Polytechnic University of the Philippines

College of Accountancy and Finance

AUDITING AND

AND
(INSTRUCTIONAL MATERIALS IN ACCO 30063)

Compiled by:

Aguila, James Robert D.

Binaluyo, Jonathan P.
Lascano, Lyra Victoria V.
TABLE OF CONTENTS
Course Outcome
Module 1: Audit of Investments
Module 2: Audit of Liabilities – Current
Module 3: Audit of Liabilities – Non current
Module 4: Audit of Shareholder’s Equity
Module 5: Special Audit Considerations

Grading System
References/Reading Materials

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COURSE OUTCOME

Upon completion of the course, the students will be able to:

a. have sound knowledge of the auditing standards applicable to
the audit procedure related to Financing Cycle, investing cycle,
and Special audit considetions.
b. apply the analytical skills in systematic problem solving.
c. present computations and prepare the working paper in good
form.
d. appreciate the importance of appropriate auditing procedures
for various users of accounting information.
e. Realize the contributions of auditing to the development of a
more socially responsible and morally upright professional
accountant.

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 Audit of Investments
Overview
Risk of material misstatement is a combination of inherent risk and control risk. Likewise,
risk of material misstatement for investments is the risk that investment accounts contain
material misstatement but the internal control cannot prevent or detect such
misstatement.

Hence, the level of risk of material misstatement for investments will depend on whether
their inherent risk is high or not and whether there are effective control procedures to
reduce the chance of risk occurring or to timely detect such risk before it has a significant
impact on financial statements.

In short, inherent risk and control risk of investments will decide the level of risk of material
misstatement and auditors will have to modify detection risk to properly respond to the
assessed risk of material misstatement.

Inherent Risk of Investments

Inherent risk is the risk that could occur on the accounts or balances before considering
any control in place. In this case, inherent risk of investments is the risk that investments
contain material misstatement before taking internal control into consideration.
In short, inherent risk of investment accounts is their susceptibility to misstatement.
Likewise, the level of inherent risk is based on nature and types of transactions. For
example, we usually consider the inherent risk of transactions that involve derivative
instruments to be high due to their complex nature.

Examples of inherent risk of investments may include:

• Improper valuation of investments due to their complexity (especially when
dealing with derivative instruments)
• Incorrect value of investments (e.g. due to changes in market value has not
been recorded)
• Impairment of investments are not properly measured and recorded
• Investment transactions are recorded in the wrong accounting period
• Incorrect method of accounting used in investments
• Losses from investments may be hidden or delayed reporting (e.g. with the
improper method of valuation)
• Wrong classification of investments (e.g. due to the staff’s lack of
knowledge)
• Revenues from investments are overstated
• Fictitious investments are recorded
• Investments are stolen
• Investments are intentionally overstated to cover fraud

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 • Inadequate disclosure about investments in financial statements

Control Risk of Investments

Control risk is the risk that the client’s internal controls cannot prevent or detect material
misstatement on the financial statements. In this case, the control risk of investments is
the risk that investment accounts contain material misstatement, but the related control
procedures cannot prevent or detect such misstatement.

Auditors usually assess the control risk when they obtain an understanding of the client’s
business and control environment. In this case, after identifying the inherent risk of
investments, auditors would usually try to assess whether there are control procedures in
place to prevent or detect such risk, especially when they conclude that inherent risk is
high.
Likewise, if the inherent risk of investments is high, the level of risk of material
misstatement will depend entirely on the control risk. Hence, only adequate internal
control procedures may reduce the risk of material misstatement for investments to some
extent.

Examples of internal control procedures that can reduce the risk of material misstatement
for investments may include:
• Proper authorization controls (e.g. all purchases and sales of investments
need to be approved by the board of directors)
• Proper segregation of duties (e.g. the persons, who have the right to make
investments and persons who are responsible for the custody of
investments, are different persons)
• Monthly reconciliation of investments schedule to the general ledger
• Proper physical controls of investments to prevent them from loss
• Adequate policies on valuation and classification of investments
• Periodic performance review of investments
• Periodic internal audit

It is useful to note that when auditors assess that the control risk of investments is low
and want to rely on internal controls to reduce some of their substantive works, they need
to perform the test of controls to obtain sufficient appropriate audit evidence to support
their assessment.
On the other hand, if they assess that the control risk is high, they will just ignore the test
of controls and go directly to substantive tests (by performing more work). After all, there
is no point of trying to prove that internal control is weak and ineffective in preventing or
detecting the risk of material misstatement that could occur in the investment accounts.

Controls to prevent, deter, and detect fraud:

• Use of system control like security admittance
• Develop many channels for employees to report any kind of fraud or fraud-related
concerns.

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 • Periodic recording of an investment company’s compliance with its investment
goals and restrictions
• Many compliance programs

Risk of Material misstatement due to Fraud:

In the Investment Company or industry, the unusual or unexpected risk of misstatement
due to the reason of fraud are as follows:
Investment performance substantially higher (or lower) when compared with industry
peers or
other relevant benchmarks, which cannot be readily attributed to the performance of
specific
securities when prices are readily available in an active market. Particular considerations
include
the following:
• Significant gains (or losses) from securities held for extremely short periods of time
• Significant gains (or losses) from instruments not typically acquired by the fund

Unusually high levels of acquisitions and sales of investments in comparison to overall

net assets of funds without an obvious economic intent.
Expense ratios that change frequently after the year and next year with insufficient
justifications. Expense ratios and the transaction cost increased the company’s norms.
Examples of internal controls procedures that can reduce risk.
• Do internal audit on periodic bases.
• Review of investments occasionally
• Adequate policies on valuation and classification of investment
• Proper physical controls of investment to prevent from loss.

It is valuable to note that when auditors evaluate that the investment control risk is low
and that they want to rely on internal controls to minimize some of their substantive work,
they need to carry out a control test in order to obtain adequate audit evidence to support
their assessment.

On the other hand, if they determine that the risk of control is high, they would actually
skip the control test and go straight to substantive testing (by doing more work). There is
no point in attempting to show after all that internal monitoring is inadequate and
Ineffective in preventing or identifying the possibility of material misrepresentation that
may occur in investment accounts.

Common Investment Control Deficiencies

It is common to have the following investment control deficiencies:
• One person buys and sells investments, records those transactions, and
reconciles the investment activity

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 • The person overseeing investment accounting does not possess sufficient
knowledge or skill to properly perform the duty
• Investment reconciliations are not performed timely or improperly
• The company does not employ sufficient assistance in valuing complex assets
such as hedges or alternative investments

Risk of Material Misstatement for Investments

Asses control risk at high for each assertion. (You may, however, assess control risk at
less than high, provided your walkthrough reveals that controls are appropriately
designed and that they were implemented. If control risk is assessed at below high, you
must test controls for effectiveness to support the lower risk assessment.)
When control risk is assessed at high, inherent risk becomes the driver of the risk of
material misstatement (control risk X inherent risk = risk of material misstatement). For
example, if control risk is high and inherent risk is moderate, then my RMM is moderate.

Substantive Procedures for Investments

1. Confirming investment balances agreeing them to the general ledger
2. Inspecting period-end activity for proper cutoff
3. Using an investment specialist to value complex instruments (if any)
4. Vetting investment disclosures with a current disclosure checklist

Common Investment Work Papers

Investments work papers normally include the following:
• An understanding of investment-related internal controls
• Risk assessment of investments at the assertion level
• Documentation of any control deficiencies
• Investment audit program
• Investment reconciliations
• Investment confirmations
• Valuations performed by specialists
• Documentation of the specialist’s experience, competence, and objectivity
• Disclosure checklist

Auditing Investments - A Simple Summary

• The primary relevant investment assertions include existence, accuracy, valuation,
and cutoff
• Perform a walkthrough of investments by making inquiries, inspecting documents, and
making observations
• The directional risk for investments is an overstatement
• Primary risks for investments include:
a. Investments are stolen
b. Investments are intentionally overstated to cover up theft
c. Investments accounts are intentionally omitted from the general ledger
d. Investments are misstated due to errors in the investment reconciliations

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 e. Investments are improperly valued due to their complexity and management’s lack
of accounting knowledge
f. Investments are misstated due to improper cutoff
g. Investments disclosures are not accurate or complete

The substantive procedures for investments should be responsive to the identified risks;
common procedures include:
• Confirming investments
• Inspecting period-end activity for proper cutoff
• Using an investment specialist to value complex instruments
• Vetting investment disclosures with a current disclosure checklist

ASSESSMENTS

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The following are transactions of Angat Company:

The market values at the end of the year are:

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Based on the above and the result of your audit, determine the following:
1. Gain or loss on sale of P500,000 RP Treasury Bonds on August 1?
2. Gain or loss on sale of 3,000 Malolos shares on October 1?
3. What amount of unrealized gain should be shown as component of income?
4. What amount of unrealized gain should be shown as component of equity as of
December 31?

You were engaged by Balagtas Company to audit its financial statements for the year
2021. During the course of your audit, you noted that the following trading securities were
properly reported as current assets at December 31, 2020:

The following transaction transpired during 2021:

The following dividend information pertains to shares owned by Balagtas:

1.How much is the total value of investment reported in 2021 FS?

2. how much is the amount reported in income statement in 2021?

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GUEST COMPANY has a stock investment in Marciano Corporation. Described below
are the transactions pertaining to this investment:

a) On January 2, 2021, GUEST purchased 10,000 shares of P100 par value common
stock at P110 per share. The company debited Investment in Stock account.

b) The Marciano Corporation was expanding and on March 2, 2021 it issued stock
rights to its stockholders. Each right entitles GUEST to purchase one fourth (1⁄4) share
of common stock at par. The market value of the stock on that date was P140 per
share. There was no quoted price for the rights. No journal entry was made to record
the foregoing.

c) On April 2, 2021, GUEST exercised all its stock rights. The Investment in Stock
account was charged for the amount paid.

d) GUEST’s accountant felt that the cash paid for the new shares was merely an
assessment since GUEST’s proportionate share in Marciano was not changed. Hence,
he credited all dividends (5% in December of each year) to the Investment in Stock
account until the debit was fully offset.

e) GUEST received a 50% stock dividend from Marciano in December 2021. Because
the shares received were expected to be sold, the company’s president instructed the
accountant not to make any entry for this dividend. The company did sell the dividend
shares in January 2022 for P160 per share. The proceeds from the sale were credited
to income.

f) In December 2022, Marciano’s stocks were split on a two-for-one basis and the new
shares were issued as no par shares. GUEST found that each new share was worth
P10 more than the P110 per share original acquisition cost. For this reason, GUEST
decided to debit the Investment in Stock account with the additional shares received at
P120 per share and credited revenue for it.

g) In August 2023, GUEST sold one half (1⁄2) of its holdings in Marciano at P100 per
share. The proceeds were credited to the Investment in Stock account.

GUEST uses the average method in recording disposals of its investment in stock.

1. Prepare the journal entry to record the receipt of stock rights on March 2, 2021.
2. What is the total cost of the shares acquired on April 2, 2021?
3. What was the average cost per share of GUEST’s Investment in Stock after the
exercise of the stock rights on April 2, 2021?

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4. Prepare the journal entry to record the stock dividend received.
5. Determine the gain or loss on the sale of dividend shares received.
6. How many shares were received by GUEST as a result of the two-for-one stock
split?
7. What journal entry should be made to record the stock split?
8. How much gain or loss should have been recognized by GUEST from the sale of
stocks in August 2023?
9. How much is the unadjusted balance of the Investment in Stock account on
December 31, 2023?
10. How much is the adjusted balance of the Investment in Stock account on December
31, 2023?

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 Audit of Current Liabilities
Introduction
Accounts payable is usually considered one of the high-risk items in the financial statements when
we audit accounts payable and purchases. This is due to accounts payable can be a subjective area
that leads to misstatement which is due to fraud or error.

Unrecorded liabilities, expense fraud, and duplicate payment could happen anytime if there are no
proper and strong control procedures in place for expense and accounts payable.
In the audit of accounts payable, when there is a high risk of fraud, the accounts payable
confirmation is usually performed by sending the accounts payable confirmation letters to
suppliers asking them to fill out information such as all outstanding invoices, payment terms,
payment histories, etc. Other procedures such as examining supporting documents and reconciling
suppliers’ statements are also performed.

