CHAPTER

SUBSTANTIVE TESTS OF
12 INTANGIBLE ASSETS

12-1. The decision whether a given expenditure on intangible asset to be treated as

expense or asset requires judgment. Expenditure giving rise to future benefits will
be classified as assets while those expenditure the future benefits from which are
uncertain are charged of as expense in the year incurred. The expected benefit
from the intangible assets can be assessed in terms of the following:
a) Patents: Actual production of the goods covered by the patent
b) Goodwill: Review of actual excess income as well as actual income of the
investee
c) Trademark / Tradename: Continuous production of the product covered by
the trademark/tradename.

12-2. Research and Development Costs vary widely among companies. Many
expenditures do have future worth, while others are so highly uncertain as to
future value that recording them as assets is clearly improper.

The auditors interest in auditing Research and Development costs stems from the
objective of determining whether they should be deferred or charged against
current operations. He shall be guided by GAAP in judging whether the clients
treatment of the Research and Development Costs is justified or not.

12-3. Menfro, Inc.

The rapid amortization of the leasehold for the first twelve (12) years resulted to
an understatement of income totaling to P60,000:
Correct amortization P450,000 x 12 P270,000
20
Amortization per client (P27,500 x 12) 330,000
Over-amortization P 60,000

In view of the above, the amount of P60,000 should be added back to Retained
Earnings as correction of prior years profits. Furthermore, amortization of
P22,500 for the 13th year should be recorded.
These adjustments would result to a net increase in the Retained Earnings balance
which will enable the company to declare dividends without depleting the
Retained Earnings balance significantly.
12-2 Solutions Manual to Accompany Applied Auditing, 2006 Edition

12-4. Requirement (a)

The annual depreciation for years 11 to 25 is P1,667. By the end of the 25 th year,
the building would be fully depreciated. [(50,000 25,000) / 15 years)

Requirement (b)
If the original lease had contained a renewal clause for an additional 20 years, the
depreciation rate would still be 5%, which is based on the original term of the
lease. The renewal of the lease contract is not certain and therefore will not be
considered in the determination of the amortization period.

12-5. Process Development Company

Process Development Company

Patents Amortization Schedule
1997 to 2005

Cost as
Description Recorded Amortization Per Client
1997 1998 to 2005 Total Adjustment As Adjusted
Patent P P 40,000 P1,212.12 P 19,393.94 P 20,606.06 P(5,151.52) P 15,454.54
Q 120,000 3,529.41 56,470.59 60,000.00 (15,000) 45,000.00
R 160,000 4,705.88 75,294.12 80,000.00 (20,000) 60,000.00
P320,000 P9,447.41 P151,158.65 P160,606.06
Less: Adjustment
as per BIR
requirement 80,000 (2,361.85) (37,789.67) (40,151.52)
As Adjusted P240,000 P7,085.56 P113,368.98 P120,454.54 P120,454.54
(a) (b)

* Based on 17 years legal life.

(a) 1997 Amortization:

30,000
P = x 0.5 = P 909.09
16.5

210,000
Q&R = x 0.5 = 6,176.47
17 P7,085.56

(b) 1998 to 2005 Amortization:

30,000
P = x 8 =P 14,545.45
16.5

210,000
Q&R = x 0.5 = 98,823.53
17 P113,368.98
 Substantive Tests of Intangible Assets 12-3
Adjusting Journal Entries
(1) Capital in excess of par value 80,000.00
Patent P 10,000.00
Patent Q 30,000.00
Patent R 40,000.00
To adjust patent valuation to conform
to BIR requirement.
(2) Accumulated amortization Patent P 5,151.52
Accumulated amortization Patent Q 15,000.00
Accumulated amortization Patent R 20,000.00
Retained earnings Correction of prior
years profit 40,151.52
To adjust amortization provision from
1997 to 2005.

12-6. Cartwright Corporation

Note to Instructor: For ease of discussion, the adjusting entries in the solution are
dated to correspond with the original erroneous journal entries. In actual practice,
they would be dated as of the year-end.

Jan. 1 Organization Expenses 17,500

Intangibles 17,500
To classify incorporation fees.
10 Organization Expenses 7,500
Intangibles 7,500
To classify legal fees for the
organization of the company.
5 Advertising Expense 15,000
Intangibles 15,000
To expense advertising costs.
Apr. 1 Land 15,000
Building 20,000
Intangibles 35,000
To reclassify land and buildings for
R & D activities.
May 15 Research and Development Expenses 15,000*
Intangibles 15,000
To expense materials purchased.
* Alternatively, unused materials and
supplies, if material, may be set up as
prepaid expenses.
12-4 Solutions Manual to Accompany Applied Auditing, 2006 Edition

June 30 Patent 10,000

Intangibles 10,000
To reclassify the patent.

