Auditing Problems you can use

8/11/2019 Auditing Problems you can use

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CHATER 7 SUBSTANTIVE TESTS OF CASH

7-1. The quoted statement is not accurate. In their work on cash, auditors are primarily concerned with the risk of an

overstatementof the cash balance. The listing of a non-existent or fictitious check on the outstanding list would havethe effect of understating the clients cash position, because too large an amount for outstanding checks would bededucted from the balance per bank, resulting in understatement of the adjusted balance.

The other element of the quoted statement relating to the auditors concern over the possible omission of a deposit intransit is also in error. To omit a deposit in transit would cause an understatement of the year-end cash balance.

If the quoted statement were revised into acceptable form, it would read along the following lines: When auditors are

verifying a clients bank reconciliation, they are particularly concerned with the possibility that an outstanding checkmay be omitted or that a non-existent deposit in transit may be included.

7-2. There is no assurance that the lapping activities of the cashier will be discovered during the annual audit. Since no

shortage exists as of the balance sheet date, the only procedure which might disclose the irregularities would be acomparison of the individual checks listed on duplicate deposit tickets with the credits to customers accounts. Since atest of this nature would probably not be made for more than a small sample of control listings it is likely that theborrowing and subsequent restoration of borrowed funds might go undetected.

7-3. (a) Lapping is a defalcation in which a cash shortage is concealed by delaying the crediting of cash receipts to the

proper accounts receivable. The first step in the fraud is to withhold from a bank deposit cash remitted by acustomer. A few days later, because the customer must receive credit for his remittance, the first customersaccount is credited with an amount from a remittance made by a second customer. The process requires the

continuous shifting of shortages from account to account and the crediting of subsequent receipts to the wrongaccount receivable.

(b) The following audit procedures would be used to uncover lapping:

(1) Compare the detail of mailroom control listings (if prepared) to entries in the cash receipts journal, postingsto the accounts receivable subsidiary ledger, and the detail of authenticated duplicate deposit slips. This

procedure should indicate any delay in journalizing, posting, and/or depositing incoming cash receipts.

(2) If control listings are not prepared, compare the remittance advices received with customers checks to the

cash journal entries, postings to accounts receivable, and deposit slips. If the client stamps remittanceadvices with the date received, particular attention should be given to comparing this date with the date of therelated journal entry and posting.

(3) Confirm accounts receivable and give close attention to exceptions made by customers about payment dates.The confirmation procedure is better applied as a surprise at an interim date so that a person engaged inlapping will not have been able to bring the lapped accounts up to da te. If the confirmations are always

prepared at year-end, the confirmation procedure may be anticipated by the person doing the lapping and theshortage given a different form such as kiting of checks. (Confirmation of accounts receivables has not been

discussed in this chapter, but some students may be familiar enough with this procedure to include it in theiranswer.)

7-4. West, Inc.

The outstanding checks said by the controller to have been distributed after December 31 should be reversed to theextent that they were actually distributed after that date. An actual overdraft should be revealed and not eliminated by

improper journal entries. The primary purpose of the reversal is to properly cut off the cash and show the proper cashbalance. Showing the correct cash balance eliminates window dressing; recorded but undistributed checks would

distort the current ratio by reducing both cash and accounts payable.


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Substantive Tests of Inventories and Cost of Goods Sold 9-27-5. Cavite Company

Requirement (a) Adjusting Journal Entries - 12.31.05

AJE (1) Gas and oil 320Supplies expense 260Delivery expense 320Repairs and maintenance 600

Advances to employees 400Petty cash fund 1,900

(2) Advances to employees 200

Petty cash fund 200

(3) Accounts receivable - cashier 100Petty cash fund 100

Shortage in PCF determined as follows:Accounting:

Currency P 1,200

Coins 200Check 1,400Unreplenished vouchers 1,900

NSF check 200Total 4,900

PCF per ledger 5,000Shortage P (100)

(4) Cash in bank 450

Salaries payable 450

Requirement (b)

Cavite CompanyPetty Cash Fund

12.31.05

Balance per ledger P 5,000Add (Deduct) adjustments

AJE (1) ( 1,900)(2) ( 200)

(3) ( 100)

Net adjustment ( 2,200)

Balance as adjusted P 2,800


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Substantive Tests of Inventories and Cost of Goods Sold 9-37-6. Pampanga Company

Requirement (a)

Proper composition of the Fund, 11/10/06

Currency and coins P 2,200Cashed checks 500Vouchers 740

NSF checks 260

Total P 3,700

Less: Petty cash receipt vouchersReturn of expense advance P 200Sale of money orders 100 300

Balance of Fund per count P 3,400Balance of Fund per records 5,000

Shortage (P 1,600)

The cashier attempted to conceal the shortage by:

1)

Adding instead of deducting the cash received thereby overstating the accounting of thefund by P 600

2) Submitting blank money orders claimed to have been purchased 600

3) Submitting additional vouchers claimed to have been misplaced 400

Total P 1,600Requirement (b)

Audit Procedures

a. Cashed checks1. Examine checks as to payee, date, endorsements and subsequent deposit.

2. Determine if checks were cashed with prior approval of a responsible official.

b. Vouchers not yet replenished1. Vouch supporting documents, invoices, etc.2. Examine vouchers as to approval by authorized officials, signature of payee, etc.

c. NSF checks1. Determine reason why NSF checks are still on hand.2. Confirm directly with drawers.

d. Return of excess travel advance1. Examine liquidation of travel advance as reported and determine accuracy of the amount returned.

2. Vouch supporting invoices.

e. Sale of money orders

1. Examine latest report of the Pampanga Co. to establish proper accountability.2. Confirm directly with the Pampanga Co. all unreported money orders sold as well as unissued as of

November 10.

f. Vouchers subsequently presented1. Examine vouchers as to date, approval, amount and nature of expenditures.2. Confirm directly with employees those items representing wage advance.

g. Book balance of the Petty Cash Fund.1. Trace to the general ledger the balance of the fund.


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Substantive Tests of Inventories and Cost of Goods Sold 9-47-7.

Requirement (1) Bank Reconciliation, June 30

Bank BooksBalances, June 1 ................................................. P18,000 P30,170 (derived)

Additions:Deposits in transit....................................... 16,000

Note and interest collected ......................... 1,860Recording error (944 854) ...................... 90

Deductions:Outstanding checks .................................... (6,000)

NSF check .................................................. (4,000)Service charge ............................................ (120)

Correct cash balance .......................................... P28,000 P28,000

Requirement (2) Adjusting entry

Accounts receivable ........................................... 4,000Service charge expense ...................................... 120

Accounts payable ....................................... 90Interest revenue .......................................... 60

Notes receivable ......................................... 1,800Cash ........................................................... 2,170

7-8. Form Company

Requirement (a)Form Company

Bank Reconciliation Statement

6.30.06

Balance per bank statement P 27,000Add: Cash on hand 9,228

Total 36,228

Less: Outstanding checksCheck no. 192 P 1,040

193 720194 816

195 692 3,268


Balance per books P 34,700Add: Note collected by bank 500

Total 35,200

Less: Shortage 2,240


Requirement (b) Shortage is P2,240.


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Substantive Tests of Inventories and Cost of Goods Sold 9-5

Requirement (c)

The cashier attempted to conceal the shortage by:

(1) Understating the outstanding checks(a ) Excluding check #192 P1,040(b) Underfooting list of outstanding checks 200

(2) Adding instead of deducting note collected by bank

thereby covering up 1,000Total P2,240

Requirement (d)

Suggestions to improve internal control:

(1) Bank reconciliation statement should be prepared by someone other than the cashier.

(2) Collections should be deposited intact.