Audit Assertions for Accounts Payable

Assertions that we usually need to test in the audit of accounts payable are included in the
following table:
Audit assertions for accounts payable

Accounts payable balances reported on the balance sheet include all

Completeness
payable transactions that have occurred during the accounting period.

Accounts payable balances reported on the balance sheet actually

Existence
exist at the reporting date.

Accounts payable have been recorded in the correct amount and their
Valuation
balances reflect the actual economic value.

The company actually owes a liability for accounts payable as at

Rights and obligation
reporting date.

Presentation and Accounts payable are properly classified on the balance sheet and
disclosure disclosed in the notes to the financial statements.

In the accounts payable audit, the completeness assertion is the most relevant assertion as the
understatement of accounts payable is our major concern. This may be due to an intentional act of
account manipulation or fraud tends to make accounts payable understated rather than overstated.

Risk of Material Misstatement for Accounts Payable

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Risk of material misstatement refers to the risk that material misstatement can occur on the
financial statements and internal control procedures cannot prevent, detect or correct the
misstatement. Risk of material misstatements consists of inherent risk and control risk.
In this case, risk of material misstatement for accounts payable is the risk that accounts payable
can be materially misstated and the related control procedures cannot prevent or detect such
misstatement.

Inherent Risk of Accounts Payable

Inherent risk is the risk that is related to the nature and complexity of the business’s transactions.
It is the susceptibility of account or balance to misstatement. Likewise, inherent risk of accounts
payable is the susceptibility of accounts payable to misstatement.

Inherent risk of accounts payable is the risk that accounts payable may contain material
misstatement regardless the related control procedures that the company has in place.
The primary inherent risk of accounts payable is usually related to the completeness of accounts
payable, in which the accounts payable may be understated. For example, the management of the
company may not want to record the liability and related Accrued expenses. Hence, payables and
related transactions may be omitted.

There is also a risk that the company may delay the recording of payables and their related Accrued
expenses to the period after year-end when they should be recorded in the current period. This also
leads to the understatement of accounts payable.

This is why when performing the audit test on accounts payable and related Accrued expenses, we
usually perform the audit procedure of search for unrecorded liabilities e.g. by examining
unrecorded invoices and the subsequent payment of accounts payable.

Control Risk of Accounts Payable

Control risk is the risk that the company’s internal control procedures cannot prevent or detect
material misstatement that can occur on financial statements. In this case, the control risk of
accounts payable is the risk that accounts payable related control procedure cannot prevent or
detect material misstatement.

Control risk of accounts payable is high if the company does not have effective control in place or
the related personnel that operates the control procedures do not perform their work properly.
If the company has proper internal control procedures related to accounts payable in place, we can
assess control risk as low and perform test of controls for accounts payable to obtain evidence to
support our assessment.

As the risk of material misstatement is the combination of inherent risk and control risk, the strong
and effective internal control can reduce the level of risk of material misstatement for accounts
payable.

For example, monthly reconciliation of supplier statements to relevant payables is a primary

internal control procedure that can help to ensure the completeness of accounts payable. Hence, it
helps to reduce the risk of unrecorded liabilities either due to error or fraud.

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Test of Control on Accounts Payable
The internal controls for account payable are directly linked to the client’s internal controls of the
purchases. Usually, the control procedures of authorization and the segregation of duties are very
important in almost all areas in the client’s internal control, especially in the purchases and
accounts payable procedures.

Likewise, test of controls for accounts payable is usually performed with those of purchases and
Accrued expenses. However, the primary risk is that accounts payable is material understated.
Hence, the primary internal control procedure of accounts payable is the procedure that can ensure
completeness of accounts payable.

In this case, the main control for accounts payable that we want to check with the client is the
reconciliation of the account payable balances with supplier statements. This type of internal
control can help to ensure the completeness of accounts payable.

If the client performs this control either monthly or yearly, we can perform the test of control for
accounts payable here by examining and evaluating the client’s procedures of performing these
reconciliations. In this case, we can perform this test by reperforming the monthly reconciliation
of supplier statements to relevant payables in the accounting record.

Additionally, we usually examine the reconciliation report to ensure that it is done by independent
personnel and is properly reviewed. This is to evaluate the effectiveness of control procedures of
accounts payable reconciliations, so that we may be able to place reliance on the client’s accounts
payable reconciliation procedures.

Otherwise, if there are no reconciliations done by the client, we will need to perform this task by
comparing supplier statements with year-end accounts payable balances in the substantive
procedures to ensure completeness.

Usually, we perform test of controls when we intend to rely on internal control and we believe that
such control procedures can reduce the risk of material misstatement.
As mention above, completeness assertion is the most relevant assertion in the audit of accounts
payable; hence we usually assess the importance of internal control concerning the completeness
of accounts payable.

Audit Procedures for Accounts Payable

Usually, our main concern regarding the misstatement that could occur on accounts payable is the
understatement of accounts payable as the fewer liabilities the company has the better it looks.
Hence, in substantive procedures to gather audit evidence on accounts payable, we usually place
our attention more on the area that exposes to the high risk of understatement of accounts payable.

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Substantive audit procedures for accounts payable may include both substantive analytical
procedures and test of details. The nature and extent of both tests are directly related to the level
of risk that the client’s accounts payable are exposed to.

If there is a low risk in this area, we may limit the test to substantive analytical procedures only;
otherwise, we need to perform further work with the test of details.

Analytical Procedures in Audit of Accounts Payable

To audit accounts payable, analytical procedures can be performed as a high-level review. This
can be done by looking at the trend and ratios of the accounts payable to see if there is any
significant fluctuation that we should take note of and make further investigation.
Comparing payable balance at the current year to the previous year is the procedure to test the
reasonableness of the changes. We also calculate the ratios of accounts payable’ turnover and
account payable days then compare them to the previous year and the industry data.
In normal cases, the ratios shouldn’t be much different from the previous year; hence, we should
expect the accounts payable’ turnover and account payable days to stay around the same as the
previous year. Therefore, we usually need to investigate further if there is a significant difference
in the result.

Test of Details in Audit of Accounts Payable

Completeness
For the audit of accounts payable, we test completeness assertion to ensure that all accounts
payable and their transactions occurred during the year have been recorded. Lack of completeness
would result in the understatement of accounts payable.
Example: tests of completeness in accounts payable audit include:
• Obtain accounts payable listing the client and perform casting and cross-casting to the
general ledger to ensure their balances are matched.
• Select a sample of suppliers’ statements and reconcile them to the accounting records.
• Test for unrecorded liabilities by examining the transactions after year-end and those of
unrecorded invoices.

Usually, by performing the reconciliation of suppliers’ statements, we can ensure the assertions of
completeness, existence, and valuation.

Existence
When we perform accounts payable audit, we test the existence assertion to ensure that the
accounts payable balance shown on the balance sheet really exists at the reporting date.
Example: tests of existence in accounts payable audit include:
• Select a sample of payable accounts and vouch them to the supporting documents, such as
purchase orders and suppliers’ invoices.
• Select a sample of payable accounts and reconcile them to the suppliers’ statements
• Perform accounts payable confirmation on a sample of suppliers

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Valuation
In the audit of accounts payable, we test the valuation assertion to ensure that the payable balances
are mathematically correct. The objective here is to make sure that payable balances are accurate.
We can test them by selecting a sample of payable accounts and agreeing them to the supporting
documents such as purchase orders and suppliers’ invoices. Additionally, reconciliation between
a sample of suppliers’ statements and payable accounts also ensure valuation.

Rights and obligation

We test right and obligation assertion to see whether the client actually has liability for accounts
payable reported. Likewise, we can test this assertion by vouching a sample of payable accounts
to supporting documents.

Audit of Accrued expenses and Provisions

Introduction
We usually perform the audit of Accrued expenses by testing various audit assertions including
completeness, cut-off, accuracy, and occurrence. Likewise, each audit may require different audit
procedures to ensure that we can gather sufficient appropriate audit evidence to make a
conclusion.

The risk that we usually have with the expense accounts is the material understatement of Accrued
expenses. This is due to the understatement of Accrued expenses would make the company’s
performance looks better than it actually is. Hence, the understatement of Accrued expenses is
likely to occur than overstatement.
Some examples of Accrued expenses include rental Accrued expenses, utilities, office supplies,
stationery, marketing and promotion, transportation, professional and consulting fees, and
insurance.

Audit Assertions for Accrued expenses

In the audit of Accrued expenses, we usually test the audit assertions that are included in the table
below:
Audit assertions for Accrued expenses

All Accrued expenses that should have been recorded have actually been
Completeness
recorded.

Cut-off All Accrued expenses have been recorded in the correct accounting period.

Accuracy All Accrued expenses transactions have been recorded correctly.

All Accrued expenses that have been recorded actually occurred and are
Occurrence
related to the client.

Classification All Accrued expenses have been properly classified.

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In the audit of Accrued expenses, completeness is the most relevant audit assertion, in which we
pay more attention to it. This is due to the lack of completeness will lead to the understatement of
Accrued expenses which results in the overstatement of profit. Likewise, the misstatement, in this
case, may due to fraud committed by the internal staff.

The cut-off is also an important audit assertion for expense accounts after completeness. This is
due to the risk that the company’s management may try to delay Accrued expenses to the next
period so that the profit in this period looks higher than it actually is. They may do this by not
recording Accrued expenses in this period even though the actual business transactions occur in
the current period.

Risk of Material Misstatement for Accrued expenses

Risk of material misstatement is the risk that may occur on financial statements and internal
control procedures in the company cannot detect or prevent such misstatement.
For the Accrued expenses account, it is the probability that the expense account contains material
misstatement and expense related control cannot prevent or detect such misstatement. In other
words, it is a combination of inherent risk and control risk.

Inherent Risk of Accrued expenses

Inherent risk of expense is the susceptibility of expense account to misstatement. It is related to
the nature and complexity of the expense account.

In the audit of Accrued expenses, the primary inherent risk is the understatement of Accrued
expenses which is related to completeness assertion. The risk of Accrued expenses here is usually
high as the management of the company may intend to not record the Accrued expenses which
lead to an understatement of Accrued expenses and overstatement of profit. This case may happen
in the circumstance that involves incentive or pressure in the company.

For example, if the company achieves a certain profit, the management will receive a big incentive.
In this case, the management is encouraged to increase profit to a certain level, hence they may
intent to understate the Accrued expenses in order to achieve their objective.

There is also an inherent risk that the Accrued expenses that occur in the current period are delayed
recording to the next accounting period in order to increase the profit in the current period. This
would also result in the understatement of Accrued expenses.
Other risks may occur in the audit of Accrued expenses include:
• The company fails to record accrued expenses that already incurred, but not yet paid
• Expense transactions are recorded as an asset resulting in an understatement of Accrued
expenses and overstatement of asset
• Repairs and maintenance Accrued expenses are recorded as additions to PPE
• The company closes the books early for Accrued expenses, e.g. close account at December
22 instead of December 31, to delay Accrued expenses into the next period

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 • Accrued expenses are broken down into smaller pieces to avoid our examination as
auditors. For instance, knowing that we examine all Accrued expenses over P10,000, the
client may intentionally breakdown Accrued expenses into the smaller piece below
P10,000 and capitalized them as fixed assets.
Control Risk of Accrued expenses
Control risk is the risk that control procedures fail to prevent or detect material misstatement that
can occur. In this case, the control risk of Accrued expenses is the risk that internal control cannot
prevent or detect misstatement on expense account.

In the audit of Accrued expenses, the internal control procedures that we usually concern about
are those that can reduce the risk of material misstatement for Accrued expenses.
In this case, examples of internal control procedures for Accrued expenses include:
• Segregation of duties between those who make purchase, receive goods, and record in the
accounting system
• Proper authorization on all Accrued expenses and payment
• Proper procedures for checking for quantity and quality when goods are received
• Expense invoices are matched to purchase order and goods received note before recording
in the accounting system
• Proper procedure to verify for the correct amount before recording in the accounting system

There can be a high risk of error or fraud if there is no proper internal control in place, especially
if no such control procedures that we mentioned in the example above.

For example, if there is no proper authorization in place for Accrued expenses acquisition and
payment, there is a risk that the Accrued expenses acquisition may have been made for personal
use or the fictitious invoices may have been created and payment is made to a personal account.

Assessing control risk is very important as the control risk will influence the nature, timing and
extent of the substantive audit procedures.
When we assess that the control risk is low and we intend to rely on the internal control to reduce
the substantive procedures, we need to perform test of controls to obtain evidence to support our
assessment.