July 1 Income Summary / Retained Earnings 12,000

Intangibles 12,000
To record operating loss.

Dec. 10 Research and Development Expenses 12,000

Intangibles 12,000
To record acquisition of equipment.

31 Research and Development Expenses 30,000

Intangibles 30,000
To expense R & D costs.

31 Research and Development Expenses 750

Accumulated Depreciation: Building 750
To record year depreciation on R
& D building (20-year life) from
April 1 entry.

31 Amortization Expense 250

Patent 250
To record year amortization (20-
year life) on June 30 patent.

PAS 38 prohibits capitalization of start-up expenses such as organization costs.

No amortization should therefore be recorded.

12-7. Harper, Inc.

Calculation of Goodwill

Average year-end net assets:

(P2,400,000 5) P 480,000

Average annual earnings

(P400,000 5) P 80,000
Less: Normal return on average year-end assets
(10% x P480,000) 48,000
Excess annual earnings P 32,000

Excess annual earnings capitalized at 20% or Goodwill

P32,000 12% = P160,000
 Substantive Tests of Intangible Assets 12-5
12-8. Bayer, Inc.

Bayer, Inc. Lead, Inc.

Net tangible assets per records, Nov. 1, 2006 P328,500 P298,500
Add: Agreed increase in value of equipment 40,000
Net adjusted tangible assets P368,500 P298,500
Add: Value of Goodwill (Schedules 1 & 2) 74,900 12,900
Total amount to be paid for net tangible assets
and goodwill P443,400 P311,400

Supporting Computations:

Schedule 1: Goodwill of Bayer, Inc.

Average pre-tax earnings 11.1.01 to 11.1.06 P82,000

Less: Additional annual depreciation equipment taken over
at P40,000 in excess of book value (P40,000 / 5) 8,000
Adjusted pre-tax earnings P74,000
Less: Required earnings on net tangible assets
(15% x P368,500) 55,275
Excess annual pre-tax earnings P18,725
Goodwill (excess earnings capitalized at 25%) P74,900

Schedule 2: Goodwill of Lead, Inc.

Average pre-tax earnings 11.1.01 to 11.1.06 P44,000

Less: Adjustment for effect of organization cost written off
in 2005 (P20,000 / 5) 4,000
Adjusted pre-tax earnings P48,000
Less: Required earnings on net tangible assets
(15% x P298,500) 44,775
Excess annual pre-tax earnings P 3,225
Goodwill (excess earnings capitalized at 25%) P12,900

12-9. Phoenix Supply Company

Requirement (a)

Allocation of the P137,500 cost to the individual assets in the group of assets
acquired is based on the relative fair value of the individual assets.
12-6 Solutions Manual to Accompany Applied Auditing, 2006 Edition

Appraisal Portion of Total Allocated

Asset Value Total Value Cost Cost
Patent A P 30,000 30/151.7 x P137,500 = P 27,192
Patent B 40,000 40/151.7 x 137,500 = 36,256
Equipment 19,700 19.7/151.7 x 137,500 = 17,856
Land 62,000 62/151.7 x 137,500 = 56,196
P151,700 P137,500

Journal entries for 2004, 2005 and 2006, relative to intangible assets, are as
follows:

2004

Apr. 27 Patent A 27,192

Patent B 36,256
Equipment 17,856
Land 56,196
Cash 137,500
To record the acquisition of assets.

Oct. 31 Amortization of Patents 4,230

Patent A (27,192 / 5 x 6/12) 2,719
Patent B (36,256 / 12 x 6/12) 1,511
To record amortization of patents
for 2004.

2005

Mar. 7 Legal Expenses 17,600

Cash 17,600
To record legal fees related to defense
of patents.

Mar. 7 Amortization of Patents 1,813

Patent A 1,813
To record amortization on Patent A
to date of write-off (Nov. 2004 to
Feb. 2005).

Mar. 7 Loss on Patent A 22,660

Patent A 22,660
To record write-off of Patent A after
unsuccessful defense.
 Substantive Tests of Intangible Assets 12-7
Oct. 31 Amortization of Patents 3,021
Patent B 3,021
To record amortization of Patent B for 2005.

