Answer Key in Applied Auditing by Cabrera 2006 Edition

CHAPTER
OVERVIEW OF THE
1 AUDIT PROCESS
1-1. Auditor’s reports are important to users of financial statements because they
inform users of the auditor’s opinion as to whether or not the statements are fairly
stated or whether no conclusion can be made with regard to the fairness of their
presentation. Users especially look for any deviation from the wording of the
standard unqualified report and the reasons and implications of such deviations.
1-2. Other requirements for an effective audit are:

a. Comprehensive knowledge of GAAP;
b. Understanding of internal control concepts;
c. Understanding of the client’s unique system of internal control; and
d. Knowledge of evidence gathering and evaluation methodology.
1-3. The scope paragraph tells what the auditor did, and whether or not the
examination was conducted in accordance with generally accepted auditing
standards (GAAS). The opinion paragraph tells what the auditor found, and
whether or not the financial statements conform to generally accepted accounting
principles (GAAP) in all material respects.
1-4. An engagement letter is the agreement or understanding between the CPA and
his/her client concerning the nature of the engagement. It provides protection for
the CPA in the event of subsequent legal action alleging negligence or breach of
contract. By committing the agreement to writing, the engagement letter also
minimizes future misunderstandings between the CPA and client concerning the
services to be performed by the CPA.
1-5. The audit program is an important part of the systematic approach to auditing, and
demonstrates that the audit was properly planned.
1-6. The pre-audit conference should be attended by all members of the audit team,
including the partner in charge of the examination. The conference should cover
the following areas:
a. Nature of the client’s activities;
b. General nature of the client’s system of internal control;
c. Unique accounting practices;
d. Duties of individual audit team members; and
e. Known areas of high audit risk.
1-2 Solutions Manual to Accompany Applied Auditing, 2006 Edition
1-7. The main feature distinguishing the interim audit phase from the final audit phase
is the focal point. In the interim audit, the primary focus is on testing the client’s
internal controls as a means for further reduction of assessed control risk. In the
final audit, the auditor is primarily concerned with the examination of transactions
and balances.
1-8. The accuracy of transactions and balances is a function of the reliability of the
information system. An effective control environment, accounting system, and
control activities (the information system), together with a system of monitoring
such that controls adapt to a changing environment, serves to produce accurate
financial data. Weak controls are more likely to produce inaccurate financial data.
By first testing the information system, the auditor is able to increase or decrease
the nature, timing, and extent of transaction and balance testing according to
his/her assessment of control risk.
1-9. The ten generally accepted auditing standards, along with the related statements
on auditing standards, provide a framework by defining the requisite quality to be
achieved in performing an audit.
1-10. Attestation refers to an expert communicating a conclusion about the reliability of

someone else’s assertion. Auditing is a form of attestation in that the auditor
communicates, to third party financial statement users, his/her conclusions
regarding the fairness of management’s assertions contained in the financial
statements. The independent auditor is considered an “expert” in both accounting
and auditing.
1-11. In planning an audit, an auditor must be familiar with the client’s industry,
business activities, accounting system, and policies and procedures. Once the
assertions to be tested have been identified, the auditor must assess the risk of
their being misstated. Auditors must be reasonably sure of issuing an appropriate
opinion. Hence, they must consider the risk of misstatements and the various
procedures available for gathering audit evidence as a basis for forming an
opinion. Audit planning includes designing the specific procedures to be
performed and assigning personnel to work on the audit.
The audit report indicates that auditors conduct audits in accordance with
generally accepted auditing standards. Further, the report communicates the role
of risk in the audit process by stating that those standards require auditors to plan
and perform the audit to obtain reasonable assurance about (not to prove) whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. Hence, an audit involves risk. Finally, auditors express an
opinion, not a guarantee. However, they believe that their audit provides a
reasonable basis for their opinion.
Overview of the Audit Process 1-3
1-12. Auditing standards indicate that auditors should report major issues discussed with
the entity’s management prior to being retained as auditor, including discussions
regarding the application of accounting principles and auditing standards.
Discussion of such matters may place pressure on the auditor to yield to
management’s view. Making the audit committee members aware of such matters
should enable them to better monitor the auditor’s independence. Standards do
not preclude clients from making suggestions about audit staff. Clients frequently
make requests to have persons on the audit who have experience in the industry.
If a client requests that minority persons not be assigned to an audit, however, the
auditor must carefully consider the ethical implications of that request.
1-13. Auditing standards require auditors associated with financial statements to issue a
report on them. An auditor is associated with financial statements when he or she
(a) “has consented to the use of his [her] name in a report, document, or written
communication containing the statements,” or (b) has prepared or assisted in
preparing the financial statements. An auditor who prepares or assists in
preparing financial statements is associated even if his or her name is not included
with the statements. Typing the financial statements on plain paper rather than on
the auditor’s letterhead therefore cannot be used to avoid association and the
requirement to issue a report.
1-14. In determining whether financial statements are presented fairly in conformity

with GAAP, the auditor should consider whether:
 The accounting principles selected and applied have general acceptance. The
accounting principles followed in preparing the financial statements must
have general acceptance, which means that the principles must be GAAP.
Auditing standards define GAAP as a “technical accounting term which
encompasses the conventions, rules, and procedures necessary to define
accepted accounting practice at a particular time.” No single reference source
exists for GAAP. Rather, auditing standards establish a hierarchy of sources
to be followed when determining which principle applies to a particular
situation.
 The accounting principles are appropriate in the circumstances.
 The statements contain appropriate disclosures.
 The financial statements reflect the underlying events and transactions in a
manner that presents the financial position, results of operations, and changes
in financial position within a range of acceptable limits; that is, limits that are
reasonable and practicable to attain in financial statements.
1-15. Auditing standards require the auditor to disclose the effects of deviations from
GAAP on the financial statements. As a result, clients often choose to adjust the
financial statements for the deviations.
1-16. An auditor may not offer reasons for the lack of independence since such
explanations might mitigate the lack of independence in the view of the reader.
CHAPTER
2 AUDIT PLANNING
2-1. Audit risk: The risk that the auditor may unknowingly fail to appropriately
modify his/her opinion of financial statements that are materially misstated.
Inherent risk: Relates to the susceptibility of an account balance or class of
transactions to error that could be material. . .assuming that there were no related
internal controls.
Control risk: The risk that material errors or irregularities are not prevented or
detected by the system of internal control.
Detection risk: The risk that errors or irregularities which are not prevented or
detected by the system of internal control, are not detected by the independent
auditor.
2-2. Study of the business and industry, and application of analytical procedures during
the planning stage of the audit assist in evaluating inherent risk. These procedures
may permit the auditor to assess inherent risk below the initial 100% assumed
level.
2-3. Sources of business and industry information are the following:

a. Management inquiry
b. Permanent audit workpaper file
c. Internal client documents (e.g. correspondence files, minutes, accounting
manuals, and policy and procedures manuals)
d. PICPA audit and accounting guides
e. Industry trade publications
f. Government publications
g. Credit reports (Dunn & Bradstreet, banks, etc.)
h. Computer data bases
i. Business periodicals
2-4. a. The audit risk model is
Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)
b. The audit risk model is useful in managing audit risk for assertions. By
determining planned audit risk for an assertion, assessing inherent and control
risks, an auditor can determine the allowable detection risk (the amount of
detection risk an auditor can allow) for an assertion. Allowable detection risk
is used to determine the nature, timing, and extent of audit procedures for the
assertion.
2-5. The amount of audit evidence an auditor must gather varies inversely with
allowable detection risk. As allowable detection risk decreases, the amount of
evidence required increases, and vice versa. Chapter 2 introduces audit
procedures and discusses how auditors modify audit procedures to obtain
sufficient competent evidential matter by changing (1) the nature, (2) the timing,
or (3) the extent of procedures.
2-6. a. Analytical procedures are used for these broad purposes:

To assist the auditor in planning the nature, timing, and extent of other
auditing procedures.
As a substantive test to obtain evidential matter about particular
assertions related to account balances or classes of transactions.
As an overall review of the financial information in the final review stage
of the audit.
b. An auditors’ expectations are developed from the following sources of

information:
Financial information for comparable prior periods giving consideration
to know changes.
Anticipated results--for example, budgets, forecasts, and extrapolations.
Relationships among elements of financial information within the period.
Information regarding the industry in which the client operates.
Relationships of financial information with relevant nonfinancial
information.
c. The factors that influence an auditor’s consideration of the reliability of data

for purposes of achieving audit objectives are whether the
Data were obtained from independent sources outside the entity or from
sources within the entity.
Sources within the entity were independent of those who are responsible
for the amount being audited.
Data were developed under a reliable system with adequate controls.
Data were subjected to audit testing in the current or prior year.
Expectations were developed using data from a variety of sources.
2-7. a. (4) b. (4)
2-8. a. (1) b. (1) c. (1)
2-9. a. (1) b. (2) c. (3)

Audit Planning 2-3
2-10. a. The audit risk model gives the following results:
AR = IR x CR x DR (or) DR x AR / (IR x CR)
(1) 2.5% (4) 3.33%

(2) 0.67% (5) 2.5%
(3) 1
In the third situation, the auditor does not have to accumulate any evidence
because inherent risk and control risk give the appropriate level of planned
audit risk.
b. (1) 3 (tied) (4) 2

(2) 5 (5) 3 (tied)
(3) 1
2-11. a. 1. Audit risk is the risk that the auditor may unknowingly fail to
appropriately modify an opinion on financial statements that are
materially misstated.
2. Inherent risk is the susceptibility of an account balance or class of

transactions to error that could be material, when aggregated with error in
other balances or classes, assuming that there were no related internal
controls.
Control risk is the risk that error in an account balance or class of

transactions that could be material, when aggregated with error in other
balances or classes, will not be prevented or detected on a timely basis by
controls.
Detection risk is the risk that an auditor’s procedures will lead the auditor
to conclude that error in an account balance or class of transactions that
could be material, when aggregated with error in other balances or
classes, does not exist, when in fact such error does exist.
3. Inherent risk and control risk differ from detection risk in that they exist
independently of the audit of financial statements, whereas detection risk
relates to the auditor’s procedures and can be changed at the auditor’s
discretion. Detection risk should bear an inverse relationship to inherent
and control risk. The less inherent and control risk the auditor believes
exists, the greater the acceptable detection risk.
b. 1. Materiality is the magnitude of an omission or misstatement of

accounting information that, in the light of surrounding circumstances,
makes it probable that the judgment of a reasonable person relying on the
information would have been changed or influenced by the omission or
misstatement. This concept recognizes that some matters, either
individually or in the aggregate, are important for the fair presentation of

financial statements in conformity with generally accepted accounting
principles whereas other matters are not important.
2. Materiality is affected by the nature and amount of an item in relation to

the nature and amount of items in the financial statements under
examination, and by the auditor’s judgment as influenced by the
auditor’s perception of the needs of a reasonable person who will rely on
the financial statements.
2-12. The primary issue raised here is how friendly an auditor should be with client
personnel. This situation is especially interesting in light of the auditor’s view of
the relationship prior to being assigned significant responsibility. The issue is
whether Josie is trying to become friendly in order to try to manipulate the
auditor’s decisions.
CHAPTER
AUDIT OF THE REVENUE AND COLLECTION
3 CYCLE: TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF TRANSACTIONS
3-1. Directly. Higher levels of control risk induce auditors to audit larger samples of
receivables, with confirmation date closer to the fiscal year end date. As for
nature of the procedures: higher levels of control risk induce auditors to use
positive confirmations instead of negative confirmations, and to consider
vouching subsequent payments by the customers.
3-2. The features of a cash receipts internal control system which would be expected to
prevent an employee from absconding with company funds and covering with
funds from the employee pension fund is the prohibition against one employee
having custody of company funds and noncompany funds. The auditor can detect
such transfers by controlling and counting both funds simultaneously.
To prevent the cash receipts journal and recorded cash sales from reflecting more
than the amount shown on the daily deposit slip, the internal control system
should provide that receipts be recorded daily and intact. A careful bank
reconciliation by an independent person could detect such errors.
3-3. A strength is defined as a control procedure that can detect, prevent or correct
errors in a timely matter from entering into the accounting records that form the
basis of financial statements. A weakness is the lack of a control procedure where
the auditor thinks one should exist.
Weaknesses are not subject to test of controls auditing because no reliance is

placed on a weakness. Strengths must be audited because the review phase only
describes apparent strengths that may not actually exist.
3-4. The evaluation after the review phase was to determine which controls appeared
adequate as a basis for justifying a low control risk assessment. The final
assessment after test of controls auditing is to determine if the controls are
actually operating as well as they appeared to be.
3-5. a. An order entry department generally receives customers’ requests to purchase

merchandise either by telephone or in the form of a written purchase order
from the customer. A purchase order is a legal offer to purchase goods under
the terms specified. In some entities, on receipt of an order, the order entry
department generally prepares a sales order. The sales order is the first
document prepared by the merchandiser in the sales and collections cycle,
and it should be prenumbered to facilitate control over processing

transactions. A copy of the sales order, acknowledging that the order has
been received and is being processed, may be mailed to the customer. Four
copies of the sales order are sent to the credit department, which either
approves or denies credit and returns a copy of the sales order to the order
entry department. The credit department then sends a copy bearing credit
approval (assuming it is granted) to the warehouse, the shipping department,
and the billing department. The sales order bearing credit approval serves as
authorization to warehouse personnel to release goods to shipping. Shipping
personnel verify that the quantity and description of goods received from the
warehouse match the copy of the sales order received directly from order
entry. Billing matches the customer order, the sales order, and the shipping
document before recording the sale.
In some entities, when an order is received, the purchase order is sent to the
credit department for approval. The credit department’s decision is returned
to the order entry department. When the credit department has approved the
sale, a multipart sales invoice is prepared. One copy serves as a shipping
order, another as the bill of lading, and another is sent to billing. The sale,
however, is not recorded (entered in the sales journal) until the bill of lading
is received by billing.
b. Before goods are shipped, the customer’s credit must be approved. The credit
department maintains a list of unauthorized customers and their credit limits,
which an employee must review to determine whether to accept an order. A
credit department employee signs a copy of the sales order authorizing the
credit sale. When an order is received from a prospective customer not on the
list or when a customer has exceeded the authorized credit limit, the credit
department generally conducts a credit investigation and makes a decision to
accept or reject the order. When the order is accepted, a copy of the sales
order is sent to the warehouse and a copy is retained in the credit department.
c. On the basis of the sales order approved by the credit department, warehouse
personnel issue goods to the shipping department. The accounting
department, rather than warehouse personnel, maintains perpetual records for
the inventory.
d. The shipping department verifies that the goods received from the warehouse
to be shipped agree with the quantity and description of goods on the sales
order. The shipping department then packs the merchandise, arranges
transportation with a common carrier, and prepares a shipping document.
The shipping document is a multicopy document that lists the items, gives
instructions to the common carrier as to whom and to what the address to ship
the merchandise, and may serve as a packing slip for the merchandise.
Copies of the shipping document are given to the carrier, and copies are sent
to the billing department. Sometimes entities use a bill of lading as a
Audit of the Revenue and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 3-3
shipping document; it may include a general description of the goods and a
quantity or number of pounds.
e. Billing involves notifying the customer (by means of an invoice) of the

amount due for the goods or services delivered. The billing function is
typically performed by a section of the accounting department and should be
independent of sales executives. Billing personnel should (1) account for the
sequence of shipping documents to determine that all shipments are billed, (2)
compare the details included on the sales order with the shipping documents
to serve as an independent check on shipping, (3) prepare the sales invoice
from data on the shipping document and sales order, (4) price the invoice by
reference to an authorized price list obtained from the sales department, (5)
extend and foot the invoices, and (6) account for the sequence of sales orders
and shipping documents to ensure that all sales are recorded.
Some entities prepare a turnaround document simultaneously with the sales

invoice. A turnaround document is a form the customer mails back to the
merchandiser, along with payment of the invoice that facilitates handling and
processing of cash receipts. It contains information, such as the customer’s
name and account number, and a place to indicate the amount of the payment.
Prior to mailing, each invoice should be reviewed by a person not involved in

its preparation. The review should cover the propriety and accuracy of prices,
extensions, footings, credit terms, and freight charges. The billing
department should develop a total of sales invoices and submit it directly to
the clerk responsible for maintaining the accounts receivable control account.
The accounts receivable subsidiary ledger clerk or data processing department
prepares the sales journal and posts debits to individual accounts in the
accounts receivable subsidiary ledger. Subsequent reconciliation of the
accounts receivable subsidiary ledger to the accounts receivable control
account is an important aspect of internal control. Shipping documents are
used by accounting to update perpetual inventory records when they are
maintained.
f. One of the best controls over cash receipts is a lockbox system in which
customers mail their remittances to a post office box controlled by a bank.
The bank’s bonded employees obtain the mail from the post office box, make
a listing of the amount by customer, mail the remittance advices and a copy of
the list to the business, and deposit the cash. When mail containing
remittances comes directly to the entity, the first step in the control process is
to obtain a listing of the cash and checks. This listing is generally prepared
by a receptionist or a mailroom employee designated to open mail. However,
the person should have a high level of integrity and not be otherwise involved
in handling cash or maintaining accounts receivable records. The listing of
cash receipts, referred to as a prelisting, serves to establish control over cash
receipts. Remittance advices are prepared if necessary, and when the listing
has been prepared, the cash and remittance advices are separated. The cash is
given to the cashier to prepare the bank deposit, and the remittance advices
are given to the accounts receivable clerk for preparing the cash receipts
journal and updating the accounts receivable subsidiary records. The
employee preparing the prelisting also develops a total of cash receipts to
send directly to the accounting department supervisor, who maintains control
over the general ledger accounts.
g. A business issues a credit memo when a customer returns merchandise or

when a price adjustment is allowed. Credit memo authorizations should bear
the signature of an employee with authority to issue a credit memo and should
be based on a receiving report when merchandise has been returned, or on
correspondence between the sales department and the customer when a price
adjustment has been authorized.
h. The allowance for uncollectible accounts expense is the result of an adjusting

entry, which should be approved by the controller or chief accountant. Any
entries recording uncollectible accounts expense should bear the written
authorization of the controller.
i. After exhausting all reasonable efforts to collect accounts, businesses should

write off accounts judged to be uncollectible. Frequently, accounts are
written off after the customer declares bankruptcy. Accounts written off
should be transferred to a separate control account, and statements should
continue to be sent to those debtors in an effort to collect the account.
3-6. a. A merchandiser prepares a shipping document that includes the name and
address of the customer and a description of the goods. The document is a
contract between the seller and the carrier and is signed by the carrier when it
accepts the goods. Businesses often use a bill of lading as a shipping
document. The document may be a copy of the invoice or a delivery ticket.
The signature of the carrier on the shipping document provides externally

created evidence that a sale has occurred. Accounting for the numerical
sequence determines that all shipments are recorded as sales.
b. A customer attaches a remittance advice to a check in payment of an invoice.

The document may be a turnaround document, a part of a check, or a
statement identifying the invoices being paid. Remittance advices facilitate
recording cash receipts. If a customer does not return a remittance advice, the
employee opening the mail usually prepares one. A remittance advice
indicates the date and amount of payment and the invoices paid. Remittance
advices are separated from cash and given to the accounts receivable clerk for
posting to accounts receivable.
c. Uncollectible account forms authorize an accounting clerk to write off an
account receivable as an uncollectible account. The form provides permanent
written evidence that authorization was made for writing off an account.
3-7. Managers may experience pressure to show high profits and may inflate sales
because of the pressure to meet target profits established by senior managers, to
obtain bonuses, to retain the respect of senior managers, or even to retain their
jobs.
3-8. Until a record of cash received has been made, removing cash is one of the easiest
forms of fraud to commit and among the hardest to detect because records do not
reflect what has occurred.
3-9. Answers will vary. Three possible examples are the following:
 A cashier in a retail establishment who does not ring up a transaction on the
cash register can generally take the cash without detection. Ringing up the
transaction adds the receipt to the total cash receipts, which can be compared
to the cash on hand.
 An employee who has access to cash receipts and maintains accounts
receivable records can record a sale at an amount lower than the invoice
amount. When the customer pays, the employee takes the difference between
the invoice and the amount recorded as a receivable.
 An employee who makes the cash deposit and also prepares the bank
reconciliation can withhold cash and hide the shortage by overstating deposits
in transit on the bank statement, underfooting the list of outstanding checks,
or omitting outstanding checks from the outstanding check list. Routinely
testing bank reconciliations should uncover this form of fraud.
3-10. Auditors are not required to perform tests of controls. However, when a client has
effective internal control, performing tests of controls is cost effective because it
may provide a basis for the auditor to assess control risk at less than maximum.
Assigning a reduced level of risk to control risk reduces the amount of substantive
testing the auditor must perform. Substantive tests are more expensive to perform
than tests of controls. Hence, auditors perform tests of controls when they believe
it will enable them to reduce the amount of substantive testing. Also, auditors
may perform much of the testing of controls before year end, thus spreading the
audit work.
3-11. Adjustments to sales include cash discounts, sales allowances or reductions in

price, returns of merchandise, volume rebates, corrections of billing errors, and
write-offs of uncollectible accounts. The greatest concern from a control point of
view is that one of these types of transactions will be recorded to cover a
misappropriation of cash receipts.
3-12. The following potential misstatements could arise:

 Fictitious cash receipts may be recorded, or cash receipts may be
misappropriated.
 Cash may be misappropriated and lapping may occur.
 Bank reconciliations may cover shortages.
 Credits posted to customers’ accounts may be overstated or understated.
 Entries may be made to the wrong accounts.
3-13. Auditors’ primary concern with regard to uncollectible accounts is that accounts
written off have actually become uncollectible, rather than being written off to
cover a misappropriation. To prevent accounts from being written off to cover
misappropriations, any account written off must be authorized by a responsible
official not involved in the granting of credit. The auditor usually tests the
effectiveness of this control by examining the approvals of accounts written off.
For a sample of accounts written off, the auditor generally examines
correspondence indicating that efforts were made to collect the account and that
the account is uncollectible. Sometimes the auditor examines credit reports on the
accounts. The auditor should trace a sample of the entries to the accounts
receivable accounts.
3-14. 1. (c) Mailing monthly statements to customers with outstanding accounts will
detect invoices posted to the wrong accounts. Customers whose accounts
were misposted for goods not ordered will contest the statements.
2. (g) Each shipping document should have a corresponding invoice when the
goods are shipped. The appropriate direction of testing is from the shipping
documents to the sales invoices.
3. (f) Daily sales summaries are from the book of original entry – the sales
journal. Comparing the summaries with the total of invoices will detect
failure to record all invoices.
4. (k) Comparing control total amounts posted to the accounts receivable

(subsidiary) ledger with the control total of all invoices for the same period
should detect invoices not posted.
5. (i) Credit approval should be received before sales are made. Thus, shipping
to customers on an approved list should reduce the risk of sales to customers
with unsatisfactory credit.
6. (b) An approved sales order should be presented to the storekeeper before

release of goods from the warehouse to prevent goods from being removed
for unauthorized orders.
7. (d) Requiring shipping clerks to compare the amounts and types of goods
received from the warehouse with approved sales orders ensures that goods
shipped agree with those ordered by customers.
8. (l) Comparing sales invoices with shipping documents will ensure that each
invoice is supported by a shipment. Fictitious sales – i.e., those for which no
shipment was made – should be detected.
9. (p) The total receipts credited to customer accounts in the subsidiary ledger
should equal the total receipts deposited, given that daily receipts are
deposited intact.
10. (c) Checks misappropriated (stolen) prior to forwarding to the cashier will
not be posted to customer accounts (assuming that the remittance advices
were stolen as well). Thus, customers will complain when their payments fail
to be reflected in the balances on the monthly statements.
11. (c) Mailing monthly statements to customers with outstanding accounts will
detect receipts posted to the wrong accounts. Customers whose accounts
were misposted will contest the statements.
12. (p) If more than one customer account is credited for the same cash receipt,
the error will be detected when the total of the amounts posted to the accounts
receivable ledger is compared with the total cash receipts.
13. (s) The bank reconciliation will detect errors in recording cash receipts (and
disbursements). The balance in the ledger will not reconcile with the amount
in the bank statement.
14. (p) If the checks are misappropriated (stolen) prior to deposit, the total of the
amounts posted to the accounts receivable ledger will be greater than the
validated bank deposit slip.
15. (n) Invalid sales returns are prevented by requiring approval of returns by the
sales department supervisor.
3-15. 1) e 2) a 3) c 4) f
3-16. 1) d 2) a 3) c 4) b
3-17. 1) a 2) a 3) d 4) d
3-18. 1) b 2) b 3) c 4) b
3-19. 1) b 2) a 3) c
3-21. 1. a. Accounting for shipping documents to determine that all shipments are
billed.
b. Observe procedure and, for a sample of shipping documents, examine
sales invoices.
c. Completeness
2. a. Prelisting of cash receipts and cash register procedures are monitored.

b. Compare deposit to cash register total and prelisting.
c. Completeness
3. a. A monthly statement should be mailed to customers by someone not

involved in handling accounts receivable or cash.
b. Observe procedure and examine follow-up files.
c. Existence or occurrence.
4. a. For goods shipped, goods should be counted and descriptions and

quantities should be compared to quantities and descriptions on sales
orders and shipping documents prior to shipping.
b. Observe procedure. For a sample, examine signature on documents
evidencing performance.
c. Rights and obligations.
5. a. Accounting for all sales invoice numbers to ensure that all are recorded.
b. Observe procedure. For a sequence of invoices, account for the
numerical sequence.
c. Completeness
6. a. Shipping documents should be accounted for to determine that all items

shipped are billed.
b. Observe procedures. Examine invoices for a sample of shipping
documents.
c. Completeness
7. a. For goods shipped, goods should be counted and descriptions and

quantities should be compared to quantities and descriptions on sales
orders and shipping documents prior to shipping.
b. Observe procedure. For a sample, examine signature on documents
evidencing performance.
c. Rights and obligations
8. a. Prenumbered sales invoices should be used and accounted for to

determine that all sales are recorded (in the proper period).
b. Observe procedure. Examine entries for a sequence of sales invoices in
sales journal.
c. Completeness
3-22. 1. a. Existence, completeness
b. Cash may be misappropriated or lapping may occur.
c. Observe separation of duties and inquire of personnel about their
responsibilities.
2. a. Existence, completeness
b. Fictitious cash receipts may be recorded or cash receipts may be
misappropriated.
c. Observe whether a prelisting is prepared and inquire of preparer about
the procedures followed.
3. a. Existence, completeness
b. Cash may be unrecorded or misappropriated.
c. Observe the procedure and inquire of personnel who perform the
procedure.
4. a. Existence
b. Bank reconciliations may hide shortages.
c. Examine bank reconciliations and determine that preparer does not have
conflicting interests.
5. a. Valuation
b. A customer may take a larger discount than appropriate.
c. For a sample of entries in the cash receipts journal, examine remittance
advices for approval of discounts taken.
6. a. Existence
b. A validated deposit ticket is obtained for daily deposits and compared to
the cash receipts summary.
c. For a sample of entries in the cash receipts journal, reconcile the total to
validated deposit tickets.
3-23.
Weakness Recommended Improvement
1. There is no segregation of duties One clerk (hereafter referred to as the
between persons responsible for collection clerk) should collect
collecting admission fees and admission fees and issue prenumbered
persons responsible for authorizing tickets. The other clerk (hereafter
admission. referred to as the admission clerk)
should authorize admission on receipt
of the ticket or proof of membership.
2. An independent count of paying The admission clerk should retain a
patrons is not made. portion of the prenumbered admission
ticket (admission ticket stub).
3. There is no proof of accuracy of The treasurer should reconcile the

amounts collected by the clerks. admission ticket stubs with cash
collected by the collection clerk each
day.
4. Cash receipts records are not Cash collections should be recorded
promptly prepared. daily by the collection clerk on a
permanent record that will serve as the
first record of accountability.
5. Cash receipts are not promptly Cash should not be left undeposited for
deposited. a week. Cash should be deposited at
least once each day.
6. There is no proof of accuracy of Authenticated deposit slips should be
amounts deposited. compared with daily cash collection
records. Discrepancies should be
promptly investigated and resolved. In
addition, the treasurer should establish
a policy that includes performing
analytical procedures to cash
collections.
7. There is no record of the internal The treasurer should issue a signed
accountability for cash. receipt for all proceeds received from
the collection clerk. These receipts
should be maintained and should be
periodically checked against cash
collection and deposit records.
3-24. The Code of Professional Conduct does not prohibit a member of the audit team
from taking advantage of discounts when purchasing goods from clients.
However, auditors may follow standards that are more restrictive than the Code of
Ethics. The purpose of this exercise is for students to consider the possibility of
such a discount’s affecting the auditor’s independence. Some auditors would
decide that independence is lost if the discount was equivalent to the discount
given employees. Students should also appreciate that auditors do not necessarily
agree on acceptable behavior in this situation. Some CPA firms impose
restrictions on employees regarding this matter.
3-25. a. Based on the information given, Honey can use the computer to
 text extensions and footings of computerized sales records that serve as a
basis for the preparation of the invoices and sales journal.
 verify the mathematical accuracy of posting from the sales journal to
appropriate ledger accounts.
Audit of the Revenue and CollectionCycle: Tests of Controls and Substantive Tests of Transactions 3-11
 determine that all sales invoices and other related documents have been
accounted for (for example, by accounting for the integrity of the
numerical sequence).
 select sales transactions for review (based on predetermined criteria)
through a review of the sales journal or the accounts receivable
subsidiary ledger.
 print a working paper that lists each item selected, with relevant data
inserted in applicable columns.
 select all debits posted to the sales account and all postings to the sales
account from a source other than the sales journal.
 perform analytical procedures on recorded sales by use of predetermined
criteria (percentage relationship, gross margin, trends, and so forth) on a
periodic or annual basis.
 compare duplicate data maintained in separate files for corrections. For
example, the computer may be used to compare the client’s records of
quantities sold with the client’s records of quantities shipped.
 examine records for quality (completeness, consistency, and so forth).
The quality of visible records is readily apparent to the auditor. Sloppy
recordkeeping and lack of completeness are observed by the auditor in
the normal course of the audit. If machine-readable records are evaluated
manually, a complete printout is needed to examine their quality. Honey
may choose to use the computer to examine these records for quality.
b. In addition to the procedures outlined above, Honey should

 trace postings from the sales journal to invoice copies.
 trace data from sales invoices to the sales journal.
 compare dates of recorded sales transactions with dates on shipping
records.
 determine that all shipping documents have been accounted for (for
example, by accounting for the integrity of the numerical sequence).
 examine documents for appropriate approval (for example, granting of
credit, shipment of goods, and determination of price and billing).
 determine the extent and nature of business transacted with major
customers (for indications of previously undisclosed relationships –
related parties – and for determination of applicability of disclosure
requirements required by generally accepted accounting principles).
 verify the sales cutoff at the beginning and end of the period to determine
whether recorded sales represent revenues of the period.
 test pricing of comparing invoice to daily price list.
3-26.
a. b. c. & d.
TYPE OF EVIDENCE TYPE OF TEST OBJECTIVE
1. Documentation (1)Test of control Existing sales transactions

are recorded (completeness)
2. Inquiry (4)Test of details of Sales transactions are

balances recorded in the proper period
3. Mechanical accuracy (4)Test of details of Accounts receivable are

balances mechanically accurate
4. Observation (4)Test of control Accounts receivable are

mechanically accurate
3-27. Alpha Drug Store, Inc., Processing Cash Collections: Internal Control
Questionnaire – The following questions should be listed:
 Are customers who pay by check identified via store identification card or
other means?
 Does company policy prohibit accepting checks for anything except
merchandise sales plus a nominal cash amount?
 Is a receipt produced by the cash register given to each customer?
 Is the reading of each cash register taken periodically by an employee who is
independent of the handling of cash receipts?
 Are cash counts made on a surprise basis by an individual who is independent
of the handling of cash receipts?
 Is the reading of each cash register regularly compared to the cash received?
 Is a summary listing of cash register readings prepared by an employee who
is independent of the physical handling of cash receipts?
 Are receipts forwarded to an independent employee who makes the bank
deposits?
 Are each day’s receipts deposited intact daily?
 Is the summary listing of cash register receipts reconciled to the duplicate
deposit slips authenticated by the bank?
 Are entries to the cash receipts journal prepared from duplicate deposit slips
or the summary listing of cash register readings?
 Are entries to the cash receipts journal compared to the deposits per bank
statement?
 Are areas involving the physical handling of cash reasonably safeguarded?
 Are employees who handle receipts bonded?
Audit of the Revenue and CollectionCycle: Tests of Controls and Substantive Tests of Transactions 3-13
3-28. 1. a. Existence
b. Cash may be misappropriated or lapping may occur.
c. Observe separation of duties and inquire of personnel about their
responsibilities.
d. For selected days, trace entries in the cash receipts journal to validated
deposit ticket, prelisting of cash receipts, and posting to accounts
receivable.
2. a. Existence
b. Fictitious cash receipts may be recorded or cash receipts may be
misappropriated.
c. Observe whether a prelisting is prepared and inquire of preparer about
the procedures followed.
d. For a sample of entries in the cash receipts journal, trace to the prelisting
of cash receipts.
3. a. Completeness
b. Cash may be unrecorded or misappropriated.
c. Observe the procedure and inquire of personnel who perform the
procedure.
d. For a sample of entries in the cash receipts journal, compare prelisting to
the deposit ticket.
4. a. Existence
b. Bank reconciliations may hide shortages.
c. Examine bank reconciliations and determine that the preparer does not
have conflicting interests.
d. Test bank reconciliations.
5. a. Valuation
b. A customer may take a larger discount than appropriate.
c. For a sample of entries in the cash receipts journal, examine remittance
advices for approval of discounts taken.
d. For a sample of entries in the cash receipts journal, examine remittance
advices and verify that discount taken was appropriate.
6. a. Existence
b. The cashier may misappropriate a portion of the cash receipts.
c. For a sample of entries in the cash receipts journal, reconcile the total to
validated deposit tickets.
d. For a sample of entries in the cash receipts journal, examine remittance
advices.
CHAPTER
AUDIT OF THE EXPENDITURE CYCLE:
4 TESTS OF CONTROLS AND SUBSTANTIVE
TESTS OF TRANSACTIONS - I
4-1. Transactions in the expenditure cycle are recorded in the purchases and cash
payments journal or in the voucher register and the check register. Relevant
accounts are cash; vouchers payable; inventory, property, plant and equipment;
purchases; purchase returns and allowances; purchase discounts; prepaid rent and
other prepaid accounts; and expense accounts.
4-2. Errors that occur in the expenditure cycle include recording purchases in the
wrong period (cutoff errors), recording goods held on consignment as a purchase,
misclassifying purchases, failing to record payments, recording payments twice,
and failing to recognize prepaid expenses. Irregularities often relate to purchases
and include paying for fictitious purchases, purchasing goods for personal use,
and obtaining kickbacks.
4-3. Audit objectives for acquisitions transactions are to verify the following
assertions:
 Existence or occurrence: Recorded acquisitions are for items that were
acquired.
 Completeness: Acquisitions that occurred are recorded.
 Rights and obligations: Recorded acquisitions are the entity’s purchases and
liabilities.
 Valuation or allocation: Acquisitions are recorded for the proper amounts.
 Presentation and disclosure: Acquisitions are recorded to result in
presentation and disclosure in accordance with GAAP.
4-4. The following misstatements could arise if controls for payments are ineffective:
Existence or occurrence
 Unauthorized or inappropriate payments may be made.
Completeness
 Checks may be issued and not recorded.
Rights and obligations
 Unauthorized payments may be made.
Valuation or allocation
 Improper amounts may be paid because of math errors or incorrect discount.
 Account may not reconcile or discrepancy may not be disclosed.
Presentation and disclosure
 Payments may be credited to wrong accounts.
4-5. A vendor’s invoice is a bill for a single purchase, whereas the vendor’s monthly
statements report the beginning balance, additional sales, any payments, and the
ending balance. Auditors reconcile the monthly statements to the details included
in the vouchers payable listing to ascertain that all vouchers payable are recorded.
Vendors’ statements are generally considered to be a strong form of evidence
about amounts owed to particular vendors.
4-6. 1) a 2) b 3) c
4-7. 1) b 2) c 3) c
4-8. 1) d 3) a 5) b 7) c
2) a 4) d 6) a
4-9. 1) b 2) b 3) c
4-10. 1) d 2) a
4-11. 1. a. A purchase requisition, purchase order, receiving report, and vendor’s

invoice should be compared and filed in support of each acquisition.
b. Examine file of documents.
c. Existence
2. a. Receiving reports should be prenumbered and accounted for.

c. Existence
3. a. A purchase requisition, purchase order, receiving report, and vendor’s

invoice should be compared and filed in support of each acquisition.
c. Existence
4. a. Invoice amounts should be verified by reference to purchase orders, and

mathematics of invoice should be rechecked.
b. Examine vouchers for signature indicating performance.
c. Valuation
Audit of the Expenditure Cycle: Tests of Controls and Substantive Tests of Transactions – I 4-3
5. a. Chart of accounts should adequately describe accounts to be debited.
Account coding should be assigned by one person and checked by
another.
b. Examine chart of accounts. Examine signature of employee performing
check.
c. Presentation and disclosure
6. a. Vouchers should be prenumbered and accounted for.

b. Observe procedure. Account for a numerical sequence.
c. Completeness
4-12. 1) a 2) b
4-13. Fresh Foods Grocery Store
1. a. 1) Adequate documents and records.

2) Independent checks on performance.
b. Transactions are properly valued.
c. 1) Make sure the billing clerk receives the current price list.
2) Internal verification by someone who has the current price list.
2. a. Adequate documents and records.

b. Recorded transactions are valid.
c. 1) Require that payments only be made on original invoices.
2) Require a receiving report be attached to vendor’s invoice before a
payment is made.

