AUDIT OF PREPAID EXPENSES,

DEFERRED CHARGES
AND OTHER CURRENT
LIABILITIES
 INTRODUCTION
Among the most common prepaid expenses that
auditors encounter are insurance, advertising services,
office supplies, rent, interest, taxes and royalties and
they are usually classified as current assets. Deferred
charges such as bond issue costs, plant rearrangement
costs or relocation charges are prepayments that are
chargeable to the operations of several years and are
separately classified as
noncurrent assets.
 Audit Objectives
3.
1. To ascertain the propriety
To determine that the prepaid of the amount charges as
expenses or deferred charges prepaid expenses or as
carried forward at the beginning deferred charges.
of the period are actually
chargeable to the operations of 4.
future periods and that definite To determine the
benefits will be received in the reasonableness and
future periods from these consistency in amortizing
expenses carried forward as prepaid expenses and
assets. deferred charges to
expenses.
2.
To ascertain the 5.
correctness of the prepaid To determine proper
or deferred amount at the presentation and classification
end of the period as well of prepaid expenses and
as the amount consumed deferred charges on the
or had expired, if any, statement of financial position.
during the period under .
review.
 SUBSTANTIVE
AUDIT PROCEDURES
The auditor’s primary objective in examining prepaid
expenses and deferred charges is to determine that
those items represent proper charges to future
operations, and that the amounts, their allocation to costs and
expenses, are reported in accordance with generally accepted
accounting principles applied on a consistent basis. To
determine propriety, validity and accuracy of these
prepayments and deferred charges the following general audit
procedures may be followed:
 A. Audit of
Prepaid Expense
1. Prepaid insurance

a) Inspect insurance policies on a

test basis.

b) Review coverage premiums.

c) Vouch premium paid and

amounts charged to expenses
during the year and amounts
prepaid at year-end.
Figure 17-1 illustrates the working papers for
Prepaid Insurance.
2. Prepaid advertising interest payments.
a) Examine advertising contracts with
b) Verify mathematical accuracy of the
advertising agencies and note effective
computation of interest expense and
dates covered by the agreement.
prepaid interest.
Determine propriety of charges in the
current year. 5. Office supplies
b) Test-count undated advertising and a) Vouch purchases of office supplies on
sales promotion materials. a test basis.

3. Prepaid rent b) Conduct physical count of supplies

a) Examine signed rental agreement inventory on a test basis.
noting the effective dates covered by
the agreement.
6. Other prepayments
a) Review existence of
b) Vouch total amount paid and compare adequate records and
with provision in the rental agreement. documentation.

c) Verify distribution of the prepaid a) Evaluate allocation of

amount to prepaid rent and rental prepaid expenses between
expense by recalculating the amounts. asset and expense
accounts.
4. Prepaid interest
a) Examine loan agreement and vouch
Figure 17.1 : Schedule of Prepaid Insurance
B. Audit of
3. Other deferred charges
Deferred Charges a) Evaluate allocation of deferred
charges between asset and
1. Plant rearrangement costs expense accounts.
a) Vouch charges to plant rearrangement
costs.
b) Review propriety of amortization policy.
c) Verify computation of amortization of
plant rearrangements costs for the
current year.

2. Deferred bond issue costs

a) Vouch expenditures related to the
issuance of bonds.
b) Verify mathematical correctness of
amortization of bond issue costs
chargeable to the current year.
C. Audit of Other
Current Liabilities
Among the items classified as current liabilities include:
a. Withholding taxes payable
b. Value added tax (VAT) payable
c. Unclaimed salaries and wages
d. Customers’ deposits
e. Liabilities under trust receipts
f. Accrued expenses payable
g. Pension plan accruals
h. Income tax payable
i. Provision for product and service warranties
j. Current portion of installment note payable
Discussion of Audit Procedures
The management assertion, audit objectives and audit procedures enumerated in
Figure 17-2 would also generally apply to the above-mentioned current liabilities. In
addition, specific audit procedures should be applied to these items as follows:

A. Withholding Taxes Payable

Income taxes withheld from employees’ pay and not remitted to the BIR as of the
statement of financial position date constitute a liability to be verified by the auditor.