2006

Oct. 31 Amortization of Patents 3,021

Patent B 3,021
To record amortization on Patent B for 2006.

Computations
Amortization for 2006:
Patent A: (P27,192 / 5 years) (6 / 12) P 2,719
Patent B: (P36,256 / 12 years) (6 / 12) 1,511
P 4,230

Amortization on Patent A, 10/31/2004 3/7/2005:

(P27,192 / 5 years) (4/12) P 1,813
Book value of Patent A to 3/7/2005:
Cost P27,192
Amortization recognized P2,719
1,813 4,532
P22,660

Amortization for 2005 and 2006:

Patent B: (P36,256/12 years) P 3,021

The cost basis of patent B is P36,256 - P1,511 + P8,800 - P3,546). 2005, a full
years amortization is taken by dividing the unamortized cost by the remaining
useful life. In 2006 this is P39,999/10 years or P3,809.

Requirement (b)

The legal costs of a court defense should be charged to expense whether the suit is
won or lost because it does not meet the recognition criteria. Also, the
unsuccessful defense implies that Patent A is of no further value to the company
and leads to the write-off of the remaining unamortized cost of that patent.
12-8 Solutions Manual to Accompany Applied Auditing, 2006 Edition

12-10. Balagtas Enterprises

Requirement (a)

Patents
1. Balance before adjustment, 12/31/06 P550,000
Correction: Deduct unamortized balance of P75,000
expenditures incorrectly debited to account on 1/1/03:
P75,000 x (7 years/10 years) (52,500) [AJE (1)]
Corrected balance before 2006 amortization P497,500
2. 2006 Amortization
Patent having two years remaining life
Unamortized cost: P210,000 x (7 years/14 years)
= P105,000

Amortization: P105,000/2 P 52,500

Remaining Patents
Unamortized cost: P497,500 - P105,000 = P392,500
Amortization: P392,500/7 56,071
P108,571 [AJE (2)]

Franchise Agreement
1. Balance before adjustment, 12/31/06 P 95,000
Correction: Deduct periodic payment charged to account (45,000) [AJE (3)]
Corrected balance before 2006 amortization P 50,000
2. 2006 Amortization:
P50,000 / 5 years P 10,000 [AJE (4)]

Organization Costs
1. Balance before adjustment, 12/31/06 P102,000
Correction: Legal fees incorrectly charged to
Goodwill account in 1998 P45,000 [AJE (5)]
Amortization of above costs,
1998 - 2004 (P45,000 / 40) (7 years) 7,875 37,125 [AJE (6)]
P139,125 [AJE (7)]

2. No amortization need be taken up in 2006. With the effectivity of PAS 38

which does not allow deferment or capitalization of organization costs, the
entire balance of this account, should have been charged off against income in
2004. Adjusting entry in 2006 will be:

Retained earnings Prior period

adjustment 139,125
Organization costs 139,125
 Substantive Tests of Intangible Assets 12-9
Goodwill
1. Balance before adjustment, 12/31/06 P345,000
Correction: Reclassification of legal fees
to Organization Costs ( 45,000)
Reclassification of advertising fee to Advertising Expense (100,000)
Amortization on Goodwill for 2004
(P200,000 / 40 years) ( 5,000)
Balance 12.31.04 P195,000

2. Effective January 2005, Revised PAS 36 prohibits amortization of intangibles

with indefinite life - Goodwill being one of them. Hence, no amortization
would be taken up starting 2005. Assessment for possible impairment should
be done annually or whenever there is an indication that the asset may be
impaired.

Adjusting Journal Entries:

Patents
AJE (1) Retained Earnings 52,500
Patents 52,500

AJE (2) Cost of Goods Sold 108,571

Patents 108,571

Franchise Agreement
AJE (3) Selling and Administrative -
Franchise Expense 45,000
Franchise Agreement 45,000

AJE (4) Selling and Administrative

Expense 10,000
Franchise Agreement 10,000

Organization Cost
AJE (5) Organization Costs 45,000
Goodwill 45,000

AJE (6) Retained Earnings 7,875

Organization Costs 7,875

AJE (7) Retained Earnings 139,125

Organization Costs 139,125
12-10 Solutions Manual to Accompany Applied Auditing, 2006 Edition

Goodwill
AJE (8) Selling and Administrative
Advertising Expense 100,000
Goodwill 100,000

AJE (9) Retained Earnings 5,000

Goodwill 5,000

Requirement (b)

(1) Retained Earnings 204,500

Selling and Administrative
Franchise Expense 45,000
Selling and Administrative
Advertising Expense 100,000
Organization Costs 102,000
Franchise Agreement 45,000
Goodwill 150,000
Patents 52,500

Summary:

Retained Earnings (Dr.) Cr.

