CHAPTER

PHASE II- RISK RESPONSE:

DESIGNING OVERALL
RESPONSES AND FURTHER
AUDIT PROCEDURES

Introduction

The Risk Response Phase in the Risk – Based Audit Approach includes the following steps:

(a) Designing the overall audit responses and further audit procedures. This will require:

(i) Updating overall audit strategy

(ii) Developing response to assessed risks
(iii) Briefing team on audit plans as required

(b) Performance of further audit procedures. This step will involve:

(i) Performing planned procedures

(ii) Assessing results and evidence obtained
(iii) Documenting findings and conclusion

The starting point for designing an effective audit response is the listing of assessed risks that
was developed at the conclusion of the risk assessment phase of the audit.

The auditor shall design and implement overall responses to address the risks identified and
assessed at the:

 financial statement level; and

 assertion level for financial statement areas and disclosures

An assessment of the risk of material misstatement is required at the financial statement and
assertion levels to obtain evidence that address risk assessments developed for each relevant
assertion.
Areas that the auditor would address in developing an overall response shall include the
determination of:

 The extent that the audit team needs to be reminded about the use of professional
skepticism;
 Which staff to assign, including those with special skills, or whether to use experts;
 The extent of supervision required throughout the audit;
  The need for incorporating some elements of unpredictability in the selection of further
audit procedures to be performed; and
 Any general changes that need to be made to the nature, timing, or extent of audit
procedures. Thesee could include the timing of procedures (interim or period
period-end), or
new/extended procedures to address specific risk factors as fraud.

The types of response required can be summarized as follows:

Figure 4.1 Types of Response

In developing the detailed

ed audit plan, the auditor would use his/her professional judgment to
select the appropriate types of possible audit procedures. To obtain the required reasonable
assurance, the auditor applies the audit procedures that, in the judgment and base on the PSA
PSAs
are deemed appropriate in the circumstances and in determining the audit procedures to be
performed in conducting an audit in accordance with Philippine Standards on Auditing, the
audits should comply with each of the PSAs relevant to the audit.

Nature of Audit Procedures

An effective program will be based on an appropriate mix of procedures that collectively reduce
audit risk to an acceptably low level. Audit procedures are the methods or acts that auditors use
to gather evidence to determine the validity of financial statement assertions. One way for the
auditors to increase the amount of evidence obtained is to select a more effective audit
procedure. For example, if thee auditors want to increase the amount of evidence about the
existence of account receivable, they could decide to confirm the accounts rather than rely upon
the inspection of internal documents.

The various types of an audit procedures available to the auditor are categorized as follows:

1. Test of Controls or Compliance Tests

These are audit procedures designed to evaluate the operating effectiveness of controls in
preventing or detecting and correcting material misstatements at the assertion level.

2. Substantive Procedures

These are audit procedures designed to detect material misstatement at the assertion
level. Substantive procedures comprise:

(i) Tests of details (of classes of transactions, account balances and disclosures), and
(ii) Substantive analytical procedures.

The auditor applies compliance tests when the purpose is to see whether prescribed accounting
control procedures are being followed. This evaluation identifies the control procedures that can
be relied on in performing restricted substantive tests. Substantive tests are applied when the
auditor’s purpose is to see whether the peso amount of an account is properly stated. Thus, there
is a relationship between the amount of reliance and the amount of additional work that will be
needed.

Types of Compliance Tests

1) No Trail

This type does not leave a visible trail in the supporting documents of the performance of
control procedure by the client’s employee. The auditor makes inquiries and observation
of office personnel and routines to determine how control procedures are performed and
who performs them.

2) Documentary Trial

This type leaves a visible trail in the supporting documents. Hence the auditor inspects
the documents supporting a particular type of transaction to see whether a control
procedure, such as approval or other checking was performed and who performed it as
indicated by signatures or initials.

Types of Substantive Tests

There are two general categories of substantive tests:

(a) Tests of Details of Transactions or Balances; and

 (b) Analytical Review Procedures

Irrespective of the assed risks of material misstatement, the auditor shall design and perform
substantive procedures for each material class of transactions, account balance and disclosure.

