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AUDIT OF LIABILITIES

EXERCISE 1
On January 1, 2014, CRC-ACE Corporation issued bonds with a face value of
P1,000,000 and a maturity date of December 31, 2023. The bonds have a stated interest
rate of 10%, payable on January 1and July 1. They were sold for P915,300. CRC-ACE
Corporation paid P30,000 to issue the bonds.
Required:
1. What is the effective interest rate on this bond?
a. 9% b. 10% c. 11% d. 12%
2. The total bond interest expense for the year 2014 is
a. 92,426 b. 106,423 c. 104,673 d. 93,577
3. Carrying amount of bonds payable as of December 31, 2015
a. 891,723 b. 1,000,000 c. 895,226 d. 898,939
4. The unamortized bond discount on December 31, 2016 is
a. 92,953 b. 114,700 c. 101,061 d. 104,774
5. Assuming that the bonds were required on January 1, 2015 at 90, how much is the
gain or loss that should be recognized in the Income Statement?
a. 8,277gain b. 8,277 loss c. 1,061 gain d. 100,000 gain

Solution:
Carrying amount P891,723
FV (900,000)
Loss: P 8,277

Answer:
1. D 2. B 3. D 4. A 5. B

EXERCISE 2

On January 1, 2014, Sea Air Company issued its 8%, 5-year convertible debt instrument
with a face amount of P8,000,000 to 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 instruments were issued, the prevailing market rate of
interest for similar debt without conversion option is 10%.
PV of 10% for an ordinary annuity of P1 after 5 periods 3.791
PV of 10% after 5 interest periods .621
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, 2013 is
9% without the conversion option.
PV of 9% for an ordinary annuity of P1 after 2 periods 1.795

PV of 9%^ after 2 interest periods .842

Required:
On the date of issue, what amount of the proceeds represents the equity components?
Solution:
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PV of 1 (800T x .621) P4,968,000

PV of I (640T x 3.791) 2,426,620

Answer: P305,760

1. What is the carrying value of the debt instruments as of December 31, 2016?
Answer: P305,760
2. On the date of retirement, what amount of the proceeds represents the equity
component?
Answer: P7,723,333
3. How much is the gain or loss that should be reported in the profit or loss on the
retirement of the convertible debt instruments?
Answer: P138,240
4. How much is the gain on cancellation of the equity component to be reported in
the shareholders equity?
Answer: P167,520

EXERCISE 4

REAL Company compensates its employees for certain absences for vacation and
sickness. Employees are entitled to one day vacation plus one day sick leave for each
month work during the year. Unused vacation days may be carried forward, but unused
sick leave does not accumulate. Employees are compensated according to their pay in
effect at the time of the leave.

The following data were taken from the records for the year 2014.

Date of Unused Vacation Sick leave

Initial Vacation taken in taken in Rate
Employee Employment 1/1/2014 2014 2014 per day
Mr. A 01/10/2012 18 8 5 P1,000
Mr. B 07/28/2013 5 4 10 800
Mr. C 09/01/2014 0 2 6 600
Mr. D 08/01/2014 0 3 5 400
Required:

1. Compute the balance of the account Liability for Compensated Absences at

December 31, 2013.
Answer: P22,000
Solution:
Employee Liabilities Expense VCT
Mr. A P18,000 P17,000 P4,000
Mr. B 4000 17,600 6,400
Mr. C 0 4,800 1,200
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Mr. D 0 4,000 800

P22,000 P43,400 P12,400

2. Compute the amount of Employees benefit expense for sick leave and vacation
leave for the year 2014.
Answer: 43,400
Solution:
Employee Benefit Expense
Mr. A P17,000
Mr. B 17,600
Mr. C 4,800
Mr. D 4,000
Total P43,400

3. Compute the balance of liability for compensated absences at December 31, 2014.
Answer: P34,400
Solution:
Liability Compensated= P22,000 + P12,400
= P34,400 (see solution 1 also)

EXERCISE 5

HOPE Company adopted the policy of leasing as the primary method of selling its
products. The entity’s main product is a small helicopter that is very popular among
politicians and entity managers. HOPE Company constructed such a helicopter for SOLO
Company at a cost of P8,500,000.

Financing the construction was at a 14% rate. The terms of the lease provided for annual
advance payment of P2,500,000 to be paid over 10 years with the ownership transferring
to the lessee at the end of the lease period. It is estimated that the helicopter will have an
economic life of 20 years and a residual value of P1,600,000 at that date.

