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VI – AUDIT OF INTANGIBLE ASSETSPROBLEM NO. 1The following are items that could be included in the Intangible Assets: Investment in a subsidiary company P1,500, 0 Timberland 2,000, Cost of engineering activity required to advance the design of a product to the manufacturing stage 120,0 00 Lease prepa...

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VI – AUDIT OF INTANGIBLE ASSETS PROBLEM NO. 1 The following are items that could be included in the Intangible Assets: 1. Investment in a subsidiary company 2. Timberland 3. Cost of engineering activity required to advance the design of a product to the manufacturing stage 4. Lease prepayments (6 months’ rent paid in advance) 5. Cost of equipment obtained under finance lease 6. Internally generated publishing title 7. Costs incurred in the formation of the corporation 8. Operating losses incurred in the start-up of the business 9. Training costs incurred in start-up operations 10. Purchase of a franchise 11. Goodwill internally generated 12. Cost of testing in search for product alternatives 13. Goodwill acquired in the purchase of a business 14. Cost of developing a patent 15. Cost of purchasing a patent from an inventor 16. Legal costs incurred in securing a patent 17. Costs of a successful legal suit to protect the patent 18. Cost of conceptual formulation of possible product alternatives 19. Cost of purchasing a copyright 20. Research and development costs 21. Long-term receivables 22. Cost of developing a trademark 23. Cost of purchasing a trademark 24. Computer software for a computer-controlled machine that cannot operate without that specific software 25. Operating system of a computer

P1,500,00 0 2,000,000 120,000 60,000 700,000 230,000 90,000 560,000 80,000 1,200,000 300,000 65,000 640,000 140,000 500,000 70,000 230,000 160,000 900,000 340,000 310,000 61,000 290,000 130,000 10,000

Question: How much could be recognized as Intangible Assets? a. P3,600,000 c. P5,830,000 b. P3,740,000 d. P3,530,000 Suggested Solution: PAS 38 par. 8 defines “Intangible asset” as an identifiable non-monetary asset without physical substance. 167

Items 10, 13, 15, 16, 19 and 23 could be recognized as intangible asset. The other items will be reported as follows: Item 1 Item 2 Item 3

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Item 4 Item 5 Item 6

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Item Item Item Item

7 8 9 11

-

Item 12

-

Item 14

-

Item 17 Item 18

-

Item 20

-

Item 21 Item 22 Item 24

-

Item 25

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Noncurrent asset in the balance sheet Property, plant, and equipment in the balance sheet Research and development expense in the income statement Current asset (prepaid rent) in the balance sheet Property, plant, and equipment in the balance sheet Not recognized. PAS 38 par. 63 states that internally generated brands, mastheads, publishing titles, customer lists and other items similar in substance shall not be recognized as intangible assets. Any costs related to creating publishing titles incurred internally must be expensed. Charge as expense in the income statement Operating losses in the income statement Charge as expense in the income statement Not recognized. PAS 38 par. 48 states that internally generated goodwill shall not be recognized as an asset. Any costs related to creating publishing titles incurred internally must be expensed. Research and development expense in the income statement Research and development expense in the income statement Charge as expense in the income statement Research and development expense in the income statement Research and development expense in the income statement Noncurrent asset in the balance sheet Charge as expense in the income statement Property, plant, and equipment in the balance sheet (see PAS 38 par. 4) Property, plant, and equipment in the balance sheet (see PAS 38 par. 4)

Answer: A

PROBLEM NO. 2

168

In connection with your audit of the Cabuyao Corporation, you noted the following transactions during 2006: Jan. 2

Paid legal fees of P450,000 and stock certificate costs of P249,000 to complete organization of the corporation.

15

Apr. 1

Hired a clown to stand in front of the corporate office for 2 weeks and hound out pamphlets and candy to create goodwill for the new enterprise. Clown cost, P30,000; pamphlets and candy, P15,000. Patented a newly developed process with costs as follows: Legal fees to obtain patent Patent application and licensing fees Total

P1,287,000 190,500 P1,477,500

It is estimated that in 6 years other companies will have developed improved processes, making the Cabuyao Corporation process obsolete. May

1

Acquired both a license to use a special type of container and a distinctive trademark to be printed on the container in exchange for 18,000 shares of Cabuyao’s no-par common stock selling for P50 per share. The license is worth twice as much as the trademark, both of which may be used for 6 years.

July

1

Constructed a shed for P3,930,000 to house prototypes of experimental models to be developed in future research projects.

Dec. 31

Incurred salaries for an engineer and chemist involved in product development totaling P750,000 in 2006.