(a) Tests of Details

This type of substantive test involves obtaining evidential mater on the items (or details)
involved in an account balance or class of transactions. Tests of details are also referred
to as follows:

 Tests of Transactions

These are tests of the processing of individual transactions by inspection of the

documents and accounting records involved in processing. For example, tracing of
receiving reports to the purchase journal to see whether receipts of merchandise have
been recorded as purchases.

 Tests of Balances

These are tests applied directly to the details of balances in general ledger accounts.
For example, confirming the balances of accounts in the accounts payable subsidiary
ledger with individual customers. These tests have the objective of establishing the
monetary corrections of the accounts they relate to.

Some auditors refer to tests of balances as direct tests of balances to emphasize the
substantive nature of the test as directly supporting an account balance. It should be
noted that substantive tests and compliance tests of control procedures that leave a
documentary trail both involve the inspection documents supporting the transactions.
For this reason, these tests are often applied together to the same group of documents.
In that case, the case, the test is referred to as a dual purpose test because it has both
compliance and substantive objectives.

(b) Analytical Review Procedures

Analytical types of tests involves study and comparison of relationships among

accounting data and related information. They identify unusual fluctuations for
investigation and focus on the rationale of relationship. They are substantive tests that
may achieve specific audit objectives if the evidential matter is considered persuasive by
the auditor. Auditing standards require the application of analytical procedures at the
planning and overall final review stages of audits. The audits may also decide to use them
during the audit as substantive tests to provide evidence as to the reasonableness of the
specific account balances.

Figure 4.2 presents examples of analytical procedures that involve comparisons

 Figure 4.2 Common Analytical Procedures that Involve Comparison

Analytical Procedure Example

(1) Compare current financial information for Compare inventory levels for the current year
prior periods. to that of prior years.
(2) Compare current financial information with Compare research and development expense to
anticipated data. the budgeted amount.
(3) Compare current financial information with Compare interest expense to the average
known or predictable relationships. outstanding balance of interest-bearing debt.
(4) Compare current financial information with Compare client’s gross profit percentage to
industry information. published industry averages.
(5) Compare current financial information with Compare production records in units to sales.
current nonfinancial information

Selecting the Audit Procedures that Will Be Applied

Audit procedures vary according to the risks associated with the client and the methods used to
record transactions. The following framework identifies audit procedures according to three
major phases of the audit:

1. Understanding Client and Industry: Preliminary Planning and Risk Analysis

a. Review prior – year work.

b. Review publicly available data about the organization.
c. Perform analytical procedures
d. Inquire of management and employees
e. Perform internal control walkthroughs

2. Asses Risk of Material Misstatement: Understand and Test Internal Controls and
System Processing

a. Inquire of management and supervisory personnel.

b. Review system documentation and perform a walkthrough of process
c. Observation system in operation. For computer applications, consider tracing transactions
through the system.
d. Documents process flow and control points.
e. Determine the effectiveness of procedures that the client has developed to monitor the
continued effectiveness of internal controls over financial reporting.
f. Select transactions and race through processing to determine if controls are working
properly.

3. Test Details of Accounts Balances and Transactions

a. Review authoritative documents and client records:

 (1) Vendor invoices and monthly statements
(2) Receiving and shipping records
(3) Legal documents and others

b. Testimonial evidence:

(1) Inquire of client personnel

(2) Inquire of outside parties

c. Auditor- generated evidence:

(1) Direct observation

(2) Perform recomputations, including recalculations and mathematical test
(3) Reprocess transactions from origin to final records
(5) Physical examine assets
(6) Perform analytical procedures
(7) Auditor analysis through reasoning and examining integrated portions of the evidence

Each of these procedures has strengths and weaknesses that should be considered in determining
the optimal approach for a client. The auditor looks at the relative weight of evidence from the
three basic phases of the audit, including the test controls, and considers the costs of procedures
and the persuasiveness of evidence needed for a particular account balance and related
management assertion(s).

After the auditor has developed specific audit objectives in relation to the assertion for a
particular account balance or class of transactions, the next step is to select audit procedures to
achieve these objectives.

