Unit 6: AUDIT of INTANGIBLE ASSETS

and Prepaid Expenses

INTRODUCTION

Intangible assets differ from the other assets on your audit client’s balance sheet because they don’t have a
physical presence and aren’t financial instruments like cash. However, like fixed assets, their expense is moved
to the income statement over their useful life through amortization.
PAS 38 is the main standard for evaluation of the client’s accounting for its intangible assets. This standard
covers definition of intangible assets, identification criteria, recognition and measurement information, fair
value definitions, treatment of internally generated intangible assets and goodwill, details on useful lives,
residual value and appropriate amortisation periods.

UNIT LEARNING OUTCOMES

By the end of this unit you should be able to:
1. Explain the importance of each assertion in the audit of intangible assets.
2. Identify key factors that can lead to an under/overstatement of the intangible assets balance.
3. Apply the directional risk of intangible assets in determining the appropriate audit procedures to be
performed.
4. Identify the different risks associated in the accounting of intangible assets.
5. Integrate the effect of each deficiency to the development of audit procedures for intangible assets.
 6. Assess the risk of material misstatement associated with the audit of intangible assets.
7. Perform the appropriate audit procedures in the audit of intangible assets.
8. Prepare in good form the audit working papers related to the audit of intangible assets.

TIMING
This unit is good for two (2) weeks. It covers the 11 th and 12th week of this course from November 12 – 25,
2020. To get the most out of this unit I encourage you to spend at least 3 hours per day studying it. You don’t
have to necessarily complete the three-hour study time in one sitting. You may spend the first hour in morning,
the second hour in the afternoon and the third hour in the evening if such style suits you better. Besides, the
content is easy to understand which helps you to build momentum in your study. From time to time, you might
also want to allocate a portion of your study time to revisit you financial accounting lessons on intangible assets
and prepayments. Reviewing the fundamentals will well help you solve faster the problems in this unit.

GETTING STARTED

6.1 Primary
Assertions for
Intangible Assets In the audit of inventory, we usually test the audit assertions included in the
table below:

Audit assertions for Intangible Assets

Existence Inventory balances reported on financial statements actually exist at the

reporting date.
Completeness Inventory reported on the balance sheet includes all inventory
transactions that have occurred during the accounting period.
Rights and All inventory reported on financial statements as at the reporting date
obligations really belongs to the company.

Valuation Inventory balances truly reflect its economic value.

Presentation and Inventory is properly classified and sufficiently disclosed in the notes to
disclosure financial statements.

6.2 Intangible Assets WALKTHROUGH

As we perform walkthroughs for intangible assets, we normally look for ways that intangibles assets might be
overstated (though it can also be understated as well). We are asking, “What can go wrong?” whether
intentionally or by mistake. Some of the questions that might be asked in an inventory walkthrough are as
follows:

In performing the walkthrough, ask questions such as:

 Are intangible assets ledgers reconciled to the general ledger?
 Does the entity use reasonable and consistent amortization methods?
 Are the amortization methods in accordance with the reporting framework?
 Who records amortization? 
 Are the economic lives assigned to intangible assets appropriate?
 What controls ensure that intangible assets are recorded in the right period?
 What controls ensure that research and development costs are appropriately expensed when incurred?
 What software is used to compute amortization?
 Are intangible assets removed from the amortization schedule upon sale?
 What controls ensure that intangible assets purchases are added to the amortization schedule?
 What controls ensure that research costs are not capitalized?

6.3 Directional Risk for Intangible Assets

What is directional risk? It’s the potential bias that a client has regarding an account balance. A client might
desire an overstatement of assets and an understatement of liabilities since each makes the balance sheet appear
healthier.

The directional risk for intangible assets is overstatement. So, in performing your audit procedures, perform
procedures to check that research costs have not been capitalized and development costs are capitalized only
after technical and commercial feasibility of the asset for sale or use have been established.

6.4 Primary Risks for Intangible Assets

The top five intangible asset risks we see companies facing are:

1. The leakage or theft of confidential information

Companies today are constantly leaking key intangible assets, with the primary sources of those leaks being
customers, suppliers or employees. According to research, 72 percent of CEOs, 71 percent of CMOs and 49
percent of business leaders admit to taking intangible assets with them from previous employers, when they
move to a new organization.

2. Not being able to prove ownership of intangible assets

Most companies cannot prove they actually own their intangible assets.

3. Hazardous use of open source code software

Today, 80% of all software code is open source with almost every company utilizing it in some way. However,
there can be significant ownership and cyber security issues around the use of open source code software if it is
not managed correctly.

