Chapter 7

Audit of Liabilities
AUDIT PROGRAM FOR ACCOUNTS PAYABLE

Audit Objectives:
To determine that:

1. Accounts payable represent amounts currently payable to

trade creditors for purchases of goods and services as the
end of the reporting period.
2. Accounts payable have been properly recorded.
3. Accounts payable are properly described and classified and
adequate disclosures have been made.

Audit procedures:
1. Obtain a list of accounts payable from the subsidiary
ledger, and:
 Check its footing.
 Check if the list reconciles with the general
ledger control account.
 Trace individual balances to the subsidiary
ledger.
 Test accuracy of balances in the subsidiary
ledger.
 Adjust non-trade accounts erroneously included in
supplier’s accounts.
 Investigate and reclassify significant debit
balances.

2. Confirm accuracy of individual balances appearing in the

subsidiary ledger by requesting statements of accounts from
suppliers, and:
 Reconcile supplier’s statements of accounts with
client records and investigate discrepancy.
 If supplier’s do not respond with the requests,
perform extended procedures, like:
 Reviewing payments after year-end.
 Checking supporting documents.
 Discussing the account with appropriate officer.
 3. Review correspondence with supplier’s for possible
adjustments.
4. Test propriety of cutoff:
 Examine purchases recorded and supplier’s deliveries
made a week before and after the end of the
reporting period and ascertain whether the purchases
were recorded in the proper period.
 Investigate large amounts of purchases returned
shortly after the end of the reporting period.

5. Ascertain whether some payables are secured with asset

pledges.
6. Compare payments after the reporting dates with year-end
schedule of accounts payable.
7. Review propriety of financial statement presentation and
adequacy of disclosures.
8. Perform analytical review procedures.
9. Obtain accounts payable representation letter.

AUDIT PROGRAM FOR NONCURRRENT LIABILITIES

Audit Objectives:
To determine:

1. Authorization of liabilities incurred.

2. Validity of recorded liabilities.
3. Recognition and recording of significant liabilities.
4. Compliance with terms, restrictions, conditions, and other
requirements of debt agreements.
5. Assets pledged or mortgaged and other guarantees related to
noncurrent liabilities incurred.
6. Accuracy of interest and other charges related to noncurrent
liabilities.
7. Propriety of financial statement presentation and adequacy
of disclosures.

Audit Procedures:
1. Obtain or prepare schedule/s of noncurrent liabilities,
indicating:

As to general nature:

 Description or nature of the noncurrent liabilities.

  Creditor/s
 Original principal amount
 Interest rate
 Collateral and/ or guarantees
 Terms, restrictions, conditions, and requirements
imposed by the creditors

As to principal amount outstanding:

 Beginning-of-the-year balance
 Additions during the year
 Payments during the year
 Balance at the year-end

As to interest:

 Accrued or prepaid at the beginning of the year

 Amount incurred during the year
 Payments during the year
 Accrued or prepaid at the year-end

2. Foot and cross-foot the schedule.

3. Verify accuracy of the schedule.

As to general nature:
 Obtain copies or excerpts of dent instruments and
trace data to the schedule.

As to principal amount outstanding:

 Trace beginning balances to last year’s working

papers, or in an initial audit, establish accuracy of
beginning balances by:
 Reference to debt instruments and prior year’s
recordings.
 Tracing to beginning ledger balances
 Trace proceeds to cash receipts records for new
liabilities incurred in the current year.
 Trace payments to cash disbursements records and
canceled checks.
 Vouch to supporting documents the renewals in the
current year.
 Agree working paper ending balances with the general
ledger accounts.
 As to interest:

 Trace beginning balances to last year’s working

papers, or in an initial audit:
 Establish accuracy by an independent computation
based on debt instruments.
 Trace to beginning ledger balances.
 Recompute the interest:
 Incurred
 Accrued
 Prepaid
 Trace payments to cash records and canceled checks.

4. Verify authorization by reference to minutes of the board of

directors’ meetings.
5. Confirm directly with the creditors or trustees the
following:
 Principal amount still outstanding
 Interest rates
 Interest incurred
 Collateral and/or guarantees

6. Determine client’s compliance with loan agreements.

7. Account for the used and unused debt instruments like bond
certificates and promissory notes.
8. Ascertain proper cancelation of paid r retired debt
instruments.
9. Recompute the accuracy of any discount or premium
amortization.
10. Reconcile interest payments with recorded liabilities.
11. Verify propriety of financial statement presentation
and adequacy of disclosures.

PROBLEM 7-1

Current Liabilities

The data below are from the records of ALMANOR, INC. on December
31,2010:

Accounts payable P 680,000

Cash balance, ABC bank 1,240,000

Cash overdraft with XYZ bank 80,000

Customer’s accounts with credit balances 25,000

Dividends in arrears on preference shares 400,000

Employee’s income tax payable 100,000

Estimated warranty payable 50,000

Estimated premium claims outstanding 90,000

Income tax payable 400,000

Notes payable(issued in 2010 maturing in 20 semi-

Annual installments beginning on April 1,2011) 4,000,000

Salaries payable 400,000

The amount to be shown as total current liabilities on Almanor’s

statement of financial position at December 31,2010, is

A. P2,225,000 C. P2,625,000
B. P2,025,000 D. P2,145,000

SOLUTION 7-1
Cash overdraft(XYZ Bank) P 80,000

Notes payable due in 2011(P4 million/20*2) 400,000

Accounts payable 680,000

Salaries payable 400,000

Employee’s income tax payable 100,000

Income tax payable 400,000

Estimated warranty payable 50,000

Estimated premium claims outstanding 90,000

Customer’s accounts with credit balances 25,000

Total current liabilities P2,225,000

Answer: A

PROBLEM 7-2
Recording Purchases: Gross Method to New Method

SAIMAA CORP. records its purchases at gross amounts but wishes to

change to recording purchases net of purchase discounts.
Discounts on purchases records from January 1,2010 to December
31,2010, totaled P80,000. Of this amount, P8,000 is still
available in the accounts payable balance. The balances in
Saimaa’s accounts as of and for the year-ended December 31,2010,
before conversion are:

Purchases P 4,000,000

Purchase Discounts 32,000

Accounts payable 1,200,000

1. The amount of purchase discounts lost to be recognized is

A. P8,000 C.P32,000
B. P0 D.P40,000

2. The accounts payable balance should be reduced by

A.P8,000 C.P32,000
B.P80,000 D.P40,000

3. The purchases account should be reduce by

A.P32,000 C.P40,000
B.P80,000 D.P8,000

4. The entry to record the conversion is

A. Accounts payable 80,000
 Purchases 80,000
B. Purchases discounts lost 32,000 32,000
C. Purchase discounts lost 40,000
Purchases discounts 32,000
Accounts payable 8,000
Purchases 80,000
D. Purchase discounts lost 32,000
Accounts payable 8,000
Purchases 40,000

SOLUTION 7-2
1. Discounts on 2010 purchases P80,000
Less: Discounts taken 32,000
Discounts still available
Accounts payable balance 8,000 40,000
Purchase discounts lost P40,000
Answer: D

2. The accounts payable should be reported net of discounts

still available at the end of the reporting period which
amounts to P8,000.
Answer: A

3. Under the net method, purchases are reported net of

discount, regardless of whether the discounts are taken or
not. Hence, the purchases account should be reduced by
P80,000.
Answer: B

4. The entry to record the conversion is:

Purchase discounts lost 40,000
Purchase discounts 32,000
Accounts payable 8,000
Purchases 80,000
Answer: C

PROBLEM 7-3
Accrued Expenses
ANGLIN CORPORATION must determine the December 31,2010, year-end
accruals for advertising and rent expenses. A P50,000 advertising
bill was received January 10,2011, comprising costs of P37,000
for advertisements in December 2010 issues, and P12,500 for
advertisements in January 2011 issues of the newspaper.

A store lease, effective December 16,2009, calls for fixed rent

of P120,000 per month from the effective date and monthly
thereafter. In addition, rent equal to 5% of net sales over
P6,000,000 per calendar year is payable on January 31 of the
following year. Net sales for 2010 were P7,500,000.

What is the total accrued liabilities that should be reported by

Anglin Corporation on its statement of financial position as at
December 31,2010?

A. P185,000 C. P97,500
B. P172,500 D. P110,000

SOLUTION 7-3
Advertising P 37,500

Fixed rent, Dec. 16-31(P120,000x1/2) 60,000

Variable rent

(P7,500,000-P6,000,000= P1,500,000x5%) 75,000

Total P172,500

Answer: B

PROBLEM 7-4
Bonus Computation

Ana Rosa, president of the APOPKA COMPANY, has a bonus

arrangement with the company under which she receives 10% of the
net income(after deducting taxes and bonuses) each year. For the
current year, the net income before deducting either the
provision for income taxes or the bonus is P4,650,000. The bonus
is deductible for tax purposes, and the tax rate is 30%.

