GERARDO S.

ROQUE

SUBSTANTIVE AUDIT OF INVESTMENTS IN DEBT/EQUITY FINANCIAL INSTRUMENTS

Investment in Equity Securities

Problem 1.
On June 30, 2018, CABBAGE COMPANY purchased 25% of the outstanding ordinary shares of IB Co. at a
total cost of P2, 100,000.The book value of IB Co.’s net assets on acquisition date was P7, 200,000. For
the following reasons, Cabbage was willing to pay more that book value for the IB Co. shares:

 IB Co. has depreciable assets with a current fair value of P180, 000 more that their book value. These
assets have a remaining useful life of 10 years.
 IB Co. owns a tract of land with a current fair value of P900, 000 more than its carrying amount.
 All other identifiable tangible assets of IB Co. have a current fair values that are equal to their carrying
amounts.
IB Co. reported net income of P1, 620,000, earned evenly during the current year ended December 31,
2018. Also in the current year, it declared and paid cash dividends of P315, 000 to its ordinary
shareholders. Market value of IB Co.’s ordinary shares at December 31, 2018, is P9 million. Cabbage
Company’s financial year end is December 31.

QUESTIONS:
1. What is the total amount of goodwill of IB Co. based on the price paid by Cabbage Company?
a. P300,000 c. P120,000
b. P1,080,000 d. P30,000
2. What amount of investment income should cabbage report in its income statement for the year ended
December 31, 2018, under the fair value method?
a. P78,750 c. P228,750
b. P202,500 d. P71,250
3. What amount of investment income should cabbage report in its income statement for the year ended
December 31, 2018, under the equity method?
a. P202,500 c. P78,750
b. P200,250 d. P123,750
4. Under the equity method, the carrying value of Cabbage Company’s investment in ordinary shares of IB
Co. on December 31, 2018, should be?
a. P2,221,500 c. P2,070,000
b. P2,100,000 d. P2,250,000
5. What amount should Cabbage Company report in its December 31, 2018, statement of financial position
as its investment in IB Co. under the fair value method?
a. P2,250,000 c. P2,221,500
b. P2,070,000 d. P2,100,000
SOLUTION:
1. C- 120,000
Underlying value of IB Co.’s owners’ equity
(2,100,000/25%) 8,400,000
Carrying value of IB Co.’s owners’ equity 7,200,000
Excess underlying value over book value 1,200,000
Attributable to depreciable assets 180,000
Attributable to land 900,000 1,080,000
Goodwill P120, 000
2. A- 78,750
Dividend received (315,000*25%) P78, 750
3. B- 200,250
Share of net income (1,620,000*25%*6/12) 202,500
Depreciation adjustments
(180,000*25%=45,000/10*6/12) (2,250)
Investment income, as adjusted P200, 250

4. A- 2,221,500
Acquisition cost 2,100,000
Share of net income, as adjusted (see no.3) 200,250
Cash dividend received (315,000*25%) (78,750)
Carrying value, Dec. 31, 2018 P2, 221,500
5. A- 2,250,000
The stock investments should be carried at its fair value of 2,250,000 (9million*25%) on
December 31, 2018.

The year adjustment is:

Investment in equity securities 150,000
Unrealized gain on equity securities 150,000

Cost 2,100,000
Fair value (9million*25%) 2,250,000
Fair value adjustment 150,000
 SUBSTANTIVE AUDIT OF PROPERTY, PLANT AND EQUIPMENT

Acquisition of Equipment on a deferred payment basis

PROBLEM 2.
SAXOPHONE COMPANY acquires a new manufacturing equipment on January 1, 2018, on installment
basis. The deferred payment contract provides for a down payment of 300,000 and an 8-year note for
3,104,160. The note is to be paid in 8 equal annual installment payments of 388,020, including 10%
interest. The payments are to be made on December 31 of each year, beginning December 31, 2018.
The equipment has a cash price equivalent of 2,370,000. Saxophone’s financial year end is December 31.

QUESTIONS:
1. What is the acquisition cost of the equipment?
a. P3,404,160 c. P2,370,000
b. P2,804,160 d. P3,104,000
2. The amount to be recognized on January 1, 2018, as discount on note payable is
a. P1,034,160 c. P827,160
b. P310,416 d. P0
3. The amount of interest expense to be recognized in 2018 is
a. P0 c. P310,416
b. P188,898 d. P207,000
4. The amount of interest expense to be recognized in 2019 is
a. P310,416 c. P207,000
b. P188,898 d. P0
5. The carrying value of the note payable at December 31, 2019 is
a. P1,689,858 c. P1,312,062
b. P1,888,980 d. P1,700,000
SOLUTION:
1. C- 2,370,000
Acquisition cost of equipment (cash price equivalent) P2, 370,000

PAS 16(Property, plant and Equipment) states that the cost of an item of PPE is its cash price
equivalent. If payment is deferred beyond normal credit terms, the difference between the cash
price equivalent and the total payment is recognized as interest expense over the credit term
unless such interest is capitalized in accordance with PAS 23.

