FAR EASTERN UNIVERSITY

Nicanor Reyes Sr. St. Sampaloc, Manila

Institute of Accounts, Business and Finance
First Semester AY2018-2019

AUDIT OF INTANGIBLE ASSETS

Account Balance Audit Objectives

 All recorded identifiable intangible assets (e.g., patents) exist; all recorded unidentifiable intangible assets (i.e., goodwill)
arose from the acquisition of a business (goodwill arising from other sources is not recorded).
 Goodwill is included on the balance sheet at the appropriate amount, and impairments, if applicable, are appropriately
identified and recorded.
 The entity owns, or has a legal right to, the identifiable intangibles included on the balance sheet. Intangibles are free of
liens, pledges, or other security interests or, if not, such liens, pledges, or security interests are identified.
 Intangible assets, goodwill, and related accounts are properly classified, described, and disclosed in the financial
statements, including notes, in conformity with prescribed accounting principles.

Research and Development cost (R&D)

Costs that are not considered R&D:
1. selling, administrative and other general overhead expenditure unless this expenditure can be directly attributed to
preparing the asset for use;
2. identified inefficiencies and initial operating losses incurred before the asset achieves planned performance; and
3. expenditure on training staff to operate the asset.
4. legal and secretarial costs incurred in establishing a legal entity
5. expenditure to open a new facility or business (ie pre-opening costs)
6. expenditures for starting new operations or launching new products or processes
7. expenditure on training activities
8. expenditure on advertising and promotional activities (including mail order catalogues).
9. expenditure on relocating or reorganizing part or all of an entity.

To assess whether an internally generated intangible asset meets the criteria for recognition, entity classifies the
generation of the asset into – (a) research phase; and (b) development phase.

PAS 38 par. 54 states that no intangible asset arising from research (or from the research phase of an internal project)
shall be recognized. Expenditure on research (or on the research phase of an internal project) shall be recognized as
an expense when it is incurred.

Examples of research activities are:

 Activities aimed at obtaining new knowledge
 The search for, evaluation and final selection of, applications of research findings or other knowledge
 The search for alternatives for materials, devices, products, processes, systems or services
 The formulation, design, evaluation and final selection of possible alternatives for new or improved materials,
devices, products, processes, systems or services.

PAS 38 par. 57 states that an intangible asset arising from development (or from development phase of an internal
project) shall be recognized if, and only if, an entity can demonstrate all of the following:
a) the technical feasibility of completing the intangible asset so that it will be available for use or sale.
b) its intention to complete the intangible asset and use or sell it.
c) its ability to use or sell the intangible asset.
d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can
demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is
to be used internally, the usefulness of the intangible asset.
e) the availability of adequate technical, financial and other resources to complete the development and to use or sell
the intangible asset.
f) its ability to measure reliably the expenditure attributable to the intangible asset during its development.

Examples of development activities are:

 the design, construction and testing of pre-production or pre-use prototypes and models
 the design of tools, jigs, molds and dies involving new technology
 the design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial
production
 the design, construction and testing of a chosen alternative for new or improved materials, devices, products,
processes, systems or services
 If an entity cannot distinguish the research phase from development phase of an internal project to create an intangible
asset, the entity treats the expenditure on that project as if it were incurred in the research phase only.

Because of the very strict requirements of PAS 38, all development expenditures in the problem were expensed since
there are no indications that all of the conditions were met.

Research and development activities normally occur prior to commercial production and distribution of a product or
process. Therefore, the following activities that relate to commercial production are not considered research and
development activities:
 Engineering follow through in an early phase of commercial production
 Quality control during commercial production including routine testing
 Trouble-shooting in connection with breakdowns during commercial production
 Routine on-going effort to refine, enrich or improve quality of an existing product
 Adaptation of an existing capability to a particular requirement or customer need
 Periodic design changes to existing products
 Routine design of tools, jigs, molds and dies
 Activity, including design and construction of engineering related to construction, relocation, rearrangement or
start-up of facilities and equipment

CASE 1
Presented below are the cost incurred by SECRET LOVE Company during the current year related to its intangible asset:

a. Quality control during commercial production including routine testing

products P1,150,000
b. Laboratory research aimed at discovery of new knowledge 1,350,000
c. Engineering follow-through in an early phase of commercial production 300,000
d. Adaption of existing capability to a particular requirement or customers
need as part of continuing commercial activity 275,000
e. Trouble shooting in connection with breakdowns during commercial
production 575,000
f. Searching for applications of new research findings 375,000
g. Cost of equipment acquired that will have alternative use in the future
research and development projects over the next 5 years 3,500,000
h. Materials consumed in research and development projects 737,500
i. Consulting fees paid to outsiders for research and development projects 1,250,000
j. Personnel costs of persons involved in research and development
projects 1,600,000
k. Indirect cost reasonably allocable to research and development projects 625,000
l. Materials purchased for future research and development 425,000
m. Testing for evaluation of new product 1,500,000
n. Design, construction, and testing of preproduction prototypes and
models 1,087,500
o. Routine, ongoing efforts to refine, enrich or otherwise improve upon the
qualities of an existing product 937,500
p. Radical modification to the formulation of a chemical product 543,750
q. Research and development cost reimbursable under a contract to
perform research and development for Mucho Corp. 1,312,500

1. How much should SECRET LOVE reported as the cost of intangible asset?
2. How much is recognized as research and development expense?