The auditors should perform the following:

1. Review the adequacy of the withholding procedures and
2. determine accuracy of computation.
3. Determine the last remittance of withholding taxes made before the statement
of financial position date. Review quarterly tax returns to the BIR before the
statement of financial position date.
4. Follow-up remittance subsequent to the statement of financial position date .
 Discussion of Audit Procedures
B. Value Added Tax (VAT) represent all unclaimed wages after each
VAT on receipts constitutes payroll distribution, and the debits represent
current liabilities of the business until they only authorized payments to employees or
are remitted to the BIR. The auditor’s transfer back to general cash funds through
responsibility includes verification of the approved procedures. Verify disposition of the
client’s periodic tax returns and remittance. account subsequent to the statement of
The auditor should also test the financial position date.
reasonableness of the liability by a
computation applying the tax rate to total D&E. Customers’ Deposits; Liabilities
taxable receipts. Debits to the liability account under Trust Receipts
for remittances to the BIR should be traced to The auditor should obtain a list of
copies of the tax return and should be the individual deposits and liabilities under
vouched to the paid checks. Verify remittance
trust receipts and reconcile to the general
of tax subsequent to the statement of financial
ledger balance. If amounts are substantial, or
position date to the BIR. internal control procedures are considered
deficient, they should be confirmed by direct
C. Unclaimed Salaries and Wages communication with customers and
The auditor should analyze this appropriate financial institutions.
account to determine that the credits
 F. Accrued Expenses
Payable
01 02
The approaches to auditing
accrued liabilities are as varied as the types of
accrued liability accounts. Many can be tested
by reference to the subsequent payment of the Examine any contracts Evaluate the
liability (accrued rent, utilities, property taxes) or other documents on accuracy of the
while others must be estimated or calculated hand that provide the detailed accounting
on the basis of transactions in other accounts basis for the accrual records
(accrued interest on the basis of interest- (e.g., pension plan maintained for this
bearing debt outstanding and accrued royalties agreement, warranty category of liability.
on the basis of sales). The basic auditing steps agreement).
for accrued liabilities:

03 04 05
Test mathematical Determine consistency Follow up actual
accuracy of the in the treatment of payment or settlement
amounts of accrual set accrued liabilities at subsequent to the
up by the client. the beginning and end statement of financial
of the period. position date.
Figure 17-2 shows a schedule of Accrued Liabilities.

G. Pension Plan
Accruals
Auditing procedures for the
accrued liability for pension costs may
begin with a review of the copy of the
pension in the auditor’s permanent file.
The auditors should determine that the
client’s accrued pension liability is
presented in accordance with PFRS 715,
including consideration of service cost,
interest cost, amortization of transaction
and service costs, and gains and losses on
pension plan assets. In auditing these
amounts, the auditors will obtain
representations from an actuary and
confirm the activity in the plan with the
trustee.
H. Income Tax
Payable
The auditor should analyze the Income
Tax Payable account and vouch all amounts to
income tax returns, paid checks, or other
supporting documents. He should also verify the
reasonableness of the tax liability by reviewing
the tax returns prepared by the client. The final
balance in the Income Taxes Payable account will
equal the taxes on the current year’s income tax
returns, less any payments thereon. Deferred
Income Taxes resulting from tax allocation
should be classified as current liabilities if they
relate to current assets. Otherwise, deferred
income taxes are classified as long-term. Follow-
up remittance to the BIR subsequent to the
statement of financial position date.
 Discussion of Audit Procedures
I. Provision for Product and
Service Warranties
Review warranty agreements with
buyers of goods and services and
determine whether expected warranty
expense or liability is recognized in the
record of the entity. The provision for
estimated liability is usually based on
historical experience of the level of
volumes, product mix and repair, and
replacement cost.
J. Current Portion of
Installment Note Payable
Inspect the copy of the
installment note payable taking
special attention to the terms of
payment. Determine the portion of
the long-term debt that is due within
12 months after the reporting period
and ensure that the client reclassifies
such portion as current liability.
Figure 17-2 : Accrued Liabilities
Illustrative Audit Case ATLAS RETAIL COMPANY
Analysis of Prepaid Expenses Account
17-1: Audit of Various December 31, 20x7

