Solution with answer applied auditing by cabrera chapter12

CHAPTER

12
12-1.

SUBSTANTIVE TESTS OF
INTANGIBLE ASSETS

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

12-2.

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

12-3.

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

P270,000

Over-amortization

P 60,000

330,000

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


12-2

Solutions Manual to Accompany Applied Auditing, 2006 Edition

12-4.

Requirement (a)

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

12-5.

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

P
Q
R

Less: Adjustment
as per BIR
requirement
As Adjusted

Cost as
Recorded
P 40,000
120,000

160,000
P320,000
80,000
P240,000

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

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

As Adjusted

P 15,454.54
45,000.00
60,000.00

(37,789.67)
P113,368.98
(b)

P120,454.54

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

210,000
17

x 0.5 = P 909.09
x 0.5 =

6,176.47
P7,085.56

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

16.5
Q&R =

210,000
17

x 0.5 =

98,823.53
P113,368.98

(40,151.52)
P120,454.54


Substantive Tests of Intangible Assets

12-3

Adjusting Journal Entries
(1)

(2)

12-6.

Capital in excess of par value
Patent P
Patent Q
Patent R

To adjust patent valuation to conform
to BIR requirement.

80,000.00

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

5,151.52
15,000.00
20,000.00

10,000.00
30,000.00
40,000.00

40,151.52

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

10

5

Apr. 1

May 15

Organization Expenses
Intangibles
To classify incorporation fees.

17,500

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

7,500

Advertising Expense
Intangibles
To expense advertising costs.

15,000

Land
Building
Intangibles
To reclassify land and buildings for

R & D activities.

15,000
20,000

Research and Development Expenses
Intangibles
To expense materials purchased.

15,000*

* Alternatively, unused materials and

17,500

7,500

15,000

35,000

15,000


12-4

Solutions Manual to Accompany Applied Auditing, 2006 Edition

June 30

July 1

Dec. 10

31

31

31

supplies, if material, may be set up as
prepaid expenses.
Patent
Intangibles
To reclassify the patent.

10,000
10,000

Income Summary / Retained Earnings
Intangibles
To record operating loss.

12,000

Research and Development Expenses
Intangibles
To record acquisition of equipment.

12,000

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

30,000

12,000

12,000

30,000

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

750

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

250

750

250

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

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

P 480,000
P 80,000
48,000
P 32,000


Substantive Tests of Intangible Assets
P32,000 ÷ 12%
12-8.

12-5

= P160,000

Bayer, Inc.

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

Bayer, Inc.
P328,500
40,000

Lead, Inc.
P298,500

P368,500
74,900

P298,500
12,900

P443,400

P311,400

Supporting Computations:
Schedule 1: Goodwill of Bayer, Inc.
Average pre-tax earnings 11.1.01 to 11.1.06
Less: Additional annual depreciation equipment taken over

at P40,000 in excess of book value (P40,000 / 5)
Adjusted pre-tax earnings
Less: Required earnings on net tangible assets
(15% x P368,500)

P82,000

Excess annual pre-tax earnings

P18,725

Goodwill (excess earnings capitalized at 25%)

P74,900

8,000
P74,000
55,275

Schedule 2: Goodwill of Lead, Inc.

12-9.

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

P44,000

Excess annual pre-tax earnings

P 3,225

Goodwill (excess earnings capitalized at 25%)

P12,900

4,000
P48,000
44,775

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


12-6

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Asset
Patent A
Patent B
Equipment
Land

Appraisal
Value

Portion of
Total Value

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

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

Total
Cost
x
x
x
x

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

P151,700

Allocated
Cost
=
=
=
=

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

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

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

Oct. 31 Amortization of Patents
Patent A (27,192 / 5 x 6/12)

Patent B (36,256 / 12 x 6/12)
To record amortization of patents
for 2004.

4,230

137,500

2,719
1,511

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

17,600

1,813
1,813

22,660
22,660


Substantive Tests of Intangible Assets

12-7

To record write-off of Patent A after
unsuccessful defense.
Oct. 31 Amortization of Patents
3,021
Patent B
To record amortization of Patent B for 2005.

3,021

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

3,021

Computations
Amortization for 2006:
Patent A: (P27,192 / 5 years) (6 / 12)
Patent B: (P36,256 / 12 years) (6 / 12)
Amortization on Patent A, 10/31/2004 – 3/7/2005:

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

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

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


12-8

Solutions Manual to Accompany Applied Auditing, 2006 Edition

12-10.

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

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

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

2.

2006 Amortization:
P50,000 / 5 years

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

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

P45,000

[AJE (5)]

7,875

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

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


Substantive Tests of Intangible Assets
Retained earnings – Prior period
adjustment
Organization costs

139,125
139,125

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

12-9

P345,000
( 45,000)
(100,000)

( 5,000)
P195,000

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

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

52,500

AJE (2) Cost of Goods Sold
Patents

108,571

52,500
108,571

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

45,000

AJE (4) Selling and Administrative
Expense
Franchise Agreement

10,000

45,000

10,000

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

45,000
45,000
7,875
7,875


12-10

Solutions Manual to Accompany Applied Auditing, 2006 Edition
AJE (7) Retained Earnings
Organization Costs

139,125
139,125

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

100,000
100,000

AJE (9) Retained Earnings
Goodwill

5,000
5,000

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

204,500
45,000
100,000
102,000

45,000
150,000
52,500

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

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

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

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

Goodwill
AJE

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

(5)
(8)
(9)


Substantive Tests of Intangible Assets

12-11.

