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Auditing ProblemsIntangiblesDianne France Carandang Ponce Martin Celebrado Jane Louise Constantino Mary Annvic CortesAuditing Problems – Intangibles, Impairment and RevaluationProblem NO. 1JOYCE CORP. holds a valuable patent on a precipitator that prevents certain types of air pollution. JOYCE does ...

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Auditing Problems Intangibles

Dianne France Carandang Ponce Martin Celebrado Jane Louise Constantino Mary Annvic Cortes

Auditing Problems – Intangibles, Impairment and Revaluation Problem NO. 1 JOYCE CORP. holds a valuable patent on a precipitator that prevents certain types of air pollution. JOYCE does not manufacture or sell the products and processes it develops. Instead, it conducts research and develops products and processes which it patents and then assigns the patents to manufacturers on a royalty basis. Occasionally, it sells a patent. The following present the summary of the activities in relation to the aforementioned patent: 1996-1997

Research conducted to develop precipitator:

Jan. 5, 1998

Design and construction of prototype

876,000

March 15

Testing the prototype models

420,000

Jan 2, 1999

Legal and other professional fees to process the patent application (useful life = legal life)

620,000

Dec 10, 2001

Legal fees paid to successfully defend the device patent

357,000

Jan. 3, 2003

Acquisition of a competitive patent aimed at protecting old patent

406,000

Acquisition of the related patent which extended the life of the patents for additional 2 years

654,375

Legal fees paid in unsuccessful patent infringement suit against a competitor

250,000

Jan. 5, 2004

Dec.31, 2006

P3840,000

1. What is the correct cost of the patent upon initial recognition? a. P5,756,000 b. P1,916,000 c. P1,040,000

d. P620,000

2. What is the carrying value of the patent on December 31, 1999? b. P988,000 c. P1,820,200 a. P589,000

d. P5, 468,200

3. What is the carrying value of the patent on December 31, 2003? a. P1, 181,000 b. P845,625 c. P465,000

d. P380,625

4. What is the carrying value of the patent on December 31, 2005? a. P1, 400,000 b. P1,300,000 c. P1,315,500

d. P1,323,529

5. What is the total loss from patent write off should be recognized in 2006? a. P1, 235,294 b. P1,213,333 c. P1,225,000 d. P1,323,667

Solution and Explanation: 1. Answer: D 620,000 2. Answer: A Compute the carrying value of patent December 31, 1999? Cost of obtaining patent 1999 620,000 Amortization 1999 (19,000) Carrying Value, Dec. 31, 1999 589,000

Cost of patent Legal Life of Patent Amortization

620,000 /20 19,000

3. Answer: B Compute the carrying value of patent December 31, 2003? Carrying value of Patent, Jan. 01, 2000 589,000 2000 Amortization (31,000) 2001 Amortization (31,000) 2002 Amortization (31,000) Carrying value of Patent, Dec. 31, 2002 496,000 Acquisition of the related patent Jan. 3, 2003 2003 Amortization Carrying value of Patent, Dec. 31, 2003

406,000 902,000 56,375 845,625

4. Answer: D Compute the carrying value of patent December 31, 2005? Carrying value of Patent, Jan. 1, 2004 845,625 Acquisition of the related patent Jan. 5, 2004 654,375 Total 1,500,000 2004 Amortization 88,235 2005 Amortization 88,235 Carrying value of Patent, Dec. 31, 2005 1, 323,529 5. Answer: A 1, 323,529 /15 88, 235

1, 323,529 88, 235 1, 235,294

An intangible asset according to PAS 38 par 21 shall be recognised if, and only if: (a) it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and (b) the cost of the asset can be measured reliably. An intangible asset shall be measured initially at cost (PAS 38 par 24) and the subsequent recognition of intangible assets shall be carried at its cost less any accumulated amortization and any accumulated impairment losses over its remaining expected life.