Test of Controls in Audit of Accrued expenses

In the audit of Accrued expenses, we perform test of controls to ensure that the client’s internal
controls are effective in preventing or detecting material misstatement in expense accounts.
However, we only perform test of controls if we assess the control risk as low and intend to rely
on internal control to reduce some of our tests of details.

In this case, we perform test of controls to obtain audit evidence to support our assessment that we
believe the internal controls can reduce the risk of material misstatement in expense accounts.
If the client’s internal controls prove to be strong and effective after the result of the test, we can
reduce some work of our tests of details. On the other hand, we may need to increase the sample
size of the tests of details if the result is different from our assessment.
Test of control procedures may include:
• Inquire the client’s personnel related to the internal controls processes

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 • Observe the clients’ staff performing their tasks on specific controls
• Inspect the supporting documents to make sure that the controls have been properly
performed
• Re-perform the controls that have been performed by clients’ personnel
When performing the above procedures, the inquiry should be performed with inspecting
documents or observation procedures to ensure that what the client tells us is actually true.
The main concerns in the controls of Accrued expenses are authorization and segregation of duties.
Good internal controls should have proper authorization and segregation of duties in the control
cycle for Accrued expenses from requesting for goods or services to the payment for goods or
services.

Control Cycle for Accrued expenses

Example of Test of Controls:

• We test the control of authorization of the expense by obtaining supporting documents to
verify whether the expense payment has properly approved by authorized persons.
• We test the control of segregation of duties by verifying whether the person who receives
goods and the person who records the transaction are different persons.

It is useful to note that if we assess the control risk as high or we do not intend to rely on the
client’s internal controls, we will not perform the test of controls. Likewise, we will go directly to
substantive audit procedures. We do not need to test the internal controls to prove that they are
weak at all.

Substantive Audit Procedures for Accrued expenses

Substantive audit procedures include substantive analytical procedures and tests of details. We
usually perform analytical procedures before the test of details. This is due to we usually determine
the size of tests of details based on the result of the analytical procedures. Though, we sometimes
go directly to test of details without performing the analytical procedures in the substantive tests.

Substantive Analytical Procedures for Accrued expenses

Substantive analytical procedures are the analytical procedures that we perform in the evidence-
gathering stage of the audit. In this case, we perform substantive analytical procedures to obtain
evidence about certain audit assertions for the expense accounts.

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We usually perform analytical procedures by evaluating financial information through analysis of
trend, ratio or relationship between data. The analysis may include both financial and non-financial
data.

In this case, we can build our expectation from the result of analysis and compare to the client’s
record. If there is a significant difference between our expectation and the client’s record, we will
perform further investigations on the difference by performing more detail tests.

For example, in testing the rental Accrued expenses, we can build our expectations from the
inquiry with the client if they have expanded the operation to other locations during the year. If
they have, we would expect a big increase in rental Accrued expenses. Otherwise, we would expect
less fluctuation in rental Accrued expenses.

Hence, we can analyze the fluctuation of rental Accrued expenses from year to year and compare
with our expectations. If the fluctuation is out of the expectation, we may need to perform further
tests to investigate the variance.

Test of Details for Accrued expenses

In the test of details for the audit of Accrued expenses, we usually focus our tests on the
completeness, cut-off, occurrence and accuracy assertion of the expense transactions.

Completeness
We test the completeness assertion to verify whether all expense transactions have recorded.
Usually, any misstatement in the completeness assertion would result in the understatement of the
Accrued expenses which lead to a higher profit than it actually is.
Example: test of completeness assertion:
• Select a sample of goods received notes (receiving reports)
• Trace the selected goods received notes to purchase orders and supplier invoices
• Trace the invoices to the expense transactions in general ledger
Also, in testing the completeness assertion, all credit side Accrued expenses (or negative Accrued
expenses) transactions in the general ledger should be examined to see whether there are unusual
transactions that could be the result of error or fraud.

Cut-Off
We test the cut-off assertion to verify whether the transactions have been recorded in the correct
accounting period. In the audit of Accrued expenses, cut-off assertion bears similar risk to
completeness as the client’s management may delay Accrued expenses to the next period so that
the profit of the current period looks better than the actual one. This would make the recorded
expense transactions not completed in the current period.
An example of testing the cut-off is reviewing the expense transactions around year-end, e.g. ten
days before year-end and after year-end. And examine whether they are recorded in the correcting
period by vouching to the supporting documents.

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Cut-off assertion can be tested by examining the date recorded in the general ledger and comparing
it to the date on the supporting invoices and goods received notes.

Occurrence
We test occurrence assertion to verify whether the expense transactions that have been recorded
in the accounting system actually occurred during the period.
Under the accrual basis, Accrued expenses should be recognized and recorded when they occurred
regardless of whether the payment have been made. It usually happens when the client receives
the goods or services.

Example: test of occurrence assertion:

• Select a sample of recorded Accrued expenses transactions from the general ledger
• Vouch the selected transactions to the supplier’s invoices to ensure transactions recorded
are based on the supplier’s invoices
• Trace the supplier’s invoices to the purchased orders and goods received notes (receiving
reports) to ensure that the goods had been received when the expense was recorded
In the audit of Accrued expenses, while we test the occurrence assertion by vouching transactions
to supporting documents, we usually also verify the mathematical accuracy of such transactions.
Hence, the accuracy assertion test is also complete here with the occurrence assertion.

Accuracy
We test the accuracy assertion to verify whether expense transactions recorded are mathematically
correct. As mentioned above, we usually test accuracy together with occurrence assertion for the
Accrued expenses.
In this case, by agreeing the expense transactions in the general ledger to supporting documents,
such as supplier’s invoice, goods received note (receiving report) and purchase order, we can
ensure both accuracy and occurrence assertion.

Classification
We test the classification assertion to examine whether expense transactions recorded are properly
classified. The major concern in this assertion is that the Accrued expenses are recorded as an asset
which leading the Accrued expenses understated and assets overstated.
As the main concern is about the wrong classification of Accrued expenses to fixed assets, we
usually perform the test of classification assertion in the audit of fixed assets. For example, we test
the classification assertion by examining fixed assets addition to verify whether the addition is
indeed the fixed asset, not Accrued expenses.

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 ASSESSMENT
PROBLEM NO. 1
You were able to obtain the following from the accountant for Matagumpay Corp. related to the
company’s liabilities as of December 31, 2021. Accounts Payable P 650,000
Notes Payable – trade 190,000
Notes Payable – bank 800,000
Wages and salaries payable 15,000
Interest payable ?
Mortgage notes payable – 10% 600,000
Mortgage notes payable – 12% 1,500,000
Bonds Payable 2,000,000

The following additional information pertains to these liabilities. a.

All trade notes payable are due within six months from the end of the reporting period.

Bank notes-payable include two separate notes payable to Allied Bank.

A P300,000, 8% note issued March 1, 2019, payable on demand. Interest is payable every six-
months.
A 1-year, P500,000, 11 ½ % not issued January 2, 2021. On December 30, 2021,
Matagumpay negotiated a written agreement with Allied Bank to replace the note with a 2-year,
P500,000, 10% note to be issued January 2, 2022. The interest was paid on December31, 2021.

The 10% mortgage note was issued October 1, 2018, with a term of 10 years. Terms of the
note give the holder the right to demand immediate payment if the company fails to make a
monthly interest payment within 10 days of the date the payment is due. As of December31,
2021, Matagumpay is three months behind in paying its required interest payment.

The 12% mortgage note was issued May 1, 2015, with a term of 20 years. The current
principal amount due is P1,500,000. Principal and interest payable annually on April 30. A
payment of P220,000 is due April 30, 2012. The payment includes interest of P180,000.

The bonds payable is 10-year, 8% bonds, issued June 30, 2012. Interest is payable semi-
annually every June 30 and December 31.

Based on the above and the result of your audit, answer the following.
1. Interest payable as of December 31, 2021 is?
2. The portion of the Note Payable-bank to be reported under current liabilities as of December 31, 2021
is?
3. Total current liabilities as of Decemberr 31, 2021 is?
4. Total noncurrent liabilities as of Decemberr 31, 2021 is?

Page 25
PROBLEM NO. 2
Elasticcompany has is a manufacturer and a retailer of household furnitures. Your audit of the
company’s financial statements for the year ended December 31, 2021, discloses the following
debt obligations of the company at the end of its reporting period. Eng-eng’s financial statements
are authorized for issuance on March 6, 2022
• Elasticcompany has the following three loans payable scheduled to be repaid on April of the
next year .The company intends to repay loan for 100,000 when it comes due in April. In the
following oct, the company intends to get a new loan for 150,000 from the same bank
• The company intends to refinance loan 2 for 300,000 when it comes due in April. The
refinancing agreement will be signed in April
• The company intends to refinance loan 3 for 500,000 before it comes due in April. The actual
refinancing took place in January
• A 250,000 short-tem obligation due on March 1 2022, its maturity could be extended to March
1 2016, provided Elastic agrees to provide additional collateral. On February12 2022, an
agreement is reached to extend the loans maturity to March 1 2016
• A short-term obligation of 3,600,000 in the form of notes payable due February 5 2022. The
company issued 75,000 ordinary shares for P36 per share on January 25 2022. The proceeds
from the issuance plus 900,000 cash, were issued to fully settle the debt on February 5 2022
• A long term obligation of 2,500,000 due on December 1 2018. On November 10 2021, Elastic
breaches the covenant on its debt obligation and the loan becomes payable on demand. An
agreement is reached to provide a waiver of the breached on December 11 2021
• A long term obligation of 4,000,000. The loan is maturing over 4-years in the amount of
1,000,000 per year. The loan is dated sept 1 2021, and the first maturity date is sept 1 2022
• A debt obligation of 700,000 maturing on December 31 2016. The debtor callable on demand
by the lender at any time

1. What amount of current liabilities should be reported on the December 31 2021 statement of financial
position?
2. What amount of noncurrent liabilities should be reported on December 31 2021 statement of financial
position?

PROBLEM NO. 3
The following information relates to Sonic Company’s obligations as of December 31, 2021. For
each of the numbered items, determine the amount if any, that should be reported as current
liability in Sonic’s December 31, 2021 balance sheet.

Accounts payable:
Accounts payable per general ledger control amounted to P5,440,000, net of P240,000 debit
balances in suppliers’ accounts. The unpaid voucher file included the following items that not had
been recorded as of December 31, 2021:
1. A Company – P224,000 merchandise shipped on December 31, 2021, FOB destination;
received on January 10, 2022.
2. B, Inc. – P192,000 merchandise shipped on December 26, 2021, FOB shipping point; received
on January 16, 2022.
3. C Super Services – P144,000 janitorial services for the three-month period ending January 31,
2022.

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4. MERALCO – P67,200 electric bill covering the period December 16, 2021 to January 15,
2022.
On December 28, 2021, a supplier authorized Sonic to return goods billed at P160,000 and shipped
on December 20, 2021. The goods were returned by Sonic on December 28, 2021, but the
P160,000 credit memo was not received until January 6, 2022.

Accrued salaries and wages Payroll deductions for:

Accrued salaries and wages, P776,000
Payroll deductions for:
Income taxes withheld, P56,000
SSS contributions, P64,000
Philhealth contributions, P16,000
Advances to employees, P80,000

Litigation:
In May, 2021, Sonic became involved in a litigation. The suit is being contested, but Sonic’s lawyer
believes it is possible that Sonic may be held liable for damages estimated in the range between
P2,000,000 and P3,000,000, and no amount is a better estimate of potential liability than any other
amount.

Bonus obligation:
Sonic Company’s president gets an annual bonus of 10% of net income after bonus and income
tax. Assume the tax rate of 30% and the correct income before bonus and tax is P9,600,000.

Note payable:
A note payable to the Bank of the Philippine Islands for P2,400,000 is outstanding on December
31, 2021. The note is dated October 1, 2020, bears interest at 18%, and is payable in three equal
annual installment of P800,000. The first interest and principal payment was made on October 1,
2021.

Purchase commitment:
During 2021, Sonic entered in a noncancellable commitment to purchase 320,000 units of
inventory at fixed price of P5 per unit, delivery to be made in 2022. On December 31, 2021, the
purchase price of this inventory item had fallen to P4.40 per unit. The goods covered by the
purchase contract were delivered on January 28, 2022.

