciation for property on hand as of June 30 and no depreciation otherwise. Art
uses the straight-line method for all depreciation and amortization.

b. The balance in the organization costs included costs incurred during the organization
period. Art has exercised its option to amortized organization costs over a five-year period
beginning January 1, 2012, for income tax purposes and will amortize these costs for
accounting purposes in the same manner. No amortization has yet been recorded.

c. On January 3, 2012, Art purchased licensing agreement 1, which was believed to have a
20-year useful life. The balance in the licensing agreement 1 account includes its purchase
price of P480,000 and costs of P20,000 related to the acquisition. On January 1, 2013, Art
bought licensing agreement 2, which has a life expectancy of 10 years. The balance in the
licensing agreement 2 account included the P580,000 purchase price and P20,000 in
acquisition costs, but it has been reduced by a credit of P10,000 for the advance collection
of 2014 revenue from the agreement .No amortization on agreement 2 has been recorded.
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 In early 2013, an explosion caused a permanent 60 percent reduction in the expected
revenue-producing value of licensing agreement 1. No entries have been made during
2012 or 2013 amortization of for the explosion in 2013.

d. The balance in the goodwill account includes (1) P80,000 paid December 30, 2012, for an
advertising program that management believes will assist in increasing Art’s sales over a
period of three to five years following the disbursement and (2) legal expenses of P160,000
incurred for Art’s incorporation on January 3, 2012. No amortization has ever been
recorded on the goodwill.

Questions:
Based on the above and the result of your audit, determine the adjusted carrying amount of the
following as of December 31, 2013:
1. Patents
2. Organization Costs
3. Licensing Agreement 1
4. Licensing Agreement 2
5. Goodwill

Problem 2
The following costs were incurred by Squishy Company during 2013:
Searching for applications of new research findings P57,000
Trouble-shooting in connection with breakdowns during commercial production 87,000
Adaptation of an existing capability to a particular requirement or customer’s need
as part of continuing commercial activity 39,000
Engineering follow-through in an early phase of commercial production 45,000
Radical modification of the formulation of a glassware product 78,000
Laboratory research aimed at discovery of new knowledge 204,000
Testing for evaluation of new products 72,000
Quality control during commercial production, including routine testing of products 174,000
Materials consumed in research and development projects 177,000
Consulting fees paid to outsiders for research and development projects 300,000
Personnel costs of persons involved in research and development projects 384,000
Indirect costs reasonably allocable to research and development projects 150,000
Materials purchased for future research and development projects 102,000
Research and development costs reimbursable under a contract to perform
research and development for Client Corporation 1,050,000
Design, construction, and testing of preproduction prototypes and models 870,000
Routing on-going efforts to refine, enrich, or otherwise improve upon the qualities
of an existing product 750,000
Total P4,539,000

What is the total amount to be classified and expensed as research and development for 2013?

Problem 3
The following information pertains to Randy Company’s intangible assets:
1. On January 1, 2014, Randy signed an agreement to operate as a franchisee of Monsters,
Inc. for an initial franchise fee of P1,500,000. Of this amount, P300,000 was paid when the
agreement was signed and the balance is payable in 4 annual payments of P300,000 each,
beginning January 1, 2015. The agreement provides that the down payment is not
refundable and no future services are required of the franchisor. The present value at
January 1, 2014, of the 4 annual payments discounted at 14% (the implicit rate for a loan of
this type) is P874,000. The agreement also provides that 5% of the revenue from the
franchise must be paid to the franchisor annually. Randy’s revenue from the franchise for
2014 was P19,000,000. Randy estimates the useful life of the franchise to be 10 years.

2. Randy incurred P1,300,000 of experimental and development costs in its laboratory to

develop a patent which was granted on January 2, 2014. Legal fees and other costs
associated with registration of the patent totaled P272,000. Randy estimates that the useful
life of the patent will be 8 years.
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 3. A trademark was purchased from Pixar Company for P640,000 on July 1, 2011.
Expenditures for successful litigation in defense of the trademark totaling P163,200 were
paid on July 1, 2013. Randy estimates that the useful life of the trademark will be 20 years
from the date of acquisition.

Questions:
1. What is the carrying value of the franchise at December 31, 2014?
2. What is the carrying value of the patent at December 31, 2014?
3. What is the carrying value of the trademark on December 31, 2014?
4. What is the total expenses resulting from the transactions that would appear on Randy’s
income statement for the year ended December 31, 2014?

Problem 4
The following situations are found in the records of Terry, Inc. in your audit of the company’s
financial statements for the year ended December 31, 2013.
1. December 1, 2013:
Advertising expense 72,000
Cash 72,000
Payment of 2014 advertising contract.

2. Balance of Office supplies expense, Dec. 31, 2013 P45,000

Balance of Unused office supplies, Dec. 31, 2013 15,000
Inventory of office supplies, Dec. 31, 2013 22,500

3. June 2, 2013:
Prepaid insurance 54,000
Cash 54,000
Payment of one-year insurance premium for inventory.

4. Balance of Factory supplies expense account, Dec. 31, 2013 P69,000

Physical inventory of factory supplies, Dec. 31, 2013 58,500

5. On May 1, 2013, a two-year subscription to the Industry Journal in the amount of P14,400
was paid. Subscriptions expense was charged for the entire amount.

