UNIT II

AUDIT OF INTANGIBLES

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AUDITOF INTANGIBLES

An intangible asset is defined as an identifiable nonmonetary

asset without physical substance (PAS 38). It must be controlled by the
entity as a result of past event and from which future benefits are
expected to flow to the entity. Intangible assets which can be sold,
transferred, licensed, or rented out separately are generally classified as
identifiable intangibles. Otherwise, the asset is considered as an
unidentifiable intangible asset.

In the audit of intangible assets, the auditor determines whether

the asset had been appropriately and correctly recognized and valued
during acquisition, the propriety of entries and valuation at disposition,
its valuation and the adequacy of required disclosures at the end of the
accounting period.

Objectives and Procedures in the Audit of Intangibles

(Adapted from Cabrera, 2012)

Assertions Objectives Audit Procedures

Existence or A. To determine that 1. Obtain an analysis of
Occurrence Intangibles exist and are ledger accounts for
represented by intangibles
contractual rights, 2. Examine documentation
privileges or earning supporting intangibles
power owned by the
company

Completeness B. To determine that all 3. Vouch additions to or

transactions related to acquisitions during the
intangibles have been year
properly recorded. 4. Evaluate dispositions and
write offs during the year

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 Assertions Objectives Audit Procedures
Rights and C. To determine that the 5. In addition to audit
Obligation intangibles are owned by procedure no. 2 above,
the company. perform analytical
procedures

Valuation or D. To determine that the 6. In addition to audit

Allocation intangibles are stated at procedure nos. 3 & 4,
cost less amortization evaluate amortization
policy and verify
computation of
amortization

Presentation E. To determine whether 7. Evaluate financial

and presentation and statement presentation
Disclosure disclosures concerning and disclosure for
intangibles are adequate intangibles
and in accordance with
PAS/PFRS

The auditor should ask from the client a schedule of the intangible
assets of the company. If this is not available, the auditor may prepare one from
the general ledger and this should be substantiated by an analysis of the
different intangibles.

To vouch entries in the general ledger, the auditor traces the entries to
entries in the journals and supporting documents. Legal documents pertaining
to the intangible assets should be examined to establish ownership and rights of
the company, including economic benefits that could be derived from the
intangible assets.

Additions and dispositions of intangible assets should likewise be

verified as to authorization and propriety of valuation. Amortizations should be
checked, together with the period within which the company expects to benefit
from the assets. As part of substantive testing, the auditor should also perform
analytical tests such as comparing amortizations for the current with those of
previous years, the ratio of amortization costs to unamortized balances for the
current and prior years. This may help the auditor determine or identify
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improperly recorded purchases, write offs and disposition of intangible assets.
Treatment of subsequent costs incurred pertaining to the assets should also be
verified.

The auditor should likewise look into the presentation in the financial
statements and adequacy and propriety of disclosures pertaining to intangibles.

Sample Working papers in the Audit of Intangibles

1. Analysis of Intangible Assets

Rihanna Development Company

Intangible Assets
December 31, 2012

Beginning balance P20,000

Adjustments:
1. Understated amortization 500
2. Gain from sale 2,500

10. 1,000
Adjusted balance P 15,000

Legend: (for tickmarks)

Prepared by Reviewed by
Initial Date Initial Date

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2. Amortization Schedule

Rihanna Development Company

Patents Amortization Schedule
2006 to 2012

Cost as
Description Recorded Amortization Per Client
2006 2007 to 2012 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 80,000 (2,361.85) (37,789.67) (40,151.52)
requirement
As Adjusted P240,000 P7,085.56 P113,368.98 P120,454.54 P120,454.54
(a) (b)

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 END OF CHAPTER REVIEW QUESTIONS
(Adapted from AICPA and review materials)

PROBLEM 1: The following costs are generally incurred by a newly

established entity:

Pre-opening costs of a business facility P 250,000

Purchased recipes and secret formulas 150,000
Training, customer loyalty, and market share 140,000
Licensing, royalty, and stand still agreement 300,000
Operating and broadcast rights 112,000
Goodwill purchased in a business combination 500,000
A license to manufacture a steroid by means of a government 150,000
grant
Cost courses taken by management in quality engineering 450,000
management
A television advertisement that will stimulate the sales in 100,000
technology industry
Investment in associate 500,000
6 month lease payment in advance 300,000
Cost of equipment acquired through a finance lease 100,500
Internally developed customer list 120,500
Cost incurred in the corporation’s formation and organization 230,000
Operating losses incurred in the start-up of the business 130,000
Initial franchise fees paid 175,000
Continuing franchise fees 50,000
Internally generated goodwill 800,000
Cost of testing in search for a product alternative 125,000
Cost purchasing a patent from an inventor 137,000
Legal cost in securing a patent 70,000
Legal cost incurred in successfully defending a patent 55,500
Cost of developing brands and mastheads 200,000
Cost of purchasing a trademark 250,000
An operating system of a computer 125,000
Amount paid to a lessor for the exclusive right to rent a facility
under an operating lease agreement for a period of 10 years 100,000
Cost of improvements on a leased facility. 250,000

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Required: Compute the amount of intangibles that should be reported in the
balance sheet at the end of the accounting period. Give details.

