CHAPTER

8
8-1.

SUBSTANTIVE TESTS
OF RECEIVABLES AND SALES

Tests of details of financial balances are designed to determine the reasonableness

of the balances in sales, accounts receivable, and other account balances which are
affected by the sales and collection cycle. Such tests include confirmation of
accounts receivable, and examining documents supporting the balance in these
accounts.
Tests of transactions for the sales and collection cycle are intended to determine
the effectiveness of internal control structure and to test the substance of the
transactions which are produced by this cycle. Such tests would consist of
examining sales invoices in support of entries in the sales journal, reconciling cash
receipts, or reviewing the approval of credit.
The results of the tests of transactions will be used to affect the procedures,
sample size, timing and particular items selected for the tests of details of financial
balances (i.e., an effective internal control structure will result in reduced testing
when compared to the tests of details required in the case of an inadequate internal
control structure).

8-2.

There are two common types of confirmations used for confirming accounts
receivable: positive confirmations and negative confirmations. A positive
confirmation is a communication addressed to the debtor requesting him to
confirm directly whether the balance as stated on the confirmation request is
correct or incorrect. A negative confirmation is also a communication addressed
to the debtor, but it requests a response only when the debtor disagrees with the
stated amount.
A positive confirmation is more reliable evidence because the auditor can perform
follow-up procedures if a response is not received from the debtor. With a
negative confirmation, failure to reply must be regarded as a correct response even
though the debtor may have ignored the confirmation request.
Offsetting the reliability disadvantage, negative confirmations are less expensive
to send than positive confirmations, and thus more of them can be distributed for
the same total cost. The determination of which type of confirmation to be sent is
an auditors decision, and it should be based on the facts in the audit. The
following are the most important circumstances where positive confirmations
should be used:

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

1.
2.
3.

There are a small number of large accounts which account for a significant
portion of total accounts receivable.
There are suspected conditions of dispute, inaccuracy, or irregularity. This
would be the case when internal controls are considered inadequate or if
prior years audit test results are unsatisfactory.
The rules of certain regulatory agencies require them. This is the case for
brokers and dealers in securities.

When the above conditions do not exist, it is acceptable to use negative

confirmations, but negative confirmations should not be used if the auditor
believes the customer is likely to ignore the confirmation. Typically, when
negative confirmations are used, the auditor is using a reduced control risk
assessment in the audit of accounts receivable. It is also common to use negative
confirmations for audits of hospitals, retail stores, and other industries where the
receivables are due from the general public. In these cases, far more assurance is
obtained from tests of internal control than from confirmations.
It is also common to use a combination of negative and positive confirmations by
sending the positives to accounts with large balances and negatives to those with
small balances.
8-3.

It is acceptable to confirm accounts receivable prior to the balance sheet date if the
internal control structure is adequate and can provide reasonable assurance that
sales, cash receipts and other credits are properly recorded between the date of the
confirmation and the end of the accounting period. Other factors the auditor is
likely to consider in making the decision are the materiality of accounts receivable
and the auditors experience in prior years. If the decision is made to confirm
accounts receivable prior to year end, it is necessary to test the transactions
occurring between the confirmation date and the balance sheet date by examining
internal documents and performing analytical procedures at year end.

8-4.

South Technologies, Inc.

(a) When confirmation requests are mailed to debtors whose accounts were
written off as uncollectible, the auditors purpose is to determine that the
receivables were genuine when they were first recorded in the accounts. In
some fraud cases, fictitious accounts receivable have been created to cover up
a shortage. Eventually these fictitious receivables must be disposed of; one
method is to write off the fictitious accounts as uncollectible.
(b) The South executive appears to believe the auditors are solely concerned with
the collectibility of accounts and notes receivable. In fact, the confirmation
process is primarily intended to establish that the receivables are genuine and
that the customers (or makers of notes) exist. Other audit procedures are
followed to determine collectibility.

Substantive Tests of Receivables and Sales

8-3

8-5.

The confirmation requests should go to the makers of the notes regardless of

whether the notes have been discounted. The act of discounting a note receivable
does not reduce the importance of the note being genuine and collectible. A
company which discounts its notes receivable remains in a position of sustaining a
loss if the makers of the notes fail to make payment at the maturity dates.

8-6.

(a) When customers fail to respond to positive confirmation requests the CPAs
may not assume with confidence that these customers reviewed the requests
and found no disagreement and therefore did not reply. Some busy customers
will not take the time to review confirmation requests and will not respond;
hence, obvious exceptions may exist without being reported to the CPAs.
(b) If there is no response to a second request, the CPAs may mail a third request
and possibly make telephone calls in an effort to get a reply directly from the
customer. When it becomes apparent that the confirmation program will not
produce further evidence, the CPAs should consider each remaining customer
as to the size, nature, and age of the balance and the apparent reason for the
lack of a reply before they decide what additional work is necessary in the
circumstances. The CPAs should carry out the alternative audit procedures of
examining customers purchase orders or contracts, shipping documents and
sales invoices of the client, and remittances by nonconfirming customers
received by the client subsequent to the balance sheet date. The auditors may
also verify the existence, location, and credit standings of the nonconfirming
customers by reference to credit agencies or other sources independent of the
client.

8-7.