4. Not owning your brand, or brand infringement

Many companies we see do either not own or control their brand, or face major brand infringement risks. A
brand is oftentimes a company’s most valuable asset, yet many companies do not understand trademark law or
trademark strategy.

5. Threatened or actual Intellectual Property litigation

There has been a significant increase in intellectual Property litigation in many countries over the last decade.

Intangible asset risks can be mitigated with foresight and planning. However, if these risks aren’t identified and
managed, then they have the potential to have a significant negative impact on a business as the cost of fixing
these issues after they’ve occurred is high. If you treat risk mitigation around your intangible assets as
important and urgent, then you avoid a number of costly issues from occurring.

6.5 Common Intangible Assets controls deficiencies

Some of the most common controls deficiencies for intangible assets are the following:

1. Companies do not have established policies and procedures to protect their most valuable data from
being accidentally or intentionally shared with third-parties.

2. Some companies fail to keep an inventory of their intangible assets, along with establishing and
registering ownership rights to these assets.

3. Failure to understand and spell out the ownership rights of any intangible assets that result from joint
development or R&D arrangements, as well as outsourced contracting arrangements.

4. Little to no understanding who actually owns the open source code being used; the licensing terms of the
software and how it impacts on the company’s own proprietary code; and associated cyber security
risks.

5. Companies do not ensure the right protections in place before entering into a joint venture or distributor
arrangement to ensure that the partner does not end-up owning or controlling the company brand.

6. Improper risk assessment of any risk exposure to Intellectual Property litigation early on and take
proactive, rather than reactive, measures to minimize this threat.

6.6 Risk of material misstatement for Intangible Assets

There is a significant risk that the requirements of PAS 38 Intangible Assets have not been followed. Research
costs must be expensed and strict criteria must be applied to development expenditure to determine whether it
should be capitalised and recognised as an intangible asset.
Development costs are capitalised only after technical and commercial feasibility of the asset for sale or use
have been established, and the company must demonstrate an intention and ability to complete the development
and that it will generate future economic benefits. The risk is that research costs have been inappropriately
classified as development costs and then capitalised, overstating assets and understating expenses.

When testing internal controls in the area of impairment of goodwill and intangible assets, auditors rely heavily
on management inquiry and inspecting documentation indicating the control had been performed. However,
their testing did not include evaluating the procedures performed, including the basis for the control owners’
expectations and whether matters identified for follow up were appropriately resolved.

Assessing and measuring goodwill and intangible assets for impairments requires fair value measurements so it
makes sense that several deficiencies in this area are related to auditing fair value measurements. Specifically,
the firms failed to perform sufficient procedures to test the issuers’ analyses of possible impairment, heavily
relying on internally-produced memoranda and schedules, as well as inquiry of management, without any
corroboration.

6.7 Substantive Procedures for Intangible Assets

ASSERTION AUDIT PROCEDURES

Existence Obtain supporting papers/legal documents pertaining to the
intangible assets and establish that the assets are in the name of the
organization; note any impediments or restrictions attached thereto;

For material transactions, examine invoices, authorizations,

contracts, agreements or other documentation that supports the
additions to the balances.
Completeness Obtain/prepare a schedule/analysis of intangible assets.

Rights and obligations Obtain supporting papers/legal documents pertaining to the

intangible assets and establish that the assets are in the name of the
organization; note any impediments or restrictions attached thereto;
Valuation Check the valuation used in the records using the following
guidelines:
1. Intangible assets are initially measured at cost.
2. Charge all research cost to expense. [IAS 38.54]
Development costs are capitalised only after technical and
commercial feasibility of the asset for sale or use have been
established. This means that the entity must intend and be
able to complete the intangible asset and either use it or sell
it and be able to demonstrate how the asset will generate
future economic benefits.
3. Those developed internally that do not have determinable
lives are expensed when incurred.
4. Intangible assets that have finite useful lives are amortized
over their useful lives straight line unless another
method better reflects economic reality.
 5. Test and verify for any impairment in the intangible assets.
If an impairment of value has occurred, the asset must be
written down to reflect its diminished value with
appropriate changes in the amortization method made
accordingly.

Presentation and Verify that intangible assets are properly classified and sufficiently
disclosure disclosed in the notes to financial statements.

The auditor should verify that the entity has made relevant
disclosures for intangible assets on amortization method, gross
carrying amount, accumulated amortization and impairment losses,
line items in the income statement in which amortization is
included. In addition auditors must check the following additional
disclosures required by PAS 38:
 basis for determining that an intangible has an indefinite life
 description and carrying amount of individually material
intangible assets
 certain special disclosures about intangible assets acquired
by way of government grants
 information about intangible assets whose title is restricted
 contractual commitments to acquire intangible assets
 intangible assets carried at revalued amounts 
 the amount of research and development expenditure
recognized as an expense in the current period

6.8 ILLUSTRATIVE PROBLEMS

PROBLEM#1

As a member of the audit team for the audit of REDHORSE COMPANY’s financial statements for the year
ended December 31,2020 have been asked to examine selected accounts. The controller for the REDHORSE
mentions that there is only one account shown below kept for intangible assets.