1. Determine the amount of Ana Rosa’s bonus.

2. Compute the appropriate provision for income tax for the
year.
3. Prepare the entry to record the bonus(which will be paid in
the following year).

SOLUTION 7-4
1. (B-Bonus; T=Tax)
B = 10% (4,650,000-B-T)
T = 30% (4,650,000-B)
T = 1,395,000-.30B)
B = 10& (4,650,000-B-[1,395,000-.30B])
B = 10% (4,650,000)-B-1,395,000+.30B)
B = 465,000-.1B-139,000+.03B
B = 325,000-.07B
1.07B = 325,000
B = 325,000/1.07
B = P304,206

2. T = 30% (P4,650,000-B)
T = 30% (P4,650,000-P304,206)
T = 30%x P4,345,794
T = P1,303,738

3. Bonus expense 304,206

Bonus payable 304,206

PROBLEM 7-5
Premiums

PUKAKI COMPANY sold 700,000 boxes of “puto mix” under anew sales
promotional program. Each box contains one coupon, which if
submitted with P40, entitles the customer to a kitchen knife.
Pukaki pays P60 per knife and P5 for handling and shipping.
Pukaki estimates that 70% of the coupons will be redeemed, even
though only 250,000 coupons had been processed during 2010.
How much should Pukaki report as liability for unredeemed coupons
at December 31,2010?

A. P6,000,000 C. P15,600,000
B. P9,600,000 D. P12,250,000

SOLUTION 7-5
Boxes of “puto mix” sold 700,000

Redemption rate 70%

Total coupons redeemable 490,000

Coupons to be redeemed(490,000-250,000) 240,000

Net cost per kitchen knife(P65-P40) x25

Liability for unredeemed coupons P6,000,000

Answer: A

PROBLEM 7-6
Premiums

In package of its products, PLACID< INC> includes coupons that

n]may be presented at retail stores to obtain discounts on other
placid products. Retailers are reimbursed for the face amount of
coupons redeemed plus 10% of that amount for handling costs.
Placid honors requests for coupon redemption by retailers up to 3
months after the consumer expiration date. Placid estimates that
60% of all coupons issued will ultimately be redeemed.
Information relating to coupons issued by Placid during 2010 is
as follows:

Consumer expiration date

Dec.31,2010

Total payments to retailers as of Dec.31,2010

P165,000
Liability for unredeemed coupons as of Dec.31,2010
P99,000

What is the total face amount of coupons issued by Placid, Inc.

in 2010?

A. P440,000 C. P600,000
B. P400,000 D. P264,000

SOLUTION 7-6
Liability for unredeemed coupons, Dec.31,2010 P99,000

Add: Total payments to retailers 165,000

Total cost 264,000

Less: Handling charges(P264,000-[P264,000/110%]) 24,000

To be redeemed 240,000

Divide by redemption rate /60%

Total face amount of coupons issued P400,000

Answer: B

PROBLEMS 7-7
Liability for Returnable Containers

OMEGA COMPANY sells its products in expensive, reusable

containers. The customer is charged a deposit for each container
delivered and receives a refund for each container returned
within two years after the year of delivery. Omega accounts for
the containers not returned within the time limit as being sold
at the deposit amount. Information for 2010 is as follows:

Containers held by customers at

December 31,2009,
From deliveries in: 2008 85,000

2009 240,000 325,000

Containers delivered in 2010 430,000

Containers returned in 2010

From deliveries in: 2008 57,000

2009 140,000

2010 157,000 354,500

1. How much revenue from container sales should be recognized

for 2010?
A. P127,500 C. P27,500
B. P267,500 D. P85,000

2. What is the total amount of Omega Company’s liability for

returnable containers ate December 31,2010?
A. P373,000 C. P267,500
B. P400,500 D. P430,000

SOLUTION 7-7
1. Containers held by customer’s at Dec.31.2009,
from deliveries in 2008 P85,500
Less: Containers returned in 2010
from deliveries in 2008 57,500
Revenue from container sales P27,500
Answer: C

2. Liability for returnable containers, Dec.31,2009 P325,000

Add: Deliveries in 2010 430,000
Total 755,000
Less: 2010 container returns P354,500
2010 container sales(see no.1) 27,500 382,000
Liability for returnable containers,
Dec. 31,2010 P373,000
Answer: A

PROBLEM 7-8
Various Transactions Involving Current Liabilities

Described below are curtained transactions of ASHBY COMPANY.

Feb. 2 The company purchased goods from Happy Corp. for P150,00
subject to cash discount terms of 2/10 , n/30. The
company record purchases and accounts payable at net
amounts after cash discounts. The invoice was paid on
February 25.

Apr. 1 The company purchased a truck for P120,000 from Broom

Motors Corp., paying P12,000 in cash and signing a one-
year, 12% note for the balance of the purchased price.

May 1 The company borrowed P240,000 from Manila bank by

signing a P276,000 noninterest bearing note due one-year
from May 1.

Aug. 1 The company’s board of director’s declared a P900,000

cash dividend that was payable on September 10
shareholders of record on August31.

1. Prepare all the journal entries necessary to record the

transactionsdescribed above.

2. Assume that Ashby Company’s financial year ends on December

31 and that no adjusting entries relative to the
transactions above have been recorded. Prepare any adjusting
journal entries concerning interest that are necessary to
present fair financial statements at December 31.

SOLUTION 7-8
1. Journal Entries

Feb. 2 Purchases 147,000

Accounts payable 147,000
(P150,000x98%)
Feb. 25 Accounts payable 147,000
Purchase discounts lost
 (P150,000x2%) 3,000
Cash 150,000
April 1 Trucks 12,000
Cash 12,000
Notes payable 108,000
May 1 Cash 240,000
Discount on notes payable 36,000
Note payable 276,000
Aug. 1 Retained earrings 900,000
Dividends payable 900,000

2. ADJUSTING ENTRIES
December 31

1. Interest expense 9,720

Interest payable 9,270
(P180,000x12%x9/12)

2. Interest expense 24,000

Discount on notes payable 24,000
(P36,000x8/12)

PROBLEM 7-9
Accounting for Warranties and Premiums

OLSON MUSIC EMPORIUM carries a wide variety of musical

instruments, sound reproduction equipment, recorded music, and
sheet music. To promote the sale of its products, OLSON uses two
promotion techniques- premiums and warranties.

PREMIUMS

The premium is offered on the recorded and sheet music.

Customer’s receive a coupon for each P10 spend on recorded music
and sheet music. Customers may exchange 200 coupons and P200 for
a CD player. Olson pays P340 for each CD player and estimates
that 60% of the coupons given to customers will be redeemed. A
total of P6,500 CD players used in the premium program were
purchased during the year and there were 1,200,000 coupons
redeemed in 2010.

WARRANTIES
Musical instruments and sound reproduction equipment are sold
with a one-year warranty for replacement of parts and labor. The
estimated warranty cost, based on past experience, is 2% of
sales. Replacement parts and labor for warranty work totaled
P1,640,000 during 2010.

Olson uses the accrual method to account for the warranty and
premium costs for financial reporting purposes. Olson’s sales for
2010 totaled P72,000,000 – P54,000,000 from musical instruments
and sound reproduction equipment and P18,000,000 from recorded
music and sheet music. The balances in the accounts related to
warranties and premiums on January 1,2010, were as shown below:

Inventory of premium CD players P399,500

Estimated premium claims outstanding 448,000

Estimated liability from warranties 1,360,000

Based on the preceding information, determine the amounts that

will be shown on the 2010 financial statements for the ff:

1. Warranty expense
A. P1,640,000 C. P800,000
B. P1,080,000 D. P360,000

2. Estimated liability for warranties

A. P1,920,000 C. P240,000
B. P1,080,000 D. P800,000

3. Premium expense
A. P1,836,000 C. P756,000
B. P840,000 D. P2,189,500

4. Inventory of premium CD players

A. P399,500 C. P2,210,000
B. P569,500 D. P739,500

5. Estimated premium claims outstanding

A. P364,000 C. P756,000
B. P840,000 D. P672,000
SOLUTION 7-9
1. Sales of musical instruments and
sound reproduction equipment P54,000,000
Estimated warranty cost x2%
Warranty expense for 2010 P1,080,000
Answer: B

2. Estimated liability from warranties Jan. 1,2010 P1,360,000

Add: 2010 warranty expense(see no.1) 1,080,000
Total 2,440,000
Less: Actual warranty costs during 2010 1,640,000
Estimated liability from warranties, Dec.31,2010 P800,000
Answer: D