North, Inc.
No, the matter remains unresolved. First, oral evidence from the client is never in
itself sufficient; the auditors must follow up to determine the reliability of the oral
evidence. Second, payment of an account receivable is not confirmation; the
account might be fictitious, and the payment could have been made by a
dishonest employee who had created the fictitious account to conceal a cash
shortage. The auditors must examine the customer purchase order or contract, and
copies of the sales invoice and shipping document, in support of the unconfirmed
receivable. They should also determine the genuineness of the customer by
reference to the telephone directory or to credit agency reports.

8-8.

Montys Meat, Inc.

a.

The workpaper does not include a description of the auditing procedures

performed in confirming the accounts. The workpaper is also incomplete in
the following respects:
1) The workpaper does not state whether the auditor traced the ABC
Grocery remittance of P3,000 to November cash receipts.

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

2) The workpaper does not state whether the auditor examined the
November 2 credit memo issued to Sari-Sari Store.
3) The workpaper does not state whether the auditor traced the Lucenas
Meat Market remittance to November cash receipts.
4) The workpaper does not state whether and how the auditor obtained
satisfaction regarding confirmation requests not returned.
5) The workpaper does not state whether the auditor examined
documentation for the Dianas Supper Club order returned and received
on October 31.
6) Rather than summarizing the confirmations returned without exception,
as was done at the bottom of Working Paper 1, these confirmations
should have been listed separately.
b.

1) Sales
Accounts receivable

P11,100
P11,100

Inventory
Cost of goods sold

8,600
8,600

To reverse 2007 sale recorded in 2006.

2) Allowance for uncollectible accounts
Accounts receivable

1,277
1,277

To write off uncollectible account.

3) Sales returns and allowances
Accounts receivable

3,634
3,634

To record return of spoiled meat and

recognize loss in period in which incurred.
Meat not restored to inventory, inasmuch
as it was spoiled.
4) Sales
Accounts receivable

13,000
13,000

To correct error in recording customer

remittance as a sale.
5) Sales Returns
Accounts receivable
Inventory
Cost of goods sold
To record return and restore meat to inventory
because meat returned in good condition.

334
334
250
250

Substantive Tests of Receivables and Sales

c.

8-5

(See completed Exhibits 1.1 and 1.2 reproduced below and on the following
page.)

Exhibit 1.1
Montys Meat, Inc.
Accounts Receivable - Trade
Aging Analysis
October 31, 2006
Conf.
No.
1060
1061
1064
1602
1603
1607
1608
1612
10/31
10/31

11/27

Customer

Balance

Culleys Meats
Jolly Roger Restaurant
ABC Grocery
(Other)
Rudys Deli
General Foods Grocers
Kims Fresh Meats
Dills Discount Grocery
Dianas Supper Club
Balance per ledger
Audit Adjustments

P 1,330
466
4,256
329,433
378
13,468
2,334
12,469
866
P365,000
P (29,345)

Audited balance

P335,655
#

Current
P

&
#

Past Due (Days)

31-60
Over 60

1,330
P
3,000
280,763

13,000
1,074
12,469
334
P 311,970
P (28,068)

466
1,256
33,467

P12,324 P 2,879
378
468

1,260
P 36,449

532
P13,234 P 3,347
P(1,277)

P 283,902

P 36,449

P13,234 P 2,070

Cash receipts 11/1 11/27

P(210,113)

P (13,353)

Outstanding

P 73,789

P 23,096

P13,234 P 2,070

10%

25%

7,379

P 5,774

Estimated percent uncollectible

10/31

1-30

Estimated uncollectible

P 24,487

0 P

70%

Reviewed by:
Initial
Date

100%

P 9,264 P 2,070

Traced subsequent collections to November remittance advices.

Obtained balances from subsidiary ledger after agreeing to general ledger control account.

Prepared by:
Initial
Date

0 &

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

Exhibit 1.2
Montys Meat, Inc.
Accounts Receivable - Trade
Allowance for Doubtful Accounts
October 31, 2006
11/1/05
11/1 - 10/31
11/1 - 10/31

Balance per general ledger

Monthly provision
Write-offs

P28,000 #
24,000 &
(37,000) @

10/31/06

Balance per general ledger

P15,000

AJE 2
AJE 6

(1,277)
P13,723
P10,777

Audited balance

P24,500 ^

10/31/06

AJE 6
Bad debts expense
Allowance for doubtful accounts

P10,777
P10,777

To adjust allowance for doubtful accounts to amount

considered reasonable in the circumstances.

#
&
@
^

Traced to last years WTB - audited balance

Traced to standard journal entries
Examined documentation and discussed with credit manager and legal counsel
In light of aging analysis, the above balance, as adjusted, appears to be adequate.

Prepared by:
Initial
Date

Reviewed by:
Initial
Date

Substantive Tests of Receivables and Sales

8-9.

8-7

Makati Company
For all of the exceptions, the auditor is concerned about four principal things.
(a) Whether there is a client error. Many times the confirmation response
differences are due to timing differences for deposits in the mail and
inventory in transit to the customer. Sometimes customers misunderstand the
confirmation or the information requested. The auditor must distinguish
between those and client errors.
(b) The amount of the client error if any.
(c) The cause of the error. It would be intentional, a misunderstanding of the
proper way to record a transaction, or a breakdown of internal control.
(d) Potential errors in the sample not tested. The auditor must estimate the error
in the untested population, based on the results of the tests of the sample.
Suggested steps to clear each of the comments satisfactorily are:
1.