PROBLEM 2: The following information reflects the different modes of

acquiring an intangible asset. For each of the following independent scenarios,
answer the requirements that follow:

A. On January 2, 2022, RAYMOND INC. acquired copyrights to the original

recordings of a famous singer. The agreement with the singer allows the
company to record and rerecord the songs of the singer for a period of five
years. During the initial six-month period of the agreement, the singer was
very sick and consequently cannot record. The studio time that was
blocked by the company had to be paid even during the period the singer
could not sing. The following costs were incurred by the company:

Legal costs of acquiring the copyrights P 10,000,000

Documentation expenses related to the copyright acquisition 1,000,000
Operational loss (studio time lost, etc.) 2,000,000
Massive advertising campaign to launch the artist 1,000,000

1. How much should the copyright be initially recognized?

2. What is the carrying value of the copyright as of December 31, 2023?

B. DEBORAH INC. acquired the net assets of DNT INC. on June 30, 2022 in
a business combination. The cost of acquisition is P2,000,000 more than
the total fair market value of the company’s identifiable net asserts. Among
the identifiable assets are the following intangibles:

Book Value Fair Market Estimated

Value Remaining Life
Trademark 250,000 400,000 4
Customer lists 500,000 750,000 3
Franchise 200,000 350,000 5

3. How much is the total intangibles including goodwill to be initially

recognized?

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4. What is the total carrying value of the various intangibles including
goodwill on December 31, 2022?

C. On December 26, 2022, ONIX CO. obtained a franchise from Marlon Corp.
to sell for 20 years Marlon products. The initial franchise fee as agreed
upon shall be P10,000,000, and shall be payable in cash, P1,000,000, when
the contract is signed and the balance in five equal installments every
December 31, thereafter, as evidenced by a noninterest bearing note. The
agreement provides that the franchisor shall provide the necessary intial
services required under a franchise contract. By the end of the year, the
company has performed all the initial services which costed Marlon
P1,497,728.

Assuming that Onix Co. could borrow money at 12%, determine the
following:

5. How much should the franchise be initially recognized?

6. What is the carrying value of the franchise on December 31, 2023?

PROBLEM 3: ERIKA INC. holds a valuable patent on a precipitator that

prevents certain types of air pollution. Erika does not manufacture or sell the
products and process it develops. Instead, it conducts research and develops
products and processes which it patents, and then assigns patents to
manufacturers on a royalty basis. Occasionally it sells patents. The following
presents the summary of the activities in relation to the aforementioned patent:

2016-2017 Research aimed at the discovery of the new P 3,840,000

technology
Jan. 5, 2018 Design and construction of a prototype 876,000
March 15 Testing the prototype models 420,000
Jan. 2, 2019 Legal and other professional fees to process the 620,000
patent application (useful life = legal life)
Dec. 10, 2020 Legal fees paid in successfully defending the 357,000
device patent
Jan. 3, 2021 Acquisition of a competitive patent aimed at 406,000
protecting old patent
Jan. 5, 2022 Acquisition of a related patent which extended 654,375
the life of the patents for additional 2 years
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Dec. 31, 2023 Legal fees paid in unsuccessful patents 250,000
infringement suit against a competitor

7. What is the correct cost of the patent upon initial recognition?

8. What is the carrying value of the patent on December 31, 2019?
9. What is the carrying value of the patent on December 31, 2021?
10. What is the carrying value of the patent of December 31, 2022?
11. What is the total loss from patent write off that should be recognized in
2023?

PROBLEM 4: On April 1, 2020, VINCENT CORP. is contemplating to acquire

all the issued and outstanding ordinary shares of JACK INC. in a business
combination accounted for as a purchase. The recorded assets and liabilities of
Jack Inc. on April 1, 2020, follows:

Cash P 800,000
Inventory 2,400,000
Property and equipment, net of accum. depn of 3,500,000
P3,200,000
Intangible assets, including 500,000 goodwill 1,300,000
Liabilities (1,800,000)

On April 1, it was determined that the inventory of Jack Inc. approximated its
fair value, the property and equipment, having an average remaining useful life
of 6 years, had a sound value of P4,100,000, and its identifiable intangibles
having indefinite useful life, had a fair value of P1,000,000.

Records show that the company earned an accumulated net income of

P4,650,000 from 2014 to 2019. The said accumulated profits included a gain on
sale of fixed assets in 2018 and 2019 totaling to P1,000,000 and president’s
annual bonus averaging to P150,000.

