Chapter 18 - Lecture notes 1 PDF

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Chapter 18: Audit of Long-Term LiabilitiesReview Questions1. Two assistant auditors were assigned by the auditor-in-charge to the verification of long-term liabilities. Sometimes later, they reported to the auditor-in-charge that they had determined that all long-term liabilities were properly recor...

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Chapter 18: Audit of Long-Term Liabilities Review Questions 1. Two assistant auditors were assigned by the auditor-in-charge to the verification of long-term liabilities. Sometimes later, they reported to the auditor-in-charge that they had determined that all long-term liabilities were properly recorded and that all recorded long-term liabilities were genuine obligations. Does this determination constitute a sufficient examination of long-term liabilities? Explain. It does not constitute a sufficient examination of the client’s long-term liabilities, because it should also include recalculation of interest, discount, and premium. The footings of individual long-term liabilities should also examine and its current state if it is secured or unsecured, and if there is a current portion of any long-term liabilities. 2. Palmer Company has issued a number of notes payable during the year, and several of these notes are outstanding at the balance sheet date. What sources of information should the auditors use in preparing a working paper analysis of the notes payable? A notes payable analysis shows the beginning balance of each individual note, additional notes issued and payments on notes during the year, and the ending balance of each note. In addition, the beginning balances of interest payable or prepaid interest, interest expense, and interest paid and the ending balances of interest payable or prepaid interest may be presented in the analysis working paper. 3. Is the confirmation of notes payable usually correlated with any other specific phase of the audit? Explain. Notes payable to financial institutions are confirmed as part of the confirmation of cash deposit balances. The standard confirmation form includes a request the financial institution confirm all borrowings by the depositor. 4. What is the principal reason for testing the reasonableness of the Interest Expense account in conjunction with the verification of notes payable? The auditors can use these procedures as a test of the completeness of recorded interest-bearing debt. The auditor can test the reasonableness of the amount in interest expense related to notes payable with the amounts of notes payable recorded. 5. What does the trust indenture used by a corporation in creating long-term bonded indebtedness have to do with the payment of dividends on common stock? A bond indenture may also restrict the amount on stock dividends that can be paid, if the earnings of the company are less than a specified amount, since the payment of stock dividends lessens the equity of the company, and may impair its ability to make future interest payments and repay principal. 6. Long-term creditors often insist upon placing certain restrictions upon the borrowing company for the term of the loan. Give the three examples of such restrictions, and indicate how each restriction protects the long-term creditor. Three examples of long-term creditors restrictions upon the borrowing company for the term of their loan:

1. The indenture often includes a restrictive covenant the prohibits the company from declaring dividends unless the amount of working capital is maintained above a specified amount. 2. The acquisition of plant and equipment, or the increasing of managerial salaries may be permitted only if the current ratio is maintained at a specified level and if net income reaches a designated amount. 3. The requirement of a sinking fund or redemption fund to be held by a trustee. 7. Most corporation with bonds payable outstanding utilize the services of a trustee. What relation, if any, does this practice have to the maintenance of adequate internal control? Use of an independent trustee largely solves the problem of internal control over bonds payable. Internal control is strengthened by the fact that the trustee does not have access to the issuing company's assets or accounting records and the fact that the trustee is a large financial institution with legal responsibility for its actions. 8. What information should be requested by the auditors from the trustee responsible for an issue of debentures payable? Bond transactions usually can be confirmed directly with the trustee. The trustee's reply should include an exact description of the bonds, including maturity dates and interest rates; bonds, retired, purchased for the treasury, or converted into stock during the year; bonds outstanding at the balance sheet date; and sinking fund transactions and balances. 9. “Auditors are not qualified to pass on the legality of a bond issue; this is a question for the company’s attorneys. It is therefore unnecessary for the auditors this bond issue classified as a current liability” An auditor ordinarily does not possess legal skills and, therefore, cannot make legal judgments concerning information coming to his attention. Accordingly, the auditor should request the client's management to send a letter of inquiry to those lawyers with whom management consulted concerning litigation, claims, and assessments. 10. Kingfield Corporation has outstanding an issue of 30-year bonds payable. There is no sinking fund for these bonds. Under what circumstances, if any, should this bond issue be classified as a current liability? If there is a requirement in the indenture for a sinking fund for the bonds and there is none then the company has violated the indenture and the bonds payable become due immediately and should be classified as a current liability.