(a) Examine supporting documents, including the sales invoices and

applicable sales and shipping orders, for propriety and valuation of the
sales.
(b) Review the cash receipts books for the period after December 31, 2005,
and note any collections from the PDQ Company. The degree of internal
control over cash receipts should be an important consideration in
determining the reliance that can be placed on the cash receipts entries.
In addition, as there is no assurance that collections after December 31
represent the payment of invoices supporting the December 31 trial
balance, consideration should be given to requesting a confirmation from
the PDQ Company of the invoices paid by their checks.

2.

(a) The cause should be investigated thoroughly. If the credit was posted to
the wrong account, it may indicate merely a clerical error. On the other
hand, posting to the wrong account may indicate lapping.
(b) Such a comment may also indicate a delay in posting and depositing of
receipts. If upon investigation such is the case, the company should be
informed immediately so that it can take corrective steps.

3.

This is a confirmation of the balance with an additional comment. Since the

customer has given us the data, it is preferable to check to see that the
information agrees with the companys records. Such a procedure may
disclose misposting or delay in recording receipts.

4.

This incomplete comment should raise an immediate question: does the

customer mean paid before or paid after December 31? Because the
customers intent is unknown, this account should be reconfirmed and the
customer asked to state the exact date. Upon receipt of the second
confirmation, the information thereon should be traced to the cash receipts
book.

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

5.

The auditor should first evaluate how long it takes to ship goods to the
customer in question. If it ordinarily takes more than five days, there is no
indication of error.
A comment of this type may indicate that the company may be recording
sales before an actual sale has taken place. The auditor should examine the
invoice and review with the appropriate officials the companys policies.
Sales, cost of sales, inventories and accounts receivable may have to be
adjusted if title has not passed to the buyer as of December 31, 2005.

6.

(a) Determine if such advance payment has been received and that it has
been properly recorded. A review should be made of other advance
payments to ascertain that charges against such advances have been
properly handled.
(b) If the advance payment was to cover these invoices, the auditor should
propose a reclassification of the P1,350, debiting the advance payment
account and crediting accounts receivable--trade.

7.

(a) Examine the shipping order for indications that the goods were shipped
and, if available, carriers invoice and/or bill of lading for receipt of the
goods.
(b) If it appears that goods were shipped, send all available information to
the customer and ask the customer to reconfirm. If the customer still
insists that goods were never received, all data should be presented to an
appropriate company official for a complete explanation. This may
indicate that accounting for shipments is inadequate and consideration
should be given to reviewing the procedures to determine if
improvements can be made.
(c) If the goods were not shipped, the auditor should recommend an
adjustment reducing sales, cost of sales, and accounts receivable, and
increasing inventories.

8.

This should be discussed with the appropriate officials and correspondence

with the customer should be reviewed to allow determination whether an
adjustment should be made in the amount receivable or if an allowance for
doubtful accounts should be set up.

9.

As title on any goods shipped on consignment does not pass until those goods
are sold, the sales entry should be reversed, inventory charged, and cost of
sales credited if it is actually a consignment sale. Other so-called sales should
be reviewed and company officials queried to determine if other sales actual
represent consignment shipments; if so, the adjustment set forth in the
preceding sentence should be made for all consignment shipments.

10. This is a noncurrent asset and should be reclassified to either deposit or

prepaid rent. A review of other accounts, especially those with round
numbers, may disclose other accounts that should be so reclassified.
11. This may indicate a misposting of the credit or a delay in posting the credit.
Comments under 2 above would also apply to credits.

Substantive Tests of Receivables and Sales

8-10.

8-9

Ken Company
Requirement (a)
Ken Company
Accounts Receivable Aging Schedule
May 31, 2006

Age Category
Not yet due
Less than 30 days past due
30 to 60 days past due
61 to 120 days past due
121 to 180 days past due
Over 180 days past due

Proportion
of
Total

Amount
in
Category

Probability
of
Non-Collection

.680
.150
.080
.050
.025
.015
1.000

P 816,000
180,000
96,000
60,000
30,000
18,000
P1,200,000

.010
.035
.050
.090
.400
.900

Estimated
Uncollectibl
e Amount
P 8,160
6,300
4,800
5,400
12,000
16,200
P52,860

Requirement (b)
Ken Company
Analysis of Allowance for Doubtful Accounts
May 31, 2006
June 1, 2005 balance
Bad debt expense accrual (3,000,000 x .04)
Balance before write-offs of bad accounts
Write-offs of bad accounts
Balance before year-end adjustment
Estimated uncollectible amount
Additional allowance needed

P 30,250
120,000
P150,250
108,750
P 41,500
52,860
P 11,360
Debit

Bad Debts Expense

Allowance for Doubtful Accounts

Credit

11,360
11,360

Requirement (c)
1.

Steps to Improve the

Accounts Receivable Situation
Establish more selective credit-granting
policies, such as more restrictive credit
requirements or more thorough credit
rating investigation.

2.

Risks and Costs

Involved
This policy could result in lost sales and
increased costs of credit evaluation. Ken
may be all but forced to adhere to the
prevailing credit-granting policies of the
office equipment and supplies industry.

Establish a more rigorous collection policy

either through external collection agencies
or by Kens own personal.

This policy may offend current customers

and thus risk future sales. Increased
collection costs could result from this
policy.