CASE 2

Sister Monica Company incurred the following cost during the year:
Periodic or routine design changes to existing products P50,000
Modification of design for specification of customer 450,000
Payment to other entity for a contract to perform research 110,000
Cost of design, construction, operation of a pilot that is not of a scale economically
feasible for commercial production 135,000
Cost of design, construction, operation of a pilot that is economically feasible for
commercial production 46,000
Cost of design of tools, jigs, molds and dies involving new technology 70,000
 Cost of quality control during commercial production 57,000
Cost of acquired building to be used in various R&D projects 500,000
Depreciation of building (above) use on one R&D projects 50,000
Trouble shooting during commercial production 80,000
Cost of routine, seasonal and periodic design of tools, jigs, molds and dies. 80,000
Cost of engineering follow through in an early phase of commercial production 50,000
Adaptation of an existing capability to particular customers need 36,000
Cost of seminars to introduce the newly develop product 120,000
Advertisement cost to introduce the newly develop product 60,000
Cost incurred for search of alternatives 35,000
Cost of final selection of possible alternatives 50,000
Cost of machine acquired to be used only in an R&D project 300,000
Radical modification to the formulation of a chemical product 40,000
Laboratory research aimed at discovery of new technology 58,000
Salaries of employees involved in R&D 300,000
Cost of activates aiming new knowledge 150,000
Cost of developing and producing prototype model 30,000
Cost of testing the prototype and safety features 100,000
Cost of revision of the design of the prototype model 250,000

1. How much is the total research and development expense?

CASE 3
You noted the following items relative to the company’s Intangible assets in connection with your audit of the Clegane
Corporation’s financial statements for the year 2018.

Franchise
On January 1, 2018, Clagane signed an agreement to operate as franchisee of Clear Copy Service, Inc. for an initial
franchise of P680,000. Of this amount, P200,000 was paid when the agreement was signed and the balance was payable in
four annual payments of P120,000 each, beginning January 1, 2019. The agreement provides that the down payment is not
refundable and no future services are required of the franchisor. The implicit rate for loan of this type is 14%. The
agreement also provides the 5% of the revenue from the franchise must be paid to the franchisor annually. Clagane’s
revenue from the franchise for 2018 was P8,000,000. Clagane estimates the useful life of the franchise to be ten years.

Patent
On July 1, 2018, Clagane purchased a patent from the inventor, who asked P1,100,000 for it. Clagane paid for the patent
as follows: cash, P400,000; issuance of 10,000 shares of its own ordinary shares, par P10 (market value, P20 per share);
and a note payable due at the end of three years, face amount, P500,000, noninterest-bearing. The current interest rate for
this type of financing is 12 percent. Clagane estimates the useful life of the patent to be ten years.

Trademark
Clagane purchased for P1,200,000 a trademark for a very successful soft drink it markets under the name PowPow!. The
trademark was determined to have an indefinite life. A competitor recently introduced a product that is in direct
competition with the PowPow! product, thus suggesting the need for an impairment test. Data gathered by the entity
suggests that the useful life of the trademark is still indefinite, but the cash flows expected to be generated by the
trademark have been reduced either to P40,000 per year (with a probability of 70%) or to P80,000 per year (with 30%
probability). The appropriate risk-free interest rate is 5%. The appropriate risk-adjusted interest rate is 10%.

Based on the above and the result of your audit, determine the following:
1. Carrying amount of franchise as of December 31, 2018?
2. Carrying amount of trademark as of December 31, 2018?
3. Total expenses related to franchise in 2018?
4. Total expenses related to patent in 2018?
5. Total expenses related to trademark in 2018

CASE 4
You are auditing the intangible assets account of Dog Company which was comprised of the following items:
Patent (Note A) P2,490,000
Trademark (Note B) 800,000
Goodwill (Note C) 1,850,000

Note A:
Dog Company was able to patent one of its new machines with the Intellectual Property Office of the Philippines on
January 7, 2018. The cost of the patent recorded by the client included the following items:
 Purchase of special equipment to be used solely P1,800,000
Research salaries and fringe benefits for engineers and scientists 200,000
Cost of testing prototype 250,000
Legal cost of filing for patent 150,000
Fees paid to government patent office 50,000
Drawings required by patent office to be filed with patent application 40,000

No amortization was recorded by Dog because management believes that the patent will be used indefinitely.

Note B:
On January 1, 2018, Dog Company acquired a trademark for P800,000. Dog Company expects to renew the trademark
indefinitely. As of December 31, 2018, there were no indicators for impairment for the trademark. Since there were no
indicators, Dog Company did not test the trademark for impairment. However, it was estimated that the trademark will
generate cash flows of P65,000 per year indefinitely.