Exercises Exercise 1 Aila Esteva, a CPA, has been engaged to examine the financial statements of Broadwall Corporation for the year ended December 31, 20X7. During the year, Broadwall obtained a long-term loan from local bank pursuant to a financing agreement that provided that the: 1. Loan was to be secured by the company’s inventory and accounts receivable. 2. Company was to maintain a debt-to-equity ratio not to exceed two to one. 3. Company was not to pay dividends without permission from the bank. 4. Monthly installment payments were to commence July 1, 20X8. In addition, during the year the company also borrowed amount, on a short-term basis, from the president of the company, including substantial amounts just prior to year-end.

Required: a. For purposes of Estava’s audit of the financial statements of Broadwall Corporation what procedures should Esteva employ in examining the described loans? Identify the audit objective served by each of the procedures. b. What financial statement disclosures should Esteva expect to find with respect to the loans from the president? Answer: Requirement (a) Esteva should apply the following procedures: 1. Send standard bank confirmation a. Direct liabilities b. Security agreements 2. Examine notes for terms, provisions, etc. 3. Review board meeting minutes a. Authority for transactions b. Dividends declared 4. Determine compliance with bank loan provisions 5. Consider effects of president’s loans on debt/equity 6. Investigate business purpose of loan 7. Trace loan proceeds to cash receipts records 8. Trace interest and principal payments to cash disbursements records 9. Recompute and verify interest expense and accrual computations 10. Consider balance sheet presentation/disclosure a. Current/non-current portions b. Assets pledged as collateral c. Related party 11. Obtain management representation letter Requirement (b) Broadwall’s financial statements should include the following related party disclosures: 1. Nature of party’s relationship 2. Description of the transaction 3. Peso volume of the loans 4. Amounts due to president and terms of settlement. Exercise 2 Pine Inc., a developer and producer of personal computers, printers, and other computer hardware, leases factory and office space at its only location in the Sto. Tomas area of Laguna. Quarterly lease payments of P150,000 are charged to rent expense as paid or accrued. The lease is non-cancellable and was signed on January 1, 20X7. The present value of the future lease payments a 1/1/20X7 is P3,467,215. This amount is based on the 12% interest rate stated in the stated in the lease agreement. Required: a. As in-charge auditor examining the Pine financial statements for the year ended 12/31/20X7, what additional information do you need in order to determine whether the lease is a financing or operating lease? b. What audit procedures would you apply in gathering the information needed in (a)? c. Assuming that the lease is considered a financing lease, and the estimated useful life and salvage value of the property are 10 years and P600,000 respectively, prepare an audit

work paper for the lease liability. Assume that the quarterly payments are due on April 1, July 1, October 1, and January 1. Include all necessary audit legends as evidence of procedures performed. d. Draft any audit adjustments indicated by the work paper prepared in (c). Answer: Requirement (a) The following additional information is needed to determine the proper lease classification as financing or operating: 1. The fair value of the building space as of the date on which the lease agreement was signed. 2. The initial lease term and whether a bargain purchase or renewal option is available at the end of the term. 3. The estimated useful life of the property. 4. Whether the quarterly lease payments include provision for executory costs (insurance, taxes, etc.) 5. Whether the residual value is guaranteed by Pine Requirement (b) The following auditing procedures should be applied in gathering the information meeting the requirements set forth in (a) above: 1. Examine the lease agreement for details surrounding the initial lease term, payment of executory costs, and the existence of purchase or renewal options. 2. Examine appraisal reports and property tax bills for an indication of fair value at date of lease. 3. Inquire of management or confirm with lessor as to the estimated useful life of the property. Requirement(c) Pine, Inc. Obligation under Capital Leases, 2006 December 31, 2006 1/1/06: Liability as calculated: NPV of P150,000 per period for 40 periods at 3% per period (ordinary annuity) P 3,467,215 4/1/06: Payment: Interest (3% x P 3,467,215) = P 104,016 Principal (P 150,000 – P 104,016) (45,984) 7/1/06: Payment: Interest [3% x (P 3,467,215 – P 45,985)] = P 102,637 Principal (P 150,000 – P 102,637) (47,363) 9/1/06: Payment: Interest [3% x (P 3,467,215 – P 45,984 – P 47,363)] = P 101,216 Principal (P 150,000 – P 101,216) (48,784) 12/31/06: Principal balance P 3,325,084 Requirement (d) Audit adjustments: (1) Lease Property 3,467,215 Interest Expense 307,869 Obligation under Capital Lease 3,325,084