7-9. Jonas Company

Analysis of the bank statement and cash account will reveal the following:

a. Deposit in-transit, June 30:................................................ P2,700

b. Checks outstanding:# 62 .................................................................................. P 900# 68 .................................................................................. 1,300 P2,200

c. Interest earned on bank balance ........................................ P 100

Bank Reconciliation, June 30

Bank BookEnding June balance ................. P22,580 Ending June balance ................. P22,980Deposits in-transit ..................... 2,700 Interest earned ........................... 100

Checks outstanding:#62 .................................... (900)#68 .................................... (1,300)

Correct cash balance ................. P23,080 P23,080

The following journal entry must be made by Jonas Company:

Cash .......................................................................................... 100

Interest revenue ......................................................................... 100

7-10. Apple Company

Requirement (1)

(a) Deposits in-transit All deposits (#51 through #56) except#56 have been recorded by the bank; therefore, thedeposit in-transit is: #56, P3,500. This amount can be verified as: P2,000 + P190,000P188,500 = P3,500.

(b) Checks outstanding: Inspection of the check numbers reveals that the following are outstanding: #121, P1,000;#177, P2,500; #178, P3,000; and #179, P1,500; total, P8,000. This amount can be verified as: P6,000 + P198,000

P196,000 = P8,000.


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Substantive Tests of Inventories and Cost of Goods Sold 9-6Requirement (2)

Bank BooksBalances, December 1 ........................................ P76,550 P56,000

Additions:Cash on hand .............................................. 400Deposit in-transit (#56) .............................. 3,500

Note collected ............................................

Principal ............................................. 6,000Interest................................................ 720

Funds received from foreign revenue ......... 10,000Deductions:

Checks outstanding (#121, #177-179) ........ (8,000)

NSF check, Customer Belinda ................... (200)United Fund transfer .................................. (50)Bank service charge ................................... (20)

Correct cash balance .......................................... P72,450 P72,450

Requirement (3)

Journal entries from bank reconciliation:

(a) Cash ........................................................... 16,720Note receivable .................................. 6,000Interest revenue .................................. 720

Foreign revenue .................................. 10,000

(b) Account receivable, NSF check,Customer Belinda .................................... 200

Contributions, United Fund ........................ 50Expense, bank service charge ..................... 20

Cash ................................................... 270

7-11. Mindanao Company

Requirement (a)Mindanao Company

Bank Reconciliation Statement

12.31.06

Bank BooksUnadjusted Balance P 88,489.12 P 58,983.46Add (Deduct) Reconciling Items

a) Outstanding checks (32,108.42)b) Receipts of 12.31.06 deposited 1.2.07 5,317.20c) Service charge for November (3.85)d) Proceeds of bank loan 9,875.00

e) Deposit of 12.23.06 omitted from bank statement 2,892.41f) Returned check from Tome Co. (417.50)g) Error by bank in entering 12.16.06 deposit, understated by 1.00h) Check of Mina Mfg. Co. erroneously charged against Mindanao acct. 2,960.00

i) Note of J. Santos Co. collected by bank, 12.10.06 2,015.00j) Erroneous bank debit memo 5,000.00k) Error by bank in entering 12.4.06 deposit; overstated by ( 10.00)l) Deposit of Mina Mfg. Co. erroneously credited to the companys

account ( 1,819.20) ___

P 70,722.11 P 70,452.11


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Unlocated difference ___ 270.00

Adjusted balance P 70,722.11 P 70,722.11

Requirement (b) Adjusting Journal Entries: December 31, 2006

1. Bank charges 3.85Cash in bank 3.85

2. Cash in bank 9,875.00

Interest expense 110.00Prepaid interest 548.00

Loan payable 10,533.00

3. Accounts receivable 417.50Cash in bank 417.50

4. Cash in bank 2,015.00

Bank charge 5.00Notes receivable 2,000.00Interest income 20.00

5. Cash in bank 270.00

Accounts receivable / Sales /Miscellaneous income 270.00

7-12. Asia Envelope Company

ASIA ENVELOPE COMPANYProof of Cash

For the month ended 5-31-06

Balance M A Y Balance

5-1-06 Receipts Disbursement 5-31-06P3,561.00 P42,700.17 P41,631.45 P4,629.72

Unadjusted book balanceAdd (Deduct) Adjustments

Bank service chargesApril 30 (6.00) (6.00)

May 31 6.80 (6.80)

NSF checks returnedApril 30 (815.00) (815.00)May 31 118.00 (118.00)

Draft collected by bankApril 1,500.00 (1,500.00)May 202.00 202.00

Check No. 6129 erroneouslyrecorded in the check register

Correct Amount P87Recorded as 78 9.00 (9.00)

Adjusted book balance P4,240.00 P41,402.17 P40,944.25 P4,697.92


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Substantive Tests of Inventories and Cost of Goods Sold 9-8Unadjusted bank balance P7,403.50 P41,776.27 P45,317.57 P3,862.20Add (Deduct) Adjustments

Deposit in transitApril 30 950.00 (950.00)

May 31 925.40 925.40Outstanding checks

April 30 (4,463.00) (4,463.00)May 31 149.68 (149.68)

Checks of Asia EngineCorp. erroneously chargedto company's account

April 349.50 (349.50)

May ________ _________ (60.00) 60.00Adjusted bank balance P4,240.00 P41,402.17 P40,944.25 P4,697.92

7-13. Tarlac Company

(1)Tarlac Company

Proof of Cash

For the month ended 12.31.06

Balance December Balance11.30.06 Receipts Disbursements 12.31.06

Balance per bank statement P 45,240 P100,000 P135,240 P10,000Add (Deduct) Reconciling items

Outstanding checksNovember 30 (10,000) (10,000)

December 31 4,000 (4,000)NSF checks returned in

December (245) 245Deposits in transit

November 30 2,500 (2,500)December 31 3,500 3,500

Bank chargesNovember 20 20

December (25) 25Check of another company

erroneously charged by bankin November, corrected in

December 260 (260) ___ __

Balance per books P 38,020 P100,740 P 128,990 P 9,770

(2)

Adjusting Journal Entries - 12.31.06

1. Accounts receivable 245Cash in bank 245

2. Bank charges 25

Cash in bank 25


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Substantive Tests of Inventories and Cost of Goods Sold 9-9(3)

Balance per books 12.31.06 P9,770Less: AJE (1) P245

(2) 25 270

Balance as adjusted P9,500

7-14. Genius Company

a. Post-dated checkreport as accounts receivable because it is not negotiable until the date on the check.

b. Report as an account receivable because it is not a negotiable instrument at this time. Debit Accounts Receivable,and credit Cash. If ultimately not collectible, write off as a bad debt.

c. Report as Note Receivable or as a short-term investment. It is inappropriate to report (or record) this as cash.

d. Include the P200 balance in petty cash in the balance reported as cash. Immediately replenish the fund for P168

and record it on December 31 as a debit to expenses (including the P1 cash short) and a credit to Cash.Alternatively, an adjustment may be made debiting expenses for P168 and crediting petty cash fund on December31, 2005.

e. Report the P30 of postage stamps as prepaid postage expensestamps are not cash.

f. Include the cashiers check in the balance because it will be accepted by banks for immediate deposit.

g. These checks should not be recorded as 2005 payments because the company still has full control of them.

h. The note and interest should not be included in the cash balance it has not been collected. The P20,000 should be

reported as a note receivable and interest of P450 (i.e., P20,000 x 9% x 3/12) should be accrued by a debit tointerest receivable and a credit to interest revenue for P450. However, if the bank reports that the note has beencollected on or before December 31 and a credit to the companys account has been made, this item may be

included in the cash balance.