Product warranty:
Sonic has a one year product warranty on selected items in its product line. The estimated
warranty liability on sales made during 2020, which was outstanding as of December 31, 2020,
amounted to P416,000. The warranty costs on sales made in 2021 are estimated at P1,504,000.
Actual warranty costs incurred during the current 2021 fiscal year are as follows:
Warranty claims honored on 2020, P416,000 Warranty claims honored on 2021, P992,00

1. How much is the total current liabilities

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PROBLEM NO. 3

In the audit process, the following data were obtained from the books of the Spurs Company which
uses a voucher system. All invoices are subject to term 2/10, n/30 and are entered net with the
discount entered in the Purchase Discount column of the voucher register. The accountant in
charge of the books went on leave to attend to his family based in New Jersey. A fresh accounting
graduate has been assigned to record the transactions. At year-end, the substitute accountant finds
that the unpaid vouchers do not agree with the Vouchers Payable control account. You are called
to adjust the matter.

A schedule of unpaid vouchers as of December 31, 2021, all of which are net of discount, is
presented to you:

Based on the above and the result of your audit, compute for the following as of December 31,
2021:
1. Adjusted balance of Vouchers Payable
2. Purchase discounts lost on unpaid vouchers
3. Purchase discounts lost on paid vouchers

4. Adjusting journal entry or entries to correct the accounts will include:

a. A debit to Purchase Discounts Lost of P11,250.
b. A debit to Purchase Discounts Lost of P5,050.
c. A credit to Vouchers Payable of P8,000.
d. A credit to Vouchers Payable of P11,250.

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PROBLEM NO. 4
LET’S MOVE ON Company had the following information related to its financial statement for
the year ended December 31, 2015 before adjustment for the result of your inquiry and observation.
You were engaged to audit the liabilities of the company and noted the following during your
performance of substantive procedures:

Notes payable:
• Arising from purchase of goods P340,000
• Arising from 3 year bank loans, on which a securities
valued at P1,000,000 have been pledge as security,
P500,000 note and another P300,000 due on
December 31, 2017. (Note 1) 800,000

Arising from advances by officers 50,000

Accounts payable, net of debit balances of P200,000
(Note 2) 3,160,000
Accrued payroll (Note 3) 240,000
Phil health, and PAG-IBIG payable 25,000
SSS payable 16,000

Employees income tax withheld 25,000

Containers deposit 80,000

Accounts receivable, net of credit balances from
customers of P40,000 560,000

Cash dividends payable 120,000

Share dividend payable 150,000
Dividend in arrears on preference shares 200,000
Estimated liability for damages 130,000

Estimated liability for premiums 95,000

Deferred revenue, expected to settle in February 14,
2017 107,000
Bonds payable 2,000,000
Accrued interest on bonds and notes 45,000
Share warrants outstanding 120,000
Share options outstanding 210,000
Unused letter of credit 500,000
Notes receivable discounted 250,000

AUDIT NOTES:

Note 1:

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The note payable of P500,000 is dated October 31, 2015 due on April 1, 2016 with 15% interest
annually. No entry made for the accrual of interest.

Note 2:
The unpaid voucher file included the following items that had not been recorded as of December
31, 2015:
a. TARA NA Company – P240,000 merchandise shipped on December 30, 2015, FOB shipping point;
received on January 10, 2016.
b. LIGAW, Inc. – P192,000 merchandise shipped on December 26, 2015, FOB destination; received on
January 16, 2016.
c. Super Bibo Services – P48,000 janitorial services for the four-month period ending January 31, 2016.
d. MERALCO – P125,800 electric bill covering the period December 16, 2015 to January 15, 2016.
e. On December 28, 2015, a supplier authorized LETS MOVE ON to return goods billed at P160,000 and
shipped on December 20, 2015. The goods were returned by LETS MOVE ON at December 28,
2015, but the P160,000 credit memo was not received until January 6, 2016.

Note 3:
Based on your inquiry and inspection of related documents, the above balance of accrued payroll
represents the gross balance of unpaid salaries of the employees who worked for the period covered
December 15-30, 2015. Total deduction includes amount withheld for SSS, Phil health, Pag-ibig,
P41,000 and employee taxes,P25,000.

1. Adjusted balance of accounts payable:

2. Total portion of the note reported as non-current:
3. Total current liabilities:
4. Total non-current liabilities:

PROBLEM NO. 5
ABC Co. provided you the unadjusted balances of accounts and notes payable for the year ended
December 31, 2015:

Accounts payable P1,250,000

Notes payable 73,000

The result of your purchase cut-off for ABC Co. revealed the following results:
Accounts payable cut-off

December, 2015 Purchases Journal

Receiving Invoice date/
Receiving
report Shipment Amount Remarks
report date
number date
010001 20-Dec 23-Dec P20,000 FOB Destination
289901 22-Dec 26-Dec 50,000 FOB Destination
349900 27-Dec 30-Dec 70,000 On consignment
FOB shipping
320901 28-Dec 2-Jan 55,000 point
022800 29-Dec 3-Jan 60,000 FOB Destination

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 FOB shipping
210021 30-Dec 4-Jan 80,000 point

January, 2016 Purchases Journal

Invoice
Receiving
date/ Receiving
report Amount Remarks
Shipment report date
number
date
200300 29-Dec 4-Jan P40,000 FOB Destination
FOB shipping
200301 30-Dec 4-Jan 50,000 point
200302 30-Dec 5-Jan 70,000 On consignment
FOB shipping
200303 2-Jan 6-Jan 75,000 point

Notes payable:
a. March 1, 2015, borrowed P25,000 on a two-year, 12 percent, interest bearing note. Interest is paid
yearly.

b. April 1, 2015, borrowed cash and signed a P20,000, two-year, noninterest bearing note. The market
rate of interest for this level of risk was 16 percent.

c. January 1, 2015, purchased a special truck with a list price of P33,000. Paid P3,000 cash and signed a
P30,000, three year, 10%, interest bearing note payable in equal payments every December 31 starting
2015 which includes interest based on outstanding balance. The market rate of interest for this level of
risk was 16 percent.

5. How much is the adjusted balance of Accounts payable?

6. How much is the current portion of the note reported in the financial statement at year end?
7. Interest payable on notes payables at year end?

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 Audit of Long Term Liabilities
(Notes payable and Bonds Payable)

Introduction
While auditing debt can be simple, sometimes it’s tricky. For instance, classification
issues can arise when debt covenant violations occur. Should the debt be classified as
current or noncurrent?

Likewise, some forms of debt (with detachable warrants) have equity characteristics,
again leading to classification issues. Is it debt or equity—or both? Additionally, leases
can create debt, even if that is not the intent. Most of the time, however, auditing debt is
simple. A company borrows money. An amortization schedule is created. And thereafter,
debt service payments are made and recorded.
Either way, whether complicated or simple, below I show you how to audit debt.

Auditing Debt — An Overview

In many governments, nonprofits, and small businesses, debt is a significant part of total
liabilities. Consequently, it is often a significant transaction area.
In this post, we will cover the following:
• Primary debt assertions
• Debt walkthroughs
• Debt-related fraud
• Debt mistakes
• Directional risk for debt
• Primary risks for debt
• Common debt control deficiencies
• Risk of material misstatement for debt
• Substantive procedures for debt
• Common debt work papers

Primary Debt Assertions

The primary relevant debt assertions include:
• Completeness
• Classification
• Obligation

In general, completeness and classification are the most important debt assertions. When
a company shows debt on its balance sheet, it is asserting that it is complete and
classified correctly. By classification, I mean it is properly displayed as either short-term

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or long-term. I also mean the instrument is debt and recorded as such (and not equity).
By obligation, I mean the debt is legally owed by the company and not another entity.
Keep these three assertions in mind as you perform your transaction cycle walkthroughs.

Debt Walkthroughs
Early in your audit, perform a walkthrough of debt to see if there are any control
weaknesses. As you perform this risk assessment procedure, what questions should you
ask? What should you observe? What documents should you inspect? Here are a few
suggestions.
As you perform your debt walkthrough ask or perform the following:
• Are there any debt covenant violations?
• If the company has violations, is the debt classified appropriately (usually
current)?
• Is someone reconciling the debt in the general ledger to a loan amortization
schedule?
• Inspect amortization schedules.
• Does the company have any unused lines of credit or other credit available?
• Inspect loan documents.
• Has the company refinanced its debt with another institution? Why?
• Who approves the borrowing of new money?
• Who approves new leases? Who handles lease accounting and are they
competent?
• Does the company have any leases that should be recorded as debt?
• Inspect new loan and lease approvals.
• How are debt service payments made (e.g., by check or wire)? Who makes
those payments?
• Are there any sinking funds? If yes, who is responsible for making deposits and
how is this done?
• Observe the segregation of duties for persons:
• Approving new loans,
• Receipting loan proceeds,
• Recording debt in the general ledger, and
• Reconciling the debt in the general ledger to the loan amortization
schedules
• Is the company required to file periodic (e.g., quarterly) reports with the lender?
Inspect sample debt-related reports, if applicable.
• Does the company have any convertible debt or debt with detachable warrants?
Are they properly recorded?
• Is the company following reporting framework requirements (e.g., FASB
Codification) for debt?
• Has collateral been pledged? If yes, what?
• What are the terms of the debt agreements?
• Has all debt of the company been recorded in the general ledger?

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 • Have debt issuance costs been accounted for properly based on the reporting
framework requirements? (FASB requires the netting of such costs with debt.)
• Has the company guaranteed the debt of another entity?
If control weaknesses exist, create audit procedures to address them. For example, if—
during the walkthrough—we see that one person approves loans, deposits loan proceeds,
and records the related debt, then we will perform fraud-related substantive procedures.

Debt-Related Fraud
A company can fraudulently inflate its equity by intentionally omitting debt from its balance
sheet. (Total assets equal liabilities plus equity. Therefore, if debt is not reported, equity
increases.)
As we saw with Enron, some entities place their debt on another company’s balance
sheet. (Enron did so using special purpose entities.) So auditors need to consider that
companies can intentionally omit debt from their balance sheets.
Another potential fraudulent presentation is showing short-term debt as long-term. When
might this happen? When debt covenant violations occur. Such violations can trigger a
requirement to classify the debt as current. If accounting personnel are aware of the
requirement to classify debt as current and don’t do so, then the reporting can be
considered fraudulent.
Additionally, mistakes can lead to errors in debt accounting.

Debt Mistakes
Errors in accounting for debt can occur when debt service payments are misclassified as
expenses rather than a reduction of debt. Also, debt can—in error—be presented as long-
term when it is current. Why? Maybe the company’s accountant doesn’t understand the
accounting rules.
Some forms of debt, such as certain types of leases, can be difficult to interpret.
Consequently, a company might errantly fail to record debt when required.
So, what is the directional risk for debt? An overstatement or an understatement?

Directional Risk for Debt

The directional risk for debt is an understatement. So, audit for completeness (and
determine that all debt is recorded).

Primary Risks for Debt

Primary risks for debt include:
1. Debt is intentionally understated (or omitted)
2. Debt is recorded as noncurrent (due more than one year from the balance
sheet date) though the amount is current (due within one year of the balance
sheet date)
It’s obvious why a company might want to understate its debt. The company looks
healthier. But why would a business desire to classify current debt as noncurrent? For the
same reason: to make the company look stronger. By recording current debt as

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noncurrent, the company’s working capital ratio (current assets divided by current
liabilities) improves.
As you think about the above risks, consider the control deficiencies that allow debt
misstatements.

Common Debt Control Deficiencies

In smaller entities, it is common to have the following control deficiencies:
• One person performs two or more of the following:
• Approves the borrowing of new funds,
• Enters the new debt in the accounting system,
• Deposits funds from the debt issuance
• Funds are borrowed without appropriate approval
• Debt postings are not agreed to amortization schedules
• Accounting personnel don’t understand the accounting standards for debt
(including lease accounting)
Another key to auditing debt is understanding the risks of material misstatement.

Risk of Material Misstatement for Debt

In auditing debt, the assertions that concern me the most are classification,
completeness, and obligation. So my risk of material misstatement for these assertions is
usually moderate to high.
My response to the higher risk assessments is to perform certain substantive procedures:
namely, a review of debt covenant compliance and a review of debt and lease
agreements—and the related accounting. Why? As we saw above, debt covenant
violations may require the company to reclassify debt from noncurrent to current. Doing
so can be significant. The loan could be called by the lender, depending on the loan
agreement. So, proper classification of debt can be critical.
Also, some leases should be recorded as debt. If such leases are not recorded, the
company looks healthier than it is. Our audit should include procedures that address
the completeness of debt and the obligationsof the company. Once your risk
assessment is complete, decide what substantive procedures to perform.

