Auditing Practice I I Third Term, AY 2013-2014

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UNIT7
AUDITOFPROVISIONS
EstimatedTime:3.0HOURS

DiscussionQuestions7-1:NatureofProvisions

1. Brieflydefinethefollowingterms:
a. Provision
b. Restructuring
c. Contingentliabilities
d. Contingentassets

2. Whataretheinitialrecognitioncriteriaforprovisions?Presentaflowchart/tableto
summarizetherequirementsofPAS37relatingtoprovisionsandcontingent
liabilities.

3. Whydoweneedareconciliationofnetincomeperbooksandtaxableincomeper
incometaxreturn?Whatkindofdifferencesarebeingreconciledinthisregard?

Problem7-1:InitialRecognitionofVariousProvisions
Considerthecasesindependently:

Case1
Anentityfaces100legalclaims,eachwitha40%likelihoodofsuccesswithnocost,
anda60%likelihoodoffailurewithacostofeachclaimof1M.

Case2
An entity faces a single legal claim, with a 40% likelihood of success with no cost,
anda60%likelihoodoffailurewithacostof1m.

Case3
An entity is required to replace a major component in an asset under a warranty.
Each replacement costs 1m. From experience, there is a 30% chance of a single
failure,50%chanceoftwofailures,anda20%chanceofthreefailures.

Case4
An entity is required to replace a major component in an asset under a warranty.
Each replacement costs 1m. From experience, there is a 40% chance of a single
failure,30%chanceoftwofailures,anda30%chanceofthreefailures.

Required:Computetherequiredprovision

Problem7-2:RestructuringProvisions

Tuna Tops Company announced a formal plan to restructure its operation as of

December 31, 2013. One of its manufacturing plant, (called plant one) was shut
downandheldforsale.Thisplaninvolvedthefollowing:

PlantOnewasshutdownonNovember30,2013andheldforsalebutthere
wasnobindingsalesagreementwithathirdparty;
100 employees had been retrenched, had left, and their accumulated
entitlementshadbeenpaid,however,anamountofP1,520,000representing
aportionofthethree(3)monthswagesfortheretrenchedemployeeshadnot
beenpaid;
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20 employees will be transferred to another plant (called plant two) of the
Company on January 15, 2014, and relocation costs of P460,000 are
expectedtobepaid;
Four of the five head-office staff had been retrenched, had left and their
accumulatedentitlements,includingthethreemonthswageshadbeenpaid.
However,oneemployee,Mr.X,remainedontocompleteadministrativetasks
relating to the closure of Plant One and the transfer of employees to Plant
Two. Mr. X was expected to stay until January 31, 2014. His salary for
JanuarywouldbeP80,000andhisretrenchmentpackagewouldbeP260,000
all of which would be paid on the day he left. He estimated that he would
spend60%ifhistimeadministeringtheclosureof PlantOneand30%ofhis
time administering the transfer of staff to Plant Two, and the remaining 10%
ongeneraladministration;
The costs to dismantle plant one is estimated to be P1,000,000. In the
jurisdictioninwhichTunaTopsoperatesplantone,thereisnolegalobligation
for dismantling plants whenabandoned. Tuna Tops is not particularly known
fordismantlingitsplantswhenabandonedbutdecidedtomakeanexception
this time. The costs to reassemble plant two have not yet been finalized at
themoment;and
RetrainingofstaffforPlantTwoisestimatedtobeP1,500,000,

You have already assessed that the recognition criteria for a restructuring provision
havebeenmetinaccordancewithPAS37par.72.

Required:

a. Howmuchistherestructuringprovision?
b. Howmuchistobeexcludedfromrestructuringprovision?

Problem7-3:VariousLiabilities

BeautifulPeopleInc.,acompanyengagedinvariousindustries,hasafiscalyear
fromApril1toMarch31.Thefollowinginformationrelatestotheliabilitiesofthe
CompanyasofMarch31,2013:

a. Thecompanyissued7%,4,000,000bondsonJuly1,2007at98.Thebonds
matureonJuly1,2017.Interestispayableannually.Straightlineamortization
isused.

b. TheCompanyhassignedvariousnotespayabletofinancialinstitutions.
AccruedinterestonthesepayablesamountedtoP90,000asofMarch31,
2013.Detailsofthenotesareasfollows:

DueDate AmountDue
April1,2013 P100,000
July1,2013 200,000
October1,2013 400,000
January31,2013 200,000
March31,2015 700,000

c. The company has a policy that for every P50 spent on the companys retail
products,acustomerisentitledtoacoupon.Customersmayexchange220
coupons and P500 for a DVD player, which originally costs P750. The
Company etimates that 55% of the coupons given to customers will be
redeemed. 6,500 DVD players were purchased during the year. The
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Companygivesaone-yearwarrantyforreplacementofpartsandlaboronits
equipment-relatedproducts.Basedonexperience,estimatedwarrantycostis
3% of sales. Replacement parts and labor for warranty work totaled
P1,870,000during2013.BPIusestheaccrualmethodtoaccountforwarranty
and premium costs. BPIs total sales amounted to P83 million which is from
instruments/equipmentsandretailproductsamountingtoP62millionandP21
million, respectively. The following are the balances at the beginning of the
year2013:

InventoryofpremiumCDplayers 410,300.00
Estimatedpremiumclaimsoutstanding 1,530,000.00
Estimatedliabilityfromwarranties 1,470,000.00

TotaldebittopremiumliabilitiesamountedtoP1,250,000.

d. StockdividendspayablecurrentlyamountingtoP1,275,000.

e. OtherAccrualsamountingtoP50,000asofMarch31,2013.

Required:

1. Howmanycouponswereredeemed?
2. Howmuchisthewarrantyexpense?
3. Howmuchistheestimatedliabilityfromwarranties?
4. Howmuchisthepremiumexpense?
5. HowmuchistheinventoryofpremiumCDplayers?
6. Howmuchistheestimatedpremiumclaimsoutstanding?
7. Totalcurrentliabilities
8. Totalnoncurrentliabilities
Problem7-4:LiabilityforReturnableContainers

Tea Sir, Inc. (TSI) charges a deposit from its customers for an item sold in an
expensive and recyclable container. The customer receives a refund for each
container returned within two years after the year of delivery. TSI considers
containers not returned with the time limit as sold at the deposit amount. Provided
belowaretheinformationfor2013:

Containersheldbycustomersat12/31/2012
fromdeliveriesin: 2011 96,000.00
2012 264,500.00 360,500.00
Containersdeliveredin2013 623,000.00
Containersreturnedin2013
fromdeliveriesin: 2011 68,400.00
2012 162,000.00
2013 521,000.00 751,400.00

Required:

1. Howmuchrevenuefromcontainersalesshouldberecordedin2013?
2. WhatistheliabilityforreturnablecontainersasofDecember31,2013?

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Problem7-5:Contingencies;EventsaftertheReportingPeriod
DuringtheperformanceoftheconcludingproceduresforPakyawsfinancial
statementauditfortheperiodendedDecember31,2013,yougatheredcorroborating
evidenceswithregardstothecompanysassertionsonpendinglitigationcasesand
unassertedclaims.Throughtheprocess,youascertainedthefollowinginformation:

a) OnJanuary7,2014,inventorypurchasedFOBshippingpointfromaforeign
countrywasdetainedattheborderduetoanupcomingcivilwar.The
shipmentisvaluedatP10M.
b) OnDecember31,2013,thecompanyisadefendantinapendinglawsuit
whicharosefromanallegedproductdefectthattheCompanysoldin2012.
Thelawyers,inresponsetoaletterofauditinquiry,statedthatitisprobable
thatthecompanywouldpaybetweenP100,000toP500,000,withP300,000
asthebestestimate.Moreover,itisreasonablypossiblethatthecompanywill
havetopaytheP500,000asaresultofthelawsuit.
c) OnJanuary17,2014,anexplosionoccurredinthecompanysplantcausing
damagestoadjacentareas.Noclaimshadyetbeenassertedbutlawyers
estimatethatP5Mwouldbeareasonableamounttosettlethisliability.
d) OnDecember5,2011,PakyawinitatedalawsuitagainstLorieInc.seeking
P2Mdamagesfrompatentinfringement.

Required:
1. HowmuchshouldberecognizedasaliabilityasofDecember31,2013?
2. Aretherecontingentassetsfromthetransactionsenumeratedabove?Will
theseberecognizedasofDecember31,2013?

Problem7-6:DebtRestructuring;ModificationofTerms

On December 31, 2013, NAMNAM Company was experiencing financial difficulties

and entered into a debt restructuring agreement with the creditor. The creditor
restructuredtheobligationasfollows:

TheprincipalamountingtoP6,000,000wasretained.
ForgavetheaccruedinterestofP480,000dueonDecember31,2013;
ExtendedthematuritydatefromDecember31,2008toDecember31,2015;
NamnamshouldpayannualinterestpaymentamountingtoP540,000starting
December31,2014

The prevailing rate of interest for a similar debt instrument including the transaction
costasofDecember31,2013is6.24%.

Required:
a) HowmuchshouldNAMNAMCompanyreportasagainasaresultofthe
restructuring?