AJE (1) (52,500)
(7) (139,125)
(9) 5,000
(6) 7,875
(204,500)

Organization Costs Dr. (Cr.)

AJE (5) 45,000
(6) (7,875)
(7) (139,125)
(102,000)

Goodwill Dr. (Cr.)

AJE (5) 45,000
(8) 100,000
(9) 5,000
150,000

(2) Cost of Goods Sold 108,571

Selling and Administrative Expense 10,000
Patents 108,571
Franchise Agreement 10,000
 Substantive Tests of Intangible Assets 12-11
12-11. Balagtas Company

Requirement (a)

The deficiencies listed below are apparent from the balance sheet and the
explanations given. The assumption is made that costs incurred have been
properly classified by Mr. Balagtas. The correct treatment of each item is
presented in the column on the right.

Deficiency Correct Treatment

1. Capitalization of expenses: Treat all the items as expenses in
Research and development 2006 income statement.
Marketing research
Personnel recruitment and training
Legal fees relative to organization
of the corporation
Operating expenses
2. No depreciation was taken on Expense appropriate amounts in the
machinery. 2006 income statement.

3. Ordinary shares account does not Increase ordinary shares by par

reflect the par value of the
outstanding shares (11,000).
4. No statement of shareholders
equity and explanation of shares
issued is presented.
5. No accumulated deficit presented.
value of 1,000 shares.
The statement should be provided,
including dates and numbers of
shares issued, peso amounts
assigned, and the bases for
assigning peso values in noncash
transactions. Also, land given by
Mario should be recorded at fair
value; services by Pedro should be
recognized as an expense at fair
value. Additional paid-in capital
may be recognized as the result of
the above.
Deficit accumulated during
development stage should be
included in the shareholders equity
section. The amount results from
corrections made in items 1 and 2
above.
12-12 Solutions Manual to Accompany Applied Auditing, 2006 Edition

Requirement (b)

Additional items which should be included are:

1. Income statement, including amounts of revenue and expenses recognized
since the inception of the enterprise in 2006.

2. Statement of cash flows, including cumulative amounts of sources and uses of

cash since the inception of the enterprise.

3. Additional disclosures: identification of the company as a development-stage

enterprise, and description of significant development-stage activities.

12-12. Nikko Corporation

Requirement (a)

In a purchase transaction, assets are recorded at their acquisition price, which

becomes the cost basis to the acquiring corporation. The book values of the assets
for Rain Company are irrelevant.

Requirement (b)

When a price is paid for a group of assets, the total price must be allocated to the
individual assets. Because we know neither the total fair value of the tangible and
other intangible assets acquired from Rain Company nor the price to be paid by
the Nikko Corporation, we cannot determine whether Nikko Corporation has any
goodwill to record. The total price to be paid by the Nikko Corporation is
indefinite but it may be estimated by discounting the expected receipts (1% of net
sales) at the end of each of the next 5 years and adding the initial P450,000 cash
payment. If the estimated purchase price exceeds the sum of the estimated fair
values of the tangible and other assets purchased, then the excess may be recorded
as goodwill.

12-13. Golden Springs Shopping Center, Inc.

Interest on mortgage bonds: An amount equal to the interest cost incurred in 2004
(P60,000) is clearly a cost that can be associated with the normal construction
period and can be regarded as a normal element of the capitalized cost of the
physical assets of the shopping center because the construction period would have
ended at the end of the year if the typhoon had not occurred. The decision to use
debt capital to finance the shopping center was made with full knowledge that
interest would accrue during the construction period and add to the total cost of
building the center and bringing it to the point at which it would produce revenue.
The future income to be generated by the shopping center must have been
estimated to be more than sufficient to recover all of the expected costs of
 Substantive Tests of Intangible Assets 12-13
building the center and preparing it for occupancy, including interest during the
construction period.

Instead of treating interest during construction as an element of the cost of the

physical assets, it can be argued that it represents an element of the general cost of
bringing the business to the point of revenue production and should therefore be
treated as an organization cost. This view regards interest during construction as
just another of the many expenditures that are necessary to acquire and organize
the physical assets of a new business but do not attach to any specific assets.
Treated as an organization cost, interest during construction would be expensed as
a start-up cost.