2) Physical control over assets.
b. Recorded transactions are valid.
c. 1) Fence in the physical facilities and prohibit employees from parking
inside the fencing.
2) Require the accounting department to maintain perpetual inventory
records and take physical counts of actual sides of beef periodically.
4. a. Independent checks on performance.

b. Transactions are properly valued.
c. Counts by qualified personnel and independent checks on performance.
5. a. Proper procedures for authorization.

b. 1) Transactions are properly valued.
2) Transactions are properly authorized.
c. 1) Make sure the salesman has a current price list.
2) Require independent approval of all transactions including the price
before shipment is made.

b. Transactions are recorded at their proper time.
c. Carefully coordinate the physical count of inventory on the last day of
the year with the recording of sales to make certain counted inventory
has not been billed and billed inventory has not been counted.
4-14. Love Company
a. Function b. Error or Irregularity c. Compliance Test(s)
1. Ordering items Purchases may be for Review evidence of

requested unauthorized purposes or matching of purchase
items. orders with receiving
reports and vendors’
invoices.
2. Receiving items Goods received may not be Review evidence of
ordered accounted for. numerical sequencing of
receiving reports.
3. Receiving items Goods delivered to Review receiving report for
ordered requisitioner may not agree signature of requisitioner.
with goods shown on
receiving report.
4. Preparing the Vouchers may be prepared Review evidence of
voucher for goods that were not matching by voucher clerk.
ordered or received.
5. Paying the liability Checks may be issued Examine supporting
without proper documentation for each
authorization. check.
6. Paying the liability An approved voucher may Examine mutilation of paid
be paid more than once. vouchers.
7. Paying the liability Checks may not agree with Examine voucher for
amount or payee on evidence of performance by
voucher. check signers.
8. Preparing the Vouchers may be incorrect Examine evidence of
voucher as to payee and amount. verification.
9. Protecting inventory Inventory may be stolen. Observe storage security.
10. Updating inventory A purchase may not be Review evidence of
records posted to inventory records. reconciliation.
11. Journalizing and A check may not be Review evidence of
posting cash recorded. verification.
disbursements
12. Maintaining A mathematical error may Review evidence of
correctness of cash in be made in computing the reconciliation.
bank bank balance.
13. Paying the liability Checks may be diverted to Review checks for names
unauthorized payees. of payees.
14. Ordering Purchases may be for Examine purchase order for
unauthorized purposes. supporting documentation.
15. Requisitioning Excess quantities of goods Examine evidence of
may be ordered. supervisor approval.
4-15. Maybelle Corporation
a. Those internal accounting control procedures that Long would expect to find if
Maybelle’s system of internal control over purchases is effective are as follows:
 Purchase requisitions are prepared and/or approved only after there has been
a proper determination of the need for the goods requested.
 One copy of the purchase requisition is maintained on file in the stores
department.
 Purchase requisitions are approved by a responsible person in the stores
department. Approval is given only after that person is satisfied that a need
exists and that the requisition is properly prepared. Approval is clearly
indicated on requisitions.
 Purchase orders are issued only after they are approved by persons given the
specific responsibility to make such approval.
 Vendors are requested to confirm purchase orders. This indicates
acceptance and constitutes a contractual commitment.
 Purchase requisitions are filed with purchase orders, and both are maintained
in an orderly file in the purchase office.
 Copies of purchase orders sent to the receiving department do not include
the quantities of merchandise ordered.
 All purchase orders are numbered, and all numbers are accounted for. This
allows control over purchase orders canceled or rejected by vendors.
 Receiving department accepts only those goods for which a purchase order
is on hand.
b. (1) The question of when to order depends primarily on quantities on hand,

rate of use, and the lead time between order placement and receipt of
goods. Other factors include the trade-off between the cost of owning and
storing merchandise versus the risk of being out of stock.
(2) Factors considered in determining how much to order include expected
use, costs of placing an order, receiving and paying for what has been
purchased, set-up costs, storage costs, interest on investment, risk of
obsolescence or deterioration, quantity discounts, and shipping costs. The
determination is made judgmentally or mathematically by arriving at an
economic order quantity.
4-16. 1. a. Rights and obligations

b. Unauthorized payments may be made.
c. Inquire and observe separation.
d. Examine vouchers and bank reconciliations.
2. a. Existence of liability
b. Documents may be reused and acquisitions may be recorded twice.
c. Examine cancellations on documents.
d. Scan voucher register for duplicate payments.
3. a. Existence or occurrence
b. Unauthorized payments may be made or checks may never be mailed.
c. Inquire and observe that authorized individual signs and promptly mails
checks.
d. Examine paid checks for appropriate signature.
4. a. Valuation
b. Improper amounts may be paid because of math errors or incorrect
discounts.
c. Examine signature on invoice indicating calculation has been verified.
d. Recalculate paid invoices.
b. Acquisitions that did not occur may be recorded.
c. For a sample of cash payments, examine a purchase requisition, purchase
order, receiving report, and vendor’s invoice filed in support of each
acquisition.
d. Scan voucher register for large or unusual items.
6. a. Completeness
b. Acquisitions or payments may not be recorded.
c. Examine reconciliations.
d. Perform reconciliations.
4-17. a. For the four conditions, the following risks are incurred:
1. Buyers would not be officially notified of the strict code of conduct to
which management expects them to adhere. Buyers could deny that they
were expected to conform to a prescribed code of conduct.
2. Only favored suppliers may be asked to bid. Low-cost supplier may be
excluded.
3. Bids from favored suppliers could be retained. Bids from nonfavored
suppliers could be discarded.
4. The defect was caused by a minor human error. The procedure seems to
be adequate and requires no improvement.
b. For the four conditions, the following controls are recommended:

1. Require buying personnel to periodically report all outside business
affiliations or employment. Issue a formal statement of policy on
conflicts of interest. Require buying personnel to report the receipt of
gifts and other personal benefits from suppliers.
2. Require personnel at appropriate levels of supervision in the purchasing
department to review and approve the list of bidders. Require buyers to
use a list of acceptable suppliers.
3. Require receipt and retention of bids until the bid-closing date, either by
an independent service or by the purchasing agents’ or purchasing
managers’ administrative assistant.
4. Verbally recommend that the responsible buyer should be instructed on
the requirements for authorized requisitions.
CHAPTER
AUDIT OF THE EXPENDITURE CYCLE:
5 TESTS OF CONTROLS AND SUBSTANTIVE
TESTS OF TRANSACTIONS - II
5-1. The following duties must be separated in the preparation of payroll: hiring,
reporting and approval of time, paycheck preparation, check signing, and
paycheck distribution.
5-2. Payroll checks should be prenumbered and accounted for in a bank reconciliation.
5-3. Auditors’ substantive tests of payroll balances are primarily analytical procedures.
Procedure Possible Error
Scan the payroll register, general Fictitious employees may be paid, or
ledger, and payroll earnings records for significant overpayments may be made
entries that appear unusual, such as to genuine employees.
very large paychecks or employees not
assigned to departments.
Compare average pay per employee for Payroll expense may be overstated or
the current year to average pay for prior understated.
year (taking into consideration pay
raises).
Compare direct labor as a percentage of Payroll expense may be overstated or
cost of sales with the previous year’s understated.
percentage.
Compare the ratio of commission Commission expense may be
expense to sales with previous year’s overstated or understated.
percentage.
Compare payroll tax expense as a Payroll tax expense may be overstated
percentage of cost of goods sold with or understated.
percentage of previous years.
5-4. a. A production order provides a record of authorization to production

personnel to produce products.
b. A bill of materials is a list that indicates components to be used in producing
a product.
c. A materials requisition is a recorded authorization to issue materials to
production.
d. A cost accumulation report is a record prepared by operating personnel of
costs incurred as goods are transferred through production.
e. A materials requisition summary is a record of materials used for a period,

such as a day.
f. A labor ticket is a record of the time a production employee works on a job.
g. A labor ticket summary provides a record of labor used in production for a
period, such as a day.
h. A completed production report provides a basis for inventory valuation.
5-5. Auditors perform three procedures that provide evidence that all production
transactions that occur are recorded. First, auditors observe that prenumbered
production orders are accounted for to determine that all materials issued are
recorded. An auditor might also account for a sequence of production orders.
A second procedure is to observe that the client accounts for prenumbered

materials requisitions to reduce inventory and to assign costs to production. An
auditor might also account for a sequence of materials requisitions.
Finally, an auditor might observe that a clerk reconciles completed and charged
time tickets with the total hours for which production workers are paid.
5-6. 1) c 2) b
5-7. 1) d 2) d 3) b 4) b
5-8. 1) d 2) c
5-9. 1) a 2) a
5-10. 1) d 3) d 5) c
2) b 4) d 6) c
5-11. 1. a. Existence or occurrence

b. Payroll may include fictitious or former employees.
c. Examine approval signatures.
d. For selected entries, examine signed authorizations for hiring and
compare signature on paid check to signature on job application.
2. a. Rights and obligations

b. Employees may be paid for more hours than they work.
c. Examine signature on cards.
d. Reconcile time charged to jobs to total hours worked.
3. a. Rights and obligations

b. Employees may be paid for more hours than they work.
c. Examine signature on cards.
d. Reconcile time charged on cards to total charged to jobs.
Audit of the Expenditure Cycle: Tests of Controls and Substantive Tests of Transactions – II 5-3
b. Payroll may include fictitious or former employees.
c. Observe separation of duties.
d. For selected entries, examine signed authorizations for hiring, pay rates,
and deductions, and compare signature on paid check to signature on
application, or distribute paychecks in a surprise payoff.
5. a. Completeness
b. Paychecks may be issued but not recorded.
c. Observe whether paychecks are prenumbered and determine whether a
bank reconciliation is prepared by a person independent of the payroll
function.
d. Test or prepare a bank reconciliation.
6. a. Completeness
b. Paychecks may be issued but not recorded.
c. Observe whether a bank reconciliation is prepared by a person
independent of the payroll function.
d. Test or prepare a bank reconciliation.
5-12. Match objectives and procedures:

1. d
2. c
3. a
5-13. 1. a. Production planning should sign a production order authorizing

personnel to undertake work.
b. Examine signature on production orders.
c. Rights and obligations.
2. a. Materials requisitions should be prenumbered and accounted for by a

clerk in accounting.
b. Observe procedure and account for a sequence of materials requisitions.
c. Completeness
3. a. Chart of accounts should adequately describe accounts to be used, and

account coding should be assigned by one person and checked by
another.
b. Examine chart of accounts and signature of employee performing check
on the account coding.
c. Presentation and disclosure
4. a. Chart of accounts should adequately describe accounts to be used, and

account coding should be assigned by one person and checked by
another.
b. Examine chart of accounts and signature of employee performing check

on the account coding.
c. Presentation and disclosure.
5. a. Production orders should be prenumbered and accounted for to determine

that all production is recorded.
b. Observe procedure and account for a numerical sequence of production
orders.
c. Completeness
6. a. Time charged on job tickets should be reconciled to time-clock cards

from which employees are paid.
b. Observe procedure.
c. Completeness
5-14. 1. a. An inventory storage clerk should sign a copy of the prenumbered

receiving report after counting goods transferred to the storage area.
b. Observe procedure and examine signature on receiving reports.
2. a. Receiving reports and requisitions should be prenumbered and accounted

for by a clerk in accounting.
b. Observe procedure and account for a numerical sequence of receiving
reports to determine that they all have been recorded.
c. Completeness
3. a. Provision for inventory obsolescence should be reviewed by officials and

adjusted as necessary.
b. Inquire about review for obsolescence.
c. Valuation
4. a. Access to inventory storage should be limited to personnel responsible

for its custody.
b. Observe procedures.
c. Completeness of inventory or completeness of issuances
5. a. A production employee should sign a copy of the purchase requisition

after counting goods transferred to production.
b. Observe procedure and examine signature on requisition.
CHAPTER
AUDIT OF THE FINANCING AND INVESTING
6 CYCLE: TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF TRANSACTIONS
6-1. Investing activities include an entity’s activities to invest in debt or equity

securities of other entities and investments in property, plant, and equipment.
These transactions are often recorded during the expenditure cycle but are so
significant that additional controls are applied to them.
6-2. Kickbacks, acquisitions of goods for personal use, appropriation of assets, and
processing of fictitious transactions can occur in the acquisition of property, plant,
and equipment, just as they do in the acquisition of goods. Related-party
transactions to acquire investments or property, plant, and equipment may result
in improper valuation of the accounts. Securities may be stolen or diverted.
Historically, business entities have manipulated the accounting values at which

assets were recorded by acquiring assets from a related party or selling assets to a
related party. Acquiring assets at inflated values may result in draining cash from
the acquiring entity. Selling assets at inflated values to related parties results in
increased revenue and assets to the selling entity, and these may never be realized.
All transactions conducted with related parties must be examined carefully.
6-3. Critical controls include separating the responsibilities for authorizing

transactions, keeping records, and having custody of the asset.
Generally, the board, or sometimes an investment committee of the board, must

approve individual investments. After obtaining board approval, the treasurer or
vice president for finance has authority to execute the purchase or sale of an
investment transaction.
Due to their large peso value and susceptibility to misappropriation, investment

certificates (stocks or bonds) are often left in the custody of a broker or bank.
When the entity takes custody of investment certificates should be stored in a safe
deposit box.
Typically the general ledger clerk maintains investment records unless the entity
has a large volume of investment transactions.
6-4. The substantive tests, grouped according to the assertions they test, are as follows:
Existence or occurrence: Recorded investments and investment income exist.
 Inspect securities on hand and trace to listing.
 Confirm securities held by others.
Completeness: All investments and investment income are recorded.
 Apply analytical procedures.
Rights and obligations: Investments and investment income are owned by the
entity.
 For investments acquired during the period, examine supporting invoices and
paid checks. For dividends, interest, and disposals of investments, examine
remittance advices.
Valuation or allocation: Investments are valued in accordance with GAAP and
investments and investment income are mathematically accurate.
 Reconcile the investment listing to the subsidiary ledger and general ledger
account.
 Recalculate interest revenue and verify dividend income by reference to
published reports of dividends.
Presentation and disclosure: Investments and investment income are presented in
accordance with GAAP.
 Review statement presentation for compliance with GAAP.
6-5. Financing activities consist of an entity’s transactions to (1) obtain long-term

(capital) funds by issuing long-term debt or capital stock; (2) make payments
associated with long-term funds, such as payment of interest and dividends; and
(3) retire long-term funds by paying off or reacquiring debt or equity obligations.
Long-term debt includes notes, mortgages, and bonds. Capital stock includes both
common and preferred stock. Often these transactions are recorded in the sales
and collections cycle, but they are so significant that additional controls are
applied to them.
6-6. The characteristics of the liability accounts that result in a different auditing
approach than followed in the audit of accounts payable are:
1) Relatively few transactions affect the account balances but each transaction
is often highly material in amount.
2) The exclusion of a single transaction could often be material by itself.
3) The relationship between the client entity and the holder of the ownership
document is legal in nature.
4) The liabilities involve accrual and payment of interest as well as debt.
Audit of the Financing and Investing Cycle: Tests of Controls and Substantive Tests of Transactions 6-3
6-7. It is common to audit the balance in notes payable in conjunction with the audit of
interest expense and interest payable because it minimizes the verification time
and reduces the likelihood of overlooking errors in the balance. Once the auditor
is satisfied with the balance in notes payable the related interest rates and due
dates for each note, it is easy to test the accuracy of accrued interest. If the
interest expense for the year is also tested at the same time, the likelihood of
omitting a note from notes payable for which interest has been paid is minimized.
When there are a large number of notes or a large number of transactions during
the year, it is usually too time consuming to completely tie out interest expense as
a part of the audit of the notes payable and related accrued interest. Normally,
however, there are only a few notes and few transactions during the year.
6-8. The most important controls the auditor should be concerned about in the audit of
notes payable are:
1) The proper authorization for the issuance of new notes (or renewals) to ensure
that the company is not being committed to debt arrangements that are not
authorized.
2) Controls over the repayment of principal and interest to ensure that no more is
paid on the note than is required.
3) Proper records and procedures to ensure that all amounts in all transactions
are properly recorded.
4) Periodic independent verification to ensure that all the controls over notes
payable are working.
6-9. Four types of restrictions long-term creditors often put on companies in granting
them a loan are:
1) Financial ratio restrictions
2) Payment of dividends restrictions
3) Operations restrictions
4) Issue of additional debt restrictions
The auditor can find out about these restrictions by examining the loan agreement
and related correspondence associated with the loan, and by confirmation. The
auditor must perform calculations and observe activities to determine whether the
client has observed the restrictions.
6-10. The major internal control over owners’ equity are:

1) Proper authorization of transactions
2) Proper record keeping
3) Adequate segregation of duties between maintaining owners’ equity records
and handling cash and stock certificates
4) The use of an independent registrar and stock transfer agent
6-11. Since it is important to verify that properly authorized dividends have been paid to
owners of stock as of the dividend record date, a comparison of a random sample
of canceled dividend checks to a dividend list prepared by management would be
inadequate. Such an audit step is useless unless the dividend list has first been
verified to include all stockholders of record at the dividend record date. A better
test is to determine the total number of shares outstanding at the dividend date
from the stock registrar and recompute the total dividends that should have been
paid for comparison with the total amount actually paid. A random sample of
canceled checks should then be compared to the independent registrar’s records to
verify that the payments were actually made to valid shareholders.
6-12. 1) c 3) c 5) c
2) d 4) d
6-13. 1) d 3) c 5) a
2) a 4) d 6) a
6-14. 1) d 2) a 3) b
6-15. 1) a 2) a 3) a 4) c
6-16. 1) b 2) a 3) c
6-17.
a. b. c.
Audit Procedure to
Purpose of Potential Financial Determine Existence
Control Statement Error of Material Error
1. To assure that all note Loss of assets through Check note request forms
liabilities are payment of excess for proper authorization.
authorized by proper interest rates or the
management. diversion of cash to
unauthorized persons.
2. To assure that note Improper disclosure or Determine if master file

transactions are errors in note payable is maintained, and
recorded in full and in through duplication. reconcile detailed
detail. contents to control.
3. To prevent misuse of Misstatement of Determine if duties are

notes and funds liabilities and cash. segregated. Perform all
earmarked for notes. substantive procedures on
extended basis.
Audit of the Financing and Investing Cycle: Tests of Controls and Substantive Tests of Transactions 6-5
4. To assure that notes Loss of cash. Check paid notes for
are not paid more than cancellation.
once.
5. To assure that all note- Misstatement of notes Determine if

related transactions payable. reconciliations are
agree with account periodically made, and
balances. verify reconciliation.
6. To further assure that Misstatement of interest Determine if interest

only the proper expense and related computations are
interest amount is paid accrual. internally verified.
and recorded. Recompute interest on a
test basis.
6-18. Since the source of the debits in the asset account is the purchase journal (or
similar record), the current period acquisitions of property, plant and equipment
have already been partially verified as part of the acquisition and payment cycle.
The disposal of assets, depreciation and accumulated depreciation are not tested as
a part of the acquisition and payment cycle.
6-19.
Item Substantive
No. Internal Control Audit Procedure
1. Use of government study Compare to government study

depreciation tables. depreciation table.
2. Make approvals required for all Test all expense charges to these
expending over a certain accounts over a certain amount.
amount.
3. Have construction foreman Examine equipment listed on the

report to accounting department books.
periodically whether or not
there have been abandonments
or replacements.
4. Have expense records Analyze depreciation and

internally verified. administrative expenses by ratio
comparison to previous years.
5. Assign tools to individual Take a physical count of the tools.

foreman and periodically count
the tools.
6. Have recording of property Review supporting documentation on

acquisitions internally verified. property acquisitions and compare to
recorded value.
7. The deposit of all cash directly (1) Confirmation of bank accounts and
into the bank account. other tests for unrecorded loans.
(2) Physical examination of plant
assets.
6-20.
Liability that could Audit Procedure to
be Uncovered Uncover Liability
a. Lawsuit Review minutes of the Board of

Directors’ meetings.
b. Building used as collateral for a Examine documents of ownership and

loan bank confirmations.
c. Unrecorded lease Examine the lease agreements.
d. Note payable Examine underlying records for the

related loan.
e. Policy loan Confirmation with life insurance

company.
f. Note payable Obtain confirmation from bank.
g. Income taxes payable for Review travel and expense reports.

nondeductible expenses
CHAPTER
SUBSTANTIVE TESTS
7 OF CASH
7-1. The quoted statement is not accurate. In their work on cash, auditors are primarily
concerned with the risk of an overstatement of the cash balance. The listing of a
non-existent or fictitious check on the outstanding list would have the effect of
understating the client’s cash position, because too large an amount for
outstanding checks would be deducted from the balance per bank, resulting in
understatement of the adjusted balance.
The other element of the quoted statement relating to the auditors’ concern over
the possible omission of a deposit in transit is also in error. To omit a deposit in
transit would cause an understatement of the year-end cash balance.
If the quoted statement were revised into acceptable form, it would read along the
following lines: “When auditors are verifying a client’s bank reconciliation, they
are particularly concerned with the possibility that an outstanding check may be
omitted or that a non-existent deposit in transit may be included.
7-2. There is no assurance that the lapping activities of the cashier will be discovered
during the annual audit. Since no shortage exists as of the balance sheet date, the
only procedure which might disclose the irregularities would be a comparison of
the individual checks listed on duplicate deposit tickets with the credits to
customers’ accounts. Since a test of this nature would probably not be made for
more than a small sample of control listings it is likely that the “borrowing” and
subsequent restoration of borrowed funds might go undetected.
7-3. (a) “Lapping” is a defalcation in which a cash shortage is concealed by delaying

the crediting of cash receipts to the proper accounts receivable. The first step
in the fraud is to withhold from a bank deposit cash remitted by a customer.
A few days later, because the customer must receive credit for his remittance,
the first customer’s account is credited with an amount from a remittance
made by a second customer. The process requires the continuous shifting of
shortages from account to account and the crediting of subsequent receipts to
the wrong account receivable.
(b) The following audit procedures would be used to uncover lapping:

(1) Compare the detail of mailroom control listings (if prepared) to entries in
the cash receipts journal, postings to the accounts receivable subsidiary
ledger, and the detail of authenticated duplicate deposit slips. This
procedure should indicate any delay in journalizing, posting, and/or

depositing incoming cash receipts.
(2) If control listings are not prepared, compare the remittance advices
received with customers’ checks to the cash journal entries, postings to
accounts receivable, and deposit slips. If the client stamps remittance
advices with the date received, particular attention should be given to
comparing this date with the date of the related journal entry and posting.
(3) Confirm accounts receivable and give close attention to exceptions made
by customers about payment dates. The confirmation procedure is better
applied as a surprise at an interim date so that a person engaged in
lapping will not have been able to bring the “lapped” accounts up to date.
If the confirmations are always prepared at year-end, the confirmation
procedure may be anticipated by the person doing the lapping and the
shortage given a different form such as kiting of checks. (Confirmation
of accounts receivables has not been discussed in this chapter, but some
students may be familiar enough with this procedure to include it in their
answer.)
7-4. West, Inc.
The outstanding checks said by the controller to have been distributed after
December 31 should be reversed to the extent that they were actually distributed
after that date. An actual overdraft should be revealed and not eliminated by
improper journal entries. The primary purpose of the reversal is to properly cut
off the cash and show the proper cash balance. Showing the correct cash balance
eliminates “window dressing”; recorded but undistributed checks would distort
the current ratio by reducing both cash and accounts payable.
7-5. Cavite Company
Requirement (a) Adjusting Journal Entries - 12.31.05
AJE (1) Gas and oil 320

Supplies expense 260
Delivery expense 320
Repairs and maintenance 600
Advances to employees 400
Petty cash fund 1,900
(2) Advances to employees 200

Petty cash fund 200
(3) Accounts receivable - cashier 100

Petty cash fund 100
Substantive Tests of Cash 7-3
Shortage in PCF determined as follows:
Accounting:
Currency P 1,200
Coins 200
Check 1,400
Unreplenished vouchers 1,900
NSF check 200
Total 4,900
PCF per ledger 5,000
Shortage P (100)
(4) Cash in bank 450

Salaries payable 450
Requirement (b)
Cavite Company
Petty Cash Fund
12.31.05
Balance per ledger P 5,000

Add (Deduct) adjustments
AJE (1) ( 1,900)
(2) ( 200)
(3) ( 100)
Net adjustment ( 2,200)
Balance as adjusted P 2,800
7-6. Pampanga Company
Requirement (a)
Proper composition of the Fund, 11/10/06
Currency and coins P 2,200
Cashed checks 500
Vouchers 740
NSF checks 260
Total P 3,700
Less: Petty cash receipt vouchers
Return of expense advance P 200
Sale of money orders 100 300
Balance of Fund per count P 3,400
Balance of Fund per records 5,000
Shortage (P 1,600)
The cashier attempted to conceal the shortage by:
1) Adding instead of deducting the cash received thereby

overstating the accounting of the fund by P 600
2) Submitting blank money orders claimed to have been purchased 600
3) Submitting additional vouchers claimed to have been misplaced 400
Total P 1,600
Requirement (b)
Audit Procedures
a. Cashed checks
1. Examine checks as to payee, date, endorsements and subsequent
deposit.
2. Determine if checks were cashed with prior approval of a responsible
official.
b. Vouchers not yet replenished
1. Vouch supporting documents, invoices, etc.
2. Examine vouchers as to approval by authorized officials, signature of
payee, etc.
c. NSF checks
1. Determine reason why NSF checks are still on hand.
2. Confirm directly with drawers.
d. Return of excess travel advance
1. Examine liquidation of travel advance as reported and determine
accuracy of the amount returned.
2. Vouch supporting invoices.
e. Sale of money orders
1. Examine latest report of the Pampanga Co. to establish proper
accountability.
2. Confirm directly with the Pampanga Co. all unreported money orders
sold as well as unissued as of November 10.
f. Vouchers subsequently presented
1. Examine vouchers as to date, approval, amount and nature of
expenditures.
2. Confirm directly with employees those items representing wage
advance.
g. Book balance of the Petty Cash Fund.
1. Trace to the general ledger the balance of the fund.
7-7.
Requirement (1) Bank Reconciliation, June 30
Bank Books
Balances, June 1 .......................................... P18,000 P30,170 (derived)
Additions:
Deposits in transit................................. 16,000
Note and interest collected ................... 1,860
Recording error (944 – 854)................ 90
Deductions:
Outstanding checks .............................. (6,000)
NSF check ............................................ (4,000)
Service charge ...................................... (120)
Correct cash balance.................................... P28,000 P28,000
Requirement (2) Adjusting entry
Accounts receivable .................................... 4,000

Service charge expense ............................... 120
Accounts payable ................................. 90
Interest revenue .................................... 60
Notes receivable ................................... 1,800
Cash...................................................... 2,170
7-8. Form Company

Requirement (a)
Form Company
Bank Reconciliation Statement
6.30.06
Balance per bank statement P 27,000
Add: Cash on hand 9,228
Total 36,228
Less: Outstanding checks
Check no. 192 P 1,040
193 720
194 816
195 692 3,268
Balance per books P 34,700
Add: Note collected by bank 500
Total 35,200
Less: Shortage 2,240
Requirement (b) Shortage is P2,240.
Requirement (c)
The cashier attempted to conceal the shortage by:
(1) Understating the outstanding checks
(a) Excluding check #192 P1,040
(b) Underfooting list of outstanding checks 200
(2) Adding instead of deducting note collected by bank
thereby covering up 1,000
Total P2,240
Requirement (d)
Suggestions to improve internal control:
(1) Bank reconciliation statement should be prepared by someone other than the
cashier.
(2) Collections should be deposited intact.
7-9. Jonas Company
Analysis of the bank statement and cash account will reveal the following:
a. Deposit in-transit, June 30:....................................... P2,700
b. Checks outstanding:
# 62 .......................................................................... P 900
# 68 .......................................................................... 1,300 P2,200
c. Interest earned on bank balance ............................... P 100
Bank Reconciliation, June 30
Bank Book
Ending June balance............. P22,580 Ending June balance............. P22,980
Deposits in-transit ................ 2,700 Interest earned ...................... 100
Checks outstanding:
#62................................. (900)
#68................................. (1,300)
Correct cash balance............. P23,080 P23,080
The following journal entry must be made by Jonas Company:
Cash................................................................................. 100
Interest revenue................................................. 100
7-10. Apple Company
Requirement (1)
(a) Deposits in-transit – All deposits (#51 through #56) except #56 have been
recorded by the bank; therefore, the deposit in-transit is: #56, P3,500. This
amount can be verified as: P2,000 + P190,000 – P188,500 = P3,500.
(b) Checks outstanding: Inspection of the check numbers reveals that the
following are outstanding: #121, P1,000; #177, P2,500; #178, P3,000; and
#179, P1,500; total, P8,000. This amount can be verified as: P6,000 +
P198,000 – P196,000 = P8,000.
Requirement (2)
Bank Books
Balances, December 1 ................................. P76,550 P56,000
Additions:
Cash on hand........................................ 400
Deposit in-transit (#56) ........................ 3,500
Note collected ......................................
Principal ........................................ 6,000
Interest .......................................... 720
Funds received from foreign revenue... 10,000
Deductions:
Checks outstanding (#121, #177-179).. (8,000)
NSF check, Customer Belinda ............. (200)
United Fund transfer ............................ (50)
Bank service charge ............................. (20)
Correct cash balance.................................... P72,450 P72,450
Requirement (3)
Journal entries from bank reconciliation:
(a) Cash...................................................... 16,720

Note receivable ............................. 6,000
Interest revenue............................. 720
Foreign revenue ............................ 10,000
(b) Account receivable, NSF check,

Customer Belinda.............................. 200
Contributions, United Fund.................. 50
Expense, bank service charge............... 20
Cash .............................................. 270
7-11. Mindanao Company

Requirement (a)
Mindanao Company
Bank Reconciliation Statement
12.31.06
Bank Books
Unadjusted Balance P 88,489.12 P 58,983.46
Add (Deduct) Reconciling Items
a) Outstanding checks (32,108.42)
b) Receipts of 12.31.06 deposited 1.2.07 5,317.20
c) Service charge for November (3.85)
d) Proceeds of bank loan 9,875.00
e) Deposit of 12.23.06 omitted from bank statement 2,892.41
f) Returned check from Tome Co. (417.50)
g) Error by bank in entering 12.16.06 deposit,
understated by 1.00
h) Check of Mina Mfg. Co. erroneously charged
against Mindanao acct. 2,960.00
i) Note of J. Santos Co. collected by bank, 12.10.06 2,015.00
j) Erroneous bank debit memo 5,000.00
k) Error by bank in entering 12.4.06 deposit;
overstated by ( 10.00)
l) Deposit of Mina Mfg. Co. erroneously credited
to the company’s account ( 1,819.20)
Total P 70,722.11 P 70,452.11
Unlocated difference 270.00
Adjusted balance P 70,722.11 P 70,722.11
Requirement (b) Adjusting Journal Entries: December 31, 2006

1. Bank charges 3.85
Cash in bank 3.85
2. Cash in bank 9,875.00

Interest expense 110.00
Prepaid interest 548.00
Loan payable 10,533.00
3. Accounts receivable 417.50

Cash in bank 417.50
4. Cash in bank 2,015.00

Bank charge 5.00
Notes receivable 2,000.00
Interest income 20.00
5. Cash in bank 270.00
Accounts receivable / Sales /
Miscellaneous income 270.00
7-12. Asia Envelope Company
ASIA ENVELOPE COMPANY

Proof of Cash
For the month ended 5-31-06
Balance MAY Balance

5-1-06 Receipts Disbursement 5-31-06
P3,561.00 P42,700.17 P41,631.45 P4,629.72
Unadjusted book balance
Add (Deduct) Adjustments
Bank service charges
April 30 (6.00) (6.00)
May 31 6.80 (6.80)
NSF checks returned
April 30 (815.00) (815.00)
May 31 118.00 (118.00)
Draft collected by bank
April 1,500.00 (1,500.00)
May 202.00 202.00
Check No. 6129 erroneously
recorded in the check register
Correct Amount P87
Recorded as 78 9.00 (9.00)
Adjusted book balance P4,240.00 P41,402.17 P40,944.25 P4,697.92
Unadjusted bank balance P7,403.50 P41,776.27 P45,317.57 P3,862.20
Deposit in transit
April 30 950.00 (950.00)
May 31 925.40 925.40
Outstanding checks
April 30 (4,463.00) (4,463.00)
May 31 149.68 (149.68)
Checks of Asia Engine
Corp. erroneously charged
to company's account
April 349.50 (349.50)
May ________ _________ (60.00) 60.00
Adjusted bank balance P4,240.00 P41,402.17 P40,944.25 P4,697.92
7-13. Tarlac Company
(1)
Tarlac Company
Proof of Cash
For the month ended 12.31.06
Balance December Balance

11.30.06 Receipts Disbursements 12.31.06
Balance per bank statement P 45,240 P100,000 P135,240 P10,000
Add (Deduct) Reconciling items
Outstanding checks
November 30 (10,000) (10,000)
December 31 4,000 (4,000)
NSF checks returned in
December (245) 245
Deposits in transit
November 30 2,500 (2,500)
December 31 3,500 3,500
Bank charges
November 20 20
December (25) 25
Check of another company
erroneously charged by bank
in November, corrected in
December 260 (260)
Balance per books P 38,020 P100,740 P 128,990 P 9,770
(2)
Adjusting Journal Entries - 12.31.06
1. Accounts receivable 245
Cash in bank 245
2. Bank charges 25
Cash in bank 25
(3)
Balance per books 12.31.06 P9,770
Less: AJE (1) P245
(2) 25 270
Balance as adjusted P9,500
7-14. Genius Company
a. Post-dated check – report as accounts receivable because it is not negotiable

until the date on the check.
b. Report as an account receivable because it is not a negotiable instrument at
this time. Debit Accounts Receivable, and credit Cash. If ultimately not
collectible, write off as a bad debt.
c. Report as Note Receivable or as a short-term investment. It is inappropriate
to report (or record) this as cash.
d. Include the P200 balance in petty cash in the balance reported as cash.
Immediately replenish the fund for P168 and record it on December 31 as a
debit to expenses (including the P1 cash short) and a credit to Cash.
Alternatively, an adjustment may be made debiting expenses for P168 and
crediting petty cash fund on December 31, 2005.
e. Report the P30 of postage stamps as prepaid postage expense – stamps are not
cash.
f. Include the cashier’s check in the balance because it will be accepted by
banks for immediate deposit.
g. These checks should not be recorded as 2005 payments because the company
still has full control of them.
h. The note and interest should not be included in the cash balance it has not
been collected. The P20,000 should be reported as a note receivable and
interest of P450 (i.e., P20,000 x 9% x 3/12) should be accrued by a debit to
interest receivable and a credit to interest revenue for P450. However, if the
bank reports that the note has been collected on or before December 31 and a
credit to the company’s account has been made, this item may be included in
the cash balance.
7-15.
Balance Sheet Classification
Cash ST
Cash Equivalent Investments Other
Checking account X
Savings account X
Rare coins kept for long-term
speculation X
Postdated checks received X
Money orders received X
Petty cash fund X
Treasury bills purchased when two
months remain in term X
Compensating balance for a short-
term loan X*
* shown separately
Balance Sheet Classification
Cash ST
Cash Equivalent Investments Other
Sinking fund to retire a bond in five
years X
Certificate of deposit (six-month
term) X
Short-term investment in
marketable equity securities X
7-16. Cordial Company
Bank Reconciliation, 12.31.06

Bank Books
Unadjusted balance P350,000 P293,500
Deposit in transit (P175,250 - P50,000) 125,250 (1)
Post dated customer’s check recorded
on 12.31.06 ( 50,000)
Note collected by bank 15,000
Outstanding checks
(P246,750 - P14,750 - P37,210) (194,790) (2)
Check payable to a supplier released on
Jan. 5, 2007 14,750 (6)
Check dated Jan. 4, 2007 recorded and
released in Dec., 2006 37,210 (6)
Erroneous bank credit corrected
on Jan. 2, 2007 (30,000)
As corrected 250,460 310,460
Unlocated difference (shortage) (60,000) (4)
Balance as adjusted P250,460 P250,460 (3)
Suggested answer to the multiple choice questions:
1. b 2. d 3. b 4. c 5. a 6. d
7-17. Pablo Corporation
PABLO CORPORATION
Proof of Cash
July 31, 2006
Reconciliation July July Reconciliation

6-30-06 Receipts Disbursements 7-31-06
Bank cash balance P13,031.78 P10,051.17 P5,326.52 P17,756.43
Deposit in transit:
July 1,098.51 1,098.51
June 146.73 (146.73)
Undeposited cash 472.50 472.50
Outstanding checks:
July: #1345 27.00 (27.00)
#1353 13.23 (13.23)
#1354 14.24 (14.24)
June: #1082 (372.15) (372.15)
#1086 (552.40) (552.40)
#1087 (196.80) (196.80)
Adjusted balance P12,057.16 P11,475.45 P4,259.64 P19,272.97
Book cash balance P12,057.16 P10,460.45 P4,102.69 P18,414.92

NSF check 113.15 (113.15)
Error 36.00 (36.00)
Note collected 1,000.00 1,000.00
Interest 15.00 15.00
Service charge 7.80 (7.80)
7-18. Jayce Corporation

JAYCE CORPORATION
Proof of Cash
August 31, 2006
Reconciliation August August Reconciliation

7-31-06 Receipts Disbursements 8-31-06
Bank cash balance P 9,852.46 P16,755.64 P14,928.85 P11,679.25
Deposit in transit:
August 1,235.32 1,235.32
July 953.71 (953.71)
Undeposited cash 421.68 421.68
Outstanding checks:
August: #2265 56.89 (56.89)
#2269 341.72 (341.72)
#2270 185.75 (185.75)
July: #2150 (345.26) (345.26)
#2151 (156.72) (156.72)
#2152 (97.43) (97.43)
Book cash balance P10,206.76 P15,913.93 P14,813.95 P11,306.74

NSF check 96.75 (96.75)
Error in recording check (9.00) 9.00
Note collected 1,500.00 1,500.00
Interest 45.00 45.00
Service charge 12.10 (12.10)
7-19. Kirsten Lim, Inc.
1. April 1 Petty Cash ................................................................ 200

Cash ................................................................ 200
2. April 10 Cash Over and Short ................................................................
2
Transportation-In ................................................................
60
Supplies Expense ................................................................
25
Postage Expense................................................................33
Receivables—Employees................................................................
17
Miscellaneous Expense ................................................................
36
Cash (P200 – P27) ................................................................
173
3. April 20 Petty Cash ................................................................ 100
Cash ................................................................ 100
Assuming no disbursements were made from April 20 to April 30 and the cashier
made up the shortage of P2, the answer is P300 (b).
7-20. Franco’s Auto Repair Service
Cash Over and Short ................................................................ 6.45

Accounts Receivable—Employees ................................................................
74.00
(P40.00 + P34.00)
Neo Franco, Drawings*................................................................170.00
Repair Expense................................................................................................
14.35
Postage Expense (P20.00 – P2.90)................................................................
17.10
Office Supplies................................................................................................
2.90
Cash (P300.00 – P15.20) ................................................................ 284.80
* Note: This debit might also be made to the capital account.
Answer: P15.20 (not among the choices; Faculty may add choice (e) P15.20)
7-21. Petty Cash, Bank Reconciliation
Balance per bank P6,522

Add:
Cash on hand 246
Deposit in transit 3,000 3,246
9,768
Deduct Checks outstanding (550)

Adjusted bank balance P9,218
Balance per books P8,315

Add: Note collected 930
9,245
Deduct Service Charge (27)
Adjusted cash balance, May 31 P9,218
P9,218 + P300 = P9,518 (a)

7-22. Powder Inc.
Powder, Inc.
Bank Reconciliation
November 30, 2006
Balance per bank statement, November 30, 2006 P56,274.20

Add:
Cash on hand, not deposited 1,915.40
58,189.60
Deduct:
Outstanding checks
#1224 P1,635.29
#1230 2,468.30
#1232 3,625.15
#1233 482.17 8,210.91
Correct cash balance, Nov. 30 P49,978.69
Balance per books, November 30, 2006 P49,178.22 *

Add:
Bond interest collected by bank 1,400.00
50,578.22
Deduct:
Bank charges not recorded in books P 27.40
Customer’s check returned NSF 572.13 599.53
Correct cash balance, Nov. 30 P49,978.69 (c)
*Computation of balance per books,

November 30, 2006
Balance per books, October 31, 2006 P 41,847.85
Add receipts for November 173,523.91
215,371.76
Deduct disbursements for November 166,193.54
Balance per books, November 30, 2006 P 49,178.22
CHAPTER
SUBSTANTIVE TESTS
8 OF RECEIVABLES AND SALES
8-1. Tests of details of financial balances are designed to determine the reasonableness
of the balances in sales, accounts receivable, and other account balances which are
affected by the sales and collection cycle. Such tests include confirmation of
accounts receivable, and examining documents supporting the balance in these
accounts.
Tests of transactions for the sales and collection cycle are intended to determine
the effectiveness of internal control structure and to test the substance of the
transactions which are produced by this cycle. Such tests would consist of
examining sales invoices in support of entries in the sales journal, reconciling cash
receipts, or reviewing the approval of credit.
The results of the tests of transactions will be used to affect the procedures,
sample size, timing and particular items selected for the tests of details of financial
balances (i.e., an effective internal control structure will result in reduced testing
when compared to the tests of details required in the case of an inadequate internal
control structure).
8-2. There are two common types of confirmations used for confirming accounts
receivable: “positive” confirmations and “negative” confirmations. A positive
confirmation is a communication addressed to the debtor requesting him to
confirm directly whether the balance as stated on the confirmation request is
correct or incorrect. A negative confirmation is also a communication addressed
to the debtor, but it requests a response only when the debtor disagrees with the
stated amount.
A positive confirmation is more reliable evidence because the auditor can perform
follow-up procedures if a response is not received from the debtor. With a
negative confirmation, failure to reply must be regarded as a correct response even
though the debtor may have ignored the confirmation request.
Offsetting the reliability disadvantage, negative confirmations are less expensive

to send than positive confirmations, and thus more of them can be distributed for
the same total cost. The determination of which type of confirmation to be sent is
an auditor’s decision, and it should be based on the facts in the audit. The
following are the most important circumstances where positive confirmations
should be used:
1. There are a small number of large accounts which account for a significant
portion of total accounts receivable.
2. There are suspected conditions of dispute, inaccuracy, or irregularity. This
would be the case when internal controls are considered inadequate or if
prior year’s audit test results are unsatisfactory.
3. The rules of certain regulatory agencies require them. This is the case for
brokers and dealers in securities.
When the above conditions do not exist, it is acceptable to use negative

confirmations, but negative confirmations should not be used if the auditor
believes the customer is likely to ignore the confirmation. Typically, when
negative confirmations are used, the auditor is using a reduced control risk
assessment in the audit of accounts receivable. It is also common to use negative
confirmations for audits of hospitals, retail stores, and other industries where the
receivables are due from the general public. In these cases, far more assurance is
obtained from tests of internal control than from confirmations.
It is also common to use a combination of negative and positive confirmations by

sending the positives to accounts with large balances and negatives to those with
small balances.
8-3. It is acceptable to confirm accounts receivable prior to the balance sheet date if the
internal control structure is adequate and can provide reasonable assurance that
sales, cash receipts and other credits are properly recorded between the date of the
confirmation and the end of the accounting period. Other factors the auditor is
likely to consider in making the decision are the materiality of accounts receivable
and the auditor’s experience in prior years. If the decision is made to confirm
accounts receivable prior to year end, it is necessary to test the transactions
occurring between the confirmation date and the balance sheet date by examining
internal documents and performing analytical procedures at year end.
8-4. South Technologies, Inc.
(a) When confirmation requests are mailed to debtors whose accounts were
written off as uncollectible, the auditors’ purpose is to determine that the
receivables were genuine when they were first recorded in the accounts. In
some fraud cases, fictitious accounts receivable have been created to cover up
a shortage. Eventually these fictitious receivables must be disposed of; one
method is to write off the fictitious accounts as uncollectible.
(b) The South executive appears to believe the auditors are solely concerned with
the collectibility of accounts and notes receivable. In fact, the confirmation
process is primarily intended to establish that the receivables are genuine and
that the customers (or makers of notes) exist. Other audit procedures are
followed to determine collectibility.
Substantive Tests of Receivables and Sales 8-3
8-5. The confirmation requests should go to the makers of the notes regardless of
whether the notes have been discounted. The act of discounting a note receivable
does not reduce the importance of the note being genuine and collectible. A
company which discounts its notes receivable remains in a position of sustaining a
loss if the makers of the notes fail to make payment at the maturity dates.
8-6. (a) When customers fail to respond to positive confirmation requests the CPAs
may not assume with confidence that these customers reviewed the requests
and found no disagreement and therefore did not reply. Some busy customers
will not take the time to review confirmation requests and will not respond;
hence, obvious exceptions may exist without being reported to the CPAs.
(b) If there is no response to a second request, the CPAs may mail a third request
and possibly make telephone calls in an effort to get a reply directly from the
customer. When it becomes apparent that the confirmation program will not
produce further evidence, the CPAs should consider each remaining customer
as to the size, nature, and age of the balance and the apparent reason for the
lack of a reply before they decide what additional work is necessary in the
circumstances. The CPAs should carry out the alternative audit procedures of
examining customers’ purchase orders or contracts, shipping documents and
sales invoices of the client, and remittances by nonconfirming customers
received by the client subsequent to the balance sheet date. The auditors may
also verify the existence, location, and credit standings of the nonconfirming
customers by reference to credit agencies or other sources independent of the
client.
8-7. North, Inc.
No, the matter remains unresolved. First, oral evidence from the client is never in
itself sufficient; the auditors must follow up to determine the reliability of the oral
evidence. Second, payment of an account receivable is not confirmation; the
account might be fictitious, and the “payment” could have been made by a
dishonest employee who had created the fictitious account to conceal a cash
shortage. The auditors must examine the customer purchase order or contract, and
copies of the sales invoice and shipping document, in support of the unconfirmed
receivable. They should also determine the genuineness of the customer by
reference to the telephone directory or to credit agency reports.
8-8. Monty’s Meat, Inc.
a. The workpaper does not include a description of the auditing procedures

performed in confirming the accounts. The workpaper is also incomplete in
the following respects:
1) The workpaper does not state whether the auditor traced the ABC
Grocery remittance of P3,000 to November cash receipts.
2) The workpaper does not state whether the auditor examined the
November 2 credit memo issued to Sari-Sari Store.
3) The workpaper does not state whether the auditor traced the Lucena’s
Meat Market remittance to November cash receipts.
4) The workpaper does not state whether and how the auditor obtained
satisfaction regarding confirmation requests not returned.
5) The workpaper does not state whether the auditor examined
documentation for the Diana’s Supper Club order returned and received
on October 31.
6) Rather than summarizing the confirmations returned without exception,
as was done at the bottom of Working Paper 1, these confirmations
should have been listed separately.
b. 1) Sales P11,100
Accounts receivable P11,100
Inventory 8,600
Cost of goods sold 8,600
To reverse 2007 sale recorded in 2006.
2) Allowance for uncollectible accounts 1,277

Accounts receivable 1,277
To write off uncollectible account.
3) Sales returns and allowances 3,634

To record return of spoiled meat and
recognize loss in period in which incurred.
Meat not restored to inventory, inasmuch
as it was spoiled.
4) Sales 13,000
To correct error in recording customer
remittance as a sale.
5) Sales Returns 334

Accounts receivable 334
Inventory 250
Cost of goods sold 250
To record return and restore meat to inventory
because meat returned in good condition.
c. (See completed Exhibits 1.1 and 1.2 reproduced below and on the following
page.)
Exhibit 1.1
Monty’s Meat, Inc.

Accounts Receivable - Trade
Aging Analysis
October 31, 2006
Conf. Past Due (Days)

No. Customer Balance Current 1-30 31-60 Over 60
1060 Culley’s Meats P 1,330 P 1,330
1061 Jolly Roger Restaurant 466 P 466
1064 ABC Grocery 4,256 3,000 1,256
(Other) 329,433 280,763 33,467 P12,324 P 2,879
1602 Rudy’s Deli 378 378
1603 General Foods Grocers 13,468 13,000 468
1607 Kim’s Fresh Meats 2,334 1,074 1,260
1608 Dill’s Discount Grocery 12,469 12,469
1612 Diana’s Supper Club 866 334 532
10/31 Balance per ledger P365,000 P 311,970 P 36,449 P13,234 P 3,347
Audit Adjustments P (29,345) P (28,068) P(1,277)
10/31 Audited balance P335,655 P 283,902 P 36,449 P13,234 P 2,070
#
Cash receipts 11/1 – 11/27 P(210,113) P (13,353) P 0 P 0 &
11/27 Outstanding P 73,789 P 23,096 P13,234 P 2,070
Estimated percent uncollectible 10% 25% 70% 100%
10/31 Estimated uncollectible P 24,487 P 7,379 P 5,774 P 9,264 P 2,070
& Traced subsequent collections to November remittance advices.

# Obtained balances from subsidiary ledger after agreeing to general ledger control account.
Prepared by: Reviewed by:

Initial Date Initial Date
Exhibit 1.2
Monty’s Meat, Inc.

