CHAPTER

SUBSTANTIVE TESTS OF RECEIVABLES AND SALES

8-1. Tests of details of financial balances are designed to determine the reasonableness of the balances in sales, accounts receivable, and other account balances which are affected by the sales and collection cycle. Such tests include confirmation of accounts receivable, and examining documents supporting the balance in these accounts. Tests of transactions for the sales and collection cycle are intended to determine the effectiveness of internal control structure and to test the substance of the transactions which are produced by this cycle. Such tests would consist of examining sales invoices in support of entries in the sales journal, reconciling cash receipts, or reviewing the approval of credit. The results of the tests of transactions will be used to affect the procedures, sample size, timing and particular items selected for the tests of details of financial balances (i.e., an effective internal control structure will result in reduced testing when compared to the tests of details required in the case of an inadequate internal control structure). 8-2. There are two common types of confirmations used for confirming accounts receivable: positive confirmations and negative confirmations. A positive confirmation is a communication addressed to the debtor requesting him to confirm directly whether the balance as stated on the confirmation request is correct or incorrect. A negative confirmation is also a communication addressed to the debtor, but it requests a response only when the debtor disagrees with the stated amount. A positive confirmation is more reliable evidence because the auditor can perform follow-up procedures if a response is not received from the debtor. With a negative confirmation, failure to reply must be regarded as a correct response even though the debtor may have ignored the confirmation request. Offsetting the reliability disadvantage, negative confirmations are less expensive to send than positive confirmations, and thus more of them can be distributed for the same total cost. The determination of which type of confirmation to be sent is an auditors decision, and it should be based on the facts in the audit. The following

8-2

Solutions Manual to Accompany Applied Auditing, 2006 Edition are the most important circumstances where positive confirmations should be used: 1. 2. 3. There are a small number of large accounts which account for a significant portion of total accounts receivable. There are suspected conditions of dispute, inaccuracy, or irregularity. This would be the case when internal controls are considered inadequate or if prior years audit test results are unsatisfactory. The rules of certain regulatory agencies require them. This is the case for brokers and dealers in securities.

When the above conditions do not exist, it is acceptable to use negative confirmations, but negative confirmations should not be used if the auditor believes the customer is likely to ignore the confirmation. Typically, when negative confirmations are used, the auditor is using a reduced control risk assessment in the audit of accounts receivable. It is also common to use negative confirmations for audits of hospitals, retail stores, and other industries where the receivables are due from the general public. In these cases, far more assurance is obtained from tests of internal control than from confirmations. It is also common to use a combination of negative and positive confirmations by sending the positives to accounts with large balances and negatives to those with small balances. 8-3. It is acceptable to confirm accounts receivable prior to the balance sheet date if the internal control structure is adequate and can provide reasonable assurance that sales, cash receipts and other credits are properly recorded between the date of the confirmation and the end of the accounting period. Other factors the auditor is likely to consider in making the decision are the materiality of accounts receivable and the auditors experience in prior years. If the decision is made to confirm accounts receivable prior to year end, it is necessary to test the transactions occurring between the confirmation date and the balance sheet date by examining internal documents and performing analytical procedures at year end. 8-4. South Technologies, Inc. (a) When confirmation requests are mailed to debtors whose accounts were written off as uncollectible, the auditors purpose is to determine that the receivables were genuine when they were first recorded in the accounts. In some fraud cases, fictitious accounts receivable have been created to cover up a shortage. Eventually these fictitious receivables must be disposed of; one method is to write off the fictitious accounts as uncollectible. (b) The South executive appears to believe the auditors are solely concerned with the collectibility of accounts and notes receivable. In fact, the confirmation process is primarily intended to establish that the receivables are genuine and

Substantive Tests of Receivables and Sales

8-3

that the customers (or makers of notes) exist. Other audit procedures are followed to determine collectibility. 8-5. The confirmation requests should go to the makers of the notes regardless of whether the notes have been discounted. The act of discounting a note receivable does not reduce the importance of the note being genuine and collectible. A company which discounts its notes receivable remains in a position of sustaining a loss if the makers of the notes fail to make payment at the maturity dates. 8-6. (a) When customers fail to respond to positive confirmation requests the CPAs may not assume with confidence that these customers reviewed the requests and found no disagreement and therefore did not reply. Some busy customers will not take the time to review confirmation requests and will not respond; hence, obvious exceptions may exist without being reported to the CPAs. (b) If there is no response to a second request, the CPAs may mail a third request and possibly make telephone calls in an effort to get a reply directly from the customer. When it becomes apparent that the confirmation program will not produce further evidence, the CPAs should consider each remaining customer as to the size, nature, and age of the balance and the apparent reason for the lack of a reply before they decide what additional work is necessary in the circumstances. The CPAs should carry out the alternative audit procedures of examining customers purchase orders or contracts, shipping documents and sales invoices of the client, and remittances by nonconfirming customers received by the client subsequent to the balance sheet date. The auditors may also verify the existence, location, and credit standings of the nonconfirming customers by reference to credit agencies or other sources independent of the client. 8-7. North, Inc. No, the matter remains unresolved. First, oral evidence from the client is never in itself sufficient; the auditors must follow up to determine the reliability of the oral evidence. Second, payment of an account receivable is not confirmation; the account might be fictitious, and the payment could have been made by a dishonest employee who had created the fictitious account to conceal a cash shortage. The auditors must examine the customer purchase order or contract, and copies of the sales invoice and shipping document, in support of the unconfirmed receivable. They should also determine the genuineness of the customer by reference to the telephone directory or to credit agency reports. 8-8. Montys Meat, Inc. a. The workpaper does not include a description of the auditing procedures performed in confirming the accounts. The workpaper is also incomplete in the following respects:

8-4

Solutions Manual to Accompany Applied Auditing, 2006 Edition 1) The workpaper does not state whether the auditor traced the ABC Grocery remittance of P3,000 to November cash receipts. 2) The workpaper does not state whether the auditor examined the November 2 credit memo issued to Sari-Sari Store. 3) The workpaper does not state whether the auditor traced the Lucenas Meat Market remittance to November cash receipts. 4) The workpaper does not state whether and how the auditor obtained satisfaction regarding confirmation requests not returned. 5) The workpaper does not state whether the auditor examined documentation for the Dianas Supper Club order returned and received on October 31. 6) Rather than summarizing the confirmations returned without exception, as was done at the bottom of Working Paper 1, these confirmations should have been listed separately. b. 1) Sales Accounts receivable Inventory Cost of goods sold To reverse 2007 sale recorded in 2006. 2) Allowance for uncollectible accounts Accounts receivable To write off uncollectible account. 3) Sales returns and allowances Accounts receivable To record return of spoiled meat and recognize loss in period in which incurred. Meat not restored to inventory, inasmuch as it was spoiled. 4) Sales Accounts receivable To correct error in recording customer remittance as a sale. 5) Sales Returns Accounts receivable Inventory Cost of goods sold 334 334 250 250 13,000 13,000 3,634 3,634 1,277 1,277 P11,100 P11,100 8,600 8,600

Substantive Tests of Receivables and Sales

8-5

c. Exhibit 1.1

To record return and restore meat to inventory because meat returned in good condition. (See completed Exhibits 1.1 and 1.2 reproduced below and on the following page.)

Montys Meat, Inc. Accounts Receivable - Trade Aging Analysis October 31, 2006 Conf. No. 1060 1061 1064 1602 1603 1607 1608 1612 10/31 Customer Culleys Meats Jolly Roger Restaurant ABC Grocery (Other) Rudys Deli General Foods Grocers Kims Fresh Meats Dills Discount Grocery Dianas Supper Club Balance per ledger Audit Adjustments Balance P 1,330 466 4,256 329,433 378 13,468 2,334 12,469 866 P365,00 0 P (29,345 ) P335,65 5 # Current P 1,330 P 3,000 280,763 13,000 1,074 12,469 1,260 466 1,256 33,467 P12,324 378 468 P 2,879 Past Due (Days) 1-30 31-60 Over 60

334 532 P P 36,449 P13,234 P 311,970 3,347 P P(1,27 (28,068) 7) P P 36,449 P13,234 P 283,902 2,070 P(210,113 ) P P (13,353 ) 0 P 0&

10/31

Audited balance Cash receipts 11/1 11/27

11/27

Outstanding Estimated percent uncollectible

P P 23,096 P13,234 P 73,789 2,070 10% P 24,487 P P 7,379 25% 70% 100% P 2,070

10/31

Estimated uncollectible

5,774 P 9,264

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

& #

Traced subsequent collections to November remittance advices. Obtained balances from subsidiary ledger after agreeing to general ledger control account.

Prepared by: Initial Date

Reviewed by: Initial Date

Exhibit 1.2
Montys Meat, Inc. Accounts Receivable - Trade Allowance for Doubtful Accounts October 31, 2006 11/1/05 11/1 - 10/31 11/1 - 10/31 10/31/06 Balance per general ledger Monthly provision Write-offs Balance ledger AJE 2 AJE 6 10/31/06 Audited balance AJE 6 Bad debts expense P10,777 Allowance for doubtful accounts P10,777 To adjust allowance for doubtful accounts to amount considered reasonable in the circumstances. per general P28,000 #

24,000 & (37,000) @ P15,000 (1,277) P13,723 P10,777 P24,500 ^

Substantive Tests of Receivables and Sales

# Traced to last years WTB - audited balance & Traced to standard journal entries @ Examined documentation and discussed with credit manager and legal counsel ^ In light of aging analysis, the above balance, as adjusted, appears to be adequate.