Prepayments
Balance
Description Dec. 31, 20x7
Unearned fire insurance P 750
You are examining the financial
statements of the Atlas Retail Company for Unexpired liability insurance 4,900
the year ended December 31, 20x7. The Utility deposits 2,000
client’s accounting department presented
Loan of officer 500
you with an analysis of the Prepaid
Expenses account at December 31, 20x7, as Purchase of postage meter, one half of invoice price 400
shown below: Bond discount 3,000
Advertising of store opening 9,600
Amount due for overpayment on purchase of fixtures 700
Unsalable inventory – entered June 30, 20x5 8,300
Book value of obsolete machinery held for resale 550
Funds delivered to New Stores with purchase offer 1,000
Total 31,700
Additional information includes the following:

1. Insurance policy data:

Type Period Covered Premium
Fire 12/31//X7 to12/31/X8 P 1,000
Liability 6/30/X7 to 6/30/X8 9,500

2. The postage meter was delivered in November and the balance due is paid January. Unused
postage of P 700 in the machine at Dec. 31, 20x7, was recorded as expense at time of purchase.
3. Bond discount represents the unamortized portion applicable to bonds maturing 20x8.
4. The P 9,600 paid and recorded for advertising was for the cost of an advertisement to be run in a
monthly magazine for six-months, beginning in December , 20x7. You examined an invoice
received from the advertising agency and extracted the following description: “Advertising
services rendered for store opened in November 20x7, P 6,900.”
5. Atlas has contracted to purchase New Stores and has been required to accompany its offer with a
check for P 1,000 to be held in escrow as an indication of good faith. An examination of paid
checks revealed the check has not been returned form the bank through January 20x8.

Required:
Assuming that you have examined acceptable underlying audit evidence, prepare a worksheet to
show the necessary adjustments, corrections, and reclassification of the items in the Prepaid
Expense account.
Solution: Illustrative Audit Case 17-1
Illustrative Audit 19-2 of Current Liabilities
From the following information, prepare the
current liabilities section of the statement of
financial position for the Drummand Company
as of December 31, 20x7.
1. Notes payable arising from the purchase of
raw material, P 114,000.
2. Notes payable-bank, due in 90 days,
P60,000. (Collateral on this consists of
P80,000 in remarkable securities.
3. Notes payable to officers, due on demand
P40,000.
4. Accounts payable arising from the purchase
of raw materials, P88,000.
5. Cash balance with First Bank, P26,000; cash
overdraft with College Station Bank, P35,000
6. Dividends in arrears on cumulative
preferences shares. P48,000
7. Income tax withheld, P2,600.
8. Advance receipts on special jobs being
manufactured to specification for customer,
P 6,000.
9. Installment notes on equipment purchased,
P40,000 of which P20,000 is due in 20x8
and the balance in 20x7.
10. Accounts receivable credit balance, P3.600.
11. Estimated costs of meeting service
requirement guarantees on products
produced an sord, P 14,400.
12. One of the company’s claim is P4,800. The
company has no insurance to cover a loss
of this time.
13. Drummand borrowed P20,000 on the cash
surrender value of its officer’s life
insurance. Cash surrender value amounts
to P80,000. Interest on this loan has been
paid to the statement of financial position
date.
 Solution: Illustrative Audit Case 17-2
DRUMMAND COMPANY
Partial Statement of Financial Position
December 31, 20x7
Current Liabilities
Accounts payable P 88,000
Bank overdraft (or Loan payable – bank) 35,000
Notes payable
- Trade P 114,000
- Bank (secured by marketable securities valued at P 80,000) 60,000
- Officers 40,000 214,000
Customers’ accounts with credit balances 3,600 Note: The policy loan of
Advances from customers 6,000 P20,000 will shown as a
Withholding taxes payable 2,600 deduction from Cash
Estimated liability on product warranties 14,400
Surrender Value Life
Insurance account in the
Estimated liability arising from product malfunction 4,800
“Long-Term Investments”
Current portion of installment notes payable 20,000
section.
Total current liabilities P 388,400
Illustrative Audit Case 17-3:
Audit of Estimated Liability under Warranties

Friday Factory provides a 2-year warranty with one of its products which was first sold 20X7. In
that year, Friday spent P 70,000 servicing warranty claims. At year-end, Friday estimates that an
additional P 500,000 will be spent in the future to service warranty claims related to 20X7 sales.
Prepare Friday’s journal entry to record the P 70,000 expenditure, and the December 31 adjusting
entry.