3. Coupons issued (P18,000,000/P10) 1,800,000

Multiply by estimated redemption rate x60%
Estimated number of coupons to be redeemed 1,080,000
Divide by exchange rate
(200 coupons for a CD player) /200
Estimated number of CD players to be issued 5,400
Multiply by net cost of a CD player (P340-P200) xP140
Premium expense for 2010 P756,000
Answer: C

4. Inventory of premium CD players P399,500

Add: Premium CD players purchased during 2010
(P340x6,500) 2,210,000
Total 2,609,500
Less: Premium CD players distributed to customers
during 2010(1,200,000/200=6,000xP340) 2,040,000
Inventory of premium CD players, Dec. 31,2010 P569,500
Answer: B

5. Estimated premium claims outstanding, Jan. 1,2010 P448,000

Add: 2010 premium expense(see no.3) 756,000
Total 1,204,000
Less: 2010 actual redemptions
(1,200,000/200=6,000xP140) 840,000
Estimated premium claims outstanding,
Dec. 31,2010 P364,000
 Answer: A

PROBLEM 7-10
Accounting for Noninterest-bearing Note

On December 31,2010, BAIKAL COMPANY acquired a piece of equipment

from Seller Company by issuing a P1,200,000 note, payable in full
December 31, 2014. Baikal’s credit rating permits it to borrow
funds from its several lines of credit at 10%. The equipment is
expected to have a 5-year life and a P150,000 salvage value. The
present value of 1 at 10% for 4 periods is 0.68301.

1. What is the equipment’s book value on December 31,2012?

A. P551,767 C. P491,767
B. 630,000 D. P341,767

2. What is the carrying value of the note at December 31, 2012?

A. P1,090,903 C. P1,200,000
B. P991,730 D. P819,612

SOLUTION 7-10
1. Cost of equipment(P1,200,000X0.68301) P819,612
Less: Accumulated depreciation, Dec. 31,2012
(P819,612-P150,000=P669,612x2/5) 267,845
Book value, Dec.31,2012 P551,767
Answer: A
2. Carrying value of note payable at Dec.31, 2012
(see discount amortization schedule below) P991,730
Answer: B

SCHEDULE OF DISCOUNT AMORTIZATION

Discount Carrying

Date Amortization Value of note

12.31.10 -- P819,612
 12.31.11 P81,961 901,573

12.31.12 90,157 991,730

12.31.13 99,173 1,090,903

12.31.14 109,097 1,200,000

1. P81,961 = P819,612*10%
2. P901,573 = P819,612+P81,961
3. P4 Adjustment due to rounding

PROBLEM 7-11
Accounting for Noninterest-bearing Note
(Payable in Installments)

OHRID COMPANY purchased machinery on December 31,2010, paying

P80,000 down and agreeing to pay the balance in four equal
installments of P60,000 payable each December 31. Implicit in the
purchase price is an assumed interest of 12%.

The following data are abstracted from the present value tables:

Present value of 1 at 12% for 4 periods

0.63552
Present value of an ordinary annuity of 1 at 12%
for 4 periods
3.03735

1. What is the cost of the machinery purchased on December

31,2010?
A. P233,083 C. P262,241
B. P320,000 D. P290,842

2. How much interest expense should be reported on Ohrid’s

income statement for the year ended December 31,2011?
 A. P38,131 C. P17,293
B. P21,869 D. P42,707

3. What is the carrying value of the note at December 31,2012?

A. P120,000 C. P99,310
B. P144,110 D. P101,403

SOLUTION 7-11
1. Down payment P80,000
Present value of installment payments
(P60,000x3.03735) 182,241
Cost of machinery P262,241
Answer: C

2. Interest expense for 2011(see amortization schedule) P21,869

Answer: B

3. Carrying value of note at Dec. 31,2012

(see amortization schedule) P101,403
Answer: D

SCHEDULE OF NOTE DISCOUNT AMORTIZATION

Date Payment Discount Carrying
Amortization Value of
note
12.31.10 P182,241
1
12.31.11 P60,000 P21,869 144,1102
12.31.12 60,000 17,293 101,403
12.31.13 60,000 12,168 53,571
12.31.14 60,000 6,429 0
1
P21,869 = P182,241 x 12%
2
P144,110 = P182,241 – P60,000 + P21,869

PROBLEM 7-12
Notes Payable

On October 1,2010, BALATON CORP. issued a P500,000, 12-month, 12%

note to ABC Company in payment of account. On the same date, the
company borrowed P1,000,000 from the Asian Bank by signing a 12-
month, noninterest-bearing, P1,200,000 note.

1. Prepare adjusting journal entries at December 31,2010.

2. What is the total/net liability to be reported on the
December 31, 2010, statement of financial position for:
a) The interest-bearing note?
b) The noninterest-bearing note?

SOLUTION 7-12
1. ADJUSTING JOURNAL ENTRIES
December 31,2010

a. Interest expense 15,000

Interest payable
15,000
(500,000 x 12% x 3/12)

b. Interest expense 30,000

Discount on notes payable
30,000
(P120,000 x 3/12)

2. a. Notes payable P50,000

Interest payable 15,000
Total P515,000

b. Note payable P1,120,000

Less: Discount on note payable
(P120,000 – P30,000) 90,000
Carrying value P1,030,000

PROBLEM 7-13
Notes Payable: Adjustments for Interest

Described below are certain transactions of TUNIS COMPANY.

1. On April 1, the corporation bought a truck for P400,000 from
General Motors Company, paying P40,000 in cash and signing a one-
year, 12% note for the balance of the purchase price.

2. On April 1, the corporation borrowed P800,000 from the Prudent

Bank by signing a P920,000 noninterest-bearing note due one-year
from May 1.

Prepare any adjusting journal entries to present a fair financial

statements at December 31.

SOLUTION 7-13
ADJUSTING JOURNAL ENTRIES

December 31

1. Interest expense 32,400

Interest payable 32,400
(P360,000 x 12 9/12)

2. Interest expense 80,000

Discount on notes payable 80,000
(P120,000 x 8/12)

PROBLEM 7-14
Analyzing Various Transactions Involving Liabilities

In conjunction with your firm’s examination of the financial

statements of BATUR< INC. as of December 31,2010, you obtained
the information from the company’s voucher register shown in the
work paper below.

Item Entry Voucher

No. Date Reference Description Amount Account
Charged
1 12/18/10 12-200 Supplies, shipped FOB destination,
12/15/10; received 12/17/10 P15,000 Supplies
on hand
2 12/18/10 12-203 Auto insurance,12/15/10-12/15/11 22,000 Prepaid
insurance
3 12/21/10 12-209 Repairs services;received 12/20/10 19,000 Repairs &
maintenance
4 12/26/10 12-212 Merchandise, shipped FOB shipping
point, 12/20/10; received 12/24/10 123,000 Inventory

5 12/21/10 12-210 Payroll, 12/7/10-12/21/10

(12 working days) 69,000 Salaries
and wages
6 12/21/10 12-234 Subscription to industry magazine
for 2011 5,000 Dues &
subscriptions
expense
7 12/28/10 12-236 Utilities for December 2010 24,000 Utilities
expense
8 12/28/10 12-241 Merchandise, shipped FOB
destination, 12/24/10; received
1/2/11 84,000 Inventory
9 12/28/10 12-242 Merchandise, shipped FOB
destination, 12/24/10; received
1/2/11 84,000 Inventory
10 1/2/11 1-1 Legal services;received 12/28/1046,000 Legal and
professional
fees
expense
11 1/2/11 1-2 Medical services for employees
for December 2010 25,000 Medical
expenses
12 1/5/11 1-3 Merchandise, shipped FOB
shipping point, 12/29/10;
received 1/4/11 15,000 Inventory
13 1/10/11 1-4 Payroll, 12/21/10-1/5/11(12 working
days in total, 4 working days in Jan.2011)72,000 Salaries
and wages
14 1/10/11 1-6 Merchandise, shipped FOB shipping
point, 1/2/11; received 1/6/11 64,000 Inventory
15 1/12/11 1-8 Merchandise, shipped FOB
destination, 1/3/11;
received 1/10/11 38,000 Inventory
16 1/13/11 1-9 Maintenance services;
received 1/9/11 9,000 Repairs &
maintenance
17 1/14/11 1-10 Interest on bank loan,10/10/10-1/10/11 30,000 Interest
expenses
18 1/15/11 1-11 Manufacturing equipment; installed
12/29/10 254,000 Machinery
& equipment
19 1/15/11 1-12 Dividend declared/ 12/15/10 160,000 Dividends
 payable

Accrued liabilities as of December 31,2010, were as follows:

Accrued payroll P48,000

Accrued interest payable 26,666
Dividends payable 100,000

The accrued payroll and accrued interest payable were reversed

effective January 1,2011.