8-7

Prepared by: Initial Date

Reviewed by: Initial Date

8-9. Makati Company For all of the exceptions, the auditor is concerned about four principal things. (a) Whether there is a client error. Many times the confirmation response differences are due to timing differences for deposits in the mail and inventory in transit to the customer. Sometimes customers misunderstand the confirmation or the information requested. The auditor must distinguish between those and client errors. (b) The amount of the client error if any. (c) The cause of the error. It would be intentional, a misunderstanding of the proper way to record a transaction, or a breakdown of internal control. (d) Potential errors in the sample not tested. The auditor must estimate the error in the untested population, based on the results of the tests of the sample. Suggested steps to clear each of the comments satisfactorily are: 1. (a) Examine supporting documents, including the sales invoices and applicable sales and shipping orders, for propriety and valuation of the sales. (b) Review the cash receipts books for the period after December 31, 2005, and note any collections from the PDQ Company. The degree of internal control over cash receipts should be an important consideration in determining the reliance that can be placed on the cash receipts entries. In addition, as there is no assurance that collections after December 31

8-8

Solutions Manual to Accompany Applied Auditing, 2006 Edition represent the payment of invoices supporting the December 31 trial balance, consideration should be given to requesting a confirmation from the PDQ Company of the invoices paid by their checks. 2. (a) The cause should be investigated thoroughly. If the credit was posted to the wrong account, it may indicate merely a clerical error. On the other hand, posting to the wrong account may indicate lapping. (b) Such a comment may also indicate a delay in posting and depositing of receipts. If upon investigation such is the case, the company should be informed immediately so that it can take corrective steps. This is a confirmation of the balance with an additional comment. Since the customer has given us the data, it is preferable to check to see that the information agrees with the companys records. Such a procedure may disclose misposting or delay in recording receipts. This incomplete comment should raise an immediate question: does the customer mean paid before or paid after December 31? Because the customers intent is unknown, this account should be reconfirmed and the customer asked to state the exact date. Upon receipt of the second confirmation, the information thereon should be traced to the cash receipts book. The auditor should first evaluate how long it takes to ship goods to the customer in question. If it ordinarily takes more than five days, there is no indication of error. A comment of this type may indicate that the company may be recording sales before an actual sale has taken place. The auditor should examine the invoice and review with the appropriate officials the companys policies. Sales, cost of sales, inventories and accounts receivable may have to be adjusted if title has not passed to the buyer as of December 31, 2005. 6. (a) Determine if such advance payment has been received and that it has been properly recorded. A review should be made of other advance payments to ascertain that charges against such advances have been properly handled. (b) If the advance payment was to cover these invoices, the auditor should propose a reclassification of the P1,350, debiting the advance payment account and crediting accounts receivable--trade. (a) Examine the shipping order for indications that the goods were shipped and, if available, carriers invoice and/or bill of lading for receipt of the goods. (b) If it appears that goods were shipped, send all available information to the customer and ask the customer to reconfirm. If the customer still insists that goods were never received, all data should be presented to an appropriate company official for a complete explanation. This may indicate that accounting for shipments is inadequate and consideration

3.

4.

5.

7.

Substantive Tests of Receivables and Sales

8-9

should be given to reviewing the procedures to determine if improvements can be made. (c) If the goods were not shipped, the auditor should recommend an adjustment reducing sales, cost of sales, and accounts receivable, and increasing inventories. 8. This should be discussed with the appropriate officials and correspondence with the customer should be reviewed to allow determination whether an adjustment should be made in the amount receivable or if an allowance for doubtful accounts should be set up. As title on any goods shipped on consignment does not pass until those goods are sold, the sales entry should be reversed, inventory charged, and cost of sales credited if it is actually a consignment sale. Other so-called sales should be reviewed and company officials queried to determine if other sales actual represent consignment shipments; if so, the adjustment set forth in the preceding sentence should be made for all consignment shipments.

9.

10. This is a noncurrent asset and should be reclassified to either deposit or prepaid rent. A review of other accounts, especially those with round numbers, may disclose other accounts that should be so reclassified. 11. This may indicate a misposting of the credit or a delay in posting the credit. Comments under 2 above would also apply to credits. Ken Company Requirement (a)
Ken Company Accounts Receivable Aging Schedule May 31, 2006 Proportion of Total .680 .150 .080 .050 .025 .015 1.000 Amount in Category P 816,000 180,000 96,000 60,000 30,000 18,000 P1,200,000 Probability of Non-Collection .010 .035 .050 .090 .400 .900 Estimated Uncollectible Amount P 8,160 6,300 4,800 5,400 12,000 16,200 P52,860

8-10.