8-10

8-11.

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Charge interest on overdue accounts.

This policy may offend current customers

and thus risk future sales.

Insist on cash on delivery (COD) or cash

on order (COO) for new customers or
poorer credit risks.

This policy could result in lost sales and

increased administrative costs.

Demo Inc.

Requirement (a)
DEMO INC.
Accounts Receivable
12-31-05
Balance
Per General
Per
Ledger
Subsidiary
Unadjusted Balances
Add (Deduct) Adjustments:
AJE (2) to correct
understatement of
accounts written off on
October 31.

P197,000

P198,240

AGIN G D ISTR IB UTION

Months Outstanding
0-1
1-3
3-6
over 6
P93,240

P76,820

P22,180

P6,000

(200)

(3) to write off definitely

uncollectible accounts

(1,000)

(1,000)

(4) to reclassify advances

from customers

2,000

2,000

(5) to reclassify accounts

with credit balances

500

500

1,440

_______

______
_

_______

_______

______

P199,740

P199,740

P95,240

P77,320

P22,180

P5,000

(6) to adjust general ledger

balance to agree with
subsidiary balance
Balances as adjusted

(1,000)
2,000
500

DEMO INC.
Allowance for Doubtful Accounts
12-31-05
Balance per Ledger
Add (Deduct) Adjustments:
AJE (1) to correct error in recording bad debts recovery
(2) to correct understatement of accounts written off
(3) to write off definitely uncollectible accounts
(4) to adjust allowance to required balance (Schedule 1)

P12,000.00
324.00
( 200.00)
( 1,000.00)
( 6,359.80)

Substantive Tests of Receivables and Sales

Balance as adjusted
Schedule 1: Computation of Required Allowance
Account Classification
0-1 month outstanding
1-3 months outstanding
3-6 months outstanding
over 6 months outstanding
Totals

Adjusted
Total
P 95,240
77,320
22,180
5,000
_______
P199,740

8-11

P 4,764.20
Required
%

Allowance
Amount

1
2
3
P2,000-50%
P3,000-20%

P 952.40
1,546.40
665.40
1,000.00
600.00
P4,764.20

Requirement (b) Adjusting Journal Entries 12-31-05

(1)
(2)
(3)
(4)
(5)
(6)
(7)

8-12.

Bad Debts
Allowance for Doubtful Accounts

324.00

Allowance for Doubtful Accounts

Accounts Receivable

200.00

Allowance for Doubtful Accounts

Accounts Receivable

1,000.00

Accounts Receivable
Advances from Customers

2,000.00

Accounts Receivable
Customers accounts with credit balances

324.00
200.00
1,000.00
2,000.00
500.00
500.00

Accounts Receivable
Sales

1,440.00

Allowance for Doubtful Accounts

Bad Debts Expense

6,359.80

1,440.00
6,359.80

Tripoli Company
Requirement (1)
Accounts receivable, trade..............................................
Advances to suppliers.....................................................
Due from officers............................................................
Subscriptions receivable share capital.........................
Expense advances to salespeople....................................
Accounts payable, trade (P19,250 P450)*............
Advances from customers on sales contracts...........
Salaries payable.......................................................
Allowance for doubtful accounts.............................

40,000
450
2,500
4,600
1,000
19,250
450
3,300
500

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

Receivables (to close permanently).........................
Customers credit balances.......................................
Requirement (2)
Current assets:
Accounts receivable, trade.......................................
Less allowance for doubtful accounts......................
Creditors debit balances..........................................
Due from officers**.................................................
Subscriptions receivable ordinary shares**..........
Expense advances to salespeople.............................

23,050
2,000

40,000
500

P39,500
450
2,500
4,600
1,000

Current liabilities:
Accounts payable, trade...........................................
Customers credit balances.......................................
Cash advances from customers on sales
(not yet shipped)...................................................
Salaries payable.......................................................
*

19,250
2,000
450
3,300

These amounts are netted against normal balances to reflect control balances;
but if material in amount, they should be reported separately on the balance
sheet as indicated in Requirement 2.

** Considered as current assets only if currently collectible.

assumed to be material in amount.
8-13.

All items are

Pearl Corporation
1.

Estimated bad debt percentage based on year-end accounts receivable:

28.5%#
Actual bad debts
Credit Sales
Outstanding receivables
(year-end)
Percentage of
outstanding
receivables
a
b
c
d
e

2003
P 3,300a
P90,000

2004
P 5,700c
P158,000

2005
P 7,800e
P210,000

2006
P 16,800
P459,000

P 9,500b

P 19,900d

P 29,500f

P 58,900

0.347

0.286

0.264

0.285#

P2,500 + P500 + P300 = P3,300

0 + P90,000 - P78,000 - P2,500 = P9,500
P4,600 + P700 + P400 = P5,700
P9,500 + P158,000 - P8,500 - P134,000 - P500 - P4,600 = P19,900
Estimated. The bad debts written off in the third year following the sale have
averaged about 7.8% [(P300 + P400) (P3,300 + P5,700)] of the total actual bad

8-13

Substantive Tests of Receivables and Sales

2.

debts in the previous 2 years. Therefore, the bad debts on 2005 sales of P6,200 and
P1,000 are about 92.2% of the total bad debts expected on 2005 sales.
P19,900 + P210,000 - P200 - P14,200 - P178,800 - P300 - P700 - P6,200 = P29,500

Bad debts estimated as a percentage of year-end accounts receivable

P29,500 + P235,000 - P300 - P19,500 - P400 - P1,000 - P200,000
= P43,300
P43,300 x 0.285 = P12,340.50, or approximately P12,300. Criteria for
recognition of bad debts or impairment of receivables under PAS 39
should be applied.