Accounts Receivable - Trade
Allowance for Doubtful Accounts
October 31, 2006
11/1/05 Balance per general ledger P28,000 #

11/1 - 10/31 Monthly provision 24,000 &
11/1 - 10/31 Write-offs (37,000) @
10/31/06 Balance per general ledger P15,000
AJE 2 (1,277)
P13,723
AJE 6 P10,777
10/31/06 Audited balance P24,500 ^
AJE 6
Bad debts expense P10,777

Allowance for doubtful accounts P10,777
To adjust allowance for doubtful accounts to amount
considered reasonable in the circumstances.
# Traced to last year’s WTB - audited balance

& Traced to standard journal entries
@ Examined documentation and discussed with credit manager and legal counsel
^ In light of aging analysis, the above balance, as adjusted, appears to be adequate.
Prepared by: Reviewed by:

Initial Date Initial Date
8-9. Makati Company
For all of the exceptions, the auditor is concerned about four principal things.
(a) Whether there is a client error. Many times the confirmation response
differences are due to timing differences for deposits in the mail and
inventory in transit to the customer. Sometimes customers misunderstand the
confirmation or the information requested. The auditor must distinguish
between those and client errors.
(b) The amount of the client error if any.
(c) The cause of the error. It would be intentional, a misunderstanding of the
proper way to record a transaction, or a breakdown of internal control.
(d) Potential errors in the sample not tested. The auditor must estimate the error
in the untested population, based on the results of the tests of the sample.
Suggested steps to clear each of the comments satisfactorily are:

1. (a) Examine supporting documents, including the sales invoices and
applicable sales and shipping orders, for propriety and valuation of the
sales.
(b) Review the cash receipts books for the period after December 31, 2005,
and note any collections from the PDQ Company. The degree of internal
control over cash receipts should be an important consideration in
determining the reliance that can be placed on the cash receipts entries.
In addition, as there is no assurance that collections after December 31
represent the payment of invoices supporting the December 31 trial
balance, consideration should be given to requesting a confirmation from
the PDQ Company of the invoices paid by their checks.
2. (a) The cause should be investigated thoroughly. If the credit was posted to
the wrong account, it may indicate merely a clerical error. On the other
hand, posting to the wrong account may indicate lapping.
(b) Such a comment may also indicate a delay in posting and depositing of
receipts. If upon investigation such is the case, the company should be
informed immediately so that it can take corrective steps.
3. This is a confirmation of the balance with an additional comment. Since the
customer has given us the data, it is preferable to check to see that the
information agrees with the company’s records. Such a procedure may
disclose misposting or delay in recording receipts.
4. This incomplete comment should raise an immediate question: does the
customer mean paid before or paid after December 31? Because the
customer’s intent is unknown, this account should be reconfirmed and the
customer asked to state the exact date. Upon receipt of the second
confirmation, the information thereon should be traced to the cash receipts
book.
5. The auditor should first evaluate how long it takes to ship goods to the
customer in question. If it ordinarily takes more than five days, there is no
indication of error.
A comment of this type may indicate that the company may be recording
sales before an actual sale has taken place. The auditor should examine the
invoice and review with the appropriate officials the company’s policies.
Sales, cost of sales, inventories and accounts receivable may have to be
adjusted if title has not passed to the buyer as of December 31, 2005.
6. (a) Determine if such advance payment has been received and that it has
been properly recorded. A review should be made of other advance
payments to ascertain that charges against such advances have been
properly handled.
(b) If the advance payment was to cover these invoices, the auditor should
propose a reclassification of the P1,350, debiting the advance payment
account and crediting accounts receivable--trade.
7. (a) Examine the shipping order for indications that the goods were shipped
and, if available, carrier’s invoice and/or bill of lading for receipt of the
goods.
(b) If it appears that goods were shipped, send all available information to
the customer and ask the customer to reconfirm. If the customer still
insists that goods were never received, all data should be presented to an
appropriate company official for a complete explanation. This may
indicate that accounting for shipments is inadequate and consideration
should be given to reviewing the procedures to determine if
improvements can be made.
(c) If the goods were not shipped, the auditor should recommend an
adjustment reducing sales, cost of sales, and accounts receivable, and
increasing inventories.
8. This should be discussed with the appropriate officials and correspondence
with the customer should be reviewed to allow determination whether an
adjustment should be made in the amount receivable or if an allowance for
doubtful accounts should be set up.
9. As title on any goods shipped on consignment does not pass until those goods
are sold, the sales entry should be reversed, inventory charged, and cost of
sales credited if it is actually a consignment sale. Other so-called sales should
be reviewed and company officials queried to determine if other sales actual
represent consignment shipments; if so, the adjustment set forth in the
preceding sentence should be made for all consignment shipments.
10. This is a noncurrent asset and should be reclassified to either deposit or
prepaid rent. A review of other accounts, especially those with round
numbers, may disclose other accounts that should be so reclassified.
11. This may indicate a misposting of the credit or a delay in posting the credit.
Comments under 2 above would also apply to credits.
8-10. Ken Company
Requirement (a)
Ken Company
Accounts Receivable Aging Schedule
May 31, 2006
Proportion Amount Probability Estimated

of in of Uncollectible
Age Category Total Category Non-Collection Amount
Not yet due .680 P 816,000 .010 P 8,160
Less than 30 days past due .150 180,000 .035 6,300
30 to 60 days past due .080 96,000 .050 4,800
61 to 120 days past due .050 60,000 .090 5,400
121 to 180 days past due .025 30,000 .400 12,000
Over 180 days past due .015 18,000 .900 16,200
1.000 P1,200,000 P52,860
Requirement (b)
Ken Company
Analysis of Allowance for Doubtful Accounts
May 31, 2006
June 1, 2005 balance P 30,250
Bad debt expense accrual (3,000,000 x .04) 120,000
Balance before write-offs of bad accounts P150,250
Write-offs of bad accounts 108,750
Balance before year-end adjustment P 41,500
Estimated uncollectible amount 52,860
Additional allowance needed P 11,360
Debit Credit
Bad Debts Expense 11,360
Allowance for Doubtful Accounts 11,360
Requirement (c)
1. Steps to Improve the 2. Risks and Costs
Accounts Receivable Situation Involved
Establish more selective credit-granting This policy could result in lost sales and
policies, such as more restrictive credit increased costs of credit evaluation. Ken
requirements or more thorough credit may be all but forced to adhere to the
rating investigation. prevailing credit-granting policies of the
office equipment and supplies industry.
Establish a more rigorous collection policy This policy may offend current customers
either through external collection agencies and thus risk future sales. Increased
or by Ken’s own personal. collection costs could result from this
policy.
Charge interest on overdue accounts. This policy may offend current customers
and thus risk future sales.
Insist on cash on delivery (COD) or cash This policy could result in lost sales and
on order (COO) for new customers or increased administrative costs.
poorer credit risks.
8-11. Demo Inc.
Requirement (a)
DEMO INC.
Accounts Receivable
12-31-05
Balance AGING DISTRIBUTION

Per General Per Months Outstanding
Ledger Subsidiary 0-1 1-3 3-6 over 6
Unadjusted Balances P197,000 P198,240 P93,240 P76,820 P22,180 P6,000

Add (Deduct) Adjustments:
AJE (2) to correct
understatement of
accounts written off on
October 31. (200)
(3) to write off definitely
uncollectible accounts (1,000) (1,000) (1,000)
(4) to reclassify advances
from customers 2,000 2,000 2,000
(5) to reclassify accounts
with credit balances 500 500 500
(6) to adjust general ledger
balance to agree with
subsidiary balance 1,440 _______ _______ _______ _______ ______
Balances as adjusted P199,740 P199,740 P95,240 P77,320 P22,180 P5,000
DEMO INC.
12-31-05
Balance per Ledger P12,000.00
AJE (1) to correct error in recording bad debts recovery 324.00
(2) to correct understatement of accounts written off ( 200.00)
(3) to write off definitely uncollectible accounts ( 1,000.00)
(4) to adjust allowance to required balance (Schedule 1) ( 6,359.80)
Balance as adjusted P 4,764.20
Schedule 1: Computation of Required Allowance
Adjusted Required Allowance
Account Classification Total % Amount
0-1 month outstanding P 95,240 1 P 952.40
1-3 months outstanding 77,320 2 1,546.40
3-6 months outstanding 22,180 3 665.40
over 6 months outstanding 5,000 P2,000-50% 1,000.00
_______ P3,000-20% 600.00
Totals P199,740 P4,764.20
Requirement (b) Adjusting Journal Entries 12-31-05
(1) Bad Debts 324.00

Allowance for Doubtful Accounts 324.00
(2) Allowance for Doubtful Accounts 200.00
Accounts Receivable 200.00
(3) Allowance for Doubtful Accounts 1,000.00
Accounts Receivable 1,000.00
(4) Accounts Receivable 2,000.00
Advances from Customers 2,000.00
(5) Accounts Receivable 500.00
Customers’ accounts with credit balances 500.00
(6) Accounts Receivable 1,440.00
Sales 1,440.00
(7) Allowance for Doubtful Accounts 6,359.80
Bad Debts Expense 6,359.80
8-12. Tripoli Company
Requirement (1)
Accounts receivable, trade ............................................. 40,000

Advances to suppliers..................................................... 450
Due from officers ........................................................... 2,500
Subscriptions receivable – share capital......................... 4,600
Expense advances to salespeople ................................... 1,000
Accounts payable, trade (P19,250 – P450)* ........... 19,250
Advances from customers on sales contracts .......... 450
Salaries payable....................................................... 3,300
Allowance for doubtful accounts ............................ 500
Receivables (to close permanently)......................... 23,050
Customers’ credit balances...................................... 2,000
Requirement (2)
Current assets:
Accounts receivable, trade ...................................... 40,000
Less allowance for doubtful accounts ..................... 500 P39,500
Creditors’ debit balances......................................... 450
Due from officers** ................................................ 2,500
Subscriptions receivable – ordinary shares** ......... 4,600
Expense advances to salespeople ............................ 1,000
Current liabilities:
Accounts payable, trade .......................................... 19,250
Customers’ credit balances...................................... 2,000
Cash advances from customers on sales
(not yet shipped)................................................... 450
Salaries payable....................................................... 3,300
* These amounts are netted against normal balances to reflect control balances;
but if material in amount, they should be reported separately on the balance
sheet as indicated in Requirement 2.
** Considered as current assets only if currently collectible. All items are
assumed to be material in amount.
8-13. Pearl Corporation
1. Estimated bad debt percentage based on year-end accounts receivable:

28.5%#
2003 2004 2005 2006
Actual bad debts P 3,300a P 5,700c P 7,800e P 16,800
Credit Sales P90,000 P158,000 P210,000 P459,000
Outstanding receivables
(year-end) P 9,500b P 19,900d P 29,500f P 58,900
Percentage of
outstanding
receivables 0.347 0.286 0.264 0.285#
a
P2,500 + P500 + P300 = P3,300
b
0 + P90,000 - P78,000 - P2,500 = P9,500
c
P4,600 + P700 + P400 = P5,700
d
P9,500 + P158,000 - P8,500 - P134,000 - P500 - P4,600 = P19,900
e
Estimated. The bad debts written off in the third year following the sale have
averaged about 7.8% [(P300 + P400)  (P3,300 + P5,700)] of the total actual bad
debts in the previous 2 years. Therefore, the bad debts on 2005 sales of P6,200 and
P1,000 are about 92.2% of the total bad debts expected on 2005 sales.
f
P19,900 + P210,000 - P200 - P14,200 - P178,800 - P300 - P700 - P6,200 = P29,500
2. Bad debts estimated as a percentage of year-end accounts receivable
P29,500 + P235,000 - P300 - P19,500 - P400 - P1,000 - P200,000
= P43,300
P43,300 x 0.285 = P12,340.50, or approximately P12,300. Criteria for
recognition of bad debts or impairment of receivables under PAS 39
should be applied.
8-14. Flores Corporation
Requirement (1)
Flores Corporation
Analysis of Changes in the
For the Year Ended December 31, 2006
Balance at January 1, 2006 P130,000

Provision for doubtful accounts (P9,000,000 x 2%) 180,000
Recovery in 2006 of bad debts written off previously 15,000
P325,000
Deduct write-offs for (P90,000 + P60,000) 150,000
Balance at December 31, 2006, before additional impairment loss P175,000
Increase in estimated uncollectible accounts during 2006 (P235,300 - P175,000) 60,300
Balance at December 31, 2006, adjusted (Schedule 1) P235,300
Schedule 1:
Computation of Allowance for Doubtful Accounts
at December 31, 2006
Aging category Balance Percent Doubtful accounts
November-December 2006 P1,140,000 2 P 22,800
July-October 600,000 10 60,000
January-June 400,000 25 100,000
Prior to 1/1/06 70,000 a 75 52,500
P235,300
a
P130,000 - P60,000
Requirement (2)
Flores Corporation
Journal Entry
December 31, 2006
Bad Debt Expense 60,300

To increase the allowance for doubtful
accounts at December 31, 2006, resulting
from evaluation of collectibility of remaining
receivables.
8-15. Visayas Company
Requirement (a)
Visayas Company
Accounts Receivable
12.31.06
Balance, 12.31.05 P 546,400

Add: Sales on account for the year 2,622,832
Total P3,169,232
Less: Collections during the year
- with discount (1) P2,050,859
- without discount (2) 848,118
Accounts written off 18,700
Credit memo for sales returns & allowances 37,000 2,954,677
Balance, 12.31.06 P 214,555
Total collections P2,857,960

Less: Accts paid w/ discount 2,009,842 ( 98% = P2,050,859) (1)
Accts paid by customers w/o
discount P 848,118 (2)
Requirement (b)
AJE (1) Doubtful accounts expense 6,599

Allowance for doubtful accounts 6,599
Supporting Analysis:
% allowance to AR 12.31.05 P 16,392 = 3%

P546,400
Required % allowance to
AR 12.31.06 2/3 x 3% = 2%
Required allowance 12.31.06
2% x P214,555 P4,291
Allowance for doubtful accounts balance, 12.31.05 P 16,392

Less: Accounts written off 18,700
P( 2,308)
Required balance, 12.31.06 4,291
Estimated bad debts expense for 12.31.06 P 6,599
8-16. Charry Company
Requirement (a) Adjusting Journal Entries
(1) Accounts Receivable 5,500

Customers’ accounts with credit balances 5,500
(P500 + P5,000)
(2) Sales 5,000

Accounts Receivable 5,000
(3) Subscriptions Receivable 15,000

(4) Deposit on Contract 15,000

(5) Claims Receivable 500

Accounts Receivable 500
(6) Advances to Employees 500

(7) Advances to Affiliated Company 10,000

(8) Advances to Supplier 5,000

Requirement (b) Balance Sheet Presentation 12-31-06
Current Assets
Accounts Receivable - Trade P59,500
Claims Receivable 500
Advances to Employees 500
Advances to Supplier 5,000
Investments
Advances to Affiliated Company 10,000
Other Assets
Deposit on Contract 15,000
Shareholders’ Equity
Subscribed Share Capital (net of subscriptions
receivable of P15,000) xxx
Charry Company
Accounts Receivable -Trade
12-31-06
Balance per ledger P105,000

AJE (1) To reclassify accounts with credit balances 5,500
(2) To reverse entry for consignment deliveries ( 5,000)
(3) To reclassify subscriptions receivable ( 15,000)
(4) To reclassify deposit on contract ( 15,000)
(5) To reclassify balance of claims from carrier for
shipping damages ( 500)
(6) To reclassify employee’s IOU’s ( 500)
(7) To reclassify advances to affiliate ( 10,000)
(8) To reclassify advances to supplier ( 5,000)
Net adjustments ( 45,500)
If correct entries were made for the transactions given, the Accounts
Receivable account would show the following postings:
Accounts Receivable
Jan. 1 Balance P 56,000 Collections P615,000
Charge Sales 625,000 Write offs 3,500
Recoveries of Merchandise returns 2,500
accounts written off 1,000 Allowance for shipping
________ damages 1,500
P682,000 P622,500
________ Balance Dec. 31 59,500
P682,000 P682,000
8-17. The Preston Companies

(amounts in P millions)
Requirement (1)
(a) Preston’s earnings would have increased (1 – 0.40) P105 million or P63
million in 2006. Net accounts receivable and total assets would have been
P105 million higher than actually reported in 2006. Ignoring differences
between tax and financial reporting, income tax payable would have
increased by P0.40 (P105 million) or P42 million, and retained earnings
would be greater by P63 million. This example illustrates the material effect
estimated bad debts can have on reported earnings and total assets.
(b) Under the allowance method, failure to write off an account has no effect on
earnings (assuming a sufficient balance exists in the allowance account), or
any net balances in the balance sheet. Only the components of net accounts
receivable would be affected. Both gross accounts receivable and the
allowance for doubtful accounts would be overstated P0.6 million.
Requirement (2)
1998
Beginning allowance balance P183
Bad debt expense 105
Ending allowance balance (212)
Write-offs of accounts P 76
Requirement (3)
(a) The ratio of bad debt expense to operating revenue for the two years is: 2006,
P105/P3,729 = 2.8%; 2005, P81/P3,534 = 2.3%. This ratio appears relatively
stable although is increasing.
(b) The composite rate of uncollectible accounts as a percentage of gross

accounts receivable = ending allowance balance/ending accounts receivable.
The ratio for 2006 is P212 / (P951 + P212) = 18.2%, and for 2005 is P183 /
(P972 + P183) = 15.8%. This ratio is less stable and also is increasing.
(c) Bad debt expense is considerably higher than the write-offs in 2006. The
firm has experienced an increase in expected write-offs. Apparently the firm
expects an increase in bad debts, which is partially an estimate of future
write-offs.
8-18. Rain Company
Requirement (1)
Present value of the note:
P150,000 x (PV1, 12%, 3) (0.71178) = P106,767

Requirement (2)
Correction and Collection Schedule:
Note Receivable
Date Explanation and Interest Revenue Change Balance
1-1-2005 Recorded originally at face amount P150,000
12-31-2005 Correction to restate to present value – P 43,233 106,767
12-31-2005 To accrue interest, P106,767 x 12% = P12,812 + 12,812 119,579
12-31-2006 To accrue interest, P119,579 x 12% = P14,349 + 14,349 133,928
12-31-2007 To accrue interest, P133,928 x 12% = P16,072* + 16,072 150,000
12-31-2007 Collection on face amount, debit Cash – 150,000 0
* Rounded.
8-19.
1. d. The Josefina note is a short-term note and is reported at face value
although the note can be recorded at present value. The Nicole note is
reported at present value: [(P20,000 + 5(0.3) (P20,000)] (PV1, 8%, 5) =
P23,000 (0.68058) = P15,653
2. c. The annual payment is computed as: P10,000 (PVA, 8%, 5) = P10,000 /
3.99271 = P2,505.
Discounting this stream of payments at 9% yields cash proceeds of:
P2,505 (PVA, 9%, 5) = P2,505 (3.88965) = P9,744.
Total interest equals total payments less proceeds = 5 (P2,505) – P9,744
= P2,781.
3. b. Interest receivable is recorded for one month.
4. c. Maturity value..................................................................... P100,000
Discount P100,000 (0.10) (6/12)......................................... (5,000)
Proceeds .............................................................................. P 95,000
8-20. Luce Company
(1) AJE: Sales returns and allowances 30,000

Inventory 12.31.06 24,000
Cost of sales 24,000
Income will decrease by P6,000 if
the above AJE is made.
Ans. (c)
(2) AJE: Sales 10,000
Income was overstated by P10,000
Ans. (a)
(3) Actual number of units sold to Mr. Lazo was 320. P48,000
P150
Ans. (b)
(4) Correct receivable from
Mr. Lazo : 320 x P100 P 32,000
Per client 48,000
Overstatement P 16,000
Ans. (d)
(5) Accounts receivable from Mr. Sia is correctly stated because the goods
are considered sold in 2006.
Ans. (a)
(6) Ans. (d)
8-21. ETC Co.

Adjusting Journal Entries
AJE 1. Cash 225,000
Other Current Liabilities (UCPB Overdraft) 225,000
2. Accounts Receivable 37,500
Cash 37,500
3. Cash 28,709
Accounts Payable 28,709
4. Notes Payable 67,500

Interest Expense 16,200
Cash 83,700
5. Cash – BPI 25,000
Other Current Liabilities (UCPB Overdraft) 25,000
6. Cash – SBTC 73,690
Cash
5.31.06
Per books P 15,825,000

AJE 1. 225,000
2. (37,500)
3. 28,709
4. (83,700)
5. 25,000
6. 73,690
Adjusted balance P16,056,199 (1) (c)
Accounts Receivable
5.31.06
Subsidiary Ledger General Ledger

P8,047,054 P7,868,029
AJE 2. 37,500 37,500
6. (73,690)
(375,215)
122,500
P7,831,839 P7,831,839 (2) (b)

Amount
Aging Estimated to be
Distribution Subsidiary Ledger % Uncollectible
Current P1,737,690.00 + P122,500 = P1,860,190.00 x 2 = P 37,203.80
Past due:
1 – 30 P1,617,340.00 = 1,617,340.00 x 5 = 80,867.00
31 – 60 P1,437,706.50 = 1,437,706.50 x 10 = 143,770.70
61 – 90 P1,474,450.00 = 1,474,450.00 x 15 = 221,167.50
Over 90 P1,779,867.50 + P37,500
___________ – P375,215 = 1,442,152.50 x 20 = 288,430.50
P8,047,054.00 P7,831,839.00 P771,439.50 (3) (a)
8-22. Ling, Inc.
Requirement (1)
LING, INC.
Long-term Receivables Section of Balance Sheet
December 31, 2005
9% note receivable from sale of division, due in annual

installments of P500,000 to May 1, 2007, less current
installment P 500,000 [1]
8% note receivable from officer, due December 31, 2007,
collaterized by 10,000 shares of Ling, Inc., ordinary shares
with a fair value of P450,000 400,000
Non-interest-bearing note from sale of patent, net of 15%
imputed interest, due April 1, 2007 84,105 [2]
Installment contract receivable, due in annual installments of
P50,000 to July 1, 2009, less current installment 112,400 [3]
Total long-term receivables P1,096,505
Requirement (2)
LING, INC.
Selected Balance Sheet Balances
December 31, 2005
Current portion of long-term receivables:

Note receivable from sale of division P500,000 [1]
Installment contract receivable 27,600 [3]
Total P527,600
Accrued interest receivable:

Note receivable from sale of division P 60,000 [4]
Installment contract receivable 11,200 [5]
Total P 71,200
Requirement (3)
LING, INC.
Interest Income from Long-Term Receivables
and Gains Recognized on Sale of Assets
Interest income:
Note receivable from sale of division P105,000 [6]
Note receivable from sale of patent 8,505 [2]
Note receivable from officer 32,000 [7]
Installment contract receivable from sale of land 11,200 [5]
Total interest income for year ended 12/31/05 P156,705
Gains recognized on sale of assets:

Patent P 37,600 [8]
Land 50,000 [9]
Total gains recognized for year ended 12/31/05 P 87,600
Explanation of amounts:
[1] Long-term Portion of 9% Note Receivable at 12/31/05

Face amount, 5/1/00 P1,500,000
Less: installment received 5/1/05 (500,000)
Balance, 12/31/05 P1,000,000
Less: installment due 5/1/06 (500,000)
Long-term portion, 12/31/05 P 500,000
[2] Non-interest-bearing Note, Net of Imputed Interest at 12/31/05

Face amount, 4/1/05 P 100,000
Less: imputed interest
[P100,000 – (P100,0000 x 0.756)] (24,400)
Balance, 4/1/05 P 75,600
Add: interest earned to 12/31/05
(P75,600 x 15% x 9/12) 8,505
Balance, 12/31/05 P 84,105
[3] Long-term Portion of Installment Contract Receivable at 12/31/05

Contract selling price, 7/1/05 P 200,000
Less: down payment, 7/1/05 (60,000)
Balance, 12/31/05 P 140,000
Less: installment due 7/1/06
[P50,000 – (P140,000 x 16%)] (27,600)
Long-term portion, 12/31/05 P 112,400
[4] Accrued Interest – Note Receivable, Sale of Division, at 12/31/05

Interest accrued from 5/1 to 12/31/05
(P1,000,000 x 9% x 8/12) P 60,000
[5] Accrued Interest – Installment Contract at 12/31/05

Interest accrued from 7/1 to 12/31/05
(P140,000 x 16% x ½) P 11,200
[6] Interest Income – Note Receivable, Sale of Division, for 2005

Interest earned from 1/1 to 5/1/05
(P1,500,000 x 9% x 4/12) P 45,000
Interest earned from 5/1 to 12/31/05
(P1,000,000 x 9% x 8/12) 60,000
Interest income P 105,000
[7] Interest Income – Note Receivable, Officer, for 2005

Interest earned 1/1 to 12/31/05 (P400,000 x 8%) P 32,000
[8] Gain Recognized on Sale of Patent

Stated selling price P 100,000
Less: imputed interest (24,400)[2]
Actual selling price (P100,000 x 0.756) P 75,600
Less: cost of patent (net)
Carrying value 1/1/05 P40,000
Less amortization 1/1 to 4/1/06
(P8,000 x ¼) (2,000) (38,000)
Gain recognized P 37,600
[9] Gain Recognized on Sale of Land
Sale of price P 200,000
Less: cost (150,000)
Gain recognized P 50,000
8-23. Grande Company
Requirement 1
PAS 39, paragraph 63 will be applied in this case. On December 31, 2006,
Grande Company should record the 2006 accrued interest and the impairment:
Notes / Interest Receivable (0.06) (100,000) 6,000
Interest Income 6,000
Bad Debts Expense 55,537 *
Allowance for decline in note value 55,537
* Carrying value of note and interest (100,000 + 6,000) P106,000
Present value / New carrying value of
note (discount rate – 6%)
Principal:
Due on 12.31.08 (P30,000 x 0.89000) P26,700
Due on 12.31.10 (P30,000 x 0.79209) 23,763 50,463
Impairment write-down P 55,537
Requirement 2
The entries with the corresponding computations follow:
Effective Interest Method
December 31, 2007
Interest income (0.06) (50,463) 3,028
December 31, 2008

Interest income
(0.06) (50,463 + 3,028) 3,209
Cash 30,000
Notes receivable 30,000
December 31, 2009

Interest income
(0.06) (50,463 + 3,208 + 3,209 – 30,000) 1,602
December 31, 2010

Allowance for decline in note value 1,698*
Interest income 1,698
* 0.06 (26,700 + 1,602)
Cash 30,000
*

To close remaining balance in
notes receivable and allowance
* At this point, the amortized cost of the notes receivable is zero.
Notes Receivable Allowance for Decline in Note Value

100,000 30,000 3,028 55,537
6,000 30,000 3,209
106,000 60,000 1,602
46,000 bal 1,698
9,537 55,537
46,000
8-24. Amy Corporation
Requirement 1
Accounts Receivable (Trade) 15,500
Accounts Receivable (Officer) 3,600
Ordinary Shares Subscriptions Receivable 12,000
Advances to Employees 1,800
Notes Receivable (Trade) 6,000
Deposit to Guarantee Contract Performance 5,000
Utility Deposit 500
Receivables 44,400
Requirement 2
Accounts receivable (trade)--current asset, trade receivable
Accounts receivable (officer)--normally current nontrade receivable
Ordinary shares subscription receivable--current or noncurrent asset, depending
on due date; nontrade receivable
Advances to employees--current asset, nontrade receivable
Notes receivable (trade)--noncurrent asset, trade receivable
Deposit to guarantee contract performance--separately classify, could be current
or noncurrent asset, depending on the length of the contract; nontrade
receivable
Utility deposit--separately classify, probably noncurrent nontrade receivable
8-25. Jane’s Department Store
Requirement 1
Estimated Estimated
Percentage Amount
Age Balance Uncollectible Uncollectible
Under 30 days P193,000 0.008 P 1,544
30- 60 days 114,000 0.020 2,280
61-120 days 73,000 0.050 3,650
121-240 days 41,000 0.200 8,200
241-360 days 25,000 0.350 8,750
Over 360 days 19,000 0.600 11,400
P465,000 P35,824
Requirement 2
a. Bad Debt Expense 35,824

b. Bad Debt Expense (P35,824 + P3,000) 38,824
c. Bad Debt Expense (P35,824 – P2,800) 33,024
8-26. Blue Corporation
Requirement 1
2005
Dec. 1 Cash [(P175,000 x 0.80) – P1,400] 138,600
Assignment Service Charge Expense
(P175,000 x 0.80 x 0.01) 1,400
Notes Payable (P175,000 x 0.80) 140,000
Dec. 1 Accounts Receivable Assigned 175,000

11 Sales Returns and Allowances 1,000

Accounts Receivable Assigned 1,000
31 Cash 86,000
31 Notes Payable 86,000

Interest Expense (P140,000
x 0.12 x 1/12) 1,400
Cash 87,400
2006
Jan. 29 Cash 60,000
29 Notes Payable (P140,000 – P86,000) 54,000

Interest Expense (P54,000
x 0.12 x 1/12) 540
Cash 54,540
29 Accounts Receivable 28,000

Accounts Receivable Assigned
(P175,000 – P1,000 –
P86,000 – P60,000) 28,000
Requirement 2
On the December 31, 2005 balance sheet of the Blue Corporation, the assigned
accounts receivable and the remaining liability would be reported as follows:
Current Assets:
Accounts receivable assigned P88,000
Current Liabilities:
Note payable P54,000
8-27. Tandy Shoes
Sept. 15 Accounts Receivable 1,995

Credit Card Expense (P2,100 x 0.05) 105
Sales 2,100
21 Sales Returns and Allowances 200

Credit Card Expense (P200 x 0.05) 10
29 Cash 1,805
8-28. Gabe Company
GABE COMPANY
Income Statement Effect
Expenses resulting from accounts receivable assigned

(Schedule 1) P15,100
Expenses resulting from accounts receivable sold
(P300,000 – P260,000) 40,000
Total expenses P55,100
Schedule 1: Computation of Expenses for Accounts Receivable Assigned

Assignment expense:
Accounts receivable assigned P200,000
x 85%
Advance by Belle P170,000
x 3%
P 5,100
Interest expense 10,000
Total expenses P 15,100
CHAPTER
SUBSTANTIVE TESTS
9 OF INVENTORIES AND
COST OF GOODS SOLD
9-1. Substantiation of the figure for inventories is an especially challenging task

because of the variety of acceptable methods of valuation. In addition, the variety
of materials found in inventories calls for considerable experience and skill to do
an efficient job of identifying and test-counting goods on hand. The possibilities
of obsolescence and of excessive stocks also create problems. Finally, the
relatively large size of inventories and their significance in the determination of
net income make purposeful misstatement by the client a possibility which the
auditors must guard against.
9-2. During an audit of a manufacturing company, the auditors review the cost system
for the following purposes:
(1) To determine that costs are properly allocated to current and future periods
and hence that cost figures used in arriving at balance sheet and income
statement amounts are supported by internal records.
(2) To obtain assurance that the cost system, as an integral part of the system of
internal control, provides proper accounting control over costs incurred and
related inventories.
(3) To ascertain, as a service to management, that the cost system is economical
and effectively provides information for reducing or controlling costs and for
determining the cost and profitability of products, and other related data
necessary for informed managerial decisions.
9-3. The auditors make test counts of inventory quantities during their observation of
the taking of the physical inventory to ascertain that an accurate count is being
made by the individuals taking the inventory. The extent of test counting will be
determined by the inventory-taking procedures; for example, the number of the
auditors’ test counts would be reduced if there were two teams, one verifying the
other, taking the inventory. On the other hand, the auditors’ test counts would be
expended if they found errors in the inventory counts.
9-4. The statement is not true. The auditors’ responsibilities with respect to
inventories include not only quantities and pricing, but also the quality or
condition of the goods, the accuracy of extensions, footing, and summaries, and
the evaluation of internal control. Weakness in internal control may cause large
losses from excessive stockpiling, obsolescence, inaccurate cost data, and many
other sources, even though the ending inventory is properly counted and priced.
9-5. The independent auditors utilize the client’s backlog of unfilled sales orders in the
determination of net realizable value of finished goods and goods-in-process, and
in the determination of losses, if any, on firm sales commitments for which no
production has yet been undertaken.
9-6. Beed Company
Since Beed Company obtained all of its merchandise inventory from the president
of the company in a related-party transaction, the auditors must determine the cost
of the merchandise to the president in his operation of a similar business as a
single proprietor. In this related-party transaction, the auditors must look beyond
form--a total cost of P100,000 for the original stock of merchandise--to substance.
Substantively, the merchandise of Beed Company should be priced, on a specific
identification basis if feasible, at its cost from the suppliers of the sole
proprietorship. Any difference between cost as thus determined and amounts
charged by the president to Beed Company represents unamortized discount on
the notes payable. The entire transaction should be fully disclosed in a note to the
financial statements of Beed Company.
9-7. Jay Company
The following procedures should be undertaken:

(a) The oral evidence that the motors are on consignment should be
substantiated by a review of the client’s records of consigned inventory,
examination of contracts and correspondence with consignors, and
confirmation of consigned stocks by direct communication with consignors.
(b) The location of the machine in the receiving department, together with the
presence of the “REWORK” tag, suggests that the machine had been
shipped to a customer but rejected and returned by the customer. The
auditors should examine the receiving report for the machine, the accounts
receivable confirmation from the customer, and records of the client’s
quality control department, to ascertain who has title to the machine. If the
customer has title, the machine should not be included in inventory, and a
liability for rework costs should be established. If the client has title, the
customer’s account should be credited for the sales return and the machine
should be included in the client’s inventory at estimated realizable value.
(c) The “Material Inspection and Receiving Report” signed by the Navy Source
Inspector, is evidence that title to the machine passed to the Phil. Naval Base
on November 30, 2006. Accordingly, the auditors should ascertain that the
sales value of the machine is included in accounts receivable, and that the
Substantive Tests of Inventories and Cost of Goods Sold 9-3
cost of the machine is not in the perpetual inventory or the physical
inventory.
(d) The location of the storeroom and the dusty condition of the goods suggest
that the items may be obsolete, or at least slow moving. The auditors should
inspect perpetual inventory records for usage of the materials, and should
inquire of production personnel whether the materials are currently useful in
production. The materials may have to be valued at scrap value.
9-8. Pancho Manufacturing Corporation
(a) Consignment out.

1. Obtain from the client a complete list of all consignees together with
copies of the consignment contracts.
2. Evaluate the consignment contract provisions relative to the following
areas:
(a) Payment of freight and other handling charges.
(b) Extension of credit.
(c) Rates and computation of commissions to consignees.
(d) Frequency and contents of reports and remittances received from
consignees.
3. Discuss with the client any variations found in the contracts which do not
seem justified by the circumstances.
4. Following review of the consignment contracts, communicate directly
with the consignees to obtain complete information in writing on
merchandise remaining unsold, receivables resulting from sales,
unremitted proceeds, and accrued expenses and commissions, which
should be reconciled with the client’s records for the period covered by
the engagement.
5. Determine that merchandise on consignment with consignees is valued
on the same basis as merchandise on hand, and included as part of the
inventory. Ascertain that any arbitrary mark-ons are deducted and that
shipping and related charges for the transfer of merchandise to the
consignees are reflected as part of the inventory.
6. Ascertain that quantities of goods in hands of consignees at the close of
the period under audit appear in the balance sheet and are separately
designated as “Merchandise on Consignment.”
(b) Finished merchandise in public warehouse pledged as collateral for

outstanding debt.
1. Determine that goods pledged to obtain funds are covered by warehouse
receipts. (The examination of warehouse receipts alone is not a sufficient
verification of goods stored in public warehouses.)
2. Request direct confirmation from the warehouses in which the
merchandise is held.
3. If available, obtain independent accountants’ reports on a warehouses’

internal controls over custody of stored goods.
4. Review the client’s procedures for acceptance and evaluation of the
performance of warehouses, and review supporting documents.
5. Review the loan agreements collateralized by warehouse receipts. These
agreements usually provide for certain payments to be made by the
borrower as pledged goods are sold.
6. Consider observing a physical inventory of goods stored at the public
warehouses.
9-9. a. (2) b. (3) c. (2) d. (2)
e. (4) f. (2)
9-10. a. Principal problems the auditor will face are related by:
1. Verification of existence of the inventory owned by the company as
against inventory belonging to the customers.
2. Proper valuation since the perpetual inventory records reflect quantities
only.
b. Steps that should be undertaken to enable the auditor to render an unqualified

opinion:
1. Verify postings to the perpetual ledger at the plant office for both stock
owned and stock being held for customers against original cost sheet to
determine amounts debited and credited to the account.
2. Require that an annual physical inventory taking be done by the client
and arrangements for the presence and observation of the auditor be
done.
3. Confirm with customers unclaimed merchandise still in the possession of
the client as of the balance sheet date.
9-11. 1. Existence or occurrence

2. Existence or occurrence
3. Valuation or allocation
4. Completeness
5. Completeness
6. Valuation or allocation
7. Completeness
8. Completeness
9. Existence or occurrence and completeness
10. Completeness
9-12. a. When the inventory is a material item in the financial statements that the
auditor is examining, observation of the taking of the physical inventory is in
compliance with the auditing standard pertaining to field work that requires
obtaining sufficient competent evidential matter to afford a reasonable basis
for an opinion regarding the financial statements. Observation is a generally
accepting auditing procedure applied in the examination of the physical
inventory.
By observing the taking of the physical inventory, the CPA is seeking to

satisfy himself or herself as to the effectiveness of the methods of inventory
taking and the measure of reliance that can be placed on the client inventory
records and their representations as to inventory quantities. The CPA must
ascertain that the physical inventory actually exists, that the inventory
quantities are being determined by reasonably accurate methods, and that the
inventory is in a salable or usable condition.
b. The CPA makes test counts of inventory quantities during observation of the
taking of the physical inventory to become satisfied that an accurate count is
being made by the individuals taking the inventory. The extent of test
counting will be determined by the inventory-taking procedures. For
example, the number of test counts would be reduced if there were two teams
taking the inventory, one checking the other. On the other hand, the CPA’s
test count would be expanded if errors were found in the inventory counts.
Some test counts are recorded by the CPA for the purpose of subsequent
comparison with the client’s compilation of the inventory. The comparison
procedure goes beyond the mere determination that quantities have been
accurately transcribed. In addition, the CPA seeks assurance that the
description and condition of the inventory items are accurate for pricing
purposes and that the quantity information, such as dozen, gross, and cartons,
is proper.
c. 1. The CPA does not regard the inventory certificate of an outside service
company as a satisfactory substitute for his or her own audit of the
inventory. The service company has merely assumed the client’s
function of taking the physical inventory, pricing it, and making the
necessary extensions. To the extent that the service company is
competent, internal control with regard to the inventory has been
strengthened. Nevertheless, as under other strong systems of internal
control, the CPA would investigate the system to become satisfied that it
is operating in a satisfactory manner. The CPA’s investigation would
necessarily entail an observation of the taking of the inventory and
testing the pricing and calculation of the inventory.
2. The inventory certificate of the outside specialists would have no effect

on the CPA’s report. The CPA must be satisfied that the inventory is
fairly stated by observing the taking of the inventory and by testing the
pricing and calculation of the inventory.
However, if the taking of the inventory was not observed and no audit
tests were applied to the computation of the inventory, the CPA would be
compelled to disclaim an opinion on the financial statements as a whole
if the amount of the inventory is material.
If it has been impracticable or impossible for the CPA to observe the

taking of the physical inventory but he or she has been satisfied by the
application of other auditing procedures, the CPA would make no
reference to the matter in the report.
3. The CPA would make no reference to the certificate of the outside

specialists in the report. The outside specialists are serving as adjuncts of
the company’s staff of permanent employees and, as such, are in
somewhat the same position as temporary employees. The outside
specialists are not independent in that they are not imbued with third-
party interests. The CPA is compelled, under certain circumstances, to
mention in the report the reports of other independent auditors, but this
compulsion does not extend to the certificate of outside specialists who
are not independent auditors.
9-13. a. For a client to dispose of the chemical compound in a manner that meets legal
requirements is admirable. However, ethical behavior frequently calls for
individual persons and companies to exhibit behavior that exceeds the
minimum standards set by law. Due to the harm to cattle and the pollution
that has resulted. Remote is involved in a matter that entails ethical issues.
b. Most auditors are hesitant to serve as judge and jury for clients on ethical
matters. For example, declining to serve this client probably would not cause
any alteration of its behavior. Further, serving the client does not facilitate
any unethical behavior. Further, serving the client does not facilitate any
unethical behavior. Hence, an auditor might choose to discuss the matter
with the board and encourage them to act as responsible citizens.
9-14. JC
Requirement (1)
Inventory, as given ......................................................... P271,500

Deduct (adjustments to cost):
50% markup in (a) [P250,000 – (P250,000  1.5)] . P83,333
60% markup in (b) (P10,000 x 0.60)....................... 6,000
Exclusion of (c)....................................................... 4,000
Incorrect amount used in (e) (P2,500 – P1,000)...... 1,500 94,833
P176,667
Add:
Freight on goods in transit in (d)............................. 800
Corrected ending inventory..................................... P177,467
Requirement (2)
Income Statement
a. Ending inventory overstated (P250,000 – P177,467) ............ P72,533
b. Cost of goods sold understated .............................................. 72,533
c. Gross margin overstated ........................................................ 72,533
d. Pretax income overstated ....................................................... 72,533
e. Income taxes overstated (P72,533 x 0.40) ............................. 29,013
f. Net income overstated (P72,533 – P29,013).......................... 43,520
Balance Sheet:
Current assets, inventory overstated ............................................ 72,533
Current liabilities, income taxes payable overstated.................... 29,013
Retained earnings overstated ....................................................... 43,520
Requirement (3)
Retained earnings (prior period adjustment) .................. 43,520

Income taxes payable ..................................................... 29,013
Inventory ................................................................. 72,533
9-15. Beginning inventory P 38,000

Purchases 19,000
Cost of goods available for sale P 57,000
Cost of goods sold (net sales of P51,000  1.50) 34,000
Ending inventory before theft P 23,000
Ending inventory after theft 15,000
Inventory lost P 8,000
9-16. LRT Company

LRT COMPANY
Computation of Value of Inventory Lost
February 16, 2006
Sales P 40,000
Less: Gross profit (40%) 16,000
Cost of goods sold P 24,000
Finished goods, February 16 75,000
Cost of goods available for sale P 99,000
Less: Finished goods, December 31, 2005 72,000
Cost of goods manufactured and completed P 27,000
Raw materials, December 31, 2005 P 65,000

Raw materials purchases 20,000
Raw materials available for production P 85,000
Raw materials before flood 70,000 (P35,000  1/2)
Raw materials used P 15,000
Direct labor 30,000
Manufacturing overhead cost 15,000
Goods in process, December 31, 2005 80,000
Cost of production P 140,000
Less: Cost of goods completed (from above) 27,000
Goods in process inventory lost in flood P 113,000
Total value of inventory = Raw materials lost + Goods in process lost

destroyed by flood
= (P70,000 - P35,000) + P113,000
= P148,000
9-17. Y Company
a. Necessary adjustments to client’s physical inventory:
Material in Car #AR38162--received in

warehouse on January 2, 2007 P 8,120
Materials stranded en route
(Sales price P19,270/125%) 15,416
Total 23,536
Less unsalable inventory 1,250*
Total adjustment P22,286
* If freight charges have been included in the client’s inventory, the

amount would be P1,600 and the amount of the total adjustment would
be P21,936. Journal entry 6 probably would have a credit to purchases
of P1,600 in this case.
b. Auditor’s worksheet adjusting entries:
1. Purchases P 2,183
Accounts Payable P 2,183
To record goods in warehouse but not
invoiced-received on RR 1060.
2. No entry required. Title to goods had passed.
3. Accounts receivable 12,700
Sales 12,700
To record goods as sold which were
loaded on December 31 and not
inventories-SI 968.
4. Sales 19,270
To reverse out of sales material included
in both sales (SI 966) and in physical
inventory (after adjustment).
5. No adjustment required.
6. Claims receivable 1,600
Purchases 1,250
Freight In 350
To record claim against carrier for
merchandise damaged in transit.
7. Inventory 22,286
Cost of goods sold 22,286
To adjust accounts for changes in physical
inventory quantities.
8. Sales 15,773
To reverse out of sales invoices #969, #970,
#971. The sales book was held open too long.
This merchandise was in warehouse at time
of physical count and so included therein.
9-18. Engine Warehouse Supply Company
a. Cutoff errors will exist for accounts payable whenever the liability for a
purchase is recorded in the wrong period. The following rules should be
followed for recording purchases:
1. Record as of date received when shipped FOB destination.
2. Record as of date shipped when shipped FOB origin.
On this basis, the receiving reports would be evaluated as follows:
Receiving Should be Was

Report Date Date Recorded Recorded
No. Amount Shipped Received FOB Point in August in August
679 P 860 8-29 8-31 Destination Yes Yes
680 1,211 8-27 9-01 Origin Yes Yes
681 193 8-20 9-01 Origin Yes Yes
682 4,674 8-27 9-01 Destination No Yes
683 450 8-30 9-02 Destination No No
684 106 8-30 9-02 Origin Yes No
685 2,800 9-06 9-02 Origin No No
686 686 8-30 9-02 Destination No No
The entry to adjust the records as of August 31 for cutoff errors in accounts
payable is as follows:
Dr. Accounts payable P4,568

Cr. Purchases P4,568
To adjust accounts payable for cutoff errors in recording inventory purchases:
RR No. 682 P4,674