In determining which audit procedures to use to obtain evidence, the auditor must consider
whether one or more procedures will provide evidence that can reduce the risk of that assertion
being misstated to an acceptable low level. It is possible that more than one audit procedure may
be required to determine the validity of an assertion. In some cases however, an audit procedure
may provide evidence about the validity of more than one assertion.

The selection of particular procedures to achieve specific audit objectives is influenced by the
following considerations:

1. The nature and materiality of the particular component of the financial statements
(account balance or class of transaction).
2. The nature of the audit objective to be achieved.
3. The reliance that can be placed on internal control structure.
4. The relative risk of material errors or irregularities.
5. The kinds and competence of available evidence.
6. The expected efficiency and effectiveness of possible audit procedures.
Auditing standards suggest that the auditor must use professional judgment in determining the
nature, timing and extent of audit procedures appropriate in a particular situation. The procedure
should satisfy the auditor’s objectives so that the evidence gathered enables the auditor to verify
the assertions in the financial statements. Thus the combination of the auditor’s reliance on
internal control (structure) and on selected substantive tests should provide a reasonable basis for
his opinion on the financial statements.

Summary of Relevant Philippine Standards on Auditing (PSA 300 and 330)

The Philippine Standards on Auditing require that the auditor shall conform with the following
guidelines:

1. The auditor shall design and implement overall responses to address the assessed risks of
material misstatement at the financial statement level.
2. The auditor shall design and perform further audit procedures whose nature, timing and
extent are based on and are responsive to the assessed risks of material misstatement at
the assertion level.
3. In design the further audit procedures to be performed, the auditor shall:

(a) Consider the reasons for the assessment given to the risk of material misstatement
at the assertion level for each class of transactions account balance and disclosure,
including:

(i) The likelihood of material misstatement due to the particular characteristics of

the relevant class of transactions, account balance disclosures, including:

(ii) Whether the risk assessment takes account of relevant controls (that is, the
control risk), thereby requiring the auditor to obtain audit evidence to determine
whether the controls are operating effectively (that is the auditor intends to rely on the
operating effectiveness of controls in determining the nature, timing and extent of
substantive procedures); and

(b) Obtain more persuasive audit evidence the higher the auditor’s assessment of risk.

4. The auditor shall develop an audit plan that shall include a description of:

(a) The nature, timing and extent of planned risk assessment procedures;
(b) The nature, timing and extent of planned further audit procedures at the assertion
level; and
(c) Other planned further audit procedures that are required to be carried out so that the
engagement complies with PSAs.

5. When designing and performing audit procedures, the auditor shall consider the relevance
and reliability of the information to be used as audit evidence.
6. When designing tests of controls and tests of details, the auditor shall determine means of
selecting that are effective in meeting the purpose of the audit procedure.
Tests of Controls

1. The auditor shall design and perform tests of controls to obtain sufficient appropriate
audit evidence as to the operating effectiveness of relevant controls if:

(a) The auditor’s assessment of risks material misstatement at the assertion level includes
an expectation that the controls are operating effectively (that is, the auditor intends to
rely on the operating effectiveness of controls in determining the nature, timing and
extent of substantive procedures); or

(b) Substantive procedures alone cannot provide sufficient appropriate audit evidence at
the assertion.

2. In designing and performing tests of controls, the auditor shall obtain more persuasive
audit evidence the greater the reliance the auditor places on the effectiveness of a control.
3. In designing and performing tests of controls, the auditor shall:

(a) Perform other audit procedures in combination with inquiry to obtain audit evidence
about the operating effectiveness of the controls, including:

(i) How the controls were applied at relevant times during the period under audit
(ii) The consistency with which they were applied
(iii) By whom or by what means they were applied.

(b) Determine whether the controls to be tested depend upon other controls (indirect
controls) and, if so, whether it is necessary to obtain audit evidence supporting the
effective operation of those indirect controls

4. If the auditor plans rely on controls over a risk the auditor has determined to be a
significant risk, the auditor shall test those controls in the current period.