QUESTIONS: Based on the above and the result of your audit, determine the following: 1. Cost of patent a. P1,477,500 b. P 190,500

c. P1,287,000 d. P 0

2. Cost of licenses a. P450,000 b. P300,000

c. P600,000 d. P 0 169

3. Cost of trademark a. P450,000 b. P300,000

c. P600,000 d. P 0

4. Carrying amount of Intangible Assets as of December 31, 2006 a. P2,137,812 c. P7,432,812 b. P2,092,812 d. P 0 5. Total amount resulting from the foregoing transactions that should be expensed when incurred a. P2,971,500 c. P5,424,000 b. P1,494,000 d. P 0 Suggested Solution: The following journal entries to record the foregoing transactions will be useful in computing for the requirements: Jan. 2 Organization expenses Cash

P 699,000

Jan. 15 Advertising expense Cash

P

P 699,000 45,000 P

Apr. 1 Patents

45,000

P1,477,500 Cash

P1,477,500

May 1 Licenses (P900,000 x 2/3) P 600,000 Trademark (P900,000 x 1/3) 300,000 Common stock (18,000 x P50) P 900,000 Jul. 1 Building Cash

P3,930,000

Dec. 31 Research and development expense Cash

P 750,000

P3,930,000

Question No. 1 See journal entry for April 1. 170

P 750,000

Question Nos. 2 & 3 See journal entry for May 1. Question No. 4 Cost: Patent Licenses Trademark Less amortization for 2006: Patent (P492,500/6 x 9/12) Licenses (P200,000/6 x 8/12) Trademark (P100,000/6 x 8/12) Carrying amount, 12/31/06

P1,477,50 0 600,000 300,000 184,688 66,667 33,333

P2,377,500

284,688 P2,092,812

Question No. 5 Organization expenses (Jan. 2 transaction) Advertising expense (Jan. 15 transaction) R and D expense (Dec. 31 transaction) Total

P 699,000 45,000 750,000 P1,494,000

Answers: 1) A; 2) C; 3) B; 4) B, 5) B PROBLEM NO. 3 In connection with your audit of the Liliw Corporation’s financial statements for the year 2006, you noted the following items relative to the company’s Intangible assets. •

A patent was purchased from Pansol Company for P4,000,000 on January 2, 2005. Liliw estimated that the remaining useful life of the patent to be 10 years. The patent was carried in Pansol’s accounting records at a carrying value of P4,000,000 when Pansol sold it to Liliw.

•

During 2006, a franchise was purchased from Makiling Company for P960,000. In addition, 5% of the revenue from the franchise must be paid to Makiling. Revenue from the franchise for 2006 was P5,000,000. Carter estimates the useful life of the franchise to be 10 years and takes full year’s amortization in the year of purchase.

171

•

Liliw incurred research and development costs of P866,000 in 2006. Liliw estimates that these costs will be recouped by December 31, 2009.

On January 1, 2006, Liliw, because of the recent events in the industry, estimates that the remaining life of the patent purchased on January 2, 2005, is only 5 years from January 1, 2006. QUESTIONS: •

Based on the above and the result of your audit, determine the following: 1. Amortization of patent for 2006 a. P900,000 b. P800,000

c. P720,000 d. P400,000

2. Carrying amount of patent as of December 31, 2006 a. P2,880,000 c. P2,700,000 b. P2,400,000 d. P3,200,000 3. Carrying amount of intangible assets as of December 31, 2006 a. P3,264,000 c. P3,564,000 b. P4,610,000 d. P3,744,000 4. Total amount that should be charged against income in 2006 a. P2,112,000 c. P2,012,000 b. P1,066,000 d. P1,932,000 Suggested Solution: Question No. 1 Cost of patent Less amortization in 2005 (P4,000,000/10) Carrying amount, 1/1/06 Divide by revised remaining useful life Patent amortization for 2006

P4,000,000 400,000 P3,600,000 5 P 720,000

Question No. 2 Carrying amount, 1/1/06 (see no. 1) Less amortization in 2006 (see no. 1) Carrying amount, 12/31/06

P3,600,000 720,000 P2,880,000

Question No. 3 Cost of franchise Less amortization in 2006 (P960,000/10) Carrying amount of franchise, 12/31/06 172

P 960,000 96,000 864,000

Carrying amount of patent, 12/31/06 (see no. 2) Carrying amount of intangible assets, 12/31/06

2,880,000 P3,744,000

Question No. 4 Patent amortization (see no. 1) Franchise amortization (see no. 3) Periodic franchise fee (P5,000,000 x 5%) R and D expense Total charged against income in 2006