2. A- 1,034,160
Cost of equipment 2,370,000
Less: down payment 300,000
Amount assigned to note payable 2,070,000
Face value of note 3,104,160
Discount on note payable, Jan. 1, 2018 P1, 034,160

3. D- 207,000
Interest expense for 2018:
Carrying value of note payable, Jan.1, 2018
(3,104,160- 1,034,160) 2,070,000
Multiply: Interest rate 10%
Discount amortization for 2018 P207, 000

4. B-188,898
Note payable, Jan. 1, 2018 3,104,160
Less: payment made on Dec. 31, 2018 388,020
Note payable, Dec. 31, 2018 2,716,140
Discount on note payable, Dec. 31, 2018
(1,034,160-207,000) (827,160)
Carrying value of note, Dec. 31, 2018 1,888,980
Multiply: Interest rate 10%
Discount amortization (interest expense) for 2019 P188, 898

5. A-1,689,858
Carrying value of note, Dec. 31, 2018 1,888,980
Discount amortization for 2019 188,898
Payment made on Dec. 31, 2019 (388,020)
Carrying value of note, Dec. 31, 2019 P1, 689,858
 SUBSTANTIVE AUDIT OF INTANGIBLE ASSETS

Acquisition and amortization of intangible assets

Problem 3.

KIKIKTAT CORPORATION was organized in 2017. Its accounting records include only one account for all
intangible assets. The following is a summary of the debit entries that have been recorded and posted
during 2017 and 2018.

INTANGIBLE ASSETS
July 1, 2017 8-year franchise; expires June 30, 2024 126,000
October 1, 2017 advanced payment on leasehold (term of
Lease is 2 years) 84,000
December 31, 2017 Net loss for 2017 including incorporation
Fee, 3,000 and related legal fees of
Organizing 15,000(all fees incurred
In 2017) 48,000
January 2, 2018 Acquired patent (10-year life) 222,000
March 1, 2018 Cost of developing a secret formula 225,000
April 1, 2018 Goodwill purchased 835,200
July 1, 2018 Legal fee for successful defense of
Patent purchased above 37,950
October 1, 2018 Research and development cost 480,000

Ignore income tax effects

QUESTIONS:
1. The unamortized patent cost at December 31, 2018, should be
a. P199,800 c. P222,000
b. P235,440 d. P197,490
2. The unamortized franchise cost at December 31, 2018 should be
a. P110,250 c. P102,375
b. P94,500 d. P118,125
3. The amount of prepaid rent to be reported in kikiktat’s December 31, 2018, statement of financial
position is
a. P73,500 c. P84,000
b. P31,500 d. P63,000
4. The adjusting entries on December 31, 2018 should include a net debit to the retained earnings account
of
a. P889,275 c. P60,375
b. P42,000 d. P66,375
 5. As a result of the adjustments at December 31, 2018 the total charges against kikiktat’s 2018 income
should be
a. P840,900 c. P597,900
b. P822,900 d. P841,275

SOLUTIONS:
1. A- 199,800
Cost of patent, Jan. 2, 2018 222,000
Less: Amortization for 2018(222,000/10 years) 22,200
Unamortized patent cot, Dec. 31, 2018 P199, 800

2. C- 102,375
Cost of franchise, July 1, 2017 126,000
Less: amortization, July 1, 2017- Dec. 31, 2018 23,625
Unamortized franchise cost, Dec. 31, 2018 P102, 375

Amortization:
(126,000/8) 15,750
(15,750*1*1/12) 7,875
23,625
3. B- 31,500
Prepaid rent, December 31, 2018(84,000*9/24) P31, 500

4. D- 66, 375
ADJUSTING ENTRIES
December 31, 2018
a. Franchises 126,000
Prepaid rent 84,000
Retained Earnings 48,000
Patents 222,000
Research and Development expense
(225,000+480,000) 705,000
Goodwill 835,200
Legal fees expense 37,950
Intangible assets 2,058,150
b. Franchise amortization expense
(126,000/8) 15,750
Retained earnings (126,000/8*6/12) 7,875
Franchises 23,625
 c. Rent expense(84,000/2) 42,000
Retained earnings (84,000*3/24) 10,500
Prepaid rent 52,500
d. Patent amortization expense 22,200
Patent (222,000/10) 22,200

Net debit to Retained Earnings

(48,000+7,875+10,500) P66, 375

5. B-822,900
Research and development expense 705,000
Legal fees expense 37,950
Franchise amortization expense 15,750
Rent expense 42,000

9
Patent amortization expense 22,200
Total P822, 900