8-14.

Flores Corporation
Requirement (1)
Flores Corporation
Analysis of Changes in the
Allowance for Doubtful Accounts
For the Year Ended December 31, 2006
Balance at January 1, 2006
Provision for doubtful accounts (P9,000,000 x 2%)
Recovery in 2006 of bad debts written off previously
Deduct write-offs for (P90,000 + P60,000)
Balance at December 31, 2006, before additional impairment loss
Increase in estimated uncollectible accounts during 2006 (P235,300 - P175,000)
Balance at December 31, 2006, adjusted (Schedule 1)

P130,000
180,000
15,000
P325,000
150,000
P175,000
60,300
P235,300

Schedule 1:
Computation of Allowance for Doubtful Accounts
at December 31, 2006
Aging category
November-December 2006
July-October
January-June
Prior to 1/1/06
a

Balance
P1,140,000
600,000
400,000
70,000 a

Percent
2
10
25
75

Doubtful accounts
P 22,800
60,000
100,000
52,500
P235,300

P130,000 - P60,000

Requirement (2)
Flores Corporation
Journal Entry
December 31, 2006
Bad Debt Expense
Allowance for Doubtful Accounts
To increase the allowance for doubtful
accounts at December 31, 2006, resulting

60,300
60,300

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

from evaluation of collectibility of remaining
receivables.

8-15.

Visayas Company
Requirement (a)
Visayas Company
Accounts Receivable
12.31.06
Balance, 12.31.05
Add: Sales on account for the year
Total
Less: Collections during the year
- with discount (1)
- without discount (2)
Accounts written off
Credit memo for sales returns & allowances

P 546,400
2,622,832
P3,169,232
P2,050,859
848,118
18,700
37,000

Balance, 12.31.06
Total collections
Less: Accts paid w/ discount
Accts paid by customers w/o
discount

2,954,677
P 214,555

P2,857,960
2,009,842

( 98% = P2,050,859) (1)

P 848,118

(2)

Requirement (b)
AJE (1) Doubtful accounts expense
Allowance for doubtful accounts

6,599
6,599

Supporting Analysis:
% allowance to AR 12.31.05
Required % allowance to
AR 12.31.06
Required allowance 12.31.06
2% x P214,555

3%

2/3 x 3%

2%

P4,291

Allowance for doubtful accounts balance, 12.31.05

Less: Accounts written off
Required balance, 12.31.06

P 16,392
P546,400

P 16,392
18,700
P( 2,308)
4,291

Substantive Tests of Receivables and Sales

Estimated bad debts expense for 12.31.06
8-16.

8-15

P 6,599

Charry Company
Requirement (a) Adjusting Journal Entries
(1)

(2)
(3)
(4)
(5)
(6)
(7)
(8)

Accounts Receivable
Customers accounts with credit balances
(P500 + P5,000)

5,500

Sales
Accounts Receivable

5,000

Subscriptions Receivable
Accounts Receivable

15,000

Deposit on Contract
Accounts Receivable

15,000

Claims Receivable
Accounts Receivable

500

Advances to Employees
Accounts Receivable

500

Advances to Affiliated Company

Accounts Receivable
Advances to Supplier
Accounts Receivable

5,500

5,000
15,000
15,000
500
500
10,000
10,000
5,000
5,000

Requirement (b) Balance Sheet Presentation 12-31-06

Current Assets
Accounts Receivable - Trade
Claims Receivable
Advances to Employees
Advances to Supplier

P59,500
500
500
5,000

Investments
Advances to Affiliated Company

10,000

Other Assets
Deposit on Contract

15,000

Shareholders Equity

8-16

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Subscribed Share Capital (net of subscriptions
receivable of P15,000)

xxx

Supporting Analysis:
Charry Company
Accounts Receivable -Trade
12-31-06
Balance per ledger
Add (Deduct) Adjustments:
AJE (1) To reclassify accounts with credit balances
(2) To reverse entry for consignment deliveries
(3) To reclassify subscriptions receivable
(4) To reclassify deposit on contract
(5) To reclassify balance of claims from carrier for
shipping damages
(6) To reclassify employees IOUs
(7) To reclassify advances to affiliate
(8) To reclassify advances to supplier
Net adjustments

P105,000
5,500
( 5,000)
( 15,000)
( 15,000)
(
500)
(
500)
( 10,000)
( 5,000)
( 45,500)

Balance as adjusted

P 59,500

If correct entries were made for the transactions given, the Accounts
Receivable account would show the following postings:
Accounts Receivable
Jan. 1 Balance
Charge Sales
Recoveries of
accounts written off

P 56,000
625,000
1,000
________
P682,000
________
P682,000

8-17.