Rent Expense 450,000 To capitalize financing lease and reverse rental charges erroneously recognized as expense. (2) Depreciation Expense 346,721 Accumulated Depreciation 346,721 To record depreciation on leased assets, assuming straight-line depreciation and full year policy concerning depreciation in the year of acquisition. (3) Interest Expense 99,753 Interest Payable 99,753 3% of P 3,325,084 (4th quarter interest) Exercise 3: Entry for Retirement of Bond; Bond Issue Costs On January 1, 20X0, Boogie Corporation issued P1,500,000 of 10% bonds at 97 due December 31, 20X9. Legal and other costs of P24,000 were incurred in connection with the issue. Interest of the bonds is payable annually each December 31. The P24,000 issue costs are being deferred and amortized on a straight-line basis over the 10-year term of the bonds. The discount on the bonds is also being amortized on a straight-line basis over the 10 years. (Straight-line is not materially different in effect from the preferable “interest method.”) The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2, 20X5, Boogie called P900,000 face amount of the bonds and retired them. Required: Ignoring income taxes, compute the amount of loss, if any, to be recognized by Boogie as a result of retiring the P900,000 of bonds in 20X7 and prepare the journal entry to record the retirement. Answer: Reacquisition price (P 900,000 X 101%) Less: Net carrying amount of bonds redeemed: Par value Unamortized discount Unamortized bond issue costs Loss on redemption Calculation of unamortized discount— Original amount of discount: P 900,000 X 3% = P 27,000 P 27,000/10 = P 2,700 amortization per year Amount of discount unamortized: P 2,700 X 5 = P 13,500 Calculation of unamortized issue costs— Original amount of costs: P 24,000 X P 900,000/P 1,500,000 = P 14,400 P 14,400/10 = P 1,440 amortization per year Amount of costs unamortized: P 1,440 X 5 = P 7,200

P 909,000 P 900,000 (13,500) (7,200)

879,300 P 29,700

January 2, 2006 Bonds Payable..................................................................................... 900,000

Loss on Redemption of Bonds ............................................................. 29,700 Unamortized Bond Issue Cost.......................................................................... 7,200 Discount on Bonds Payable............................................................................ 13,500 Cash.............................................................................................................. 909,000 Exercise 4: Entries for Retirement and Issuance of Bonds Stargazer Company had bonds outstanding with a maturity value of P300,000. On April 30, 20X7, when these bonds had an unamortized discount of P10,000, they were called in at 104. To pay for these bonds, Stargazer had issued other bonds a month earlier bearing a lower interest rate. The newly issued bonds had a life of 10 years. The new bonds were issued at 103 (face value P300,000). Issue costs related to the new bonds were P3,000. Required: Ignoring interest, compute the gain or loss and record this refunding transaction. Answer: Reacquisition price (P 300,000 X 104%)................................ Less: Net carrying amount of bonds redeemed: Par value....................................................................... Unamortized discount.................................................. Loss on redemption......................................................