The lease payments began January 1, 2014. HOPE Company incurred initial direct cost
of P500,000 in financing the lease agreement with SOLO. The present value of an
annuity due of 1 at 14% for 10 periods is 5.95.

1. What is the gross profit on sale that should be recognized by HOPE company?
a. P5,875,000 b. P6,375,000 c. P4,275,000 d. P4,775,000
Answer: a
Solution:
Advance payment P2,500,000
X PV of annuity 5.95
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Total P14,875,000
Less: Opex 9,000,000
Gross profit P5,875,000

2. What is the unearned interest income on January 1, 2014?

a. P10,125,000 b. P11,725,000 c. P9,625,000 d. P8,525,000
Answer: a
Solution:
Advance payment P2,500,000
X 10 years
Total P25,000,000
Less: 14,875,000
Interest income P10,125,000

3. What is the interest income for 2014?

a. P2,082,500 b. P1,732,500 c. P2,306,500 d. P1,956,500
Answer: b
4. What is the cost of the helicopter that should be recognized by SOLO?
a. P25,000,000 b. P6,900,000 c. P8,500,000 d. P14,875,000
Answer: d
Solution:
Advance payment P2,500,000
X PV of annuity 5.95
Total Cost P14,875,000

5. What is the depreciation expense that should be recognized by SOLO in 2014?

a. P743,750 b. P663,750 c. P1,327,500 d. P345,000
Answer: b
Solution:
Total cost P14,875,000
Residual value (1,600,000)
Total 13,275,000
Over 20 years
Dep’n expense P663,750

EXERCISE 6

Irene Co., a lessor of office equipment, purchased a new equipment for P1,000,000 on
December 31, 2013. The equipment was delivered on the dame day to Gabby Co., the
lessee.

The following information relates to the lease transaction:

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1. The leased asset has an estimated economic life of seven years, which is also at
the lease term.
2. At the expiration of the lease, the equipment will revert to Irene, at which time it
is expected to have a residual value of P120,000 (none of which is guaranteed)
3. Irene implicit interest rate is 12% which is known by Gabby
4. Gabby’s incremental borrowing rate is 14% at December 31, 2013
5. Lease rentals consist of seven equal payments, the first of which was paid on
December 31, 2013.
6. Irene properly accounts for this lease a direct financing lease and as a finance
lease by Gabby. Both lessor and lessee are calendar year corporations and
depreciate all property, plant, and equipment on the straight line basis.

The present value tables show the following present value factors:
Present value of 1 for seven periods at 12% 0.4523
Present value of 1 for seven periods at 14% 0.3996
Present value of annuity due for seven periods at 12% 5.1114
Present value of annuity due for seven periods at 14% 4.8387
1. How much is the annual lease payment?
a. P135,103.43 b. P142,857.14 c. P185,022.50 d.P195,641.12
Answer: c
Solution:
Annual lease payment= P945,724/5.1114
= P185,022.50

2. How much unearned interest income should be recognized by Irene at the

inception of the lease?
a. P0 b. P65,724 c. P120,000 d. P415, 157.50
Answer: d
Solution:
ALP P185,022
X 7 years
Total P,295,154
Add: RV 120,000
P1,415,154
Less: (999,9996.5)
UnE Int. Inc P415,157.50

3. What is the amount of depreciation expense that Gabby should record for 2014?
a. P0 b. P135,103.43 c. P142,857.14 d. P185,022.50
Answer: b
Solution:
Dep’n Expense= P945,724/ 7years = P 135,103.
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4. The amount of interest expense that should be recorded by Gabby for 2014 is
a. P76,070.15 b. P91,284.18 c. P100,000 d. P113,487
Answer: b
Solution:
Cost P945,724
Less: ALP (185,022)
Total: P760,702
X 12%
Int. Expense P91,284.18

EXERCISE 7

WALMART Corporation is in the business of leasing new sophisticated computer

systems. As a lessor of computers, WALMART purchased a new system on December
31, 2014. The system was delivered the same day (by prior system arrangement) to
General Investment Company, a lessee. The corporation accountant revealed the
following information relating to the lease transactions:

Cost of system to WALMART P550,000

Estimated useful life and lease term 8 years
Expected residual value (unguaranteed) P40,000
WALMART implicit rate of interest 12%
General’s incremental borrowing rate 14%
Date of first lease payment Dec. 31, 2014
Additional information is as follows:

(a) At the end of the lease, the system will revert to WALMART.
(b) General is aware of Walmart rate of implicit interest.
(c) The lease rental consists of equal annual payments.