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

Requirement (b) Ken Company Analysis of Allowance for Doubtful Accounts May 31, 2006 June 1, 2005 balance Bad debt expense accrual (3,000,000 x .04) P 30,250 120,000

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Solutions Manual to Accompany Applied Auditing, 2006 Edition Balance before write-offs of bad accounts Write-offs of bad accounts Balance before year-end adjustment Estimated uncollectible amount Additional allowance needed Debit Bad Debts Expense Allowance for Doubtful Accounts Requirement (c)
Steps to Improve the Accounts Receivable Situation Establish more selective credit-granting policies, such as more restrictive credit requirements or more thorough credit rating investigation. Establish a more rigorous collection policy either through external collection agencies or by Kens own personal. Charge interest on overdue accounts. Insist on cash on delivery (COD) or cash on order (COO) for new customers or poorer credit risks. 1. 2. Risks and Costs Involved This policy could result in lost sales and increased costs of credit evaluation. Ken may be all but forced to adhere to the prevailing credit-granting policies of the office equipment and supplies industry. This policy may offend current and thus risk future sales. collection costs could result policy. This policy may offend current and thus risk future sales. customers Increased from this customers

P150,250 108,750 P 41,500 52,860 P 11,360 Credit 11,360 11,360

This policy could result in lost sales and increased administrative costs.

8-11.

Demo Inc. DEMO INC. Accounts Receivable 12-31-05

Balance Per Per General Ledger Subsidiar y AGING DISTRIBUTION Months Outstanding 0-1 1-3 3-6 over 6

Requirement (a)

Unadjusted Balances Add (Deduct) Adjustments: AJE (2)to correct

P197,0 00

P198,2 40

P93,2 40

P76,82 0

P22,18 0

P6,000

Substantive Tests of Receivables and Sales

understatement of accounts written off on October 31. (3) to write off definitely uncollectible accounts (4) to reclassify advances from customers (5) to reclassify accounts with credit balances (6) to adjust general ledger balance to agree with subsidiary balance Balances as adjusted

8-11

(200)

(1,000)

(1,000 )

(1,000 )

2,000

2,000

2,000

500

500

500

1,4 40 P199,7 40

_______

______ _ P95,2 40

_______

_______

______

P199,7 40

P77,32 0

P22,18 0

P5,000

DEMO INC. Allowance for Doubtful Accounts 12-31-05 Balance per Ledger Add (Deduct) Adjustments: AJE (1)to correct error in recording bad debts recovery (2)to correct understatement of accounts written off (3)to write off definitely uncollectible accounts (4)to adjust allowance to required balance (Schedule 1) Balance as adjusted Schedule 1: Computation of Required Allowance Account Classification 0-1 month outstanding 1-3 months outstanding 3-6 months outstanding over 6 months outstanding Totals Adjusted Total P 95,240 77,320 22,180 5,000 _______ P199,740 Required % 1 2 3 P2,000-50% P3,000-20% P12,000.00 324.00 ( 200.00) ( 1,000.00) ( 6,359.80) P 4,764.20 Allowance Amount P 952.40 1,546.40 665.40 1,000.00 600.00 P4,764.20

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Solutions Manual to Accompany Applied Auditing, 2006 Edition Requirement (b) Adjusting Journal Entries 12-31-05 (1) (2) (3) (4) (5) (6) (7) Bad Debts Allowance for Doubtful Accounts Allowance for Doubtful Accounts Accounts Receivable Allowance for Doubtful Accounts Accounts Receivable Accounts Receivable Advances from Customers Accounts Receivable Customers accounts with credit balances Accounts Receivable Sales Allowance for Doubtful Accounts Bad Debts Expense 324.00 324.00 200.00 200.00 1,000.00 1,000.00 2,000.00 2,000.00 500.00 500.00 1,440.00 1,440.00 6,359.80 6,359.80

8-12.

Tripoli Company

Requirement (1) Accounts receivable, trade.............................................. Advances to suppliers..................................................... Due from officers............................................................ Subscriptions receivable share capital......................... Expense advances to salespeople.................................... Accounts payable, trade (P19,250 P450)*............ Advances from customers on sales contracts........... Salaries payable....................................................... Allowance for doubtful accounts............................. Receivables (to close permanently)......................... Customers credit balances...................................... Requirement (2) Current assets: Accounts receivable, trade....................................... Less allowance for doubtful accounts...................... Creditors debit balances.......................................... Due from officers**................................................. Subscriptions receivable ordinary shares**.......... Expense advances to salespeople............................. 40,000 450 2,500 4,600 1,000 19,250 450 3,300 500 23,050 2,000

40,000 500

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

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

8-13

19,250 2,000 450 3,300

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

** Considered as current assets only if currently collectible. assumed to be material in amount. 8-13. 1. Pearl Corporation