(2) Cost of Goods Sold
Selling and Administrative Expense
Patents
Franchise Agreement
Balagtas Company

12-11

108,571
10,000
108,571

10,000

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

Correct Treatment

1.

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

Treat all the items as expenses in
2006 income statement.

2.

No depreciation was taken on
machinery.

Expense appropriate amounts in the

2006 income statement.

3.

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

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

4.

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

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

5.

No accumulated deficit presented.

“Deficit accumulated during
development stage” should be
included in the shareholders’ equity


12-12

Solutions Manual to Accompany Applied Auditing, 2006 Edition
section. The amount results from
corrections made in items 1 and 2
above.
Requirement (b)
Additional items which should be included are:

12-12.

1.

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

2.

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

3.

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

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

12-13.

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

Substantive Tests of Intangible Assets

12-13

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.


12-14

Solutions Manual to Accompany Applied Auditing, 2006 Edition
The 2005 advertising cost may also be considered as a start-up cost or simply
expensed as advertising cost incurred.


12-16
12-14.

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

General Ledger Accounts

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

Trial Balance
Debit
Credit
P 61,000
92,500
P
500
38,500
75,000

29,000
10,000
85,000
26,000
10,500
29,000
24,000
50,000
49,000

27,000
454,000

Selling and general expenses
Start-up expenses

173,000

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

improvements
Net income for 2006

3,500
12,000

Totals
*

P1,239,000

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

P1,239,000

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

P 2,500

(1)
(8)

17,000
8,500

Income Statement
Debit
Credit
P

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

(3)

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

1,000

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

29,000

24,000
1,250
29,250

(3)

1,000

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

(4)
(5)

1,250
29,250

(10)

1,500
P124,400

Balance Sheet
Debit
Credit
61,000

95,000
(500)
38,500
92,000
37,500
(10,000)
68,000
15,000
10,500
19,500
50,000

P

464,400

P

P

768,500

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

181,000
45,000
3,500

12,000
(2)

3,400

(3,400)

(10)

3,000

(3,000)

(6)

5,500

(5,500)

(30,500) *

(1,500) *
62,600

62,600
P124,400

P

768,500

P

768,500

P

470,600

P

470,600

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


Substantive Tests of Intangible Assets
12-14.

12-17

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

(2)

(3)

(4)

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

17,000
17,000

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

3,400

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

1,000

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

life). (Note 1)

3,400

1,000

1,250
1,250

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

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

29,250
29,250


Substantive Tests of Intangible Assets
(6)

(7)

(8)

(9)

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

5,500
5,500

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

8,000
16,000

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

29,000

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

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

12-18

24,000

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

1,500
1,500
3,000


Substantive Tests of Intangible Assets
12-15.

12-19

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

P 61,830

14,350
42,706
P118,886

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

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

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

P16,400

(2,050)
P14,350


12-20

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

P40,000

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

P40,000
(7,000)
P33,000

Accumulate
d
Amortizatio
n
P7,000
P7,000

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

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

P 6,870
45,000
6,118
P57,988
2,050

10,000
2,000
P72,038


Substantive Tests of Intangible Assets

12-21

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
Costs of meetings of incorporators to discuss
organizational activities
State filing fees to incorporate

Total organization costs

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

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

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

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

P1,440,000
432,000

P1,872,000


12-22

Solutions Manual to Accompany Applied Auditing, 2006 Edition

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

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

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

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

Requirement (b)
Jo Tan Company

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

P360,000
P 48,000
125,000

173,000
433,000
P966,000

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

2004

Month
10

17
204
P150


Substantive Tests of Intangible Assets
2005
2006
2007

12-23

12
12
12
46

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

2006
2007

10
120
P125

Month
6
12
12
30

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

4
48
P300

Month
4
12

16

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

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

Requirement (b)
Analysis of 2008 transactions
1.

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


12-24

Solutions Manual to Accompany Applied Auditing, 2006 Edition
2.

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

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

P11,250
5,154
P 6,096

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

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

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

Patent AA amortization

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

9 1/2
114
P320

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

x
x
x

0.9259 =
0.8573 =
0.7983 =

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

or
2,000
12-20.

x

2.582 =

P5,164

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


Substantive Tests of Intangible Assets

12-25

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

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

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

Requirement (b)

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

CV 12.31.06
Amortization, 2007
CV 12.31.07

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

P3,200,000
÷ 10 years
P 320,000

Recovery
Requirement (c)

Fair Value
12.31.07

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

P3,400,000
520,000


12-26

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

12-22.

Español Co.
Franchises...............................................................................................................
42,000
Prepaid Rent...................................................................................................................
28,000
Retained Earnings (Organization Costs of P6,000 in
2006).........................................................................................................................
6,000
Retained Earnings (P16,000 – P6,000)...........................................................................
10,000
Patents............................................................................................................................
74,000
Legal fees.......................................................................................................................
12,650

Research and Development Expense..............................................................................
(P75,000 + P160,000)..................................................................................................
235,000
Goodwill........................................................................................................................
278,400
Intangible Assets..............................................................................................
686,050
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
1996 amortization (P62,050 ÷ 17)
Carrying value, 12/31/99

P62,050
(3,650)
P58,400