P 720,000 96,000 250,000 866,000 P1,932,000

Answers: 1) C; 2) A; 3) D; 4) D

PROBLEM NO. 4 You gathered the following information related to the Patents account of the Majayjay Cookie Corporation in connection with your audit of the company’s financial statements for the year 2006. In 2005, Majayjay developed a new machine that reduces the time required to insert the fortunes into its fortune cookies. Because the process is considered very valuable to the fortune cookie industry, Majayjay patented the machine. The following expenses were incurred in developing and patenting the machine: Research and development laboratory expenses Metal used in the construction of the machine Blueprints used to design the machine Legal expenses to obtain patent Wages paid for the employees’ work on the research, development, and building of the machine (60% of the time was spent in actually building the machine) Expense of drawing required by the patent office to be submitted with the patent application Fees paid to the government patent office to process application

P1,000,000 320,000 128,000 480,000

1,200,000

68,000 100,000

During 2006, Majayjay paid P150,000 in legal fees to successfully defend the patent against an infringement suit by Cookie Monster Corporation.

173

It is the company’s policy to take full year amortization in the year of acquisition. QUESTIONS: Based on the above and the result of your audit, determine the following: 1. Cost of patent a. P580,000 b. P648,000

c. P1,128,000 d. P 798,000

2. Cost of machine a. P1,236,000 b. P1,648,000

c. P1,040,000 d. P1,168,000

3. Amount that should charged to expense when incurred in connection with the development of the patented machine a. P1,480,000 c. P1,608,000 b. P1,000,000 d. P 0 4. Carrying amount of patent as of December 31, 2006 a. P522,000 c. P1,015,200 b. P583,200 d. P 837,900 Suggested Solution: Question No. 1 Legal expenses to obtain patent Expense of drawing required by the patent office Fees paid to the government patent office Cost of patent

P480,000 68,000 100,000 P648,000

Question No. 2 Metal used in the construction of the machine Blueprints used to design the machine Wages paid to the employees (P1,200,000 x 60%) Cost of machine

P 320,000 128,000 720,000 P1,168,000

Question No. 3 Research and development laboratory expenses Wages paid to the employees (P1,200,000 x 40%) R & D expense 174

P1,000,000 480,000 P1,480,000

Question No. 4 Cost of patent (see no. 1) Less amortization (P648,000 x 2/20) Carrying amount of patent, 12/31/06

P648,000 64,800 P583,200

Notes: 1) Cost of defending the patent should be expensed. 2) Since the useful life is not given, the patent was amortized using the legal life of 20 years. Answers: 1) B; 2) D; 3) A; 4) B

PROBLEM NO. 5 On January 2, 1998, Nagcarlan Company spent P480,000 to apply for and obtain a patent on a newly developed product. The patent had an estimated useful life of 10 years. At the beginning of 2002, the company spent P144,000 in successfully prosecuting an attempted patent infringement. At the beginning of 2003, the company purchased for P280,000 a patent that was expected to prolong the life of its original patent by 5 years. On July 1, 2006, a competitor obtained rights to a patent that made the company’s patent obsolete. QUESTIONS: Based on the above and the result of your audit, determine the following: 1. Carrying amount of patent as of December 31, 2002 a. P360,000 c. P369,600 b. P240,000 d. P355,200 2. Amortization of patent in 2003 a. P64,000 b. P64,960

c. P52,000 d. P63,520

3. Carrying amount of patents as of December 31, 2005 a. P448,000 c. P444,640 b. P454,720 d. P364,000 4. Loss on patent obsolescence a. P338,000 b. P416,000

c. P448,000 d. P364,000

Suggested Solution:

175

Question No. 1 Cost of patent Less amortization up to 12/31/02 (P480,000 x 5/10) Carrying amount of patent, 12/31/02

P480,000 240,000 P240,000

Question No. 2 Amortization on original patent (P240,000/10) Amortization on related patent (P280,000/10) Total amortization in 2003

P24,000 28,000 P52,000

Question No. 3 Original patent (P240,000 x 7/10) Related patent (P280,000 x 7/10) Carrying amount of patents, 12/31/05

P168,000 196,000 P364,000

Question No. 4 Carrying amount of patents, 12/31/05 Less amortization, 1/1/06 to 7/1/06: Original patent (P240,000/10 x 6/12) Related patent (P280,000/10 x 6/12) Loss on patent obsolescence

P364,000 P12,000 14,000

26,000 P338,000

Answers: 1) B; 2) C; 3) D; 4) A

PROBLEM NO. 6 You noted the following items relative to the company’s Intangible assets in connection with your audit of the Paete Corporation’s financial statements for the year 2006. •

On January 1, 2006, Paete signed an agreement to operate as franchisee of Clear Copy Service, Inc. for an initial franchise of P680,000. Of this amount, P200,000 was paid when the agreement was signed and the balance was payable in four annual payments of P120,000 each, beginning January 1, 2007. The agreement provides that the down payment is not refundable and no future services are required of the franchisor. The implicit rate for loan of this type is 14%. The agreement also provides the 5% of the revenue from the franchise must be paid to the franchisor annually. Paete’s revenue from the franchise for 2006 was P8,000,000. Paete estimates that the useful life of the franchise to be ten years.