RR No. 684 ( 106)
P4,568
b. Sales should be recorded as of the date shipped. The following shipping

documents were dated on September 1 and recorded in August:
311 P 56
312 3,194
313 635
314 193
P4,078
The adjusting entry will be:
Dr. Sales P4,078

Cr. Accounts receivable P4,078
To adjust sales for cutoff errors at August 31.
c. 1. Inventory received near the balance sheet date should be included in
inventory if it is recorded as a purchase and excluded if it is not recorded
as a purchase.
2. Inventory shipped near the balance sheet date should be excluded from
inventory if it is recorded as a sale and included if it has not been
recorded as a sale.
These principles lead to the following analysis.
Receipt of Goods
1. Inventory for all receiving reports up to 684 are included in inventory.
2. Using the analysis in part a, column 6, inventory for all receiving reports
up to 684, except 682 and 683, should be included in accounts payable
and inventory.
Should be Included in Was Included

Report No. Amount Purchases and Inventory in Inventory
679 860 Yes Yes
680 1,211 Yes Yes
681 193 Yes Yes
682* 4,674 No Yes
683* 450 No Yes
684 106 Yes Yes
685 2,800 No No
686 686 No No
* Requires removal from inventory.
3. Inventory for receiving reports 682 and 683 should therefore be removed
from the physical count:
Amount
682 4,674
683 450
5,124
Shipment of Goods
1. Inventory for shipping documents 314 to 317 were included in inventory.
All inventory for documents 313 and earlier were excluded.
2. Sales, after adjustments, were included only for shipments 310 and those
preceding, as shown in the analysis in part b.
3. Inventory for shipping documents 311 to 313 should therefore be added
to inventory. The amount of the cost of the inventory cannot be
determined without reference to inventory costs. Presumably, cost will

be less than the sales value shown in part b.
Shipping Included in Recorded as Sale After

Document No. Physical Adjustments in Part b
310 No Yes
311* No No
312* No No
313* No No
314 Yes No
315 Yes No
316 Yes No
317 Yes No
318 Yes No
* Requires addition to inventory at cost.
Shipping Selling
Document No. Price
311 P 56
312 3,194
313 635
Inventory cost 3,885
(70% of selling price) 2,719
Summary
Reduction of inventory due to physical count error
resulting from receipt of goods. P5,124.00
Increase of inventory due to physical count error
resulting from shipment of goods. 2,719.50
Net reduction of inventory required P2,404.50
d. The accuracy about September 1 receipts and shipments of goods could be

verified by reference to bills of lading.
9-19. Green Company
Requirement (a)
Green Company
Inventory
12.31.06
Per Audit
Item Quantity Unit Price * Amount Per Client
A – 510 720 units P 2.64 / doz. P 218.40 P 2,592.00
A – 520 48 units 4.70 each 225.60 252.60
A – 530 146 units 16.50 each 2,409.00 2,706.00
A – 540 86 units 5.15 each 442.90 353.60
A – 550 80 units 8.50 each 680.00 7,280.00
A – 560 140 units 2.00 each 3,360.00 280.00
A – 570 910 gross 132 gross 120,120.00 27,360.00
Total P127,455.90 P 40,824.20
Add: AJE (1) __________ 86,631.70
P127,455.90 P127,455.90
* Lower of cost or market
Requirement (b)
Inventory 86,631.70
Cost of sales 86,631.70
9-20.
Requirement (a) Requirement (b)
1. Exclude Title to the goods passed to the client on January 3, 2007
or upon receipt because the term of shipment was FOB
Destination.
2. Exclude Goods held on consignment are not owned by the client.
3. Include Regular stock item even if segregated but not actually
delivered as of the end of the year is still part of the
client’s inventory.
4. Include Title to the goods passed to the client on December 31,
2006 or upon shipment because the invoice showed FOB
supplier’s warehouse.
5. Exclude Goods fabricated to order for a customer are considered
sold as soon as completed even if not yet delivered.
9-21. Isabela Company
ISABELA COMPANY
Worksheet to Correct Selected Accounts
12-31-06
Inventory Accounts Payable Sales

Initial amounts P1,250,000 P1,000,000 P9,000,000
Adjustments
Increase (Decrease)
1 P (155,000) P (155,000) None
2 (22,000) None None
3 None None P 40,000
4 210,000 None None
5 25,000 25,000 None
6 2,000 2,000 None
7 (5,300) (5,300) None
Total adjustments P 54,700 P (133,300) P 40,000
Adjustment amounts P1,304,700 P 866,700 P9,040,000
9-22. Stockroom W
Stockroom W
Reconciliation of Inventory
Opening Ending
Inventory Receipts Withdrawals Inventory
Balance per Accounting Department P 22,600 P28,000 P 26,000 P 24,600
Add (Deduct) Reconciling Items
1) Receipt of materials
erroneously posted by the
Accounting Department to
Stockroom W. 480 480
2) Correction of error in the
Accounting Department. ( 600) ( 600)
3) Shortage not recorded in the
Accounting Department. _______ ______ 90 (90)
Balance per Factory Records P 22,000 P28,480 P 25,490 P 24,990
9-23. Pinas Company
Requirement (1)
Audit Adjustments, 12.31.06
1. Retained earnings 300

Purchases 300
2. Inventory, January 1, 2006 700
Retained earnings 700
3. Accounts receivable 500
Sales 500
4. Purchases 500
Accounts payable 500
5. Inventory, Dec. 31, 2006 B/S 400
Inventory, Dec. 31, 2006 I/S 400
6. a. Purchases 1,200
Accounts payable 1,200
b. Inventory, Dec. 31, 2006 B/S 1,200
Inventory, Dec. 31, 2006 I/S 1,200
7. Accounts payable 800
Purchases 800
Requirement (2)
Pinas Company
Cost of Sales
2006
Per Adjustments Per

Client Dr Cr Audit
Inventory, Jan. 1 P 3,200 P 700 (2) P 3,900
Purchases 21,100 500 (4) P 300 (1)
_______ 1,200 (6a) 800 (7) 21,700
Total available 24,300 25,600
Less: Inventory, Dec. 31 4,300 400 (5)
_______ ______ 1,200 (6b) 5,900
Cost of sales P 20,000 P 2,400 P 2,700 P19,700
9-24. Bers Company
Uncorrected Items for Correction Corrected

Amounts (a) (b) (c) (d) (e) Amounts
Income statement:
Sales revenue ............................ P90,000 – 12,000 – 15,000 P 63,000
Cost of goods sold .................... 50,000 + 6,000 + 15,000 – 8,000 63,000
Gross margin............................. 40,000 0
Expenses ................................... 30,000 + 7,000 37,000
Income ...................................... P10,000 – 7,000 – 12,000 – 6,000 – 15,000 – 7,000 P(37,000)
Balance sheet:
Accounts receivable.................. P42,000 – 12,000 – 15,000 P15,000
Inventory................................... 20,000 – 15,000 + 8,000 13,000
Remaining assets ...................... 30,000 30,000
Accounts payable...................... 11,000 * + 6,000 17,000 *
Remaining liabilities................. 6,000 * + 7,000 13,000 *
Share capital, ordinary .............. 60,000 * 60,000 *
Retained earnings † ................... 15,000 * – 7,000 – 12,000 – 6,000 – 15,000 – 7,000 (32,000)
Totals..................................... P 0 P 0
* Credits.
† Retained Earnings is negative after correction.
9-25.
1. Jap Co.
P150,000 – (P150,000 X .20) = P120,000;
P120,000 – (P120,000 X .10) = P108,000, cost of goods purchased
2. Fred Company
P1,100,000 + P69,000 = P1,169,000. The P69,000 of goods in transit on
which title had passed on December 24 (f.o.b. shipping point) should be
added to 12/31/06 inventory. The P29,000 of goods shipped (f.o.b. shipping
point) on January 3, 2007, should remain part of the 12/31/06 inventory.
3. B. May Corp.
Because no date was associated with the units issued or sold, the periodic
(rather than perpetual) inventory method must be assumed.
FIFO inventory cost: 1,000 units at P24 P 24,000

1,100 units at 23 25,300
Total P 49,300
Average cost: 1,500 at P21 P 31,500

2,000 at 22 44,000
3,500 at 23 80,500
1,000 at 24 24,000
Totals 8,000 P180,000
P180,000  8,000 = P22.50
Ending inventory (2,100 X P22.50) is P47,250.
4. Emmett Lopez Inc.

The inventoriable costs for 2007 are:
Merchandise purchased P909,400

Add: Freight-in 22,000
931,400
Deduct: Purchase returns P16,500
Purchase discounts 6,800 23,300
Inventoriable cost P908,100
9-26.
(a) (1) 8/10

Purchases 9,000
8/13
Purchase Returns and Allowances 1,200
8/15
Purchases 12,000
8/25
Purchases 15,000
8/28
Cash 12,000
(2) Purchases—addition in cost of goods sold section of income

statement.
Purchase returns and allowances—deduction from purchases in cost
of goods sold section of the income statement.
Accounts payable—current liability in the current liabilities section of
the balance sheet.
(b) (1) 8/10

Purchases 8,820
Accounts Payable (P9,000 X .98) 8,820
8/13
Purchase Returns and Allowances 1,176
(P1,200 X .98)
8/15
Purchases 11,880
8/25
Purchases 14,700
8/28
Purchase Discounts Lost 120
Cash 12,000
(2) 8/31
Purchase Discounts Lost 156
Accounts Payable
(.02 X [P9,000 – P1,200]) 156
(3) Same as part (a) (2) except:

Purchase Discounts Lost—treat as financial expense in income
statement.
(c) The second method is better theoretically because it results in the inventory
being carried net of purchase discounts, and purchase discounts not taken
are shown as an expense. The first method is normally used, however, for
practical reasons.
9-27. MAR Company
(a) Purchases Sales

Total Units Total Units
April 1 (balance on hand) 100 April 5 300
April 4 400 April 12 200
April 26 500 Total units 1,400
April 30 200
Total units 1,700
Total units sold 1,400
Total units (ending inventory) 300
Assuming costs are not computed for each withdrawal:
(1) First-in, first-out.
Date of Invoice No. Units Unit Cost Total Cost

April 30 200 P5.80 P1,160
April 26 100 5.60 560
P1,720
(2) Average cost.
Cost of Part X available.
Date of Invoice No. Units Unit Cost Total Cost

April 1 100 P5.00 P 500
April 4 400 5.10 2,040
April 11 300 5.30 1,590
April 18 200 5.35 1,070
April 26 500 5.60 2,800
April 30 200 5.80 1,160
Total Available 1,700 P9,160
Average cost per unit = P9,160  1,700 = P5.39.

Inventory, April 30 = 300 X P5.39 = P1,617.
(b) Assuming costs are computed for each withdrawal:
(1) First-in, first out.
The inventory would be the same in amount as in part (a), P1,720.
(2) Average cost.
Purchased Sold Balance

No. of Unit No. of Unit cost No. of Unit
Date units cost units units cost* Amount
April 1 100 P5.00 100 P5.0000 P 500.00
April 4 400 5.10 500 5.0800 2,540.00
April 5 300 P5.0800 200 5.0800 1,016.00
April 11 300 5.30 500 5.2120 2,606.00
April 12 200 5.2120 300 5.2120 1,563.60
April 18 200 5.35 500 5.2672 2,633.60
April 26 500 5.60 1,000 5.4336 5,433.60
April 27 800 5.4336 200 5.4336 1,086.72
April 28 100 5.4336 100 5.4336 543.36
April 30 200 5.80 300 5.6779 1,703.36
Inventory April 30 is P1,703.

*Four decimal places are used to minimize rounding errors.
9-28. Timmy Turner
Requirement (a)
Merchandise on hand, January 1 P38,000
Purchases P72,000
Less purchase returns and allowances 2,400
Net purchases 69,600
Freight-in 3,400 73,000
Total merchandise available for sale 111,000
Cost of goods sold* 75,000
Ending inventory 36,000
Less undamaged goods 10,900
Estimated fire loss P 25,100
33 1/3%
*Gross profit = = 25% of sales.
100% + 33 1/3%
Cost of goods sold = 75% of sales of P100,000 = P75,000.
Requirement (b)
Cost of goods sold = 66 2/3% of sales of
P100,000 = P66,667
Ending inventory [P111,000 (as computed above) –
P66,667] P44,333
Less undamaged goods 10,900
Estimated fire loss P33,433
9-29. Cosmo and Wanda Company
Beginning inventory P170,000

Purchases 390,000
560,000
Purchase returns (30,000)
Total goods available 530,000
Sales P650,000
Sales returns (24,000)
Net sales 626,000
Less gross profit (40% X P626,000) (250,400) 375,600
Estimated ending inventory (unadjusted for
damage) 154,400
Less goods on hand—undamaged (at cost)
P21,000 X (1 – 40%) (12,600)
Less goods on hand—damaged (at net
realizable value) (5,300)
Fire loss on inventory P136,500
CHAPTER
SUBSTANTIVE TESTS OF
10 INVESTMENTS
10-1. The CPAs would accept a confirmation of the securities on hand from the
custodian in lieu of their personal inspection of the securities after they had
investigated and satisfied themselves as to the standing of the custodian. The
CPAs would probably be satisfied if they found the custodian to be a well-known,
reliable financial institution, completely independent of the client and with
resources substantially larger in amount than the securities of the CPAs’ client that
are on deposit.
10-2. The auditors can make an independent computations of dividends earned during
the year by reference to dividend record books published by investment advisory
services.
10-3. Securities owned by the client may not be on hand at the balance sheet date
because they are held by others for safekeeping, pledged as collateral for loans,
deposited as assurance of performance under contracts, or in the hands of brokers
or others for transfer.
10-4. When the inspection of securities cannot be made for two weeks after the balance
sheet date, the client at the auditors’ suggestion may instruct the bank that the safe
deposit box is not to be opened until the time of the auditors’ inspection. A letter
may be obtained from the bank stating that the box has not been opened between
the balance sheet date and the auditors’ arrival. If the securities are in the client’s
office, it will be necessary to verify any security transactions between the date of
inspection and the balance sheet date and to reconcile the results of the inspection
with the securities owned at the balance sheet date. The count of cash and other
negotiable assets should be coordinated with the inspection of securities.
10-5. Pink Corporation
(a) Instructions to be given to the assistant regarding the examination of the

securities kept in the safe deposit box include the following:
(1) A copy of the client’s record of the contents of the box should be
obtained and used in connection with the inspection of the securities.
Comparing the contents of the box and the record will provide assurance
that all securities listed in the record are on hand. (The validity of the
record will be determined by examination of the transactions pertaining
to investments.) The copy of the record, after being verified, should be
added to the auditors’ working papers as evidence of work performed.
(2) The bank’s record of persons entering the deposit box should be
examined to determine that only authorized persons have had access to
the box and that there was no entry to the box between December 31 and
January 11. Entry to the box between those dates may be an indication
that a security was returned to safekeeping after being “borrowed” at
year-end. The security may have been “borrowed” and used as collateral
to obtain cash to cover a shortage at December 31.
(3) The assistant should be instructed to insist that the treasurer be present
while the securities are being examined. Most auditors prefer to obtain a
signed statement that all investments inspected were returned at the
completion of the inspection made in the presence of the custodian. In
any event, the working papers should note the date of the inspection and
the name of the witness to the inspection.
(4) The following details of the securities should be examined:
a) The name of the registered owner appearing on each security other
than bearer bonds should be noted to determine that Pink
Corporation is a registered owner and that securities belonging to
another owner have not been substituted.
b) The name of the corporation issuing the security and the class of the
security (Class A, Par Value, 1st Preference, etc.) should be noted
for assurance that a lower priced security (perhaps somewhat similar
in corporate name or a different security of the issuing corporation)
has not been substituted for a higher priced security.
c) The face value of bonds and the number of shares represented by
each share certificate should be compared with the client record to
determine that the entire amount of the corporation’s holdings of
each security is on hand.
d) The serial numbers of the securities should be compared with those
on the record and, for those securities carried over from the prior
year, compared with the serial numbers of securities listed in the
prior year’s working papers. A change in serial numbers that cannot
be properly explained may be an indication of manipulation of the
securities. Verification of serial numbers also helps establish the
cost of securities sold under either the FIFO or specific identification
cost method.
e) The certificates should be read to ascertain the interest rates and
payment dates for bonds and the dividend rates and payment dates, if
given, for preference shares. This information may be used later in
the verification of investment revenue.
f) Bonds should be examined to determine maturity dates. Maturity
dates are needed for verifying the computation of the amortization of
bond premiums or discounts. In addition, the maturity dates will
disclose whether any bonds on hand have matured. The presence of
matured bonds may be a sign of internal control weakness or may
indicate that the bonds are in default.
Substantive Tests of Investments 10-3
g) Coupon bonds should be inspected to determine that no past-due
interest coupons are unclipped and all future interest coupons are
attached. The presence of past-due coupons may be caused by poor
internal control and may indicate an understatement of interest
revenue. On the other hand, past-due coupons may indicate the
interest is in default and that the principal is uncollectible. Missing
future interest coupons may be an indication of an irregularity.
h) The auditors should be alert for any obvious alterations to securities
or forged certificates. Although auditors usually are not held
responsible for the genuineness of the certificates, any apparent
forgeries (or exceptions noted in the foregoing audit procedures)
may point out the need for obtaining confirmations from the
corporations issuing the certificates.
(b) The treasurer’s entry into the safe deposit box on January 4 has violated
the auditors’ control over negotiable assets which must be inspected or
counted simultaneously or kept under control until counted to avoid the
substitution of a counted asset for an uncounted asset in an attempt to
conceal a shortage. The auditors would probably apply the following
additional procedures:
(1) Reconcile bank balances at both year-end and at the date of
inspecting securities.
(2) Obtain a bank confirmation as of the inspection date.
(3) Examine cash journals between year-end and the inspection date for
any unusual entries.
(4) Examine all investment transactions taking place between the
balance sheet date and the inspection date to verify the amount of the
investment at the balance sheet date.
(5) If the client keeps a large fund of cash on hand, make a surprise
count of the cash fund.
(6) Review the transactions since year-end relating to any other
negotiable assets, such as notes receivable, to determine if any
substitutions have been made.
10-6. (a) (4) Having the securities held in safekeeping by a bank provides strong
internal control because the bank has no direct contact with the
employees responsible for maintaining the accounting record of the
securities and that individual has no access to the securities. Thus the
separation of the custody of securities from the accounting function is
complete.
(b) (1) The investment committee of the board of directors is not involved in the
routine of making buy and sell decisions and can therefore review the
transactions objectively. On the other hand, the chief operating officer,
the controller, and the treasurer may be closely associated on a daily
basis with the financial executive responsible for the investment
decisions.
10-7. Voltron Company

Voltron Company
Marketable Securities
12.31.06
Balance, 1.1.06 P2,350.00

Lie Company, 25 shares @ P42
Lipay Company, 20 shares @ P65
Add: Purchase of Lambing Co., 5% bonds, 5 shares 4,762.50
Total P7,112.50
Less: Sale of 10 shares of Lipay Co., stocks P 650.00
Sale of 5 shares of Lambing Co., bonds 4,762.50 5,415.50
Balance per ledger, 12.31.06 P1,700.00
Add (Deduct) Adjustment(s)
AJE (1) To correct error in recording purchase
of Lambing Co., bonds ( 62.50)
(2) To correct error in recording sale of
Lipay Co., stocks 130.00
(3) To correct error in recording sale of
Lambing Co., bonds 62.50
Net 130.00
Balance as adjusted P1,830.00
Lie Co., 25 shares @ P42 P1,050.00
Lipay Co., 15 shares @ P52 780.00
P1,830.00
Adjusting Journal Entries:

(1) Interest income 62.50
Marketable securities – Trading 62.50
(2) Marketable securities – Trading 130.00
Gain on sale of marketable securities 130.00
Proceeds ( 10 x P65 ) P 650.00
Cost: ( 10 x P1,300 )
520.00
25
Gain P 130.00
(3) Marketable securities – Trading 62.50

Interest income 62.50
(4) Securities fair valued adjusted – Trading 120.00
Unrealized gain on trading securities (P/L) 120.00
Lie Co. (P45 – P42) (25 shares) P 75
Lipay Co. (P55 – P52) (15 shares) 45
P120
10-8. Color Company
Requirement (a)
COLOR COMPANY
Investment
12.31.06
Changes during the year

Balance 1.1.06 No. of Shares Amount Balance 12.31.06 Adjustments Balance
No. of No. of
Description Shares Amount Acquired Sold Acquired Sold Shares Amount Dr (Cr) As Adjusted
Red Company, ordinary

Purchased in June 1993 @ P20 1,000 P 20,000 1,000 P 20,000 P 20,000
Purchased in Aug. 1996 @ P16 2,000 32,000 2,000 32,000 32,000
Purchased in May, 2004 @ P22 1,500 33,000 1,000 P 21,364 500 11,636 (1) ( 636) 11,000
85,000 63,000
White Company, ordinary
Purchased in Jan., 2004 @ P33 2,000 66,000 2,000 66,000 66,000
Purchased in March, 2006 ________ 500 P12,125 500 12,125 12,125
66,000 78,125
Blue Company, ordinary
Purchased in Aug., 1995 @ P13 100 7,300 100 SD 100 10,000 8,750 100 8,550 (2) (10,000)
(3) 5,100 3,650
Green Company, 15% bonds
Purchased in July, 1998 20 20,000 20 22,500 ( 2,500) (4) 2,500 -
Total P178,300 P 22,125 P 52,614 P147,811 P(3,036) P 144,775

10-8. Color Company (continued. . . . .)
Requirement (b) Adjusting Journal Entries
AJE (1) Loss on sale of investment 636

Investment 636
(2) Dividend income 10,000

Investment 10,000
(3) Accounts receivable - President 3,750

Investment 5,100
Gain on sale of investment 8,850
(4) Investment 2,500

Gain on sale of investment 2,000
Interest income 500
(5) Securities fair value adjusted – Trading 5,225

Unrealized gain in trading securities
– (P/L) 5,225
10-9. Kalayaan Corporation
The Kalayaan Corporation

Investments
December 31, 2006
I N V E S T M E N T
Per Books Adjustments As Adjusted Adjustments to Other Accounts
Date Transactions Dr Cr Dr Cr Dr (Cr) Name of Account Dr Cr
2006
Jan. 3 Purchased 100 shares, National Motors P 4,500 P 4,500
5 Purchased 100 shares, Major Electronics 500 (13) 500 - Loss on investment on
Major Electronics (13) 500
Mar. 31 Cash dividend, National Motors P 50 (1) 50 - Dividend income (1) 50
Apr. 5 Sold 100 shares, National Motors 4,800 (2) 300 (4,500) Gain on sale of investment (2) 300
6 Purchased 100 shares, Ace Investment 2,300 2,300
6 Purchased 100 shares, General Utility 2,400 (3) 120 2,280 Investment in rights issues (3) 120
May 1 Received 100 rights issues, General Utility 100 (4) 100 - Miscellaneous income (4) 100
July 2 Purchased 10 shares, General Utility 130 (5) 60 190 Investment in rights issues (5) 60
15 Purchased 50 shares, Acme Laboratories 1,900 1,900
18 Purchased 20 shares, The Kalayaan Corp. 3,000 (6) 3,000 - Treasury shares (6) 3,000
Aug. 15 Sold 10 shares, The Kalayaan Corporation 1,550 (7) 1,550 - Treasury shares (7) 1,500
Dec. 8 Received 2 shares, Acme Laboratories 80 (8) 80 - Additional paid on Capital -
TS trans. (7) 50
8 Cash dividend, Acme Laboratories 20 (9) 2 ( 18) Gain on sale of fractional (9) 2
shares
15 Cash dividend, Ace Investment 90 (10) 80 ( 10) Dividend income (10) 80
31 Cash dividend, General Utility 120 (11) 120 - Miscellaneous income (11) 120
Dividends receivable (12) 110
Dividend income (12) 110
Loss on expiration of rights
issues (14) 60
Investment in rights issues (14) 60
_______ _______ ________ ________ ________
15,030 6,510 2,042 3,920 Adjusting Journal Entry
8,520 1,878 Unrealized holding loss on
Balance P 15,030 P 15,030 P 3,920 P 3,920 P 6,642 SAS (Equity) (15) 1,142
Securities Fair Value
Adjustment – SAS (15) 1,142
10-10. Canada Corporation

Note to Instructor: This problem contains petty cash journal entries and a bank
reconciliation, previously covered in Chapter 7.
Requirement (1)
2005
Jan. 1 Investment in Available-for-Sale Securities
[(150 x P20)] + (200 x P30) + (100 x P25)] 11,500.00
Cash 11,500.00
Feb. 1 Investment in Available-for-Sale Securities
(P20,000 + P12,000) 32,000.00
Interest Revenue [(P20,000 x 0.12 x 5/12)
+ (P12,000 x 0.10 x 4/12)] 1,400.00
Cash 33,400.00
1 Petty Cash 500.00
Cash 500.00
28 Cash 1,200.00
Interest Revenue [P20,000 x 0.12 x 6/12] 1,200.00
28 Postage Expense 110.00
Office Supplies Expense 170.65
Transportation Expense 45.00
Miscellaneous Expense 43.50
Cash 369.15
a
28 Cash Short and Over 5.35
Cash 5.35
a
P125.50 – (P500.00 – P369.15)
Mar. 31 Cash (P1,500 + P600) 2,100
Interest Receivable (P20,000 x 0.12 x 1/12;
A Co. bonds) 200
Dividend Revenue 1,500
Interest Revenue [(P12,000 x 0.10 x
6/12) + (P20,000 x 0.12 x 1/12)] 800
31 Unrealized Increase/Decrease in Value of
Available-for-Sale Securities 900.00
Allowance for Change in Value of
Investment 900b
b
P42,600 – (P11,500 – P32,000)
31 Postage Expense 140.00
Office Supplies Expense 75.30
Miscellaneous Expense 54.20
Cash 269.50
Requirement (2)
CANADA CORPORATION
Bank Reconciliation
March 31, 2005
Balance per bank statement P13,459.75

Add: Deposits in transit 2,100.00
P15,559.75
Deduct: Outstanding checks (2,365.40)
Adjusted cash balance P13,194.35
Balance per company records P11,689.95

Add: Note collected by bank P1,500.00
Interest on note 100.00 1,600.00
P13,289.95
Deduct: Bank service charge P 20.00
NSF check returned 75.60 (95.60)
Adjusted cash balance P13,194.35
Requirement (3)
2005
Mar. 31 Cash 1,600.00
Notes Receivable 1,500.00
Interest Revenue 100.00
31 Miscellaneous Expense 20.00

Accounts Receivable 75.60
Cash 95.60
10-11. Patrick Company

1.
P10,000 dividend revenue for 2005 (10,000 shares x P1.00)
P30,000 12/31/05 unrealized increase in value of available-for-sale securities
[10,000 x (P63 – P60)]
P630,000 12/31/05 carrying value of investment (10,000 shares x P63 market
price)
2.
P40,000 investment income for 2005 (P400,000 net income x 0.10
ownership)
P110,000 investment income for 2006 [(P300,000 x 0.10) + (P200,000 x
0.40)]
P2,626,000 12/31/06 carrying value [P650,000 a + P1,950,000 cost + P80,000
investment income for second half of 2006 – P54,000 dividends
(40,000 x P1.35; 10/1/06)]
a
P1,950,000  30,000 shares = P65
P65 x 10,000 = P650,000
10-12. Belle Manufacturing Corporation
a. The auditing objectives and procedures relative to the Laribee Investment

account are as follows:
(1) Objective: Ascertain that the shares exist and are owned by Belle.
Procedures: Examine the shares for existence and ownership.
(2) Objective: Establish correctness of beginning balance in investment
account.
Procedures: Examine last year’s audit work papers.
(3) Objective: Determine proper approval of the 2006 purchase.
Procedures: Examine directors’ minutes authorizing the transaction.
(4) Objective: Establish the cost of shares purchased in 2006.
Procedures: Examine brokers’ advice and canceled check.
(5) Objective: Determine that the proper amount of dividends were received,
properly recorded as a decrease in the investment carrying value, and
deposited in the bank.
Procedures: Refer to a dividend reporter (e.g., Standard and Poors),
recalculate Belle’s share of the dividend, trace to remittance advice and
bank statement, and examine journal entry for proper recording.
(6) Objective: Ascertain in that Belle has properly recorded its shares of
Laribee income as an increase in the investment account.
Procedures: Examine Laribee’s income statement and Belle’s journal
entry, if any, to record its share of the income.
b. If this investment is significant in relation to Belle’s total assets, and/or its

share of Laribee income is significant relative to Belle’s total income, Flores
must insist that the financial statements of Laribee be audited, either by
Castro & Horario, or by other independent CPAs.
c.
Belle Manufacturing Company
Investment in Laribee Industries
December 31, 2006
No. of Shares
12/31/06: Final balance - 1,000 shares P 50,000 < 1,000
1/2/07: Purchased 1,500 shares 75,000 * @ 1,500
12/31/07: Ledger balance 125,000 2,500
AJE No. 1 210,000 _____
12/31/07: Audited balance P335,000 2,500 &
To WP–H
AJE 1
Investment in Laribee Ordinary P210,000
Dividend Revenue 40,000
Equity in Income of Unconsolidated
Subsidiary P250,000
To adjust investment account for excess
of Belle’s share of Laribee income over
Laribee dividends.
Dividends:
4/1/07 (P 12,500) “ #
7/1/07 (P 12,500) “ #
10/1/07 (P 15,000) “ #
(P 40,000)
Income:
25% of P1 million P250,000 X
P210,000
< Compared with 12/31/06 work papers.

* Vouched to broker’s advice and canceled check.
& Examined minutes for directors’ authorization.
“ Recalculated.
# Traced to remittance advice, cash receipts record, and bank statement.
X Examined audited income statement.
d. Flores should be aware of the possible existence of related party transactions

between Belle and Laribee. In this regard, she should be particularly alert to
possible disparities between the legal form of transactions and their economic
substance. For example, Belle manufactures earth moving equipment and
Laribee is a leasing company. Significant sale and leaseback transactions
may have occurred given the nature and relationship of the respective
companies. If these transactions did take place, Flores must ascertain that any
gains on sale of equipment have been deferred. Also, given the equity
method of accounting, Flores must determine that any intercompany profits
resulting from transactions between Belle and Laribee have been eliminated.
Finally, cases abound in which parent companies have “manufactured”

earnings by fabricating or misrepresenting transactions with subsidiaries. For
this reason, Flores must be alert to this possibility, and should carefully audit
all significant transactions between the two companies.
10-13. Analen, Inc.
Requirement (1)
Analen, Inc.
Income Before Income Taxes from Investment in Bel Company
October 1, 2006: Dividends received from

Bel Company (10,000 shares x P0.90) P 9,000
Requirement (2)
Analen, Inc.
Income Before Income Taxes From Investment in Bel Company
For the Years Ended December 31, 2007, and 2006, Restated
2007 2006 Restated

Equity in earnings of Bel Company (Schedule 1) P110,000 P 40,000
Schedule 1: Equity in Earnings of Bel Company

Year ended December 31, 2006 (P400,000 x 10%) P 40,000
Year ended December 31, 2007

Six months ended June 30, 2007 [P300,000
(P500,000 - P200,000) x 10%] P 30,000
Six months ended December 31, 2007 (P200,000 x 40%) 80,000
Total P110,000
10-14. Elmar Company
Requirement (1)
July 2005: purchase of investment in trading security:
Investment in trading security: Celebrity Corp. bonds
(P1,000 x 8 x 1.02) .................................................. 8,160
Interest receivable (P8,000 x 9% x 2/12;
May 1 – July 1)........................................................ 120
Cash.................................................................. 8,280
Requirement (2)
November 2005 - Interest collected:
Cash (P8,000 x 9% x 6/12)........................................... 360
Interest revenue........................................................ 240
Interest receivable.................................................... 120
Requirement (3)
Dec. 31, 2005: accrue interest on the Celebrity Corp. bonds held
as a trading securities investment:
Interest receivable (P8,000 x 9% x 2/12, Nov. – Dec.). 120
Interest revenue........................................................ 120
Dec. 31, 2005: record fair value:

Unrealized loss on investment in trading securities
(close to Income summary) ....................................... 340
Valuation allowance: Celebrity Corp. bonds* ........ 340
* Investment in Bonds:
Original cost ............................................................. P8,000
Fair value.................................................................. 7,760
Unrealized loss ......................................................... P 240
Previously recorded unrealized loss ......................... 0
DR<CR> to valuation allowance.............................. P 240
Requirement (4)
Income Statement for 2005:
Interest revenue (P200 + P100) .................................... P 300
Unrealized loss on investment in trading securities...... <240>
Balance sheet at Dec. 31, 2005:

Current assets: Interest receivable ............................... P 120
Investments in trading securities................................... P8,000
Less: Allowance to reduce to fair value....................... 240
Investments in trading securities, at fair value.............. P7,760
10-15. Jeng Company
Requirement (1) Equity method

January 1, 2004 – Acquisition of long-term investment:
Investment in equity-basis company: Zash Corp......... 153,000
Cash [(30,000 x 0.30 = 9,000 shares) x P17]........... 153,000
During 2004 – Dividends declared and paid by Zash Corp.:

Cash (P8,000 x 0.30) .................................................. 2,400
Long-term investment in equity-basis company:
Zash Corp. ............................................................ 2,400
December 31, 2004 – To recognize proportionate part of Zash Corp.

income:
Zash Corp. ................................................................. 6,600
Investment income: equity in earnings of
associated company (P24,000 x 0.30) .................. 6,600
December 31, 2004 – To recognize additional depreciation expense:

associated company ................................................... 600
Zash Corp. ............................................................ 600
Computation:
(P220,000 – P200,000) = P20,000; (P20,000 x 0.30)
 10 yrs. = P600
December 31, 2004 – To recognize additional cost of goods sold:

associated company ................................................... 3,000
Zash Corp. ............................................................ 3,000
Computation:
[(P260,000 – P250,000) = P10,000] x 0.30 = P3,000
During 2005 – Dividends declared and paid by Zash Corp.:

Cash (P5,000 x 0.30) .................................................. 1,500
Zash Corp. ............................................................ 1,500
December 31, 2005 – To recognize Zash loss:

associated company (P10,000 x 0.30) ....................... 3,000
Zash Corp. ............................................................ 3,000
December 31, 2005 – To recognize additional depreciation:

Investment income: equity in loss of
associated company ................................................... 600
Zash Corp. ............................................................ 600
Requirement (2)
January 1, 2006 – To record sale of 500 shares of Zash shares:
Cash [(500 shares x P18), Zash Corp. .......................... 9,000
Zash Corp. ............................................................ 8,250
Gain on disposal of long-term securities ................. 750
Computation:
Balance in investment account (P153,000 + P6,600 –
P2,400 – P600 – P3,000 – P1,500 – P3,000 – P600) ...
= P140,500.
P148,500 x 500/9,000 shares = P8,250
Requirement (3)
2004 2005 2006

Income statement:
Investment income (loss)
(P6,600– P600 – P3,000)...................... P3,000 (-P3,000– P600) ....................... (3,600) *
Gain (loss) on disposal ............................. 0 0 P750
Balance sheet:
Investment in equity-basis company
(P153,000 + P6,600 – P2,400 (P153,600 – P1,500 – P3,000
- P600 – P3,000).................................... P153,600 – P600)...............................P148,500
* Investment income for 2006 is not known, as no data are given for this year.
10-16. Del Corporation
Requirement (1)
Assuming “other income” is zero, then the entire P74 million for 2006 and the
P127 million for 2005 are equity in the income of affiliated companies:
2006 2005
Equity in income of affiliated companies...................................... P 74 P127
Less: Undistributed equity in income of affiliated companies ..... 27 84
Maximum amount of dividends that could be received................. P 47 P 43
If dividends were zero, then all of the equity in income of affiliated companies
would be retained. Since the amount actually retained was P27 million, the
amount of other income is P74 million less P27 million, or P47 million.
Requirement (2)
Investment at December 31, 2006.......................................... P1,456
Investment at December 31, 2005.......................................... 1,332
Increase in investment in equity............................................. P 124
Amount of increase resulting from undistributed equity
in income of affiliated companies ................................... 27
Amount of increase (decrease) in investment from other
sources ............................................................................ P 97
It appears Del either increased its equity holdings in its affiliated companies, or
made “advances” which had been recorded in the Investments account.
Requirement (3)
Rate of return on average investment in equity-basis companies = P74 / ([P1,332
+ P1,456] / 2) = 0.053%
Requirement (4)
If the investment at equity represents a 50% owned joint venture with no goodwill
or adjustment for book value to fair value of net assets, the total shareholders’
equity (TSE) can be approximated as:
Investment in Affiliate, at equity = 50% x TSE of Affiliate Joint Venture
TSE of Affiliate = P1,456 / 0.50 = P2,912 million.
Knowing the percentage owned allows estimates of the net assets of the equity-
basis companies to be made, assuming there are no adjustments or goodwill
involved.
10-17. BYDG Company
(a) Securities Fair Value Adjustment—Trading ........ 5,000

Unrealized Holding Gain or Loss—
Income....................................................... 5,000
(b) Securities Fair Value Adjustment—

Available-for-Sale ............................................ 5,000
Equity........................................................ 5,000
(c) The Unrealized Holding Gain or Loss—Income account is reported in the

income statement under Other Revenues and Gains. The Unrealized Holding
Gain or Loss—Equity account is reported as a part of other comprehensive
income and as a component of shareholders’ equity until realized. The
Securities Fair Value Adjustment account is added to the cost of the
Available-for-Sale or Trading Securities account to arrive at fair value.
10-18. Troy Company
(a) December 31, 2006

Unrealized Holding Gain or Loss—Income......... 1,400
Securities Fair Value Adjustment (Trading) . 1,400
(b) During 2007

Cash...................................................................... 9,400
Loss on Sale of Securities .................................... 600
Trading Securities ......................................... 10,000
(c) December 31, 2007

Unrealized
Securities Cost Fair Value Gain (Loss)
Eric Corp. shares P20,000 P19,100 (P (900)
Brad Co. shares 20,000 20,500 ( 500)
Total of portfolio P40,000 P39,600 ( (400)
Previous securities fair value
adjustment balance—Cr. ( (1,400)
Securities fair value
adjustment—Dr. (P1,000)
Securities Fair Value Adjustment (Trading) ........ 1,000

Income....................................................... 1,000
10-19. Francis Corporation
The unrealized gains and losses resulting from changes in the fair value of
available-for-sale securities are recorded in an unrealized holding gain or loss
account that is reported as other comprehensive income and as a separate
component of shareholders’ equity until realized. Therefore, the following
adjusting entry should be made at the year-end:
Unrealized Holding Gain or Loss—Equity ................. 8,000

Securities Fair Value Adjustment
(Available-for-Sale) ......................................... 8,000
Unrealized Holding Gain or Loss—Equity is reported as other comprehensive

income and as a separate component in shareholders’ equity and not included in
net income. The Securities Fair Value Adjustment (Available-for-Sale) account is
a valuation account to the related investment account.
CHAPTER
11 PROPERTY, PLANT AND
EQUIPMENT
11-1. Factors which facilitate the auditors’ verification of plant and equipment but are
not applicable to audit work on current assets include the following:
(a) High peso amount of individual items. A relatively few transactions may
support a large balance sheet amount.
(b) Usually little change in property accounts year to year. Land, buildings, and
equipment often remain unchanged for many years; hence there is little
accounting activity to verify. In contrast, such current assets as accounts
receivable and inventory may have a complete turnover several times a year.
(c) Minor effect on net income from cutoff errors. Cutoff errors in recording
transactions in plant and equipment are much less likely to have a material
effect on net income than are errors in the cutoff of transactions for purchase
and sale of merchandise. For example, a cutoff error which causes a
P30,000 year-end sales transaction to be recorded a day prior to shipment
may cause a P30,000 overstatement of the current year’s pretax income.
11-2. The auditors must question the service lives adopted by the client for plant assets.
To do otherwise would be to fail in the collection of sufficient competent evidence
for the client’s depreciation policies and procedures.
11-3. The principal objective of the auditors in analyzing a Maintenance and Repairs
expense account is to disclose any capital expenditures which were erroneously
recorded as expense.
11-4. Documentary evidence usually available in the client’s office to substantiate legal
ownership of property, plant, and equipment includes deeds, policies of title
insurance or abstract of title and an attorney’s opinion as to title, property tax bills,
insurance policies, purchase contracts, purchase orders, invoices, and paid checks.
The auditors may also secure written representations from the client as to
ownership of these assets.
11-5. The auditors employ the following substantive tests to detect unrecorded
retirements of property, plant, and equipment:
(a) If major additions of plant and equipment have been made during the year,
ascertain whether old equipment was traded in or superseded by the new
units.
(b) Analyze the Miscellaneous Revenue account to locate any cash proceeds
from sale of plant assets.
(c) If any of the company’s products have been discounted during the year,
investigate the disposition of plant facilities formerly used in manufacturing
such products.
(d) Inquire of executives and supervisors whether any plant assets have been
retired during the year.
(e) Examine retirement work orders or other source documents for authorization
by the appropriate official or committee.
(f) Investigate any reduction of insurance coverage to see whether this was
caused by retirement of plant assets.
11-6. Kris Corporation
(a) This is the first audit of Kris Corporation by Ian and Ronna. Moreover, the
company has not been audited by other public accountants during the two
previous years of operation. Under these circumstances, the auditors must
investigate fully transactions relating to plant and equipment during the two
prior years of the company’s existence, as well as the records of the year
under audit. The adequacy of internal control over plant acquisitions and
disposals would be an important part of this review. Since Kris is a relatively
new company, this study of prior years’ transactions can be completed within
reasonable time limits.
The review of prior years’ transactions relating to plant and equipment would
include analysis of the Repairs and Maintenance expense account and should
bring to light the erroneous treatment of plant acquisitions as revenue
expenditures during Years 1 and 2.
If Ian and Ronna did not investigate the property transactions of the two prior
years and the internal controls in force, there would be no satisfactory support
for the balances of the property accounts at the end of Year 3, or for the
depreciation expense of the year under audit. Remember that one of the
auditors’ basic objectives for plant and equipment is to determine that the
property accounts (including the amounts carried forward from prior years)
are fairly stated.
(b) Both the income statement and the balance sheet prepared at the end of Year
3 would be affected by the errors made in Years 1 and 2. In the balance
sheet, the plant and equipment and also the total assets would be understated
by the undepreciated cost of the assets which were improperly expensed.
Current liabilities and total liabilities would be understated by the additional
income taxes applicable to the understatement of prior periods’ net income
due to the accounting errors. The retained earnings and total shareholders’
equity would be understated by the difference between the understatement of
total assets and the understatement of total liabilities. In the Kris income
statement, depreciation expense would be understated, income taxes expense
overstated, and net income overstated.
Substantive Tests of Property, Plant and Equipment 11-3
11-7. Sparrow Company
1. Change in depreciation method is considered change in accounting estimate --
cumulative effect adjustment:
a. No correcting entry
b. Depreciation Expense 25,750
Accumulated Depreciation: Machine 25,750
To record depreciation for 2006.
Previous depreciation amount
2004 P400,000 x (2 x 10%) P 80,000
2005 (P400,000 - P80,000) x (2 x 10%) = 64,000
P144,000
Cost P400,000
Less: Accumulated depreciation 144,000
Carrying value 12.31.05 P256,000
256,000 – 50,000
Depreciation in 2006 = = P25,750
8
2. Change in estimate--prospective adjustment:
a. No correcting entry
Depreciation base P450,000
Original life = = = 9 years
Annual depreciation P50,000
Remaining life = (9-5) years + 1 year = 5 years
Book value – Residual value P250,000 – P50,000
Depreciation = = = P40,000 per year
Remaining life 5
3. Error--prior period adjustment:

a. Retained Earnings 8,000
Prior period adjustment for error
(P80,000 - P72,000).
Previous depreciation - erroneously calculated (P200,000 – P20,000) x
(2 x 20%) = P72,000
Correct depreciation (P200,000) x (2 x 20%) = P80,000
2006 correct depreciation (P200,000 – P80,000) x (2 x 20%) = P48,000
11-8. Jamboree Trucking Company
Requirement (1)
Accumulated depreciation on the trucks, January 1, 2003
Annual Years Accumulated

Truck Cost Life Depreciation Owned Depreciation
1 P120,000 5 P24,000 3 P 72,000
2 104,000 5 20,800 2½ 52,000
3 128,000 5 25,600 1 25,600
4 150,000 5 30,000 ½ 15,000
P164,600
Note: This schedule is used to help determine the accumulated depreciation

to date for each correcting entry. Also see correct depreciation
schedule later in solution.
July 1, 2003
Correct entry:
Cash 10,000
Accumulated Depreciation: Trucks
[P72,000 + (P24,000 x ½)] 84,000
Loss 26,000
Trucks 120,000
Entry made:
Cash 10,000
Trucks 10,000
Correcting entry #1:

Accumulated Depreciation: Trucks 84,000
Retained Earnings 26,000
Trucks 110,000
January 1, 2004
Correct entry:
Accumulated Depreciation:
Trucks (P25,600 + P25,600) 51,200
Trucks (new) 120,000
Cash 17,800
Trucks (old) 128,000
Gain on exchange 25,400
Entry made:
Trucks 17,800
Cash 17,800

Trucks (new) 102,200
Trucks (old) 128,000
Retained earnings 25,400
July 1, 2005
Correct entry:
Accumulated Depreciation: Trucks
(P15,000 + P30,000 + P30,000 + P15,000) 90,000
Cash 10,000
RE on disposition of trucks 50,000
Trucks 150,000
Entry made:
Cash 10,000
Miscellaneous Revenue 500
Trucks 9,500

Trucks 140,500
Correct depreciation:
Truck 2003 2004 2005 2006

1 P12,000 – – –
2 P20,800 P20,800 P10,400 –
3 P25,600 – – –
4 P30,000 P30,000 P15,000 –
5 – P18,920 P18,920 P18,920 (P94,600  5 = P18,920)
6 – – P12,000 P24,000 (P120,000  5 = P24,000)
Total P88,400 P69,720 P56,320 P42,920
Depreciation (88,400) (54,360) (41,460) (28,560)

Under (over)
statement – P15,360 P14,860 P14,360
Effect of errors on earnings (all reductions)
2003 P26,000
2004 P15,360
2005 P50,500 + P14,860 = P65,360
2006 P14,360

Depreciation Expense 14,360
Accumulated Depreciation 44,580
Requirement (2)
Compound AJE:
Accumulated Depreciation: Trucks (P84,000 +

P51,200 + P90,000 – P44,580) 180,620
Retained Earnings (P26,000 – P25,400 + P50,500
+ P30,220) 81,320
Trucks (P110,000 + P102,200 – P128,000
– P140,500) 276,300
11-9. AFH Company
Note: This question requires knowledge that corrections of errors in prior years
are recorded to Retained Earnings.
Adjusting entries at December 31, 2007, to correct the books. The building and
machinery should be recorded in separate accounts. Ignore effect on income
taxes.
Purchase price of P60,000 is a lump-sum purchase.