Collections
Write offs
Merchandise returns
Allowance for shipping
damages
Balance Dec. 31

P615,000
3,500
2,500
1,500
P622,500
59,500
P682,000

The Preston Companies

(amounts in P millions)
Requirement (1)
(a) Prestons earnings would have increased (1 0.40) P105 million or P63
million in 2006. Net accounts receivable and total assets would have been

Substantive Tests of Receivables and Sales

8-17

P105 million higher than actually reported in 2006. Ignoring differences

between tax and financial reporting, income tax payable would have
increased by P0.40 (P105 million) or P42 million, and retained earnings
would be greater by P63 million. This example illustrates the material effect
estimated bad debts can have on reported earnings and total assets.
(b) Under the allowance method, failure to write off an account has no effect on
earnings (assuming a sufficient balance exists in the allowance account), or
any net balances in the balance sheet. Only the components of net accounts
receivable would be affected. Both gross accounts receivable and the
allowance for doubtful accounts would be overstated P0.6 million.
Requirement (2)
Beginning allowance balance
Bad debt expense
Ending allowance balance
Write-offs of accounts

1998
P183
105
(212)
P 76

Requirement (3)
(a) The ratio of bad debt expense to operating revenue for the two years is: 2006,
P105/P3,729 = 2.8%; 2005, P81/P3,534 = 2.3%. This ratio appears relatively
stable although is increasing.
(b) The composite rate of uncollectible accounts as a percentage of gross
accounts receivable = ending allowance balance/ending accounts receivable.
The ratio for 2006 is P212 / (P951 + P212) = 18.2%, and for 2005 is P183 /
(P972 + P183) = 15.8%. This ratio is less stable and also is increasing.
(c) Bad debt expense is considerably higher than the write-offs in 2006. The firm
has experienced an increase in expected write-offs. Apparently the firm
expects an increase in bad debts, which is partially an estimate of future
write-offs.
8-18.

Rain Company
Requirement (1)
Present value of the note:
P150,000 x (PV1, 12%, 3) (0.71178) = P106,767

8-18

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Requirement (2)
Correction and Collection Schedule:
Date
1-1-2005
12-31-2005
12-31-2005
12-31-2006
12-31-2007
12-31-2007

Explanation and Interest Revenue

Recorded originally at face amount
Correction to restate to present value
To accrue interest, P106,767 x 12% = P12,812
To accrue interest, P119,579 x 12% = P14,349
To accrue interest, P133,928 x 12% = P16,072*
Collection on face amount, debit Cash

+
+
+

Note Receivable
Change
Balance
P150,000
P 43,233
106,767
12,812
119,579
14,349
133,928
16,072
150,000
150,000
0

* Rounded.

8-19.
1.

d.

The Josefina note is a short-term note and is reported at face value

although the note can be recorded at present value. The Nicole note is
reported at present value: [(P20,000 + 5(0.3) (P20,000)] (PV1, 8%, 5) =
P23,000 (0.68058) = P15,653

2.

c.

The annual payment is computed as: P10,000 (PVA, 8%, 5) = P10,000 /

3.99271 = P2,505.
Discounting this stream of payments at 9% yields cash proceeds of:
P2,505 (PVA, 9%, 5) = P2,505 (3.88965) = P9,744.
Total interest equals total payments less proceeds = 5 (P2,505) P9,744
= P2,781.

8-20.

3.

b.

Interest receivable is recorded for one month.

4.

c.

Maturity value..................................................................... P100,000

Discount P100,000 (0.10) (6/12).........................................
(5,000)
Proceeds............................................................................... P 95,000

Luce Company
(1)

AJE:

Sales returns and allowances

Inventory 12.31.06
Accounts receivable
Cost of sales

30,000
24,000
30,000
24,000

Income will decrease by P6,000 if

the above AJE is made.
(2)

Ans.

(c)

AJE:

Sales

10,000

Substantive Tests of Receivables and Sales

Accounts receivable

8-19
10,000

Income was overstated by P10,000

Ans.
(3)

Actual number of units sold to Mr. Lazo was 320.

Ans.

(4)

8-21.

(a)
P48,000
P150

(b)

Correct receivable from

Mr. Lazo : 320 x P100
Per client
Overstatement
Ans. (d)

P 32,000
48,000
P 16,000

(5)

Accounts receivable from Mr. Sia is correctly stated because the goods are
considered sold in 2006.
Ans. (a)

(6)

Ans.

(d)

ETC Co.
Adjusting Journal Entries
AJE 1.
2.
3.
4.

5.
6.

Cash
Other Current Liabilities (UCPB Overdraft)

225,000
225,000

Accounts Receivable
Cash

37,500

Cash
Accounts Payable

28,709

Notes Payable
Interest Expense
Cash

67,500
16,200

Cash BPI
Other Current Liabilities (UCPB Overdraft)

25,000

Cash SBTC
Accounts Receivable

73,690

37,500
28,709

83,700

73,690

Cash
5.31.06
Per books
AJE
1.
2.
3.

25,000

P 15,825,000
225,000
(37,500)
28,709

8-20

Solutions Manual to Accompany Applied Auditing, 2006 Edition

4.
(83,700)
5.
25,000
6.
73,690
Adjusted balance
P16,056,199
Accounts Receivable
5.31.06

AJE 2.
6.

Subsidiary Ledger
P8,047,054
37,500

(1) (c)

General Ledger
P7,868,029
37,500
(73,690)

(375,215)
122,500
P7,831,839

P7,831,839

(2) (b)

Allowance for Doubtful Accounts

Aging
Distributio
n
Current
Past due:
1 30
31 60
61 90
Over 90

Subsidiary Ledger

P1,737,690.00 + P122,500 = P1,860,190.00 x 2 = P 37,203.80

P1,617,340.00
P1,437,706.50
P1,474,450.00
P1,779,867.50 + P37,500
___________ P375,215
(3) (a) P8,047,054.00

8-22.