P 312,000 P 300,000 (10,000)

Bonds Payable.......................................................................... Loss on Redemption of Bonds................................................ Discount on Bonds Payable........................................ Cash.............................................................................. (To record redemption of bonds payable)

300,000 22,000

Cash.......................................................................................... Unamortized Bond Issue Costs.............................................. Premium on Bonds Payable....................................... Bonds Payable............................................................. (To record issuance of new bonds)

306,000 3,000

290,000 P 22,000

10,000 312,000

9,000 300,000

Exercise 5: Asset Retirement Obligation Grease Products Company purchases an oil tanker depot on January 1, 20X1, at a cost of P600,000. Grease Products expects to operate the depot for 10 years, at which time it is legally required to dismantle the depot and remove the underground storage tanks. It is estimated that it will costs P75,000 to dismantle the depot and remove the tanks at the end of the depot’s useful life. Required: a. Prepare the journal entries to record the depot and the asset retirement obligation for the depot on January 1, 20X1. Based on an effective interest rate of 6%, the present value of the asset retirement obligation on January 1, 20X1, is P41,879. b. Prepare the journal entries required for the depot and the asset retirement obligation at December 31, 20X1. Grease Products uses straight-line depreciation; the estimated residual value for the depot is zero. c. On December 31, 20X6, Grease Products pays a demolition firm to dismantle the depot and remove the tanks at a price of P80,000. Prepare the journal entry for the settlement of the asset retirement obligation.

Answer: Requirement (a) Depot......................................................................... Cash.............................................................. Depot......................................................................... Asset Retirement Obligation....................... Requirement (b) Depreciation Expense.............................................. Accumulated Depreciation.........................

600,000 600,000 41,879 41,879

60,000 60,000

Depreciation Expense............................................. Accumulated Depreciation.........................

4,187.90

Interest Expense..................................................... Asset Retirement Obligation..................... *P41,879/10. **P41,879X.06.

2,512.74

Requirement (c) Asset Retirement Obligation................................ Loss on ARO Settlement...................................... Cash............................................................

4,187.90* 2,512.74**

75,000 5,000 80,000

Exercise 6: Settlement of Debt Miguel Company owes a P200,000 plus P18,000 accrued interest to Prime National Bank. The debt is a 10-year, 10% note. During 20X7, Miguel’s business deteriorated due to a faltering regional economy. On December 31, 20X7, Prime National Bank agrees to accept an old machine and cancel the entire debt. The machine has a cost of P390,000, accumulated depreciation of P221,000, and a fair market value of P190,000. Required: a. Prepare journal entries for Miguel Company and Prime National Bank to record this debt settlement. b. How should Miguel report the gain or loss on the disposition of machine an on restructuring of debt in its 20X7 statement of comprehensive income? c. Assume that, instead of transferring the machine, Miguel decides to grant 15,000 shares of its ordinary shares (P10 par) which has a fair market value of P190,000 in full settlement of the loan obligation. If Prime National Bank treats Miguel’s shares as a trading investment, prepare the entries to record the transaction for both parties. Answer: Requirement (a) Transfer of property on December 31, 2006: Miguel Company (Debtor): Note Payable.................................................................` Interest Payable............................................................ Accumulated Depreciation — Machine..................... Machine............................................................. Gain on Disposition of Machine......................

200,000 18,000 221,000 390,000 21,000a

Gain on Debt Restructuring............................ a P 190,000 – (P 390,000 – P 221,000) = P 21,000. b (P 200,000 + P 18,000) – P 190,000 = P 28,000. Prime National Bank (Creditor): Machine........................................................................ Allowance for Doubtful Accounts............................... Note Receivable................................................ Interest Receivable...........................................

28,000b

190,000 28,000 200,000 18,000

Requirement (b) “Gain on Machine Disposition” and the “Gain on Debt Restructuring” should be reported as an ordinary gain in the income statement. Requirement (c) Granting of equity interest on December 31, 2006: Miguel Company (Debtor): Note Payable.............................................................. 200,000 Interest Payable......................................................... 18,000 Ordinary Shares............................................ Additional Paid-in Capital........................... Gain on Debt Restructuring........................

150,000 40,000 28,000

Prime National Bank (Creditor): Investment (Trading)........................................................... 190,000 Allowance for Doubtful Accounts....................................... 28,000 Note Receivable.................................................................... Interest Receivable........................................................