Questions:

Based on the above and the results of your audit, answer the following:

1. The annual lease payment under the lease is

a. P110,717 b. P95,950 c. P102,665 d. 91,664
Answer: b

2. The total financial revenue to be earned by the lessor over the lease term is
a. P257,600 b. P183,312 c. P271,320 d. P335,736
Answer: a
Solution:
APL P95,950
X 8 years *Cost of system P550,000
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Total P767,600 less: RS (40,000)

Less:TCoS (510,000)* TCS P510,000
Revenue P257,600
3. The interest income to be recognized by the lessor in 2015 is
a. P53,680 b. P52,714 c. P54,486 d. P52,547
Answer: c
Solution:
Interest income = P454,050 x 12%
= P54,486
4. The total expenses related to the lease that will be recognized by the lessee in
2015 is
a. P121,464 b. P130,792 c. P112,630 d. P119,278
Answer: d

Solution:
Depreciation P66,731
Add: interest 52,547
Total P119,278

5. The amount to be reported under current liabilities as liability under finance lease
as of December 31, 2015 is
a. P60,239 b. P48,611 c. P35,715 d. P64,963
Answer: b
Solution:
Cost P437,894
X 1.12
Total P490,441
Less: ALP (95,950)
P394,491
Less: (345,880)
Total P48,611

EXERCISE 8

In connection with the audit of financial statements of BLAKE Company, you were able
to obtain the following information regarding a non-cancellable lease agreement that
BLAKE entered into on January 1, 2014.
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The lease term is for a three year period beginning January 1, 2014. Under the terms of
the operating lease, lease payments will be as follows:

Year 1 P1,000,000
2 1,200,000
3 1,300,000
In addition, BLAKE paid a refundable rental deposit of P1,200,000. However, as an
inducement to enter the lease, the lessor granted BLAKE Company the first six months of
the lease, rent free. Assume that BLAKE’s incremental borrowing rate is 10%.

1. What is the rent expense that should be recognized in 2014?

a. 1,000,000 b. 1,100,000 c. 1,166,667 d. 1,266,667
Answer: b

Solution:
Y1 (1000/2) P 500
Y2 1,200
Y3 1,300 *1000 x 10% = P100
Total P3,000
÷ 3 years
Total: P1,000
Add: 100*
Total rent exp. P1,100

2. What is the interest income that should be recognized in 2015?

a. 99,000 b. 90,000 c. 120,000 d. 0
Answer: a
Solution:
Interest Income = P990 x 10%
= P99,000

EXERCISE 9

You were engaged to audit the financial statements of FELIX Company for the year
ended December 31, 2014. During the course of the audit, you obtained the following
information about the company’s liabilities outstanding at December 31, 2014:

1. At December 31, 2014, FELIX has an obligation to its suppliers for the purchase
of raw materials amounting to P128,500.
2. At the end of 2014, the company was in breach of a loan covenant in respect of a
P600,000 long term loan from a bank that is otherwise repayable three years after.
A review of subsequent events disclosed that before the financial statements were
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approved for issue, the bank formally agreed not to demand early repayment of
the loan.
3. On January 1, 2014, FELIX issued 1,000 of its P1,000 bonds for P1,000,000 in a
private transaction. On 1 January each year interest at the fixed rate of 5 percent
per year is payable on outstanding capital amount of the bonds. On 31 December
each year, the entity has a contractual obligation to redeem 100 of the bonds at
P1,000 per bond.
4. At December 31, 2014, the carrying amount of the entity’s unfunded obligation
for long-service leave was P100,000, P40,000 of which employees are entitled to
take as leave in twelve months following the end of the reporting period. The
balance of P60,000 is in respect of leave that employees are entitled to take only
after the end of the next annual reporting period. The entity anticipates that only
75 per cent of its employees will take the leave due during the next annual
reporting period.