Amount
Estimated to be
Uncollectible

= 1,617,340.00 x 5 = 80,867.00
= 1,437,706.50 x 10 = 143,770.70
= 1,474,450.00 x 15 = 221,167.50
= 1,442,152.50 x 20 = 288,430.50
P7,831,839.00
P771,439.50

Ling, Inc.
Requirement (1)
LING, INC.
Long-term Receivables Section of Balance Sheet
December 31, 2005
9% note receivable from sale of division, due in annual
installments of P500,000 to May 1, 2007, less current
installment
8% note receivable from officer, due December 31, 2007,
collaterized by 10,000 shares of Ling, Inc., ordinary shares
with a fair value of P450,000
Non-interest-bearing note from sale of patent, net of 15%
imputed interest, due April 1, 2007

P 500,000 [1]
400,000
84,105 [2]

Substantive Tests of Receivables and Sales

Installment contract receivable, due in annual installments of
P50,000 to July 1, 2009, less current installment
Total long-term receivables

8-21

112,400 [3]
P1,096,505

Requirement (2)
LING, INC.
Selected Balance Sheet Balances
December 31, 2005
Current portion of long-term receivables:
Note receivable from sale of division
Installment contract receivable
Total

P500,000 [1]
27,600 [3]
P527,600

Accrued interest receivable:

Note receivable from sale of division
Installment contract receivable
Total

P 60,000 [4]
11,200 [5]
P 71,200

Requirement (3)
LING, INC.
Interest Income from Long-Term Receivables
and Gains Recognized on Sale of Assets
For the Year Ended December 31, 2005
Interest income:
Note receivable from sale of division
Note receivable from sale of patent
Note receivable from officer
Installment contract receivable from sale of land
Total interest income for year ended 12/31/05

P105,000
8,505
32,000
11,200
P156,705

Gains recognized on sale of assets:

Patent
Land
Total gains recognized for year ended 12/31/05

P 37,600 [8]
50,000 [9]
P 87,600

Explanation of amounts:
[1] Long-term Portion of 9% Note Receivable at 12/31/05
Face amount, 5/1/00
Less: installment received 5/1/05
Balance, 12/31/05

P1,500,000
(500,000)
P1,000,000

[6]
[2]
[7]
[5]

8-22

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Less: installment due 5/1/06
Long-term portion, 12/31/05

(500,000)
P 500,000

[2] Non-interest-bearing Note, Net of Imputed Interest at 12/31/05

Face amount, 4/1/05
P 100,000
Less: imputed interest
[P100,000 (P100,0000 x 0.756)]
(24,400)
Balance, 4/1/05
P 75,600
Add: interest earned to 12/31/05
(P75,600 x 15% x 9/12)
8,505
Balance, 12/31/05
P 84,105
[3] Long-term Portion of Installment Contract Receivable at 12/31/05
Contract selling price, 7/1/05
P 200,000
Less: down payment, 7/1/05
(60,000)
Balance, 12/31/05
P 140,000
Less: installment due 7/1/06
[P50,000 (P140,000 x 16%)]
(27,600)
Long-term portion, 12/31/05
P 112,400
[4] Accrued Interest Note Receivable, Sale of Division, at 12/31/05
Interest accrued from 5/1 to 12/31/05
(P1,000,000 x 9% x 8/12)
P 60,000
[5] Accrued Interest Installment Contract at 12/31/05
Interest accrued from 7/1 to 12/31/05
(P140,000 x 16% x )

11,200

[6] Interest Income Note Receivable, Sale of Division, for 2005

Interest earned from 1/1 to 5/1/05
(P1,500,000 x 9% x 4/12)
P 45,000
Interest earned from 5/1 to 12/31/05
(P1,000,000 x 9% x 8/12)
60,000
Interest income
P 105,000
[7] Interest Income Note Receivable, Officer, for 2005
Interest earned 1/1 to 12/31/05 (P400,000 x 8%)
[8] Gain Recognized on Sale of Patent
Stated selling price
Less: imputed interest
Actual selling price (P100,000 x 0.756)
Less: cost of patent (net)

32,000

P 100,000
(24,400)
[2]
P 75,600

8-23

Substantive Tests of Receivables and Sales

Carrying value 1/1/05
Less amortization 1/1 to 4/1/06
(P8,000 x )
Gain recognized

P40,000
(2,000)
P

[9] Gain Recognized on Sale of Land

Sale of price
Less: cost
Gain recognized
8-23.