7-15.Balance Sheet Classification

CashCash

EquivalentST

Investments OtherChecking account X

Savings account X

Rare coins kept for long-termspeculation X

Postdated checks received X

Money orders received X

Petty cash fund X

Treasury bills purchased when twomonths remain in term X

Compensating balance for a short-term loan X*

* shown separately

Balance Sheet Classification

CashCash

EquivalentST

Investments OtherSinking fund to retire a bond in five

years X

Certificate of deposit (six-monthterm) X

Short-term investment inmarketable equity securities X


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Substantive Tests of Inventories and Cost of Goods Sold 9-107-16. Cordial Company

Bank Reconciliation, 12.31.06Bank Books

Unadjusted balance P350,000 P293,500Add (Deduct) AdjustmentsDeposit in transit (P175,250 - P50,000) 125,250 (1)

Post dated customers check recordedon 12.31.06 ( 50,000)

Note collected by bank 15,000Outstanding checks

(P246,750 - P14,750 - P37,210) (194,790) (2)Check payable to a supplier released on

Jan. 5, 2007 14,750 (6)Check dated Jan. 4, 2007 recorded and

released in Dec., 2006 37,210 (6)

Erroneous bank credit correctedon Jan. 2, 2007 ____ (30,000) __

As corrected 250,460 310,460

Unlocated difference (shortage) ___ ____ (60,000) (4)

Balance as adjusted P250,460 P250,460 (3)

Suggested answer to the multiple choice questions:1. b 2. d 3. b 4. c 5. a 6. d

7-17. Pablo CorporationPABLO CORPORATION

Proof of Cash

July 31, 2006

Reconciliation6-30-06

JulyReceipts

JulyDisbursements


Bank cash balance

Deposit in transit:JulyJune

Undeposited cash

Outstanding checks:July: #1345

#1353#1354

June: #1082

#1086

#1087Adjusted balance

Book cash balanceNSF checkError

Note collected

InterestService chargeAdjusted balance

P13,031.78

146.73

(372.15)

(552.40)

(196.80)P12,057.16

P12,057.16

P12,057.16

P10,051.17

1,098.51(146.73)472.50

P11,475.45

P10,460.45

1,000.00

15.00

P11,475.45

P5,326.52

27.0013.2314.24

(372.15)

(552.40)

(196.80)P4,259.64

P4,102.69113.15

36.00

7.80P4,259.64

P17,756.43

1,098.51

472.50

(27.00)(13.23)(14.24)

P19,272.97

P18,414.92(113.15)

(36.00)1,000.00

15.00(7.80)

P19,272.97


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Substantive Tests of Inventories and Cost of Goods Sold 9-117-18. Jayce Corporation JAYCE CORPORATION

Proof of Cash

August 31, 2006


AugustReceipts

AugustDisbursements


Bank cash balanceDeposit in transit:

AugustJuly

Undeposited cash

Outstanding checks:August: #2265

#2269#2270

July: #2150#2151

#2152Adjusted balanceBook cash balance

NSF checkError in recording check

Note collected

InterestService chargeAdjusted balance

P 9,852.46

953.71

(345.26)(156.72)

(97.43)P10,206.76P10,206.76

P10,206.76

P16,755.64

1,235.32(953.71)421.68

P17,458.93P15,913.93

1,500.00

45.00

P17,458.93

P14,928.85

56.89341.72185.75

(345.26)(156.72)

(97.43)P14,913.80P14,813.95

96.75(9.00)

12.10P14,913.80

P11,679.25

1,235.32

421.68

(56.89)(341.72)(185.75)

P12,751.89P11,306.74

(96.75)9.00

1,500.00

45.00(12.10)

P12,751.89

7-19. Kir sten L im, In c.

1. April 1 Petty Cash .................................................................................................. 200

Cash ........................................................................................... 200

2. April 10 Cash Over and Short .................................................................................. 2Transportation-In ....................................................................................... 60Supplies Expense ....................................................................................... 25

Postage Expense . ....................................................................................... 33ReceivablesEmployees .......................................................................... 17Miscellaneous Expense ............................................................................. 36

Cash (P200P27) ..................................................................... 173

3. April 20 Petty Cash .................................................................................................. 100Cash ........................................................................................... 100

Assuming no disbursements were made from April 20 to April 30 and the cashier made up the shortage of P2, theanswer is P300 (b).

7-20. Francos AutoRepair Servi ce

Cash Over and Short ............................................................................................... 6.45Accounts ReceivableEmployees ......................................................................... 74.00

(P40.00 + P34.00)Neo Franco, Drawings* .......................................................................................... 170.00Repair Expense ....................................................................................................... 14.35Postage Expense (P20.00P2.90) ......................................................................... 17.10

Office Supplies ....................................................................................................... 2.90Cash (P300.00P15.20) ........................................................................ 284.80

* Note: This debit might also be made to the capital account.

Answer: P15.20 (not among the choices; Faculty may add choice (e) P15.20)


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7-21. Petty Cash, Bank Reconcil iati on

Balance per bank P6,522

Add:Cash on hand 246Deposit in transit 3,000 3,246

9,768

Deduct Checks outstanding (550)Adjusted bank balance P9,218

Balance per books P8,315

Add: Note collected 9309,245

Deduct Service Charge (27)

Adjusted cash balance, May 31 P9,218

P9,218 + P300 = P9,518 (a)

7-22. Powder I nc.

Powder, Inc.Bank Reconciliation

November 30, 2006

Balance per bank statement, November 30, 2006 P56,274.20Add:

Cash on hand, not deposited 1,915.4058,189.60

Deduct:Outstanding checks

#1224 P1,635.29#1230 2,468.30#1232 3,625.15#1233 482.17 8,210.91

Correct cash balance, Nov. 30 P49,978.69

Balance per books, November 30, 2006 P49,178.22 *Add:

Bond interest collected by bank 1,400.0050,578.22

Deduct:

Bank charges not recorded in books P 27.40Customers check returned NSF 572.13 599.53

Correct cash balance, Nov. 30 P49,978.69 (c)

*Computation of balance per books,November 30, 2006

Balance per books, October 31, 2006 P 41,847.85Add receipts for November 173,523.91

215,371.76Deduct disbursements for November 166,193.54Balance per books, November 30, 2006 P 49,178.22


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Substantive Tests of Inventories and Cost of Goods Sold 9-13CHAPTER 8 SUBSTANTIVE TESTS OF RECEIVABLES AND SALES

8-1. Tests of details of financial balances are designed to determine the reasonableness of the balances in sales, accountsreceivable, and other account balances which are affected by the sales and collection cycle. Such tests includeconfirmation 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 controlstructure 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 approvalof credit.

The results of the tests of transactions will be used to affect the procedures, sample size, timing and particular itemsselected 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 andnegative 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 negativeconfirmation is also a communication addressed to the debtor, but it requests a response only when the debtor disagreeswith the stated amount.

A positive confirmation is more reliable evidence because the auditor can perform follow-up procedures if a response isnot received from the debtor. With a negative confirmation, failure to reply must be regarded as a correct responseeven 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 importantcircumstances where positive confirmations should be used:1. There are a small number of large accounts which account for a significant portion of total accounts

receivable.

2. There are suspected conditions of dispute, inaccuracy, or irregularity. This would be the case when internalcontrols are considered inadequate or if prior years audit test results are unsatisfactory.3. 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 negativeconfirmations should not be used if the auditor confirmations are used, the auditor is using a reducedcontrol 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 thegeneral 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 accountswith 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 adequateand 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 decisionare the materiality of accounts receivable and the auditors experience in prior years. If the decision is made to confirmaccounts receivable prior to year end, it is necessary to test the transactions occurring between the confirmation date andthe balance sheet date by examining internal documents and performing analytical procedures at year end.


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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 somefraud cases, fictitious accounts receivable have been created to cover up a shortage. Eventually these fictitiousreceivables 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 andnotes receivable. In fact, the confirmation process is primarily intended to establish that the receivables are genuineand that the customers (or makers of notes) exist. Other audit procedures are followed to determine collectibility.

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. Acompany which discounts its notes receivable remains in a position of sustaining a loss if the makers of the notes fail tomake payment at the maturity dates.