The industry’s normal rate of return is at 9%.

a. Assuming that the company contemplates the acquisition price at

P8,000,000, how much is the goodwill resulting from the business
combination?
b. How much is the resulting goodwill and the assumed acquisition price if
goodwill is computed using the “purchase of excess earnings” method
over a 10 year period?
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 c. How much is the resulting goodwill and the assumed acquisition price if
the average earnings will be capitalized at 12%?

d. How much is the resulting goodwill and the assumed acquisition price if
the average earnings will be capitalized at 10%?

e. How much is the resulting goodwill and the assumed acquisition price if
the present value method is in place and that the prevailing rate of
interest is at 10% over the 10 year period excess earnings is expected to
be generated?

PROBLEM 5: Bohol Corporation maintains the following items in its

Intangibles account as of the fiscal year ended June 30, 2021:
Intangibles:
Research AM123 P 65,650
Copyrights 63,000
Goodwill 32,000

Audit findings:
a) Research AM123 is for a research project which consists of the following
charges:

Salaries of research staff P 18,500

Patent acquired solely for the use in the project 12,000
Special equipment acquired and useful for various 10,000
similar research activities
Patent acquired for use in several research 16,200
projects including Project AM 123
Cost of pilot models 8,950
Total P 65,650

The patent have generally been found to be useful for approximately ten years
while the special equipment useful for five years. You have further discovered
both patents and the specialized equipment were acquired at the beginning of
the fiscal year, and that cost of model and salaries were incurred evenly
throughout the fiscal year. Amortization is yet to be made on the related
intangible.

b) The company’s copyright were accounted for as follows:

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 Asset Acquisition Date Useful life Cost
Copyright January 2, 2017 25 years P30,000
ABC
Copyright July 15, 2017 15 years 33,000
XYC

You have discovered that the company made no amortizations on the above
intangibles from the year of acquisition.

c) The company’s goodwill was acquired as part of a business combination

when it acquired the net assets of its then rival, Cebu Corp. at an acquisition
cost amounting to P1,582,000 on February 24, 2019. Cebu’s net assets were
carried in its books at P1,550,000 while their fair value aggregated to
P1,560,000.

d) Management has now decided to correct its past accounting treatment

deciding to use the straight line method of amortizing intangibles computed to
the nearest half – year.

1. What is the carrying value of the following intangibles as of June 30, 2021?
2. Prepare working papers to compute the intangibles.
3. Prepare all necessary adjusting entries

PROBLEM 6: COMPUTRONIX CORP is engaged in developing computer

software for small business at home computer market. Most of computer
programmers are involved in developmental work designed to produce software
that will perform fairly specific tasks in a user friendly manner. Extensive
testing of the working model is performed before it is released to production for
preparation of masters and further testing. As a result of careful preparation,
Computronix Corp. has produced several products that have been very
successful in the market place. The following costs were incurred during 2022:

Salaries and wages of programmers doing research P 440,000

Expenses related to projects prior to establishment of 313,600
technological feasibility
Cost of completing the detailed program design 500,000
Cost of testing the product master after technical 94,000
feasibility has been established
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 Cost of testing the product master after technical 104,000
feasibility has been established.
Amortization of capitalized software development cost 107,000
from current ands prior years
Costs to produce and prepare software for sale 225,200

Additional data for 2022:

Sales of products for the year P 2,060,000
Beginning inventory 568,000
Portion of goods available for sale sold during year 60 %

1. Amount to be capitalized as software development cost subject to

amortization
2. Cost of ending inventory
3. Total amount related to the development of computer software that should
be expense when incurred:

PROBLEM 7: Transaction during 2022 of the newly organized OSAKA

CORP. included the following:

Jan. 2 Paid legal fees of P75,000 and stock certificate costs of

P41,500 to complete the organization of the corporation.
Jan. 15 Hired a clown to stand in front of the corporate office for 2
weeks and hand out pamphlets and candy to create goodwill for
the new enterprise. Clown cost, P5,000; pamphlets and candy,
P2500.
Apr. 1 Patented a newly developed process with costs as follows:
Legal fees to obtain patent P214,500
Patent application and licensing fees 31,750
Total 246,250

It is estimated that in 6 years, other companies will have

developed improved processes, making the Osaka Corporation
obsolete.
May 1 Acquire both a license to use a special type of container and a
distinctive trademark to be printed on the container in exchange
for P6,000 shares of Pink’s no par common stock selling for
P25 per share. The license is worth twice as much as the
trademark, both of which may be used for 6 years.
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July 1 Constructed a shed for P655,000 to house prototypes of
experimental models to be developed in future research
projects.
Dec. 31 Incurred salaries for an engineer and chemist involved in
product development totaling P875,000 in 2022.

1. What is the correct cost of patent?

2. What is the correct cost of license?
3. What is the correct cost of trademark?
4. Prepare all necessary adjusting entries

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