UNIT 7

AUDIT OF PROVISIONS
Estimated Time: 3.0 HOURS

Discussion Questions:
1. Discuss the following terms:
a. Provision
b. Restructuring
c. Contingent liability
d. Contingent asset
2. Differentiate the following terms:
a. Permanent and temporary differences
b. Taxable and deductible temporary differences
c. Deferred tax liability and deferred tax asset
d. Current tax expense and income tax expense
e. Deferred tax expense and benefit

Problem 7-1:
PAS 37 sets out three conditions that must all be satisfied in order to recognize a
provision:
an entity has a present obligation (legal or constructive) as a result of a past event
it is probable that a transfer of economic benefits will be required to settle the
obligation, and
a reliable estimate can be made of the amount of the obligation.
The first criterion derives from the definition of a liability. The second and third criteria
derive from the recognition of a liability. In the table below please indicate the
application of these criteria and your suggested action.
Situation:
Provision? Action
1 Past event has occurred resulting in a possible
obligation for which a transfer of benefits is
possible but not probable.
2 Past event has occurred resulting in a present
obligation for which there may possibly be a
transfer of benefits, but there probably will not.
3 Past event has occurred resulting in a present
obligation for which it is likely there will be a
transfer of benefits, but a reliable estimate
cannot be made of the amount of the obligation.
4 Past event has occurred resulting in a present
obligation for which it is more likely than not
that there will be a transfer of benefits, and a
reliable estimate can be made of the amount of
the obligation.
5 An obligating event has not taken place on the
balance sheet date, but it takes place after the
balance sheet date resulting in an obligation for
which it is likely there will be a transfer of
benefits, and a reliable estimate can be made
of the amount of the obligation.

Auditing Practice II
Workbook

Third Term, AY 2015-2016

Page 1-1

Problem 7-2: Restructuring Provisions

JKL Company announced a formal plan to restructure its operation as of December
31, 2016. One of its manufacturing plant, (called plant one) was shut down and
held for sale. This plan involved the following:
a. Plant One was shut down on November 30, 2016 and held for sale but there was
no binding sales agreement with a third party;
b. 100 employees had been retrenched, had left, and their accumulated entitlements
had been paid, however, an amount of P 1,520,000 representing a portion of the
three (3) months wages for the retrenched employees had not been paid;
c. 20 employees will be transferred to another plant (called plant two) of the
Company on January 15, 2017, and relocation costs of P460,000 are expected to
be paid;
d. Four of the five head-office staff had been retrenched, had left and their
accumulated entitlements, including the three months wages had been paid.
However, one employee, Mr. X, remained on to complete administrative tasks
relating to the closure of Plant One and the transfer of employees to Plant Two.
Mr. X was expected to stay until January 31, 2017. His salary for January would
be P80,000 and his retrenchment package would be P260,000 all of which would
be paid on his last day of work. He estimated that he would spend 60% if his time
administering the closure of Plant One and 30% of his time administering the
transfer of staff to Plant Two, and the remaining 10% on general administration;
e. The costs to dismantle plant one is estimated to be P1,000,000. In the jurisdiction
in which JKL operates plant one, there is no legal obligation for dismantling plants
when abandoned. JKL is not particularly known for dismantling its plants when
abandoned but decided to make an exception this time. The costs to reassemble
plant two have not yet been finalized at the moment; and
f. Retraining of staff for Plant Two is estimated to be P1,500,000,
You have already assessed that the recognition criteria for a restructuring provision
have been met in accordance with PAS 37 par. 72.