Problem NO. 2 Jimar Co. incurred the following costs during the year:

Cost of activities aimed at obtaining new knowledge

P700,000

Marketing research to study consumer tastes

16,000

Cost of developing and producing a prototype model

23,000

Cost of testing the prototype model for safety and environmental friendliness

80,000

Cost of revising designs for flaws in the prototype model

15,000

Salaries of employees, consultants, and technicians involved in R&D

120,000

Amount paid for conference for the introduction of the newly developed product including fee of a model hired as endorser Advertising to establish recognition of the newly developed product

102,000 43,000

Cost incurred on search for alternatives for material, devices, products, processes, systems or services

30,000

Cost of final selection of possible alternatives for a new process

96,000

Periodic or routine design changes to existing products Modification of design for a specific customer

2,500 10,000

Cost of design, construction and operation of a pilot plant that is not Of a scale economically feasible for commercial production

5,000

Cost of routine, seasonal, and periodic design of tools, jigs, molds and dies

18,000

Cost of quality control during commercial production

32,000

Cost of building acquired to be used in various R&D projects Depreciation on the building described above

1,000,000 100,000

Personnel costs of persons involved in research and development projects

41,200

Design, construction, and testing of production prototypes and models

96,000

1. Compute for the total research and development expense during the year. a. P1,306,200 b. P1,176,200 c. P1,223,500 d. P1,034,000

Solution and Explanation: Cost of activities aimed at obtaining new knowledge

P 700,000

Cost of developing and producing a prototype model

23,000

Cost of testing the prototype model for safety and environmental friendliness

80,000

Cost of revising designs for flaws in the prototype model

15,000

Salaries of employees, consultants, and technicians involved in R&D

120,000

Cost incurred on search for alternatives for material, devices, products, processes, systems or services

30,000

Cost of final selection of possible alternatives for a new process

96,000

Cost of design, construction and operation of a pilot plant that is not Of a scale economically feasible for commercial production Depreciation on the building described above Personnel costs of persons involved in research and development projects Design, construction, and testing of production prototypes and models Total Reseach and Development Expense

Charge all research cost to expense (PAS 38, par.54)

5,000 100,000 41,200 96,000 1,306,200

Development costs are capitaliz ed only after technical and commercialfeasibility of the asset for sale or use have been established. This means that the entity must intend and be able to complete the intangible asset and either uses it or sell it and be able to demonstrate how the asset will generate future economic benefits. ( PAS 38, par.57) If an entity cannot distinguish the research phase of an internal project to create an intangible asset from the development phase, the entity treats the expenditure for that project as if it were incurred in the research phase only. Problem NO. 3 You gathered the following information related to the Patents account of the Lady Han Cookie Corporation in connection with your audit of the company’s financial statements for the year 2006. In 2005, Lady Han 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, Lady Han patented the machine. The following expenses were incurred in developing and patenting the machine: Research and 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

P1000,000 320,000 128,000 128,000 1,200,000

68,000 100,000

During 2006, Lady Han paid P150,000 in legal fees to successfully defend the patentagainst an infringement suit by Cookie Monster Corporation. 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 a. P580,000

b. P1,128,000

c. P648,000

d. P 798,0001

2. Cost of Machine a. P1,236,000

b. P1,040,000

c. P1,648,000

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 b. P1,608,000 c. P1,000,000 d. P 01

4. Carrying amount of patent as of December 31,2006 a. P522,000 b. P1,015,200 c. P583,200

d. P 837,900

5. The most effective means for the auditor to determine whether a recordedintangible asset possesses the characteristics of an asset is to a. Analyze research and development expenditures to determine that only those expenditures possessing future economic benefit have been capitalized. b. Vouch the purchase by reference to underlying documentation. c. Inquire as to the status of patent applications. d. Evaluate the future revenue-producing capacity of the intangible asset.

Solution and Explanation: 1. ANSWER: C Legal Expenses to obtain patent

480, 000

Expenses of drawing required by the patent office to be submitted with the patent application

68, 000

Fees paid to the government patent office to process application

100, 000

Cost of Patent

648, 000

Explanation: Cost of an internally generated intangible asset (PAS 38 paragraph 65, 66, and 67) The cost of an internally generated intangible asset for the purpose of paragraph 24 is the sum of expenditure incurred from the date when the intangible asset first meets the recognition criteria in paragraphs 21, 22 and 57. Paragraph 71 prohibits reinstatement of expenditure previously recognized as an expense. The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce, and prepare the asset to be capable of operating in the manner intended by management. Examples of directly attributable costs are: (a) costs of materials and services used or consumed in generating the intangible asset; (b) costs of employee benefits (as defined in IAS 19) arising from the generation of the intangible asset;

(c) fees to register a legal right; and (d) amortisation of patents and licences that are used to generate the intangible asset. IAS 23 specifies criteria for the recognition of interest as an element of the cost of an internally generated intangible asset. The following are not components of the cost of an internally generated intangible asset: (a) selling, administrative and other general overhead expenditure unless this expenditure can be directly attributed to preparing the asset for use; (b) identified inefficiencies and initial operating losses incurred before the asset achieves planned performance; and (c) expenditure on training staff to operate the asset. 2. ANSWER: D Metal used in the construction of the machine