8-6. (a) When customers fail to respond to positive confirmation requests the CPAs may not assume with confidence thatthese customers reviewed the requests and found no disagreement and therefore did not reply. Some busycustomers 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 inan effort to get a reply directly from the customer. When it becomes apparent that the confirmation program willnot 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 inthe circumstances. The CPAs should carry out the alternative audit procedures of examining customers purchaseorders or contracts, shipping documents and sales invoices of the client, and remittances by nonconfirmingcustomers 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 sourcesindependent 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 mustfollow up to determine the reliability of the oral evidence. Second, payment of an account receivable is notconfirmation; 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 orderor contract, and copies of the sales invoice and shipping document, in support of the unconfirmed receivable. Theyshould also determine the genuineness of the customer by reference to the telephone directory or to credit agencyreports.


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Substantive Tests of Inventories and Cost of Goods Sold 9-158-8. Montys Meat, Inc.

a. The workpaper does not include a description of the auditing procedures performed in confirming theaccounts. 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 toNovember cash receipts.

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 Cluborder 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 P11,100

Accounts receivable P11,100Inventory 8,600

Cost of goods sold 8,600To reverse 2007 sale recorded in 2006.

2) Allowance for uncollectible accounts 1,277Accounts receivable 1,277

To write off uncollectible account.3) Sales returns and allowances 3,634

Accounts receivable 3,634To record return of spoiled meat andrecognize loss in period in which incurred.Meat not restored to inventory, inasmuch

as it was spoiled.4) Sales 13,000

Accounts receivable 13,000To correct error in recording customer

remittance as a sale.

5) Sales Returns 334Accounts receivable 334

Inventory 250Cost of goods sold 250To record return and restore meat to inventory

because meat returned in good condition.


16/51


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

Exhibit 1.1

Montys Meat, Inc.Accounts Receivable - TradeAging AnalysisOctober 31, 2006

Conf. Past Due (Days)No. Customer Balance Current 1-30 31-60 Over 60

1060 Culleys Meats P 1,330 P 1,3301061 Jolly Roger Restaurant 466 P 4661064 ABC Grocery 4,256 3,000 1,256

(Other) 329,433 280,763 33,467 P12,324 P 2,879

1602 Rudys Deli 378 3781603 General Foods Grocers 13,468 13,000 4681607 Kims Fresh Meats 2,334 1,074 1,2601608 Dills Discount Grocery 12,469 12,4691612 Dianas Supper Club 866 334 532

10/31 Balance per ledger P365,000 P 311,970 P 36,449 P13,234 P 3,347Audit Adjustments P (29,345) P (28,068) P(1,277)

10/31 Audited balance P335,655 P 283,902 P 36,449 P13,234 P 2,070#

Cash receipts 11/111/27 P(210,113) P (13,353) P 0 P 0 &

11/27 Outstanding P 73,789 P 23,096 P13,234 P 2,070

Estimated percent uncollectible 10% 25% 70% 100%

10/31 Estimated uncollectibleP 24,487

P 7,379 P 5,774 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: Reviewed by:

Initial Date Initial Date


17/51


Exhibit 1.2

Montys Meat, Inc.Accounts Receivable - Trade

Allowance for Doubtful AccountsOctober 31, 2006

11/1/05 Balance per general ledger P28,000 #11/1 - 10/31 Monthly provision 24,000 &11/1 - 10/31 Write-offs (37,000) @

10/31/06 Balance per general ledger P15,000

AJE 2 (1,277)P13,723

AJE 6 P10,777

10/31/06 Audited balance P24,500 ^

AJE 6

Bad debts expense P10,777Allowance for doubtful accounts P10,777

To adjust allowance for doubtful accounts to amountconsidered 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: Reviewed by:

Initial Date Initial Date

8-9. 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 fordeposits in the mail and inventory in transit to the customer. Sometimes customers misunderstand theconfirmation 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 abreakdown of internal control.

(d) Potential errors in the sample not tested. The auditor must estimate the error in the untested population, based onthe results of the tests of the sample.


18/51


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, forpropriety and valuation of the sales.

(b) Review the cash receipts books for the period after December 31, 2005, and note any collections from thePDQ Company. The degree of internal control over cash receipts should be an important consideration indetermining the reliance that can be placed on the cash receipts entries. In addition, as there is no assurancethat 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 invoicespaid 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 isthe 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 ispreferable 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 afterDecember 31? Because the customers intent is unknown, this account should be reconfirmed and the customerasked to state the exact date. Upon receipt of the second confirmation, the information thereon should be traced to

the cash receipts book.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 anappropriate 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 canbe 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 fordoubtful 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 salesshould be reviewed and company officials queried to determine if other sales actual represent consignmentshipments; 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.


19/51

Substantive Tests of Inventories and Cost of Goods Sold 9-198-10. Ken Company

Requirement (a)Ken Company

Accounts Receivable Aging ScheduleMay 31, 2006

Age Category

Proportion

ofTotal

Amount

inCategory

Probability

ofNon-Collection

Estimated

UncollectibleAmount

Not yet due .680 P 816,000 .010 P 8,160

Less than 30 days past due .150 180,000 .035 6,300

30 to 60 days past due .080 96,000 .050 4,80061 to 120 days past due .050 60,000 .090 5,400121 to 180 days past due .025 30,000 .400 12,000Over 180 days past due .015 18,000 .900 16,200

1.000 P1,200,000 P52,860

Requirement (b)Ken Company

Analysis of Allowance for Doubtful AccountsMay 31, 2006

June 1, 2005 balance P 30,250Bad debt expense accrual (3,000,000 x .04) 120,000Balance before write-offs of bad accounts P150,250

Write-offs of bad accounts 108,750Balance before year-end adjustment P 41,500Estimated uncollectible amount 52,860

Additional allowance needed P 11,360

Debit Credit

Bad Debts Expense 11,360Allowance for Doubtful Accounts 11,360

Requirement (c)

1. Steps to Improve theAccounts Receivable Situation

2. Risks and CostsInvolved

Establish more selective credit-granting policies, suchas more restrictive credit requirements or morethorough credit rating investigation.

This policy could result in lost sales and increased costsof credit evaluation. Ken may be all but forced toadhere to the prevailing credit-granting policies of the

office equipment and supplies industry.

Establish a more rigorous collection policy eitherthrough external collection agencies or by Kens own

personal.

This policy may offend current customers and thus riskfuture sales. Increased collection costs could result

from this policy.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.


20/51

Substantive Tests of Inventories and Cost of Goods Sold 9-208-11. Demo I nc.

Requirement (a)

DEMO INC.Accounts Receivable

12-31-05

Balance A G I N G D I S T R I B U T I O N

Per General Per M o n t h s O u t s t a n d i n g

Ledger Subsidiary 0 - 1 1 - 3 3 - 6 over 6

Unadjusted Balances P197,000 P198,240 P93,240 P76,820 P22,180 P6,000Add (Deduct) Adjustments:AJE (2) to correct understatement of

accounts written off on October31.

(200)

(3) to write off definitely uncollectibleaccounts (1,000) (1,000) (1,000)

(4) to reclassify advances fromcustomers 2,000 2,000 2,000

(5) to reclassify accounts with creditbalances 500 500 500

(6) to adjust general ledger balanceto agree with subsidiary balance

1,440 _______ _______ _______ _______ ______

Balances as adjusted P199,740 P199,740 P95,240 P77,320 P22,180 P5,000

DEMO INC.