Review the given data above and prepare journal entries to adjust
the accounts on December 31, 2010. Assume that the company
follows FOB terms for recording inventory purchases.

SOLUTION 7-14
ADJUSTING JOURNAL ENTRIES
December 31,2010

1. Insurance expense 917

Prepaid insurance 917
(P22,000 x 5/12)

2. Prepaid dues and subscriptions 5,000

Dues and subscriptions expense 5,000

3. Accounts payable 111,500

Inventory
111,500

4. Accounts payable 84,000

Inventory
84,000

5. Legal and professional fees expense 46,000

 Accounts payable
46,000

6. Medical expenses 25,000

Accounts payable
25,000

7. Inventory 55,000
Accounts payable
55,000

8. Machinery and equipment 254,000

Accounts payable
254,000

PROBLEM 7-15
Loss Contingency

On November 1,2010, 69 passengers on CANYON AIRLINES Flight No.

143 were injured upon landing when the plane skidded off the
runway. Personal injury suits for damages totaling P10,000,000
were filed on January
12,2011, against the airline by 21 injured passengers. The
airline carries no insurance. Legal counsel has studied each suit
and advised Canyon that is can reasonably expect to pay 70% of
the damages claimed. The financial statements for the year ended
December 31,2010, were authorized for issue on February 12, 2011.
During the past decade, the company has experienced at least one
accident per year and incurred average damages of P4,100,000.

1. Prepare the journal entry that should be made as of December

31, 2010, to recognize the loss.

2. What liability due to the risk of loss from lack of insurance

coverage should Canyon Airlines record or disclose? (Ignore the
November 1, 2010, accident.)

SOLUTION 7-15
1. Loss from uninsured accident 7,000,000
Liability for uninsured accident
7,000,000
(P10,000,000 x 70%)

The loss contingency should be accrued because the cause for

litigation occurred before the end of the reporting period and an
unfavorable outcome is both probable and reasonably estimable.

Under PAS 37: Provisions, Contingent Liabilities, and Contingent

assets, a provision shall be recognized when:

a. an entity has a present obligation (legal or constructive) as

a result of a past event;

b. it is probable that an outflow of resources embodying

economic benefit will be required to settle the obligation;
and

c. a reliable estimate can be made of the amount of the

obligation.

2. The company is not required to establish a liability for risk

of loss from lack of insurance coverage. However, the fact
that the company is self-insured will require a note
disclosure.

PROBLEM 7-16
Currently Maturing Debt Expected to be Refinanced

NAMEKUS COMPANY has the following three loans payable scheduled

to be repaid in February of next year. The company’s accounting
year ends on December 31.

a. The company intends to repay Loan 1 for P100,000 when it

comes due in February. In the following October, the company
intends to get a new loan for P80,000 from the same bank.

b. The company intends to refinance Loan 2 for P150,000 when it

comes due in February. The refinancing agreement, for
P180,000, will be signed in April, after the financial
statements for this year have been authorized for issue.

c. The company intends to refinance Loan 3 for P200,000 before

it comes due in February. The actual refinancing, for
P175,000, took place in January, before the financial
statements for this year have been authorized for issue.

1. As of December 31 of this year, the total current liabilities

to be reported on the company’s statement of financial
position should be
A. P100,000 C. P450,000
B. P250,000 D. P125,000

2. As of December 31 of this year, the total noncurrent

liabilities to be reported on the company’s statement of
financial position should be
A. P25,000 C. P175,000
B. P0 D. P350,000

SOLUTION 7-16
1. Loan 1 P100,000
Loan 2 150,000
Loan 3 200,000
Total current liabilities P450,000
Answer: C

2. Noncurrent liabilities P0
Answer: B

Under PAS 1: Presentation of Financial Statements, an entry

classifies its financial liabilities as current when they are due
to be settled within 12 months after the end of the reporting
period, even if:

a. the original term was for a period longer than 12 months; and

b. an agreement to refinance, or to reschedule payments, on a

long-term basis is completed after the end of the reporting
period and before the financial statements are authorized for
issue.
PAS 1 further provides that if the refinancing on a long-term
basis occurs between the end of the reporting period and the date
the financial statements are authorized for issue, such event
qualifies for disclosure as a non adjusting event in accordance
with PAS 10.

PROBLEM 7-17
Short-term Loan Refinancing

The following items are based on the financial statements of

CARMEL COMPANY.

Current assets P750,000

Short-term loan payable 600,000
Total liabilities 3,000,000
Current ratio 1.5
Debt-to-equity ratio 1.5

Carmel Company has arranged with its bank to refinance its short-
term loan when it becomes due in 3 months. The new loan will have
a term of 5 years.

1. Compute the following:

a. Total current liabilities
b. Total shareholder’s equity
c. Total noncurrent liabilities

2. As the auditor of Carmel Company, how would you verify the

validity of the short-term loan refinancing?

SOLUTION 7-17
1. a. Current ratio = Current assets
Current liabilities
1.5 = P750,000
Current liabilities
Current liabilities = P750,000/1.5
= P500,000
b. Debt-to-equity ratio = Total liabilities
Total equity
1.5 = P3,000,000
Total equity
Total equity = P3,000,000/1.5
= P2,000,000
c. Total liabilities P3,000,000
Less: Current liabilities 500,000
Noncurrent liabilities P2,500,000

2. The refinancing should occur on or before the end of the

reporting period. The refinancing agreement should be
examined to verify that the refinancing has actually taken
place.

PROBLEM 7-18
Debt Restructuring Asset Swap

CAREY CO. owes P1,998,000 to Loan Shark Corp. The debt is a 10-
year, 11% note. Because Carey Co. is in financial trouble, Loan
Shark Corp, agrees to accept land and cancel the entire debt. The
land has a book value of P800,000 and a fair market value of
P1,200,000.

What entry should be made by Carey Co. for the debt restructure?

SOLUTION 7-18
Notes payable 1,998,000
Land 800,000
Gain on restructuring of debt 1,198,000
 Total liability 1,998,000
Book value of land 800,000
Gain on debt restructuring P1,198,000

PAS 39: Financial Instruments: Recognition and Measurement,

provides that a financial liability should be derecognized only
when it is extinguished. The standard further provides that the
difference between carrying amount of a financial liability
extinguished and the consideration paid, including any noncash
assets transferred or liabilities assumed, shall be recognized in
profit or loss.

Asset swap is a form of debt restructuring which involves the

debtor’s transfer of assets (such as land, investments, or
receivables) to the creditor in full settlement of a liability

PROBLEM 7-19
Debt Restructuring

NAKURU CORPORATION is having financial difficulty and therefore

has asked Naawa Bank to restructure its P3 million note
outstanding. The present note has 3 years remaining and pays a
current rate of interest of 12%. The note was issued at its face
value.

Presented below are two independent situations. Prepare the

journal entry that Nakuru would make for each of the following
types of debt restructuring.

a. Naawa Bank agrees to accept land in exchange for

relinquishing its claim on this note. The land has a book
value of P2,000,000 and a fair value of P2,500,000.

b. Naawa Bank agrees to reduce the principal balance due to

P2,000,000 and interest rate to 10%.

The following present value factors are abstracted from the

present value tables.

12% 10%
Present value of 1 for 3 periods 0.71178 0.75132
Present value of an ordinary annuity of 1
for 3 periods 2.40182 2.48685

SOLUTION 7-19
a. ASSET SWAP

Notes payable 3,000,000

Land 2,000,000
Gain on debt restructuring 1,000,000

b. SUBSTANTIAL MODIFICATION OF TERMS

Note payable – old 3,000,000

Discount on notes payable 96,074
Note payable – new 2,000,000
Gain on debt restructuring 1,000,000

Present value of principal (P2,000,000 x .71178) P1,423,560

Present value if interest payments
(P2,000,000 x 10% = P200,000 x 2.40183) 480,366
Total P1,903,926

Note payable – old P3,000,000

Present value of restructured liability 1,903,926
Gain on debt restructuring P1,096,074

Face value of note payable – new P2,000,000

Present value of restructured liability 1,903,926
Discount on note payable P 96,074

PAS 39 provides that a substantial modification of the terms of

an existing financial liability shall be accounted for as an
extinguishment of the original financial liability and the
recognition of a new financial liability.

The Application Guidance of PAS 39 states that the terms are

substantially different if the present value of the cash flows
under the new terms discounted using the original effective
interest rate is at least 10% different from the discounted
present value of the remaining cash flowing of the original
financial liability.

PROBLEM 7-20
Classification of Debt

At December 31,2010, KISU COMPANY liabilities include the

following:

1. 10 million of 10% notes are due on March 31, 2015. The

financing agreement contains a covenant that requires Kisu to
maintain current assets at least equal to 200% of its current
liabilities. As of December 31,2010, Kisu has breached this
loan covenant. On February 31,2011, before Kisu’s financial
statements are authorized issue, Kisu obtained having
convinced the bank that the company’s 3 to 1 ratio of current
assets to current liabilities will be reestablished during
2011.

