Chapter14 - Answer

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.

CHAPTER14 SUBSTANTIVE TESTS OF

LIABILITIES

14-2 Solutions Manual to Accompany Applied Auditing, 2006 Edition

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.

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.,

Substantive Tests of Liabilities 14-3

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. a14-8. 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

1.1T = P27,000 – 0.3 B T = P27,000 – 0.3 (P8,181.82)T = P24,545.45

(c) Let B = Bonus; Let T = Income TaxB = 0.10 (P90,000 – T)T = 0.30 (P90,000 – B) Proof: Income Tax

NI bef B & T P90,000.00B = P6,495 Less: B 6,495.00T = 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 P90,000.00B = P5,888 Less: B ( 5,888.00)T = P25,234 T (25,234.00)

Balance P58,878.00x 10%P 5,887.80

14-10. Broadwall Corporation

a. Esteva should apply the following procedures:

1. Send standard bank confirmation


a. Direct liabilitiesb. Security agreements

2. Examine notes for terms, provisions, etc.3. Review board meeting minutes

a. Authority for transactionsb. Dividends declared

4. Determine compliance with bank loan provisions5. Consider effects of president’s loans on debt/equity6. Investigate business purpose of loan7. Trace loan proceeds to cash receipts records8. Trace interest and principal payments to cash disbursements records9. Recompute and verify interest expense and accrual computations10. Consider balance sheet presentation/disclosure

a. Current/noncurrent portionsb. Assets pledged as collateralc. Related party

11. Obtain management representation letter

b. Broadwall’s financial statements should include the following related party disclosures:

1. Nature of party’s relationship2. Description of the transaction3. Peso volume of the loans4. Amounts due to president and terms of settlement.

14-11. Bem, Inc.

Item No. A J E

1 None

2 Insurance expense 9,167Prepaid insurance 9,167

3 None

4 None

5 None

6 Prepaid dues and subscriptions 500Dues and subscriptions expense 500

7 NoneItem No. A J E

8 None


9 Accounts payable 8,400Inventory 8,400

10 Legal and professional fees 4,600Accrued legal and professional fees 4,600

11 Medical expenses 2,500Accrued medical expenses 2,500

12 Inventory 5,500Accounts payable 5,500

13 None (adjustment already made by client)

14 None


16 None

17 None


19 Machinery and equipment 25,400Accounts 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 CreditReport # Error(s) Account Amount Account Amount

2631 None

2632 Received prior to year end and not recorded

Inventory 3,709.16 Accountspayable

3,709.16

2633 Included in accounts payable and not inventory

Inventory 5,182.31 Purchases 5,182.31

2634 Received prior to year end and not recorded

Inventory 6,403.00 Accountspayable

6,403.00

2635 Included in accounts payable and not inventory

Inventory 8,484.91 Purchases 8,484.91

2636 None

2637 Title passed prior to year end and not recorded

Inventory 7,515.50 Accounts payable

7,515.50

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 liabilitiesNotes payable P 600,000Accounts payable to trade creditors 325,000Accrued salaries and wages 145,000Payroll taxes and deductions withheld

(P15,000 + P30,000 + P3,000) 48,000Income taxes payable 250,000Other taxes payable (P100,000 + P185,000) 285,000Estimated warranty payables (P55,000 + P145,000 - P130,000) 70,000Cash dividends payable (2,500,000 x P0.40) 1,000,000Accrued interest [(P4,000,000 x .07 x 1/4) + P90,000] 160,000Miscellaneous 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 PineRequirement (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) = P104,016Principal (P150,000 - P104,016) (45,984) C

7/1/06: Payment:Interest [3% x (P3,467,215 - P45,985)] = P102,637Principal (P150,000 - P102,637) (47,363) C

9/1/06: Payment:Interest [3% x (P3,467, 215 - P45,984 - P47,363)]

= P101,216Principal (P150,000 - P101,216) (48,784) C

12/31/06: Principal balance P3,325,084

FRequirement (d)

Audit adjustments:

(1)Lease PropertyInterest Expense

3,467,215307,869

Obligation under Capital LeaseRent Expense

3,325,084450,000 T

To capitalize financing lease and reverse rental charges erroneously recognized as expense.

(2)Depreciation Expense 346,721

Accumulated Depreciation 346,721To record depreciation on leased


assets, assuming straight-line depreciation and full year policy concerning depreciation in the year of acquisition.