Estimated bad debt percentage based on year-end accounts receivable: 28.5%# Actual bad debts Credit Sales Outstanding receivables (year-end) Percentage of outstanding receivables
a b c d e

2003 P 3,300a P90,000 P 9,500b 0.347

2004 P 5,700c P158,000 P 19,900d 0.286

2005 P 7,800e P210,000 P 29,500f 0.264

2006 P 16,800 P459,000 P 58,900 0.285#

P2,500 + P500 + P300 = P3,300 0 + P90,000 - P78,000 - P2,500 = P9,500 P4,600 + P700 + P400 = P5,700 P9,500 + P158,000 - P8,500 - P134,000 - P500 - P4,600 = P19,900 Estimated. The bad debts written off in the third year following the sale have averaged about 7.8% [(P300 + P400) (P3,300 + P5,700)] of the total actual bad debts in the previous 2 years. Therefore, the bad debts on 2005 sales of P6,200 and P1,000 are about 92.2% of the total bad debts expected on 2005 sales. P19,900 + P210,000 - P200 - P14,200 - P178,800 - P300 - P700 - P6,200 = P29,500

2.

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

8-14.

Flores Corporation

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

Flores Corporation Analysis of Changes in the Allowance for Doubtful Accounts For the Year Ended December 31, 2006 Balance at January 1, 2006 Provision for doubtful accounts (P9,000,000 x 2%) Recovery in 2006 of bad debts written off previously Deduct write-offs for (P90,000 + P60,000) Balance at December 31, 2006, before additional impairment loss Increase in estimated uncollectible accounts during 2006 (P235,300 - P175,000) Balance at December 31, 2006, adjusted (Schedule 1) P130,000 180,000 15,000 P325,000 150,000 P175,000 60,300 P235,300

Requirement (1)

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

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

Percent 2 10 25 75

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

P130,000 - P60,000 Flores Corporation Journal Entry December 31, 2006

Requirement (2)

Bad Debt Expense Allowance for Doubtful Accounts To increase the allowance for doubtful accounts at December 31, 2006, resulting from evaluation of collectibility of remaining receivables. 8-15. Visayas Company Requirement (a) Visayas Company Accounts Receivable 12.31.06 Balance, 12.31.05

60,300 60,300

P 546,400

Substantive Tests of Receivables and Sales Add: Sales on account for the year Total Less: Collections during the year - with discount (1) - without discount (2) Accounts written off Credit memo for sales returns & allowances Balance, 12.31.06 Total collections Less: Accts paid w/ discount Accts paid by customers w/o discount Requirement (b) AJE (1) Doubtful accounts expense Allowance for doubtful accounts Supporting Analysis: % allowance to AR 12.31.05 Required % allowance to AR 12.31.06 Required allowance 12.31.06 2% x P214,555 P 16,392 P546,400 2/3 x 3% P4,291 = = 6,599 P2,857,960 2,009,842 P 848,118

8-15

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

2,954,677 P 214,555

( 98% = P2,050,859) (1) (2)

6,599

3% 2%

Allowance for doubtful accounts balance, 12.31.05 Less: Accounts written off Required balance, 12.31.06 Estimated bad debts expense for 12.31.06 8-16. Charry Company

P 16,392 18,700 P( 2,308) 4,291 P 6,599

Requirement (a) Adjusting Journal Entries (1) Accounts Receivable Customers accounts with credit balances (P500 + P5,000) Sales 5,500 5,500 5,000

(2)

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Solutions Manual to Accompany Applied Auditing, 2006 Edition Accounts Receivable (3) (4) (5) (6) (7) (8) Subscriptions Receivable Accounts Receivable Deposit on Contract Accounts Receivable Claims Receivable Accounts Receivable Advances to Employees Accounts Receivable Advances to Affiliated Company Accounts Receivable Advances to Supplier Accounts Receivable 15,000 15,000 15,000 15,000 500 500 500 500 10,000 10,000 5,000 5,000 5,000

Requirement (b) Balance Sheet Presentation 12-31-06 Current Assets Accounts Receivable - Trade Claims Receivable Advances to Employees Advances to Supplier Investments Advances to Affiliated Company Other Assets Deposit on Contract Shareholders Equity Subscribed Share Capital (net of subscriptions receivable of P15,000) Supporting Analysis: Charry Company Accounts Receivable -Trade 12-31-06 Balance per ledger Add (Deduct) Adjustments: AJE (1) To reclassify accounts with credit balances P105,000 5,500 P59,500 500 500 5,000 10,000 15,000

xxx

Substantive Tests of Receivables and Sales (2) (3) (4) (5) (6) (7) (8) To reverse entry for consignment deliveries To reclassify subscriptions receivable To reclassify deposit on contract To reclassify balance of claims from carrier for shipping damages To reclassify employees IOUs To reclassify advances to affiliate To reclassify advances to supplier Net adjustments Balance as adjusted