Note C:
The goodwill of Dog Company was due to the acquisition of Puppy during 2018. The carrying amount and fair value of
the assets and liabilities of Puppy as of the date of acquisition were as follows:
Carrying Amount Fair Value
Cash P 50,000 P 50,000
Accounts receivable 500,000 500,000
Inventory 1,000,000 1,500,000
Investment property 0 250,000
Property, plant and equipment 2,000,000 3,000,000
Liabilities 2,000,000 2,000,000

The bookkeeper of Dog recorded goodwill at the excess of purchase price over the book value of the net assets of Puppy.
The pre-tax discount rate, if applicable, is 10%.

Determine the following:

1. How much should be capitalized as patent?
2. How much should be recognized as research and development expense for 2018?
3. How much should be reported as trademark as of December 31, 2018?
4. How much should be reported as goodwill as of December 31, 2018?

CASE 5
The Baby Shark Company acquired several small companies at the end of 2017 and, based on the acquisitions, reported
the following intangibles in its December 31, 2017 statement of financial position:

Patent P400,000
Copyright 700,000
Trade name 750,000
Computer software 600,000
Goodwill 1,200,000

The company’s accountant determines that patent has an expected life of 12 years and P40,000 residual value, and that it
will generate approximately equal benefits each year. The company expects to use the copyright and trade name for the
foreseeable future. The accountant knows that the computer software is used in the company’s sales offices. The software
was part of the mainframe computers of the said offices which is used to record sales transactions and to bill customers.
The mainframe computer in which the computer software is part of is expected to be used for 8 years.

On December 31, 2018, there are no indications of impairment of patent and computer software and mainframe
computers. The following information relates to the other intangible assets.
a. Because of the rampant piracy, the copyright is expected to generate cash flows of just P55,500 per year.
b. The trade name is expected to generate cash flows of P82,500 per year. The cash flows are expected to benefit the
company for the next 10 years.
c. The goodwill is associated with Baby Shark’s manufacturing reporting unit. The cash flows expected to be
generated by the manufacturing reporting unit is P270,800 per year for the next 22 years. The reporting unit has a
carrying amount of P3,300,000.
d. Discount rate used on all appropriate items is 8%.

Based on the above and the result of your audit, determine the following:
1. How much is the amortization recognized in 2018?
2. How much is the impairment loss recognized related to intangible assets in 2018?
3. How much is the carrying value of goodwill reported in 2018 financial statement?
4. How much is the intangible assets – net in 2018 statement of financial position?
5. How much is the recoverable amount of trade name?
CASE 6
The accounting record of Sterling Corp. which was organized in 2017 includes only one account for all intangible assets.
The following is a summary of the items debited to the said account in 2017 and 2018:

Date Description Amount

July 1, 2017 Franchise (indefinite term) P1,260,000
Oct. 1 Lease advance payments (2 year term, starting October 1 ,2017) 840,000
Net loss for 2017 including incorporation fees, P30,000 and related legal fees of
Dec. 31
organizing the business, P150,000 480,000
Jan. 2, 2018 Purchased patent (10 year life) 2,220,000
Mar. 1 Cost of developing a recipe 250,000
Apr. 1 Purchased goodwill 8,352,000
July 1 Legal fees for successful defense of the patent purchased in Jan. 1, 2018. 379,500

Audit notes:
a. On December 31, 2017, the management estimates that the annual net future cash flows from the franchise’s
continued use was at P180,000. On December 31, 2018, this estimate was revised due to decline in product demand to
P150,000 annually.
b. On December 31, 2018, the estimated annual net future cash flows from the patent’s continued used was at P337,822
over its remaining useful life.
c. The prevailing market rate of interest as of December 31, 2017 and 2018 was consistent at 12%.

Based on the result of your audit, answer the following:

1. What is the carrying value of the franchise as of December 31, 2018?
2. What is the correct carrying value of the patent as of December 31, 2018?
3. What is the total retroactive adjustment to retained earnings beginning in 2018 as a result of your audit?
4. What is the total amount chargeable to expense for the current year (2018) as a result of your audit?

CASE 7

Kenny Inc., had the following information for intangible assets for year under audit. The following were noted during the
period:

Note 1: Identifiable assets

Kenny Inc. acquired the net assets of Bee Inc. on June 30, 2018 in a business combination. The cost of acquisition is
P500,000 greater that the total book value of the company’s identifiable net assets. The book value of the company’s
identifiable assets approximate their fair values except for the following:
Book value Fair value Estimated remaining life
Patent 250,000 500,000 5
Customer lists 750,000 600,000 3
Franchise 600,000 900,000 4

Note 2: Non identifiable assets

Kenny Inc. engaged your services to compute the goodwill and purchase price for the acquisition of Rogers Inc. The
following data are available for Rogers Inc.:
Year Net Income Net Assets
2013 P1,200,000 P6,400,000
2014 1,500,000 8,600,000
2015 2.100,000 8,800,000
2016 2,200,000 9,000,000

It was agreed that goodwill should be measured by capitalizing excess earnings at 20% with normal return on average net
assets at 18%.

1. How much are the total intangibles initially recognized for 2018?
2. How much is the amortization expense recognized in 2018?
3. How much is the carrying value of all identifiable intangibles on December 31, 2018?
4. How much is the average excess earnings?
5. How much is the goodwill?