Substantive Procedures for Debt

My customary tests for auditing debt are as follows:
1. Summarize and test debt covenants
2. Review new leases to determine if debt should be recorded
3. Confirm all significant debt with lenders
4. Determine if all debt is classified appropriately (as current or noncurrent)
5. Agree the end-of-period balances in the general ledger to the amortization
schedules
6. Agree future debt service payment summaries to amortization schedules
7. Review accruals of any significant interest

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 8. Review interest expense (usually comparing current and prior year interest)

Common Debt Work Papers

My debt work papers normally include the following:
• An understanding of debt-related internal controls
• Documentation of any internal control deficiencies related to debt
• Risk assessment of debt at the assertion level
• Debt audit program
• A copy of all significant debt agreements (including lease and line-of-credit
agreements)
• Minutes reflecting the approval of new debt
• A summary of debt activity (beginning balance plus new debt minus principal
payments and ending balance)
• Amortization schedules for each debt
• Summary of all debt information for disclosure purposes (e.g., future debt
service to be paid, interest rates, types of debt, collateral, etc.)

If there are questions regarding debt agreements and their presentation, I include
additional language in the representation letter to address the issues. For example, if an
owner loans funds to the company but there is no written debt agreement, the owner or
management might verbally explain the arrangement. In such cases, I include language
in the management representation letter to cover the verbal responses.

ASSESSMENTS

Problem 1: Bond Redemption Prior to Maturity Date – Full Redemption

On January 2, 2016, Green Art Sir, Inc. (GASI) obtained an 8% bonds payable of
P500,000 less unamortized discount of P45,000. This bond was issued to yield 11%
and amortized using the effective interest rate method. Interest was paid on January 1
and July 1 of each year. On July 1, 2016, GASI retired the bonds at 106 before maturity.

Required: How much is the carrying value of the bonds on the date of retirement?

Problem 2: Bond Redemption Prior to Maturity Date – Partial Redemption

During the year, Sir Pent Property, Inc. (SPPI) obtained a 12%, 10-year bond dated
January 1, 2015. Cash proceeds from the issuance of 1,000, P1,000 bonds amounted
to P1,029,284. Prevailing market rate is 11.5%. On January 1, 2016 and July 1, 2016, it
paid interest amounting to P60,000. It accrued P60,000 in December 31, 2016 in
addition to the P60,000 of the accrued interest balance at the beginning of the year.
Redemption price and interest to date on 200 bonds permanently retired on December
31, 2016 amounted to P245,000.

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Required: (Round off present value factors to four decimal places.)

1. How much is the carrying value of bonds payable as of December 31, 2016?
2. How much is the loss on bond redemption?
3. What is the balance of the accrued interest on bonds at December 31, 2016?
4. How much is the interest expense for the year December 31, 2016?

Problem 3 Convertible Debt

On January 1, 2014, Faith Company issued its 8%, 5-year convertible debt instruments
with a face amount of P8,000,00 for P7,700,000. Interest is payable every December 31
of each year. The debt instrument is convertible into 50,000 ordinary shares with a par
value of P100. When the debt instrument were issued, the prevailing market rate of
interest for similar debt without conversion option is 10%.

On December 31, 2016, all the convertible debt instruments were retired for
P8,000,000. The prevailing rate of interest on a similar debt instrument as of December
31, 2016 is 9% without the conversion option.

Required: (Round off present value factors to four decimal places.)

1. On the date of issue, what amount of the proceeds represents the equity

component?

2. How much is the carrying value of the debt instruments as of December 31, 2016

prior to its retirement?

3. On the date of retirement, what amount of the proceeds represents the equity

component?

4. How much is the gain or loss that should be reported in the profit or loss on the

retirement of the convertible debt instruments?

5. How much is the gain on cancellation of the equity component to be reported in

the shareholders’ equity?

Problem 4: Convertible Debt

On January 1, 2012, AAB Company issued a 10% convertible bond with a face value of
P4,000,000 maturing on December 31, 2021. Each P1000 bond is convertible into

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ordinary shares of AAB at a conversion price of P25 per share. Interest is payable half
yearly in cash. At the date of issue, AAB Company could have issued nonconvertible
debt with a ten-year term bearing a coupon interest rate of 11%.

On January 1, 2017, the convertible bond has a fair value of P4,400,000. AAB
Company makes a tender offer to the holders to repurchase the bonds for P4,400,000.
The holders of the P2,000,000 bonds accepted the offer. At the date of repurchase,
AAB Company could have issued non-convertible debt with a five year term bearing a
coupon interest of 8%.

On December 31, 2017, to induce the holders of the remaining bonds to convert the
bonds promptly, AAB reduces the conversion price to P20 if the bonds are converted
before March 1, 2018 (i.e., within 2 months). The market price of AAB’s ordinary shares
on the date when the terms are amended is P32 per share.

Required: (Round off present value factors to four decimal places.)

1. How much is the equity component allocated from the proceeds of issuance of

convertible bonds?

2. How much is the carrying amount of the bonds on December 31, 2016?
3. How much is the amount to be recognized in the P/L as a result of the
repurchase

of the bonds on January 1, 2017?

4. The repurchase of the bonds on January 1, 2017 decreased equity by how

much?
5. The amount to be recognized in the profit or loss as a result of the amendment of

the terms on December 31, 2017 is?

Problem 5: Interest bearing: principal – lump sum, interest – annual; effective rate higher
than the nominal rate Cameroon Company constructed for Virginia Distributors a
warehouse that was completed and ready for occupancy on January 1, 2017. Virginia
paid for the warehouse by issuing a P900,000 four–year note that required 7% interest to
be paid on December 31 of each year. The warehouse was custom–built for Virginia, so
its cash price was not known. By comparison with similar transactions, it was determined
that an appropriate interest rate was 10%.

a. How much is the carrying value of the notes payable as of December 31, 2018?
b. How much is the interest expense in 2018?
c. How much is the carrying value of the notes payable as of December 31, 2018?

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 d. How much is the interest expense in 2018?

Problem 6: The following information was obtained from the accountant of Elena Gilberts
Corp. related to the company’s liability as of December 31, 2018.
Notes payable – trade 190,000
Notes payable – bank 800,000
Notes payable – 10% 600,000
Notes payable – 12% 1,500,000

The following additional information pertains to these liabilities:

a. Bank notes payable include two separate notes payable to Banco De Oro.
1. A P300,000, 8% note issued March 1, 2018, payable after 4 years. Interest is payable
every six months.
2. A 1-year, P500,000, 11% note issued January 2, 2018. On December 30, 2018 Elena
Gilberts negotiated a written agreement with Banco De Oro to replace the note with 2-
year, P500,000, 10% note to be issued January 2, 2019. The interest was paid on
December 31, 2018 for year 2018.
b. The 10% note was issued October 1, 2016. With a term of 10 years. Terms of the note
give the holder the right to demand immediate payment if the company fails to make the
monthly interest payment within 10 days after the date the payment is due. As of
December 31, 2018, the 2018 interest is still unpaid.
c. The 12% note was issued May 1, 2015, with a term of 20 years. The principal amount
outstanding is P1,500,000. Principal and interest is payable annually on April 30 of each
year. A total payment of P220,000 is due April 30, 2019. The payment includes interest
for one year.

a. How much is the total current portion of the notes payable as of December 31,
2018?
b. How much is the total accrued interest as of December 31, 2018?
c. How much is the total interest expense in 2018?
d. How much is the total non-current notes payable as of December 31, 2018?

Problem 7: The following notes was issued by Winston Company during the year:
On January 1, 2018, Winston Company purchased land for P500,000 by issuing a 5–year
non–interest bearing promissory note payable in five annual payments every December 31
as follows.
2018 – P150,000 2019 – P100,000 2021 – P170,000 2022 –
P80,000

The prevailing market rate for a note of this kind is 11%.

a. How much is the interest expense in 2018?
b. How much is the interest expense in 2019?
c. How much is the interest expense in 2020?
d. How much is the current notes payable as of December 31, 2019?
e. How much is the noncurrent notes payable as of December 31, 2019?

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 Audit of Shareholders Equity
Overview
In the audit of share capital, we usually test various audit assertions, such as existence,
completeness, and valuation. Hence, we usually try to detect the material misstatement that could
occur at various assertion levels.
Additionally, we also need to review whether the client has complied with the law regarding share
issues or the purchase of shares. Likewise, compliance with law and regulation is also our main
concern, as auditors, when we perform the audit of share capital.
Share capital in the owner’s equity of the corporate clients can be the common share or preferred
share. In this case, share capital accounts can change when the corporation issues or repurchases
the shares.

Audit Assertions for Share Capital

In the audit of share capital, we usually test the audit assertions for share capital included in the
table below:
Audit assertions for share capital

Share capital reported on the balance sheet really exists at the reporting
Existence
date.

All share capital transactions that should have been recorded have been
Completeness
recorded.

Share capital balances are valued in accordance with applicable

Valuation
accounting standards.

Sufficient information about share capital have been properly disclosed

Present and disclosure
in accordance with applicable accounting standards.

Audit Procedures for Share Capital

We usually use the substantive approach in the audit procedures for share capital. This is due to
the number of transactions related to the share capital is usually small.
In this case, we usually perform the test of details in the audit work by testing various assertions,
including existence, completeness, and valuation as well as present and disclosure.

Existence and Completeness

Existence assertion tests whether the share capital on the balance sheet actual exists while
completeness assertion tests whether all share capital transactions have been recorded.
Example: test of existence and completeness assertions in the audit of share capital
• Obtain the client’s articles of incorporation, bylaws and board meeting minutes
• Agree the authorized share capital to the supporting documents above

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 • Reconcile the authorized share capital with the general ledger
Valuation
Valuation assertion tests whether the share capital on the balance sheet has been properly valued
in accordance with applicable accounting standards. Usually, valuation doesn’t have many issues
as the share issue is usually done in the form of cash transactions.

However, if the share issue is not in the form of cash, we need be careful in evaluating whether
share capital value is correct or not.
Example: test of valuation assertion in the audit of share capital
• Obtain the client’s board meeting minutes
• Agree share transactions records (either our own records or independent agent) to
the board meeting minutes e.g. for the evidence of share issue
• If the share issue is in the form of cash,
• trace the proceed from the share issue to the cash receipts journal
• vouch the share issue transactions to supporting documents to make sure
that they are properly and accurately recorded in capital accounts.
• If the share issue is in the form of non-cash transactions, make sure that the client
has properly followed an applicable accounting standard, when recording the share
issue.

Presentation and disclosure

In the audit of share capital, presentation and disclosure assertion is also an important assertion
that we need to properly examine. We need to make sure that sufficient and proper information
about share capital have been disclosed in accordance with applicable accounting standards.

Common Equity Control Deficiencies

In smaller entities, it is common to have the following control deficiencies:
• One person performs two or more of the following:
• Approves the sale of equity interests,
• Enters the new equity in the accounting system,
• Deposits funds from the sale of the equity instruments
• Accounting personnel lack knowledge regarding equity transactions

Another key to auditing equity is understanding the risks of material misstatement.

Risk of Material Misstatement for Equity

In auditing equity, the assertions that concern me the most are existence, classification, and rights.
So my risk of material misstatement for these assertions is usually moderate to high.
A company may desire to overstate its equity. Also, misclassifications occur due to
misunderstandings about equity accounting.

Once your risk assessment is complete, you’ll decide what substantive procedures to perform.

Substantive Procedures for Equity

Substantive tests for auditing equity include:

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 1. Summarizing and reviewing all equity transactions
2. Reviewing all equity accounts for proper classification
3. Agreeing all beginning of period balances to the prior period’s ending balances
4. Reviewing equity disclosures for compliance with the requirements of the reporting
framework (e.g., GAAP)

In light of my risk assessment and substantive procedures, what equity work papers do I normally
include in my audit files?