(3)Interest Expense 99,753

Interest Payable 99,7533% 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 LeaseAmortization Schedule


December 31, 2006

(1) (2) (3) (4)

Period Cash-credit

InterestExpense-debit

[2% x (4)]

Obligations under Long-term

Lease-debit[(1) – (2)]

LeaseLiability-balance

[(4) – (3)]

1/2/06 P4,185,388 C1/2/06 P150,000 P150,000 P4,035,3884/1/06 P150,000 P80,708 P69,292 P3,966,0967/2/06 P150,000 P79,322 P70,678 P3,895,41810/1/06 P150,000 P77,908 P72,092 P3,823,3261/2/07 P150,000 P76,467 P73,533 P3,749,7934/1/07 P150,000 P74,996 P75,004 P3,674,7897/1/07 P150,000 P73,496 P76,504 P3,598,28510/1/07 P150,000 P71,966 P78,034 P3,520,2511/2/08 P150,000 P70,405 P79,595 P3,440,6564/1/08 P150,000 P68,813 P81,187 P3,359,4697/1/08 P150,000 P67,189 P82,811 P3,276,65810/1/08 P150,000 P65,533 P84,467 P3,192,1911/2/09 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 LeaseDecember 31, 2006


Date Description Cash-credit

Lease Obligation

debit

Lease Obligation balance

Interest Expense

Interest Payable

1/2/06 Belle warehouse lease

P4,185,388 E &

1/2/06 Initial payment P150,000 @ P150,000 C P4,035,3884/1/06 Payment P150,000 @ P 69,292 C P3,966,096 P 80,708 C7/1/06 Payment P150,000 @ P 70,678 C P3,895,418 P 79,322 C10/1/06 Payment P150,000 @ P 72,092 C P3,823,326 P 77,908 C12/31/06 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 1Interest expense 314,405

Interest payable 76,467Obligation under long-term lease 237,938

To adjust obligation for interest not recognized in lease payments.

@ Examined canceled check.E Examine lease agreement and

recalculated net present value of minimum lease payments. Also inspected warehouse.

Lease Terms:Term: 10 years with no purchase

or renewal option.Payments: P150,000 per quarter

payable in advance.^ Determined that this is a capital

lease. NPV of lease payments equals P4,185,388, the fair value of the warehouse at date of lease.

Executory costs assumed by lessee.Interest rate: 8 percent per annum.Market value of warehouse:

P4,185,388.Date of lease: January 2, 2006

C Calculated. Date of first payment: January 2,& Examined directors’ minutes to

establish proper authorization of lease transaction.

2006

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:


2006Dec. 31 Estimated Loss from Litigation 70,000

Estimated Liability from Pending Lawsuit 70,000

2. 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 estimated cost of repairs (P200,000) as follows:

2006Dec. 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.

3. 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 minimum amount of the range (P40,000) because it is not likely that the loss will be less, as follows:

2006Dec. 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%) P909,000Less: Net carrying amount of bonds redeemed:

Par value P900,000Unamortized discount (13,500)Unamortized bond issue costs (7,200) 879,300

Loss on redemption P 29,700Calculation of unamortized discount—

Original amount of discount: P900,000 X 3% = P27,000P27,000/10 = P2,700 amortization per yearAmount 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 = P14,400P14,400/10 = P1,440 amortization per yearAmount of costs unamortized: P1,440 X 5 = P7,200

January 2, 2006Bonds Payable........................................................................................................................900,000Loss on Redemption of Bonds ..............................................................................................29,700

Unamortized Bond Issue Cost.................................................................................7,200Discount on Bonds Payable.....................................................................................13,500


Cash.........................................................................................................................909,000

14-19. Stargazer Company

Reacquisition price (P300,000 X 104%)...............................................................................P312,000Less: Net carrying amount of bonds redeemed:

Par value................................................................................................................P300,000 Unamortized discount............................................................................................ (10,000) 290,000

Loss on redemption................................................................................................................P 22,000

Bonds Payable........................................................................................................................300,000Loss on Redemption of Bonds...............................................................................................22,000

Discount on Bonds Payable.....................................................................................10,000Cash.........................................................................................................................312,000 (To record redemption of bonds payable)

Cash........................................................................................................................................306,000Unamortized Bond Issue Costs..............................................................................................3,000

Premium on Bonds Payable.....................................................................................9,000Bonds 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............................................................................................................200,000Interest Payable.......................................................................................................18,000Accumulated Depreciation—Machine....................................................................221,000 Machine...........................................................................................................390,000 Gain on Disposition of Machine......................................................................21,000a

Gain on Debt Restructuring.............................................................................28,000b

aP190,000 – (P390,000 – P221,000) = P21,000.b(P200,000 + P18,000) – P190,000 = P28,000.

Prime National Bank (Creditor):Machine...................................................................................................................190,000Allowance 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............................................................................................................200,000Interest 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)...............................................................................................190,000Allowance 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......................................................................................................................................41,879Asset Retirement Obligation...................................................................................41,879

Requirement (b)Depreciation Expense............................................................................................................60,000

Accumulated Depreciation......................................................................................60,000

Depreciation Expense............................................................................................................4,187.90Accumulated Depreciation......................................................................................4,187.90*

Interest Expense.....................................................................................................................2,512.74Asset Retirement Obligation...................................................................................2,512.74**

*P41,879/10.**P41,879 X .06.

Requirement (c)

Asset Retirement Obligation........................................................................75,000Loss on ARO Settlement.......................................................................................................5,000


Cash.........................................................................................................................80,000

14-22. Johnny B. Good Corporation

December 311. 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

Chapter14 - Answer

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