Substantive Tests

1. Irrespective of the assessed risks of material misstatement, the auditor shall design and
perform substantive procedures for each material class of transactions, account balance and
disclosure.
2. The auditor shall consider whether external confirmation procedures are to be performed as
substantive audit procedures.
3. The auditor’s substantive procedures shall include the following audit procedures related to
the financial statement closing procedures:

(a) Agreeing or reconciling the financial statements with the underlying accounting
records; and
 (b) Examining material journal entries and other adjustments made during the course of
preparing the financial statements.

4. If the auditor has determined that an assessed risk of material misstatement at the assertion
level is a significant risk, the auditor shall perform substantive procedures that are
specifically responsive to that risk. When the approach to a significant risk consists only of
substantive procedures, those procedures shall include tests of details.
5. If substantive procedures are performed at an interim date, the auditor shall cover the
remaining period by performing:

(a) Substantive procedures, combined with test of controls for the intervening period; or

(b) If the auditor determines that it is sufficient, further substantive procedures only,

That provides a reasonable basis for extending the audit conclusions from the interim
date to the period end

6. The auditor shall perform audit procedures to evaluate whether the overall presentation of
the finance statements, including the related disclosures, is in accordance with the applicable
financial reporting framework.

Illustrative Comprehensive Case Study on Risk Assessment and Risk Response

CASE FACTs:

Introduction

Mercury Technologies and Networks, Inc. (MTN) designs, develops, manufactures, markets,
services and supports a wide range of computer systems and networking hardware and software.

The CPA firm of Villamor& Co. has audited the financial statements of MTN for the past three
years. For this year’s audit, the staff of the firm has prepared audit planning working papers.

Read through the information for you to obtain an understanding of the nature of the information
that is important to planning an audit engagement.

The selective audit planning working papers include:

 The statement of financial position and statement of comprehensive income for

the company for 2014.
 A trial balance for December 31, 2015, with comparative amounts for 2014.
 The analytical ratios working paper that is partially completed. (The ratios for
2015 have been left off.)
 The audit plan for the financial statements for the year ended December 31, 2015.
 A fraud risk assessment
 Mercury Technologies and Networks, Inc.
Statement of Financial Position
December 31, 2014
(In P000’s)

Assets

Current Assets
Cash P 27
Trade receivables, less allowance for doubtful accounts of P10 884
Accounts receivable- officers 57
Inventory 696
Prepaid expenses 40
Total current assets P1, 664
Noncurrent Assets
Equipment and leasehold equipment’s, at cost
Office equipment and furniture P 281
Leasehold improvements 17
P 298
Less accumulated depreciation 125
Total fixed assets P 172
P,1,836

Liabilities and Shareholder’s Equity

Current Liabilities
Note payable P 309
Accounts payable 505
Current maturities of capital lease obligations 20
Accrued expenses 115
Total current liabilities P 949

Capital lease obligations, less current maturities 135

Total liabilities P1, 084

Shareholder’s equity
Ordinary shares, P 1 par value, 100, 000 shares authorized; 20, 000
shares issued and outstanding P 20
Additional paid-in-capital 42
Retained earnings P, 752
P, 1, 836

Mercury Technologies and Networks, Inc.

Statement of Comprehensive Income and Retained Earnings
Year Ended December 31, 2014
 (In P000’s)

Net sales P 10, 227

Cost of gods sold 6, 867
Gross profit P 3, 360
Selling expenses:
Salaries P 513
Payroll benefits and taxes 97
Advertising and promotion 82
Travel and entertainment 38
Miscellaneous 16 P 746
Operating and administration expenses:
Operating salaries P 803
Administrative salaries 438
Payroll benefits and taxes 223
Rent 124
Utilities 92
Insurance 110
Legal and accounting 73
Bad debt 34
Supplies 93
Depreciation 25
Software development 83
Miscellaneous 42
Total selling, operating, and
administrative expenses 2, 140 P2, 886
Operating income P 474
Interest expense 69
Income before income taxes P 405
Income taxes:
Current P 71
Deferred 3

Net income 74
Retained earnings, January 1, 2014 P 331
Retained earnings, December 31, 2014 P 358
P 689
 Mercury Technologies and Networks, Inc.
Audit Plan
December 31, 2015
Date
Prepaid by: KC Lopez (Senior) August 14, 2015
Reviewed by: Jo Hernandez (Manager) August 28, 2015
Reviewed by: Ela Hector (Partner) September 5, 2015

Audit Objective
Audit of the financial statements of Mercury Technologies and Networks, Inc. (MTN) for the
year ended December 31, 2015. Also, the company’s debt agreement with Eastern Financial
Services requires the company to furnish the lender a report by our firm on MTN’s compliance
restrictive debt covenants.