Allowance for Doubtful Accounts12-31-05

Balance per Ledger P12,000.00

Add (Deduct) Adjustments:AJE (1) to correct error in recording bad debts recovery 324.00

(2) to correct understatement of accounts written off ( 200.00)(3) to write off definitely uncollectible accounts ( 1,000.00)(4) to adjust allowance to required balance (Schedule 1) ( 6,359.80)

Balance as adjusted P 4,764.20Schedule 1: Computation of Required Allowance

Adjusted Required Allowance

Account Classification Total % Amount

0-1 month outstanding P 95,240 1 P 952.401-3 months outstanding 77,320 2 1,546.40

3-6 months outstanding 22,180 3 665.40over 6 months outstanding 5,000 P2,000-50% 1,000.00

_______ P3,000-20% 600.00Totals P199,740 P4,764.20


21/51

Substantive Tests of Inventories and Cost of Goods Sold 9-21Requirement (b) Adjusting Journal Entries 12-31-05

(1) Bad Debts 324.00Allowance for Doubtful Accounts 324.00

(2) Allowance for Doubtful Accounts 200.00Accounts Receivable 200.00

(3) Allowance for Doubtful Accounts 1,000.00Accounts Receivable 1,000.00

(4) Accounts Receivable 2,000.00Advances from Customers 2,000.00

(5) Accounts Receivable 500.00Customers accounts with credit balances 500.00

(6) Accounts Receivable 1,440.00Sales 1,440.00

(7) Allowance for Doubtful Accounts 6,359.80Bad Debts Expense 6,359.80

8-12. Tri poli Company

Requirement (1)

Accounts receivable, trade ....................................................... 40,000Advances to suppliers .............................................................. 450Due from officers ..................................................................... 2,500Subscriptions receivableshare capital ................................... 4,600

Expense advances to salespeople ............................................. 1,000Accounts payable, trade (P19,250P450)*..................... 19,250Advances from customers on sales contracts ................... 450

Salaries payable................................................................ 3,300Allowance for doubtful accounts ..................................... 500Receivables (to close permanently) .................................. 23,050Customers credit balances............................................... 2,000

Requirement (2)

Current assets:Accounts receivable, trade ............................................... 40,000

Less allowance for doubtful accounts .............................. 500 P39,500Creditors debitbalances .................................................. 450Due from officers** ......................................................... 2,500Subscriptions receivableordinary shares** .................. 4,600

Expense advances to salespeople ..................................... 1,000

Current liabilities:Accounts payable, trade ................................................... 19,250

Customers credit balances............................................... 2,000Cash advances from customers on sales

(not yet shipped)............................................................ 450Salaries payable................................................................ 3,300

* These amounts are netted against normal balances to reflect control balances; but if material in amount, theyshould be reported separatelyon the balance sheet as indicated in Requirement 2.

** Considered as current assets only if currently collectible. All items are assumed to be material in amount.


22/51


8-13. Pearl Corporation

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

28.5%#

2003 2004 2005 2006Actual bad debts P 3,300a P 5,700c P 7,800e P 16,800Credit Sales P90,000 P158,000 P210,000 P459,000

Outstanding receivables (year-end)P 9,500b P 19,900d P 29,500f P 58,900

Percentage of outstanding

receivables

0.347 0.286 0.264 0.285#

a P2,500 + P500 + P300 = P3,300b 0 + P90,000 - P78,000 - P2,500 = P9,500c

P4,600 + P700 + P400 = P5,700d P9,500 + P158,000 - P8,500 - P134,000 - P500 - P4,600 = P19,900e 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 debts in the previous 2 years. Therefore, the bad debts on2005 sales of P6,200 and P1,000 are about 92.2% of the total bad debts expected on 2005 sales.

f P19,900 + P210,000 - P200 - P14,200 - P178,800 - P300 - P700 - P6,200 = P29,500

2. Bad debts estimated as a percentage of year-end accounts receivableP29,500 + 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 orimpairment of receivables under PAS 39 should be applied.

8-14. F lores Corporation

Requirement (1)Flores Corporation

Analysis of Changes in theAllowance for Doubtful Accounts

For the Year Ended December 31, 2006

Balance at January 1, 2006 P130,000Provision for doubtful accounts (P9,000,000 x 2%) 180,000Recovery in 2006 of bad debts written off previously 15,000

P325,000

Deduct write-offs for (P90,000 + P60,000) 150,000Balance at December 31, 2006, before additional impairment loss P175,000Increase in estimated uncollectible accounts during 2006 (P235,300 - P175,000) 60,300

Balance at December 31, 2006, adjusted (Schedule 1) P235,300

Schedule 1:

Computation of Allowance for Doubtful Accountsat December 31, 2006

Aging category Balance Percent Doubtful accountsNovember-December 2006 P1,140,000 2 P 22,800July-October 600,000 10 60,000

January-June 400,000 25 100,000Prior to 1/1/06 70,000 a 75 52,500

P235,300aP130,000 - P60,000


23/51


Requirement (2)

Flores CorporationJournal Entry

December 31, 2006

Bad Debt Expense 60,300Allowance for Doubtful Accounts 60,300

To increase the allowance for doubtful accounts at December 31,2006, resulting from evaluation of collectibility of remainingreceivables.

8-15. Visayas Company

Requirement (a)Visayas Company

Accounts Receivable

12.31.06

Balance, 12.31.05 P 546,400Add: Sales on account for the year 2,622,832

Total P3,169,232Less: Collections during the year

- with discount (1) P2,050,859

- without discount (2) 848,118Accounts written off 18,700Credit memo for sales returns & allowances 37,000 2,954,677

Balance, 12.31.06 P 214,555

Total collections P2,857,960

Less: Accts paid w/ discount 2,009,842 ( 98% = P2,050,859) (1)Accts paid by customers w/o discount

P 848,118 (2)

Requirement (b)

AJE (1) Doubtful accounts expense 6,599

Allowance for doubtful accounts 6,599

Supporting Analysis:

% allowance to AR 12.31.05 P 16,392 = 3 %

P546,400Required % allowance to

AR 12.31.06 2/3 x 3% = 2 %

Required allowance 12.31.062% x P214,555 P4,291

Allowance for doubtful accounts balance, 12.31.05 P 16,392Less: Accounts written off 18,700

P( 2,308)

Required balance, 12.31.06 4,291

Estimated bad debts expense for 12.31.06 P 6,599


24/51


8-16. Charr y Company

Requirement (a) Adjusting Journal Entries

(1) Accounts Receivable 5,500Customers accounts with credit balances 5,500

(P500 + P5,000)

(2) Sales 5,000Accounts Receivable 5,000

(3) Subscriptions Receivable 15,000

Accounts Receivable 15,000

(4) Deposit on Contract 15,000


(5) Claims Receivable 500Accounts Receivable 500

(6) Advances to Employees 500Accounts Receivable 500

(7) Advances to Affiliated Company 10,000


(8) Advances to Supplier 5,000Accounts Receivable 5,000

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

Current Assets

Accounts Receivable - Trade P59,500Claims Receivable 500Advances to Employees 500Advances to Supplier 5,000

InvestmentsAdvances to Affiliated Company 10,000

Other AssetsDeposit on Contract 15,000

Shareholders EquitySubscribed Share Capital (net of subscriptions

receivable of P15,000) xxx


25/51

Substantive Tests of Inventories and Cost of Goods Sold 9-25Supporting Analysis:

Charry CompanyAccounts Receivable -Trade

12-31-06

Balance per ledger P105,000Add (Deduct) Adjustments:

AJE (1) To reclassify accounts with credit balances 5,500(2) To reverse entry for consignment deliveries ( 5,000)(3) To reclassify subscriptions receivable ( 15,000)(4) To reclassify deposit on contract ( 15,000)

(5) To reclassify balance of claims from carrier for shipping

damages ( 500)(6) To reclassify employees IOUs ( 500)(7) To reclassify advances to affiliate ( 10,000)

(8) To reclassify advances to supplier ( 5,000)

Net adjustments ( 45,500)


If correct entries were made for the transactions given, the Accounts Receivable account would show thefollowing postings:

Accounts Receivable

Jan. 1 Balance P 56,000 Collections P615,000Charge Sales 625,000 Write offs 3,500Recoveries of Merchandise returns 2,500

accounts written off 1,000 Allowance for shipping

________ damages 1,500

P682,000 P622,500________ Balance Dec. 31 59,500

P682,000 P682,000

8-17. 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 P105 million higher than actually reported in 2006. Ignoring differencesbetween 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 effectestimated 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 sufficientbalance exists in the allowance account), or any net balances in the balance sheet. Only the components of netaccounts receivable would be affected. Both gross accounts receivable and the allowance for doubtful accounts

would be overstated P0.6 million.