Building P39,000 60%
Machinery 26,000 40%
P65,000 100%
Machinery is valued at 40% x P60,000 = P24,000

Building is valued at 60% x P60,000 = P36,000
AJE (1) Machinery 24,000
Building 36,000
Property, Plant, and Equipment 60,000
(2) Machinery 280

Building 420
Property, Plant, and Equipment 700
The legal fees are allocated in the
same proportion as the original
purchase.
(3) Retained Earnings 2,400

To correct the insurance paid in
2005 that was incorrectly recorded
in the asset account.
(4) Property, Plant, and Equipment 6,310

Accumulated Depreciation: Building 1,821
Accumulated Depreciation: Machinery 3,035
To remove the depreciation of
P6,310 incorrectly credited to
Property, Plant, and Equipment in
2005; to credit the correct
depreciation to Accumulated
Depreciation: Building (P36,420 
20); to credit the correct
Depreciation: Machinery (P24,280
 8); and to correct the amount
recorded as depreciation expense by
a credit to Retained Earnings.

To correct the 2006 repairs that were
incorrectly recorded in the asset
account.
(6) Building 10,000

To properly classify the 2006
addition to the building.

Depreciation: Building [P1,821 +
(P10,000  19)] (this assumes the
addition has the same life as the
building); to credit the correct
Depreciation: Machinery (P24,280
 8); and to correct the amount
recorded as depreciation expense by
a credit to Retained Earnings.
(8) Repairs Expense 3,000

To expense the repairs for 2007,
before the books are closed.
(9) Insurance Expense 1,400

Prepaid Insurance 1,400
To correctly classify the 2007
insurance payment, before the books
are closed.
(10) Machinery 7,000

To correctly classify the machinery
purchased in 2007.
(11) Loss on Disposal of Machinery 100

Property, Plant, and Equipment 500
Accumulated Depreciation: Machinery 200
Machinery 800
To correctly record the disposal of
the machinery in 2007; the machine
is 2 years old and so has P200
related accumulated depreciation.
Depreciation: Building; to credit the
correct depreciation to Accumulated
Depreciation: Machinery [(P24,280
+ P7,000 - P800)  8]; and to correct
the depreciation expense before the
books are closed.
11-10. Briggs, Inc.
Adjusting Journal Entries - 12/31/06
(1) Organization costs 3,000

Fixed assets 3,000
(2) Discount on bonds payable 5,650

Interest expense 350
Fixed assets 6,000
(3) Land 500,000

Fixed assets 500,000

Fixed assets 5,000
(5) Land 4,000

Fixed assets 4,000
(6) Land 7,000

Fixed assets 7,000
(7) Interest expense 30,000

Fixed assets 30,000
(8) Salaries expense 50,000

Fixed assets 50,000

Fixed assets 40,000
(10) Taxes and licenses 7,000

Fixed assets 7,000
(11) Building 2,000,000

Fixed assets 2,000,000
11-11. Aerospace Company
Requirement (1)
Machinery (cost)
Raw materials used P13,600
Labor 9,800
Installation cost 1,400
Materials used in trial runs 600
Factory overhead (incremental) 2,900
Total P28,300
Less: Cash discount on materials 400
Net P27,900
Accumulated depreciation - 12/31/06

(P27,900 x 10% x 4/12) P 930
Machine Tools (cost) P 2,250

Less: Amortization for 2006 (4/36 x 2,250) 250
Balance, 12/31/06 P 2,000
Requirement (2) Adjusting Journal Entries - 12/31/06
(1) Loss on disposition of machinery 70

Machinery 70
(2) Profit on construction 6,900

Machinery 6,900
(3) Machine tools 2,250

Machinery 2,250
(4) Machinery 3,462
Depreciation expense 2,532
Accumulated depreciation - machinery 930
(5) Purchase discount 400

Machinery 400
(6) Machinery 2,900

Factory overhead control 2,900
(7) Tools expense 250

Machine tools 250
11-12. XYZ Manufacturing Company
Adjusting Journal Entries - 12/31/06

AJE (1) Retained Earnings 1,200.00
Machinery 1,200.00
To correct error in recording
purchase of machine on
installment basis.
List Price P6,000
Add: Installation charges 200
Total P6,200
Total installments paid
& installation 7,400
Financing charges P1,200
(2) Retained Earnings 160.00

Machinery 160.00
To take up cash discount on
machinery purchased on 6/30/03.
(3) Machinery (new) 2,620.00

Allowance for depreciation 2,620.00
Machinery (old) 5,240.00
To write off machinery traded in
for a new one.
Cost of new machine:
Cash payment P5,000
NBV of old machine 2,620
Total P7,620
(4) Allowance for depreciation 2,640.00

Machinery 2,025.00
Retained earnings 615.00
To correct the recording of sale of
machinery on 1/1/05.
Cost P4,400
Less: Acc. Depr. 2,640
NBV 1,760
Proceeds (2,500 - 125) 2,375
Gain P 615
(5) Allowance for depreciation 3,800.00

Machinery 3,200.00
Gain on sale of machinery 600.00
To correct the recording of sale of
machinery on 10/1/06.
Cost P4,000
Less: Acc. Depr. 3,800
NBV 200
Proceeds 800
Gain P 600
(6) Machinery 19,900.60

To set up client’s depreciation
provisions from 2002 to 2006
erroneously credited to the
Machinery acct. (Schedule A).
(7) Depreciation expense 2,190.90

Retained earnings 1,536.50
To correct error in depreciation
provisions of client (Schedule B).
XYZ Manufacturing Corporation

Machinery
12/31/06
Balance per ledger (Schedule A) P10,964.40

AJE (1) ( 1,200.00)
(2) ( 160.00)
(3) 2,620.00
(4) ( 5,240.00)
(5) ( 2,025.00)
(6) ( 3,200.00)
19,900.60
Net P10,695.60
Composition:
Machine acquired on 9/30/02 P 6,200.00
Machine acquired on 6/30/03 7,840.00
Machine acquired on 6/30/04 7,620.00
Total P21,660.00
XYZ Manufacturing Corporation

Allowance for Depreciation
12/31/06
Balance per ledger P 0.00

AJE (3) ( 2,620.00)
(4) ( 2,640.00)
(5) ( 3,800.00)
(6) 19,900.60
(7) 3,727.40
Composition:
A D - Machine acquired on 9/30/02 P 5,270.00
- Machine acquired on 6/30/03 5,488.00
- Machine acquired on 6/30/04 3,810.00
Total P14,568.00
Schedule A Machinery Account per Ledger
Date Particulars Dr Cr Balance

1/1/02 Purchase P 5,240.00
4,000.00
4,400.00 P13,640.00
9/30/02 Purchase on installment
Payments from Sept. to Dec. 2,400.00 16,040.00
10/10/02 Freight and installation 200.00 16,240.00
12/31/02 Depreciation (20%) P 3,248.00 12,992.00
2003 Installment payments for acquisition

on 9/30/02 4,800.00 17,792.00
6/30/03 Purchase 8,000.00 25,792.00
12/31/03 Depreciation (20%) 5,158.40 20,633.60
6/30/04 Acquisition - old machine traded in 5,000.00 25,633.60
12/31/04 Depreciation (20%) 5,126.72 20,506.88
1/1/05 Sale 2,375.00 18,131.88
12/31/05 Depreciation (20%) 3,626.38 14,505.50
10/1/06 Sale 800.00 13,705.50
12/30/06 Depreciation (20%) 2,741.10 10,964.40
Schedule B Depreciation Schedule
Date
Acquired Cost 2002 2003 2004 2005 2006
1/1/02 P 5,240 P 1,048.00 P1,048.00 P 524.00 P 0.00 P 0.00
4,000 800.00 800.00 800.00 800.00 600.00
4,400 880.00 880.00 880.00 0.00 0.00
9/30/02 6,200 310.00 1,240.00 1,240.00 1,240.00 1,240.00
6/30/03 7,840 0.00 784.00 1,568.00 1,568.00 1,568.00
6/30/04 7,620 0.00 0.00 762.00 1,524.00 1,524.00
Total correct
depreciation provision P 3,038.00 P4,752.00 P 5,774.00 P5,132.00 P4,932.00
Provision by client 3,248.00 5,158.40 5,126.72 3,626,38 2,741.10
(Over) Underprovision P (210.00) P (406.40) P 647.28 P1,505.62 P2,190.90
11-13. Sunlight Service Center
Audit Adjustment No. 1 was determined as follows:
Client’s Entry Correct Entry

(1) To record disposal of delivery truck:
Cash 2,000 Cash 2,000
Trucks 2,000 Accum. Depr. 50,000
Trucks 50,000
Gain/Loss on Disp. 2,000
(2) To record disposal of service truck:
Cash 8,000 Cash 8,000
Trucks 8,000 Accum. Depr. 15,000
Gain/Loss on Disp. 2,000
Trucks 25,000
(3) To record 2006 depreciation:

Depr. Expense 95,000 Depr. Expense 101,250
Accum. Depr. 95,000 Accum. Depr. 101,250
Correct amount of depreciation determined as follows:

Disposal of service truck (1/2 year) P 2,500
Purchase of delivery truck (1/2 year) 6,000
Purchase of service truck (1/2 year) 2,750
Two delivery truck @ 10,000 each 20,000
Fourteen service trucks @ 5,000 each 70,000
Total P101,250
Audit Adjustment as shown below:

Accumulated Depreciation - Trucks 58,750
Depreciation Expense - Trucks 6,250
Trucks 65,000
b. The audit objectives for examining the asset and related accumulated
depreciation accounts are:
(1) Existence or occurrence: To establish the physical presence of the assets
and the validity of the purchase and sale transactions.
(2) Rights and obligations: To ascertain that Sunlight owns the trucks.
(3) Valuation or allocation: To determine that the company has properly
recorded the acquisitions and disposals, and that depreciation has been
properly calculated for 2006.
(4) Presentation and disclosure: To resolve that all trucks are used in the
company’s operations; that fully-depreciated trucks are removed from the
books if no longer in use; that trucks and accumulated depreciation are
reflected as operating assets; and that depreciation expense is reflected as
an operating expense.
Auditing procedures appropriate in meeting the above objectives are the

following:
(1) Existence or occurrence, valuation or allocation, and ownership: Trace to
last year’s audit workpapers and examine titles for trucks purchased prior to
2006 (to determine that trucks are still owned by the client; examine titles and
invoices for trucks purchased in 2006; examine remittance advices, journal
entries and bank statement credits for 2006 disposals; and recompute
depreciation expense and gain/loss on disposals.
(2) Presentation and disclosure: Examine subsidiary ledger for fully depreciated
assets and inquire as to whether in use. Reclassify as necessary.
11-13. Sunlight Service Center (CONTINUED. . . . Requirements a and c)
SUNLIGHT SERVICE CENTER
TRUCKS
December 31, 2006
Final Final
Balances Balances Gain (loss)
Description 12/31/01 Additions Disposals 12/31/02 on Disposals
Assets:
Delivery Trucks P150,000 P 60,000  P51,000 P160,000 P 2,000 *
Service Trucks P375,000 P 27,500  P25,000 P377,500 (P2,000) (A)
P525,000 & P 87,500 P76,000 P537,500 P 0
F F F F
12/31/06: Ledger balance P602,500 (A)
AJE No. 1 P 65,000 Cost P25,000
12/31/06: Audited balances P537,500 Accum. Depr:
WP G 2003 2,500 (1/2 yr.)
2004 5,000
2005 5,000
2006 2,500 (1/2 yr.)
Accumulated Depreciation: 15,000
Delivery Trucks P 95,000 P 26,000 (B) P 50,000 P 71,000
Service Trucks P225,000 P 75,250 (C) 15,000 (A) P285,250 Book Value P10,000
P320,000 & P101,250 P 65,000 P356,250 Sales Price 8,000 *
Loss P 2,000
F F F F
12/31/06: Ledger balances P 95,000 P415,000
AJE No. 1 P 6,250 P 58,750 (B)
P101,250 P356,250 2 x 10,000 20,000
1 x 6,000 6,000 (1/2 yr.)
Evaluated depreciation policy and estimated lives for reasonableness. No exception: WP G P 26,000
AJE No. 1
Depreciation expense - trucks P 6,250 14 x 5,000 70,000
Accum. depreciation - trucks 58,750 1 x 2,500 2,500 (1/2 yr.)
Trucks P65,000 1 x 2,750 2,750 (1/2 yr.)
P 75,250
& Traced to last year’s working trial balance F Footed and crossfooted
* Traced to remittance advice and cash receipts  Examined invoices and titles
11-14. Tatty Company’s
Requirement (1)
Tatty Company
Analysis of Land Account
for 2007
Balance at January 1, 2007 P 100,000

Land site number 621:
Acquisition cost P1,000,000
Commission to real estate agent 60,000
Clearing costs P15,000
Less: Amounts recovered (5,000) 10,000
Total land site number 621 1,070,000
Land site number 622:

Acquisition cost P 300,000
Demolition cost of building 30,000
Total land site number 622 330,000
Balance at December 31, 2007 P1,500,000
Tatty Company
Analysis of Buildings Account
for 2007

Cost of new building constructed on
land site number 622:
Construction costs P150,000
Excavation fees 11,000
Architectural design fees 8,000
Building permit fee 1,000 170,000
Balance at December 31, 2007 P970,000
Tatty Company
Analysis of Leasehold Improvements Account
for 2007

Electrical work 35,000
Construction of extension to current
work area (P80,000 x ½) 40,000
Office space 65,000
Tatty Company
Analysis of Machinery and Equipment Account
for 2007

Cost of new machines acquired:
Invoice price P75,000
Freight costs 2,000
Unloading charges 1,500 78,500
Requirement (2)
Items in the fact situation which were not used to determine the answer to
Requirement 1 above, and where, or if, these items should be included in Tatty’s
financial statements are as follows:
a. Land site number 623, which was acquired for P600,000, should be included
in Tatty’s balance sheet as land held for resale.
b. Painting of ceilings for P10,000 should be included as a normal operating
expense in Tatty’s income statement.
c. Royalty payments of P13,000 should be included as a normal operating
expense in Tatty’s income statement.
11-15. Nikko Company
Note to Instructor: This problem includes material from previous chapters.
JOURNAL ENTRIES DURING 2006:
(1) Land 175,000 a

Ordinary Shares, P10 par 70,000
Additional Paid-in Capital 105,000
a
P25 x 7,000
Cash 500,000
Notes Payable 500,000
Building 700,000
Cash 700,000
(2) Machine 430,000
Machine 500,000
Cash 60,000
Gain on exchange 5,000
(3) Cash 800,000

Sales Revenue 800,000
Cost of Goods Sold 350,000

Inventory 350,000

Cash 400,000
Inventory 480,000
(4) Dividends Distributed (or Retained Earnings) 92,500

Cash 92,500 a
a
37,000 x P2.50
ADJUSTMENTS AT END OF 2006:

Building 42,000 b
Interest Payable 60,000 a
a
P500,000 x 12%
b
[(P0 + P700,000)  2] x 12%
Depreciation Expense - Machinery 75,000 a

Accumulated Depreciation 75,000 a
a
(P430,000 – P55,000)  5
Rent Expense 60,000

Prepaid Rent 60,000
Income Tax Expense 90,600 a

Income Taxes Payable 90,600
a
See income statement
FINANCIAL STATEMENTS FOR 2006:
NIKKO COMPANY
Income Statement
For Year Ended December 31, 2006
Sales revenue P800,000

Less: Expenses
Cost of goods sold P350,000
Rent expense 60,000 (503,000)
Operating income P297,000
Gain on exchange of machinery 5,000
Income before income taxes P302,000
Income tax expense (30%) 90,600
Net income P211,400
Earnings per share (37,000 shares) P 5.71
NIKKO COMPANY
Statement of Retained Earnings
Beginning retained earnings P200,000

Add: Net income 211,400
P411,400
Less: Dividends (92,500)
Ending retained earnings P318,900
NIKKO COMPANY
Balance Sheet
December 31, 2006
Assets
a
Cash P 587,500
b
Inventory 580,000
Land 175,000
Building 742,000
Machine P430,000
Less: Accumulated depreciation (75,000) 355,000
Total Assets P2,439,500
Liabilities and Equities
c
Accounts payable P 480,000
Notes payable 500,000
Interest payable 60,000
Income taxes payable 90,600
Total Liabilities P1,130,600
d
Ordinary shares, P10 par P 370,000
e
Additional paid-in capital 620,000
Total Shareholders’ Equity P1,308,900
Total Liabilities and Shareholders’ Equity P2,439,500
a
P540,000 + P500,000 – P700,000 – P60,000 + P800,000 – P400,000 – P92,500
= P587,500
b
P450,000 – P350,000 + P480,000 = P580,000
c
P400,000 – P400,000 + P480,000 = P480,000
d
P300,000 + P70,000 = P370,000
e
P515,000 + P105,000 = P620,000
11-16. Apple Company
Requirement 1
Total expenses, 2005 = Units sold x (Depletion + Depreciation

+ Production costs)
= (6 x 9,000) x (P3.00a + P0.20b + P8.00)
= 54,000 x P11.20
= P604,800
a
Cost – Residual Value
Depletion rate =
Life in tons
= P2,000,000  (P100,000 – P200,000)

700,000
P2,100,000
=
700,000
= P3.00 per ton

b
Cost – Residual Value
Depreciation rate =
Life in tons
P150,000 – P10,000
=
700,000
= P0.20 per ton
Requirement 2
Cost of inventory, 12/31/2005 = 6 x (10,000 – 9,000) x P11.20

= P67,200
Requirement 3
Total expenses, 2006 = Units sold x (Depletion + Depreciation

+ Production costs)
= (6 x P11.20) + [(12 x 10,000) – 6,000] x
(P3.84a + P0.256b + P8.00)
= P67,200 x P1,378,944
= P1,446,144
a
New depletion rate = Book value – Residual Value
Remaining Life
[P2,000,000  (60,000 x P3.00)] – (P100,000 – P200,000)]
=
500,000
= P1,820,000 + P100,000
500,000
= P1,920,000
500,000
= P3.84 per ton
b Book value – Residual Value

New depreciation rate =
Remaining Life
= [P150,000  (60,000 x P0.20)] – P10,000

500,000
= P128,000
500,000
= P0.256 per ton
11-17.
January 1, 2001
Equipment 5,000,000
Cash 5,000,000
December 31, 2001
December 31, 2002
January 1, 2003
Equipment 625,000
Revaluation Surplus 500,000
December 31, 2003

December 31, 2004

December 31, 2005

January 1, 2006
1) Revaluation surplus 312,500
Accumulated depreciation 312,500
Equipment 625,000
2) Impairment loss / Depreciation expense 500,000

or
Revaluation surplus 312,500
Impairment loss / Depreciation expense 500,000
Equipment 625,000
11-18. Sweetie Company
Requirement (a)
December 31, 2006

Loss on Impairment / Depreciation................................................................
3,200,000
Accumulated Depreciation—Equipment ................................ 3,200,000
Cost P9,000,000
Accumulated depreciation 1,000,000
Carrying amount 8,000,000
Fair value 4,800,000
Loss in impairment P3,200,000
Requirement (b)
December 31, 2007

Depreciation Expense................................................................................................
1,200,000
Accumulated Depreciation—Equipment ................................ 1,200,000
New carrying amount P4,800,000

Useful life 4 years
Depreciation per year P1,200,000
Requirement (c)
Carrying value, 12.31.07 had impairment not been recognized on 12.31.06
Cost P9,000,000
Accumulated depreciation
(P1,000,000 + P2,000,000) 3,000,000
Net carrying value, 12.31.07 P6,000,000
Fair value, 12.31.07 P5,100,000

Carrying value, 12.31.07 3,600,000
Recovery of impairment loss P1,500,000
Entry will be:
Accumulated depreciation 1,500,000
Depreciation expense or
Gain on recovery of previously
recognized impairment 1,500,000
11-19. Bobby Corporation
Requirement (1)
BOBBY CORPORATION
Land Account (Site Number 501)
As of September 30, 2007
Acquisition cost P600,000

Real estate broker’s commission 36,000
Legal fees 6,000
Title guarantee insurance 18,000
Cost of razing existing building 75,000
Balance, September 30, 2007 P735,000
Requirement (2)
BOBBY CORPORATION
Capitalized Cost of Office Building
Contract cost P3,000,000

Plan, specifications, and blueprints 12,000
Architects’ fees for design and supervision 95,000
Capitalized interest--2006 (P900,000 x 14% x 10/12) 105,000
Capitalized interest--2007 (P2,300,000 x 14% x 9/12) 241,500
Total capitalized cost, September 30, 2007 P3,453,500
Requirement (3)
BOBBY CORPORATION
Computation of Depreciation of Office Building
Using 150% Declining Balance Method
Capitalized cost P3,453,500

150% declining balance rate
(100%  40 years = 2.5% x 1.5) x 3.75%
Annual depreciation P 129,506
Depreciation October 1 to December 31, 2007
(P129,506 x 3/12) P 32,377
CHAPTER
12 INTANGIBLE ASSETS
12-1. 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 P270,000
20
Amortization per client (P27,500 x 12) 330,000
Over-amortization P 60,000
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.
12-4. Requirement (a)

The annual depreciation for years 11 to 25 is P1,667. By the end of the 25 th 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
Cost as
Description Recorded Amortization Per Client
1997 1998 to 2005 Total Adjustment As Adjusted
Patent P P 40,000 P1,212.12 P 19,393.94 P 20,606.06 P(5,151.52) P 15,454.54
Q 120,000 3,529.41 56,470.59 60,000.00 (15,000) 45,000.00
R 160,000 4,705.88 75,294.12 80,000.00 (20,000) 60,000.00
P320,000 P9,447.41 P151,158.65 P160,606.06
Less: Adjustment
as per BIR
requirement 80,000 (2,361.85) (37,789.67) (40,151.52)
As Adjusted P240,000 P7,085.56 P113,368.98 P120,454.54 P120,454.54
(a) (b)
* Based on 17 years legal life.
(a) 1997 Amortization:

30,000
P = x 0.5 = P 909.09
16.5
210,000
Q&R = x 0.5 = 6,176.47
17 P7,085.56
(b) 1998 to 2005 Amortization:

30,000
P = x 8 =P 14,545.45
16.5
210,000
Q&R = x 0.5 = 98,823.53
17 P113,368.98
Substantive Tests of Intangible Assets 12-3
(1) Capital in excess of par value 80,000.00
Patent P 10,000.00
Patent Q 30,000.00
Patent R 40,000.00
To adjust patent valuation to conform
to BIR requirement.
(2) Accumulated amortization – Patent P 5,151.52
Accumulated amortization – Patent Q 15,000.00
Accumulated amortization – Patent R 20,000.00
Retained earnings – Correction of prior
years’ profit 40,151.52
To adjust amortization provision from
1997 to 2005.
12-6. 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 Organization Expenses 17,500

Intangibles 17,500
To classify incorporation fees.
10 Organization Expenses 7,500
Intangibles 7,500
To classify legal fees for the
organization of the company.
5 Advertising Expense 15,000
Intangibles 15,000
To expense advertising costs.
Apr. 1 Land 15,000
Building 20,000
Intangibles 35,000
To reclassify land and buildings for
R & D activities.
May 15 Research and Development Expenses 15,000*
Intangibles 15,000
To expense materials purchased.
* Alternatively, unused materials and
supplies, if material, may be set up as
prepaid expenses.
June 30 Patent 10,000

Intangibles 10,000
To reclassify the patent.
July 1 Income Summary / Retained Earnings 12,000

Intangibles 12,000
To record operating loss.
Dec. 10 Research and Development Expenses 12,000

Intangibles 12,000
To record acquisition of equipment.
31 Research and Development Expenses 30,000

Intangibles 30,000
To expense R & D costs.
31 Research and Development Expenses 750

Accumulated Depreciation: Building 750
To record ¾ year depreciation on R
& D building (20-year life) from
April 1 entry.
31 Amortization Expense 250

Patent 250
To record ½ year amortization (20-
year life) on June 30 patent.
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) P 480,000
Average annual earnings

(P400,000  5) P 80,000
Less: Normal return on average year-end assets
(10% x P480,000) 48,000
Excess annual earnings P 32,000
Excess annual earnings capitalized at 20% or Goodwill

P32,000  12% = P160,000
12-8. Bayer, Inc.
Bayer, Inc. Lead, Inc.

Net tangible assets per records, Nov. 1, 2006 P328,500 P298,500
Add: Agreed increase in value of equipment 40,000
Net adjusted tangible assets P368,500 P298,500
Add: Value of Goodwill (Schedules 1 & 2) 74,900 12,900
Total amount to be paid for net tangible assets
and goodwill P443,400 P311,400
Supporting Computations:
Schedule 1: Goodwill of Bayer, Inc.
Average pre-tax earnings 11.1.01 to 11.1.06 P82,000

Less: Additional annual depreciation equipment taken over
at P40,000 in excess of book value (P40,000 / 5) 8,000
Adjusted pre-tax earnings P74,000
Less: Required earnings on net tangible assets
(15% x P368,500) 55,275
Excess annual pre-tax earnings P18,725
Goodwill (excess earnings capitalized at 25%) P74,900
Schedule 2: Goodwill of Lead, Inc.
Average pre-tax earnings 11.1.01 to 11.1.06 P44,000

Less: Adjustment for effect of organization cost written off
in 2005 (P20,000 / 5) 4,000
Adjusted pre-tax earnings P48,000
Less: Required earnings on net tangible assets
(15% x P298,500) 44,775
Excess annual pre-tax earnings P 3,225
Goodwill (excess earnings capitalized at 25%) P12,900
12-9. 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.
Appraisal Portion of Total Allocated

Asset Value Total Value Cost Cost
Patent A P 30,000 30/151.7 x P137,500 = P 27,192
Patent B 40,000 40/151.7 x 137,500 = 36,256
Equipment 19,700 19.7/151.7 x 137,500 = 17,856
Land 62,000 62/151.7 x 137,500 = 56,196
P151,700 P137,500
Journal entries for 2004, 2005 and 2006, relative to intangible assets, are as
follows:
2004
Apr. 27 Patent A 27,192

Patent B 36,256
Equipment 17,856
Land 56,196
Cash 137,500
To record the acquisition of assets.
Oct. 31 Amortization of Patents 4,230

Patent A (27,192 / 5 x 6/12) 2,719
Patent B (36,256 / 12 x 6/12) 1,511
To record amortization of patents
for 2004.
2005
Mar. 7 Legal Expenses 17,600

Cash 17,600
To record legal fees related to defense
of patents.
Mar. 7 Amortization of Patents 1,813

Patent A 1,813
To record amortization on Patent A
to date of write-off (Nov. 2004 to
Feb. 2005).
Mar. 7 Loss on Patent A 22,660

Patent A 22,660
To record write-off of Patent A after
unsuccessful defense.
Patent B 3,021
To record amortization of Patent B for 2005.
2006

Patent B 3,021
To record amortization on Patent B for 2006.
Computations
Amortization for 2006:
Patent A: (P27,192 / 5 years) (6 / 12) P 2,719
Patent B: (P36,256 / 12 years) (6 / 12) 1,511
P 4,230
Amortization on Patent A, 10/31/2004 – 3/7/2005:

(P27,192 / 5 years) (4/12) P 1,813
Book value of Patent A to 3/7/2005:
Cost P27,192
Amortization recognized P2,719
1,813 4,532
P22,660
Amortization for 2005 and 2006:

Patent B: (P36,256/12 years) 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.
12-10. 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 P 52,500

Remaining Patents
Unamortized cost: P497,500 - P105,000 = P392,500
Amortization: P392,500/7 56,071
P108,571 [AJE (2)]
Franchise Agreement
1. Balance before adjustment, 12/31/06 P 95,000
Correction: Deduct periodic payment charged to account (45,000) [AJE (3)]
Corrected balance before 2006 amortization P 50,000
2. 2006 Amortization:
P50,000 / 5 years P 10,000 [AJE (4)]
Organization Costs
Correction: Legal fees incorrectly charged to
Goodwill account in 1998 P45,000 [AJE (5)]
Amortization of above costs,
1998 - 2004 (P45,000 / 40) (7 years) 7,875 37,125 [AJE (6)]
P139,125 [AJE (7)]
2. 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

adjustment 139,125
Organization costs 139,125
Goodwill
Correction: Reclassification of legal fees
to Organization Costs ( 45,000)
Reclassification of advertising fee to Advertising Expense (100,000)
Amortization on Goodwill for 2004
(P200,000 / 40 years) ( 5,000)
Balance 12.31.04 P195,000
2. 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.
Patents
AJE (1) Retained Earnings 52,500
Patents 52,500
AJE (2) Cost of Goods Sold 108,571

Patents 108,571
Franchise Agreement
AJE (3) Selling and Administrative -
Franchise Expense 45,000
Franchise Agreement 45,000
AJE (4) Selling and Administrative

Expense 10,000
Organization Cost
AJE (5) Organization Costs 45,000
Goodwill 45,000

Organization Costs 7,875

Goodwill
AJE (8) Selling and Administrative –
Advertising Expense 100,000
Goodwill 100,000

Goodwill 5,000
Requirement (b)

Selling and Administrative –
Franchise Expense 45,000
Selling and Administrative –
Advertising Expense 100,000
Goodwill 150,000
Patents 52,500
Summary:
Retained Earnings (Dr.) Cr.

AJE (1) (52,500)
(7) (139,125)
(9) 5,000
(6) 7,875
(204,500)
Organization Costs Dr. (Cr.)

AJE (5) 45,000
(6) (7,875)
(7) (139,125)
(102,000)
Goodwill Dr. (Cr.)

AJE (5) 45,000
(8) 100,000
(9) 5,000
150,000
(2) Cost of Goods Sold 108,571

Selling and Administrative Expense 10,000
Patents 108,571
12-11. Balagtas Company
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: Treat all the items as expenses in
Research and development 2006 income statement.
Marketing research
Personnel recruitment and training
Legal fees relative to organization
of the corporation
Operating expenses
2. No depreciation was taken on Expense appropriate amounts in the
machinery. 2006 income statement.
3. Ordinary shares account does not Increase ordinary shares by par

reflect the par value of the value of 1,000 shares.
outstanding shares (11,000).
4. No statement of shareholders’ The statement should be provided,
equity and explanation of shares including dates and numbers of
issued is presented. 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
above.
Requirement (b)
Additional items which should be included are:

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.
12-12. 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
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. Lee Manufacturing Corporation
Lee Manufacturing Corporation
Financial Statement Worksheet
Trial Balance Adjustments Income Statement Balance Sheet
General Ledger Accounts Debit Credit Debit Credit Debit Credit Debit Credit
Cash P 61,000 P 61,000
Accounts receivable 92,500 (8) P 2,500 95,000
Allowance for doubtful accounts P 500 (500)
Inventories 38,500 38,500
Machinery 75,000 (1) 17,000 92,000
Equipment 29,000 (8) 8,500 37,500
Accumulated depreciation 10,000 (10,000)
Patents 85,000 (1) P 17,000 68,000
Leasehold improvements 26,000 (8) 11,000 15,000
Prepaid expenses 10,500 10,500
Organization costs 29,000 (9) 29,000
Goodwill 24,000 (7) 24,000
Licensing agreement no. 1 50,000 (4) 1,250 19,500
(5) 29,250
Licensing agreement no. 2 49,000 (3) 1,000 50,000
Accounts payable 147,500 P 147,500
Unearned revenue 12,500 (3) 1,000 13,500
Capital stock 300,000 300,000
Retained earnings, Jan. 1, 2006 27,000 (27,000)
Sales 768,500 P 768,500
Cost of goods sold 454,000 (2) 3,400 P 464,400
(6) 5,500
(10) 1,500
Selling and general expenses 173,000 (7) 8,000 181,000
Start-up expenses (7) 16,000 45,000
(9) 29,000
Interest expense 3,500 3,500
Extraordinary losses 12,000 12,000
Accumulated amortization:
patents (2) 3,400 (3,400)
leasehold improvements (10) 3,000 (3,000)
licensing agreements (6) 5,500 (5,500)
Prior period adjustment – (4) 1,250 (30,500) *
licensing agreement no. 1 (5) 29,250
Prior period adjustment –
amortization of leasehold
improvements (10) 1,500 (1,500) *
Net income for 2006 62,600 62,600
Totals P1,239,000 P1,239,000 P124,400 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.
12-14. Lee Manufacturing Corporation (continued . . . )
Adjusting entries (shown on worksheet):

Patents 17,000
To transfer cost of improving
machinery to the fixed asset account.

Accumulated Amortization: Patents 3,400
To record 2006 patent amortization
(1/20 x P68,000).
(3) Licensing Agreement No. 2 1,000

Unearned Revenue 1,000
To classify revenue received in advance
on licensing agreement as unearned
revenue.
(4) Prior Period Adjustment – Licensing Agreement

No. 1 1,250
Licensing Agreement No. 1 1,250
To take up 2005 amortization (40 year
life). (Note 1)
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 29,250
Licensing Agreement No. 1 29,250
To write off the permanent 60%
reduction in the expected revenue-
producing value of licensing agreement
no. 1 caused by the December 2005
explosion (60% x P48,750).

Accumulated Amortization: Licensing
Agreements 5,500
To record 2006 amortization of
licensing agreement no. 1 [(P50,000 –
P1,250 – P29,250)  39] and no. 2
(P50,000  10).
(7) Selling and General Expenses 8,000

Start-up Expenses 16,000
Goodwill 24,000
To transfer items improperly charged to
Goodwill.
(8) Start-up Expenses 29,000

To expense other organization costs.
(9) Equipment 8,500

Accounts Receivable – Lessor 2,500
Leasehold Improvements 11,000
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.

Prior Period Adjustment – Amortization of
Leasehold Improvements 1,500
Accumulated Amortization: Leasehold
Improvements 3,000
To record 2005 and 2006 amortization
of leasehold improvements based on
10-year life of lease (2 x 10% x
P15,000).
12-15. 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) P 61,830
Patent, net of accumulated amortization of P2,050
(Schedule 2) 14,350
Trademark, net of accumulated amortization of
P7,294 (Schedule 3) 42,706
Total intangibles P118,886
Schedule 1:
Computation of Franchise from

IE Copy Service, Inc.
Cost of franchise at January 1, 2006

Down payment P25,000
Present value of installments 43,700
Initial amount capitalized P68,700
Amortization of franchise for 2006 (P68,700  10
years) (6,870)
Franchise balance, December 31, 2006 P61,830
Schedule 2:
Computation of Patent
Capitalized cost of patent at January 2, 2006 – legal

fees and other costs associated with registration P16,400
Amortization of patent for 2006 (P16,400  8 years) (2,050)
Patent balance, December 31, 2006 P14,350
Schedule 3:
Computation of Trademark
Accumulated
Cost Amortization
Cost of trademark at July 1, 2003 P40,000
Amortization through December 31, 2006
(P40,000  20 years = P2,000 x 3 ½ years) P7,000
Balance, December 31, 2006 P40,000 P7,000
Deduct accumulated amortization (7,000)
Trademark balance, December 31, 2006 P33,000
Cost of successful litigation in defense of trademark should be charged to

expense.
Requirement (2)
Broadway Corporation
Expenses Resulting from Intangibles Transactions
Franchise from IE Copy Service, Inc.

Amortization of franchise (Schedule 1) P 6,870
Franchise fee on revenues from operations
(P900,000 x 5%) 45,000
Imputed interest expense on unpaid balance of
initial franchise fee (P43,700 x 14%) 6,118
P57,988
Amortization of patent (Schedule 2) 2,050
Litigation expense – Trademark 10,000
Amortization of trademark 2,000
Total expenses P72,038
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.
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 P15,000
Costs of meetings of incorporators to discuss
organizational activities 7,000
State filing fees to incorporate 1,000
Total organization costs 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) P1,440,000
Franchise from JC Company, net of accumulated
amortization of P48,000 (Schedule 2) 432,000
Total intangibles P1,872,000
Schedule 1 Computation of Patent from Francis Argante Company

Cost of patent at date of purchase P2,000,000
Amortization of patent for 2006 (P2,000,000  10 years) (200,000)
1,800,000
Amortization of patent for 2007 (P1,800,000  5 years) (360,000)
Patent balance P1,440,000
Schedule 2 Computation of Franchise from JC Company

Cost of franchise at date of purchase P 480,000
Amortization of franchise for 2004 (P480,000  10) (48,000)
Franchise balance 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) P360,000
Franchise from JC Company:
Amortization of franchise for 2007
(P480,000  10) P 48,000
Payment to Reagan Company
(P2,500,000 X 5%) 125,000 173,000
Research and development costs 433,000
Total charged against income P966,000
12-19. Twinkle Industries
Requirement (a)
Patent X
Life in years 17
Life in months (12 X 17) 204
Amortization per month P150
Number of months amortized to date
Year Month
2004 10
2005 12
2006 12
2007 12
46
Book value 12/31/07 P23,700: (P30,600 – [46 X P150])

Patent Y
Life in years 10
Year Month
2005 6
2006 12
2007 12
30
Book value 12/31/07 P11,250: (P15,000 – [P125 X 30])
Patent Z
Life in years 4
Year Month
2006 4
2007 12
16
Book value 12/31/07 P9,600: (P14,400 – [P300 X 16])
At December 31, 2007

Patent X P23,700
Patent Y 11,250
Patent Z 9,600
Total P44,550
Requirement (b)
Analysis of 2008 transactions
1. The P245,700 incurred for research and development should be expensed.
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 P11,250

Less: Present value of future
cash flows 2,000 X 2.57710 5,154
Loss recognized P 6,096
Patent Y carrying amount (12/31/08) P5,154
At December 31, 2008
Patent X P21,900 (P23,700 – [12 X P150])

Patent Y 5,164 (Present value of future cash flows)
Patent Z 6,000 (P9,600 – [12 X P300])
Patent AA 34,560 (P36,480 – P1,920*)
Total P67,624
Patent AA amortization
Life in years 9 1/2
Life in months 114
P320 X 6 = P1,920
Patent Y: Value in Use

2,000 x 0.9259 = P1,852
2,000 x 0.8573 = 1,715
2,000 x 0.7983 = 1,597
P5,164
or
2,000 x 2.582 = P5,164
12-20. 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
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 P4,300,000

Fair value 3,200,000
Loss on impairment P1,100,000
Requirement (b)
Copyright Amortization Expense................................ 320,000*

Copyrights................................................................ 320,000
*New carrying amount P3,200,000

Useful life  10 years
Amortization per year P 320,000
Fair Value
Historical Cost Fair Value 12.31.07
CV 12.31.06 P4,300,000 P3,200,000
Amortization, 2007 430,000 320,000
CV 12.31.07 P3,870,000 P2,880,000 P3,400,000
Recovery 520,000
Requirement (c)
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
Franchise Amortization Expense (P42,000  8)................................ 5,250

Retained Earnings (P42,000  8 X 6/12)................................ 2,625
Franchises ................................................................ 7,875
Rent Expense (P28,000  2)................................................................