Business and Industry Environment

MTN sells and installs microcomputers and networking hardware and software to business
customers. The company’s primary competitive strategy is to maintain a high level of technical
expertise and a broad range of services. The company provides repair, maintenance, training, and
software customization services. MTN has also begun developing its own computer networking
software to be sold as a product to its customers and MTN competes with large retailers of
microcomputers. The market for microcomputers and related products is extremely competitive.
The company also competed with other value-added resellers who provide microcomputers and
software products directly to customers. To effectively compete, the company must be able to
obtain inventories of state-of-the-art equipment on a timely basis. Because the company does not
have the buying power of some of its competitors, it generally must charge a higher price for its
products. Its customers are willing to pay the higher price because of the high level of expertise
and service that the company provides.

Planning Meetings

On July 20, Jo Hernandez, and I met with Janelle Santos, controller, and GianBasco, president,
of MTN to discuss the planning of the audit for the current year. On August 2, a planning
meeting was held in our office with all members of the engagement team assigned to the audit.

Audit Approach

The company has had no significant changes in its internal control from the prior year.
Therefore, consistent with the approach used in last year’s audit, we plan to perform tests of
controls to assess control risk at less than the maximum for most financial statement assertions.

Risks

Several factors affect the risk of this engagement, including:

  AS described above, MTN is in a very competitive business that is sensitive to economic
conditions.
 MTN is a closely held company owned by five shareholders, Miguel Lee, Patrick Lee,
Francis Lee, Rain Young, and JC Young. Miguel and Patrick are active members of the
company’s board of directors. None of the other owners take an active part in
management of the business.
 Audited financial statements are required by Bank of the Philippine Islands as a part of
the company’s line of credit agreement.
 The officers receive significant bonuses based on quarterly results. (see P- 10 for
implications of the risk).

These factors indicate that the engagement to audit MTN has high risk

Significant Accounting and Auditing Matters

The company began offering for sale extended warranties on computers during the current year.
We need to review the method of revenuerecognition to determine whether it complies with the
requirements of PAS 18, Revenue.

In the prior year, MTN began developing networking software products for sale. This year the
company has started capitalizing certain costs of development. We need to review the method of
accounting for the cost of software development to determine whether it complies with the
requirements of PAS 38, Intangibles.

Planning Materiality

Because the firm has experienced steady growth in sales and earnings over the last three years,
we believe that operating results are the most appropriate basic for estimating planning
materiality as described on the next page:

Comparisons of Bases Computation of Planning Materiality

Financial Annualized Materiality
Statement Base for 12/3/15 Base Amount Percentage Estimate
Sales P11,000,000 Sales P11,000,000 1% P110,000
Total assets 2,000,000 Total assets 2,000,000 1 20,000
Pretax net income 525,000 Pretax net income 525,000 10 52,500

The range for planning materiality is from P20, 000 to P110, 000. Based on the company’s
steady growth in sales and earnings and the fact that the company is not a public company, we
have selected P70, 000 as a reasonable materiality amount for planning purposes.

Scheduling and Staffing Plan

Based on discussions with Ms. Santos the following are tentative dates of importance for the
audit:
Begin interim audit work November 10, 2015
Complete interim audit work By November 15, 2015
Issue management letter on interim work By November 30, 2015
Observe physical inventory December 31, 2015
Begin year-end audit work February 12, 2016
Complete fieldwork By February 20, 2016
Closing conference February 25, 2016
Issue audit report By March 5, 2016
Issue letter required by financing agreement By March 5, 2016
Issued updated management letter By March 10, 2016

Staffing time requirements for the engagement are described below:

Assistant Senior Manager Partner Total

Interim 40 40 10 10 100
Final 40 30 10 10 90
80 70 20 20 190

Fraud Risk Assessment

8.14.15

Client:Mercury and Networks, Inc.