Auditing Practice I I Third Term, AY 2013-2014

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Problem7-7:DebtRestructuring;AssetSwap,EquitySwap,andModificationof
terms

Incredibles Company was experiencing financial difficulties and entered into a debt
restructuring agreement with its creditors. The total amount of the loan was
P9,370,000.Nointerestwasaccrued.

a. P370,000worthofloanwassettledbygiving30,000P10parvalueofshareswith
acurrentfairvalueofP15.
b. Half of the remaining loan is to be settled by giving land and equipment with a
carrying value of P3,000,000 and P998,000 respectively. The fair values of the
landandequipmentareP3,500,000andP1,000,000.
c. The remaining loan will be reduced to a principal of P3,000,000. The maturity
datewillbeextendedfortwomoreyears.Theinterestrateof15%willbereduced
to10%.Theprevailingmarketrateforsimilarnotesis12%.

Required:

Computeforthecorrectamountofthefollowing:

1. Sharepremiumrelatedwiththesettlement
2. Gainondebtextinguishmentrelatedtotheassetswap
3. Gainondebtextinguishmentrelatedtothemodificationofterms

Problem7-8:IncomeTaxAccounting;

ApolInc.,awellknowncompanyinthetechnologicalindustry,reportedpretax
financialincomeamountingtoP700,000for2013.However,forincometaxpurposes,
thefollowingarenotconsideredtaxable/deductible:

Interestincomesubjecttofinaltax P 50,000
DepreciationExpensedeductibleinthefuture 160,000
Collectionofbeginningrentreceivable 220,000
FinesandPenalties 40,000

TaxrateapplicabletotheCompanyis30%.

Required:
a) Ofthedifferencesenumeratedabove,computeforthefollowing:
a. TemporaryDifferences;
b. PermanentDifferences;
c. NetTaxableIncome
b) Howmuchisthetotaltaxcurrentlypayable?Proposeadjustingjournalentries
torecognizethetaxpayabletoBIR.

Auditing Practice I I Third Term, AY 2013-2014

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Problem7-9:ProvisionforIncomeTaxandDeferredIncomeTax

Thefollowingdifferencesenterintothereconciliationoffinancialincomeandtaxable
incomeofChibiMoonCompanyfortheyearendedDecember31,2013,itsfirstyear
ofoperation:

Interestincomeonpesodeposits(netof20%finaltax) =P235,000
Interestincomeondollardeposits(netof7.5%finaltax) =98,050
Accrualofpensionexpense =1,300,000
Lifeinsuranceexpense =345,000
Excesstaxdepreciation =1,240,000
Warrantyexpense =360,000
Unamortizedcomputersoftware =2,800,000
Unearnedrentincomedeferredonthebooksbutappropriately
recognizedintaxableprofit =498,000
Provisionfordoubtfulaccounts =654,000
Unrealizedforeignexchangegain =950,000
Litigationaccrual =367,000
Interestincomefromlong-termpesocertificateofdepositisexpected
tobeP320,000eachyearuntiltheirmaturityattheendof2017.
=320,000
Dividendsreceivedfromanotherdomesticcorporation =140,000

Additionalinformation:

a. OnAugust 3, 2013, Chibi Moonpaid insurancepremium of P400,000onthe

lifeofanofficerwithChibiMoonCompanyasthebeneficiary.
b. Excess tax depreciation will reverse equally over the years 2014 to 2017.
TotaldepreciationexpenserecordedinthebooksisP4,300,000.
c. The warranty liability is the estimated warranty cost that was recognized as
expensein2009butdeductiblefortaxpurposeswhenactuallypaid.
d. Itisestimatedthatthelitigationliabilitywillbepaidin2017.
e. In March 2013, Chibi Moon Company incurred P3,500,000 of computer
softwarecost.Consideringthetechnicalfeasibilityoftheproject,thiscostwas
capitalized andamortized over fiveyears for accounting purposes. However,
thetotalamountwasexpensedin2013fortaxpurposes.
f. Rent income will be recognized for accounting purposes during the last year
ofthelease,2017.
g. Interest income from the long-term peso certificate of deposit is expected to
beP320,000eachyearuntiltheirmaturityattheendof2017.Notethatthisis
alsonetof20%finaltax.
h. Unrealizedforeignexchangegainisexpectedtoberealizedin2015.
i. Chibi Moon Company recorded an interest expense for 2013 of P400,000.
ThetaxaccountantofthecompanynotedthatwiththeenactmentofRepublic
Act No. 9337, the non-deductibleexpensefor interest is now 33% (since the
incometaxratefor2009onwardsis30%),insteadof42%(whichwasapplied
whentheincometaxratewas35%).Moreover,thenon-deductibleinterestis
computed based on the grossed-up value of interest income subject to final
tax.
j. The actuarial valuation for funding for 2013 provides that the current service
cost (or normal cost) of the retirement plan is P500,000 and the amortized
pastservicecostisP80,000.Thetaxaccountantwasinformedbytheauditor
that the company can only deduct for tax purposes, the normal cost and
amortizedpastservicecostaspensionexpensefortheyear.
k. Netincomebeforeincometaxfor2013isP13,500,000.
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l. The Companys cost of sales is 40% of its net sales for the year 2013. All
expensesenumeratedabovearepartofoperatingexpenses.