2. P15 million of noncancelable 12% bonds were issued at face

value on September 30,1989. The bonds mature on August 31,
2011. Kisu expects to have sufficient cash available to
redeem the bonds at maturity.

3. P20 million of 10% bonds were issued face value on June 30,
1991. The bonds mature on June 30,2010, but bondholders have
the option to call (demand payments on) the bonds on June
30,2011. However, the call option is no expected to be
exercised, given prevailing market conditions.

What portion of Kisu Company’s debt should be reported as a

noncurrent liability?

A. P10 million C. P20 million

B. P30 million D. P0
SOLUTION 7-20
All of the above liabilities should be reported as current
liabilities on Kisu’s statement of financial position as of
December 31,2010, for the following reasons:

1. P10 million notes – The period of grace was given by the bank
onlyafter Kisu’s reporting date. As of December 31,2010,
Kisu does not havean unconditional right to defer settlement
of its liability for atleast 12 months from the end of the
reporting period.

2. P15 million bonds – These are payable in the succeeding year.

As of the end of the reporting period, no long-term
refinancing has been made by Kisu.

3. P20 million callable bonds – Because these bonds are callable

by thecreditor in the succeeding year, Kisu does not have an
unconditional right to defer its settlement beyond 12 months
from the end of the reporting period, even if the debt is not
expected to be called.

Answer: D

PROBLEM 7-21
Contingencies, Provisions, and Events After the End of the
Reporting Period

Your audit client, CHALA COMPANY, is involved in the situations

described below. Chala’s accounting year ends on December
31,2010, and its financial statements are authorized for issue on
March 20, 2011.

1. Chala is involved in a lawsuit resulting from a dispute with

acustomer. On January 28,2011, judgment was rendered against
Chala in the amount of P20 million. Chala plans to appeal the
judgment and isunable to predict its outcome though
management believes that it willnot have a material adverse
effect on the company.

2. On April 25,2011, the Bureau of Internal Revenue (BIR) is in

theprocess of examining Chala’s tax returns for 2008 and
2009, but has notproposed a deficiency agreement. Management
feels an assessment isreasonably possible, and if an
assessment is made, an unfavorablesettlement of up to P5
million is reasonably possible.

On January 5,2011, inventory purchased FOB shipping point

from a foreign country was detained at that country’s border
because of political unrest. The shipment is valued at P1
million. Chala’s lawyers have stated that it is probable that
Chala will be able to obtain the shipment.

4. On November 1, 2010, a lawsuit was filed by a disgruntled

customer who discovered a safety hazard on ine of the Chala’s
best-selling products. Chala’s lawyers feel it is probable
that the company will be liable for P500,000.

5. On December 5, 2010, Chala initiated a lawsuit seeking P1

million in damages from a patent infringement.

Determine the appropriate means of reporting each situation.

Prepare any necessary journal entries on December 31,2010.

SOLUTION 7-21
1. No accrual of the P20 million loss would be made. The
judgment will beappealed and the outcome is uncertain. A
note disclosure would beappropriate.

2. Neither accrual nor disclosure would have to be made. The BIR

claim isas yet unasserted, and an assessment is no probable.

3. No adjustment or disclosure is required because the

possibility of loss is remote.

4. The loss is both probable and reasonably estimable. Thus, the

related obligation is not a contingent liability but should
be recognized as a provision as mandated by PAS 37. The entry
to recognize the provision is as follows:

Loss – litigation 500,000

Liability-litigation 500,000
5. The situation involves a contingent asset because the company
is the plaintiff in the lawsuit. Under PAS 37, a contingent
asset shall not be recognized because this may result to
recognition of income that may never be realized. A
contingent asset is only disclosed when it is probable.
However, when the realization of income is virtually certain,
the related asset is no longer a contingent asset and its
recognition become appropriate.

PROBLEM 7-22
Analysis of Amortization Schedule

LARIO COMPANY issued 10-year bonds on January 1,2010. The

company’s year-end is December 31, and financial statements are
prepared annually. The amortization and interest schedule below
reflects the bond issuance and the subsequent interest payments
and charges.

AMORTIZATION SCHEDULE
Interest Interest Amount Carrying
Date Paid Expense Unauthorized Value
01/01/10 -- -- P28,253 P471,747
12/31/10 P55,000 P56,610 26,643 473,357
12/31/11 55,000 56,803 24,840 475,160
12/31/12 55,000 57,019 22,821 477,179
12/31/13 55,000 57,261 20,560 479,440
12/31/14 55,000 57,533 18,027 481,973
12/31/15 55,000 57,837 15,190 484,810
12/31/16 55,000 58,177 12,013 487,987
12/31/17 55,000 58,558 8,455 491,545
12/31/18 55,000 58,985 4,470 495,530
12/31/19 55,000 59,470* -- 500,000

*Adjustment due to rounding.

1. The bonds were issued at
A. A premium C. Face value
B. A discount D. Par value

2. What amortization method is used in the amortization schedule

presented?
A. Straight-line method C. Effective interest method
B. Bonds outstanding method D. Declining balance method

3. What is the nominal (stated) interest rate of the bonds

issued onJanuary 1,2010?
A. 11% C. 10%
B. 12% D. 6%

4. What is the effective interest rate of the bonds issued on

January1,2010?
A. 11% C. 10%
B. 12% D. 6%

5. On the basis of the schedule presented, what is the journal

entry torecord the issuance of the bonds on January 1,2010?
A. Cash 500,000
Bonds payable 500,000
B. Cash 471,747
Interest expense 28,253
Bonds payable 500,000
C. Cash 500,000
Premium on bonds payable 28,253
Bonds payable 471,747
D. Cash 471,747
Discount on bonds payable 28,253
Bonds payable 500,000

SOLUTION 7-22
1. The bonds were sold at a discount of P28,253. The issue price
(P471,747) is less than the maturity value (or face value) of
P500,000on December 31,2019.

Answer: B
2. The amortization schedule presents an increasing interest
charge whichcharacterizes the effective interest method of
amortizing bond premiumor discount. Under the straight-line
method, the annual interest wouldhave been P57,825.30 (see
computation below).

Interest payment P55,000.00

Amortization of discount(P28,253/10) 2,825.30
Total P57,285.30
Answer: C

3. Stated or nominal interest rate (P55,000/P500,000) 11%

Answer: A

4. Effective interest rate (P56,610/P471,747) 12%

Answer: B

5. Cash 471,747
Discount on bonds payable 28,253
Bonds payable 500,000
Answer: D

PROBLEM 7-23
Classifying Liabilities

ELEANOR CORP. has been producing quality disposable diapers for

more than two decades. The company’s fiscal year runs from April
1 to March 31. The following information relates to the
obligations of Eleanor as of March 31,2010.

BONDS PAYABLE

Eleanor issued P10,000,000 of 10% bonds on July 1,2008. The

prevailing market rate of interest for these bonds was 12% on the
date of issue. The bonds will mature on July 1, 2018. Interest is
paid semiannually on July 1 and January 1. Eleanor uses the
effective interest rate method to amortize bond premium or
discount.
The following present value factors are taken from the present
value tables:

Present value of 1 at 12% for 10 periods

0.32917
Present value of 1 at 6% for 20 periods
0.31180
Present value of an ordinary annuity of 1 at 12%
for 10 periods
5.65022
Present value of an ordinary annuity of 1 at 6%
for 20 periods
11.46992

NOTES PAYABLE

Eleanor has signed several long-term notes with financial

institutions. The maturities of these notes are given in the
schedule below. The total unpaid interest for all of these notes
amounts to P600,000 on March 31,2010.

Due Date Amount Due

April 1, 2010 P400,000
July 1, 2010 600,000
October 1, 2010 300,000
January 1, 2011 300,000
April 1, 2011 – March 31,2012 1,200,000
April 1, 2012 – March 31,2013 1,000,000
April 1, 2013 – March 31,2014 1,400,000
April 1, 2014 – March 31,2015 800,000
April 1, 2015 – March 31,2016 1,000,000
P7,000,000

ESTIMATED WARRANTIES

Eleanor has a one-year product warranty on some selected items in

its product line. The estimated liability on sales made during
the 2008-2009 fiscal year and still outstanding as of March 31,
2009 amounted to P180,000. The warranty costs on sales made from
April 1, 2009, through March 31, 2010, are estimated at P520,000.
The actual warranty costs incurred during the current 2009-2010
fiscal year are as follows:

Warranty claims honored on 2008-2009 sales P180,000

Warranty claims honored on 2009-2010 sales 178,000
Total warranty claims honored P358,000

OTHER INFORMATION

1. TRADE PAYABLES
Accounts payable for supplies, goods and services purchased
on openaccount amount to P740,000 as of March 31, 2010.