Financial Statement Date: 12/31/15

Procedure Performed by Comments

1. Consider the results of the discussion among See WP-21
engagement personnel about the risk of material for the agenda
misstatement due to fraud EH
2. Consider results of inquiries of management about
the risks of fraud and how they are addressed. EH
3. Consider the results of planning analytical procedures. EH
4. Consider the existence of fraud risk factors listed on
WP-30 through WP-35. EH
5. Consider any other information that might be relevant
to the risk of material misstatement due to fraud. EH

Risk of Material Misstatement Due to Fraud

Management may be motivated to misstate financial

results due to performance bonuses. Specifically, management
may attempt to:

1. Provide inappropriate incentives to sign sales contracts near

quarter-and year-end.
2. Overstate revenue at quarter-end and year-end.
3. Overstate inventories, quantities, or pricing

Overall Responses

Risks were considered in staffing the engagement and determining

the appropriate level of supervision.

Alterations of the Nature, Timing and Extent of

Procedures

Risks were considered in designing audit procedures

for sales and accounts receivable and inventories.

Procedures were performed to address the risk of

management override of internal controls. (See Wp-
23- WP-24).

REQUIREMENTS

1. The audit plan of Mercury Technologies and Networks, Inc. appears on pages 116
through 120. Review each major section of the audit plan and briefly describe the
purpose and content of the section.
Organize your presentation in the following manner.

Section Purpose Content

Objectives of the To describe the services that The objectives are (1)
Engagement are to be rendered to the client. audit of MTN’s
financial statements
for the year ended
12/31/15 and (2)
issuance of a letter
on compliance with
covenants of the
client’s letter of credit
agreement
Business and Industry
Conditions

2. In the audit plan for the audit of Mercury Technologies and Networks, Inc., there is a
section on significant accounting and auditing matters. The first of the matters
described in this section involves the appropriate accounting for the sale of extended
warranty contracts. Research this accounting issue and write a brief memorandum for
the working papers describing the issue and summarizing the appropriate method of
accounting for the revenue received from these contracts.
3. In the audit for the audit of Mercury Technologies and Networks, Inc. there is a
section on significant accounting and auditing matters. The second matter described
involves capitalizing the costs of developing a software program for sale.

Required

a. Research this issue and write a brief memorandum for the working papers describing the
issue and summarizing the appropriate method of accounting for the development costs.
b. Based on your research, described the major audit issue that you believe will be
involved in auditing the software development costs.

4. A partially completed analytical ratios working paper for Mercury Technologies and
Networks. Inc., is presented on page 116.

Required:

a. Complete the working paper by computing the financial ratios for 2015.
b. After completing part (a), review the ratios and identify financial statement accounts that
should be investigated because the related ratios are not comparable to prior-year ratios
and industry averages.
c. For each account identified in part (b), list potential reasons for the unexpected account
balances and related ratios.