Required:

1. Compute the amount of the current liability as of December 31, 2014.

a. P313,500 b. P903,500 c. P908,500 d. P303,500

Answer: c
Solution:
Current Liabilities
Payment of RM P128,500
Bonds issued 1,000,000
Bonds redeem (150,000)
Recovered ( 70,000)
Total P908,500

2. Compute the amount of non-current liability as of December 31, 2014.

a. P1,470,000 b. P1,460,000 c. P870,000 d. P860,000
Answer: c

Solution:
Non- Current Liabilities
Long term loan P600,000
Long service leave 100,000
Leave 12 mos. 40,000
Balance to be paid 60,000
Long term payable 70,000
Total P870,000
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EXERCISE 10

Included in MORGAN Corporation’s liability account balances at December 31, 2014

were the following:

Note payable, bank P2,800,000

Liability Under Finance Lease 430,000
Deferred income taxes 360,000
Transactions during 2015 and other information relating to MORGAN’s liabilities were
as follows:

1. The principal amount of the note payable is P2,800,000 and bears interest at 15%.
The note is dated April 1, 2014 and is payable in four equal installments of
P700,000 beginning April 1, 2015. The first principal and interest payment was
made on April 1, 2015.
2. The capitalized lease is for ten-year period beginning December 31, 2012. Equal
annual payments of P100,000 are due December 31 of each year, and the 14%
interest rate implicit in the lease is known by MORGAN. The present value at
December 31, 2014, of the seven remaining lease payments (due December 31,
2015, through December 31, 2017) discounted at 14% was P430,000.
3. Deferred income taxes are provided in recognition of timing differences between
financial statement and income tax reporting of depreciation. For the year ended
December 31, 2015 depreciation per tax return exceeded book depreciation by
P90,000. MORGAN’s effective income rate for 2015 was 40%.
4. On July 1, 2015, MORGAN issued for P1,774,000, P2,000,000 face amount of its
10%, P1,000 bonds. The bonds were issued to yield 12%. The bonds are dated
July 1,2015 and mature on July 1, 2020. Interest is payable annually on July 1.
MORGAN uses the interest method to amortize bond discount.

Compute for the following as of December 31, 2015:

A B C D

1. Long-term liabilities 3,921,268 3,525,268 3,885,268 3,966,640

2. Current Portion of Long- 1,081,622 754,372 745,372 700,000
Term Liabilities
3. Accrued Interest payable 100,000 336,250 286,250 436,250
4. Interest Expense 401,450 547,690 543,890 507,890

Answers:

1. A 2. C 3. B 4.D
EXERCISE 12
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COMPANY ALY starts operations at the beginning of 2014. The company has elected
the revaluation model under IAS 16 for PPE as its accounting policy:

During 2014, COMPANY ALY invests in shares of publicly traded companies. Part of
them, purchased for 3 million, are classified/ designated as “at fair value through profit or
loss” (FVPL) and the other ones, with a purchased cost of 25 million, are classified as
available-for-sale (AFS).

The market value of the FVPL securities at the end of the year is 4.2 million. In respect of
AFS securities the company has recognized an impairment loss of 1.5 million.

As a result of revaluation of PPE acquired during the year, the company has recognized
both a positive revaluation of 10 million and a negative revaluation of 26 million on
different PPE assets.

Tax regulation in the country of the company’s incorporation is as follows:

 No capital gain and losses

 Tax rate is 30%
 Tax depreciation is based on historical cost.
 Gains and losses on financial assets are taxable/deductible when realized.

Required:

1. What is the deferred tax asset at the end of the year?

Answer: P600,000
Solution:
Purchased cost P 2,500,000
Less: nega. Revaluation (500,000)
Total cost P2,000,000
X 30%
Deferred Tax Asset P600,000

2. What is the deferred tax liability at the end of the year?

Answer: P1,860,000
Solution:
FVPL P4,200,000
Add: total cost 2,000,000
Total P6,200,000
X 30%
Deferred tax liab. P1,860,000
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3. What is the total tax expense, assuming taxable income is P10M?

Answer: P2,760,000
Solution:
Taxable income = P10,000,000 x 30% - 240,000

= P2,760,000

EXERCISE 13

JENNINGS Co. gives warranties at the time of sale to purchasers of its product. Under
the terms of the contract for sale, JENNINGS Co. undertakes to make good, by repair or
replacement, manufacturing defects that become apparent within one year from the date
of sale. On the basis of experience, it is probable (ie more likely than not) that there will
be some claims under warranties.