176

•

Paete incurred P624,000 of experimental and development costs in its laboratory to develop a patent which was granted on January 2, 2006. Legal fees and another costs associated with the registration of the patent totaled P131,200. Paete estimates that the useful life of the patent will be eight years.

•

A trademark was purchased from Tsek Company for P320,000 on July 1, 2003. Expenditures for successful litigation in defense of the trademark totaling P80,000 were paid on July 1, 2006. Paete estimates that the trademark’s useful life will be indefinite.

QUESTIONS: Based on the above and the result of your audit, determine the following: (Round off present value factors to 4 decimal places) 1. Total expenses related to franchise in 2006 a. P503,914 c. P448,950 b. P535,200 d. P454,964 2. Carrying amount of franchise as of December 31, 2006 a. P549,644 c. P538,733 b. P494,680 d. P612,000 3. Carrying amount of patent as of December 31, 2006 a. P131,200 c. P124,640 b. P114,800 d. P123,482 4. Carrying amount of trademark as of December 31, 2006 a. P320,000 c. P304,000 b. P288,000 d. P400,000 5. Carrying amount of intangible assets as of December 31, 2006 a. P1,046,800 c. P1,009,480 b. P 984,444 d. P 929,480 Suggested Solution: Question No. 1 Down payment Add PV of installment payments (P120,000 x 2.9137) Cost of franchise Divide by useful life Amortization of franchise Periodic franchise fee (P8,000,000 x 5%) Imputed interest expense (P349,644 x 14%) Total expenses related to franchise in 2006 177

P200,000 349,644 549,644 10 54,964 400,000 48,950 P503,914

Question No. 2 Cost of franchise (see no. 1) Less amortization in 2006 (see no. 1) Carrying amount of franchise, 12/31/06

P549,644 54,964 P494,680

Question No. 3 Cost of patent Less amortization in 2006 (P131,200/8) Carrying amount of patent, 12/31/06

P131,200 16,400 P114,800

Question No. 4 Carrying amount of trademark, 12/31/06

P320,000

Notes: 1) Cost of defending the trademark should be expensed. 2) PAS 38 par. 107 states that an intangible asset with an indefinite useful life shall not be amortized. Question No. 5 Franchise (see no. 2) Patent (see no. 3) Trademark (see no. 4) Carrying amount of intangible assets, 12/31/06

P494,680 114,800 320,000 P929,480

Answers: 1) A; 2) B; 3) B; 4) A, 5) D

PROBLEM NO. 7 Presented below are five unrelated situations. For situation no. 1, compute for the normal earnings for the purposes of computing goodwill. For situations 2 to 5, compute the amount of goodwill. 1. Calauan Corporation’s pretax accounting income for the year 2006 was P1,275,000 and included the following items Amortization of goodwill Amortization of identifiable intangibles Depreciation on building Loss from fire 178

P 90,000 85,500 120,000 66,000

Gain on sale of machinery Profit-sharing payments to employees

225,000 97,500

Cavinti Corporation is planning to purchase Calauan Corporation. In attempting to measure Calauan’s normal earnings for 2006, Cavinti determined that the fair value of the building is triple the carrying value and that the remaining economic life is double that used by Calauan. Cavinti would continue the profit-sharing payments to employees; such payments are based on income before depreciation and amortization. a. P1,056,000 b. P1,206,000

c. P1,146,000 d. P 966,000

2. On January 1, 2006, Alaminos Corporation purchased Bay Company by paying P500,000 cash and issuing a P200,000 note payable. At January 1, 2006, the balance sheet of Bay Company was as follows: Cash Receivables Inventory Land Buildings – net Equipment – net Trademark

P100,000 180,000 200,000 80,000 150,000 140,000 20,000 P870,000

Accounts payable Bay, capital

P400,000 470,000 P870,000

The recorded amounts all approximate current values except land (worth P120,000), inventory (worth P250,000), and trademark (worthless) a. P160,000 b. P230,000

c. P30,000 d. P 0

3. The net assets of Famy Company excluding goodwill totaled P2,400,000 and earnings for the last 5 years totaled P2,670,000. Included in the latter figure are gain on sale of equipment P225,000, typhoon loss of P120,000, and sales commissions of P45,000. In developing a sales price for the business a 14% return on the net worth is considered normal for the industry, and the annual excess earnings are to be capitalized at 20% in arriving at goodwill. a. P885,000...