INTANGIBLE ASSETS
Debit Credit Balance
Feb. 1 Organizing costs P 72,000 P 72,000
Mar 2 Research and development cost 1,880,000 1,952,000
April 3 Legal costs to obtain patent 150,000 2,102,000
May 1 Payment of 12 months’ rent on property
leased by Redhorse 240,000 2,342,000
 Jun 15 Promotional expenses related to start 414,000 2,756,000
up of business

Dec. 31 Unamortized expenses bond discount 168,000 2,924,000

on bonds due December 31,2011

Dec.31 Operating losses for the first year 482,000 3,406,000

1. The amount of organization expenses to be reported in REDHORSE’s income statement for the
year ended December 31,2020 is

A. P2,348,000
B. P486,000
C. P582,000
D. P240,000

2. What is the carrying value of the patent at December 31,2020 assuming that useful life is 10 years?

A. P 150,000
B. P138,000
C. P135,000
D. 0

3. The prepaid rent to be shown on REDHORSE statement financial position at December 31,2020
is?

A. P160,000
B. P240,000
C. P80,000
D. 0

PROBLEM#2
GILAS CORP. was incorporated on January 2, 2019. The corporation’s financial statements for its first year’s
operations were not examined by a CPA. You have been engaged to audit the financial statements for the year
ended December 31, 2020, and your audit is substantially completed. The corporation’s trial balance appears
below.

GILAS Corp.
TRIAL BALANCE
December 31, 2020

Debit Credit
Cash ₱ 450,000
Accounts Receivable 2,190,000
Allowance for doubtful accounts ₱ 43,800
Inventories 1,506,000
Machinery and equipment 3,570,000
Accumulated depreciation 786,000
Patents 3,846,000
Leasehold Improvements 900,000
Prepaid expenses 1,350,000
Goodwill 900,000
Licensing agreement No. 1 1,800,000
Licensing agreement No. 2 1,680,000
Accounts payable 2,190,000
Unearned revenue 518,400
Share capital 9,000,000
Retained earnings, January 1, 2016 4,771,800
Sales 21,600,000
Cost of goods sold 14,250,000
Selling and administrative expenses 5,583,000
Interest expense 285,000
Loss on extinguishments of debt 600,000
Totals ₱ 38,910,000 ₱ 38,910,000

The following information relates to accounts that may yet require adjustment.

1. Patents for GILAS’ manufacturing process were acquired January 2, 2020 at a cost of ₱ 2,805,000. An
additional ₱ 1,041,000 was spent on December 29, 2020, to improve machinery covered by the patents
and charged to the Patents account. Depreciation on property, plant, and equipment has been properly
recorded for 2020. GILAS uses the straight-line method for all depreciation and amortization and the
legal life on its patents.

2. On January 3, 2019, GILAS purchased Licensing Agreement No. 1, which was believed to have an
indefinite useful life. The balance in the Licensing Agreement No. 1 account includes its purchase price
of ₱ 1,710,000 and expenses of ₱ 90,000 related to the acquisition. On January 1, 2020, GILAS
purchases Licensing Agreement No. 2, which has a life expectancy of 10 years. The balance in the
Licensing Agreement No. 2 accounts include its ₱ 1,620,000 purchase price and ₱180,000 in
acquisition expenses, but it has been reduced by a credit of ₱120,000 for the advance collection of 2019
revenue from the agreement.

3. In late December 2019, an explosion caused a permanent reduction in the expected revenue-producing
value of Licensing Agreement No. 1, and in January 2019, a flood caused additional damage that
rendered the agreement worthless. The recoverable amount of Licensing Agreement No. 1 was
determined to be ₱ 720,000 at December 31, 2019.

4. The balance in the Goodwill account represents amount paid on December 30, 2019, for a four-year
advertising program, estimated to assist in increasing Acero’s sales.