Required:

1. Computeforthefollowing:

a. Deferredtaxliability
b. Deferredtaxasset
c. Currenttaxexpense
d. Totalincometaxexpense
e. Costofsales

Problem7-10:ComprehensiveProblem

Yourauditclient,DoraemonCompany,isinvolvedinthesituationsdescribedbelow.
Doraemons accounting year ends on December 31, 2010, and its financial
statements are authorized for issue on March 20, 2011. The unaudited balance of
the companys total liabilities as of December 31, 2010 is P7,600,000 before taking
intoconsiderationthefollowing:

a. Doraemon is involved in a lawsuit resulting from a dispute with a customer. On

January 28, 2011, judgment was rendered against Doraemon in the amount of
P13 million. Doraemon plans toappealthe judgment andis unabletopredict its
outcome though management believes that it will not have a material adverse
effectonthecompany.

b. On April 25, 2011, the Bureau of Internal Revenue (BIR) is in the process of
examining Doraemons tax returns for 2008 and 2009, but has not proposed a
deficiency assessment. Management feels an assessment is reasonably
possible, and if an assessment is made, an unfavorable settlement of up P6.3
millionisreasonablypossible.

c. On January 5, 2011, inventory purchased FOB shipping point from a foreign

country was detained at that countrys border because of political unrest. The
shipment is valued at P1.4 million. Doraemons lawyers have stated that it is
probablethatDoraemonwillbeabletoobtaintheshipment.

d. On November 1, 2010, a lawsuit was filed by a disgruntled customer who

discovered a safety hazard in one of Doraemons best-selling products.
Doraemons lawyers feel that it is probable that the company will be liable for
P660,000.

e. On December 5, 2010, Doraemon initiated a lawsuit seeking P1.3 million in

damagesfromapatentinfringement.

f. Nobita, president of Doraemon Company, has a bonus arrangement with the

company under which he receives 10% of net income after bonus and after tax
eachyear.Fortheyear2010,thefollowinginformationaregiven

NetincomeafterbonusbutbeforetaxisP580,000
Thetaxrateis30%
DoraemonrecordedthebonusasP58,000
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Required:
Compute the adjusted balance of Doraemons total liabilities as of December 31,
2010.

Problem7-11:ComprehensiveProblem

Included in Bristol Corporations liability account balances at December 31, 20X3

werethefollowing:

Notespayable,bank P2,800,000
Obligationunderfinancelease 430,000
Deferredincometaxes 360,000

Transactionsduring20X4andotherinformationrelatingtoBristolsliabilitieswereas
follows:

a. TheprincipalamountofthenotepayableisP2,800,000andbearsinterestat15%.
ThenoteisdatedApril1,20X3andispayableinfourequalannualinstallmentsof
P700,000 beginning April 1, 20X4. The first principal and interest payment was
madeonApril1,20X4.

b. The finance lease is for a ten-year period beginning December 31, 20X1. Equal
annual payments of P100,000 are due on December 31, of each year, and the
14% interest rate implicit in the lease is known by Bristol. The present value at
December31,20X3ofthesevenremainingleasepayments(dueDec.31,20X4,
throughDec.31,20Y0)discountedat14%wasP430,000.

c. Deferredincometaxesareprovidedinrecognitionoftimingdifferencesbetween
financialstatementandincometaxreportingofdepreciation.Fortheyearended
December 31, 20X4 depreciation per tax return exceeded book depreciation by
P90,000.Bristolseffectiveincometaxratefor20X4was35%.

d. On July 1, 20X4. Bristol issued for P1,774,000, P2,000,000 face amount of its
10%, P1,000bonds. Thebonds were issuedto yield12%. Thebonds aredated
July1,20X4andmatureonJuly1,20Y4.InterestispayableannuallyonJuly1.
Bristolusestheinterestmethodtoamortizebonddiscount.

Required:

Prepare audit working paper to show the current and noncurrent portion of each of
theliabilityaccountsenumeratedabove.