CASE ANALYSIS

Requirement (1) Analysis of Audit Plan for MTN

Section Purpose Content

OBJECTIVES OF To describe the services that is
The objectives are (1) of
THE ENGAGEMENT to be rendered to the client. MTN’s financial statements
for the year ended 12/31/13,
and (2) issuance of a letter on
compliance with covenants of
the client’s letter of credit
agreement.
BUSINESS AND To describe the nature of MTN sells and services micro-
INDUSTRY MTN’s business and industry computers, networking
CONDITIONS hardware and software to
business customers. The
industry is sensitive to
economic conditions and very
competitive, with MTN
competing with companies
much larger than itself.
PLANNING To indicate meetings held with At this point, one meeting has
MEETINGS client and with CPA been held with client
 engagement team. personnel and one with the
engagement team.
AUDIT APPROACH To describe the overall Consistent with the previous
approach to be taken on the year’s audit, the CPAs will
audit plan to perform tests of
controls to be assess control
risk at less than the maximum
for most assertions.
RISKS To describe factors affecting The engagement has high risk.
the risk of the engagement. The primary risk factors are:
(1) management domination
by a few individuals, (2)
existence of a line of credit
agreement and (3) the owners
have entered into an
agreement to sell the business
and the audited financial
results will significantly affect
the sales price. This last risk
results in a fraud risk.
SIGNIFICANT To describe particular Two particular concerns exist:
ACCOUNTING AND accounting and auditing (1) proper accounting for
AUDITING matters of concern. extended warranties and (2)
MATTERS capitalization of software
costs.
PLANNING To identify an amount to be Based on an analysis of sales,
MATERIALITY used as a measure for planning total assets, and pretax net
materiality. income an amount of P70, 000
will be used as a measure of
planning materiality.
SCHEDULING AND To provide the schedule for The section includes major
STAFFING PLAN major portions of the audit, dates beginning with interim
and the staffing requirements audit work through the
for the engagement issuance of an updated
management letter. A total of
118 hours are budgeted for the
audit.
Requirement (2) Research made on MTN Extended Warranty Contracts

MERCURY TECHNOLOGIES & NETWORKS, INC.

December 31, 2015

Memorandum on Accounting Issues – Accounting for Extended Warranties

MTN began offering extended warranties on computers during the current year. We must
determine that both revenues and expenses relating to these warranties are properly accounted
for. PAS 18, Revenue and PAS 37, Provisions, Contingent Liabilities and Contingent Assets,
provide guidance in this area bit for accrual of revenue and amortization of costs.

The Philippine Accounting Standards require that revenue from extended warranties be
deferred and recognized in income on a straight-line basis over the contract period, except when
sufficient historical evidence indicates that the costs of performing services under the contract
incurred on other than a straight-line basis. In those circumstances, revenue should be recognized
over the contract period in proportion to the costs expected to be incurred in performing the
services. Because the company has no historical experience with these warranties, revenue
should be deferred and recognized on a straight-line basis.

The costs related to extend warranties include those directly related to acquisition of the
warranty and other costs. Costs directly related to the acquisition of a warranty contract that
would not have been incurred but for the acquisition of the contract should be deferred and
charged to expense in proportion to the revenge recognized. All other costs (e.g., costs of
services performed, general and administrative, advertising expenses) should be charged to
expense as incurred.

In circumstances in which the sum of expected costs of providing services an unamortized

acquisition costs exceed unearned revenue a different approach is appropriate-a loss should be
recognized first by charging any unamortized acquisition costs to expense. If the loss is greater
than the unamortized costs, a liability should be recognized for the excess amount of costs.

KC Lopez
(September 30, 2015)
Requirement (3) Research made on Capitalization of Software Development Costs

(a) MERCURY TECHNOLOGIES & NETWORKS, INC.

December 31, 2015

Memorandum on Accounting Issues- Capitalization of Software Development Costs

In 2014, MTN began developing software product for sale. This year the company has
started capitalizing certain costs of development. PAS 38, Intangibles, provides guidance in this
area. PAS 38 makes clear that the nature of the activity for which the software is being
developed should be included or excluded in research and development. PAS 38 indicates that to
the extent that the acquisition, development, or improvement of a process by an enterprise for
use in its selling or administrative activities includes costs for computer software, those costs are
not research and development costs. Examples of such costs include development of a general
management information system and the computerized reservation system of an airline. This
does not appear to be the type of costs involved in this situation.

PAS 38 further clarifies the issue by stating that all costs incurred to establish the
technological feasibility of a computer software product to be sold, leased or otherwise marketed
are research and development costs. The technological feasibility of a product is established
when the enterprise has completed all planning, designing, coding, and testing activities that
are necessary to establish that the product can be produced to meet its design specifications
including functions, features and technological performance requirements. PAS 38 provides a
summary of tests to indicate whether technological feasibility has been established.

Costs incurred subsequent to establishing technological feasibility are to be capitalized. The

capitalization of computer software costs ceases when the product is available for general release
to customers. Costs of maintenance and customer support should be charged to expense when
related revenue is recognized or when the costs are incurred, whichever occurs first.