26/51


1998Beginning allowance balance P183Bad debt expense 105Ending allowance balance (212)Write-offs of accounts 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 allowancebalance/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 inexpected write-offs. Apparently the firm expects an increase in bad debts, which is partially an estimate of futurewrite-offs.

8-18. Rain Company

Requirement (1)

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

Requirement (2)

Correction and Collection Schedule:

Note Receivable

Date Explanation and Interest Revenue Change Balance1-1-2005 Recorded originally at face amount P150,00012-31-2005 Correction to restate to present value P 43,233 106,76712-31-2005 To accrue interest, P106,767 x 12% = P12,812 + 12,812 119,57912-31-2006 To accrue interest, P119,579 x 12% = P14,349 + 14,349 133,92812-31-2007 To accrue interest, P133,928 x 12% = P16,072* + 16,072 150,00012-31-2007 Collection on face amount, debit Cash 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.

3. b. Interest receivable is recorded for one month.

4. c. Maturity value .............................................................................. P100,000Discount P100,000 (0.10) (6/12) .................................................. (5,000)Proceeds ....................................................................................... P 95,000


27/51

Substantive Tests of Inventories and Cost of Goods Sold 9-278-20. Luce Company

(1) AJE: Sales returns and allowances 30,000Inventory 12.31.06 24,000

Accounts receivable 30,000Cost of sales 24,000

Income will decrease by P6,000 if the above AJE ismade.

Ans. (c)

(2) AJE: Sales 10,000Accounts receivable 10,000

Income was overstated by P10,000

Ans. (a)

(3) Actual number of units sold to Mr. Lazo was 320. P48,000P150

Ans. (b)

(4) Correct receivable fromMr. Lazo : 320 x P100 P 32,000Per client 48,000

Overstatement P 16,000

Ans. (d)

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

(6) Ans. (d)

8-21. ETC Co.

Adjusting Journal Entries

AJE 1. Cash 225,000Other Current Liabilities (UCPB Overdraft) 225,000

2. Accounts Receivable 37,500Cash 37,500

3. Cash 28,709Accounts Payable 28,709

4. Notes Payable 67,500Interest Expense 16,200

Cash 83,700

5. CashBPI 25,000Other Current Liabilities (UCPB Overdraft) 25,000

6. CashSBTC 73,690Accounts Receivable 73,690


28/51

Substantive Tests of Inventories and Cost of Goods Sold 9-28Cash

5.31.06

Per books P 15,825,000

AJE 1. 225,0002. (37,500)3. 28,7094. (83,700)

5. 25,0006. 73,690

Adjusted balance P16,056,199 (1) (c)

Accounts Receivable5.31.06

Subsidiary Ledger General Ledger

P8,047,054 P7,868,029AJE 2. 37,500 37,500

6. (73,690)

(375,215)

122,500

P7,831,839 P7,831,839 (2) (b)

Allowance for Doubtful Accounts

AgingDistribution Subsidiary Ledger %

mount Estimated

o be Uncollectible

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

Past due:130 P1,617,340.00 = 1,617,340.00 x 5 = 80,867.003160 P1,437,706.50 = 1,437,706.50 x 10 = 143,770.70

6190 P1,474,450.00 = 1,474,450.00 x 15 = 221,167.50Over 90 P1,779,867.50 + P37,500

___________ P375,215 = 1,442,152.50 x 20 = 288,430.50P8,047,054.00 P7,831,839.00 P771,439.50

8-22. 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 ofP500,000 to May 1, 2007, less current installment P 500,000[1]

8% note receivable from officer, due December 31, 2007, collaterizedby 10,000 shares of Ling, Inc., ordinary shares with a fair valueof P450,000 400,000

Non-interest-bearing note from sale of patent, net of 15% imputedinterest, due April 1, 2007 84,105 [2]

Installment contract receivable, due in annual installments of P50,000to July 1, 2009, less current installment 112,400 [3]

Total long-term receivables P1,096,505

(3) (a)


29/51


LING, INC.Selected Balance Sheet Balances

December 31, 2005

Current portion of long-term receivables:

Note receivable from sale of division P500,000 [1]

Installment contract receivable 27,600 [3]

Total P527,600

Accrued interest receivable:

Note receivable from sale of division P 60,000 [4]

Installment contract receivable 11,200 [5]

Total P 71,200

Requirement (3)

LING, INC.Interest Income from Long-Term Receivables

and Gains Recognized on Sale of AssetsFor the Year Ended December 31, 2005

Interest income:

Note receivable from sale of division P105,000 [6]

Note receivable from sale of patent 8,505 [2]

Note receivable from officer 32,000 [7]

Installment contract receivable from sale of land 11,200 [5]Total interest income for year ended 12/31/05 P156,705

Gains recognized on sale of assets:

Patent P 37,600 [8]

Land 50,000 [9]

Total gains recognized for year ended 12/31/05 P 87,600

Explanation of amounts:

[1] Long-term Portion of 9% Note Receivable at 12/31/05Face amount, 5/1/00 P1,500,000

Less: installment received 5/1/05 (500,000)Balance, 12/31/05 P1,000,000

Less: installment due 5/1/06 (500,000)Long-term portion, 12/31/05 P 500,000


30/51


[2] Non-interest-bearing Note, Net of Imputed Interest at 12/31/05Face amount, 4/1/05 P 100,000

Less: imputed interest[P100,000(P100,0000 x 0.756)] (24,400)

Balance, 4/1/05 P 75,600Add: 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 140,000Less: installment due 7/1/06

[P50,000(P140,000 x 16%)] (27,600)Long-term portion, 12/31/05 P 112,400

[4] Accrued InterestNote Receivable, Sale of Division, at 12/31/05Interest accrued from 5/1 to 12/31/05

(P1,000,000 x 9% x 8/12) P 60,000

[5] Accrued InterestInstallment Contract at 12/31/05Interest accrued from 7/1 to 12/31/05

(P140,000 x 16% x ) P 11,200

[6] Interest IncomeNote Receivable, Sale of Division, for 2005Interest earned from 1/1 to 5/1/05

(P1,500,000 x 9% x 4/12) P 45,000Interest earned from 5/1 to 12/31/05

(P1,000,000 x 9% x 8/12) 60,000Interest income P 105,000

[7] Interest IncomeNote Receivable, Officer, for 2005Interest earned 1/1 to 12/31/05 (P400,000 x 8%) P 32,000

[8] Gain Recognized on Sale of PatentStated selling price P 100,000Less: imputed interest (24,400) [2]

Actual selling price (P100,000 x 0.756) P 75,600

Less: cost of patent (net)

Carrying value 1/1/05 P40,000Less amortization 1/1 to 4/1/06(P8,000 x ) (2,000) (38,000)

Gain recognized P 37,600

[9] Gain Recognized on Sale of LandSale of price P 200,000Less: cost (150,000)

Gain recognized P 50,000


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Substantive Tests of Inventories and Cost of Goods Sold 9-318-23. Grande Company

Requirement 1

PAS 39, paragraph 63 will be applied in this case. On December 31, 2006, Grande Company should record the 2006accrued interest and the impairment:

Notes / Interest Receivable (0.06) (100,000) 6,000Interest Income 6,000

Bad Debts Expense 55,537 *Allowance for decline in note value 55,537

* Carrying value of note and interest (100,000 + 6,000) P106,000

Present value / New carrying value ofnote (discount rate6%)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 50,463Impairment write-down P 55,537

Requirement 2

The entries with the corresponding computations follow:

Effective Interest Method

December 31, 2007

Allowance for decline in note value 3,028

Interest income (0.06) (50,463) 3,028

December 31, 2008Allowance for decline in note value 3,209

Interest income

(0.06) (50,463 + 3,028) 3,209

Cash 30,000

Notes receivable 30,000

December 31, 2009


Interest income

(0.06) (50,463 + 3,208 + 3,20930,000) 1,602


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December 31, 2010

Allowance for decline in note value 1,698*

Interest income 1,698

* 0.06 (26,700 + 1,602)