2. PAYROLL RELATED ITEMS

Accrued salaries and wages P300,000

Withholding taxes payable 94,0000
Other payroll deductions 10,000
Total P404,000

3. MISCELLANEOUS ACCRUALS

Other accounts not separately classified amount to P150,000

as of March 31, 2010.

4. DIVIDENDS

On March 15,2010, Eleanor’s board of directors declared a

cash dividend of P0.20 per ordinary share and a 10% stock
dividend. Both dividends were to be distributed on April 12,
2010, to the shareholders of record at the close of business
on March 31,2010. Data regarding Eleanor ordinary share
capital are as follows:

Par value P5.00 per share

Number of shares issued and outstanding 6,000,000shares

Market values of ordinary shares:

March 15,2010 P22.00 per share
March 31,2010 21.50per share
April 12,2010 22.50 per share
1. How much was received by Eleanor from the sale of the bonds
on July1,2008?
A. P8,852,960 C. P10,500,000
B. P10,000,000 D. P10,647,040

2. What is the current portion of Eleanor’s notes payable at

March 31, 2010?
A. P2,800,000 C. P1,300,000
B. P1,600,000 D. P3,800,000

3. The balance of the estimated warranties payable at March

31,2010?
A. P342,000 C. P520,000
B. 18,000 D. P180,000

4. On March 31,2010, Eleanor’s statement of financial position

would report total current liabilities of
A. P5,286,000 C. P5,336,000
B. P4,386,000 D. P5,642,000

5. On March 31,2010, Eleanor’s statement of financial position

would report total noncurrent liabilities of
A. P14,289,350 C. P14,370,783
B. P14,352,217 D. P14,252,960

SOLUTION 7-23
1. Present value of principal (P10,000,000 x 0.31180) P3,118,000
Present value of interest payments
(P10,000,000 x 5% = P500,000 x 11.46992) 5,734,960
Issue price/Proceeds P8,852,960

Answer:A

2. Notes payable – current portion:

April 1, 2010 P400,000
July 1,2010 600,000
October 1,2010 300,000
January 1,2011 300,000
Total P1,600,000

Answer: B
3. Estimated warranties payable:
Balance, April 1,2009 P180,000
Add: Warranty expense for current year 520,000
Total 700,000
Less: Actual warranty costs 358,000
Balance, March 31,2010 P342,000

Answer: A

4. Notes payable – current portion (see no.2) P1,600,000

Estimated warranties payable (see no.3) 342,000
Accounts payable 740,000
Payroll-related accruals and deductions withheld 404,000
Miscellaneous accruals 150,000
Cash dividends payable 1,200,000
Accrued interest on:
Bonds payable (P10,000,000 x 10% x 3/12) 250,000
Notes payable 600,000
Total current liabilities P5,286,000
Answer: A

5. AMORTIZATION SCHEDULE (PARTIAL)

Interest Interest Discount Carrying

Date Paid Expense Amortization Value
07/01/08 -- -- -- P8,852,960
12/31/08 P500,000 P531,178 P31,178 8,884,138
07/01/09500,000 533,048 35,031 8,917,186
12/31/09 500,000 535,031 35,031 8,952,217
07/01/10 500,000 537,133 37,133 8,989,350

Bonds payable

Carrying value, Jan. 1,2010 P8,952,217

Add: Discount amortization
Jan. 1 – Mar. 31 (P37,133 x 3/6) 18,566 P8,970,783

Notes payable– noncurrent portion:

(P7,000,000 – P1,600,000 current portion) 5,400,000

Total noncurrent liabilities P14,370,783

Answer: C
PROBLEM 7-24
Bond Redemption Prior to Maturity Date

The following data were obtained from the initial audit of

HANSTEEN COMPANY:

15%, 10-year, Bonds payable, dated January 1,2009

Debit Credit Balance

Cash proceeds from issue on
January 1,2009 of 1,000,
P1,000 bonds. The market rate
of interest on the date of issue
was 12%. P1,172,044
P1,172,044

Bond Interest Expense

Cash paid, 1/2/10 P75,000 P75,000

Cash paid, 7/1/10 75,000 150,000
Accrual, 12/31/10 75,000 225,000

Accrued Interest on Bonds

Balance, 1/1/10 P75,000

P75,000
Accrual, 12/31/10 75,000
150,000

Treasury Bonds

Redemption price and interest to

date on 200 bonds permanently
retired on Dec.31,2010 P265,000 P265,000

Based on the preceding information, determine the following:

1. Carrying value of bonds payable at December 31,2010

A. P831,110 B. P1,151,583
B. P800,000 D. P921,266
2. Loss on bond redemption
A. P4,683 B. P15,000
B. P19,683 D. P34,683

3. Accrued interest on bond at December 31,2010

A. P75,000 B. P60,000
B. P135,000 D. P52,000

4. Bond interest expense for the year ended December 31,2010

A. P150,000 C. P69,745
B. P139,174 D. P160,826

SOLUTION 7-24
1. AMORTIZATION SCHEDULE (PARTIAL)

Interest Interest Premium Carrying

Date Paid Expense Amortization Value
01/01/09 -- -- -- P1,172,044
07/01/09 P75,000 P70,323 P4,677 1,167,367
01/01/10 75,000 70,042 4,958 1,162,409
07/01/10 75,000 69,745 5,255 1,157,154
01/01/11 75,000 69,429 5,571 1,151,583

Carrying value of bonds, Dec. 31,2010

(P1,151,583 x 800/1,000) P921,266

Answer: D

2. Cash paid P265,000

Less: Interest (P200,000 x 15% x 6/12) 15,000
Redemption price 250,000
Carrying value of bonds redeemed
(P1,151,583 x 200/1,000) 230,317
Loss on bond redemption P19,683

Answer: B

3. Accrued interest, Dec. 31,2010

(P800,000 x 15% x 6/12) P60,000

Answer: C
4. Interest expense for the year ended Dec.31,2010
(see amortization schedule):

Jan. 1 – July 1 P69,745

July 1 – Dec.31 69,429
Total P139,174

Answer: B

PROBLEM 7-25
The long-term debt section of ELMO COMPANY’s statement of
financial position as of December 31,2009, included 9% bonds
payable of P400,000 less unauthorized discount of P32,000.
Further examination revealed that these bonds were issued to
yield 10%. The amortization of the bond discount was recorded
using the effective interest method. Interest was paid on January
1 and July 1 of each year. On July 1,2010, Elmo retired the bonds
at 105 before maturity.

What is the amount of loss to be recognized on the retirement of

bonds?
A. P52,400 C. P51,600
B. P20,000 D. P 0

SOLUTION 7-25
Effective interest
(P400,000 – P32,000 = P368,000 x 10% x 1/2) P18,400
Nominal interest
(P400,000 x 9% x 1/2) 18,000
Discount amortization, Jan.1,2010 – July 1,2010 P400

Retirement price (P400,000 x 105%) P420,000

Carrying value of bonds:
Face value P400,000
 Less: Unauthorized discount
(P32,000 – P400) 31,600
368,400
Loss on retirement of bonds P51,600
Answer: C

PROBLEM 7-26
Bond Refunding

MALOMBE CORP. had outstanding P6,000,000 of 11% bonds

(interest payable July 31 and January 31) due in 10 years.
On July 1, it issued P9,000,000 of 10%, 15-year bonds
(interest payable July 1 and January 1) at 97. A portion of
the proceeds was used to call the 11% bonds at 103 August 1.
Unamortized bond discount and issue cost applicable to the
11% bonds were P240,000 and P60,000, respectively.

Prepare journal entries to record the following:

a. sale of the new issue
b. retirement of the old issue

SOLUTION 7-26
a. Cash 8,730,000
Discount on bonds payable 270,000
(P9,000,000 x 3%) 9,000,000

b. Bonds payable 6,000,000

Loss on redemption of bonds 480,000
Cash (P6,000,000 x 103%) 6,180,000
Discount on bonds payable 240,000
Unamortized bond issue costs 60,000
Redemption price P6,180,000
Carrying value of bonds redeemed:
Face value P6,000,000
Unamortized bond discount (240,000)
 Unamortized bond issue costs (60,000)5,700,000
Loss on redemption P480,000

PROBLEM 7-27
Convertible Debt Issue

On January 1,2010, DIAS COMPANY issued 3-year, 4,000

convertible bonds at face value of P1,000 per bond. Interest
is to be paid annually in arrears at the stated coupon rate
at 6%. Each bond is convertible, at the option, into 200 P2
par value ordinary shares at any time up to maturity. On the
date of issuance, the prevailing market interest rate for
similar debt without the conversion previlege was 9%. On the
same date, the market price of one ordinary share was P3.
The bonds were converted on December 31,2011.