KC Lopez
(October 15, 2015)

(b) The major audit issue involve will be determining that the client has properly categorized
costs between research and development (those costs involved in establishing technological
feasibility) and those costs that should be capitalized. The auditors will have to determine at what
point the software product reached the point of technological feasibility.
Requirement (4) MTN Ratio Analysis

Mercury Technologies & Networks, Inc.,

Analytical Review Ratios
For the Period Ended December 31, 2015

12/31/15 12/31/14 industry

Current Ratio 1, 858 1, 752 1, 300

Days’ Sales in Accounts Receivable

Computed with Average Accounts
Receivable 29, 524 33, 224 37.000

Allowance for Doubtful Accounts/

Accounts Receivable .010 .011 --------

Bad Debt Expenses/Net Sales .005 .003 -------

Inventory Turnover Computed with

Average inventory 9.255 10.397 10.000

Days’ Inventory oh Hand, Computed

with Average inventory 39.436 35.222 36.000

Total liabilities to Net Worth 1.107 1.444 2.900

Return on Total Assets .194 .180 .090

Return on Net Worth .409 .441 .290

Return on Net Sales .040 .032 .023

Gross Profit/Net Sales .362 .329 .240

Selling, Operating and Administrative

Expense .305 .282 .239

Times Interest Earned 8.541 6.902 5.500

Supporting Computation for 2015 ratios (P000’s)

Current Ratio Current Assets/Current Liabilities

P2,091 / P1.126 = 1.858
Days Sales in A/R Computed Sales per day = Sales / 365
with Average A/R = P11,602 / 365 = 32
Average A/R = (Beg. A/R + End A/R) / 2
= (P853 + P1, 023)/2 = P938
Days sales = Average A/R / Sales per day
= P938 / P32 = 29.524
Allowance for Bad Debts / A/R P 10/P1,023 = 0.10
Bad Debts Expense / Net Sales P56 / P11,602 = .005
Inventory Turnover Computed Average Inv. = (Beg. Inv. + End Inv) / 2
Average Inventory = (P695 + P904) / 2 = P799
Inv. Turnover = Cost of Goods Sold / Average Inv.
= P7, 396/ P799 = 9.255
Days Inventory Computed with CGS per day = Cost of Goods Sold / 365
Average Inventory =P 7, 397 / 365 = P20
Days Inv. = Average Inv. / CGS per day
= P 799/P20 = 39.430
Total Liabilities to Net Worth Total Liabilities / Shareholder’s Equity
P 1, 240/ P1, 120 = 1.107
Return on Total Assets Net income / Total Assets
P458/P2, 360 = .194
Return on Net Worth Net income/ Shareholders’Equity
P458 /1, 120 = .409
Return on Net Sales Net Income / Net Sales
P 458 / P1, 602 = .040
Gross Profit / Net Sales Gross Profit / Net Sales
P 4, 205 / P 11, 602 = .362
Selling, Operating and Admin. Selling, Operating and Admin. Exp. / Net Sales
Expense / Net Sales P 3, 544/ P11, 602 = .305
Times Interest Earned Operating Income/Interest Expense
P661 / P77 = 8.541
(b) and (c) This part of the case reveals how difficult ratio analysis is when there are no major
changes in ratios. However, the following ,might be considered in comparing the current year’s
ratios with those of last year’s.

Days Sales in Accounts Receivable

 Changes in credit policy
 Better economic conditions
 Change in customer mix
 Overstatement of sales
 Understatement of receivables

Inventory Turnover
 Change in inventory policy
 Inventory obsolescence
 Overstatement of inventory
 Understatement of purchase

Days Inventory on Hand

 Change in inventory policy

 Inventory obsolescence
 Overstatement of inventory
 Understatement of purchases

Gross Profit / Net Sales

 Change in sales mix

 Increase in sales pricing
 Reduction of costs
 Understatement of cost goods sold and related overstatement of inventory

A number of the other ratios show significant changes which seem due primarily to the increased
to the increased level of profitability.