14,000
Retained Earnings (P28,000  2 X 3/12)................................ 3,500
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 P62,050

1996 amortization (P62,050  17) (3,650)
Carrying value, 12/31/99 P58,400
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 P58,400

2000 amortization (P62,050  17) P3,650
2001 amortization 3,650 (7,300)
51,100
Legal fees to defend patent 12/01 35,700
Carrying value, 12/31/01 86,800
2002 amortization (P86,800  14) 6,200
2003 amortization 6,200 (12,400)
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 P74,400

2004 amortization (P74,400  5) P14,880
2005 amortization 14,880
2006 amortization 14,880 (44,640)
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.
CHAPTER
13 PREPAID EXPENSES AND
DEFERRED CHARGES
13-1. Rights and obligations are tested by examining the insurance policies and
confirming the policy with insurance carriers. In turn, an auditor tests valuation
by recalculating unexpired premiums through evidence obtained from the prior
year’s unexpired insurance and from current premiums. In addition, to address
clerical accuracy, the auditor reconciles premium payments with cash
disbursements records, and total expense and unexpired premiums with the
general ledger.
13-2. Rhan Corporation
Rent Expense per client’s record P 105,000

Less: Rent Expense per audit
Last month’s rent P 10,000
Nonrefundable payment
amortization P60,000 x 1/12 1,000 11,000
5
Amount to be deferred P 94,000
Answer: (c)
13-3. Brown Company
Funded past service cost P 59,600

Amortized past service cost 46,700
Deferred pension cost P 12,900
Answer: (a)
13-4. Hansen, Inc.
Balance of Bond Discount, 1-1-06 P 61,000

Amortized Bond Discount:
Nominal Interest P 90,000
Effective Interest 93,900 (3,900)
Unamortized Bond Discount P 57,100
Answer: (a)
13-5. Walton Company
Prepaid rent for 1/2 year (P36,000 x 1/2) P 18,000

Unexpired
P24,000 x 2.5 20,000
3
Total P 38,000
Answer: (d)
13-6. Miller Corporation
The past service cost of P500,000 should be amortized over 10 years that is, from
2006 to 2015.
Answer: (c)
13-7. Mabini, Inc.
a. Prepaid advertising P12,000

Advertising expense P12,000
b. Office supplies on hand 250

Office supplies expense 250
c. Insurance expense 350

Prepaid insurance 350
d. Factory supplies on hand 1,100

Factory supplies expense 1,100
e. Unexpired subscriptions 1,400

Subscriptions expense 1,400
28 x P1,800
36
f. Insurance expense 400

Prepaid insurance 400
4 x P3,600
36
Substantive Tests of Prepaid Expenses and Deferred Charges 13-3
g. Prepaid closing costs 11,400
Rent expense 11,400
9.5 x P12,000
10
h. Unexpired dues and subscriptions 800

Dues and subscriptions expense 800
8 x P1,200
12
i. Dues and subscriptions expense 360

Prepaid dues and subscriptions 360
j. Prepaid vacation expense 3,000

Vacation expense 3,000
13-8. Raven Construction Company
Requirement (1)
Raven Construction Company
Insurance Schedule
12-31-06
Premium
Policy Type of Peso Period Covered Total Chargeable to Expense Prepaid
No. Company Coverage Coverage From To Premium Prior to 2006 2006 12-31-06
0010 Atlas Fire - Bldgs. P100,000 8-1-05 8-1-08 P 1,872 P 260 P 624.00 P 988.00
0020 Clara Fire - Bldgs. 150,000 2-1-06 2-1-09 2,736 - 836.00 1,900.00
0030 Pioneer Fire - Office 100,000 3-1-05 3-1-07 720 300 360.00 60.00
0040 Fortune Product Liability 100,000 7-1-04 7-1-08 768 288 192.00 288.00
0050 Mayon Fire and Theft-Inventory 65,000 8-1-06 8-1-09 360 - 50.00 310.00
0060 Matino Medical-Officers 100,000 6-1-05 6-1-07 1,200 350 600.00 250.00
0070 Matalino Delivery Equipment 50,000 11-1-06 11-1-07 240 - 40.00 200.00
0080 Maganda Blanket Position Bond 30,000 2-1-05 2-1-07 480 220 240.00 20.00
0090 Malinis Construction 100,000 4-1-06 4-1-07 195 - 146.25 48.75
0100 Mabuti Personnel 75,000 5-1-05 5-1-09 2,160 360 540.00 1,260.00
0110 Malayan Officer’s Life 50,000 9-1-06 9-1-07 120 - 40.00 80.00
0120 AFLA Officer’s Life 50,000 9-1-06 9-1-07 120 - 40.00 80.00
P10,971 P1,778 P3,708.25 P5,484.75
Requirement (2) Adjusting Journal Entry:
Insurance expense P 3,708.25

Retained earnings 1,778.00
Prepaid insurance P 5,486.25
Substantive Tests of Prepaid Expenses and Deferred Charges 13-5
13-9. Queen Company
Requirement (a)
Queen Company
Insurance Schedule
12.31.06
Policy Insurance Period Covered Amount of Total Prepaid
No. Company Coverage From To Coverage Premium Prior to 2006 2006 12.31.06
101 Pioneer Fire and extended, factory building 7/1/05 7/1/08 P 50,000 P 648 P 108 P 216 P 324
102 Pioneer Fire and extended, factory building 8/16/06 8/16/09 150,000 1,728 - 216 1,512
103 Commonwealth Fire and extended, office building 2/1/02 2/1/07 25,000 300 235 60 5
104 Malayan Fire and extended, office building 10/1/03 10/1/08 27,000 480 216 96 168
105 AFISCO Fire, merchandise 5/1/06 5/1/07 10,000 444 - 296 148
106 Domestic Comprehensive delivery equipment 8/1/06 8/1/07 15,000 240 - 100 140
107 Philam Liability, delivery equipment 8/1/06 8/1/07 50,000 360 - 150 210
100,000
108 Filipinas Inside theft and burglary 11/1/06 11/1/09 20,000 450 - 25 425
109 Bankers Employee fidelity 3/1/06 3/1/09 30,000 900 - 250 650
110 Fortune Workmen’s Compensation 9/1/06 9/1/07 Payroll total 500 - 205 295
at P0.25 per
P100
Total P 6,050 P 559 P1,614 P 3,877
Requirement (b)
Prepaid insurance 3,877
Insurance expense 3,008
To set up prepaid insurance as of 12.31.06
and to correct insurance expense for 2006
and prior years’ profits.
CHAPTER
14 LIABILITIES
14-1. a. Accounts receivable – the auditor’s objective is to test the existence of

accounts receivable.
Accounts payable – the auditor’s objective is to test the completeness of
accounts payable.
b. Accounts receivable – In selecting accounts for confirmation, auditors focus

on a variety of characteristics, including
 high-volume vendors.
 high-value accounts.
 accounts significantly smaller than in a previous period.
 small or zero-balance accounts.
Accounts payable – In selecting accounts for confirmation, auditors focus on

large, small, or dormant accounts and on vendors the client starts using
around year end.
c. Basic information included on the confirmation requests is the same for

accounts receivable and for accounts payable.
d. Procedures for mailing are substantially the same for accounts receivable and
for accounts payable.
e. For accounts receivable, an auditor examines documentary evidence that

indicates the customer was shipped goods and ultimately paid for them. For
accounts payable, if the objective of the confirmation process is to test the
existence of a payable and the vendor does not respond, the auditor should
attempt to verify existence of the liability by performing tests such as
examining the purchase order, the receiving report, and the vendor’s invoice
for the transaction. If the objective is to test completeness, the auditor should
reconcile accounts payable or reconcile to subsequent payments.
14-2. a. The auditor should perform the following procedures:

 Trace balance per confirmation request to confirmation of the supplier /
creditor.
 Trace balance per general ledger to subsidiary ledger.
 Trace payments made to cash payments journal and paid checks.
 For invoices not received at December 31, 2006, determine invoice date.
 For goods shipped FOB destination, examine invoice to determine terms.

 For goods shipped FOB shipping point, examine shipping document.
 Ask client to explain unlocated differences, and then follow up to
determine that the client’s explanation was valid.
b. For accounts not confirmed, the auditor should substantiate that a shipment
was received by examining the receiving report, the invoice copy, and
subsequent payment if possible.
c. The accounts payable clerk should not routinely perform the reconciliation of
monthly statements to the listing of accounts or vouchers payable. Whether
the accounts payable clerk or another employee performs the activity, the
auditor must substantiate the validity of the explanations.
14-3. a. The accounts payable audit procedures should be directed toward searching
for proper inclusion of all accounts payable (completeness) and ascertaining
that recorded amounts are reasonably stated (valuation), because the primary
audit purpose is to reveal any possible material understatements. The
principal objectives of the accounts payable examination are
 to determine the adequacy of internal control for processing and payment
of invoices.
 to prove that amounts shown on the balance sheet are in agreement with
supporting accounting records.
 to determine that liabilities existing at the balance sheet date have been
recorded.
b. Tan is not required to use accounts payable confirmation procedures. Unlike

accounts receivable, accounts payable require no opinions as to valuation.
The auditor is required to obtain direct confirmation of accounts receivable,
since the primary audit test is for possible material overstatements and the
client usually has available only internal documents, such as sales invoices.
For accounts payable, the auditor can examine external evidence, such as
vendor invoices and vendor statements that substantiates the accounts payable
balance. Although not required, accounts payable confirmation procedures
are often used. The auditor might consider using them when
 internal controls are weak.
 the company is in a tight cash position, and bill paying is slow.
 physical inventories exceed general ledger inventory balances by
significant amounts.
 certain vendors do not send statements.
 vendor accounts are pledged by assets.
 vendor accounts include unusual transactions.
Substantive Tests of Liabilities 14-3
c. A selection technique using the large peso balances of accounts is generally
used when the primary audit objective is to test for overstatements (e.g.,
accounts receivable audit work). Accounts with zero balances or relatively
small balances would not be subjected to selection under such an approach.
When auditing accounts payable, the auditor is primarily concerned with the
possibility of unrecorded payables or understatement of recorded payables.
Selection of accounts with relatively small or zero balances for confirmation
is the more efficient direction of testing since understatements are more likely
to be detected when examining such accounts. When selecting accounts
payable for confirmation, the following procedures could be followed:
 Analyze the accounts payable population and stratify it into accounts
with large balances, accounts with small balances, and accounts with
zero balances.
 Use a sampling technique that selects items based on criteria other than
the peso amount of the items (e.g., select based on terminal digits, select
every nth item based on predetermined interval, etc.).
 Design a statistical sampling plan that will place more emphasis on
selecting accounts with zero balances or relatively small balances,
particularly when the client has had substantial transactions with such
vendors during the year.
 Select prior-year vendors that are no longer used.
 Select new vendors used in the subsequent period.
 Select vendor that do not provide periodic statements.
 Select accounts reflecting unusual transactions during the year.
 Select accounts secured by pledged assets.
14-4. a. The fact that the client made a journal entry to record vendors’ invoices that
were received late should simplify the CPA’s test for unrecorded liabilities
and reduce the possibility of the need for a further adjustment, but the CPA’s
test is nevertheless required. Clients normally are expected to make
necessary adjustments to their books so that the CPA can examine statements
that the client believes are complete and correct. If the client has not
journalized late invoices, the CPA is compelled to substantiate what
ultimately will be recorded as an adjusting entry. In this examination, the
CPA should test entries in the 2004 voucher register to ascertain that all items
that – according to dates of receiving reports or vendors’ invoices – were
applicable to 2006 have been included in the journal entry recorded by the
client.
b. No. The CPA should obtain a letter in which responsible executives of the
client’s organization represent that to the best of their knowledge all liabilities
have been recognized. However, this is done as a normal audit procedure to
afford additional assurance to the CPA; it does not eliminate the need to
perform his or her own tests.
c. Whenever a CPA is justified in relying on work done by an internal auditor,

he or she should curtail (but not eliminate) his or her own audit work. In this
case, the CPA should have ascertained early in the examination that Oracle’s
internal auditor is qualified by being both technically competent and
reasonably independent. Once satisfied on these points, the CPA should
discuss the nature and scope of the internal audit program with the internal
auditor and should review the working papers so that the CPA may properly
coordinate his or her own program with that of the internal auditor. If the
Oracle internal auditor is qualified and has made tests for unrecorded
liabilities, the CPA can perform only a brief test in this audit area.
d. Work done by an auditor for a government agency will normally have no

effect on the scope of the CPA’s audit, since the concern of the government
auditors is usually limited to matters unrelated to the financial statements.
Nevertheless, the CPA should discuss the government auditor’s work
program with her since there are isolated situations where specific procedures
followed to a satisfactory conclusion by a government auditor will furnish the
CPA with added assurance and therefore permit certain work in a particular
area to be curtailed. However, government auditors are usually primarily
interested in substantiating as valid and allowable those costs that a company
has allocated against specific government contracts or sales to the
government; consequently, there is little likelihood that the auditor for a
government agency would check for unrecorded liabilities at Oracle.
e. In addition to the 2007 voucher register, the CPA should consider the
following sources for possible unrecorded liabilities:
 Unentered vendors’ invoice file
 Tax returns for prior years, the status of which is still open
 Discussions with employees
 Representations from management
 Comparison of account balances with preceding-year balances
 Examination of individual accounts during the audit
 Existing contracts and agreements
 Minutes of meetings
 Attorneys’ bills and letters of representation
 Status of renegotiable business
 Correspondence with principal suppliers
 Audit testing of cutoff date for reciprocal accounts (e.g., inventory, fixed
assets)
14-5. d
14-6. b
14-7. a
14-8. d (P900,000 + P50,000 + P25,000)
14-9. Pelagio Corporation
Computation of Bonus and Income Tax
(a) Bonus = 10% x P90,000

= P9,000
Income Tax = 30% (P90,000 – P9,000)
= P24,300
(b) Bonus:
B = 10% (P90,000 – B)
Income Tax:
T = 30% (P90,000 – B)
Computation:
B = P9,000 – 0.10 B; B = P9,000 = P8,181.82
1.1
T = P27,000 – 0.3 B
T = P27,000 – 0.3 (P8,181.82)
T = P24,545.45
(c) Let B = Bonus; Let T = Income Tax

B = 0.10 (P90,000 – T)
T = 0.30 (P90,000 – B) Proof: Income Tax
NI bef B & T P90,000.00
B = P6,495 Less: B 6,495.00
T = P25,051.50 P83,505.00
Tax rate x 30%
Tax P25,051.50
(d) B = 0.10 (P90,000 – B – T)

T = 0.30 (P90,000 – B) Proof: Bonus
NI bef B & T P90,000.00
B = P5,888 Less: B ( 5,888.00)
T = P25,234 T (25,234.00)
Balance P58,878.00
x 10%
P 5,887.80
14-10. Broadwall Corporation
a. Esteva should apply the following procedures:

1. Send standard bank confirmation
a. Direct liabilities
b. Security agreements
2. Examine notes for terms, provisions, etc.
3. Review board meeting minutes
a. Authority for transactions
b. Dividends declared
4. Determine compliance with bank loan provisions
5. Consider effects of president’s loans on debt/equity
6. Investigate business purpose of loan
7. Trace loan proceeds to cash receipts records
8. Trace interest and principal payments to cash disbursements records
9. Recompute and verify interest expense and accrual computations
10. Consider balance sheet presentation/disclosure
a. Current/noncurrent portions
b. Assets pledged as collateral
c. Related party
11. Obtain management representation letter
b. Broadwall’s financial statements should include the following related party

disclosures:
1. Nature of party’s relationship
2. Description of the transaction
3. Peso volume of the loans
4. Amounts due to president and terms of settlement.
14-11. Bem, Inc.
Item No. AJE
1 None
2 Insurance expense 9,167
3 None
4 None
5 None
6 Prepaid dues and subscriptions 500
Dues and subscriptions expense 500
7 None
Item No. AJE
8 None
9 Accounts payable 8,400
Inventory 8,400
10 Legal and professional fees 4,600
Accrued legal and professional fees 4,600
11 Medical expenses 2,500
Accrued medical expenses 2,500
12 Inventory 5,500
13 None (adjustment already made by client)
14 None
16 None
17 None
19 Machinery and equipment 25,400
Accounts payable - others 25,400
14-12. AFC Manufacturing
Requirement (a)
It is essential to coordinate the cutoff tests with the physical observation of

inventory. If the cutoff is inconsistent with the physical inventory there can be
significant errors in the income statement and the balance sheet. For example,
assume an inventory acquisition for P40,000 is received late in the afternoon of
December 31, after the physical inventory is completed. If the acquisition is
included in accounts payable and purchases but excluded from inventory, the
result is an understatement of net earnings of P40,000. On the other hand, if the
acquisition is excluded from both inventory and accounts payable, there is an error
in the balance sheet, but the income statement is correct.
Requirement (b)
Adjusting Entry
Receiving Description of Debit Credit
Report # Error(s) Account Amount Account Amount
2631 None
2632 Received prior to Inventory 3,709.16 Accounts 3,709.16
year end and not payable
recorded
2633 Included in accounts Inventory 5,182.31 Purchases 5,182.31
payable and not
inventory
2634 Received prior to Inventory 6,403.00 Accounts 6,403.00
recorded
2635 Included in accounts Inventory 8,484.91 Purchases 8,484.91
payable and not
inventory
2636 None
2637 Title passed prior to Inventory 7,515.50 Accounts 7,515.50
recorded
2638 None
Requirement (c)
Typically errors which have an effect on earnings are most important because of
the importance of earnings to users of financial statements. Receiving report
numbers 2633 and 2635 affect earnings. In addition, these errors are more
important because they represent the recording of part of the entry. If they are not
adjusted, the inventory balance the following year will be understated by
P13,667.22 (P5,182.31 + P8,484.91). For the other three items (receiving report
numbers 2632, 2634 and 2637), the error is less important because they would be
recorded the following year and the account balances would then be proper.
14-13. Cute People, Inc.
Requirement (a)
Current Liability Section of the Balance Sheet for Cute People, Inc.
Current liabilities
Notes payable P 600,000
Accounts payable to trade creditors 325,000
Accrued salaries and wages 145,000
Payroll taxes and deductions withheld
(P15,000 + P30,000 + P3,000) 48,000
Other taxes payable (P100,000 + P185,000) 285,000
Estimated warranty payables (P55,000 + P145,000 - P130,000) 70,000
Cash dividends payable (2,500,000 x P0.40) 1,000,000
Accrued interest [(P4,000,000 x .07 x 1/4) + P90,000] 160,000
Miscellaneous accruals 50,000
Total current liabilities P2,933,000
Requirement (b)
The following items of information were not used in preparing the current liability
section of the balance sheet:
1. Bonds payable were not included among current liabilities, because they
mature in 2010. Interest accrued on these bonds, however, for the period
January 1 - March 31, 2006 (P4,000,000 x 7% x 1/4 year = P70,000) is
included.
2. Notes payable due after March 31, 2007, totaling P2,400,000, were excluded
because they are not due within the next year.
3. The par and market values of the ordinary shares are not used. These items
would be needed to record the stock dividend, but have no impact on current
liabilities.
14-14. Pine, Inc.
Requirement (a)
The following additional information is needed to determine the proper lease
classification as financing or operating:
1. The fair value of the building space as of the date on which the lease
agreement was signed.
2. The initial lease term and whether a bargain purchase or renewal option is
available at the end of the term.
3. The estimated useful life of the property.
4. Whether the quarterly lease payments include provision for executory costs
(insurance, taxes, etc.)
5. Whether the residual value is guaranteed by Pine
Requirement (b)
The following auditing procedures should be applied in gathering the information
meeting the requirements set forth in (a) above:
1. Examine the lease agreement for details surrounding the initial lease term,
payment of executory costs, and the existence of purchase or renewal options.
2. Examine appraisal reports and property tax bills for an indication of fair value
at date of lease.
3. Inquire of management or confirm with lessor as to the estimated useful life
of the property.
Requirement (c)
Pine, Inc.
Obligation under Capital Leases, 2006 
December 31, 2006
1/1/06: Liability as calculated:

NPV of P150,000 per period for 40 periods
at 3% per period (ordinary annuity) P3,467,215 C
4/1/06: Payment:
Interest (3% x P3,467,215) = P104,016
Principal (P150,000 - P104,016) (45,984) C
7/1/06: Payment:
Interest [3% x (P3,467,215 - P45,985)] = P102,637
Principal (P150,000 - P102,637) (47,363) C
9/1/06: Payment:
Interest [3% x (P3,467, 215 - P45,984 - P47,363)]
= P101,216
Principal (P150,000 - P101,216) (48,784) C
12/31/06: Principal balance
P3,325,084
F
Requirement (d)
Audit adjustments:
(1)
Lease Property 3,467,215
Obligation under Capital Lease 3,325,084
Rent Expense 450,000 T
To capitalize financing lease and
reverse rental charges erroneously
recognized as expense.
(2)
To record depreciation on leased
assets, assuming straight-line
depreciation and full year policy
concerning depreciation in the year
of acquisition.
(3)
Interest Payable 99,753
3% of P3,325,084 (4th quarter interest)
AUDIT LEGENDS:  Examined lease agreement C Calculated

T Traced to general ledger F Footed
14-15. Roehl Wholesale Foods, Inc.
a. See Exhibit A.1.
b. This is a capital lease inasmuch as the present value of the minimum lease
payments exceeds 90% of the fair value of the property at the date of lease
signing.
c. In auditing the Belle lease, the student should identify the following
objectives:
1) Determine that the warehouse exists and that the transaction was
completed in 2006.
2) Establish proper classification of the lease as to capital or operating.
3) Verify proper recording of the lease.
4) Ascertain validity of the quarterly payments and determine that they have
been correctly classified as to interest expense and principal reduction.
5) Determine proper authorization of the lease transaction.
6) Verify terms of the lease, i.e., initial lease term, explicit interest rate,
quarterly lease payments and dates of payment, responsibility for
executory costs, and absence of contingent rentals.
d. See Exhibit B.1.

Exhibit A.1.
Belle Warehouse Lease

Amortization Schedule
December 31, 2006
(1) (2) (3) (4)

Obligations Lease
Interest under Long-term Liability-
Expense-debit Lease-debit balance
Period Cash-credit [2% x (4)] [(1) – (2)] [(4) – (3)]
1/2/06 P4,185,388 C
1/2/06 P150,000 P150,000 P4,035,388
4/1/06 P150,000 P80,708 P69,292 P3,966,096
7/2/06 P150,000 P79,322 P70,678 P3,895,418
10/1/06 P150,000 P77,908 P72,092 P3,823,326
1/2/07 P150,000 P76,467 P73,533 P3,749,793
4/1/07 P150,000 P74,996 P75,004 P3,674,789
7/1/07 P150,000 P73,496 P76,504 P3,598,285
10/1/07 P150,000 P71,966 P78,034 P3,520,251
1/2/08 P150,000 P70,405 P79,595 P3,440,656
4/1/08 P150,000 P68,813 P81,187 P3,359,469
7/1/08 P150,000 P67,189 P82,811 P3,276,658
10/1/08 P150,000 P65,533 P84,467 P3,192,191
1/2/09 P150,000 P63,844 P86,156 P3,106,035
C Calculated as follows:
Net present value of an annuity due of P150,000
per period for 40 periods at 2% equals P4,185,388.
Exhibit B.1.
ROEHL WHOLESALE FOODS, INC.

Belle Warehouse
Obligation Under Long-Term Lease
December 31, 2006
Lease Lease
Obligation Obligation Interest Interest
Date Description Cash-credit debit balance Expense Payable
1/2/06 Belle warehouse

lease P4,185,388 E &
1/2/06 Initial payment P150,000 @ P150,000 C P4,035,388
4/1/06 Payment P150,000 @ P 69,292 C P3,966,096 P 80,708 C
7/1/06 Payment P150,000 @ P 70,678 C P3,895,418 P 79,322 C
10/1/06 Payment P150,000 @ P 72,092 C P3,823,326 P 77,908 C
12/31/06 Accrual P 0 ------------- --------------- P 76,467 C P76,476
12/31/06 Audited Balances P3,823,326 P314,405 P76,467
To WP P To WP R To WP R
12/31/06 Balance per Ledger P3,585,388 P 0 P 0
AJE 1 P 237,938 P314,405 P76,467
12/31/06 Balance per Audit - as above P3,823,326 P314,405 P76,467
AJE 1
Interest payable 76,467
Obligation under long-term lease 237,938
To adjust obligation for interest not
recognized in lease payments.
@ Examined canceled check.

E Examine lease agreement and Lease Terms:
recalculated net present value Term: 10 years with no purchase
of minimum lease payments. or renewal option.
Also inspected warehouse. Payments: P150,000 per quarter
payable in advance.
^ Determined that this is a capital Executory costs assumed by lessee.
lease. NPV of lease payments Interest rate: 8 percent per annum.
equals P4,185,388, the fair Market value of warehouse:
value of the warehouse at date P4,185,388.
of lease. Date of lease: January 2, 2006
C Calculated. Date of first payment: January 2,
& Examined directors’ minutes to 2006
establish proper authorization
of lease transaction.
14-16. Franda Company
1. This loss contingency is accrued at the end of 2006 because (a) it is an

existing condition, (b) a loss is probable, and (c) the loss can be reasonably
estimated. The loss is accrued at the most likely amount (P70,000) within the
range of amounts as follows:
2006
Dec. 31 Estimated Loss from Litigation 70,000
Estimated Liability from Pending
Lawsuit 70,000

estimated. The loss is accrued at the estimated cost of repairs (P200,000) as
follows:
2006
Dec. 31 Estimated Expense from Recall Repairs 200,000
Estimated Liability for Recall Repairs 200,000
The potential lawsuits for injury claims are disclosed in a note to the financial
statements because there is a reasonable possibility that a loss may have been
incurred.

estimated. The loss is accrued at the minimum amount of the range (P40,000)
because it is not likely that the loss will be less, as follows:
2006
Dec. 31 Estimated Loss from Pollution Fine 40,000
Estimated Liability from Pollution Fine 40,000
4. Because of conservatism, this gain contingency is not accrued but is disclosed

in the notes to the financial statements.
14-17.
# Assets Liabilities Owners’ Equity Net Income

1 I I NE NE
2 NE NE NE NE
3 NE I D D
4 I I NE NE
# Assets Liabilities Owners’ Equity Net Income
5 NE I D D
6 I I I I
7 D I D D
8 NE I D D
9 NE I D D
10 I I NE NE
11 NE I D D
12 NE I D D
13 NE I D D
14 D D NE NE
15 I I I I
16 D NE D D
17 NE D I I
18 NE I D D
14-18. Boogie Corporation
Reacquisition price (P900,000 X 101%) P909,000

Less: Net carrying amount of bonds redeemed:
Par value P900,000
Unamortized discount (13,500)
Unamortized bond issue costs (7,200) 879,300
Loss on redemption P 29,700
Calculation of unamortized discount—
Original amount of discount:
P900,000 X 3% = P27,000
P27,000/10 = P2,700 amortization per year
Amount of discount unamortized:
P2,700 X 5 = P13,500
Calculation of unamortized issue costs—
Original amount of costs:
P24,000 X P900,000/P1,500,000 = P14,400
P14,400/10 = P1,440 amortization per year
Amount of costs unamortized:
P1,440 X 5 = P7,200
January 2, 2006
Bonds Payable ................................................................................................
900,000
Loss on Redemption of Bonds ................................................................
29,700
Unamortized Bond Issue Cost................................ 7,200
Discount on Bonds Payable ................................ 13,500
Cash ................................................................................................ 909,000
14-19. Stargazer Company
Reacquisition price (P300,000 X 104%) ................................ P312,000

Less: Net carrying amount of bonds redeemed:
Par value................................................................P300,000
Unamortized discount ................................................................
(10,000) 290,000
Loss on redemption ................................................................ P 22,000
Bonds Payable ................................................................................................

300,000
Loss on Redemption of Bonds ................................................................
22,000
Discount on Bonds Payable ................................ 10,000
Cash ................................................................................................ 312,000
(To record redemption of bonds
payable)
Cash................................................................................................
306,000
Unamortized Bond Issue Costs ................................................................ 3,000
Premium on Bonds Payable ................................ 9,000
Bonds Payable................................................................ 300,000
(To record issuance of new bonds)
14-20. Miguel Company
Requirement (a)
Transfer of property on December 31, 2006:
Miguel Company (Debtor):

Note Payable ................................................................200,000
Interest Payable................................................................
18,000
Accumulated Depreciation—Machine................................ 221,000
Machine................................................................ 390,000
Gain on Disposition of Machine ................................ 21,000a
Gain on Debt Restructuring ................................ 28,000b
a
P190,000 – (P390,000 – P221,000) = P21,000.
b
(P200,000 + P18,000) – P190,000 = P28,000.
Prime National Bank (Creditor):
Machine ................................................................................................
190,000
Allowance for Doubtful Accounts ................................ 28,000
Note Receivable ................................................................ 200,000
Interest Receivable................................................................ 18,000
Requirement (b)
“Gain on Machine Disposition” and the “Gain on Debt Restructuring” should be
reported as an ordinary gain in the income statement.
Requirement (c)
Granting of equity interest on December 31, 2006:
Miguel Company (Debtor):
Note Payable ................................................................ 200,000
Interest Payable................................................................ 18,000
Ordinary Shares................................................................ 150,000
Additional Paid-in Capital................................................................
40,000
Gain on Debt Restructuring ................................................................
28,000
Prime National Bank (Creditor):

Investment (Trading)................................................................
190,000
Allowance for Doubtful Accounts ................................ 28,000
Note Receivable ................................................................ 200,000
Interest Receivable................................................................ 18,000
14-21. Grease Products Company
Requirement (a)
Depot ................................................................................................
600,000
Cash................................................................................................ 600,000
Depot ................................................................................................
41,879
Asset Retirement Obligation ................................ 41,879
Requirement (b)
Depreciation Expense ................................................................ 60,000
Accumulated Depreciation ................................................................
60,000
Depreciation Expense ................................................................4,187.90
Accumulated Depreciation ................................................................
4,187.90*
Interest Expense................................................................ 2,512.74
Asset Retirement Obligation ................................ 2,512.74**
*P41,879/10.
**P41,879 X .06.
Requirement (c)
Asset Retirement Obligation................................ 75,000
Loss on ARO Settlement ................................................................5,000
Cash................................................................................................ 80,000
14-22. Johnny B. Good Corporation
December 31
1. No adjustment necessary
2. Interest Expense (P36,000 X 12% X 9/12) 3,240

Interest Payable 3,240
3. Interest Expense (P12,000 X 8/12) 8,000

Discount on Notes Payable 8,000
4. No adjustment necessary
CHAPTER
15 OWNERS’ EQUITY ACCOUNTS
15-1. (a) Procedures applicable to the existence or occurrence of shareholders’ equity

balances are: (1) review authorizations and terms of share issues, (2) confirm
shares outstanding with registrar and transfer agent, (3) inspect share
certificate book, and (4) inspect certificates of shares held in treasury.
(b) Procedures applicable to rights and obligations are (1) make inquiries of legal
counsel, and (2) review articles of incorporation and by-laws.
15-2. In vouching dividend entries, the auditor should (a) establish that preferential or
other rights of shareholders and any restrictions on dividend distributions have
been recognized, (b) establish the number of shares outstanding on the date of
record and verify the accuracy of the total dividend declaration by recalculation,
(c) ascertain the propriety of the entry to record the declaration, and (d) trace
dividend payments to canceled checks and other documentation.
15-3. The procedures consist of: (a) review minutes of board of directors’ meetings and
(b) compare statement presentation with GAAP.
15-4. Earla Company
a. (1) Certificates may have been surrendered in exchange for others without
attaching the surrendered certificates to the stub book.
(2) The excess certificates may have been issued under proper authority for
services or for property and not recorded in the financial books.
(3) They may have been issued improperly in exchange for cash, services or
property, or without consideration. The impropriety might result from
oversight or from fraudulent design.
(4) The error may have occurred because an item which should have been
posted to the share capital account was not in fact so posted.
(5) An error may have occurred in entering the number of shares issued on
the certificate stub.
(6) Additional shares may have been issued near the end of 2006 but the cash
received was not recorded until 2007.
b. (1) Make a quick inspection of open stubs to determine whether they provide
a ready clue to the reason for difference, e.g., one certificate issued for
10,000 shares. If so, investigate the facts regarding its issue.
(2) If a quick inspection fails to provide a clue, refer to a list of shareholders
supporting the entries in the cash receipts book for the 72,000 shares
originally sold. Check this list item by item against stubs for shares
originally issued and mark the stubs so checked. Then check returned
certificates attached to stubs against new stubs issued in exchange for
those certificates, marking the new stubs. Prepare a list of unmarked
stubs. This should total 10,000 shares and serve to identify the
outstanding certificates with respect to which shares are not recorded in
the general ledger.
(3) If errors are found in the number of shares issued, as shown by stubs in
the share certificate book after comparison with the cash receipts entries,
it may be necessary to circularize the original shareholders to determine
how many shares were actually issued.
The cash receipts book and general journal for the first few days of
2007 should be examined for entries which may be for shares issued late
in 2006.
(4) If it is found that excess shares have been issued, inquiry should be made
of responsible officers with respect to the circumstances in which they
were issued. The answers obtained should be substantiated by
appropriate evidence, e.g., resolutions of the board, etc.
15-5. The proposal for the limitation of procedure is not justified by the stated facts.
Although the transfer agent and the registrar know the number of shares issued,
they do not necessarily know the number of shares outstanding. Furthermore, the
audit of share capital includes more than determining the number of shares
outstanding. For example, the auditor must determine what authorizations exist
for the issuance of shares, what assets were received in payment of shares, how
the transactions were recorded, and what subscription contracts have been entered
into. Confirmation from the registrar could not help in determining these things.
In addition to confirmation from the registrar, the audit of share capital might
include the following procedures for which the purposes are briefly indicated:
(1) Examine the corporation charter to determine the number of shares authorized
and the special provisions relating to each class of shares if more than one
class is authorized.
(2) Examine minutes of shareholders’ and directors’ meetings to determine
authorization for appointments of the registrar and the transfer agent, and to
determine authorization for the issuance or reacquisition of shares.
(3) Examine provisions relating to share capital in the corporation law of the state
of incorporation to determine any special provisions such as, for example,
those relating to the issuance of no-par shares.
Substantive Tests of Owners’ Equity Accounts 15-3
(4) Analyze the share capital accounts to obtain an orderly picture of share
transactions for use as a guide to other auditing procedures and as a
permanent record.
(5) Trace the consideration received for share capital into the records to
determine what consideration has been received and how it has been
recorded.
(6) Examine and schedule treasury shares and review entries for treasury shares
to determine the existence of treasury shares, as authorized, and to determine
that a proper record has been made.
(7) Review registrar’s invoices and cash disbursements to determine that original
issue taxes have been paid.
(8) Compare dividends with shares outstanding at dividend dates to determine
that dividends have been properly paid and also to substantiate the shares
outstanding.
(9) Review subscription and option contracts, etc., to determine the facts in
regard to subscriptions and options and to determine that these facts have
been properly recorded and that they are adequately disclosed.
15-6. Talisay Corporation
Based on the limited data made available in the problem, the Balance Sheet is
presented as follows:
Talisay Corporation
Balance Sheet
December 31, 2006
Assets
Current assets (including share subscriptions receivable) P 34,000
Noncurrent assets
Land 9,000
Other fixed assets (net of accumulated depreciation of
P16,000) 40,000
Total assets P 83,000
Liabilities and Shareholders’ Equity

Current liabilities P 20,000
Long-term liabilities 8,000
Total liabilities P 28,000
Shareholders’ equity
10% Preference shares (P10 par value; 1,000 shares
authorized, issued, and outstanding) P 10,000
Ordinary shares (P2 par value; 4,500 shares authorized,
4,000 shares issued, and 3,250 outstanding) 8,000
a
Ordinary shares subscribed (500 shares) 1,000
Paid-in capital in excess of par (preference) 2,000

Paid-in capital in excess of par (ordinary) 20,250 b
Donated capital 9,000
Retained earnings 19,750 c
Less: Treasury shares (750 shares at cost) (15,000) d
Total liabilities and shareholders’ equity P 83,000
_____________________
a
500 shares x P2 par value = P1,000
b
Amount on issued ordinary shares
[P18,000 - (4,000 x P2)] P10,000
Amount on subscribed ordinary shares
[P10,000 - (500 x P2)] 9,000
P19,000
Sale of treasury shares (250 x P25) P 6,250
Cost of treasury shares sold (250 x P20) ( 5,000) 1,250
P20,250
c
P20,000 - P1,250 (improper gain) + P1,000 (improper loss) P19,750
d
P15,000 total cost  P20 cost per share = 750 shares
15-7. Hope, Inc.
Hope, Inc.
P2 Cumulative redeemable preference shares (P15 par value;

500,000 shares authorized; 8,000 shares issued and
outstanding) P 120,0000
Ordinary shares (P10 par value; 1,000,000 shares authorized,
114,500 shares issued, 110,000 shares outstanding) 1,145,000
Ordinary shares subscribed, 10,000 shares 100,000
Paid-in capital in excess of par (ordinary) 217,500
Discount on preference shares (20,000)
Treasury shares (4,500 shares at cost) (121,500)
P2,112,000
(a)
Preference Shares Schedule
# of Shares Amount
Balance 9/30/06 4,000 P 60,000
Shares issued to purchase land 8,000 120,000
Shares redeemed (4,000) (60,000)
Balance 9/30/07 8,000 P120,000
(b)
Ordinary Shares Schedule
# of Shares Amount
Balance 9/30/06 110,000 P1,100,000
T. Santos 4,500 45,000
Balance 9/30/07 114,500 P1,145,000
(c)
Paid-in Capital Schedule
Amount
Balance 9/30/06 -0-
Sale to T. Santos [4,500 x (P25 - P10)] P 67,500
Subscription by K. Reyes [10,000 x (25 - P10)] 150,000
P217,500
(d)
Retained Earnings Schedule
Amount
Balance 9/30/06 P622,000
Net income 250,000
Preference shares redemption [4,000 x (P18 - ( 12,000)
P15)]
Cash dividend – ordinary (110,000 x P1.50) (165,000)
Cash dividend – preference (12,000 x P2) ( 24,000)
P671,000
15-8. Baguio Company
Baguio Company
December 31, 2007
Ordinary shares (15 par value; 100,000 shares authorized,
and outstanding) P1,500,000
Paid-in capital in excess of par 2,425,000 *
Retained earnings (from Dec. 31, 2007) -0-
______________________
* Original balance P1,750,000
Reduction of par value of ordinary shares (P10 x 100,000) 1,000,000
Additional contribution 600,000
Elimination of deficit (925,000) **
Paid-in capital in excess of par P2,425,000
** Original deficit P750,000
Loss on revaluation of plant assets 175,000
Deficit to be eliminated P925,000
15-9. Parañaque Company
Retained Earnings before adjustments P 131,000

(a) Premium on share capital credited
to retained earnings (P 15,000)
(b) Gain on sale of treasury shares
incorrectly charged ( 10,000)
(c) Appraisal increase of land incorrectly
credited to Retained Earnings ( 30,000)
Total adjustments P( 55,000)
Retained Earnings after adjustments P 76,000
Answer: a
15-10. 1) c 3) c 5) d 7) c 9) b
2) b 4) a 6) a 8) b 10) d
15-11. A4 Corporation
Requirement (1) Part a
1. The legal capital is P417,000 (P210,000 + P207,000).

2. The average issuance price of the preference share is P109 per share
[(P210,000 + P18,900)  2,100 shares].
3. The number of ordinary shares issued is 9,000 shares (P207,000  P23).
Requirement (2) Part b
A4 Corporation
Contributed Capital Section of the Balance Sheet
December 31, 2006
Contributed Capital
8% Preference shares, P100 par (6,000 shares authorized,
2,550 shares issued and outstanding) P255,000
Ordinary shares, no par 24,000 shares authorized, 10,800
shares issued and outstanding) 266,050 *
Premium on preference shares 27,850 
Additional paid-in capital from share subscription default 100
Additional paid-in capital from treasury shares 1,000
Total contributed capital P550,000
* P207,000 + P29,700 + P13,600 + P15,750 = P266,050
 P18,900 + P8,800 – P1,100 + P1,250 = P27,850
The above schedule is supported by the following entries for the transactions that
occurred in 2006:
2006
Mar. 2 Cash (P10 x 400) 4,000
Subscriptions Receivable (P112 x 400) 44,800
Preference Shares Subscribed (P100 x 400) 40,000
Premium on Preference Shares 8,800
Apr. 3 Cash (P33 x 900) 29,700

Ordinary Shares, no par (900 shares) 29,700
13 Land (P34 x 400) 13,600

Ordinary Shares, no par (400 shares) 13,600
May 1 Cash (P112 x 350) 39,200

Preference Shares Subscribed (P100 x 350) 35,000
Subscriptions Receivable 39,200
Preference Shares, P100 par 35,000
4 Preference Shares Subscribed (50 x P100) 5,000

Premium on Preference Shares (50 x P22) 1,100
Subscriptions Receivable (50 x P112) 5,600
Cash (50 x 0.8 x P10) 400
Additional Paid-in Capital from Share
Subscriptions Default 100
June 1 Treasury Shares – Ordinary 18,500

Cash (500 x P37) 18,500
Oct. 19 Cash 27,000

Ordinary Shares, no par (500 shares) 15,750*
Preference Shares, P100 par 10,000
Premium on Preference Shares 1,250
500 x P35
* Ordinary shares: P27,000 x (500 x P35) + (100 x P125) = P15,750
100 x P125
Preference shares: P27,000 x = P11,250
(500 x P35) + (100 x P125)
P27,000
Nov.16 Cash (P39 x 500) 19,500

Treasury Shares 18,500
Additional Paid-in Capital from
Treasury Shares 1,000
Dec.31 Retained Earnings 21,600*

Cash 21,600
* Ordinary dividends: (9,000 + 900 + 400 + 500) x P2 = P21,600
31 Retained Earnings 20,400*

Cash 20,400
* Preferred dividends: (2,100 + 350 + 100) x

(0.08 x P100) = P20,400
15-12. Partner Corporation
Partner Corporation
December 31, 2006
Share capital
Preference shares, P4 cumulative, par value P50 per share;
authorized 50,000 shares, issued and outstanding 10,000
shares P 500,000
Ordinary shares, par value P1 per share; authorized 500,000
shares, issued 150,000 shares, and outstanding 140,000
shares 150,000
Total share capital P 650,000
Additional paid-in capital – ordinary
In excess of par value 1,560,000
From sale of treasury shares 250,000
Total paid-in capital P2,460,000
Accumulated other comprehensive income (loss)
Unrealized decrease in value of available for sale securities (25,000)
Total paid-in capital, retained earnings, and accumulated other
comprehensive income (loss) P2,666,000
Less: Treasury shares, 10,000 shares at cost (180,000)
Total shareholders’ equity P2,486,000
15-13. Del-V Company
Requirement (1)
Del-V Company
Retained earnings, as previously reported,

January 1, 2006 P206,000
Less: Correction of overstatement of previous
net income (net of P5,400 income tax credit) (12,600)
Adjusted retained earnings, January 1, 2006 P193,400
P251,400
Less: Cash dividends P 9,000
Share dividends 6,000
Reduction due to retirement of preference 40,000 (55,000)
shares
Retained earnings, December 31, 2006 (See Note A) P196,400
Requirement (2)
Note A: Retained earnings are restricted in the amount of P14,000, the cost of the
ordinary shares being held as treasury shares.
15-14. RICY Corporation
Requirement (1)
a. Write-down of property and equipment

Retained Earnings (P80,000 – P45,000) 35,000
b. Write-down of inventories
Current Assets (inventories) 6,000
c. Write-down of accounts receivable

Current Assets (accounts receivable) 3,000
d. Change in par value of ordinary shares

Additional Paid-in Capital on
Ordinary Shares 90,000
e. Elimination of retained earnings deficit

Additional Paid-in Capital on
Ordinary Shares 114,000
Retained Earnings * 114,000
* P114,000 = P70,000 deficit + P35,000 + P6,000 + P3,000
Requirement (2)
RICY Corporation
Balance Sheet
December 31, 2006
Current assets P 11,000

Property and equipment 110,000
Less: Accumulated depreciation (65,000)
Total assets P 56,000
Liabilities P 30,000
Ordinary shares, P1 par 10,000
Additional paid-in capital on ordinary shares 16,000
Retained earnings (see Note A) 0
Total liabilities and shareholders’ equity P 56,000
Notes to Financial Statements
Note A: Retained earnings as of December 31, 2006 has a zero balance due to a
quasi-reorganization on that date. At that time, net assets were revalued, the par
value of ordinary share was reduced from P10 to P1 per share, and a P114,000
deficit was charged against additional paid-in capital.
15-16. JTC Company
Requirement (1)
Preference Ordinary
a. Preferred dividend (2,000 x 0.10 x P100) P20,000
Remainder to ordinary (P80,000 – P20,000) P60,000
Total P20,000 P60,000
b. Dividends in arrears (2 x 2,000 x 0.10 x P100) P40,000
Current preferred dividend (2,000 x 0.10 x P100) 20,000
Remainder to ordinary (P80,000 – P60,000) 20,000
Total P60,000 P20,000
c. Dividends in arrears (1 x 2,000 x 0.10 x P100) P20,000

Current preferred dividends 20,000
Ordinary proportional share (0.10 x 30,000 x P10) P30,000
Remainder shared * (P80,000 – P70,000) 4,000 6,000
Total P44,000 P36,000
2,000 x P100
* Preference: P10,000 extra dividend x = P4,000
(2,000 x P100) + (30,000 x P10)
P300,000
* Ordinary: P10,000 extra dividend x = P6,000
P500,000
d. Preference dividend P20,000

Ordinary proportional share (0.10 x 30,000 x P10) P30,000
Preference extra (0.05 x P200,000) 10,000
Ordinary extra (0.05 x P300,000) 15,000
Remainder to ordinary (P80,000 – P75,000) 5,000
P30,000 P50,000
Requirement (2)
Dividends per share
Dividend yield =
Market price per share
P20,000 / 2,000 P10

Preference share: = = 8%
P125 P125
P60,000 / 30,000 P2
Ordinary share: = = 10%
P20 P20
15-16. Empire Plastics
Rate of return on ordinary share equity:
P213,718 P213,718
= = 17.1%
P875,000 + P375,000 P1,250,000
P135,000
Rate of interest paid on bonds payable: = 13.5%
P1,000,000
Emporia Plastics, Inc. is trading on the equity successfully, since its return on
ordinary share equity is greater than interest paid on bonds.
15-17. MLA Corporation
MLA Corporation
SHAREHOLDERS’ EQUITY
December 31, 2007
Paid-in Capital:
Preference shares, P100 par value
10,000 shares authorized, 4,000 shares P400,000
issued & outstanding
Ordinary shares, P50 par value