320, 000

Blueprints used to obtain patent

480, 000

Wages paid for the employees’ work on the R&D and building of machine (1, 200,000 *60%) Cost of machine

720, 000 1, 168, 000:

PAS 16, paragraph 16; 17 Elements of cost The cost of an item of property, plant and equipment comprises: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates. (b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. (c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. Examples of directly attributable costs are: (a) costs of employee benefits (as defined in IAS 19 Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment;

(b) costs of site preparation; (c) initial delivery and handling costs; (d) installation and assembly costs; (e) costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition (such as samples produced when testing equipment); and (f) professional fees.

3. ANSWER: A Amount that should charged to expense when incurred in connection with the development of the patented machine. Research and development laboratory expenses

1,000,000

Wages paid for the employees’ work on the R&D and building of machine (1, 200,000 *40%) Development expense

480, 000 1, 480, 000

PAS 38, paragraph 54 and 57 Research phase No intangible asset arising from research (or from the research phase of an internal project) shall be recognised. Expenditure on research (or on the research phase of an internal project) shall be recognised as an expense when it is incurred

Development phase An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if, and only if, an entity can demonstrate all of the following: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale. (b) its intention to complete the intangible asset and use or sell it. (c) its ability to use or sell the intangible asset.

(d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset. (e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset. (f) its ability to measure reliably the expenditure attributable to the intangible asset during its development.

4. ANSWER: C Carrying amount of patent as of December 31, 2006 Solution: Cost of Patent (refer to no. 1) Less: Amortization (648,000 / 20)*2 Carrying amount

648, 000 64, 800 583, 200

PAS 38, paragraph 97 Amortization period and amortization method The depreciable amount of an intangible asset with a finite useful life shall be allocated on a systematic basis over its useful life. Amortisation shall begin when the asset is available for use, ie when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. Amortisation shall cease at the earlier of the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with IFRS 5 and the date that the asset is derecognised. The amortisation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably, the straight-line method shall be used. The amortisation charge for each period shall be recognised in profit or loss unless this or another Standard permits or requires it to be included in the carrying amount of another asset.

5. ANSWER: D Evaluate the future revenue-producing capacity of the intangible asset PAS 38 Criteria for initial recognition

The previous version of IAS 38 required an intangible asset to be recognised if, and only if, it was probable that the expected future economic benefits attributable to the asset would flow to the entity, and its cost could be measured reliably. These recognition criteria have been included in the Standard. However, additional guidance has been included to clarify that: (a) the probability recognition criterion is always considered to be satisfied for intangible assets that are acquired separately or in a business combination. (b) the fair value of an intangible asset acquired in a business combination can be measured with sufficient reliability to be recognised separately from goodwill. Future economic benefits The future economic benefits flowing from an intangible asset may include revenue from the sale of products or services, cost savings, or other benefits resulting from the use of the asset by the entity. For example, the use of intellectual property in a production process may reduce future production costs rather than increase future revenues

Problem NO. 4 Transactions during 2005 of the newly organized Pink Corporation included the following: Jan. 2

15

Apr. 1

Paid legal fees of P150,000 and stock certificate costs of P83,000 to complete organization of the corporation. 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, P10,000; pamphlets and candy, P5,000. Patented a newly developed process with costs as follows: Legal fees to obtain patent Patent application and licensing fees Total

P 429,000 63,500 P 492,500

It is estimated that in 6 years other companies will have developed improved processes, making the Pink 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 6,000 shares of Pink 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 P1,310,000 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 P1,750,000 in 2008.

QUESTIONS: Based on the above and the result of your audit, determine the following: 1. Cost of patent a. P492,500

b. P429,000

c. P63,500

d. P0

2. Cost of licenses a. P150,000

b. P200,000

c. P100,000

d. P0

3. Cost of trademark a. P150,000 b. P200,000

c. P100,000

d. P0

4. Carrying amount of Intangible Assets a. P712,604 b. P2,477,604

c. P697,604

d. P0

5. Total amount resulting from the foregoing transactions that should be expensed when incurred. a. P4,100,500 b. P1,983,000 c. P1,998,000 d. P0

Solution and Explanation: 1. Answer: See journal entry for April 1

Journal Entries Jan. 2

Organization Expenses

P 233, 000

Cash 15

P 233, 000

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