8-17

( 5,000) ( 15,000) ( 15,000) ( 500) ( 500) ( 10,000) ( 5,000) ( 45,500) P 59,500

If correct entries were made for the transactions given, the Accounts Receivable account would show the following postings: Accounts Receivable Jan. 1 Balance Charge Sales Recoveries of accounts written off P 56,000 625,000 1,000 ________ P682,000 ________ P682,000 8-17. The Preston Companies (amounts in P millions) Collections Write offs Merchandise returns Allowance for shipping damages Balance Dec. 31 P615,000 3,500 2,500 1,500 P622,500 59,500 P682,000

Requirement (1) (a) Prestons earnings would have increased (1 0.40) P105 million or P63 million in 2006. Net accounts receivable and total assets would have been P105 million higher than actually reported in 2006. Ignoring differences between tax and financial reporting, income tax payable would have increased by P0.40 (P105 million) or P42 million, and retained earnings would be greater by P63 million. This example illustrates the material effect estimated bad debts can have on reported earnings and total assets. (b) Under the allowance method, failure to write off an account has no effect on earnings (assuming a sufficient balance exists in the allowance account), or any net balances in the balance sheet. Only the components of net accounts receivable would be affected. Both gross accounts receivable and the allowance for doubtful accounts would be overstated P0.6 million.

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

Requirement (2) Beginning allowance balance Bad debt expense Ending allowance balance Write-offs of accounts Requirement (3) (a) The ratio of bad debt expense to operating revenue for the two years is: 2006, P105/P3,729 = 2.8%; 2005, P81/P3,534 = 2.3%. This ratio appears relatively stable although is increasing. (b) The composite rate of uncollectible accounts as a percentage of gross accounts receivable = ending allowance balance/ending accounts receivable. The ratio for 2006 is P212 / (P951 + P212) = 18.2%, and for 2005 is P183 / (P972 + P183) = 15.8%. This ratio is less stable and also is increasing. (c) Bad debt expense is considerably higher than the write-offs in 2006. The firm has experienced an increase in expected write-offs. Apparently the firm expects an increase in bad debts, which is partially an estimate of future write-offs. 8-18. Rain Company 1998 P183 105 (212) P 76

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

Requirement (2) Correction and Collection Schedule:

Date 1-1-2005 12-31Explanation and Interest Revenue Recorded originally at face amount Correction to restate to present Note Receivable Chang Balance e P150,00 0 P 106,767

Substantive Tests of Receivables and Sales

2005 12-312005 12-312006 12-312007 12-312007 * Rounded. value To accrue 12% = To accrue 12% = To accrue 12% = Collection Cash interest, P12,812 interest, P14,349 interest, P16,072* on face P106,767 P119,579 P133,928 x + x + x + 43,233 12,812 14,349 16,072 150,00 0

8-19

119,579 133,928 150,000 0

amount, debit

8-19. 1. d. The Josefina note is a short-term note and is reported at face value although the note can be recorded at present value. The Nicole note is reported at present value: [(P20,000 + 5(0.3) (P20,000)] (PV1, 8%, 5) = P23,000 (0.68058) = P15,653 The annual payment is computed as: P10,000 (PVA, 8%, 5) = P10,000 / 3.99271 = P2,505. Discounting this stream of payments at 9% yields cash proceeds of: P2,505 (PVA, 9%, 5) = P2,505 (3.88965) = P9,744. Total interest equals total payments less proceeds = 5 (P2,505) P9,744 = P2,781. 3. 4. b. c. Interest receivable is recorded for one month. Maturity value..................................................................... P100,000 Discount P100,000 (0.10) (6/12)......................................... (5,000) Proceeds............................................................................... P 95,000

2.

c.

8-20.

Luce Company (1) AJE : Sales returns and allowances Inventory 12.31.06 Accounts receivable Cost of sales Income will decrease by P6,000 if the above AJE is made. Ans. (2) AJE : (c) Sales Accounts receivable Income was overstated by P10,000 Ans. (a) 10,000 10,000 30,000 24,000 30,000 24,000

8-20

Solutions Manual to Accompany Applied Auditing, 2006 Edition (3) Actual number of units sold to Mr. Lazo was 320. Ans. (4) (b) P 32,000 48,000 P 16,000 P48,000 P150

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

(5)

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

(6) 8-21.

ETC Co. AJE 1. 2. 3. 4. Cash Other Current Liabilities (UCPB Overdraft) Accounts Receivable Cash Cash Accounts Payable Notes Payable Interest Expense Cash Cash BPI Other Current Liabilities (UCPB Overdraft) Cash SBTC Accounts Receivable Cash 5.31.06 Per books AJE 1. 2. 3. 4. 5. 6. P 15,825,000 225,000 (37,500) 28,709 (83,700) 25,000 73,690 225,000 225,000 37,500 37,500 28,709 28,709 67,500 16,200 83,700 25,000 25,000 73,690 73,690

Adjusting Journal Entries

5. 6.