Required: Prepare the adjusting journal entries on December 31, 2013, based on the situations
described.

Problem 5
Among the account balances of Sulley Corporation at December 31, 2012 are the following:
Patent, net P2,450,000
Installment contract receivable 7,200,000

Relevant transactions and other information for 2013 were as follows:

a) The patent was purchased from Imbentor Company for P3,150,000 on September 1, 2009. On
that date, the remaining legal life was fifteen years, which was also determined to be the useful
life.

b) The installment contract receivable represents the balance of the consideration received from
the sale of factory building to Lexi Company on March 31, 2011, for P12,000,000. Lexi made a
P3,000,000 down payment and signed a five-year 13% note for the P9,000,000 balance. The first
of equal annual principal payments of P1,800,000 was received on March 31, 2012 together with
interest to that date. The note is collateralized by the factory building with a fair value of
P10,000,000 at December 31, 2013. The 2013 payment was received on time.

c) On January 2, 2013, Sulley purchased a trademark from Cody Corporation for P2,500,000.
Sulley considers the life of the trademark to be indefinite.

d) On May 1, 2013, Sulley sold the patent to Yesha Company in exchange for a P5,000,000 non-
interest bearing note due on May 1, 2016. There was no established exchange price for the
patent, and the note had no ready market. The prevailing rate of interest for a note of this type at

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 May 1, 2013 was 14%. The present value of 1 for three periods at 14% is 0.675. The collection of
the note receivable from Yesha is reasonably assured.

e) On July 1, 2013, Sulley paid P18,800,000 for 750,000 ordinary shares of Apex Corporation,
which represented a 25% investment in Apex. The fair value of all of Apex’s identifiable assets
net of liabilities equals their carrying amount of P64,000,000. The market price of Apex’s ordinary
share on December 31, 2013 was P26.00 per share.

f) Apex reported net income and paid dividends of

Net Income Dividends per share
Six months ended 6/30/13 P5,760,000 None
Six months ended 12/31/13 7,040,000 P2.00

Dividend was paid on November 30, 2013.

Questions:
Based on the above and the result of your audit, compute for the following:
1. Gain on sale of patent
2. Total interest income for 2013
3. Noncurrent portion of the installment contract receivable as of December 31, 2013
4. Carrying amount of the note receivable from sale of patent as of December 31, 2013
5. The carrying amount of the investment in Apex Corporation as of December 31, 2013

Problem 6 (10 marks)

The accountant of Nikola Corporation made the following adjusting entries on December 31, 2010:

(a) Prepaid Rent P36,000

Rent Expense P36,000

(b) Advertising Materials P49,000

Advertising Expense P49,000

(c) Rent Income P18,000

Unearned Rent Income P18,000

(d) Office Supplies P20,000

Office Supplies Expense P20,000

(e) Prepaid Insurance P21,000

Insurance Expense P21,000

Further information is provided as follows:

(a) Annual rent is paid in advance every October 1.

(b) Advertising materials are paid at one time (June 1) and are used evenly throughout the year.

(c) Annual rent is received in advance every March 1.

(d) Office supplies are purchased every June 30 and used evenly throughout the year.

(e) Yearly insurance premium is payable each August 1.

QUESTIONS:
For each adjusting entry, indicate the original transaction entry that was recorded for-
1. Prepaid rent
2. Advertising materials
3. Unearned rent income
4. Office supplies
5. Prepaid insurance

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Problem 7
For each situation, reconstruct the adjusting entry that was made to arrive at the ending balance.
Assume statements and adjusting entries are prepared only once each year.

1. Salaries Payable:
Balance beginning of year P42,860
Balance end of year 34,760

Salaries are paid biweekly. All salary payments during the year were debited to Salaries
Expense.

2. Prepaid Insurance:
Balance beginning of year P5,600
Balance end of year 6,400

During the year, an additional business insurance policy was purchased. A 2-year premium of
P2,500 was paid and charged to Prepaid Insurance.

3. Unearned Rent:
Balance beginning of year P11,000
Balance end of year 15,000

Warehouse quarterly rent received in advance is P18,000. During the year, equipment was
rented to another company at an annual rent of P9,000. The quarterly rent payments were
credited to Rent Income; the annual equipment rental was credited to Unearned Rent.

4. Accumulated Depreciation:
Balance beginning of year P85,200
Balance end of year 88,700

During the year, a depreciable asset that cost of P7,500 and had carrying value of P1,600 was
sold for P2,400. The disposal of the asset was recorded correctly.

5. Allowance for doubtful accounts at beginning of the year was P50,000. The balance in the
allowance account at the end of the year after making the annual adjusting entry was P60,000
and during the year bad debts written off amounted to P30,000.

PART II. ESSAY.

1. How does the auditor ascertain the future economic benefit of recorded intangibles? (2
marks)
2. Research and development expenditures should be examined as part of the intangible
assets. Explain, why? (2 marks)

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