Cash 30,000




To close remaining balance in

notes receivable and allowance

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

Notes Receivable Allowance for Decline in Note Value

100,000 30,000 3,028 55,5376,000 30,000 3,209

106,000 60,000 1,60246,000 bal 1,698

9,537 55,53746,000

8-24. Amy Corporation

Requirement 1

Accounts Receivable (Trade) 15,500Accounts Receivable (Officer) 3,600Ordinary Shares Subscriptions Receivable 12,000Advances to Employees 1,800

Notes Receivable (Trade) 6,000Deposit to Guarantee Contract Performance 5,000Utility Deposit 500

Receivables 44,400

Requirement 2

Accounts receivable (trade)--current asset, trade receivableAccounts receivable (officer)--normally current nontrade receivable

Ordinary shares subscription receivable--current or noncurrent asset, depending on duedate; nontrade receivable

Advances to employees--current asset, nontrade receivableNotes receivable (trade)--noncurrent asset, trade receivable

Deposit to guarantee contract performance--separately classify, could be current ornoncurrent asset, depending on the length of the contract; nontrade receivable

Utility deposit--separately classify, probably noncurrent nontrade receivable

*


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Substantive Tests of Inventories and Cost of Goods Sold 9-338-25. Janes Department Store

Requirement 1

Age Balance

Estimated

PercentageUncollectible

Estimated

AmountUncollectible

Under 30 days P193,000 0.008 P 1,54430- 60 days 114,000 0.020 2,280

61-120 days 73,000 0.050 3,650121-240 days 41,000 0.200 8,200241-360 days 25,000 0.350 8,750Over 360 days 19,000 0.600 11,400

P465,000 P35,824

Requirement 2

a. Bad Debt Expense 35,824

Allowance for Doubtful Accounts 35,824

b. Bad Debt Expense (P35,824 + P3,000) 38,824Allowance for Doubtful Accounts 38,824

c. Bad Debt Expense (P35,824P2,800) 33,024

Allowance for Doubtful Accounts 33,024

8-26. Blue Corporation

Requirement 1

2005

Dec. 1 Cash [(P175,000 x 0.80)P1,400] 138,600Assignment Service Charge Expense

(P175,000 x 0.80 x 0.01) 1,400Notes Payable (P175,000 x 0.80) 140,000

Dec. 1 Accounts Receivable Assigned 175,000


11 Sales Returns and Allowances 1,000Accounts Receivable Assigned 1,000

31 Cash 86,000Accounts Receivable Assigned 86,000

31 Notes Payable 86,000Interest Expense (P140,000

x 0.12 x 1/12) 1,400Cash 87,400

2006

Jan. 29 Cash 60,000

Accounts Receivable Assigned 60,000

29 Notes Payable (P140,000 P86,000) 54,000Interest Expense (P54,000

x 0.12 x 1/12) 540

Cash 54,540


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29 Accounts Receivable 28,000Accounts Receivable Assigned

(P175,000 P1,000 P86,000 P60,000) 28,000

Requirement 2

On the December 31, 2005 balance sheet of the Blue Corporation, the assigned accounts receivable and theremaining liability would be reported as follows:Current Assets:

Accounts receivable assigned P88,000

Current Liabilities:Note payable P54,000

8-27. Tandy Shoes

Sept. 15 Accounts Receivable 1,995Credit Card Expense (P2,100 x 0.05) 105

Sales 2,100

21 Sales Returns and Allowances 200Accounts Receivable 190Credit Card Expense (P200 x 0.05) 10

29 Cash 1,805Accounts Receivable 1,805

8-28. Gabe Company

GABE COMPANY

Income Statement EffectFor the Year Ended December 31, 2005

Expenses resulting from accounts receivable assigned(Schedule 1) P15,100

Expenses resulting from accounts receivable sold

(P300,000 P260,000) 40,000Total expenses P55,100

Schedule 1: Computation of Expenses for Accounts Receivable Assigned

Assignment expense:Accounts receivable assigned P200,000

x 85%Advance by Belle P170,000

x 3%P 5,100

Interest expense 10,000Total expenses P 15,100


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Substantive Tests of Inventories and Cost of Goods Sold 9-35CHAPTER 9 SUBSTANTIVE TESTS OF INVENTORIES AND COST OF GOODS SOLD

9-1. Substantiation of the figure for inventories is an especially challenging task because of the variety of acceptablemethods of valuation. In addition, the variety of materials found in inventories calls for considerable experience andskill to do an efficient job of identifying and test-counting goods on hand. The possibilities of obsolescence and ofexcessive stocks also create problems. Finally, the relatively large size of inventories and their significance in the

determination of net income make purposeful misstatement by the client a possibility which the auditors must guardagainst.

9-2. During an audit of a manufacturing company, the auditors review the cost system for the following purposes:

(1) To determine that costs are properly allocated to current and future periods and hence that cost figures used inarriving at balance sheet and income statement amounts are supported by internal records.

(2) To obtain assurance that the cost system, as an integral part of the system of internal control, provides properaccounting control over costs incurred and related inventories.

(3) To ascertain, as a service to management, that the cost system is economical and effectively provides informationfor reducing or controlling costs and for determining the cost and profitability of products, and other related datanecessary for informed managerial decisions.

9-3. The auditors make test counts of inventory quantities during their observation of the taking of the physical inventory to

ascertain that an accurate count is being made by the individuals taking the inventory. The extent of test counting willbe determined by the inventory-taking procedures; for example, the number of the auditors test counts would bereduced if there were two teams, one verifying the other, taking the inventory. On the other hand, the auditors testcounts would be expended if they found errors in the inventory counts.

9-4. The statement is not true. The auditors responsibilities with respect to inventories include not only quantities andpricing, but also the quality or condition of the goods, the accuracy of extensions, footing, and summaries, and the

evaluation of internal control. Weakness in internal control may cause large losses from excessive stockpiling,obsolescence, inaccurate cost data, and many other sources, even though the ending inventory is properly counted and

priced.

9-5. The independent auditors utilize the clients backlog of unfilled sales orders in the determination of net realizable valueof finished goods and goods-in-process, and in the determination of losses, if any, on firm sales commitments for whichno production has yet been undertaken.

9-6. Beed Company

Since Beed Company obtained all of its merchandise inventory from the president of the company in a related-partytransaction, the auditors must determine the cost of the merchandise to the president in his operation of a similar

business as a single proprietor. In this related-party transaction, the auditors must look beyond form--a total cost ofP100,000 for the original stock of merchandise--to substance. Substantively, the merchandise of Beed Companyshould be priced, on a specific identification basis if feasible, at its cost from the suppliers of the sole proprietorship.Any difference between cost as thus determined and amounts charged by the president to Beed Company representsunamortized discount on the notes payable. The entire transaction should be fully disclosed in a note to the financial

statements of Beed Company.


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9-7. Jay Company

The following procedures should be undertaken:

(a) The oral evidence that the motors are on consignment should be substantiated by a review of the clients recordsof consigned inventory, examination of contracts and correspondence with consignors, and confirmation ofconsigned stocks by direct communication with consignors.

(b) The location of the machine in the receiving department, together with the presence of the REWORK tag,

suggests that the machine had been shipped to a customer but rejected and returned by the customer. Theauditors should examine the receiving report for the machine, the accounts receivable confirmation from thecustomer, and records of the clients quality control department, to ascertain who has title to the machine. If thecustomer has title, the machine should not be included in inventory, and a liability for rework costs should be

established. If the client has title, the customers account should be credited for the sales return and the machineshould be included in the clients inventory at estimated realizable value.

(c) The Material Inspection and Receiving Report signed by the Navy Source Inspector, is evidence that title to the

machine passed to the Phil. Naval Base on November 30, 2006. Accordingly, the auditors should ascertain thatthe sales value of the machine is included in accounts receivable, and that the cost of the machine is not in the

perpetual inventory or the physical inventory.