The following present value factors are obtained from the

present value tables:

6% 9%

Present value of 1 for 3 periods 0.3962 0.77218

Present value of an ordinary annuity of 1
for 3 periods 2.67301 2.53130
Present value of an annuity due of 1
for 3 periods 2.83339 2.75911

1. The liability component of the convertible debt is

A. P4,000,000 C. P1,6000,000
B. P3,696,232 D. P3,730,242
 2. The equity component of the convertible debt is
A. P303,768 C. P1,6000,000
B. P1,973,621 D. P2,400,000

3. The interest expense to be reported on Dias Company’s

income statement for the year ended December 31, 2011 is
A. P101,000 C. P240,000
B. P110,107 D. P341,000

4. The entry to record the bond conversion on December

31,2011, should include a credit to share premium-
issuance of
A. P2,289,893 C. P2,593,661
B. P2,400,000 D. P0

SOLUTION 7-27
1.Present value of principal(P4,000,000 x 0.77218) P3,088,721
Present value of interest payments
(P4,000,000 x 6% = P240,000 x 2.3130) 607,514
Liability component of convertible debt P3,696,232
Answer: B

2. Proceeds P4,000,000
Less: Liability component (see no.1) 3,696,232
Equity component of convertible debt P3,696,232
Answer: A

3. AMORTIZATION SCHEDULE

Interest Interest Discount Carrying

Date Paid Expense Amortization Value
01/01/10 -- -- - P3,696,232
12/31/10 P240,000 P332,661 P92,661 3,788,893
12/31/11 240,000 341,000 101,000 3,889,893
12/31/12 240,000 350,107* 110,107 4,000,000

*Adjustment due to rounding.

Interest expense for 2011
(see amortization schedule) P341,000
Answer: C

4. Carrying value of bonds, Dec. 31,2011

(see amortization schedule) P3,889,893
Add: Share premium – conversion privilege 303,768
Total consideration 4,193,661
Par value of ordinary shares [P2 x (4,000 x 200)] 1,600,000
Share premium – issuance P2,593,661

The entry to record the bond conversion is:

Bonds payable 4,000,000

Share premium – conversion privilege 303,768
Bond discount(P4,000,000 – P3,889,893) 110,107
Ordinary shares (P2 x 800,000 shares) 1,600,000
Share premium – issuance 2,593,661
Answer: C

Under PAS 32: Financial Instruments: Disclosure and Presentation,

a convertible bond is a compound financial instrument that
contains both a liability component and an equity component. Such
components should be classified separately on an entity’s
statement of financial position. The separation of components is
made at the time the instrument is issued and is not subsequently
revised.

An equity instrument evidences a residual interest in the assets

of an entity after deducting all of its liabilities. Thus, when
the initial carrying amount of a compound financial instrument is
allocated to its equity and liability components, the equity
component is assigned the residual amount after deducting from
the fair value of the instrument as a whole (i.e., the net
proceeds from the issue) the amount separately determined for the
liability component.

In the case of convertible bonds, the amount allocated to the

liability component is the fair value of the bonds without the
conversion privilege. In the absence of the fair value without
the conversion privilege, the sum of the present value of the
face amount of the bonds and the present value of the face amount
of the bonds and the present value of the future interest
payments discounted using the effective interest rate is assigned
to the liability component.

On the conversion date, the carrying value of the bonds converted

is used to measure the ordinary shares issued. No gain or loss is
recognized.

PROBLEM 7-28
Deferred Tax Liability

EYASI, INC. began operating on January 1,2010. A the end of the

first year of operations, Eyasi reported P7,500,000 income before
income taxes on its income statement but only P700,000 taxable
income on its tax return. Analysis of the P6,800,000 difference
revealed that P2,600,000 was a permanent difference related to a
current asset. A the end of 2011, the accumulated temporary tax
liability difference related to future years is P1,100,000. The
enacted tax rate is 30% for 2010 and 2011.

1. The journal entry to adjust the deferred tax liability at the

end of2011 should include a
A. Debit to Deferred tax liability of P150,000
B. Credit to deferred tax liability of P150,000
C. Debit to Deferred tax asset of P150,000
D. Credit to Deferred tax liability of P330,000

2. Assume that at the end of 2011, the accumulated temporary tax

liability difference related to future years to P550,000.
What journal entry should be made to adjust the deferred tax
liability at the end of 2011?

A. Income tax expense 165,000

Deferred tax liability 165,000
B. Deferred tax asset 15,000
Income tax liability 15,000
C. Deferred tax liability 15,000
Income tax expense 15,000
D. Deferred tax liability 15,000
Deferred tax asset 15,000
SOLUTION 7-28
1. Deferred tax liability, Dec.31,2011
(P1,100,000 x 30%) P330,000
Deferred tax liability, Dec.31,2010
(P600,000 x 30%) 180,000
Increase in deferred tax liability P150,000

Journal entry:
Income tax expense 150,000
Deferred tax liability 150,000
Answer: B

2. Deferred tax liability, Dec.31,2011

(P550,000 x 30%) P165,000
Deferred tax liability, Dec.31,2011
(P600,000 x 30%) 180,000
Decrease in deferred in tax liability P(15,000)

Journal entry:
Deferred tax liability 15,000
Income tax expense 15,000
Answer: C

PROBLEM 7-29
Deferred Income Tax Asset and Liability

At December 31,2009, GALILIEE CORPORATION had a temporary

difference (related to depreciation) and reported a related
deferred tax liability of P60,000 on its statement of financial
position. At December 31,2010, Galilee has four temporary
differences. An analysis of these reveals the following:

Future Taxable
Temporary Difference (Deductible) Amounts
Later Year
2011 2012

1. Use of straight-line depreciation for

accounting purposes and accelerated P160,000 P220,000
depreciation for tax purposes. P760,000
2. Rent collected in depreciation;
recognized when earned for accounting (380,000)
purposes and when received for tax purposes

3. Various expenses accrued when

incurred for accounting purposes; (90,000)
recognized for tax purposes when paid

4. Recognition of gain on installment sales

during the period of sale for accounting
purposes and during the period of collection
for tax purposes 276,000 210,000
____ (P34,000)P430,000
P760,000

Assume that the company has income taxes of P435,000 due per the
year tax return for 2010. The installment receivable collectible
in 2012 is classified as noncurrent. The enacted tax rate is 30%
of all periods.

1. What amount of deferred tax asset should be shown on

Galilee’s statement of financial position at December
31,2010?
A. P114,000 C. P141,000
B. P514,800 D. P27,000

2. What amount of deferred tax liability should be shown on

Galilee’s statement of financial position at December
31,2010?
A. P342,000 C. P141,000
B. P456,000 D. P487,000

3. How much is Galilee’s pretax accounting income for 2010?

A. P1,563,900 C. P1,450,000
C. P2,406,000 D. P2,606,000

4. How much is Galilee’s net income for 2010?

A. P1,971,000 C. P2,406,000
B. P1,684,200 D. P1,450,000
SOLUTION 7-29
1. Deferred tax asset, December 31,2010
(see computation below) P141,000
Answer: C

2. Deferred tax liability, December 31,2010

(see computation below) P487,800
Answer: D

COMPUTATION OF DEFERRED TAX ASSET AND LIABILITY

Future Taxable Tax Deferred
TaxTemporary Difference (Deductible) Amounts Rate
Asset Liability
Depreciation P1,140,000 30% P342,000
Unearned rent (380,000) 30% P114,000
Accrued expenses (90,000) 30% 27,000
Installment sale 486,000 30% 145,800
Totals P141,000 P487,800

3. Taxable income (P435,000/30%) P1,450,000

Excess depreciation for tax (P160,000 + P220,000 +
P760,000 – P200,000*) 940,000
Excess rent income per tax (380,000)
Excess expenses for books (90,000)
Excess income per books for installment sale
(P276,000 + P210,000) 486,000
Pretax accounting income P2,406,000

* Beginning cumulative temporary difference related to

depreciation.
(P200,000 = P60,000/30%)
Answer: B

4. Deferred tax liability, Dec.31,2010

(see computation) P487,800
 Deferred tax liability, Jan. 1,2010 60,000
Deferred tax expense for 2010 P427,800

Deferred tax asset, Dec.31,2010 (see computation) P141,000

Deferred tax asset, Jan. 1,2010 0
Deferred tax benefit for 2010 P141,000

Income before income taxes P2,406,000

Income tax expense:
Current P435,000
Deferred(P427,800 – P141,000) 286,800
(721,800)
Net income P1,684,200
Answer: B

Alternative computation

Pretax accounting income P2,406,000

Less: Income tax (P2,406,000 x 30%) 721,800
Net income P1,684,200

PROBLEM 7-30
Deferred Income Tax and Liability

The following data pertain to the CARROLL COMPANY.