Solution: Illustrative Audit Case 17-3

20X7 Warranty Expense 70,000

Cash, Inventory, etc. 70,000

12/31/X7 Warranty Expense 500,000

Estimated Liability Under Warranties 500,000
Illustrative Audit Case 17-4:
Audit of Estimated Liability for Premiums
Summer Company offers a set of building blocks to customers who send in 3 UPC codes from
Summer cereal, along with P 50,000. The blocks sets cost Summer P 110 each to purchase and
P60.00 each to mail to customers. During 20X7, Summer sold 1,000,000 boxes of cereal. The
company expects 30% of the UPC codes to be sent in. During 20X7, 120,000 UPC codes are
redeemed Prepare Summer’s December 31, 20X7, adjusting entry.

Solution: Illustrative Audit Case 17-4

Premium Expense 7,200,000

Estimated Liability for Premiums 7,200,000

UPC codes expected to be send in

(30% x 1,000,000) 300,000
UPC codes already redeemed 120,000
Estimated future redemptions 180,000
Cost of estimated claims outstanding
(180,000 + 3) x (110.00 + P60.00-P50.00) 7,200,000
Illustrative Audit Case 17-5:
Audit of Warranties and Premiums
Melody Music Emporium carries a wide variety of musical instruments, sound reproduction
equipment, recorded music, and sheet music. Melody uses two sales promotion techniques –
warranties and premiums – to attract customers.

Musical Instruments and sound equipment are sold with one-year warranty for replacement of
parts and labor. The estimated warranty cost, based on past experience, is 2% of sales.

The premium is offered on the recorded and sheet music. Customers receive a coupon for each
peso spent on recorded music of sheet music. Customers may exchange 200 coupons and P20 for
CD player. Melody pays P34 for each CD player and estimates that 60% of the coupons given to the
customers will be redeemed.

Melody’s total sales for 20X7 were P7,200,000 – P 5,400,000 from musical instruments an sound
reproduction equipment and P1,800,000 from recorded music and sheet music. Replacement
parts and labor for warranty work totaled P164,000 during 2017. A total of 6,500 CD players used
in the premium program were purchase during the year and there were 1,200,000 coupons
redeemed in 20X7.

The accrual method is used by Melody to account for the warranty and premium costs for
financial reporting purposes. The balances in the accounts related to warranties and premiums on
January 1, 20X7, were as shown below:
Illustrative Audit Case 17-5:
Audit of Warranties and Premiums
Inventory of Premium CD Players P39,950
Estimated Premium Claims Outstanding 44,500
Estimated Liability from Warranties 136,000

Required:
Melody Music Emporium is preparing its financial statements for the year ended December 31,
20X7. Determine the amounts that will be shown on the 20X7 financial statements for the
following:
1. Warranty Expense.
2. Estimated Liability from Warranties.
3. Premium Expense.
4. Inventory of Premium CD Players.
5. Estimated Premium Claims Outstanding.
Solution: Illustrative Audit Case 17-5
1. Sales of musical instruments and sound equipment P5,400,000
Estimated warranty cost .02
Warranty Expense for 20X7 P 108,000
2. Estimated liability for warranties – 1/1/X7 P 136,000
20X7 warranty expense (Requirement 1) 108,000
Subtotal 244,000
Actual warranty costs during 20X7 164,000
Estimated liability from warranties – 12/31/X7 80,000

3. Coupons issued (1 coupon/P1 sale) 1,800,000

Estimated redemption rate .60
Estimated number of coupons to be redeemed 1,080,000
Estimated rate (200 coupons for a cassette player) ÷ 200
Estimated number of premium cassette players to be issued 5,400
Net cost cassette players (P34-P20) 14
Premium Expense for 20X7 P 75,600

4. Inventory of premium cassette players – 1/1/X7 P 39,950

Premium cassette players purchased during 20X7
(6,500 x P34) 221,000
Premium cassette players available 260,950
Premium cassette players exchanged for coupons
during the 20X5 (1,200,000 x P34) P 204,000
Inventory of premium cassette players – 12/31/X7 P 56,950
5. Estimated liability for premiums – 1/1/X7 P 44,800
20X7 premium expense (Requirement 3) 75,600
Subtotal P 120,400
Actual redemptions during 20X7
[1,200,000 / 200 x (P34 – P20) P 84,000
Estimated liability for premiums – 12/31/X7 P 36,400
Thank
You!
Cuadra
Cusipag