Required:
1. How much is the restructuring provision?
2. How much is to be excluded from restructuring provision?
Problem 7-3: Contingencies, Provisions, Events after the End of the Reporting Period
Cash Sir, Inc. (CSI) asked for your audit services for its December 31, 2016 financial
statements. During the year, it encountered the following transactions:
a. On November 11, 2016, CSI initiated a lawsuit seeking P2 million in damages
from infringement of its patent.
b. On December 4, 2016, a lawsuit was filed by a customer after discovering a
biohazard in CSIs products. CSIs legal counsel estimates that P300,000 would
be a reasonable amount of liability.
c. During 2016 CSI was involved in a lawsuit against a customer. On January 12,
2017, the court rendered judgement against CSI for the amount of P15 million.
CSI plans to appeal but is unable to predict the outcome. The management
believes that it will not have a material adverse effect on the Company.
d. On February 17, 2016, inventory purchased amounting to P5 million with terms of
FOB shipping point from a foreign country was detained at that countrys border
due to political conflict. Legal counsel feels it is probable that CSI will be able to
obtain the goods.
e. On April 28, 2016, BIR is in the process of examining CSIs tax returns for 2013
and 2014, but has not proposed a deficiency assessment. Management feels an
assessment is reasonably possible, and if an assessment is made, an
unfavourable settlement of up to P3 million is reasonably possible.

Required: Prepare all the necessary adjusting journal entries for each case.
Auditing Practice II
Workbook

Third Term, AY 2015-2016

Page 1-2

Problem 7-4: Liability for Returnable Containers

Tea Sir, Inc. (TSI) charges a deposit from its customers for an item sold in an
expensive and recyclable container. The customer receives a refund for each
container returned within two years after the year of delivery. TSI considers
containers not returned with the time limit as sold at the deposit amount. Provided
below are the information for 2016:
Containers held by customers at 12/31/2015
from deliveries in:
2014
2015
Containers delivered in 2016
Containers returned in 2016
from deliveries in:
2014
2015
2016

96,000.00
264,500.00
68,400.00
162,000.00
521,000.00

360,500.00
623,000.00

751,400.00

Required:
1. How much revenue from container sales should be recorded in 2016?
2. How much is the liability for returnable containers as of December 31, 2016?
Problem 7-5: Warranties and Premiums
LaySir Music Inc. (LMI) sells a variety of sound reproduction equipment, CDs and
musical instruments, and offers premiums and warranties to its customers. For every
P50 spent on CDs, a customer is entitled to a coupon. Customers may exchange
220 coupons and P500 for a DVD player, which originally costs P750. LMI estimates
that 55% of the coupons given to customers will be redeemed. 1,100,000 coupons
were redeemed in 2016 and 6,500 DVD players were purchased during the year. LMI
gives a one-year warranty for replacement of parts and labor on equipments and
musical instruments sold. Based on experience, estimated warranty cost is 2% of
sales. Replacement parts and labor for warranty work totaled P1,870,000 during
2016. LMI uses the accrual method to account for warranty and premium costs. LMIs
total sales amounted to P83 million which is from instruments/equipments and CDs
amounting to P62 million and P21 million, respectively. The following are the
balances at the beginning of the year 2016:
Inventory of premium CD players
Estimated premium claims outstanding
Estimated liability from warranties

410,300.00
1,530,000.00
1,470,000.00

Required:
1. How much is the warranty expense?
2. How much is the estimated liability from warranties?
3. How much is the premium expense?
4. How much is the inventory of premium CD players?
5. How much is the estimated premium claims outstanding?

Auditing Practice II
Workbook

Third Term, AY 2015-2016

Page 1-3

Problem 7-6 Income Tax Accounting;

Apol Inc., a well known company in the technological industry, reported pretax
financial income amounting to P700,000 for 2016. However, for income tax purposes,
the following are not considered taxable/deductible:
Interest income subject to final tax
Depreciation Expense deductible in the future
Unearned income, end of year
Collection of beginning rent receivable
Unrealized foreign exchange gain
Fines and Penalties

P50,000
160,000
100,000
220,000
200,000
40,000

Tax rate applicable to the Company is 30%. The beginning balance of deferred tax
liability amounts to 66,000.

Required:
1. Of the differences enumerated above, compute for the following:
a) Temporary Differences;
b) Permanent Differences;
c) Net Taxable Income
2. How much is the total tax currently payable?
3. How much is the deferred tax assets as of December 31, 2016?
4. How much is the deferred tax liabilities as of December 31, 2016?
5. Propose adjusting journal entries to record the current and deferred income tax
transactions.

Auditing Practice II
Workbook

Third Term, AY 2015-2016

Page 1-4