Common Equity Work Papers

My equity work papers normally include the following:
• An understanding of equity-related internal controls
• Documentation of any equity internal control deficiencies
• Risk assessment of equity at the assertion level
• Equity audit program
• A copy of (sample) equity instruments
• Minutes reflecting the approval of new equity or the retirement of existing equity
• A summary of equity activity (beginning balances plus new equity less equity
distributions and ending balance)

Audit Retained Earnings and Dividends

As auditors, we usually examine all relevant transactions in the audit of retained earnings and
dividends. This is due to there are usually only a few transactions of retained earnings and
dividends, but the amount of these transactions is usually material.

The audit work regarding the retained earnings and dividends is usually about the review and
analysis of the changes in retained earnings. Likewise, the changes usually come from the two
types of transactions, such as net income transferred from profit and loss statement and the
dividend. That is why dividend is included in the audit of retained earnings here.
For net income, it is the net result of all revenues deducting all expenses during the year. And the
revenue and expense transactions usually have already been examined by the time we start
auditing retained earnings.

Of course, other transactions such as prior-period adjustment may also affect the changes in
retained earnings. And sometimes, there are restrictions on retained earnings that bar the
company from paying out the dividend to its shareholders. Hence, we may need to pay more
attention to these issues if any of them occur.

Audit assertions for retained earnings and dividends

Like many other financial statement line items, we usually need to test various audit assertions in
the audit of retained earnings and dividends. Likewise, these audit assertions for retained
earnings and dividend are included in the table below:

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 Audit assertions for retained earnings and dividends

All retained earnings related transactions (e.g. dividends declared

Completeness and prior-year adjustment) that should have been recorded have
actually been recorded.

Dividends recorded in the financial statements, resulting in the

Existence deduction of retained earnings, have been properly approved and
declared.

Sufficient and appropriate disclosures (e.g. any restrictions on

Presentation and
retained earnings, dividend preference, dividend rate, dividends in
disclosure
arrears, etc.) have been made in the notes to financial statements.

Audit procedures for retained earnings and dividends

Completeness, existence, and presentation and disclosure are the three audit assertions that we
usually have concerns on when we perform the audit of retained earnings and dividends.
Likewise, we need to examine these three assertions in the audit procedures for retained earnings
and dividends.

Completeness
We test completeness assertion for retained earnings and dividends to verify whether all related
transactions that occurred during the year, such as declared dividends and prior-period errors
correction, are properly recorded in the client’s accounts.
Example: test of completeness assertion in the audit of retained earnings and dividends include:
• Request board minutes from the client and make inspection for the evidence of
declaration of dividend
• Trace evidence of dividend declaration in board minutes to the general ledger
• Trace prior-period errors correction or adjustment with supporting documents to
retained earnings account
• Verify if the declared dividends should have been recorded in the current period
The declared dividends that should have been recorded in the current period but are recorded in
the next period is the issue of completeness.

Existence
In the audit of retained earnings and dividends, we test the existence assertion to examine
whether there are dividends that are recorded and/or paid without evidence of declaration from
the client’s board of directors. Additionally, dividends that are not properly approved before
being declared should not be recognized in the accounting records either.
Example: test of existence assertion for retained earnings and dividends include:
• Select all dividend transactions, such as declared and/or paid dividends, that
occurs during the year
• Vouch all those dividend transactions to board minutes for the evidence of
approval and declaration

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 • Verify if the declared dividends have been recorded in the correct accounting
period
The declared dividends that should have been recorded in the next period but are recorded in the
current period instead is the issue of existence.

Presentation and disclosure

The main concern regarding presentation and disclosure for retained earnings account is that
there may be some restrictions that are placed on the retained earnings by the client’s banks,
bondholders, or other creditors. Such restrictions usually limit the client’s ability to make
payments of dividends to its shareholders.

ASSESSMENT

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 Special Audit Considerations

LEASES TRANSACTIONS
The Six Audit Assertions Assessed For Lease Accounting
It isn’t anything new for auditors to assess risk and perform audit procedures at the
assertion level. In understanding what to expect in your external audit, it’s important to
understand how your auditors assess risk and the procedures designed to mitigate those
risks. In the age of IT systems and cloud computing, auditors rely heavily on their client’s
systems for audit evidence. For leases, auditors are looking for a detailed description of
how their client’s leasing system and processes are designed and operating. This
understanding helps to develop their audit procedures. Below, we will walk through the
audit procedures that our firm uses to assess risk.

1) Completeness
Completeness, a major audit area for leases in particular, asserts that all leases have
been captured and properly capitalized on the balance sheet. One of the biggest changes
under ASC 842 is that lessees are required to recognize a right of use asset and a lease
liability. As such, an asset and liability will be recognized on the balance sheet for both
operating and finance leases. The easiest approach to ensuring auditors don’t spend too
much time on this assertion is to have the completeness evidence prepared before your
auditor walks in the door.

A best practice is to reconcile rent expense as of the most recent reporting period, for
example to the underlying lease agreements and cross-reference to your lease
accounting software solution (or spreadsheet). Additionally, a customer should support
procedures performed to ensure a full inventory of leases (considering embedded leases,
IT assets, and equipment leases) have been evaluated. Absent this evidence, auditors
will spend excessive time performing additional procedures to ensure the lease
population is complete.

These procedures can range from searching through file cabinets, interviewing everyone
in the contracting process, physical inventorying of assets, and reconciling rent expense
on your behalf. These procedures can result in an extra audit bill, be time-consuming for
your employees, and suggest to the audit firm that you may not have an appropriate
process in place. You can also expect a deficiency or a written management letter on the
subject.

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2) Existence/Occurrence
Existence/Occurrence, while not a high risk area for leases, asserts whether or not the
lease actually exists. Directionally, auditors generally don’t spend much time on this
assertion as financial statement preparers may be incentivized to understate liabilities
(i.e. lease liabilities). However, based on how management evaluates a business’
financial results, the company could be incentivized to overstate assets without regard for
lease liabilities, therefore, the auditors would spend some time ensuring that physical
assets and contracts exist and/or occurred.

3) Valuation/Allocation
Valuation/Allocation asserts the proper present value calculations of your leases. The
primary drivers of this calculation are payment streams, lease term, and discount rates.
Auditors will spend time ensuring these components agree to the contract or have
evidence to support them.
Discount rates receive audit scrutiny. Management needs to ensure there is a
documented rationale supporting the accounting policy. A white paper document is the
best deliverable for the auditors on this topic. Commonly, auditors will utilize valuation
specialists to get comfortable with the present value calculations and the discount rate
model.

4) Cut-off
Cut-off asserts whether or not the lease has been recorded in the correct accounting
period. As a lessee, if you have a lease that commences after your ASC 842 transition
date, the lease should be recognized after your transition date, on the lease
commencement (or possession) date. To test this, auditors will select leases before and
after your transition or reporting date and ensure they are recorded within the proper
period.

For companies that took the package of practical expedients, the cut-off procedures
would be focused on leases after the transition date, since the determination of the lease
term and classification would not change in transition. However, there is a hindsight
practical expedient available that would allow companies to re-evaluate lease term in
transition. If a company utilizes the hindsight practical expedient, the auditor will need to
perform cut-off procedures before and after transition.

5) Rights/Obligations
Rights/Obligations asserts that assets are actually owned (or have the right to own) and
liabilities are actually owed. With leases, the risks are somewhat neutralized as they result
in asset and liabilities that net to approximately zero. However, as mentioned above in
Existence/Occurrence, a company’s financial incentives could align in such a manner that
this assertion could become high risk.

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6) Classification/Presentation & Disclosure
Classification/Presentation & Disclosure asserts that transactions have been properly
classified in the financial statements. For leases, the risk is that operating leases are
improperly classified as finance leases (for which interest expense is recorded) or as
short-term leases (whereby the lease liability and corresponding right of use asset are not
recorded on the balance sheet), or vice versa. Due to income statement impact of
misclassification (i.e. EBITDA), this is a major area of audit scrutiny.

It’s important to understand the audit assertions and related testing procedures, and the
extent of these procedures should demonstrate to companies the value of a proven lease
accounting solution. Not only will a good tool make transitioning to the new standard
easier and more accurate, a solution that houses all of the audit-ready reports in one
location will make an auditor’s job a lot more efficient as well.

Key considerations for internal audit controls

In an ideal situation, businesses have a contracting process in place to identify whether
their agreements contain assets (and potentially a lease agreement) or not. This process
is a centralized contract management solution that shows all contracts going through that
system for approval. In a less than ideal but workable situation, contracting is
decentralized and key team members are surveyed on a periodic basis for lease
identification purposes.

For lease accounting, there are two types of recommended controls:

1) Preventative Controls:
As you might expect, these are controls that prevent errors on the front end of a process.
Since leases initiate with the execution of a contract, it’s logical to insert a control in this
process to prevent any leases from slipping through the cracks. A very simple
preventative control in lease accounting is to insert a brief question “does this agreement
contain property or equipment?” If there is an electronic workflow for contracting, this
question can be inserted into that process. If no workflow exists, perhaps utilize a cover
page for approvals and include this question.

It’s important for companies to keep the preventative controls as simple as possible. Too
many preventative controls can create bottleneck issues in the contracting process. The
last thing you want is for accounting compliance to burden your business processes.

2) Detective Controls:
These are controls you can do periodically. For example, a detective control could include
reviewing a listing of all contracts executed and the related lease accounting conclusions,
or analytical procedures, such as analyze rent expense per month or look at the Right of
Use assets as a percentage of rent expense. Different metrics or ratios can be employed
to help identify missed leases. These controls are typically done by the key owners of that
area, meaning a lease accountant would be the owner of the lease’s detective controls.

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A proper lease accounting solution can help consolidate a significant portion of the
detective control reporting in one area. Internal users or external auditors can quickly run
a listing of all the leases within the solution that are active in the period and compare to
the number of amortization tables you have, and immediately locate and correct any
major disconnects between the two.

EMPLOYEE BENEFITS
Employee benefits have been characterized by the Bureau of Labor Statistics as any type of
aberrant or non-monetary remuneration paid to a worker. These might be legally necessary
or guideline, as are business commitments to Social Security or medicinal services benefits,
or they might be optional, for example, commitments to retirement investment funds or took
care of time. Associations offer benefits to their employees since they advance employment
fulfillment and motivate laborer steadfastness, which, thus, can prompt better money related
execution. They are given by associations notwithstanding compensation to make an
aggressive bundle for the potential worker. Benefits can be very significant. Restorative
protection alone can cost a few hundred dollars every month. That is the reason it’s essential
to think about benefits as a feature of your complete remuneration. Benefits can assist you
with separating your business from rivals. Benefits keep on advancing. For instance,
numerous businesses offer an expanding cluster of choices that give laborers more prominent
adaptability in offsetting work with different aspects of life. Family-accommodating strategies,
(for example, working from home) and profession related benefits, (for example, instructive
help) are only a couple of the contributions from contemporary bosses.

However, giving more elevated levels of benefits includes some significant downfalls. Over
the previous decade, the adjustment in benefits costs has outpaced the adjustment in the
expense of wages and pay rates. This is inferable, to some extent, to the expanded expense
of medicinal services benefits. Additionally, benefits are not equally spread among the
workforce; a few laborers are almost certain than others to approach benefits. All-day
laborers, for instance, have more prominent access to benefits than do low maintenance
laborers, and laborers in enormous foundations normally have more noteworthy access to
benefits than do those in little foundations. Laborers who have a place with a trade guild
likewise are bound to be offered benefits than the individuals who are in occupations in which
laborers are not unionized. In addition, approaching an advantage doesn’t really imply that
laborers decide to get that advantage. It basically implies that the business makes the
advantage accessible.

Legal Requirements
In the event that you’ve at any point earned a check, you’ve most likely seen that a portion of
your cash is taken out for things other than charges. Where does this cash go? A portion of
these findings goes toward paying for lawfully required benefits.
For instance, the two managers and employees must add to two obligatory social protection
programs: Social Security and Medicare. Government disability, the biggest segment of
legitimately required benefits, gives budgetary help to laborers and their families when

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laborers resign, bite the dust, or become incapacitated. Medicare gives human services help
to more established specialists and to individuals with long haul inabilities. Commitments to
these projects are part equally among employees and businesses.