Another alternative to capitalizing an amount equal to the 2004 interest cost is to

treat it as interest expense. This treatment is inappropriate because it assumes that
the decision to use debt capital to finance construction is a decision deliberately to
incur an expense for the interest that accrues during the expected construction
period.

The extension of the construction period to October 2005 because of the typhoon
was externally imposed and so the interest capitalization period continues until
final construction is complete. That is, the additional interest cost is capitalized
and not expensed as a loss from the typhoon.

Cost of obtaining tenants: Both the 2004 and 2005 costs of obtaining tenants
should be capitalized and amortized over the life of the leases. The fact that all of
the tenants who were signed when the typhoon occurred accepted the October
occupancy date indicates that the total cost of obtaining tenants was not affected
by the delay.

The cost of obtaining tenants has a direct and easily identifiable relationship to the
rental income to be earned over the terms of the leases. Under these
circumstances, the problem of reliably measuring periodic net income is best
solved by matching costs with the revenues to which they are directly related.

Promotional advertising: The 2004 cost of promotional advertising should be

written off as a start-up cost. The 2005 cost of promotional advertising should
also be expensed.

The initial expense treatment of the 2004 advertising cost is appropriate because it
is a start-up cost.

The 2005 advertising cost may also be considered as a start-up cost or simply
expensed as advertising cost incurred.
12-14 Solutions Manual to Accompany Applied Auditing, 2006 Edition
12-14. Lee Manufacturing Corporation
Lee Manufacturing Corporation
Financial Statement Worksheet
For the Year Ended December 31, 2006
Trial Balance Adjustments Income Statement Balance Sheet
General Ledger Accounts Debit Credit Debit Credit Debit Credit Debit Credit
Cash P 61,000 P 61,000
Accounts receivable 92,500 (8) P 2,500 95,000
Allowance for doubtful accounts P 500 (500)
Inventories 38,500 38,500
Machinery 75,000 (1) 17,000 92,000
Equipment 29,000 (8) 8,500 37,500
Accumulated depreciation 10,000 (10,000)
Patents 85,000 (1) P 17,000 68,000
Leasehold improvements 26,000 (8) 11,000 15,000
Prepaid expenses 10,500 10,500
Organization costs 29,000 (9) 29,000
Goodwill 24,000 (7) 24,000
Licensing agreement no. 1 50,000 (4) 1,250 19,500
(5) 29,250
Licensing agreement no. 2 49,000 (3) 1,000 50,000
Accounts payable 147,500 P 147,500
Unearned revenue 12,500 (3) 1,000 13,500
Capital stock 300,000 300,000
Retained earnings, Jan. 1, 2006 27,000 (27,000)
Sales 768,500 P 768,500
Cost of goods sold 454,000 (2) 3,400 P 464,400
(6) 5,500
(10) 1,500
Selling and general expenses 173,000 (7) 8,000 181,000
Start-up expenses (7) 16,000 45,000
(9) 29,000
Interest expense 3,500 3,500
Extraordinary losses 12,000 12,000
Accumulated amortization:
patents (2) 3,400 (3,400)
Accumulated amortization:
leasehold improvements (10) 3,000 (3,000)
Accumulated amortization:
licensing agreements (6) 5,500 (5,500)
Prior period adjustment (4) 1,250 (30,500) *
licensing agreement no. 1 (5) 29,250
Prior period adjustment
amortization of leasehold
improvements (10) 1,500 (1,500) *
Net income for 2006 62,600 62,600
Totals P1,239,000 P1,239,000 P124,400 P124,400 P 768,500 P 768,500 P 470,600 P 470,600
* Generally, adjustments in the current period that could have been determined by management in a prior period should enter into the determination of net income in the current
period. However, because the 2006 financial statements were not prepared in conformity with generally accepted accounting principles, these retroactive adjustments are
considered to be errors and treated as prior period adjustments and, therefore, should be applied against beginning retained earnings.
 Substantive Tests of Intangible Assets 12-15
12-14. Lee Manufacturing Corporation (continued . . . )

Adjusting entries (shown on worksheet):

(1) Machinery 17,000

Patents 17,000
To transfer cost of improving
machinery to the fixed asset account.

(2) Cost of Goods Sold 3,400

Accumulated Amortization: Patents 3,400
To record 2006 patent amortization
(1/20 x P68,000).

(3) Licensing Agreement No. 2 1,000

Unearned Revenue 1,000
To classify revenue received in advance
on licensing agreement as unearned
revenue.