15,000 shares authorized,
8,000 shares issued 7,700 shares
outstanding 400,000 P 800,000
Additional Paid-in Capital:

Paid-in capital in excess of par—
preference 52,000
Paid-in capital in excess of par—
ordinary 61,000
Paid-in capital from treasury shares—
preference 4,700 117,700
Total Paid-in Capital 917,700
Retained Earnings: 235,400*

1,153,100
Less cost of treasury shares

(300 shares—ordinary) 19,800
*P610,000 – P312,600 – (P62 X 1,000 shares)
15-18. Odyssey, Inc.
(a) Basic formulas:
Value of bonds without warrants

Value of bonds without warrants + X Issue price = Value assigned to bonds
Value of warrants
Value of warrants
Value of bonds without warrants + X Issue price = Value assigned to
Value of warrants warrants
P136,000
P136,000 + P24,000 X P152,000 = P129,200 Value assigned to bonds
P24,000 22,800 Value assigned to warrants

P136,000 + P24,000 X P152,000 = P152,000 Total
Cash...................................................................... 152,000
Discount on Bonds Payable.................................. 40,800
(P170,000 – P129,200)
Bonds Payable........................................ 170,000
Paid-in Capital—Share Warrants ........... 22,800
(b) When the warrants are non-detachable, separate recognition is not given to
the warrants. The accounting treatment parallels that given convertible debt
because the debt and equity element cannot be separated.
The entry if warrants were non-detachable is:
Cash...................................................................... 152,000
Discount on Bonds Payable.................................. 18,000
Bonds Payable............................................... 170,000
15-19. Simmy Corporation
Requirement (a)
Net income for year P9,500,000

Add: Adjustment for interest (net of tax) 234,000*
P9,734,000
* Maturity value P5,000,000

Stated rate X 7%
Cash interest 350,000
Discount amortization [(1.00 – .98) X P5,000,000 X 1/10] 10,000
1 – tax rate (35%) X 0.65
After-tax interest P 234,000
P5,000,000/P1,000 = 5,000 debentures

Increase in diluted earnings per share denominator:

5,000
X 18
90,000
Earnings per share:

Basic EPS P9,500,000 ÷ 2,000,000 = P4.75
Diluted EPS P9,734,000 ÷ 2,090,000 = P4.66
Requirement (b)
If the convertible security were preference shares, basic EPS would be the same
assuming there were no preference dividends declared or the preference was
noncumulative. For diluted EPS, the numerator would be the net income amount
and the denominator would be 2,090,000.
CHAPTER
16 INCOME STATEMENT ACCOUNTS
16-1. a
16-2. d
16-3. Red Company
Requirement (1)
2006 2005
Reported net income P 35,000 P 27,000
Subtract ending inventory overstatement (2,000) (5,000)
Add beginning inventory overstatement 5,000
Subtract wages payable when incurred (800) (700)
Add wages payable when expensed 700
Subtract bad debts (400)* (1,300)
Add back prepayments in year recorded as expense 200 500
Subtract prepayments in year expense is incurred (500)
Correct net income P 37,200 P 20,500
* P1,700 – P1,300
Requirement (2)
2007
Jan. 1 Retained Earnings 4,300
Insurance Expense 200
Inventory 2,000
Wages Expense 800
16-4. Orange Corporation
Requirement (1)
(1) Allowance for Uncollectible Accounts 17,400

Administrative Expenses (37,000 – 19,600) 17,400
To reflect reduction in loss experience
rate.
(2) Unrealized Holding Loss on Trading Marketable
Securities 19,000
Valuation Allowance 16,000
To reduce marketable securities to
market valuation and correct prior
year’s profit.
Cost of Sales 2,100
Merchandise Inventory 6,100
To adjust for overstatements in opening
and closing inventories.
(4) a. Equipment 12,000
Operating Expenses 1,100
Accumulated Depreciation: Equipment 2,200
To adjust for error in recording of
equipment purchase in 2005 and
related depreciation for 2005 and
2006.
b. Accumulated Depreciation: Equipment 17,500
Equipment 15,000
Other Income 2,500
To adjust for misposting of
equipment sale.
(5) Prepaid Expenses 900
Operating Expenses 900
To adjust for nonrecognition of prepaid
expense in 2005 and 2006.
(6) Ordinary Shares 60,000
Capital in Excess of Par 60,000
To adjust for capital contributed in
excess of par value.
Substantive Tests of Income Statement Accounts 16-3
Requirement (2)
Orange Corporation
Computation of Corrected Net Income
For Years Ended December 31, 2006 and 2005
2006 2005
Debit (Credit) Debit (Credit)
Reported income P(220,000) P(195,000)
Change in accounts receivable loss
experience rate (17,400) ---
Unrealized loss (gain) on marketable securities 19,000 (3,000)
Ending merchandise inventories overstated:
December 31, 2005 (4,000) 4,000
December 31, 2006 6,100
Misposting of equipment purchase:
Decrease in operating expenses – 2005 (10,900)
Increase in operating expenses – 2006 1,100
Misposting of proceeds of equipment sold (2,500)
Recognition of prepaid insurance 900 (1,800)
Corrected net income P(216,800) P(206,700)
16-5. XOR Corporation
XOR Corporation
Worksheet to Correct Net Profit and Balance Sheet Accounts
From 2004 to 2006
Net Profit Adjustments to Balance Sheet Accounts
Retained Prepaid Prepaid Accrued Accrued
2004 2005 2006 Inventory Earnings Expenses Income Expenses Income
Unadjusted balance P 7,500 P 6,500 P 5,500 P25,000 P27,000    

(1) Overvaluation of inventory
2004 (7,000) 7,000
2005 (8,000) 8,000
(2) Undervaluation of inventory
2003 (6,000)
2006 9,000 9,000 9,000
(3) Prepaid expenses omitted at
end of year
2003 (900)
2004 700 (700)
2005 500 (500)
2006 600 600 600
(4) Prepaid income omitted at
end of year
2004 (400) 400
2006 (300) (300) 300
(5) Accrued expenses omitted at
end of year
2003 200
2004 ( 75) 75
2005 (100) 100
2006 ( 50) ( 50) 50
(6) Accrued income omitted at
end of year
2004 125 (125)
2006 150 150 150
        
Adjusted amount P(5,850) P 5,550 P22,500 P34,000 P36,400 P 600 P 300 P 50 P 150
Substantive Tests of Income Statement Accounts 16-5
16-6. Sun Freight Company
1. a P107,700 (P112,500 – P4,800)

2. c P376,800
3. c P159,000 (P204,000 – P45,000)
4. a P320,550
5. a P25,000
6. c P125,000
7. a P68,600
8. d P179,650
9. a P703,250
10. a P144,250 (P9,500 + P25,000 + P16,250 + P18,250 + P75,250)
CHAPTER
17 COMPLETING THE AUDIT
17-1. a. (3) b. (1) c. (4) d. (3)
17-2. a. (4) b. (3) c. (1) d. (4)
17-3. a. (3) b. (1) c. (1) d. (2) e. (1)
17-4. Tracy Brewing Company
a. 4 - The amount appeared collectible at the end of the field work.

b. 1 - The uncollectible amount was determined before end of field work.
c. 3 - Amount should have been determined to be uncollectible before end of
field work, but it was discovered after the issuance of the statements. The
financial statements should have been known to be in error on 8-20-06.
d. 2 - The cause of the bankruptcy took place after the balance sheet date,
therefore the balance sheet was fairly stated. Account may be written off as
uncollectible at 6-30-06, but they are not required to do so. Footnote
disclosure is necessary because the subsequent event is material.
e. 2 - The sale took place after the balance sheet date but, since the loss was
material and will affect future profits, footnote disclosure is necessary.
f. 2 - The lawsuit originated in the current year, but the amount of the loss is
unknown.
g. 1 - The settlement should be reflected in the 6-30-06 financial statements as
an adjustment of current period income and not a prior period adjustment.
h. 4 - The financial statements were believed to be fairly stated for 6-30-06 or 8-
19-06.
i. 2 - The cause of the lawsuit occurred before the balance sheet date and the
lawsuit should be included in the 6-30-06 footnotes.
17-5. Flowmeter, Inc.
Item Required Disclosure

No. Audit Procedures and Reasons
1. Goods “in-transit” would be The receipt of the goods provides
detected in the course of the additional evidence with respect to
auditor’s review of the year-end conditions that existed at the date
“cutoff” of purchases. The auditor of the balance sheet and hence the
would examine receiving reports financial statements should be
and purchase invoices to make adjusted to take into account such
certain that the liability to suppliers additional information.
had been recorded for all goods
included in inventory, and that all
goods for which the client was
liable at year-end were recorded in
inventory.
2. Settlements of litigation would be The settlement of litigation would
revealed by requesting from the require an adjustment of the
company’s legal counsel a financial statements since the
description and evaluation of any events that gave rise to the
litigation, impending litigation, litigation had taken place prior to
claims, and contingent liabilities of the balance sheet date.
which he has knowledge that
existed at the date of the balance
sheet being reported upon, together
with a description and evaluation
up to the date the information is
furnished. A review of cash
disbursements for the period
between the balance sheet date and
completion of field work may also
reveal evidence of the settlement.
3. The purchase would normally be The purchase of a new business is
revealed in general conversations not an event that provides evidence
with the client and would further with respect to conditions existing
be detected by reading the minutes at the balance sheet date; hence, it
of meetings of stockholders, does not require adjustment in the
directors, and appropriate financial statements. However,
committees. In addition, because such an event would normally be
the amount paid is likely to be of such importance that disclosure
unusually large in relation to other of it is required to keep the
cash disbursements, a review of financial statements from being
cash disbursements for the period misleading. If the acquisition is
between the balance sheet date and significant enough, it might be
completion of field work is likely advisable to supplement the
to reveal such an extraordinary historical statements with pro
Completing the Audit 17-3
transaction. Moreover, because a forma statements indicating the
purchase of a business usually financial results if the two firms
requires a formal purchase had been consolidated for the year
agreement, the letter from the ending December 31, 2005.
firm’s legal counsel would Otherwise, disclosure in footnotes
probably have revealed the to the statements would be
purchase. adequate. Occasionally, a situation
of this type may have such a
material impact on the entity that
the auditor may wish to include in
his report an explanatory paragraph
directing the reader’s attention to
the event and its effect.
4. Inventory losses attributable to a Losses attributable to floods
flood would be brought to the subsequent to the balance sheet
auditor’s attention through date do not provide information
inquiries and discussions with with respect to conditions that
corporate officers and executives. existed at the balance sheet date;
Moreover, the auditor would know hence, it does not require an
the location of the plants and adjustment in the financial
warehouses of his client and upon statements. However, such an
becoming aware of any major incident may be of sufficient
floods in such a location, he would importance to require footnote
investigate to determine if his disclosure. Occasionally, a
client’s facilities had suffered any situation of this type may have
damage. such a material impact on the entity
that the auditor may wish to
include in his report an explanatory
paragraph directing the reader’s
attention to the event and its effect.
5. The sale of bonds or other Sales of bonds or capital stock are
securities would require a filing transactions of the type that do not
with the SEC in which the auditor provide information with respect to
would presumably be involved. In conditions that existed at the
addition, the sale would be balance sheet date; hence,
revealed by reading the minutes of adjustment of the financial
directors’ and finance committee’s statement is not required.
meetings, by corresponding with However, such sales may be of
the client’s attorneys and by sufficient importance to require
examining the cash receipts book footnote disclosure. Occasionally,
in the period subsequent to the a situation of this type may have
balance sheet date for evidence of such a material impact on the entity
unusually large receipts. that the auditor may wish to
include in his report an explanatory
paragraph directing the reader’s
attention to the event and its effect.
17-6. Olars Manufacturing Corporation
1. The government’s approval of a plan for the construction of an express

highway would have come to the CPA’s attention through his inquiries of
officers and key personnel, his examination of the minutes of the meetings of
the board of directors and stockholders, and his reading of local newspapers.
The details of the item would not have to be disclosed as a separate footnote
because all fixed assets of the corporation, including the right to the
condemnation award, were to be sold as of March 1, 2006 (see item 6).
2. It is improbable that the CPA would learn the source of the P25,000 unless it
were revealed in a discussion with the president or his personal accountant, or
unless the auditor prepared the president’s personal income tax return, in
which case the interest charges would have lead to his investigation of the use
to which the funds were put. Setting out the loan in the balance sheet as a
loan from an officer would be sufficient disclosure. The source from which
the officer obtained the funds would not be disclosed because it is the
officer’s personal business and has no effect upon the corporation’s financial
statements. Indeed, disclosure of the funds’ source might be construed as
detrimental to the officer.
3. The additional liability for the ore shipment would have been revealed to the
CPA in his scanning of January transactions. His regular examination of
2001 transactions and related documents such as purchase contracts would
have caused him to note the time for subsequent follow up to determine the
final liability. In addition the client’s letter of representation might have
mentioned the potential liability. The item would not require separate
disclosure by footnote or otherwise and would be handled by adjusting the
financial statement amounts for purchases, ending raw materials inventory,
and accounts payable by the amount of the additional charge, P9,064 {[(72 -
50) / 50] = 0.44; 0.44 x P20,600 = P9,064}.
4. The CPA might learn of the agreement to purchase the treasurer’s stock
ownership through his inquiries of management and legal counsel,
examination of the minutes of the meetings of the board of directors and
stockholders and subsequent reading of the agreement. The absence of the
treasurer might also arouse the CPA’s curiosity. The details of the agreement
would be disclosed in a footnote because the use of company cash for the
repurchase of stock and the change in the amount of stock held by
stockholders might have a heavy impact on subsequent years’ financial
statements. Usually, a management change, such as the treasurer’s
resignation, does not require disclosure in the financial statements. The
details underlying the separation (personal disagreements and divorce) should
not be disclosed because they are personal matters.
Completing the Audit 17-5
5. Through inquiries of management, review of financial statements for January,
scanning of transactions, and observations, the CPA would learn of the
reduced sales and of the strike. Disclosure would not be made in the financial
statements of these conditions because such disclosure might create doubt as
to the reasons therefore and misleading inferences might be drawn.
6. The contract with Lopez Industries would come to the CPA’s attention
through his inquiries of management and legal counsel, his reading of the
minutes of the meetings of the board of directors and stockholders, and his
examination of the contract. All important details of the contract should be
disclosed in a footnote because of the great effect upon the corporation’s
future. The factors contributing to the entry into the contract need not be
disclosed in statements; while they might be of interest to readers, they are by
no means essential to make the statements not misleading.
CHAPTER
PREPARATION OF AUDITED
18 FINANCIAL STATEMENTS
18-1. Salve Company
Requirement (1)
Salve Company
Schedule 1: Cost of Goods Sold
Inventory, 1/1/2006 P 37,800

Purchases P173,000
Transportation-in 13,500
Cost of purchases P186,500
Less: Purchases discounts taken P4,100
Purchases returns and allowances 6,200 (10,300)
Net purchases 176,200
Cost of goods available for sale P214,000
Less: Inventory, 12/31/2006 (34,100)
Schedule 2: Selling Expenses
Sales commissions and salaries P 18,200

Sales supplies used 5,600
Delivery expense 7,700
Promotion and advertising expense 17,000
Total selling expenses P 48,500
Schedule 3: General and Administrative Expenses
Bad debt expense P 2,700

Office supplies expense 1,400
Insurance and property tax expense 8,500
Office and administrative salaries expense 32,000
Total general and administrative expenses P 44,600
Schedule 4: Depreciation Expense
Buildings and office equipment P 14,500

Sales equipment 9,600
Total depreciation expense P 24,100
Requirement (2)
Salve Company
Income Statement
Sales P340,700
Less: Sales discounts taken P 4,900
Sales returns and allowances 12,100 (17,000)
Net sales P323,700
Cost of goods sold (Schedule 1) (179,900)
Gross profit P143,800
Operating expenses
Selling expenses (Schedule 2) P48,500
General and administrative expenses (Schedule 3) 44,600
Depreciation expense (Schedule 4) 24,100
Total operating expenses (117,200)
Operating income P 26,600
Other items
Rent revenue P 6,900
Interest expense (3,700)
Loss on sale of office equipment (5,000)
Loss from flood (12,000) (13,800)
Pretax income from continuing operations P 12,800
Income tax expense (P7,440 – P3,600) (3,840)
Income from continuing operations P 8,960
Results from discontinued operations
Loss from operations of discontinued segment R
(net of P2,610 income tax credit) P(6,090)
Gain on disposal of segment R (net of P3,000
income taxes) 7,000 910
Net income P 9,870
Earnings per Ordinary Share

Components of Income (8,000 ordinary shares)
Income from continuing operations P1.12
Results from discontinued operations 0.11
Net income P1.23
Preparation of Audited Financial Statements 18-3
Note: Due to recently increased obsolescence, the sales equipment is being
depreciated over a shorter useful life. The related P9,600 depreciation expense for
2006 is P2,500 more than the amount that would have been reported using the
original useful life. This caused a decrease in 2006 income from continuing
operations and net income of P1,750 (after taxes) and a decrease in earnings per
share of P0.22.
Requirement (3)
Salve Company
Retained earnings, 1/1/2006 P183,700

Less: Prior period adjustment, correction of
understatement of 2005 depreciation expense (net
of P3,300 income tax credit) (7,700)
Adjusted retained earnings, 1/1/2006 P176,000
P185,870
Less: Cash dividends (P0.60 per share) (4,800)
18-2. Mindanao Manufacturing Company
Requirement (1)
Mindanao Manufacturing Company

Schedule 1: Cost of Goods Sold
Raw materials used P 70,200

Direct labor 81,000
Factory overhead:
Factory superintendence salaries expense P25,000
Factory maintenance expense 7,000
Factory utilities expense 21,000
Factory indirect labor expense 23,000
Depreciation expense: factory 18,000 94,000
Current manufacturing costs P245,200
Add: Goods in process, 1/1/200 19,900
Less: Goods in process, 12/31/2006 (22,000)
Cost of goods manufactured P243,100
Add: Finished goods inventory, 1/1/2006 32,000
Cost of goods available for sale P275,100
Less: Finished goods inventory, 12/31/2006 (36,000)
Schedule 2: Selling Expenses

Sales salaries expense P 27,400
Delivery expenses 11,700
Sales personnel travel expenses 8,300
Depreciation expense: sales equipment 9,000
Advertising expense 15,700
Total selling expenses P 72,100
Schedule 3: General and Administrative Expenses

Depreciation expense: buildings and office equipment P 14,400
Office and administrative salaries 30,000
Property taxes and insurance expense 9,000
Miscellaneous administrative expense 3,000
Total general and administrative expenses P 56,400
Requirement (2)
Income Statement
Sales P472,100
Less: Sales returns (5,000)
Net sales P467,100
Cost of goods sold (Schedule 1) (239,100)
Gross profit P228,000
Operating expenses
Selling expenses (Schedule 2) P72,100
General and administrative expenses (Schedule 3) 56,400
Other items
Interest revenue P 3,200
Miscellaneous rent revenue 5,900
Loss on sale of factory equipment (4,100)
Loss from expropriation (27,000) (22,000)
Pretax income from continuing operations P 77,500
Income tax expense (P31,350 – P9,000) (22,350)
Income from continuing operations P 55,150
Loss from operations of discontinued segment E
(net of P4,800 income tax credit) P(11,200)
Gain on disposal of segment E (net of P12,600
income taxes) 29,400 18,200
Net income P 73,350
Earnings per Ordinary Share
Components of Income (20,000 ordinary shares)
Income from continuing operations P2.71
Results from discontinued operations 0.91
Net income P3.62
Requirement (3)


Less: Prior period adjustment, correction of
understated depreciation expense of 2005 (net of
P3,030 income tax credit) (7,700)
Adjusted retained earnings, 1/1/2005 P190,730
P264,080
Less: Cash dividends (P1.20 per share) (24,000)
Requirement (4)
Return on shareholders’ equity = Net income

Average shareholders’ equity
= P73,350
P500,000
= 14.67%
Mindanao Manufacturing Company’s return on shareholders’ equity for 2006 of

14.67% was below its target of 15%.
18-3.
1. Income statement; disclose as Other Items. Although the earthquake is
unusual in nature in this area and it is of infrequent occurrence, PAS 1 does
not allow presentation of extraordinary gain or loss in the Income Statement.
2. Income statement; disclose as Other Items. Same rationale as in (1).
3. Income statement; include in current depletion expense because it is a change

in accounting estimate. Disclose effect of change on net income and earnings
per share in a note.
4. Income statement; disclose as part of Other Items. Same reason as in (1).
5. Income statement; disclose as Other Items. Same reason as in (1).
6. Income statement; disclose as part of Other Items. Same reason as in (1).
7. Retained earnings statement; as a cumulative effect on prior years’ income of

a change in accounting principle.
8. Note; disclosure of the change in depreciation method may be made.
9. Income statement; disclose as part of Other Items.
10. Income statement; disclose in Results from Discontinued Operations. Since

the segment constitutes a major line of business and is distinguishable from
the remainder of the business, the gain (as well as the operating profit or loss)
is shown separately in Results from Discontinued Operations.
11. Statement of retained earnings; since it is a correction of last year’s income, it

should be disclosed as a prior period adjustment.
12. Income statement; disclose as Other Items.

18-4. Tigger Company
Tigger Company
Comparative Statements of Income
For the Year Ended December 31
2006 2005
a b
Sales P 2,900,000 P 3,900,000
c d
Cost of goods sold (980,000) (2,310,000)
Gross profit P 1,920,000 P 1,590,000
e f
Operating expenses (970,000) (1,390,000)
Operating income P 950,000 P 200,000
Other items:
Loss from obsolete inventory (150,000)
Casualty loss (60,000)
Gain on early retirement of bonds 250,000
g h
Miscellaneous (50,000) (90,000)
Pretax income from continuing
operations P 750,000 P 300,000
Income tax expense (30%) (225,000) (90,000)
Income from continuous operations P 525,000 P 210,000
Income (loss) from operations of
discontinued segment (net of
P90,000 income tax credit in
2006 and P90,000 income taxes
in 2005) (210,000) i 210,000 j
Net income P 315,000 P 420,000
a
P3,500,000 – P400,000 – P200,000
b
P4,600,000 – P700,000
c
P1,600,000 – P320,000 – P300,000
d
P2,600,000 – P290,000
e
P1,300,000 – P180,000 – P100,000
f
P1,500,000 – P110,000
g
P(200,000) + P150,000 (disclosed in same section but as a separate line item)
h
P100,000 + P60,000 – P250,000
i
(P600,000 – P620,000 – P280,000) x 70%
j
(P700,000 – P290,000 – P110,000) x 70%
Note: The properties of the discontinued segment should be reclassified as

Noncurrent Assets Held for Sale and valued at the lower of carrying value and fair
value less selling costs. Since the Expected Selling Price as of March 21, 2007 far
exceeds the carrying value, there is no indication that the company will incur loss
in write-down of assets of discontinued segment.
18-5. Inee Company
Requirement (1)
Inee Company
Income Statement
Sales revenues (net) P200,000

Cost of goods sold (121,120)
Gross profit P 78,880
Operating expenses
Selling expenses P26,000
Administrative expenses 16,000
Other items
Interest revenue P 1,000
Loss due to flood (5,000) (8,880)
Pretax income before extraordinary item P 21,000
Income tax expense (6,300)
Net income P 14,700
Earnings per share (5,000 ordinary shares) P2.94

Requirement (2)
Inee Company
Working Paper for Segment Reporting
(not required)
All Operating Segments Segment

1 2 Remaining Totals Unallocated Totals
Total revenues (sales) P 98,000 P60,000 P42,000 P200,000 P 0 P200,000
Operating expenses
Cost of goods sold P 60,760 P36,000 P24,360 P121,120 P 0 P121,120
Sales salaries 3,000 2,000 1,000 6,000 0 6,000
Sales commissions 1,960 1,200 840 4,000 0 4,000
Delivery costs 3,000 1,500 500 5,000 0 5,000
Advertising expense 4,600 3,200 1,500 9,300 1,200 10,500
Misc. selling expenses 0 0 0 0 500 500
Bad debts expense 980 600 420 2,000 0 2,000
Administrative salaries 4,000 2,300 1,600 7,900 2,100 10,000
Property taxes 560 490 350 1,400 1,600 3,000
Misc. administrative
expenses 0 0 0 0 1,000 1,000
Depreciation expense 2,240 1,680 1,680 5,600 1,400 7,000
Total operating
expenses P 81,100 P48,970 P32,250 P162,320 P 7,800 P170,120
Segment profit / operating
income P 16,900 P11,030 P 9,750 P 37,680 P(7,800) P 29,880
Segments assets P138,000 P84,000 P54,000 P276,000 P24,000 P300,000
Inee Company
Industry Segment Financial Results
Reportable Operating Segments All Other Total

1 2 Segments Results
Segment revenues (sales) P 98,000 P 60,000 P 42,000 P200,000
Segment profit (pretax) P 16,900 P 11,030 P 9,750 P 37,680
General corporate expenses (7,800)
Interest revenue 1,000
Loss due to flood (5,000)
P 21,000
Identifiable assets at
December 31, 2006 P138,000 P 84,000 P 54,000 P276,000
General corporate assets 24,000
Total assets at
December 31, 2006 P300,000
Requirement (3)
Segment profit is total revenue less operating expenses. In computing segment

profit, none of the following items has been added or deducted: general corporate
expenses, interest revenue, interest expense, income taxes, or the flood loss
(relating to the company’s operations in Division 1).
Depreciation for Divisions 1 and 2 was P2,240 and P1,680, respectively. Capital
expenditures amounted to P25,000 in Division 1 and P6,000 in Division 2 during
2006 and are included in the total assets on December 31, 2006.
18-6. Lawin Company
Lawin Company
Balance Sheet
December 31, 2006
Assets
Current Assets
Cash P 190,000
Temporary investments in
marketable securities 280,000
Less: Allowance for doubtful
accounts (80,000) 510,000
Inventory 600,000
Prepaid items:
Insurance P120,000
Office supplies 80,000 200,000
Total current assets P1,780,000
Long-term Investments
Investment in held-to-maturity bonds 1,030,000
Plant and Equipment
Land P 810,000
Buildings and equipment P3,560,000
Less: Accumulated depreciation (920,000) 2,640,000
Total plant and equipment 3,450,000
Intangible Assets
Patents (net) 470,000
Liabilities
Current Liabilities
Accounts payable P1,020,000
Salaries payable 150,000
Taxes payable 250,000
Unearned rent 90,000
Total current liabilities P1,510,000
Long-Term Liabilities
Bonds payable (due 2012) P1,100,000
Less: Discount on bonds payable (100,000)
Total long-term liabilities 1,000,000
Contributed Capital
Ordinary shares, P10 par P1,200,000
Premium on ordinary shares 930,000
Total contributed capital P2,130,000
Retained Earnings 2,420,000
Total contributed capital and retained
earnings P4,550,000
Less: Treasury shares (at cost) (330,000)
18-7. Blue Manufacturing Company
Blue Manufacturing Company

Balance Sheet
December 31, 2006
Assets
Current Assets
Cash P 6,100
Marketable securities (short-term) 8,400
Less: Allowance for doubtful
accounts (1,000) 14,300
Inventory 6,000
Raw materials P10,100
Goods in process 14,700
Finished goods 23,800 48,600
Total current assets P 80,000
Long-term Investments
Bond sinking fund P 7,700
Investment in available-for-sale shares 16,400
Total long-term investments 24,100
Plant and Equipment

Land P17,000
Buildings P92,500
Machinery and equipment P57,800
Total property, plant and
equipment 104,900
Intangible Assets
Patents (net) 8,600
Total Assets P217,600
Liabilities
Current Liabilities
Notes payable P 4,900
Interest payable 500
Wages payable 2,700
Dividends payable 5,600
Unearned rent 5,000
Total current liabilities P 48,500
Bonds payable (due 2020) P28,000
Less: Discount on bonds payable (2,500) P 25,500
Accrued pension cost 13,300
Total long-term liabilities 38,800
Other Liabilities
Deferred taxes payable 2,800
Total Liabilities P 90,100
Contributed Capital
Preference shares, P100 par P 30,000
Premium on preference shares 7,000
Total contributed capital P 97,400
Accumulated Other Comprehensive
Income
Unrealized increase in value of
available-for-sale shares 2,000
Total Shareholders’ Equity P127,500
Total Liabilities and Shareholders’ Equity P217,600
Additional parenthetical or note disclosures which might be made include:
1. Inventory costing and valuation method(s) for raw materials, goods in
process, and finished goods.
2. Valuation method for marketable securities and investment in shares.
3. Number of preference and common shares authorized and issued.
4. Pension plan information.
5. Bond indenture provisions, including sinking fund information.
Working capital = Current assets – Current liabilities
P31,500 = P80,000 – P48,500
Current ratio = Current assets  Current liabilities
1.65 = P80,000  P48,500
18-8. Nick Company

Nick Company
Balance Sheet
December 31, 2006
Assets
Current Assets
Cash P 3,800
Temporary investments in
available-for-sale securities 4,600
Less: Allowance for doubtful accounts (700) 17,800
Inventory 30,500
Noncurrent Investments
Notes receivable (due 2013) P 10,000
Investment in Day Company bonds 9,000
Sinking fund for bond retirement 7,000
Total long-term investments 26,000
Property, Plant and Equipment
Land P 12,000
Buildings P63,400
Equipment P29,600
equipment 71,000
Intangible Assets
Patents (net) P 5,900
Trademarks (net) 3,700
Total intangible assets 9,600
Liabilities
Current Liabilities
Wages payable 4,100
Current portion of mortgage payable 4,000
Mortgage payable P 16,000
Bonds payable (due 2017) P40,000
Add: Premium on bonds payable 4,300 44,300
Contributed Capital
Premium on preference shares 2,400
Total contributed capital P 34,100
Income
Unrealized increase in value of
available-for-sale securities 1,100
Total contributed capital, retained
earnings and accumulated other
comprehensive income P 73,000
Less: Treasury shares (at cost) (1,800)
Total Shareholders’ Equity P 71,200
18-9. Hera Manufacturing Corporation
Hera Manufacturing Company

Balance Sheet
December 31, 2006
Assets
Current Assets
Cash P 109,000 a
b
Accounts receivable (net) 317,700
Inventories 560,000
c, j
Long-term Investment, at market value 47,000
Property, Plant, and Equipment at cost
Land P 200,000 d
Buildings P1,750,000
Machinery and equipment 1,964,000
Total P3,714,000
Less: Accumulated depreciation (420,000) 3,294,000
equipment 3,494,000
Intangible Asset
Goodwill 37,000
Other Assets
Cash restricted for building
purposes P 100,000 a
Officer’s note receivable 1 30,000 b
Land held for future building site 250,000 d 380,000


Current Liabilities
Accounts payable P 119,800 e
Current installments of long-term

debt 200,000 f, g
Lawsuit liability 80,000

h
Deferred tax liability 5,000
Long-Term Debt
f
Mortgage payable P 800,000
Note payable 400,000 g
Deferred tax liability 23,000

Total long-term debt 1,223,000
Ordinary shares, authorized
100,000 shares of P50 par
value; issued 40,000 shares;
i
outstanding 39,800 shares P2,000,000
i
Total paid-in capital P2,231,000
Loss
Unrealized decrease in value of
long-term investment (4,300) j

Total P3,302,100
Less: Cost of treasury shares (6,400) c
Total Shareholders’ Equity 3,295,700

1 Alternatively, this could be reported under Long-Term Investments
Explanation of Amounts
a Cash, per unaudited balance sheet P225,000
Less: Unrecorded checks in payment of accounts
payable (14,000)
NSF check not recorded (2,000)
Cash restricted for building purposes
(reported in other assets) (100,000)
Corrected balance P109,000
b
Accounts receivable (net), per unaudited balance sheet P345,700
Add charge-back for NSF check [see (a)] 2,000
Less: Officer’s note receivable (reported in other
assets) (30,000)
c
Investments, per unaudited balance sheet P 57,700
Less: Long-term investment [reported separately,
see (j)] (51,300)
Treasury shares (reported in shareholders’
equity) (6,400)
Corrected balance P 0
d
Land, per unaudited balance sheet P450,000
Less: Land acquired for future building site
(reported in other assets) (250,000)
e Accounts payable, per unaudited balance sheet P133,800
Less: Unrecorded payments [see (a)] (14,000)
f Mortgage payable, per unaudited balance sheet P900,000
Less: Current portion (P50,000 x 2) (100,000)
Refinanced as long-term mortgage payable P800,000
g
Note payable, per unaudited balance sheet P500,000
Less: Current portion (100,000)
Long-term note payable P400,000
h
Income taxes payable, per unaudited balance sheet P 61,200
Less: Prepaid income taxes (40,000)
Corrected balance P 21,200
i Ordinary shares, per unaudited balance sheet P2,231,000
Less: Additional paid-in capital in excess of par value (231,000)
Corrected balance P2,000,000
j Long-term investment, at cost [see (c)] P 51,300
Less: Unrealized decrease in value (4,300)
Long-term investment, at market value P 47,000
18-10. Kiko Company
Kiko Company
Balance Sheet
December 31, 2006
Assets
Current Assets
a
Cash P 2,900
b
Accounts receivable (net) 5,000
c
Inventory 4,200
Total current assets P12,100
d
Land P 6,800
e
Buildings and equipment P 82,800
f
equipment 73,600
Liabilities
Current Liabilities
g
h
Salaries payable 1,500
Bonds payable P 6,000
i
Less: Discount on bonds payable (300)
Total Liabilities P10,200
Contributed Capital
j
Ordinary shares, P5 par P16,500
k
Total contributed capital P29,200
l
Total Shareholders’ Equity P75,500
a
Last item on statement of cash flows
b
P5,000 = P3,900 + P1,100
c
P4,200 = P4,700 – P500
d
P6,800 = P9,800 – P3,000 sold
e
P82,800 = P68,900 + P13,900 purchased
f
P16,000 = P14,100 + P1,900 annual depreciation
g
P3,000 = P4,000 – P1,000
h
P1,500 = P1,100 + P400
i
P300 = P6,000 face value – P5,700 issue price
j
P16,500 = P13,500 + P3,000 issued
k
P12,700 = P11,200 + P1,500 in excess
l
P46,300 = P44,400 + P5,000 net income – P3,100 dividends
18-11. Lifer Company
Lifer Company
Balance Sheet
December 31, 2006
Assets
Current Assets
Cash P 1,200
Inventories 10,890
Prepaid items 1,420
Land P 13,600
Buildings P103,000
Equipment 18,100 P121,100
Less: Accumulated
depreciation (32,520) 88,580
Total property, plant and equipment 102,180
Patents (net) 5,500
Liabilities
Current Liabilities
Miscellaneous payable 1,400
10% bonds payable P15,000
Less: Discount on bonds payable (900) P14,100
Mortgage payable 20,000

Premium on preference shares 2,300 P23,300
Ordinary shares, P10 par P17,500
Premium on ordinary shares 14,300 31,800
Total Shareholders’ Equity 80,300
Supporting calculations (for Balance Sheet):
Balance Balance
Account 1/1/06 Calculations 12/31/06
Cash P 1,900 Decreased (P700) from 1/1/06 P 1,200
Accounts
receivable 5,100 Decreased (P1,100) from 1/1/06 4,000
Inventories 13,900 Decreased (P3,010) from 1/106 10,890
Prepaid items 1,300 Increased P120 from 1/1/06 1,420
Land 12,000 Received for land P(2,800)
Add loss on sale (400)
Cost of land sold P(3,200)
Land purchased by shares 4,800
Net change in land P 1,600 13,600
Buildings 60,000 Purchase of building P43,000
* Note: Mortgage account
will be included under
long-term liabilities 103,000
Equipment 20,000 Cost of equipment sold P(1,900) 18,100
Accumulated Change in accumulated depreciation:
depreciation (29,000)
Cost of equipment sold P(1,900) Cr
Gain on sale of equipment (180) Cr
Proceeds from sale 500 Dr
Reduction in accumulated
depreciation P 1,580 Dr
Current depreciation (5,100) Cr
Increase in accumulated
depreciation P(3,520) Cr (32,520)
Patents (net) 7,100 Amount received for

patent P(2,100)
Less: Gain on sale 1,100
Carrying value sold P(1,000)
Add: Patents amortized (600)
Net decrease P(1,600) 5,500
Accounts payable 5,500 Decreased P(400) from 1/1/06 5,100
Income taxes
payable 4,100 Increased P190 from 1/1/06 4,290
Misc. payables 1,200 Increased P200 from 1/1/06 1,400
10% bonds payable 15,000 No change 15,000
Discount on bonds
payable (1,000) Amortization P100 (900)
Mortgage payable 0 Incurred in purchase of building,
P20,000 20,000
Preference shares 17,000 Issued 40 shares for land
40 x P100 par = P4,000 21,000
Premium on Value from issuance for land P 4,800
preference 1,500 Less: Par value of issue (4,000)
shares Increase in premium P 800 2,300
Ordinary shares, Issue 150 shares @ P10 par = P1,500
P10 par 14,000 Share dividend 200 shares
@ P10 par = 2,000
Total increase P3,500 17,500
Premium on Value of shares issued
ordinary shares 11,200 for cash P3,000
Par value of shares issued (1,500)
Increase in premium P1,500
Value of share dividend
200 @ P18 P3,600
Par value of shares issued (2,000)
Increase in premium P1,600
Total increase:
P1,500 + P1,600 = P3,100 14,300
Retained earnings 23,800 Add: Net income P10,000
Less: Cash dividend (5,000)
Less: Share dividend (3,600)
Increase in retained earnings P 1,400 25,200
18-12. Harry Company
Requirement (1)
Harry Company
Worksheet for Statement of Cash Flows
12/3/1/05 Post-Closing 12/31/06 Adjusted
Trial Balance Trial Balance Change Worksheet Entries
Accounts Debit Credit Debit Credit Debit Credit Debit Credit
Cash 2,700 3,300 600 (s) 600
Accounts receivable 7,300 6,200 1,100 (i) 1,100
Inventory 8,100 9,900 1,800 (j) 1,800
Investment in bonds 10,000 18,600 8,600 (n) 8,600
Property and equipment 105,300 133,300 28,000 (o) 28,000
Accumulated depreciation 42,400 49,200 6,800 (h) 6,800
Accounts payable 8,100 8,500 400 (k) 400
Salaries payable 1,300 700 600 (l) 600
Interest payable 0 300 300 (m) 300
Notes payable 0 9,000 9,000 (p) 9,000
Ordinary shares, no par 43,600 58,100 14,500 (r) 14,500
Retained earnings 38,000 31,500 6,500 (q) 6,500
Sales 89,000 89,000 (a) 89,000
Cost of goods sold 48,800 48,800 (c) 48,800
Depreciation expense 6,800 6,800 (h) 6,800
Salaries expense 12,000 12,000 (d) 12,000
Other operating expenses 1,700 1,700 (f) 1,700
Interest revenue 1,200 1,200 (b) 1,200
Interest expense 900 900 (e) 900
Income tax expense 6,000 6,000 (g) 6,000
Totals 133,400 133,400 247,500 247,500 122,300 122,300 122,300 122,300
(Worksheet continued on next page)
18-12. Harry Company (continued. . . . .)
Requirement (1) continued . . . . .
Worksheet Entries
Debit Credit
Cash Flows From Operating Activities
Collections from customers (a) 89,000
(i) 1,100
Interest and dividends collected (b) 1,200
Other operating receipts --
Payments to suppliers (k) 400 (c) 48,800
(j) 1,800
Payments to employees (d) 12,000
(l) 600
Payments of interest (m) 300 (e) 900
Other operating payments (f) 1,700
Payments of income taxes (g) 6,000
Cash Flows From Investing Activities

Payment for purchase of investments (n) 8,600
Payment for purchase of building (o) 28,000
Cash Flows From Financing Activities

Proceeds from issuance of note payable (p) 9,000
Proceeds from issuance of ordinary shares (r) 14,500
Payment of dividends (q) 6,500
Net Increase in Cash (s) 600

Totals 115,500 115,500
18-12. Harry Company (continued. . . . .)
Requirement (2)
Harry Company
Statement of Cash Flows
Cash Flows From Operating Activities

Cash Inflows:
Collections from customers P 90,100
Interest collected 1,200
Cash inflows from operating activities P 91,300
Cash Outflows:
Payments to suppliers P(50,200)
Payments to employees (12,600)
Payments of interest (600)
Other operating payments (1,700)
Payments of income taxes (6,000)
Cash outflows from operating activities (71,100)
Net cash provided by operating activities P 20,200
Cash Flows From Investing Activities
Payment for purchase of investments P (8,600)
Payment for purchase of building (28,000)
Net cash used for investing activities (36,600)
Cash Flows From Financing Activities
Proceeds from issuance of note payable P 9,000
Proceeds from issuance of ordinary shares 14,500
Payment of dividends (6,500)
Net cash provided by financing activities 17,000
Net Increase in Cash P 600
Cash, January 1, 2006 2,700
Cash, December 31, 2006 P 3,300
18-13. Serene Company
Serene Company
Statement of Changes in Shareholders’ Equity
Additional Additional
Paid-in Paid-in Accumulated
Preference Ordinary Capital on Capital on Other
Shares Shares Preference Ordinary Retained Comprehensive Treasury
P100 par P10 par Shares Shares Earnings Income Shares Total
Balances, 1/1/06 P50,000 P100,000 P6,000 P130,000 P224,000 P510,000
Unrealized increase in
value of available-for-
sale securities P9,000 9,000
Ordinary shares issued 20,000 30,000 50,000
Preference shares issued 11,000 1,760 12,760
Ordinary shares P(10,400) (10,400)
reacquired
Net income 57,000 57,000
Cash dividend paid on
preference* (4,270) (4,270)
Cash dividend paid on
ordinary (14,500) (14,500)
Balances, 12/31/06 P61,000 P120,000 P7,760 P160,000 P262,230 P9,000 P(10,400) P609,590
* Preference dividend: P7 x (500 + 110 shares) = P4,270.
* Ordinary dividend: P1.25 x (10,000 + 2,000 – 400 treasury shares) = P14,500.

18-14. Circle Company
CIRCLE COMPANY
Schedule to Analyze Effects of Errors
Balance Sheet
Dec. 31, 2007
Income 2005 Income 2006 Income 2007 Amount
Explanation Debit Credit Debit Credit Debit Credit Debit Credit Account
1. Sales tax accrual omitted:
December 31, 2005 2,000a 2,000
December 31, 2006 5,000 5,000
December 31, 2007 9,000 9,000 Sales taxes payable
2. Accounts payable and inventory omitted: No correction because errors offset each other
3. Inventory recorded twice 4,000 4,000
4. Bad debtsb 5,000 1,000 2,200 8,200 Allowance for doubtful
accounts
5. Bond premium 1,200 1,200 12,000 9,600 Additional paid-in
capital, Bond premium
6. Travel advances 18,000 18,000
7. Salary accrual 10,000 11,000 10,000 7,000 11,000 7,000 Salaries payable
8. Cost misclassification 5,000c 25,000 5,000 5,000 15,000 Accumulated depreciation
a
The correct sales tax expense for 2005 is P12,000 (P200,000 x 6%). Since P10,000 was recorded in 2005, the correcting amount is
P2,000. However, this P2,000 would have been recorded by the company in 2006, so the total recorded sales tax expense of
P15,000 includes only P13,000 for sales made in 2006. Therefore the correct balance of P18,000 (P300,000 x 6%) is obtained by a
correcting amount of P5,000. Similarly, in 2007 the P5,000 would have been recorded by the company, so the total recorded sales
tax expense of P26,000 includes only P21,000 for sales made in 2004. Therefore the correct balance of P30,000 (P500,000 x 6%)
is obtained by a correcting amount of P9,000.
b
Since bad debts were written off each year directly to bad debts expense, the increase in the Allowance for Doubtful Accounts
balance each year represents the additional bad debts expense.
c
The residual value is ignored because it would have been included in the computation of the depreciation on the machine.
CHAPTER
COMPREHENSIVE AUDIT OF
19 BALANCE SHEET AND INCOME
STATEMENT ACCOUNTS
19-1. Daffodil, Inc.