The employees’ segment is taken straightforwardly from their checks as a duty, regularly
alluded to and noted on pay stubs as Federal Insurance Contributions Act or Old Age,
Survivors, and incapacity protection for Social Security findings and as Medicare emergency
clinic protection for Medicare derivations. Businesses’ and workers’ commitments are saved
to a money related establishment and afterward moved to the Internal Revenue Service.
Other lawfully required benefits incorporate Federal and State joblessness protection and, in
many States, laborers’ pay. Managers add to the Federal-State Unemployment Insurance
Program, which gives money related help to laborers who lose their positions through no
issue of their own; at any rate, three States expect workers to make commitments, as well.
In many States, bosses additionally should add to State laborers’ remuneration programs,
which give budgetary help to individuals who can’t fill in because of a work environment
damage or sickness.

Medical Coverage
Restorative protection takes care of the expenses of doctor and specialist charges, medical
clinic rooms, and physician endorsed drugs. Dental and optical consideration may be offered
as a component of a general benefits bundle. It might be offered as independent pieces or
not secured by any means. Inclusion can some of the time incorporate the employee’s family
(wards). Bosses, as a rule, pay all or part of the premium for employee medicinal protection.
Regularly employees pay a level of the month to month cost. The expense of protection
through a business. Most plans give inclusion to visits to essential care doctors and pros,
hospitalization, and crisis care. Elective restorative care, wellbeing, remedy, vision, and
dental care inclusion will fluctuate by the arrangement and manager. Managers are required
to give human services to employees who work at any rate of 30 hours out of every week.
Some low maintenance laborers are secured by boss plans, yet many are not secured. A few
businesses give a motivating force to employees to quit their arrangement.

Dental Care Plan Coverage

Organizations with dental consideration benefits offer protection that helps pay a part of the
expense for dental treatment and care. Contingent upon the organization’s arrangement for
dental care benefits, dental inclusion incorporates a scope of medicines and strategies. Most
protection plans spread the fundamental strategies, for example, routine teeth cleaning like
clockwork.
Essential administrations would likewise incorporate fillings, crisis help with discomfort, root
trenches, and dental crowns. At last, Major administrations can incorporate bridgework,
intelligence teeth expulsion, false teeth, and other complex methodology. A few plans spread
all practices, as orthodontic work notwithstanding fundamental dental care.

Incidental benefits and Perks

While these benefits are important and do hold money related worth, the employee’s pay
continues as before, and the worker can’t “money in” or exchange the ideas for more
significant compensation. Incidental benefits are not legally necessary and differ from boss

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to boss. Different sorts of benefits are not legally necessary yet are normally given to laborers.
Since these benefits are intentional, businesses and workers have more noteworthy authority
over them. The table on page 17 shows the absolute most normally offered benefits and the
percent of laborers who approach them. The benefits in the table are depicted on the pages
that pursue and incorporate medicinal services, life, and other protection; paid leave and
retirement; and different benefits, for example, vocation related and family-accommodating
projects.

Accounting Perspective
Adding to the trouble with finding a reasonable meaning of worker benefits is that universally,
perspectives on “benefits” are altogether different than those in the United States. The
International Accounting Standards Board characterizes employee benefits as “all types of
thought given by a substance in return for administration rendered by workers or for the end
of business”. The IASB definition doesn’t look to separate the two parts of remuneration, in
particular, wages and benefits; its motivation is to guarantee that all types of installments to
employees are effectively represented as some type of pay thus the definition is essentially
a comprehensive one. Among industrialized countries, employee benefits may contrast both
in degree and in kind, depending, to some extent, on how much the benefits are controlled or
financed by governments. Medicinal services, for instance, are commonly regulated through
one of three kinds of projects: a national wellbeing administration, a national medical
coverage framework, or a multi-payer protection framework.
In the initial two, medicinal services are made good on thorough assessments and don’t go
into the business relationship. In nations utilizing some type of the multi-payer framework,
managers and employees add to human services costs. Note, however, that a couple of
countries have “unadulterated” forms of these projects.

Audit Procedures:
When the audit strategy is being designed, a key preference is given to the judgments that
shall be made, in order for the selection of the most effective and efficient audit procedures to
be performed. This judgment process of the selection of effective auditing procedures is best
done considering the following three factors of the audit:

Nature
The nature of the audit allows the auditor to choose from a variety of audit procedures. These
methodologies incorporate review, perception, request, affirmation, recalculation,
investigative techniques, and re-execution and might be utilized all through all phases of the
review procedure.

Timing
The auditor tests resource adjusts “as of” the announcement of net resources accessible for
benefits date. Nonetheless, once in a while data gave to the examiners to help adjusts is
starting at a date other than the announcement of net resources date.

Extent
The auditor decides the degree of testing the person in question will perform. The important
degree of a substantive review technique will regularly rely upon the materiality of the record,

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divulgence or exchanges; the surveyed danger of material misquote, and the vital level of
confirmation from the system.
In order for the audit of the Employee benefits plan to be efficient and productive, the auditors
shall consider some of the below-stated procedures to evaluate the information from the
employee benefits plan as part of the audit process:
• Discuss with trustees, plan administrator, or another appropriate representative of the
plan, the scope of the audit. Determine whether the scope of the audit will be restricted
(limited-scope audit).
• Make inquiries of plan management concerning whether the arrangement’s budget
summaries will be set up incongruity with for the most part acknowledged bookkeeping
norms or with another exhaustive premise of bookkeeping.
• Make inquiries of employee benefits plan management concerning investment assets
held by outside custodians
• Make inquiries of employee benefits plan management concerning who keeps up the
arrangement’s bookkeeping records and members’ information
• Make inquiries of employee benefits plan management concerning extent to which
computer applications are used
• Make inquiries of employee benefits plan management concerning preparation and
use of interim financial statements
• Make inquiries of employee benefits plan management concerning preparation and
use of budget
• Make inquiries of employee benefits plan management concerning the plan’s
maintenance of a list of parties in interest
• Make inquiries of employee benefits plan management concerning the benefit plan
procedures for identifying reportable transactions

INCOME AND DEFERRED TAXES

Deferred tax refers to either a positive (asset) or negative (liability) entry on a company’s
balance sheet regarding tax owed or overpaid due to temporary differences
Deferred tax can fall into one of two categories. Deferred tax liabilities, and deferred tax
assets. Both will appear as entries on a balance sheet and represent the negative and
positive amounts of tax owed. Note that there can be one without the other - a company
can have only deferred tax liability or deferred tax assets.
Depending on whether the tax is owed or paid will determine whether it is considered an
asset or liability.

Deferred tax and taxable temporary differences

An important concept to explain in relation to deferred tax is that of taxable temporary
differences. This occurs when a business has an asset with a liability value that does not
match with the current taxable value of the asset. This can happen when the accounting
approach and tax laws differ in how the depreciation of an asset is handled.

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These temporary differences can impact on a financial account because they mean that
income and expenses appear within one accounting period, but the tax is payable in a
different accounting period. A taxable difference can be either taxable or deductible.

Deferred tax liability

A deferred tax liability occurs when a business has a certain amount of income for an
accounting period and that amount is different from the taxable amount on their tax return.
When the amount is less than the estimated tax, an entry is placed on the balance sheet
in the form of a liability.
Deferred tax typically refers to liabilities, wherein the amount entered on the balance
sheet is payable at a future time. However, deferred tax can also apply in the opposite
sense.

Example of a deferred tax liability

Company XYZ owns machinery that is classified as an asset. They choose to use a
certain depreciation method - in this case, an accelerated method that allows higher
deductions earlier in ownership of the asset and lower deductions further on
This differs from the slower, straight-line depreciation that is used by tax authorities,
which means the the depreciation is spread evenly over the useful life of the asset.

The depreciation method affects how much the charges will be for each accounting
period. These charges can be claimed for capital allowance

Because the depreciation method chosen by Company XYZ would result in at first a larger
deduction than the method used by tax authorities, their income would be higher than
what would be considered the taxable income. In this case, the temporary difference
would be added as a liability to the balance sheet.

Deferred tax asset

When a company overpays for a particular tax period, this can be marked as a deferred
tax asset on the balance sheet. If taxes are overpaid or paid in advance, then the amount
of overpayment can be considered an asset and illustrates that the business should
receive some tax break in the next filing.

Paying in advance to create deferred tax assets can aid a business looking to decrease
their tax liability in a future period.

A deferred tax asset can also occur due to losses that are carried over to a new
accounting period from a previous accounting period and can then be claimed in the new
period as an asset.

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 ASSESSMENTS

The following lease transactions took place during the year.

Case 1: On March 1, 2019, Mansion Company entered into five-year nonrenewable

lease, commencing on that date, for office space and made the following payments to
ABC Properties:
Bonus to obtain lease 120,000
First month’s rent 40,000
Last month’s rent 40,000
In its income statement for the year ended Dec. 31, 2019, what amount should Mansion
report as rent expense?

Case 2: On January 1, 2019, Travel Corporation signed an 8-year operating lease for office space
at P300,000 per year. The lease included a provision for additional rent of 5% of annual company
sales in excess of P2,000,000. Travel’s sales for the year ended Dec. 31, 2019 were P2,500,000.
Upon execution of the lease, Travel Corporation paid P100,000 as a bonus for the lease. Travel’s
rent expense for the year ended Dec. 31, 2019 is?

Case 3: On September 1, 2019, Trend Sound System Company leased office space at a monthly
rental of P40,000 for 10 years expiring August 31, 2019. As an inducement for Trend to enter
into lease, the lessor permitted Trend to occupy the premises rent-free from September 1 to
November 30, 2019. Improvements were made at the leased office at a total costs of P300,000,
the improvements were finished on September 30, 2019. It was estimated that the improvements
will be useful for 5 years. For the year ended December 31, 2019, Trend should record total
expense related to the lease facilities of?

Case 4: Orange Company owns an office building and normally charges tenants P3,000 per
square meter per year for the office space. Because the occupancy rate is low, Orange Company
lease 100 sq. m to Comical. Company at P2,000 per square meter for the first two years of a four
year operating lease. Rent for remaining years will be at the P3,000 rate. Comical Company
moved into the building on January 1, 2019, and paid the first year’s rent in advance. What
amount of unearned rental revenue should Orange Company report in its balance sheet
for the year ended September 30, 2019?

1. The following lease transactions took place during the year.

Case 1: On January 2, 2019, Nature Company entered into a ten-year non-cancelable lease
requiring year end payments of P200,000. Nature’s incremental borrowing rate is 12%, while the
lessor’s implicit interest rate, known to Nature Company, is 10%. There is no bargain purchase

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option. The leased property has an estimated economic life of 12 years. What amount should
Nature capitalize for this leased property on January 2, 2019?

Case 2: Vanity Company leased a new machine from Beagle Co. on Jan. 1, 2019, under a lease
with the following information:
Annual rental payable at beginning of each lease year 400,000
Lease term 10 years
Useful life of machine 12 years
Implicit interest rate 14%

Vanity has the option to purchase the machine on Jan. 1, 2029, by paying P200,000, which is
sufficiently lower than the expected fair value of the machine on the option exercise date. In its
December 31, 2019 balance sheet, is the leased asset should have a book value of?

2. Coco Corporation manufactures specialized equipment and offers leasing alternative to its
customer who do not have the necessary funds or financing available for outright purchase.
The data relative to a typical lease offered to Remember Me Company are as follows:
i. The lease is initiated on January 1, 2019. Payments are due on every December 31 for
the duration of the lease term.
ii. The non-cancellable fixed portion of the lease term is 5 years. The estimated useful life of
the asset is 10 years. The lessor desires a return of 12 percent which is the implicit rate
of return.
iii. The lessor is to receive equal annual payments over the term of the lease and the leased
property reverts back to the lessor on termination of the lease.
iv. The selling price of the equipment for an outright purchase is P1,707,263. The cost of the
equipment to Coco is P1,250,000. The lessee incurs costs associated with the inception
of the lease in the amount of P55,000.
v. The equipment is expected to have residual value of P150,000 at the end of 5 years which
is guaranteed by Remember Me Company.
a. How much is the annual lease payment?
b. How much is the balance of finance lease obligation (lessee) and net finance lease
receivable (lessor) at December 31, 2019?
c. How much is the interest expense (lessee) and interest income (lessor) in 2019?
d. How much is the amount of sale should Coco recognized in 2019?
e. How much is the gross profit on sale immediately recognized by Coco if any?