Based on the above and the result of your audit, answer the following questions:

1. What is the carrying value of Patents on December 31, 2020?

2. What amount of impairment loss should be recognized in 2019?
3. What is the carrying value of Licensing Agreement no. 2 on December 31, 2020?
4. How much is the goodwill to be presented in the statement of financial position as of December 31,
2020?
5. How much would be the total intangible assets to be presented in the statement of financial
position as of December 31, 2020?
SOLUTION:

Question#1

Cost of patents ₱ 2,805,000

Amortization for 2020 (₱ 2,805,000/ 20 years) (140,250)
Carrying value, Dec. 31, 2020 ₱ 2,664,750

Question#2

Cost of licensing agreement no. 1 ₱ 1,800,000

Recoverable value 720,000
Impairment loss ₱ 1,080,000

Question#3

Cost of licensing agreement no. 1

(₱ 1, 620,000 + ₱ 180,000) ₱ 1,800,000
Amortization (₱ 1,800,000/10) (180,000)
Carrying value, Dec. 31, 2020 ₱ 1,620,000
Question#4

Zero. The amount paid for the four-year advertising should have been recorded as PREPAID
ADVERTISING not as goodwill.

Question#5

Patents ₱ 2,664,750
Goodwill ---
Licensing agreement No. 1 720,000
Licensing agreement No. 2 1,620,000
TOTAL INTANGIBLE ASSETS ₱ 5,004,750

PROBLEM NO. 3

Transactions during 2020 of the newly organized GWAPS Corporation included the following:

Jan. 2 Paid legal fees of P150,000 and stock certificate costs of P83,000 to complete organization of the
corporation.

Jan 15 Hired a clown to stand in front of the corporate office for 2 weeks and hound out pamphlets and
candy to create goodwill for the new enterprise. Clown cost, P10,000; pamphlets and candy,
P5,000.

Apr. 1 Patented a newly developed process with costs as follows:

Legal fees to obtain patent P 429,000
 Patent application and licensing fees 63,500

It is estimated that in 6 years other companies will have developed improved processes, making the GWAPS
Corporation process obsolete.

May 1 Acquired both a license to use a special type of container and a distinctive trademark to be
printed on the container in exchange for 6,000 shares of GWAPS’s no-par common stock selling
for P50 per share. The license is worth twice as much as the trademark, both of which may be
used for 6 years.

July 1 Constructed a shed for P1,310,000 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 totalling
P1,750,000 in 2020.

QUESTIONS: Based on the above and the result of your audit, determine the following:

1. Cost of patent
a. P492,500 b. P429,000 c. P63,500 d. P 0

2. Cost of licenses
a. P150,000 b. P200,000 c. P100,000 d. P 0

3. Cost of trademark
a. P150,000 b. P200,000 c. P100,000 d. P 0

4. Carrying amount of Intangible Assets

a. P712,604 b. P2,477,604 c. P697,604 d. P 0

5. Total amount resulting from the foregoing transactions that should be expensed when incurred
a. P4,100,500 b. P1,983,000 c. P1,998,000 d. P0

PROBLEM#4

On December 31, 2019, POGI Corporation acquired the following three intangible assets:

n A trademark for P300,000. The trademark has 7 years remaining legal life. It is anticipated that the
trademark will be renewed in the future, indefinitely, without problem.
n Goodwill for P1,500,000. The goodwill is associated with POGI’s Mask Manufacturing reporting unit.
n A customer list for P220,000. By contract, POGI has exclusive use of the list for 5 years. Because of
market conditions, it is expected that the list will have economic value for just 3 years.

On December 31, 2020, before any adjusting entries for the year were made, the following information was
assembled about each of the intangible assets:
 n Because of a decline in the economy, the trademark is now expected to generate cash flows of just
P10,000 per year. The useful life of trademark still extends beyond the foreseeable horizon.
n The cash flows expected to be generated by the Mask Manufacturing reporting unit is P250,000 per year
for the next 22 years. Book values and fair values of the assets and liabilities of the Mask Manufacturing
reporting unit are as follows:
Book values Fair values
Identifiable assets P2,700,000 P3,000,000
Goodwill 1,500,000 ?
Liabilities 1,800,000 1,800,000

c) The cash flows expected to be generated by the customer list are P120,000 in 2021
and P80,000 in 2022.

REQUIRED:

Based on the above and the result of your audit, determine the following: (Assume that the appropriate
discount rate for all items is 6%):

1. Total amortization for the year 2020

a. P73,333 b. P141,515 c. P116,190 d. P86,857

2. Impairment loss for the year 2020

a. P90,476 b. P133,333 c. P179,584 d. P – 0 –

3. Carrying value of Trademark as of December 31, 2020

a. P300,000 b. P257,143 c. P166,667 d. P120,416

4. Carrying value of Goodwill as of December 31, 2020

a. P1,500,000 b. P1,431,818 c. P1,425,000 d. P1,462,500

5. Carrying value of Customer list as of December 31, 2020

a. P220,000 b. P146,667 c. P176,000 d. P0