Substantive Tests of Receivables and Sales Adjusted balance P16,056,199 Accounts Receivable 5.31.06 Subsidiary Ledger P8,047,054 37,500 (375,215) 122,500 P7,831,839 General Ledger P7,868,029 37,500 (73,690) (1) (c)

8-21

AJE 2. 6.

P7,831,839

(2) (b)

Allowance for Doubtful Accounts Aging Distribution Current Past due: 1 30 31 60 61 90 Over 90 Amount Estimated to be Subsidiary Ledger % Uncollectible P1,737,690.00 + P122,500 = P1,860,190.00 x 2 = P 37,203.80 P1,617,340.00 P1,437,706.50 P1,474,450.00 P1,779,867.50 + P37,500 ___________ P375,215 P8,047,054.00 = 1,617,340.00 x 5 = 80,867.00 = 1,437,706.50 x 10 = 143,770.70 = 1,474,450.00 x 15 = 221,167.50 = 1,442,152.50 x 20 = 288,430.50 P7,831,839.00 P771,439.50 (3) (a)

8-22.

Ling, Inc.

Requirement (1) LING, INC. Long-term Receivables Section of Balance Sheet December 31, 2005 9% note receivable from sale of division, due in annual installments of P500,000 to May 1, 2007, less current installment 8% note receivable from officer, due December 31, 2007, collaterized by 10,000 shares of Ling, Inc., ordinary shares with a fair value of P450,000 Non-interest-bearing note from sale of patent, net of 15% imputed interest, due April 1, 2007 Installment contract receivable, due in annual installments of P50,000 to July 1, 2009, less current installment Total long-term receivables

P 500,000 [1] 400,000 84,105 [2] 112,400 [3] P1,096,505

8-22

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Requirement (2) LING, INC. Selected Balance Sheet Balances December 31, 2005 Current portion of long-term receivables: Note receivable from sale of division Installment contract receivable Total Accrued interest receivable: Note receivable from sale of division Installment contract receivable Total Requirement (3) LING, INC. Interest Income from Long-Term Receivables and Gains Recognized on Sale of Assets For the Year Ended December 31, 2005 Interest income: Note receivable from sale of division Note receivable from sale of patent Note receivable from officer Installment contract receivable from sale of land Total interest income for year ended 12/31/05 Gains recognized on sale of assets: Patent Land Total gains recognized for year ended 12/31/05 Explanation of amounts: [1] Long-term Portion of 9% Note Receivable at 12/31/05 Face amount, 5/1/00 Less: installment received 5/1/05 Balance, 12/31/05 Less: installment due 5/1/06 Long-term portion, 12/31/05 P1,500,000 (500,000) P1,000,000 (500,000) P 500,000 P105,000 8,505 32,000 11,200 P156,705 [6] [2] [7] [5] P500,000 [1] 27,600 [3] P527,600 P 60,000 [4] 11,200 [5] P 71,200

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

Substantive Tests of Receivables and Sales

8-23

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

11,200

[6] Interest Income Note Receivable, Sale of Division, for 2005 Interest earned from 1/1 to 5/1/05 (P1,500,000 x 9% x 4/12) P 45,000 Interest earned from 5/1 to 12/31/05 (P1,000,000 x 9% x 8/12) 60,000 Interest income P 105,000 [7] Interest Income Note Receivable, Officer, for 2005 Interest earned 1/1 to 12/31/05 (P400,000 x 8%) [8] Gain Recognized on Sale of Patent Stated selling price Less: imputed interest Actual selling price (P100,000 x 0.756) Less: cost of patent (net) Carrying value 1/1/05 Less amortization 1/1 to 4/1/06 (P8,000 x ) P 32,000

P 100,000 (24,400) [2] P 75,600 P40,000 (2,000) (38,000)

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Solutions Manual to Accompany Applied Auditing, 2006 Edition Gain recognized [9] Gain Recognized on Sale of Land Sale of price Less: cost Gain recognized P 37,600

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

8-23.