(4) Prior Period Adjustment Licensing Agreement

No. 1 1,250
Licensing Agreement No. 1 1,250
To take up 2005 amortization (40 year
life). (Note 1)

Note 1: Under the revised PAS 38 made

effective January 1, 2005, intangible assets with
indefinite useful lives need not be amortized but
periodically assessed for possible impairment.
This problem may also be solved by
disregarding the 40-year amortization period for
Licensing Agreement #1. The flood that
rendered Licensing Agreement #1 worthless in
January 2007 should be fully disclosed in the
December 31, 2006 statements.

(5) Prior Period Adjustment Licensing Agreement

No. 1 29,250
Licensing Agreement No. 1 29,250
To write off the permanent 60%
reduction in the expected revenue-
producing value of licensing agreement
no. 1 caused by the December 2005
explosion (60% x P48,750).
12-16 Solutions Manual to Accompany Applied Auditing, 2006 Edition

(6) Cost of Goods Sold 5,500

Accumulated Amortization: Licensing
Agreements 5,500
To record 2006 amortization of
licensing agreement no. 1 [(P50,000
P1,250 P29,250) 39] and no. 2
(P50,000 10).

(7) Selling and General Expenses 8,000

Start-up Expenses 16,000
Goodwill 24,000
To transfer items improperly charged to
Goodwill.

(8) Start-up Expenses 29,000

Organization Costs 29,000
To expense other organization costs.

(9) Equipment 8,500

Accounts Receivable Lessor 2,500
Leasehold Improvements 11,000
To charge the Equipment account with
movable equipment and to record a
receivable from the landlord for the real
estate taxes erroneously paid by Lee.

(10) Cost of Goods Sold 1,500

Prior Period Adjustment Amortization of
Leasehold Improvements 1,500
Accumulated Amortization: Leasehold
Improvements 3,000
To record 2005 and 2006 amortization
of leasehold improvements based on
10-year life of lease (2 x 10% x
P15,000).
 Substantive Tests of Intangible Assets 12-17
12-15. Broadway Corporation

Requirement (1)

Broadway Corporation
Intangibles Section of Balance Sheet
December 31, 2006

Franchise from IE Copy Service, Inc., net of

accumulated amortization of P6,870 (Schedule 1) P 61,830
Patent, net of accumulated amortization of P2,050
(Schedule 2) 14,350
Trademark, net of accumulated amortization of
P7,294 (Schedule 3) 42,706
Total intangibles P118,886

Schedule 1:

Computation of Franchise from

IE Copy Service, Inc.

Cost of franchise at January 1, 2006

Down payment P25,000
Present value of installments 43,700
Initial amount capitalized P68,700
Amortization of franchise for 2006 (P68,700 10
years) (6,870)
Franchise balance, December 31, 2006 P61,830

Schedule 2:

Computation of Patent

Capitalized cost of patent at January 2, 2006 legal

fees and other costs associated with registration P16,400
Amortization of patent for 2006 (P16,400 8 years) (2,050)
Patent balance, December 31, 2006 P14,350
12-18 Solutions Manual to Accompany Applied Auditing, 2006 Edition

Schedule 3:

Computation of Trademark

Accumulated
Cost Amortization
Cost of trademark at July 1, 2003 P40,000
Amortization through December 31, 2006
(P40,000 20 years = P2,000 x 3 years) P7,000
Balance, December 31, 2006 P40,000 P7,000
Deduct accumulated amortization (7,000)
Trademark balance, December 31, 2006 P33,000

Cost of successful litigation in defense of trademark should be charged to

expense.

Requirement (2)
Broadway Corporation
Expenses Resulting from Intangibles Transactions
For the Year Ended December 31, 2006

Franchise from IE Copy Service, Inc.

Amortization of franchise (Schedule 1) P 6,870
Franchise fee on revenues from operations
(P900,000 x 5%) 45,000
Imputed interest expense on unpaid balance of
initial franchise fee (P43,700 x 14%) 6,118
P57,988
Amortization of patent (Schedule 2) 2,050
Litigation expense Trademark 10,000
Amortization of trademark 2,000
Total expenses P72,038

12-16. Precious Opal Corporation

(a) 2006 amortization: P16,000 10 = P1,600.

12/31/06 book value: P16,000 P1,600 = P14,400.
2007 amortization: (P16,000 10) = P1,600.
12/31/07 book value: (P16,000 P3,200) = P12,800.

(b) 2007 amortization: (P12,800) 4 = P3,200.