(38,000)
37,600

P 200,000
(150,000)
P 50,000

Grande Company
Requirement 1
PAS 39, paragraph 63 will be applied in this case. On December 31, 2006,
Grande Company should record the 2006 accrued interest and the impairment:
Notes / Interest Receivable (0.06) (100,000)
Interest Income

6,000
6,000

Bad Debts Expense

Allowance for decline in note value

55,537 *
55,537

* Carrying value of note and interest (100,000 + 6,000)

Present value / New carrying value of
note (discount rate 6%)
Principal:
Due on 12.31.08 (P30,000 x 0.89000)
P26,700
Due on 12.31.10 (P30,000 x 0.79209)
23,763
Impairment write-down

P106,000

50,463
P 55,537

Requirement 2
The entries with the corresponding computations follow:
Effective Interest Method
December 31, 2007
Allowance for decline in note value
Interest income (0.06) (50,463)
December 31, 2008
Allowance for decline in note value
Interest income
(0.06) (50,463 + 3,028)
Cash
Notes receivable

3,028
3,028
3,209
3,209
30,000
30,000

8-24

Solutions Manual to Accompany Applied Auditing, 2006 Edition

December 31, 2009
Allowance for decline in note value
Interest income
(0.06) (50,463 + 3,208 + 3,209 30,000)

1,602
1,602

December 31, 2010

Allowance for decline in note value
Interest income
*
0.06 (26,700 + 1,602)

1,698*
1,698

Cash
*
Notes receivable

30,000

Allowance for decline in note value

Notes receivable
To close remaining balance in
notes receivable and allowance

46,000

30,000
46,000

* At this point, the amortized cost of the notes receivable is zero.

Notes Receivable
100,000
30,000
6,000
30,000
106,000
60,000
46,000 bal

8-24.

Allowance for Decline in Note Value

3,028
55,537
3,209
1,602
1,698
9,537
55,537
46,000

Amy Corporation
Requirement 1
Accounts Receivable (Trade)
Accounts Receivable (Officer)
Ordinary Shares Subscriptions Receivable
Advances to Employees
Notes Receivable (Trade)
Deposit to Guarantee Contract Performance
Utility Deposit
Receivables

15,500
3,600
12,000
1,800
6,000
5,000
500
44,400

Requirement 2
Accounts receivable (trade)--current asset, trade receivable
Accounts receivable (officer)--normally current nontrade receivable
Ordinary shares subscription receivable--current or noncurrent asset, depending
on due date; nontrade receivable

Substantive Tests of Receivables and Sales

8-25.

8-25

Advances to employees--current asset, nontrade receivable

Notes receivable (trade)--noncurrent asset, trade receivable
Deposit to guarantee contract performance--separately classify, could be current
or noncurrent asset, depending on the length of the contract; nontrade
receivable
Utility deposit--separately classify, probably noncurrent nontrade receivable
Janes Department Store
Requirement 1
Age
Under 30 days
30- 60 days
61-120 days
121-240 days
241-360 days
Over 360 days

Balance
P193,000
114,000
73,000
41,000
25,000
19,000
P465,000

Estimated
Percentage
Uncollectible
0.008
0.020
0.050
0.200
0.350
0.600

Estimated
Amount
Uncollectible
P 1,544
2,280
3,650
8,200
8,750
11,400
P35,824

Requirement 2
a.

35,824

Bad Debt Expense (P35,824 + P3,000)

Allowance for Doubtful Accounts

38,824

Bad Debt Expense (P35,824 P2,800)

Allowance for Doubtful Accounts

33,024

b.

Bad Debt Expense

Allowance for Doubtful Accounts

c.
8-26.

35,824
38,824
33,024

Blue Corporation
Requirement 1
2005
Dec.

Dec.

1
11

Cash [(P175,000 x 0.80) P1,400]

138,600
Assignment Service Charge Expense
(P175,000 x 0.80 x 0.01)
1,400
Notes Payable (P175,000 x 0.80)

140,000

Accounts Receivable Assigned

Accounts Receivable

175,000

Sales Returns and Allowances

Accounts Receivable Assigned

175,000
1,000
1,000

8-26

Solutions Manual to Accompany Applied Auditing, 2006 Edition

31
31

2006
Jan. 29
29

29

Cash
Accounts Receivable Assigned

86,000

Notes Payable
Interest Expense (P140,000
x 0.12 x 1/12)
Cash

86,000

Cash
Accounts Receivable Assigned

60,000

86,000

1,400
87,400

60,000

Notes Payable (P140,000 P86,000) 54,000

Interest Expense (P54,000
x 0.12 x 1/12)
540
Cash

54,540

Accounts Receivable
Accounts Receivable Assigned
(P175,000 P1,000
P86,000 P60,000)

28,000

28,000

Requirement 2
On the December 31, 2005 balance sheet of the Blue Corporation, the assigned
accounts receivable and the remaining liability would be reported as follows:

8-27.

Current Assets:
Accounts receivable assigned

P88,000

Current Liabilities:
Note payable

P54,000

Tandy Shoes
Sept. 15

21

29

Accounts Receivable
Credit Card Expense (P2,100 x 0.05)
Sales
Sales Returns and Allowances
Accounts Receivable
Credit Card Expense (P200 x 0.05)
Cash
Accounts Receivable

1,995
105
2,100
200
190
10
1,805
1,805

Substantive Tests of Receivables and Sales

8-28.

8-27

Gabe Company
GABE COMPANY
Income Statement Effect
For the Year Ended December 31, 2005
Expenses resulting from accounts receivable assigned
(Schedule 1)
Expenses resulting from accounts receivable sold
(P300,000 P260,000)
Total expenses

P15,100
40,000
P55,100

Schedule 1: Computation of Expenses for Accounts Receivable Assigned

Assignment expense:
Accounts receivable assigned
Advance by Belle

Interest expense
Total expenses

P200,000
x
85%
P170,000
x
3%
P 5,100
10,000
P 15,100