Grande Company Requirement 1 PAS 39, paragraph 63 will be applied in this case. On December 31, 2006, Grande Company should record the 2006 accrued interest and the impairment: Notes / Interest Receivable (0.06) (100,000) Interest Income Bad Debts Expense Allowance for decline in note value * Carrying value of note and interest (100,000 + 6,000) Present value / New carrying value of note (discount rate 6%) Principal: Due on 12.31.08 (P30,000 x 0.89000) P26,700 Due on 12.31.10 (P30,000 x 0.79209) 23,763 Impairment write-down Requirement 2 The entries with the corresponding computations follow: Effective Interest Method December 31, 2007 Allowance for decline in note value Interest income (0.06) (50,463) December 31, 2008 Allowance for decline in note value Interest income (0.06) (50,463 + 3,028) Cash 3,028 3,028 6,000 6,000 55,537 * 55,537 P106,000

50,463 P 55,537

3,209 3,209 30,000

Substantive Tests of Receivables and Sales Notes receivable December 31, 2009 Allowance for decline in note value Interest income (0.06) (50,463 + 3,208 + 3,209 30,000) December 31, 2010 Allowance for decline in note value Interest income * 0.06 (26,700 + 1,602) Cash Notes receivable Allowance for decline in note value Notes receivable To close remaining balance in notes receivable and allowance 1,602

8-25

30,000

1,602

1,698* 1,698 30,000 46,000 46,000

30,000

* At this point, the amortized cost of the notes receivable is zero. Notes Receivable 100,000 6,000 106,000 30,000 30,000 60,000 46,000 bal Allowance for Decline in Note Value 3,028 55,537 3,209 1,602 1,698 9,537 55,537 46,000

8-24.

Amy Corporation Requirement 1

8-26

Solutions Manual to Accompany Applied Auditing, 2006 Edition Accounts Receivable (Trade) Accounts Receivable (Officer) Ordinary Shares Subscriptions Receivable Advances to Employees Notes Receivable (Trade) Deposit to Guarantee Contract Performance Utility Deposit Receivables Requirement 2 Accounts receivable (trade)--current asset, trade receivable Accounts receivable (officer)--normally current nontrade receivable Ordinary shares subscription receivable--current or noncurrent asset, depending on due date; nontrade receivable Advances to employees--current asset, nontrade receivable Notes receivable (trade)--noncurrent asset, trade receivable Deposit to guarantee contract performance--separately classify, could be current or noncurrent asset, depending on the length of the contract; nontrade receivable Utility deposit--separately classify, probably noncurrent nontrade receivable Janes Department Store Requirement 1 Age Under 30 days 30- 60 days 61-120 days 121-240 days 241-360 days Over 360 days Requirement 2 a. b. c. Bad Debt Expense Allowance for Doubtful Accounts Bad Debt Expense (P35,824 + P3,000) Allowance for Doubtful Accounts Bad Debt Expense (P35,824 P2,800) Allowance for Doubtful Accounts 35,824 35,824 38,824 38,824 33,024 33,024 Balance P193,000 114,000 73,000 41,000 25,000 19,000 P465,000 Estimated Percentage Uncollectible 0.008 0.020 0.050 0.200 0.350 0.600 Estimated Amount Uncollectible P 1,544 2,280 3,650 8,200 8,750 11,400 P35,824 15,500 3,600 12,000 1,800 6,000 5,000 500 44,400

8-25.

8-26.

Blue Corporation

Substantive Tests of Receivables and Sales Requirement 1 2005 Dec. 1 Cash [(P175,000 x 0.80) P1,400] 138,600 Assignment Service Charge Expense (P175,000 x 0.80 x 0.01) 1,400 Notes Payable (P175,000 x 0.80) Accounts Receivable Assigned Accounts Receivable Sales Returns and Allowances Accounts Receivable Assigned Cash Accounts Receivable Assigned Notes Payable Interest Expense (P140,000 x 0.12 x 1/12) Cash Cash Accounts Receivable Assigned 175,000 175,000 1,000 1,000 86,000 86,000 86,000 1,400 87,400 60,000 60,000

8-27

140,000

Dec.

1 11 31 31

2006 Jan. 29 29

Notes Payable (P140,000 P86,000) 54,000 Interest Expense (P54,000 x 0.12 x 1/12) 540 Cash Accounts Receivable Accounts Receivable Assigned (P175,000 P1,000 P86,000 P60,000) 28,000

54,540

29

28,000

Requirement 2 On the December 31, 2005 balance sheet of the Blue Corporation, the assigned accounts receivable and the remaining liability would be reported as follows: Current Assets: Accounts receivable assigned Current Liabilities: Note payable P88,000 P54,000

8-28
8-27.

Solutions Manual to Accompany Applied Auditing, 2006 Edition Tandy Shoes Sept. 15 Accounts Receivable Credit Card Expense (P2,100 x 0.05) Sales Sales Returns and Allowances Accounts Receivable Credit Card Expense (P200 x 0.05) Cash Accounts Receivable 1,995 105 2,100 200 190 10 1,805 1,805

21

29

8-28.

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

P15,100 40,000 P55,100

Schedule 1: Computation of Expenses for Accounts Receivable Assigned Assignment expense: Accounts receivable assigned Advance by Belle P200,000 x 85% P170,000 x 3% P 5,100 10,000 P 15,100

Interest expense Total expenses

Substantive Tests of Receivables and Sales

8-29