12/31/07 book value: P12,800 P3,200 = P9,600.

Legal fees in successfully defending the trade name should be charged to

expense.
 Substantive Tests of Intangible Assets 12-19
(c) Carrying amount (P19,733) > Fair Value (P15,000); thus the tradename fails
the recoverability test. The new carrying value is P15,000.

The fair value is considered the recoverable amount. The estimated total
future flows from the trade name of P16,000 need to be discounted and the
resulting present value would in most probability be a lower amount than
P15,000.

2008 amortization (after recording impairment loss):

P15,000 8 = P1,875.
12/31/08 book value: P15,000 P1,875 = P13,125

12-17. Miguel Alfonso Corporation

Requirement (a)
Attorneys fees in connection with organization
of the corporation P15,000
Costs of meetings of incorporators to discuss
organizational activities 7,000
State filing fees to incorporate 1,000
Total organization costs P23,000
Drafting and design equipment, P10,000, should be classified as part of fixed
assets, rather than as organization costs.

Requirement (b)
Organization Expense ................................................................ 23,000
Cash (Payables)................................................................ 23,000

12-18. Jo Tan Company

Requirement (a)
Jo Tan Company
INTANGIBLES SECTION OF BALANCE SHEET
December 31, 2007
Patent from Francis Argante Company, net of accumulated
amortization of P560,000 (Schedule 1) P1,440,000
Franchise from JC Company, net of accumulated
amortization of P48,000 (Schedule 2) 432,000
Total intangibles P1,872,000
 12-20 Solutions Manual to Accompany Applied Auditing, 2006 Edition

Schedule 1 Computation of Patent from Francis Argante Company

Cost of patent at date of purchase P2,000,000
Amortization of patent for 2006 (P2,000,000 10 years) (200,000)
1,800,000
Amortization of patent for 2007 (P1,800,000 5 years) (360,000)
Patent balance P1,440,000

Schedule 2 Computation of Franchise from JC Company

Cost of franchise at date of purchase P 480,000
Amortization of franchise for 2004 (P480,000 10) (48,000)
Franchise balance P 432,000

Requirement (b)
Jo Tan Company
Income Statement Effect
For the year ended December 31, 2007
Patent from Francis Argante Company:
Amortization of patent for 2007
(P1,800,000 5 years) P360,000
Franchise from JC Company:
Amortization of franchise for 2007
(P480,000 10) P 48,000
Payment to Reagan Company
(P2,500,000 X 5%) 125,000 173,000
Research and development costs 433,000
Total charged against income P966,000

12-19. Twinkle Industries

Requirement (a)

Patent X
Life in years 17
Life in months (12 X 17) 204
Amortization per month P150
Number of months amortized to date
Year Month
2004 10
2005 12
2006 12
2007 12
46

Book value 12/31/07 P23,700: (P30,600 [46 X P150])

 Substantive Tests of Intangible Assets 12-21
Patent Y
Life in years 10
Life in months (12 X 10) 120
Amortization per month P125
Number of months amortized to date
Year Month
2005 6
2006 12
2007 12
30

Book value 12/31/07 P11,250: (P15,000 [P125 X 30])

Patent Z
Life in years 4
Life in months (12 X 4) 48
Amortization per month P300
Number of months amortized to date
Year Month
2006 4
2007 12
16
Book value 12/31/07 P9,600: (P14,400 [P300 X 16])

At December 31, 2007

Patent X P23,700
Patent Y 11,250
Patent Z 9,600
Total P44,550

Requirement (b)

Analysis of 2008 transactions

1. The P245,700 incurred for research and development should be expensed.

2. The book value of Patent Y is P11,250 and its estimated future cash flows are
P6,000: (3 X P2,000) therefore Patent Y is impaired. The impairment
loss is imputed as follows:

Book value P11,250

Less: Present value of future
cash flows 2,000 X 2.57710 5,154
Loss recognized P 6,096
12-22 Solutions Manual to Accompany Applied Auditing, 2006 Edition

Patent Y carrying amount (12/31/08) P5,154

At December 31, 2008

Patent X P21,900 (P23,700 [12 X P150])

Patent Y 5,164 (Present value of future cash flows)
Patent Z 6,000 (P9,600 [12 X P300])
Patent AA 34,560 (P36,480 P1,920*)
Total P67,624

Patent AA amortization
Life in years 9 1/2
Life in months 114
Amortization per month P320
P320 X 6 = P1,920