(d) The location of the storeroom and the dusty condition of the goods suggest that the items may be obsolete, or atleast slow moving. The auditors should inspect perpetual inventory records for usage of the materials, and

should inquire of production personnel whether the materials are currently useful in production. The materialsmay have to be valued at scrap value.

9-8. Pancho Manufactur ing Corporation

(a) Consignment out.1. Obtain from the client a complete list of all consignees together with copies of the consignment contracts.2. Evaluate the consignment contract provisions relative to the following areas:

(a) Payment of freight and other handling charges.

(b) Extension of credit.(c) Rates and computation of commissions to consignees.(d) Frequency and contents of reports and remittances received from consignees.

3. Discuss with the client any variations found in the contracts which do not seem justified by the

circumstances.4. Following review of the consignment contracts, communicate directly with the consignees to obtain complete

information in writing on merchandise remaining unsold, receivables resulting from sales, unremittedproceeds, and accrued expenses and commissions, which should be reconciled with the clients records for

the period covered by the engagement.5. Determine that merchandise on consignment with consignees is valued on the same basis as merchandise on

hand, and included as part of the inventory. Ascertain that any arbitrary mark-ons are deducted and thatshipping and related charges for the transfer of merchandise to the consignees are reflected as part of the

inventory.6. Ascertain that quantities of goods in hands of consignees at the close of the period under audit appear in the

balance sheet and are separately designated as Merchandise on Consignment.

(b) Finished merchandise in public warehouse pledged as collateral for outstanding debt.

1. Determine that goods pledged to obtain funds are covered by warehouse receipts. (The examination ofwarehouse receipts alone is not a sufficient verification of goods stored in public warehouses.)

2. Request direct confirmation from the warehouses in which the merchandise is held.

3. If available, obtain independent accountants reports on a warehouses internal controls over custody of stored goods. 4. Review the clients procedures for acceptance and evaluation of the performance of warehouses, and review

supporting documents.5. Review the loan agreements collateralized by warehouse receipts. These agreements usually provide for

certain payments to be made by the borrower as pledged goods are sold.6. Consider observing a physical inventory of goods stored at the public warehouses.


37/51


9-9. a. (2) b. (3) c. (2) d. (2) e. (4) f. (2)

9-10. a. Principal problems the auditor will face are related by:

1. Verification of existence of the inventory owned by the company as against inventory belonging to thecustomers.

2. Proper valuation since the perpetual inventory records reflect quantities only.

b. Steps that should be undertaken to enable the auditor to render an unqualified opinion:

1. Verify postings to the perpetual ledger at the plant office for both stock owned and stock being held forcustomers against original cost sheet to determine amounts debited and credited to the account.

2. Require that an annual physical inventory taking be done by the client and arrangements for the presence and

observation of the auditor be done.

3. Confirm with customers unclaimed merchandise still in the possession of the client as of the balance sheetdate.

9-11. 1. Existence or occurrence2. Existence or occurrence

3. Valuation or allocation4. Completeness

5. Completeness6. Valuation or allocation7. Completeness8. Completeness9. Existence or occurrence and completeness

10. Completeness

9-12. a. When the inventory is a material item in the financial statements that the auditor is examining, observation of thetaking of the physical inventory is in compliance with the auditing standard pertaining to field work that requires

obtaining sufficient competent evidential matter to afford a reasonable basis for an opinion regarding the financialstatements. Observation is a generally accepting auditing procedure applied in the examination of the physicalinventory.

By observing the taking of the physical inventory, the CPA is seeking to satisfy himself or herself as to theeffectiveness of the methods of inventory taking and the measure of reliance that can be placed on the clientinventory records and their representations as to inventory quantities. The CPA must ascertain that the physicalinventory actually exists, that the inventory quantities are being determined by reasonably accurate methods, and

that the inventory is in a salable or usable condition.

b. The CPA makes test counts of inventory quantities during observation of the taking of the physical inventory tobecome satisfied that an accurate count is being made by the individuals taking the inventory. The extent of test

counting will be determined by the inventory-taking procedures. For example, the number of test counts would bereduced if there were two teams taking the inventory, one checking the other. On the other hand, the CPAs testcount would be expanded if errors were found in the inventory counts.

Some test counts are recorded by the CPA for the purpose of subsequent comparison with the clients compilation

of the inventory. The comparison procedure goes beyond the mere determination that quantities have beenaccurately transcribed. In addition, the CPA seeks assurance that the description and condition of the inventoryitems are accurate for pricing purposes and that the quantity information, such as dozen, gross, and cartons, is

proper.


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Substantive Tests of Inventories and Cost of Goods Sold 9-38c. 1. The CPA does not regard the inventory certificate of an outside service company as a satisfactory substitute for his

or her own audit of the inventory. The service company has merely assumed the clients function of taking

the physical inventory, pricing it, and making the necessary extensions. To the extent that the servicecompany is competent, internal control with regard to the inventory has been strengthened. Nevertheless, as

under other strong systems of internal control, the CPA would investigate the system to become satisfied thatit is operating in a satisfactory manner. The CPAs investigation would necessarily entail an observation ofthe taking of the inventory and testing the pricing and calculation of the inventory.

2. The inventory certificate of the outside specialists would have no effect on the CPAs rep ort. The CPA must besatisfied that the inventory is fairly stated by observing the taking of the inventory and by testing the pricingand calculation of the inventory.

However, if the taking of the inventory was not observed and no audit tests were applied to the computation

of the inventory, the CPA would be compelled to disclaim an opinion on the financial statements as a wholeif the amount of the inventory is material.

If it has been impracticable or impossible for the CPA to observe the taking of the physical inventory but he

or she has been satisfied by the application of other auditing procedures, the CPA would make no referenceto the matter in the report.

3. The CPA would make no reference to the certificate of the outside specialists in the report. The outside specialistsare serving as adjuncts of the companys staff of permanent employees and, as such, are in somewhat thesame position as temporary employees. The outside specialists are not independent in that they are notimbued with third-party interests. The CPA is compelled, under certain circumstances, to mention in thereport the reports of other independent auditors, but this compulsion does not extend to the certificate of

outside specialists who are not independent auditors.

9-13. a. For a client to dispose of the chemical compound in a manner that meets legal requirements is admirable.However, ethical behavior frequently calls for individual persons and companies to exhibit behavior that exceeds

the minimum standards set by law. Due to the harm to cattle and the pollution that has resulted. Remote isinvolved in a matter that entails ethical issues.

b. Most auditors are hesitant to serve as judge and jury for clients on ethical matters. For example, declining to serve

this client probably would not cause any alteration of its behavior. Further, serving the client does not facilitateany unethical behavior. Further, serving the client does not facilitate any unethical behavior. Hence, an auditormight choose to discuss the matter with the board and encourage them to act as responsible citizens.

9-14. JC

Requirement (1)

Inventory, as given ................................................................... P271,500

Deduct (adjustments to cost):

50% markup in (a) [P250,000(P250,000 1.5)] .......... P83,333

60% markup in (b) (P10,000 x 0.60) ................................ 6,000Exclusion of (c) ................................................................ 4,000Incorrect amount used in (e) (P2,500P1,000) ............... 1,500 94,833

P176,667Add:

Freight on goods in transit in (d) ...................................... 800Corrected ending inventory .............................................. P177,467


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Income Statementa. Ending inventory overstated (P250,000P177,467) ...................... P72,533

b. Cost of goods sold understated ........................................................ 72,533c. Gross margin overstated .................................................................. 72,533d. Pretax income overstated ................................................................. 72,533e. Income taxes overstated (P72,533 x 0.40) ....................................... 29,013

f. Net income overstated (P72,533P29,013) ................................... 43,520

Balance Sheet:Current assets, inventory overstated ...................................................... 72,533

Current liabilities, income taxes payable overstated .............................. 29,013

Retained earnings overstated ................................................................. 43,520

Requirement (3)

Retained earnings (prior period adjustment) ............................ 43,520Income taxes payable ...............................................................

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