3. Use the following information for lease transactions:

Case 1: ABC Finance Corp. leased an equipment with a cost of P700,000 to XYZ on
January 1, 2018. The company incurred direct cost related to the negotiation and
arranging the lease agreement at P20,955. Under the lease agreement appropriately
accounted for on the books of ABC as a direct finance lease, since ABC is engaged
solely in financing operations, XYZ shall pay P200,000 annually for five years every
December 31, starting 2018. The equipment has a useful life of five years. The implicit
lease rate as a result of the direct lease cost was at 12%.
1. How much profit from sale should be immediately recognized by ABC Finance Corp.?
2. What is the interest income should be recognized by ABC Finance Corp. in 2019?
3. What is the balance of the lease receivable as of December 31, 2019?

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Case 2: GHI Corp., a dealer of specialized machinery, leased an equipment with a cost
of P1,000,000 to XYZ Inc. on January 1, 2018. The company incurred direct cost related
to the negotiation and arranging the lease agreement at P50,000. Under the lease
agreement appropriately accounted for as a sales type lease, XYZ Inc. shall pay
P400,000 annually for five years at the end of each year. The equipment has a useful life
of six years. The implicit lease rate is at 10%. The asset has an expected residual value
of P100,000 after five years and shall be reverted back to the company after the lease
term.

If XYZ guaranteed the residual value of the asset after 5 years at P100,000,
1. What is the amount to be credited to Sales account as a result of the transaction?
2. What is the cost of sales?
3. What is the profit from sale that should be immediately recognized by GHI Corp.?
4. What is the interest income to be recognized in 2019?

Case 3: Using the information in the previous case except that XYZ does not guarantee
the residual value of the asset after 5 years:
1. What is the amount to be credited to Sales account as a result of the transaction?
2. What is the cost of sales?
3. What is the profit from sale that should be immediately recognized by GHI Corp.?
4. What is the interest income to be recognized in 2016?

4. The following sale-lease back transaction occurred during the year:

Case 1: The following information pertains to an operating sale and leaseback of

equipment by Tremble Co. on December 31, 2019: Sales price, P420,000; Carrying
amount, P360,000; Monthly lease payment, P37,316; Estimated remaining life, 12 years;
Lease term, 1 year; Implicit rate, 12%.
1. What amount of realized gain on the sale should Tremble report at December 31, 2019,
assuming that the fair market value of the equipment is at P420,000?

2. What amount of deferred gain on the sale should Tremble report at December 31, 2019,
assuming that the fair market value of the equipment is at P380,000?
3. What amount of deferred gain on the sale should Tremble report at December 31, 2019,
assuming that the fair market value of the equipment is at P320,000?
4. What amount of realized gain on the sale should Tremble report at December 31, 2019,
assuming that the fair market value of the equipment is at P450,000?

Case 2: On June 30, 2019 Forest Co. sold equipment with an estimated useful life of 10
years and immediately leased it back for 5 years. The equipment’s carrying amount was
P540,000. The sales price was P400,000. The lease agreement is an operating lease.
1. What amount of deferred loss should the company recognized on June 30, 2019
assuming future rental is below market rate rent, and that the fair market value of the
equipment is at P480,000?

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 2. What amount of deferred loss should the company recognized on June 30, 2019
assuming future rental is higher than market rate rent, and that the fair market value of
the equipment is at P480,000?

PFRS 16 – Leases
5. On January 1, 2019, Vampire Diaries Company enters into a ten year lease of floor building,
with an option to extend for five years. Lease payments are P1,000,000 per year during the
initial term and P1,200,000 per year during the optional period, all payable at the beginning of
each year. To obtain the lease, Vampire Diaries Company incurs initial direct cost of
P500,000, of which P300,000 relates to payment to a former tenant occupying that floor of the
building and P200,000 relates to a commission paid to the real estate agent that arrange the
lease. As an incentive to Vampire Diaries Company for entering the lease, the lessor agrees
to reimburse to Vampire Diaries Company the real estate commission of P100,000 and
leasehold improvements of P120,000. Lessee’s incremental borrowing rate is 9% per annum,
which reflects the fixed rate at which lessee could borrow an amount similar to the value of
the right-of-use asset, in the same currency, for a ten year and fifteen-year term and with
similar collateral.

At the commencement of the lease, Vampire Diaries Company concludes that it is

reasonably certain to exercise the option to extend the lease term.

Lease liability:
a. How much interest expense is recognized in 2019?
b. How much lease liability is presented in the statement of financial position at the
end of 2019?
c. How much lease liability is presented in the statement of financial position at the
end of 2020?

Right-of-use asset:
a. At what amount should the right of use asset for lease of building is initially
recognized?
b. How much is the depreciation expense recognized by Vampire Diaries Company
in 2019?
c. How much is the balance of right of use asset – property, plant and equipment at
the end of 2019?

1. Pepsi Cola Company has a define contribution plan that covers its existing employees. The
terms of the plan required Pepsi Cola to contribute 10% of the annual employees; salaries to
the retirement plan each year. The payroll show the annual salaries as follows:
2018 P12,000,000
2019 P12,500,000

Pepsi Cola contributed P1,000,000 in the plan in 2018 and P1,500,000 in 2019.

a. How much is the benefit expense in 2018?

b. How much is the balance of prepaid (accrued) benefit expense in 2018?
c. How much is the benefit expense in 2019?

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 d. How much is the balance of prepaid (accrued) benefit expense in 2019?

2. Tomas Company had a liability for compensated absences of P402,750 that reflects the
probable unused sick leave and vacation leaves in 2018 and prior to 2018 carried over to
2019. No entry had been made during the current year affecting the liability account and
payments to employee are recorded as compensation expense (compensated absences).
Employees are allowed to carry-over unused leaves over 2 years from year of grant,
thereafter, it shall expire. Salary rates increased for the current year by 10%. An analysis of
the cumulative unused sick leave and vacation leaves are as follows:

Prior to 2018 leaves carried over to 2019 270 days

2018 leaves carried over to 2019 625 days
Prior to 2019 leaves used in 2019* 700 days
Leaves earned in 2019 carried over 2020 550 days
*from prior to 2019 leaves used in 2019, 200 were earned by employees prior to 2018.

a. How much is the employee benefit expense in form of compensated absences in

2019?
b. How much is the balance of liability for compensated absences at the end of
2019?
c. What is the adjusting entry required to correct the balance of compensated
absences and liability accounts in 2019?

3. Salvatore Company had a pension benefit to its employees as follows:

Based in the company’s plan, to encourage employees older than 60 years old to
extend their employment with the entity, Salvatore Corp promises its 60-year old
employee’s a lump sum benefit equal to 1% of final salary for each year of service that
they remain employed by the entity after their 60th birthday, provided they remain
employed until they are 65, at which time, in accordance with local laws, employees
are required to retire. The benefit is payable to the employees on retirement. Elena’s
60th birthday is on January 1, 2018. Her salary for the year ended December 31, 2018
is P1,000,000.

In 2018 the entity made the following assumptions:

• Elena’s salary should increase by 5% (compound) each year.
• There is a 20% probability that Elena’s employment with the entity will terminate
before January 1, 2022.
• The appropriate discount rate to be used is 10% which is the rate of high quality
corporate bonds at this time.
• Elena’s salary for 2019 is P1,050,000.

In 2019 the entity revised its actuarial assumptions as follows:

• Elena’s salary should be increased by 15% (compound) each year.

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 • There is a 10% probability that Elena’s employment with the entity will terminate
before reaching retirement date of January 1, 2022.
• The discount rate remains the same.

a. How much is the total benefit expense recognized in profit or loss in 2018?
b. How much is the present value of the DBO at the end of 2018?
c. How much is the total benefit expense in 2019?
d. How much is the present value of the DBO at the end of 2019?

4. Chatime Corporation maintains a defined benefit pension plan. One of its employee is entitled
to the pension plan. Micah Tee, the employee, will be paid a lump sum amount equal to 5%
of his final year’s salary for every year of service upon retirement. His retirement is expected
to span in 10 years’ time.

As of January 1, 2019, the following information relates to pension plan:

a. Micah Tee have rendered service for 15 years.
b. Micah Tee is being paid P1,000,000 and is expected to increase by 8% annually.
c. Micah Tee is expected to retire after another 20 years.

The interest on high quality corporate bonds is 7% for 2019 and 2020. On January 1,
2020, the pension formula related to Micah Tee was amended. Under the amendment,
the employee will be paid a lump sum amount equal to 6% of final year’s salary for
every year of service.

a. How much is the amount of benefit expense in profit or loss for the year
ended December 31, 2019?
b. How much is the defined benefit obligation (DBO) as of December 31, 2019?
c. How much is the past service cost in 2020?
d. How much is the total benefit expense in 2020?
e. How much is the defined benefit obligation (DBO) as of December 31, 2020?

5. The following are made available for the defined benefit pension plan of Pores Corporation as
of December 31, 2019:

Fair value of Plan asset, Jan 1 P3,000,000

Total actual return on plan asset ?
Payment made to retirees 600,000
Payment of pension benefit settled on active
employees 400,000
Contribution during the year 500,000
Discount rate 6%

a. What is the fair value of plan asset as of December 31, 2019?

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 b. What amount of the total actual return on plan asset should be included in profit or
loss?
c. What amount of the total actual return on plan asset should be reported in other
comprehensive income?
1. Tommy Corporation reported a pretax financial income of P5,000,000 for the year ended
December 31, 2019. The following items are included in the determination of the financial
income:

Provision for litigation loss which will become tax deductible when settled in the future,
P300,000; Realized revenue that has yet to be received, P400,000; Other unearned
revenue, P150,000; Dividend received from a domestic corporation, P100,000.
If the tax rate is 32% for all years, what amount if total tax expense and current
tax expense should Tommy report, respectively?

2. At the beginning of 2019, Potter Co. purchased an asset for P600,000 with an estimated useful
life of 5 years and an estimated residual value of P50,000. For financial reporting purposes
that asset is being depreciated using the straight line method; for tax purposes the double
declining balance method is being used. Potter’s tax rate is 40% for 2019 and in the future
years.
At the end of 2019, how much is the amount of future taxable amount and
balance of deferred tax liability, respectively?

3. Trixie Corporations partial income statement after its first year of operations is as follows”
Income before Income
taxes P3,750,000
Income tax expense

Current P1,035,000
Deferred 90,000 1,125,000

Net Income P2,625,000

Trixie uses the straight line method of depreciation for financial reporting purposes and
accelerated method for tax purposes. The amount charge to depreciation expense on its
books this year was P1,500,000. No other differences existed between the book income and
taxable income except for the amount of depreciation.
Assuming a 30% tax rate, what was the deducted depreciation expense on
corporation’s tax return for the current year?

4. Ex and Why Company commenced operations on January 1, 2019. It purchased a machine

for P200,000. The machine is being depreciated on a straight line basis over 5-year life, for
income tax purposes under double declining balance method. The company capitalizes
product development expenditure in the amount of P120,000 in accordance with PAS 38., for
income tax purposes, such expenditure is claimed in the year it is incurred. For the year ended
December 31, 2019, the company made a profit before tax of P500,000. This profit was after

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 deducting general allowance for bad debts of P50,000 and provision for warranties of
P80,000. At year end, the balance of the gross trade receivable account was P300,000. For
income tax purposes tax rate is at 32%
a. What amount of deferred tax asset should the company have recognized in 2019?
b. What amount of deferred liability asset should the company have recognized in
2019?

5. Bestlook Company provided the following information for its first year of operations ended
December 31, 2019 in connection with the preparation of it income tax return:

Accounting income P8,000,000

Nondeductible expenses 400,000
Nontaxable revenue 600,000
Deferred income on installment sales included in
financial income but taxable in 2020 900,000
Doubtful accounts recorded 200,000
Financial depreciation 600,000
Tax depreciation 700,000
Estimated warranty cost accrued in 2019 but not
deductible for tax purposes until paid 200,000
Income tax rate (current and future) 35%
a. How much is the current tax expense?
b. How much is the deferred tax asset?
c. How much is the deferred tax liability?
d. How much is the total tax expense?

6. Titan Company issued a convertible bonds on January 1, 2019 that will mature in 5-years.
The bonds can be converted into ordinary shares at anytime. Titan has calculated that the
liability and equity components of the bonds are P3,000,000 for the liability and P1,000,000
for the equity, giving the total amount of the bond at the time of issuance of P4,000,000. The
interest rate of the bond is 6% and the local tax legislation allows a tax deduction for the
interest paid in cash.
What amount of deferred tax should the company have reported in profit or loss
at the time the bonds were issued?

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COURSE GRADING SYSTEM

REFERENCES

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