12.31.07
AJE (1) Share donation 60,000

Treasury shares 35,000
Land 10,000
Building 15,000
(2) Accumulated depreciation - machinery 1,000

Loss on sale of machinery 2,000
Machinery 3,000
Cost P 5,000
Less: AD (20%) 1,000
NBV P 4,000
Proceeds 2,000
Loss P 2,000
(3) (a) Accumulated depreciation - building 300

(b) Factory operating expenses 21,300

Accumulated depreciation - building 6,300
Accumulated depreciation - machinery 15,000
Building (P315,000 x 2%)

Machinery:
5,000 x 10% = P 500
145,000 x 10% = 14,500
P15,000
(4) Merchandise inventory, 12.31.07 B/S 175,000

Merchandise inventory, 12.31.07 I/S 175,000
(5) Administrative expenses 1,000

(6) Factory operating expenses 3,000

Unexpired insurance 3,000
(7) Retained earnings 2,500

Bond interest expense 2,500
Unamortized bond discount 5,000
(8) Sinking fund assets 23,500

First Mortgage SF Bonds 23,500
(9) Sinking fund assets 1,500

Sinking fund income 1,500
Comprehensive Audit of Balance Sheet and Income Statement Accounts 19-3
19-1. Daffodil, Inc. (continued)
Daffodil, Inc.
Working Trial Balance
12.31.07
Trial Balance Adjustments Income Statement Balance Sheet
Dr Cr Dr Cr Dr Cr Dr Cr
Cash P 64,000 P 64,000
Accounts receivable 200,000 200,000
Provision for doubtful accounts P 1,000 (5) 1,000 P 2,000
Inventories, 12.31.06 223,000 P 223,000
Unexpired insurance, 12.31.06 6,000 (6) 3,000 3,000
Land 220,000 (1) 10,000 210,000
Buildings 330,000 (1) 15,000 315,000
Accumulated Depreciation - Buildings 6,600 (3a) 300 (3b) 6,300 12,600
Machinery 148,000 (2) 3,000 145,000
Accumulated Depreciation - Machinery 15,000 (2) 1,000 (3b) 15,000 29,000
Sinking fund assets 25,000 (8) 23,500
(9) 1,500 50,000
Unamortized bond discount 25,000 (7) 5,000 20,000
Treasury shares, ordinary 35,000 (1) 35,000 -
Accounts payable 88,000 88,000
Bond interest accrued 3,750 3,750
1st Mortgage, 6% SF Bonds 226,500 (8) 23,500 250,000
Ordinary shares 500,000 500,000
Premium on ordinary shares 50,000 50,000
Share donation 60,000 (1) 60,000 -
Retained earnings, 12.31.06 74,150 (7) 2,500 (3a) 300 71,950
Sales 875,000 P 875,000
Purchases 283,500 283,500
Payroll 169,000 169,000
Factory operating expenses 121,500 (3b) 21,300
(6) 3,000 145,800
Administrative expenses 35,000 (5) 1,000 36,000
Bond interest expense 15,000 (7) 2,500 17,500

P1,900,000 P1,900,000
Loss on sale of machinery (2) 2,000 2,000
Merchandise inventory 12.31.07 (4) 175,000 (4) 175,000 175,000 175,000
Sinking fund income (9) 1,500 1,500
P 293,600 P 293,600 P 876,800 P1,051,500 P1,182,000 P1,007,300
Net Income 174,700 174,700
P1,051,500 P1,051,500 P1,182,000 P1,182,000
19-2.
Part I Adjusting Journal Entries, 12-31-05
AJE (1) Depreciation expense 1,778

[(P22,000 – P2,000) – P4,000]

9
(2) Prepaid interest 5,000

(3) Merchandise inventory, 12-31-07, BS 15,000

Merchandise inventory, 12-31-07, IS or 15,000
Cost of Sales

Purchases 6,000
(5) Prepaid insurance 3,000
Insurance expense 3,000
(6) Store supplies inventory 1,450
Store supplies expense 550
(7) Retained earnings 730
Commissions expense 240
Accrued commissions payable 970
(8) Cash in bank 650
Miscellaneous income 650
(9) Purchases 800
Accounts payable 800
(10) Income from Investment 3,000
Investment 3,000
(11) Prepaid advertising and promotions 90,000
Advertising and promotions expense 90,000
(12) NO AJE

Depreciation expense – machinery 167
Allowance for depreciation – machinery 167
Repairs and maintenance 20,000
(14) Miscellaneous income 2,000
Gain on sale of treasury shares 5,000
Land 2,000
Additional paid-in capital arising from
Treasury Share transactions 5,000
(15) Doubtful accounts expense 14,500
Allowance for uncollectible accounts 14,500
Required allowance as of 12-31-07

– on past due accounts (5% x P30,000) P 1,500
– on current accounts (1% x P400,000) 4,000
Total P 5,500
Unadjusted debit balance of the “Allowance”
account 9,000
Additional Provision P14,500
Part II Column B – Adjustment, 12-31-07
AJE (a) Retained earnings xx

Purchases xx
(b) NONE xx
xx
(c) Retained Earnings xx
Allowance for depreciation xx
(d) Retained Earnings xx

(e) Machinery xx
Retained earnings xx
(f) Depreciation xx
(g) Retained earnings xx

Taxes xx
19-3. International Company
AJE (1) Depreciation expense 3,200

Accumulated depreciation – delivery vehicle 3,200
(2) Cost of sales 19,000


Inventory 8,500
(4) Cash 5,600

(5) Accumulated depreciation – equipment 22,000

Equipment 18,300
Gain on sale of equipment 3,700
(6) Estimated litigation loss 125,000

Estimated litigation liability 125,000
(7) Unrealized holding gain or loss – Income 2,000

Allowance for decline in value of securities 2,000
(8) Accrued salaries payable 3,800

Salaries expense 3,800
(9) Depreciation expense 4,000

Equipment 32,000
Repairs expense 32,000
Accumulated depreciation – equipment 4,000
(10) Insurance expense 5,000

(11) No adjusting entry. Trademark has indefinite

life and no amortization need be made.
19-4. Sunshine Cosmetics, Inc.
Requirement (1)
AJE (1) Inventory, Dec. 31, 2006 (BS) 67,200

Inventory, Dec. 31, 2006 (IS) or
(2) Doubtful accounts expense 14,920

Allowance for doubtful accounts
(15,660 – 740) 14,920
(3) Accounts payable 20,760

Purchase returns and allowances 20,760
(4) Sales commissions 216
Accrued commissions payable 216
(5) Freight-in 1,600

(6) Advertising expense 1,212

Prepaid advertising 1,212
(7) Freight-out or Expense 8,400

Sales 8,400
(8) Interest receivable 1,380

Interest income 1,380
(9) Depreciation expense 1,300

(10) Supplies expense 1,160
Unused Supplies 1,160
(11) Provision for Income tax expense 107,386
Income tax payable 107,386
Requirement (2)
Sunshine Cosmetics, Inc.
Income Statement
Revenue from sales:

Sales P998,800 (a)
Less: Sales returns and
and allowances P 22,400
Sales discounts 1,760 24,160 P974,640
Cost of goods sold:
Inventory, January 1 P179,400
Net purchases:
Purchases P346,000
Less purchase returns
and allowances 20,760 (c) 325,240
Freight-in 12,650 (b)
Cost of goods available
for sale P517,290
Less Inventory, December 31 108,300 (d) 408,990
Gross profit on sales P565,650
Other income:
Interest revenue P 2,780 (i)
Dividend revenue 14,300
Gain on sale of assets 37,000 54,080
Total income P619,730
Operating expenses:
Selling expenses:
Sales salaries and
commissions P 70,216 (e)
Advertising expense 33,392 (f)
Depreciation expense –
Sales/delivery equipment 13,500 (g)
Freight expense 8,400
Travel expense – sales
representatives 9,120
Miscellaneous selling
expenses 4,400 P139,028
General and administrative
expenses:
Legal services P 4,450
Insurance and licenses 17,000
Depreciation expense –
office equipment 9,600
Utilities 12,800
Telephone and postage 2,950
Supplies expense 1,160 (k)
Officers’ salaries 73,200
Doubtful accounts expense 14,920 (h) 136,080
Other expense and losses:
Interest expense P 9,040
Loss on sale of equipment 45,200 (54,240)
Income from continuing
operations before income taxes P290,382
Income taxes 92,922 (j)
Income from continuing
operations P197,460
Discontinued operations:
Gain from discontinued
operations (net of income
taxes of P25,600) 54,400
Net income P251,860
Earnings per ordinary share:
Income from continuing operations (P197,460  78,000 shares) P2.53
Gain from discontinued operations (P54,400  78,000 shares) 0.70
Net income (P251,860  78,000 shares) P3.23
Computations:
(a) Sales: P990,400 + P8,400 = P998,800

(b) Freight-in: P11,050 + P1,600 = P12,650
(c) Purchase returns and allowances: P346,000 x 6% = P20,760
(d) Inventory: P41,100 + P67,200 = P108,300
(e) Sales salaries and commissions: P70,000 + (P7,200 x 3%) = P70,216
(f) Advertising expense: P32,180 + (P3,636 x 2/6) = P33,392
(g) Depreciation expense: P12,200 + (P15,600 x 10/120) = P13,500
(h) Doubtful accounts expense: (P522,000 x 3%) – P740 = P14,920
(i) Interest revenue: P1,400 + P1,380 = P2,780
(j) Income taxes: P335,582 x 32% = P107,387
(k) Supplies expense: P4,360 – P3,200 = P1,160
Sunshine Cosmetics, Inc.

Retained Earnings Statement
Retained earnings, January 1 P 881,340

Add net income per income statement 251,860
P1,133,200
Deduct dividends paid 66,000
Retained earnings, December 31 P1,067,200
19-5. Del Bakery
Working papers are not required, but they facilitate the preparation of a corrected
balance sheet.
Del Bakery
Working Papers for Corrected Balance Sheet
December 31, 2007
Balance Sheet Corrections Corrected Balance

Sheet
Account Title Debit Credit Debit Credit Debit Credit
Current Assets ..................... 53,415 .............. ............. (a) 53,415 .............. ..............
Current Liabilities ................. .............. 29,000 (c) 29,000 ............. .............. ..............
Other Assets ........................ 75,120 .............. ............. (b) 75,120 .............. ..............
Other Liabilities .................... .............. 3,600 (d) 3,600 ............. .............. ..............
Investment in Business ........ .............. 95,935 (e) 95,935 ............. .............. ..............
128,535 128,535 ............. ............. .............. ..............
Cash..................................... .............. .............. (a) 10,600 ............. 10,600 ..............

Investment Securities –
trading (at market value).... .............. .............. (a) 2,575 ............. 2,575 ..............
Trade Accounts Receivable. .............. .............. (a) 12,500 ............. 12,500 ..............
Inventory............................... .............. .............. (a) 8,040 ............. 8,040 ..............
Supplies Inventory................ .............. .............. (a) 425 ............. 425 ..............
Delivery Truck ...................... .............. .............. (a) 2,100 ............. 2,100 ..............
Fixtures................................. .............. .............. (a) 12,500 ............. 12,500 ..............
Accumulated Depreciation –
Fixtures............................... .............. .............. ............. (a) 2,100 .............. 2,100
Cash Surrender Value of
Insurance on Officers’
Lives................................... .............. .............. (a) 4,100 ............. 4,100 ..............
Retained Earnings................ .............. .............. (a) 2,675 ............. .............. ..............
.............. .............. (b) 7,750 ............. .............. ..............
.............. .............. (d) 350 ............. .............. 30,160
.............. .............. ............. (e) 40,935 .............. ..............
Land ..................................... .............. .............. (b) 30,000 ............. 30,000 ..............
Buildings............................... .............. .............. (b) 62,000 ............. 62,000 ..............
Accumulated Depreciation –
Buildings [2 ½ (P62,000  20)]
.............. .............. ............. (b) 7,750 .............. 7,750
11% Mortgage Payable........ .............. .............. ............. (b) 12,000 .............. 12,000
11% Mortgage Payable (current
portion) ............................... .............. .............. ............. (b) 4,000 .............. 4,000
Interest Payable ................... .............. .............. ............. (b) 880 .............. 880
Trade Accounts Payable...... .............. .............. ............. (c) 29,000 .............. 29,000
Miscellaneous Liabilities ...... .............. .............. ............. (d) 3,950 .............. 3,950
Share Capital, P5 stated value,
5,000 shares ...................... .............. .............. ............. (e) 25,000 .............. 25,000
Paid-in Capital from Sale of
Shares at More Than Stated
Value .................................. .............. .............. ............. (e) 30,000 .............. 30,000
284,150 284,150 144,840 144,840
Corrections: (a) To restate current assets (d) To restate other liabilities

(b) To restate other assets (e) To restate owners’ equity accounts
(c) To restate current liabilities
Del Bakery
Corrected Balance Sheet
December 31, 2007
Assets
Current assets:
Cash ........................................................................ P10,600
Investment securities – trading (reported at
market; cost P4,250) ......................................... 2,575
Trade accounts receivable (fully collectible).......... 12,500
Inventory................................................................. 8,040
Supplies inventory .................................................. 425 P 34,140
Investments:
Cash surrender value of life insurance.................... 4,100
Land, buildings and equipment:
Land........................................................................ P30,000
Buildings.................................................. P62,000
Less accumulated depreciation .......... 7,750 54,250
Fixtures .................................................... P12,500
Less accumulated depreciation .......... 2,100 10,400
Delivery truck ......................................................... 2,100 96,750
Total assets ................................................................... P134,990
Liabilities
Current liabilities:
Mortgage payable, portion due this year ................ P 4,000
Accounts payable.................................................... 29,000
Interest payable....................................................... 880
Miscellaneous accrued liabilities ............................ 3,950 P 37,830
11% Mortgage payable (noncurrent portion) ............... 12,000
Total liabilities.............................................................. P 49,830
Owners’ Equity
Contributed capital:
Share capital, P5 stated value,
5,000 shares ....................................... P25,000
Paid-in capital from sale of
ordinary shares at more than
stated value ........................................ 30,000 P55,000
Retained earnings ......................................................... 30,160
Total owners’ equity..................................................... 85,160
Total liabilities and owners’ equity .............................. P134,990
19-6. Masipag Corporation
Adjusting Journal Entries, Dec. 31, 2007
AJE (1) Cash 200,000

(2) Accounts receivable 10,000

Cash 10,000
(3) Bank loan payable 400,000

Other expenses 12,500
Cash 412,500
(4) Cash 75,000

(5) Operating expenses 1,500

Cash 1,500
(6) Cash 16,000

Other income 16,000
(7) Accounts receivable – others (2,000 + 3,000) 5,000

Operating expenses 2,000
Cash 7,000
(8) Marketable securities 40,000

Other income 40,000
(9) Other income 54,000

Marketable securities 54,000
(10) Marketable securities 32,000

Other income 32,000
(10.a) Valuation allowance – Marketable securities –

Trading 145,600
Other income – Unrealized holding gain 145,600
(11) Sales 500,000

(12) Inventory 400,000

(13) Accounts receivable – others (30,000 – 15,000) 15,000

(14) Accounts receivable – others 55,000


Other current liabilities 50,000

(17) Other income 54,545

Discount on notes receivable 54,545
(18) Discount on notes receivable 4,545

Other income 4,545



Inventory 16,000
(23) Sales 13,000


Prepaid expenses 46,250

(26) Other assets 60,000

Operating expense 120,000
(27) Long-term bond investment 5,777

Other income 5,777

Other income 5,333
(29) Land 1,062,500

Building 3,187,500
Land and building 4,250,000
(30) Building 425,000

Land and building 425,000


(33) Land and building 237,500

Accumulated depreciation – building 121,922
(34) Prepaid expenses 10,000

Equipment 20,000

Accumulated depreciation – equipment 55,400
(36) Accounts payable 50,000


Estimated liability on warranties 15,000
(38) Other current liabilities 50,000

Other expenses 50,000
(39) Income taxes payable 115,290

Provision for income tax 115,290
MASIPAG CORPORATION
Balance Sheet
December 31, 2007
Assets
Current assets
Cash P 734,000
Marketable securities P 400,000
Valuation allowance 145,600 545,600
Accounts receivable P 442,000
Allowance for doubtful accounts (33,150) 408,850
Notes receivable P 600,000
Discount on notes receivable (50,000) 550,000
Accounts receivable – others 96,333
Inventory, December 31, 2007 1,960,500
Total current assets P4,470,533
Investments
Long-term bond investment 744,077
Property, plant and equipment
Land P1,062,500
Building P3,612,500
Accumulated depreciation – Building (121,922) 3,490,578
Equipment P1,654,000
Accumulated depreciation – Equipment (235,400) 1,418,600
Total property, plant and equipment 5,971,678
Other assets 110,000
Total assets P11,296,288
Current liabilities
Bank loan payable 1,100,000
Accrued expenses payable 59,000
Estimated liability on warranties 70,000
Total current liabilities P 2,336,558
Shareholders’ equity
Ordinary shares P5,000,000
Additional paid-in capital 1,655,250
Total shareholders’ equity 8,959,730
Total liabilities and shareholders’ equity P11,296,288
MASIPAG CORPORATION
Income Statement
Sales P 6,437,000
Cost of sales (4,060,000)
Gross profit P 2,377,000
Other income 225,710
Operating expenses (1,511,509)
Other expenses (37,500)
Income before taxes P 1,053,701
Provision for income tax (342,441)
Net Income P 711,260
19-7. Felicity Company
Adjusting Journal Entries, Dec. 31, 2007
AJE (1) Cash 31,000

Prepaid interest 3,000
Other charges 2,000
Long-term debt (current portion) 24,000
Long-term debt 12,000
(2) Cash 2,000

Accounts payable and others 2,000
(3) Investments in SMC shares – available for sale

(non-current) 72,000
Marketable securities 72,000
(4) Unrealized loss due to decline in value of

non-current investment (equity) 20,000
(5) Allowance for doubtful accounts 41,100



(8) Sales 14,400

(9) Revaluation increment 120,000

Property and equipment 200,000
(10) Accumulated depreciation 36,000


(12) Revaluation increment 24,000

(13) Property and equipment 30,000

(14) Retained earnings 13,000

Cumulative effect of change in accounting 13,000
principle

Cash 22,000
(16) Provision for income tax 25,445
Income tax payable 25,445
FELICITY COMPANY
Balance Sheet
December 31, 2007
Assets
Current Assets:
Cash............................................................................................ P 123,600
Accounts receivable ................................................................... 1,751,820
Allowance for doubtful accounts ............................................... (27,000)
Accounts receivable -others ....................................................... 62,000
Inventories.................................................................................. 262,000
Prepaid interest........................................................................... 3,000
Non-current Assets:
Advances to affiliate .................................................................. 48,000
Investments in SMC shares – available for sale......................... 72,000
Allowance for decline in value of non-current investment ........ (20,000)
Property and equipment ............................................................. 2,600,000
Accumulated depreciation.......................................................... (1,172,000)
Total Assets P 3,703,420
Accounts payable and others (including current portion of

bank loan of P24,000) ............................................................... P 434,616
Income tax payable............................................................................ 100,205
Long-term debt.................................................................................. 72,000
Ordinary share capital ....................................................................... 2,042,000
Retained earnings .............................................................................. 978,599
Unrealized loss due to decline in value of investment in SMC ......... (20,000)
Revaluation increment....................................................................... 96,000
Total Liabilities and Shareholders’ Equity P 3,703,420
FELICITY COMPANY
Income Statement
Sales .................................................................................................. P 2,757,124

Cost of sales ...................................................................................... 2,257,604
Gross profit........................................................................................ P 499,520
Operating expenses ........................................................................... (83,522)
Other charges..................................................................................... (102,000)
Income from continuing operations before tax.................................. P 313,998

Provision for income tax (35%) ........................................................ 109,899
Income from continuing operations after tax .................................... P 204,099
Discontinued operations (net) ........................................................... (6,500)
Net income ........................................................................................ P 197,599
19-8. Learn Company
Condensed Comparative Income Statements
2009 2008 2007

Construction revenue P900,000 P420,000 P200,000
Construction expense (420,000) (182,000) (80,000)
Other expenses (80,000) (70,000) (50,000)
Income before income taxes P400,000 P168,000 P 70,000
Income tax expense (120,000) (50,400) (21,000)
Net income P280,000 P117,600 P 49,000
Comparative Statements of Retained Earnings
2009 2008 2007

Balance at beginning of year,
as previously reported P 77,000 P 7,000 P 0
Add: Adjustment for the
cumulative effect on prior years
of applying retroactively the
new method of accounting for
long-term contracts (net of
b a
income taxes) 89,600 42,000 0
as adjusted P166,600 P 49,000 P 0
Net income 280,000 117,600 49,000
Balance at end of year P446,600 P166,600 P 49,000
Note: The company has accounted for revenue and costs for long-term
construction contracts by the percentage-of-completion method in 2009, whereas
in prior years revenues and costs were determined by the completed-contract
method. The new method of accounting for long-term contracts was adopted to
(state justification for change in accounting principle) and financial statements of
prior years have been restated to apply the new method retroactively. The effect
of the accounting change on income of 2009 and on income as previously reported
in 2007 and 2008 is as follows:
Increase
2009 2008 2007
c
Net income P112,000 P47,600 P42,000
Earnings per ordinary share P11.20 P4.76 P4.20
The balances of retained earnings for 2008 and 2009 have been adjusted for the
after-tax effect of applying the new method of accounting retroactively.
a
P49,000 – P7,000
b
(P49,000 + P117,600) – (P7,000 + P70,000)
c
P280,000 – [(P600,000 – P280,000 – P80,000) x (1 – 0.30)]
19-9. Goody Construction Company
Requirement (1)
2007
Jan. 1 Construction in Progress 70,000 a
Retained Earnings [P70,000 x (1 – 0.30)] 49,000
Deferred Tax Asset 21,000
a
[(P100,000 + P120,000) + (P125,000 +
P75,000)] – (P100,000 + P250,000)
Requirement (2)
GOODY CONSTRUCTION COMPANY

Condensed Comparative Income Statements (Partial)
2007 2006 2005

Income before income taxes P400,000 P200,000 P220,000
Income taxes at 30% (120,000) (60,000) (66,000)
Net income P280,000 P140,000 P154,000
Earnings per ordinary share

(100,000 shares) P2.80 P1.40 P1.54
Comparative Statements of Retained Earnings
2007 2006 2005

c b
as previously reported P245,000 P 70,000 P 0
Add: Adjustment for the
cumulative effect on prior years
of applying retroactively
applying the new method of
accounting for long-term
e d
contracts (net of income taxes) 49,000 84,000 0
as adjusted P294,000 P154,000 P 0
Net income 280,000 140,000 154,000
Balance at end of year P574,000 P294,000 P154,000
b
P100,000 x (1 – 0.30)
c
P250,000 x (1 – 0.30) + P70,000
d
[(P100,000 + P120,000) – P100,000] x (1 – 0.30)
e
[(P100,000 + P120,000 + P125,000 + P75,000) – (P100,000 + P250,000)]
x (1 – 0.30)
Note: The company has accounted for revenue and costs for long-term
construction contracts by the percentage-of-completion method in 2007, whereas
in prior years revenues and costs were determined by the competed-contract
method. The new method of accounting for long-term contracts was adopted to
(state justification for change in accounting principle) and financial statements of
prior years have been restated to apply the new method retroactively. The effect
of the accounting change on income of 2007 and on income as previously reported
in 2005 and 2006 is as follows:
Increase
2007 2006 2005
h g f
Net income P(49,000) P(35,000) P84,000
Earnings per ordinary share P(0.49) P(0.35) P0.84
The balances of retained earnings and deferred taxes for 2006 and 2007 have been
adjusted for the after-tax effect of applying the new method of accounting
retroactively:
f
(P220,000 – P100,000) x (1 – 0.30)
g
(P200,000 – P250,000) x (1 – 0.30)
h
[P400,000 – (P820,000 – P350,000)] x (1 – 0.30)
Items Restated:
On the 2005 and 2006 income statements, construction revenues and expenses
would be restated to the appropriate amounts for the percentage of completion
method. The construction in progress, deferred income taxes, and retained
earnings on the balance sheets would also be restated.
19-10. Sand Company
Requirement (1)
a. Incorrect entries:
Building 60,000
Depreciation Expense: Building
(P60,000  30) 2,000
Correct entries:
a
Building 40,981
a
P60,000 x 0.683013
b
Depreciation Expense: Building 1,366
c
b
P40,981  30
c
Interest computed using effective
interest method: 10% x P40,981
Entries to correct error:

Building 19,019
Depreciation Expense: Building 634
b. Retained Earnings 40,000

To correct error from prior year.

Inventory 15,000
To correct error in current year.
c. The error from 2005 was counterbalanced at

the end of 2006, so it can be ignored.
Salaries and Wages Expense 18,000
To correct error in salary and wage
accrual in 2006.
Salaries and Wages Expense 10,000
Salaries and Wages Payable 10,000
To accrue salaries and wages at
December 31, 2007.
Requirement (2)
a. See Requirement 1.a. of this solution for the incorrect entries that were made
and the correct entries that should have been made.
Discount on Notes Payable (total discount

of P19,019 less amount of P4,098
amortized for 2007) 14,921
d
Building 19,019
d
Correction of interest expense
understatement of P4,098 less
depreciation overstatement of P634
b. The error from 2006 was counterbalanced

by the end of 2005, so it can be ignored.

Inventory 15,000
c. The errors from 2005 and 2006 were counterbalanced by the end of 2006 and
2007; respectively, so they can be ignored.

Salaries and Wages Payable 10,000
19-11. Play Company
Requirement (1)
SFAS No. 13 paragraphs 42 and 43 state that “a change in accounting policy
should be applied retroactively unless the amount of any resulting adjustment that
relates to prior periods is not reasonably determinable. Any resulting adjustment
should be reported as an adjustment to the opening balance of retained earnings.
Comparative information should be restated unless it is impracticable to do so.
The financial statements, including the comparative information for prior periods,
are presented as if the new accounting policy had always been in use. Therefore,
comparative information is restated in order to reflect the new accounting policy.
The amount of the adjusting relating to periods prior to those included in the
financial statements is adjusted against the opening balance of retained earnings of
the earliest period presented. Any other information with respect to prior periods,
such as historical summaries of financial data, is also restated.”
PLAY COMPANY
Worksheet to Correct Income Before Income Taxes
Year Ended December 31

2007 2006
Income before income taxes, before adjustments P4,030,000 P3,330,000
Adjustments:
Depreciate certain equipment over 8-year life
instead of 10-year life (Schedule 1) (25,000) --
Correct 2006 error 180,000 (180,000)
Record 2007 provision for doubtful accounts
(P58,500,000 x 0.2%) (117,000) --
Increase estimated warranty liability (170,000) --
Effect of change in accounting principle from
expensing to capitalizing relining costs in the
year of the change (Schedule 2)
Furnace A (Jan. 2006) (56,000) 224,000
Furnace B (Jan. 2007) 240,000 --
Net adjustments 52,000 44,000
Income before income taxes P4,082,000 P3,374,000
Schedule 1:
Computation of Adjusted Depreciation
Cost of equipment (no salvage value) P1,000,000

Depreciation based on 10-year life P 100,000
Depreciation based on 8-year life (125,000)
Adjustment P (25,000)
Schedule 2:
Computation of Effect of Change in Accounting
Principle From Expensing to Capitalizing
Relining Costs on the Year of the Change
Capitalization of Furnace B P300,000

Depreciation on Furnace B based on 5-year life
(P300,000 x 20%) (60,000)
Depreciation on Furnace A based on 5-year life
(P280,000 x 20%) (56,000)
Adjustment P184,000
Requirement (2)
PLAY COMPANY
Effect Before Income Taxes
of Change in Accounting Principle From
Expensing to Capitalizing Relining Costs
Capitalization of Furnace A P280,000

Depreciation on Furnace A based on 5-year life
(P280,000 x 20%) (56,000)
Adjustment P224,000
19-12. Jo Francisco, Inc.
Net Income for 2005 Retained Earnings 12/31/06

Item Understated Overstated Understated Overstated
1. P14,100 0 0 0
2. P 7,000 0 P 5,000 0
3. 0 P22,000 0 P11,000
4. P33,000 0 P33,000 0
5. 0 P20,000 0 P10,000
6. P18,200 0 0 0
Although explanations were not required in answering the question, they are
included below for your interest.
Explanations:
1. The net income would be understated in 2005 because interest income is
understated. The net income would be overstated in 2006 because interest
income is overstated. The errors, however, would counterbalance (wash) so
that the Balance Sheet (Retained Earnings) would be correct at the end of
2006.
2. The depreciation expense in 2005 should be P1,000 for this machine. Since
the machine was bought on July 1, 2005, only one-half of a year should be
taken in 2005 (P8,000/4 X 1/2 = P1,000). The company expensed P8,000
instead of P1,000 so net income is understated by P7,000 in 2006. An
additional P2,000 of depreciation expense should have been taken in 2006. At
the end of 2006, retained earnings would be understated by P5,000 (P7,000 –
P2,000).
3. PAS 38, paragraphs 54 to 57 govern the accounting for research and
development costs. Net income in 2005 is overstated P22,000 (P33,000
research and development costs capitalized less P11,000 amortized). By the
end of 2006, only P11,000 of the research and development costs would
remain as an asset. Therefore, retained earnings would be overstated by
P11,000 (P33,000 research and development costs – P22,000 amortized).
4. The security deposit should be a long-term asset, called refundable deposits.
The P8,000 of last month’s rent is also an asset, called prepaid rent. The net
income of 2005 is understated by P33,000 (P25,000 + P8,000) because these
amounts were expensed. Retained earnings will continue to be understated by
P33,000 until the last year of the lease. The security deposit will then be
refunded, and the last month’s rent should be expensed.
5. P10,000 or one-third of P30,000 should be reported as income each year. In
2005, P30,000 was reported as income when only P10,000 should have been
reported. Because P20,000 too much was reported, the net income of 2005 is
overstated. At the end of 2006, P20,000 should have been reported as income,
so retained earnings is still overstated by P10,000 (P30,000 – P20,000).
6. The ending inventory would be understated since the merchandise was
omitted. Because ending inventory and net income have a direct relationship,
net income in 2005 would be understated. The ending inventory of 2005
becomes the beginning inventory of 2006. If beginning inventory of 2006 is
understated, then net income of 2006 is overstated (inverse relationship). The
omission in inventory over the two-year period will counterbalance, and
retained earnings at the end of 2006 will be correct.
19-13. JC Patrick Corporation
2006 2007
Net income, as reported P29,000 P37,000
Rent received in 2006, earned in 2007 (1,300) 1,300
Wages not accrued, 12/31/05 1,100
Wages not accrued, 12/31/06 (1,500) 1,500
Wages not accrued, 12/31/07 (940)
Inventory of supplies, 12/31/05 (1,300)
Inventory of supplies, 12/31/06 740 (740)
Inventory of supplies, 12/31/07 1,420
Corrected net income P26,740 P39,540
CHAPTER
20 WRITING THE AUDIT REPORT
20-1. The purposes of the scope paragraph in the auditor’s report are to inform the
financial statement users that the audit was conducted in accordance with
generally accepted auditing standards, in general terms what those standards
mean, and whether the audit provides a reasonable basis for an opinion.
The information in the scope paragraph includes:

1. The auditor followed generally accepted auditing standards.
2. The audit is designed to obtain reasonable assurance about whether the
statements are free of material misstatement.
3. Discussion of the audit evidence accumulated.
4. Statement that the auditor believes the evidence accumulated was appropriate
for the circumstances to express the opinion presented.
20-2. The purpose of the opinion paragraph is to state the auditor’s conclusions based
upon the results of the audit evidence. The most important information in the
opinion paragraph includes:
1. The words “in our opinion” which indicate that the conclusions are based on
professional judgment.
2. A restatement of the financial statements that have been examined and the
dates thereof or a reference to the introductory paragraph.
3. A statement about whether the financial statements were presented fairly and
in accordance with generally accepted accounting principles.
20-3. The common definition of materiality as it applies to accounting and, therefore, to

audit reporting is:
A misstatement in the financial statements can be considered material if
knowledge of the misstatement would affect a decision of a reasonable user
of the statements. Auditors must have knowledge of the likely uses of their
client’s statements and the decisions that are being made. Materiality
involves both quantitative and qualitative considerations. In assessing the
quantitative importance of a misstatement, it is necessary to relate the peso
amount of the error to the financial statements under examination.
Qualitative considerations, on the other hand, relate to the causes of the
misstatement. An error that may not be material quantitatively, may be

material qualitatively. This may occur, for instance, when the misstatement is
attributed to an irregularity or an illegal act by the client.
20-4. Materiality for lack of independence in audit reporting is easiest to define. If the
auditor lacks independence as defined by the Code of Professional Ethics, it is
always considered highly material and therefore a disclaimer of opinion is always
necessary. For failure to follow GAAP, there are three levels of materiality:
immaterial, material, and highly material.
20-5. The auditor’s opinion may be qualified by scope limitations caused by client
restrictions or by limitations resulting from conditions beyond the client’s control.
The former occurs when the client will not, for example, permit the auditor to
confirm material receivables or physically observe inventories. The latter may
occur when the engagement is not agreed upon until after the client’s year end
when it may not be possible to physically observe inventories or confirm
receivables.
A disclaimer of opinion is issued if the scope limitation is so material that the

auditor cannot determine if the overall financial statements are fairly presented. If
the scope limitation is caused by the client’s restriction the auditor should be
aware that the reason for the restriction may be to deceive the auditor. For that
reason a disclaimer is more likely for client restrictions than for conditions beyond
anyone’s control.
When there is a scope restriction that results in the failure to verify material, but
not pervasive accounts, a qualified opinion may be issued. This is more likely
when the scope limitation is for conditions beyond the client’s control than for
restrictions by the client.
20-6. When another CPA has performed part of the audit, the primary auditor issues one
of the following types of reports based on the circumstances.
1. No reference is made to the other auditor. This will occur if the other
auditor examined an immaterial portion of the statement, the other auditor is
known or closely supervised, or if the principal auditor has thoroughly
reviewed the other auditor’s work.
2. Issue a shared opinion in which reference is made to the other auditor. This
type of report is issued when it is impractical to review the work of the other
auditor or when a portion of the financial statements audited by the other
CPA is material in relation to the total.
3. The report may be qualified if the principal auditor is not willing to assume
any responsibility for the work of the other auditor. A disclaimer may be
issued if the segment audited by the other CPA is highly material.
Writing the Audit Report 20-3
20-7. 1) Disclaimer of opinion. Because the client refuses to allow the auditor to
expand the scope of his examination, a disclaimer of opinion is appropriate
rather than a qualified as to scope and opinion.
2) Disclaimer of opinion. The auditor cannot issue an unqualified opinion on
the income statement or the statement of cash flows because a disclaimer of
opinion is necessary for the beginning balance sheet. The auditor may issue
an unqualified opinion on the ending balance sheet and a disclaimer of
opinion on the income statement, statement of cash flows, and the beginning
balance sheet.
3) Unqualified opinion. The auditor is able to satisfy him or herself that with the
use of alternative procedures, a qualified opinion is not necessary.
4) Qualified opinion or adverse opinion for failure to follow generally accepted
accounting principles. The materiality of twenty per cent of net earnings
before taxes would be sufficient for many auditors to require an adverse
opinion. That materiality question is a matter of auditor judgment.
5) Disclaimer of opinion. Lack of independence by audit personnel on the
engagement mandates a disclaimer for lack of independence.
6) Unqualified opinion. The company has made a decision to follow a different
financing method which is adequately disclosed. There is no change of
accounting principle.
20-8.
a. b.
CONDITION TYPE OF REPORT COMMENT
1. Failure to (4) Qualified opinion only Disclosure of this
follow GAAP. – except for or information is required in a
(7) Adverse footnote. Failure to do so is
a violation of GAAP and is
likely to be a qualified
opinion, or it could be so
important as to require an
adverse.
2. Scope of the (1) Unqualified – standard Because the auditor was
auditor’s able to obtain alternative
examination has evidence, no scope
been restricted. qualification is necessary.
If there were such a
qualification, it would be a
qualified scope and opinion
or a disclaimer, depending
on materiality.
3. Failure to (4) Qualified opinion only Retail Auto Parts has used a
follow GAAP. – except for replacement cost inventory
rather than lower of cost or
market. It is not
sufficiently material to
require an adverse opinion.
4. Failure to (7) Adverse FASB No. 2 requires the
follow GAAP. expending in the current
period of all research and
development costs
regardless of the benefit in
future years. Given the
materiality of the amount,
an adverse opinion would
be required.
5. Scope of the (5) Qualified scope and Because the auditor was
auditor’s opinion unable to satisfy himself
examination has about beginning
been restricted. inventories, it would be
necessary to issue either a
qualified or disclaimer of
opinion on the income
statement and statement of
cash flows as well as the
beginning balance sheet.
The use of a qualified or
disclaimer would depend
upon the opinion given in
the prior year. An
unqualified opinion could
be issued for the current
period balance sheet.
6. Scope of the (6) Disclaimer Failure of the client to
auditor’s allow the auditor to inspect
examination has the minutes book would be
been restricted. a material client-imposed
restriction. Due to the
importance of the minutes
book, a disclaimer would
be necessary. The certified
copy of all resolutions and
actions would not be a
satisfactory alternative
procedure.
Writing the Audit Report 20-5
7. Accounting (1) Unqualified – standard The change of estimated

principles used wording life is a change of condition
in the financial and not a change in
statements have accounting principles.
not been Therefore, an unqualified
consistently opinion is appropriate since
applied. there is adequate
disclosure.
20-9. Young Manufacturing Corporation
The auditor’s report on his examination of the financial statements of the Young
Manufacturing Corporation includes the following deficiencies:
1. The audit report has no title. It should include a phrase such as “independent
auditor’s report.”
2. The audit report is addressed to the president. It is usually more appropriate
to address it to the stockholders or board of directors.
3. The date of the auditor’s report should be the date of the completion of the
auditor’s field work, not the balance sheet date.
4. The report includes only two paragraphs. It should be three paragraphs if it
is standard wording, or more if there is a violation of GAAP, which there is.
5. There must be reference to both the 2007 and 2006 financial statements in
the scope and opinion paragraphs, including a statement about the degree of
responsibility the auditor is taking for each year’s statements.
6. The auditor’s report is deficient because the dates of the balance sheet and
the period covered by the income statement are not given. These dates
should be given so that the reader will clearly understand that the opinion is
limited to specific financial statements. Clarification as to the statements
covered by the opinion is imperative because comparative financial
statements are presented.
7. The title “Balance Sheet” is used in the report, but “statements of condition”
is employed as the title of the financial statement. Different titles should not
be used because a criterion of professional work is that uniform and accurate
terminology be used.
8. Although the auditor’s report states that he or she examined the Statement of
Income and Retained Earnings, the attached financial statements do not
include the Retained Earnings statement. All financial statements referred to
in the auditor’s report should be appended to the report.
The difference of P66,481 between the opening and closing balances of the
Retained Earnings account is not reconcilable to the reported net income for
the year of P52,924. Because an amount of P13,557 in the Retained

Earnings account is not accounted for, the auditor’s report should contain at
least a qualification on the grounds of inadequate disclosure. If the auditor’s
examination disclosed that the P13,557 is a net amount of charges and
credits to the Retained Earnings account, some of which bear directly upon
the current year’s income statement, the auditor may be compelled to render
an adverse opinion.
9. There is no reference in the introductory paragraph to the responsibilities of
the auditor and management.
10. The mandatory standard scope paragraph is excluded.
11. Two items in the Statements of Condition, “Accounts receivable” and
“Inventories,” are listed as “pledged,” but no footnotes or comments disclose
the nature or extent of the commitments. The item “other liabilities”
probably represents the liability for which the assets serve as security; its
nature should be appropriately disclosed in the statements. Also, the terms
of the long-term mortgage should be disclosed. Therefore, the auditor
should disclose this information in a separate paragraph in the report and his
or her opinion should be appropriately qualified.
12. The auditor’s report is written in the first person apparently because the
auditor is an individual practitioner. Although some CPAs contend that it is
inappropriate for an individual to practice under a style that denotes a
partnership, individual practitioners generally use “we” rather than “I” in
writing their reports. The “we” used in the report is the so-called “editorial
we” and it is used because it is more formal, impersonal, and carries more
dignity. As used in auditor’s reports “we” is not to be taken in its literal
(plural) sense.
13. The opinion paragraph should contain the phrase “in our opinion” to clearly
disclose that the statement as to fair presentation is a professional opinion,
not a statement of fact.
14. A statement of cash flows is not included in the financial statements of the
audit report’s introductory paragraphs. A qualified opinion is required when
no statement of cash flows is included.
15. There is not inclusion of the phrase “in all material respects” in the opinion.
16. There should be no reference to consistency in the opinion paragraph.
17. The opinion paragraph should include no reference to what is done on the
audit. That should be in the scope paragraph.
18. As stated above, the opinion paragraph should not be unqualified, because of
the missing statements or retained earnings and cash flow and the omitted
footnotes.

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CHAPTER

1-2. Other requirements for an effective audit are:

1-10. Attestation refers to an expert communicating a conclusion about the reliability of

1-14. In determining whether financial statements are presented fairly in conformity

2-3. Sources of business and industry information are the following:

2-4. a. The audit risk model is

2-6. a. Analytical procedures are used for these broad purposes:

b. An auditors’ expectations are developed from the following sources of

c. The factors that influence an auditor’s consideration of the reliability of data

2-7. a. (4) b. (4)

2-8. a. (1) b. (1) c. (1)

2-9. a. (1) b. (2) c. (3)

(1) 2.5% (4) 3.33%

b. (1) 3 (tied) (4) 2

2. Inherent risk is the susceptibility of an account balance or class of

Control risk is the risk that error in an account balance or class of

b. 1. Materiality is the magnitude of an omission or misstatement of

individually or in the aggregate, are important for the fair presentation of

2. Materiality is affected by the nature and amount of an item in relation to

Weaknesses are not subject to test of controls auditing because no reliance is

3-5. a. An order entry department generally receives customers’ requests to purchase

and it should be prenumbered to facilitate control over processing

e. Billing involves notifying the customer (by means of an invoice) of the

Some entities prepare a turnaround document simultaneously with the sales

Prior to mailing, each invoice should be reviewed by a person not involved in

g. A business issues a credit memo when a customer returns merchandise or

h. The allowance for uncollectible accounts expense is the result of an adjusting

i. After exhausting all reasonable efforts to collect accounts, businesses should

The signature of the carrier on the shipping document provides externally

b. A customer attaches a remittance advice to a check in payment of an invoice.

3-11. Adjustments to sales include cash discounts, sales allowances or reductions in

3-12. The following potential misstatements could arise:

4. (k) Comparing control total amounts posted to the accounts receivable

6. (b) An approved sales order should be presented to the storekeeper before

2. a. Prelisting of cash receipts and cash register procedures are monitored.

3. a. A monthly statement should be mailed to customers by someone not

4. a. For goods shipped, goods should be counted and descriptions and

6. a. Shipping documents should be accounted for to determine that all items

7. a. For goods shipped, goods should be counted and descriptions and

8. a. Prenumbered sales invoices should be used and accounted for to

3. There is no proof of accuracy of The treasurer should reconcile the

b. In addition to the procedures outlined above, Honey should

1. Documentation (1)Test of control Existing sales transactions

2. Inquiry (4)Test of details of Sales transactions are

3. Mechanical accuracy (4)Test of details of Accounts receivable are

4. Observation (4)Test of control Accounts receivable are

4-11. 1. a. A purchase requisition, purchase order, receiving report, and vendor’s

2. a. Receiving reports should be prenumbered and accounted for.

3. a. A purchase requisition, purchase order, receiving report, and vendor’s

4. a. Invoice amounts should be verified by reference to purchase orders, and

6. a. Vouchers should be prenumbered and accounted for.

4-13. Fresh Foods Grocery Store

1. a. 1) Adequate documents and records.

2. a. Adequate documents and records.

3. a. 1) Adequate documents and records.

4. a. Independent checks on performance.

5. a. Proper procedures for authorization.

6. a. 1) Adequate documents and records.

4-14. Love Company

a. Function b. Error or Irregularity c. Compliance Test(s)

1. Ordering items Purchases may be for Review evidence of

4-15. Maybelle Corporation

b. (1) The question of when to order depends primarily on quantities on hand,