At 31 December 2013 JENNINGS Co., appropriately recognized P50,000 warranty

provision. JENNINGS Co., incurred and charged P140,000 against the warranty
provision in 2014. P80,000 of this related to warranties for sales made in 2014. The
increase during 2014 in the discounted amount recognized as a provision at 31 December
2014 arising from the passage of time is P2,000.

At 31 December 2013 JENNINGS Co., estimated that it would incur expenditures in

2015 to meet its warranty obligations at 31 December 2014, as follows:

 5 per cent of probability of P400,000

 20 per cent of probability of P200,000
 50 per cent of probability of P80,000
 25 per cent of probability of P20,000

Assume for simplicity that the 2015 cash flows for warranty repairs and replacements
take place, on average, on 30 June 2015.

An appropriate discount rate is 10 per cent per year. An appropriate rate adjustment
factor to reflect the uncertainties in the cash flow estimates is in increment of 6 per cent
to the probability-weighted expected cash flows. JENNINGS Co., is the defendant in a
breach of patent lawsuit. Its lawyers believe there is 70 per cent chance that JENNINGS
Co., will successfully defend the case. However, the court rules in favor of the claimant,
the lawyers believe that there is 60 per cent chance that the entity will be required to pay
damages of P2 million (the amount sought by the claimant) and 40 per cent chance that
the entity will be required to pay damages of P1 million (the amount that recently
awarded by the same judge in a similar case). Other amounts of damages are unlikely.

The court is expected to rule in late December 2015. There is no indication that the
claimant will settle out of court.
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A 7 per cent risk adjustment factor to the cash flows is considered appropriate to reflect
the uncertainties in the cash flow estimates.

An appropriate discount rate is 10 per cent per year.

1. What is the interest expense in 2014?

a. P0 b. P1,000 c. P2,000 d. P3,000
Answer: P2,000
2. The provision for warranty at December 31, 2014 is
a. P105,000 b. P111,300 c. P100,000 d. P106,000
Answer: P111,300
Solution:
P400,000 x 5% P20,000
200,000 x 20% 40,000
80,000 x 50% 40,000
20,000 x 25% 5,000
Total P105,000
X 1.06
Prov. For warranty P111,300
3. The warranty expense in 2014 is
a. P196,000 b. P186,000 c. P114,000 d. P194,000
Answer: d
Solution:
Warranty expense = P106,000 + 140,000 – 50,000
= P194,000
4. How much provision should be recognized from lawsuit?
a. P1,500,000 b. P1,600,000 c. P2,000,000 d. P0
Answer: 0

EXERCISE 14

You are the continuing auditor of CRESCENT Company. The comparative balance sheet
of CRESCENT Company for 2013 and 2014 follows:
December 31

Assets 2014 2013

Cash 200,000 115,000
Installment accounts receivable 420,000 310,000
Inventory 180,000 125,000
Equipment-net of accumulated depreciation 360,000 480,000
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Liabilities and Stockholders’ Equity

Accounts payable 150,000 200,000
Unearned Rent 70,000 40,000
Estimated Warranties Obligation 120,000 60,000
Other liabilities (including Deferred tax liability)150,000 145,000
Stockholders’ Equity 670,000 585,000
You have satisfied yourself as to the accuracy of the balances shown above. In addition,
the following information was obtained:

 The company’s installment sales are taxable when cash are collected.
 CRESCENT Company uses the straight-line method of depreciation for financial
reporting purposes and sum of the years digit method for tax purposes. The
equipment was acquired in January 2013 and was estimated to have 5 year life.
 Rental income is taxable when cash is received.
 Warranty expense is deductible only when actual expenditure is made.
 CRESCENT Company reported a taxable income of P1,000,000 for 2014.

Required:

1. The amount of net deferred tax liability at January 1, 2014 is

a. P101,500 b. P135,000 c. P87,000 d. P30,000
2. The amount of net deferred tax liability as at December 31,2014 is
a. P57,000 b. P48,000 c. P105,000 d. P162,000
Answer: c
Solution:
Deferred Tax Liability P162,000
Less: Deferred Tax Asset 57,000
Total P105,000

3. Income tax expense-current for 2014 is

a. P270,000 b. P360,000 c. P330,000 d. P300,000
4. Total income tax expense for 2014 is
a. P318,000 b. P300,000 c. P371,000 d. P282,000

Answer:
1. C 2. C 3. D 4. A