1. At December 31,2010, the company has a P900,000 liability

reported for estimated litigation claims. This P900,000
balance represents amounts that have been charged to income
but are not tax deductible until they are paid. The company
expects to pay the claims thus have tax-deductible amounts in
the future in the following manner:

Year Payments
2013 P150,000
2014 690,000
2015 60,000
P900,000

2. The company uses different depreciation methods for financial

reporting and tax purposes. Consequently, at December
31,2010, the company has a cumulative temporary difference
due to depreciable property of P2,240,000. This P2,240,000
cumulative temporary difference is to result in, taxable
amounts in future years in the following manner:

Year Amount
2011 P 480,000
2012 480,000
2013 480,000
2014 480,000
2015 480,000
P2,400,000

3. The income tax rate 30%.

4. Taxable income for 2010 is P2,400,000. The company expects to

report taxable income for the next five years.

5. No temporary differences existed at the end of 2009.

1. The deferred tax liability to be reported on Carroll’s

statement of financial position at December 31,2010., is
A. P720,000 C. P450,000
C. P480,000 D. P270,000

2. The deferred tax asset to be reported on Carroll’s statement

of financial position at December 31,2010, is
A. P270,000 C. P450,000
C. P150,000 D. P720,000

3. The amount of current income tax payable to be reported on

Carroll’s statement of financial position at December
31,2010, is
A. P630,000 C. P540,000
C. P546,000 D. P720,000

4. Carroll’s pretax accounting income for 2010 is

A. P3,900,000 C. P2,874,000
B. P900,000 D. P2,400,000

5. Carroll’s net income for 2010 is

A. P2,730,000 C. P1,230,000
C. P2,630,000 D> P4,350,000
SOLUTION 7-30
1. Deferred tax liability, December 31,2010
(P480,000 x 5 x 30%) P720,000
Answer: A

2. Deferred tax asset, December 31,2010

(P900,000 x 30%) P270,000
Answer: A

3. Tax income for 2010 P2,400,000

Tax rate 30%
Income tax payable for 2010 (current) P 720,000
Answer: A

4. Taxable income for 2010 P2,400,000

Future taxable temporary difference – depreciation 2,400,000
Future deductible temporary difference – litigation (900,000)
Pretax accounting income for 2010 P3,900,000
Answer: A

5. Pretax accounting income (see no.4) P3,900,000

Income tax expense:
Current (see no.3) P720,000
Deferred (P720,0001 – P270,0002) 450,000 (1,170,000)
Net income P2,730,000
1
Deferred tax liability, December 31,2010 P720,000
Deferred tax liability, January 1, 2010 0
Deferred tax expense for 2010 P720,000
2
Deferred tax asset, December 31,2010 P270,000
Deferred tax asset, January 1,2010 0
Deferred tax benefit for 2010 P270,000
Answer: A

PROBLEM 7-31
Deferred Income Tax Asset and Liability
KAMPESCA< INC., in its first year of operations, has the
following differences between the carrying value and tax base of
its assets and liabilities at the end of 2010:

Carrying Value Tax

Base
Equipment (net) P800,000 P680,000
Estimated warranty liability 400,000 0

Kampesca estimates that the warranty liability will be settled in

2011.

The difference in equipment (net) will result in taxable amounts

as shown below:

Year Amount
2011 P40,000
2012 60,000
2013 20,000

The company has taxable income of P1,040,000 for 2010. The income
tax rate is 30%.

1. What amount of deferred tax liability should be reported on

Kampesca’sstatement of financial position at December
31,2010?
A. P36,000 C. P24,000
B. P30,000 D. P84,000

2. What amount of deferred tax asset should be reported on

Kampesca’sstatement of financial position at December
31,2010?
A. P156,000 C. P120,000
B. P0 D. P84,000

3. What is the amount of income tax payable (current) to be

reported on Kampesca’s statement of financial position at
December 31,2010?
A. P228,000 C. P321,000
C. P296,000 D. P156,000

4. What is the total income tax expense for 2010?

A. P228,000 C. P192,000
C. P396,000 D. P348,000
SOLUTION 7-31
1.Deferred tax liability, December 31,2010

(P40,000 + P60,000 + P20,000 = P120,000 x 30%) P36,000

Answer: A

2. Deferred tax asset, December 31,2010

(P400,000 x 30%) P120,000
Answer: C

3. Taxable income for 2010 P1,040,000

Tax rate x 30%
Income tax payable for 2010 P 312,000
Answer: C

4. Current tax expense for 2010 (see no.3) P312,000

Deferred tax expense for 2010 36,000
Deferred tax benefit for 2010 (120,000)
Income tax expense for 2010 P228,000
Answer: A

PROBLEM 7-32
Liability Under Finance Lease

On December 31,2009, LEMAN CO. signs a 10-year noncancelable

lease agreement to lease a storage building from Storage Company.
The following information pertains to this lease agreement:

1. The agreement requires equal rental payments of P720,000

beginning on December 31,2009.

2. The fair value of the building on December 31,2009 is

P4,400,000.

3. The building has an estimated economic life of 12 years, with

an unguaranteed residual value of P100,000. Leman appreciates
similar buildings on the straight-line method.

4. The lease in nonrenewable. At the termination of the lease,

the building reverts to the lessor.
5. The Leman’s incremental borrowing rate is 12% per year. The
lessor’simplicit rate is not known by Leman.

6. The yearly rental payment includes P24,705 of executory costs

related to taxes on the property.

The following present value factors are for 10 periods at 12%

annual interest rate:

Present value of an annuity due to 1 6.32825

Present value of an ordinary annuity of 1 5.65022
Present value of 1 0.32197

1. What amount should be capitalized as the cost of the leased

storage building?
A. P4,556,340 C. P4,432,197
B. P4,400,000 D. P0

2. What amount should be included in the current liabilities

section of Leman’s statement of financial position at
December 31,2010?
A. P720,000 C. P695,295
C. P414,477 D. P280,818

3. What amount should be included in the noncurrent liabilities

section of Leman’s statement of financial position at
December 31,2010?
A. P3,453,975 C. P5,562,360
C. P3,173,157 D. P0

4. What is the total lease-related expenses to be reported on

Leman’s income statement for the year ended December 31,2010?
A. P909,270 C. P1,160,000
C. P879,182 D. P464,705

SOLUTION 7-32
1. Present value of minimum lease payments:
(P720,000 – P24,705 [executory costs] x 6.32825) P4,400,000
Answer: B

2. Lease liability, Dec. 31,2010 (current position)

(P695,295 – P414,477) P280,818
Answer: D

3. Lease liability, Dec. 31,2010 (noncurrent position)P3,173,157

Answer: B

LEASE AMORTIZATION SCHEDULE (PARTIAL)

Annual Interest
Payment Less on Unpaid Balance of
Date Executory Costs Lease Liability Lease
Liability
12/31/09 --- --- P4,400,000
12/31/09 P695,295 --- 3,704,705
12/31/10 695,295 P444,565 3,453,975
12/31/11 695,295 414,477 3,173,157

4.LEASE RELATED EXPENSES FOR 2010

Interest expense (see amortization schedule) P444,565

Executory costs – property tax 24,705
Depreciation expense (P4,400,000/10years) 400,000
Total P909,270
Answer: A

PROBLEM 7-33
Liability Under Finance Lease
JACOMO COMPANY enters into a lease agreement with Lessor Co. on
July 1, 2010, to lease a machine to be used in its manufacturing
operations.

The followingdata pertain to this agreement:

1. The term of the noncancelable lease is 3 years, with no

renewal operation and no residual value at the end of the
lease term. Payments of P212,024 are due on July 1 of each
year, beginning July 1,2010.

2. The fair value of the machine on July 1,2010, is P620,000.

The machine has a remaining economic life of 5 years, with no
salvage value. The machine reverts to the lessor upon the
termination of the lease.

3. Jacomo Company elects to depreciate the machine on the

straight-line method.

4. Jacomo Company’s incremental borrowing rate is 10% per year,

and it hasno knowledge of the implicit rate computed by the
lessor.

5. The present value factor of an ordinary annuity of 1 for 3

periods at 10% year is 2.48685. The present value factor of
an annuity due 1 for 3 periods at 10% is 2.73554.

How much lease liability should be recognized by Jacomo at the

beginning of the lease contract?
A. P0 C. P580,000
C. P527,272 D. P636,072

SOLUTION 7-33
Present value of lease payments (P212,024 x 2.73554) P580,000
Answer: C
The amount to be capitalized land recognized as liability is the
present value of the minimum lease payments because it is lower
than the asset’s fair value.