Patent Y: Value in Use

2,000 x 0.9259 = P1,852
2,000 x 0.8573 = 1,715
2,000 x 0.7983 = 1,597
P5,164
or
2,000 x 2.582 = P5,164

12-20. Depp Corporation

Requirement (a)

Cash................................................................................................
50,000
Receivables................................................................................................
90,000
Inventory ................................................................................................
125,000
Land................................................................................................
60,000
Buildings ................................................................................................
75,000
Equipment ................................................................................................
70,000
Trademarks................................................................................................
15,000
Goodwill................................................................................................
65,000
Accounts Payable ................................................................ 200,000
Notes Payable ................................................................ 100,000
Cash................................................................................................ 250,000

Note that the building and equipment would be recorded at the 7/1/06 cost to
Brigham; accumulated depreciation accounts would not be recorded.
 Substantive Tests of Intangible Assets 12-23
Requirement (b)

1. Amortization Expense (Trademarks) ................................ 1,500

Trademarks ([P15,000 P3,000] 1/4 X 6/12)................................ 1,500

2. Goodwill will not be amortized.

12-21. Bill Santos Company

Requirement (a)

December 31, 2006

Loss on Impairment................................................................
1,100,000*
Copyrights................................................................ 1,100,000

*Carrying amount P4,300,000

Fair value 3,200,000
Loss on impairment P1,100,000

Requirement (b)

Copyright Amortization Expense................................ 320,000*

Copyrights................................................................ 320,000

*New carrying amount P3,200,000

Useful life 10 years
Amortization per year P 320,000

Fair Value
Historical Cost Fair Value 12.31.07
CV 12.31.06 P4,300,000 P3,200,000
Amortization, 2007 430,000 320,000
CV 12.31.07 P3,870,000 P2,880,000 P3,400,000

Recovery 520,000
Requirement (c)

Copyrights................................................................................................
520,000
Copyright Amortization Expense
or Gain on Recovery of Previously
Recognized Impairment ................................ 520,000
12-24 Solutions Manual to Accompany Applied Auditing, 2006 Edition

12-22. Espaol Co.

Franchises................................................................................................
42,000
Prepaid Rent................................................................................................
28,000
Retained Earnings (Organization Costs of P6,000 in
2006) ................................................................................................
6,000
Retained Earnings (P16,000 P6,000) ................................ 10,000
Patents ................................................................................................
74,000
Legal fees ................................................................................................
12,650
Research and Development Expense ................................................................
(P75,000 + P160,000) ................................................................ 235,000
Goodwill................................................................................................
278,400
Intangible Assets................................................................ 686,050

Franchise Amortization Expense (P42,000 8)................................ 5,250

Retained Earnings (P42,000 8 X 6/12)................................ 2,625
Franchises ................................................................ 7,875

Rent Expense (P28,000 2)................................................................

14,000
Retained Earnings (P28,000 2 X 3/12)................................ 3,500
Prepaid Rent................................................................ 17,500

Patent Amortization Expense ................................................................

7,400
Patents................................................................................................
7,400
(P74,000 10)

NoteNo amortization of goodwill; goodwill should be tested for impairment on

at least an annual basis in future periods.

12-23. Sim Laboratories

Requirement (a)

Costs to obtain patent Jan. 1999 P62,050

1996 amortization (P62,050 17) (3,650)
Carrying value, 12/31/99 P58,400

All costs incurred prior to January 1999 are related to research and development
activities and were expensed as incurred.
 Substantive Tests of Intangible Assets 12-25
Requirement (b)

1/1/00 carrying value of patent P58,400

2000 amortization (P62,050 17) P3,650
2001 amortization 3,650 (7,300)
51,100
Legal fees to defend patent 12/01 35,700
Carrying value, 12/31/01 86,800
2002 amortization (P86,800 14) 6,200
2003 amortization 6,200 (12,400)
Carrying value, 12/31/03 P74,400

The costs incurred in 2000 and 2002 are related to research and development
activities and are expensed as incurred. Legal fees in successful defense of the
patent in 2001 could be capitalized and considered GAAP.

Requirement (c)

1/1/04 carrying value P74,400

2004 amortization (P74,400 5) P14,880
2005 amortization 14,880
2006 amortization 14,880 (44,640)
Carrying value, 12/31/06 P29,760

The legal costs in 2006 were expensed because the suit was unsuccessful. Even if
the lawsuit was successful, the legal fees would be likewise charged to expense.
This is in accordance with PAS 38, Intangibles which was made effective in 2004.