CHAPTER 17

Audit of Prepaid Expenses,

Deferred Charges and Other
Current Liabilities
 LEARNING OUTCOMES
1. Describe the auditor's objectives for the substantive audit
of details of balances of prepaid expenses, deferred charges
and other current liabilities.

2. Describe the nature of the audit procedures to accomplish

the auditor's' objectives for the audit of prepaid expenses,
deferred charges and other current liabilities.

3. Understand and prepare audit working papers to document

audit procedures for prepaid expenses, deferred charges and
other current liabilities.
 INTRODUCTION
Among the most common prepaid expenses that
auditors encounter are insurance, advertising
services, office supplies, rent, interest, taxes
and royalties and they are usually classified as
current assets. Deferred charges such as bond
issue costs, plant rearrangement costs or
relocation charges are prepayments that are
chargeable to the operations of several years and
are separately classified as noncurrent assets.
 AUDIT OBJECTIVES
1. To determine that the prepaid expenses or deferred charges
carried forward at the beginning of the period are actually chargeable
to the operations of future periods and that definite benefits will be
received in the future periods from these expenses carried forward
as assets.

2. To ascertain the correctness of the prepaid or deferred amount at

the end of the period as well as the amount consumed or had
expired, if any, during the period under review.

3. To ascertain the propriety of the amount charged as prepaid

expenses or as deferred charges.
 SUBSTANTIVE AUDIT PROCEDURE
A. Audit of Prepaid Expenses

1. Prepaid insurance

a. Inspect insurance policies on a test basis.

b. Review coverage premiums.
c. Vouch premium paid and amounts charged to expense
during the year and amounts prepaid at year-end.
 SUBSTANTIVE AUDIT PROCEDURE
A. Audit of Prepaid Expenses

2. Prepaid advertising

a. Examine advertising contracts with advertising agencies and note

effective dates covered by the agreement. Determine propriety of
charges in the current year.
b. Test-count undated advertising and sales promotion materials.
 SUBSTANTIVE AUDIT PROCEDURE
A. Audit of Prepaid Expenses

3. Prepaid rent

a. Examine signed rental agreement noting the effective dates

covered by the agreement.
b. Vouch total amount paid and compare with provision in the rental
agreement.
c. Verify distribution of the prepaid amount to prepaid rent and rental
expense by recalculating the amounts.
 SUBSTANTIVE AUDIT PROCEDURE
A. Audit of Prepaid Expenses

4. Prepaid interest

a. Examine loan agreement and vouch interest payments.

b. Verify mathematical accuracy of the computation of interest
expense and prepaid interest.
 SUBSTANTIVE AUDIT PROCEDURE
A. Audit of Prepaid Expenses

5. Office supplies

a. Vouch purchases of office supplies on a test basis.

b. Conduct physical count of supplies inventory on a test basis.
 SUBSTANTIVE AUDIT PROCEDURE
A. Audit of Prepaid Expenses

6. Other prepayments

a. Review existence of adequate records and documentation.

b. Evaluate allocation of prepaid expenses between asset and
expense accounts.
Figure 17-1: Schedule of Prepaid Insurance
B. Audit Deferred Charges

1. Plant rearrangements costs

a. Vouch charges to plant rearrangement costs.
b. Review propriety of amortization policy.
c. Verify computation of amortization of plant rearrangements costs for the current
years.
2. Deferred bond issue costs
a. Vouch expenditures related to the issuance of bonds.
b. Verify mathematical correctness of amortization of bond issue costs chargeable
to the current year.
3. Other deferred charges
a. Evaluate allocation of deferred charges between asset and expense accounts.
C. Audit for other Current Liabilities

Among the items classified as current liabilities

include:
a. Withholding taxes payable
b. Value added tax (VAT) payable
c. Unclaimed salaries and wages
d. Customers' deposits
e. Liabilities under trust receipts
f. Accrued expenses payable
g. Pension plan accruals
h. Income tax payable
i. Provision for product and service warranties
j. Current portion of installment note payable
The management assertion, audit objectives and audit procedures
enumerated in Figure 17-2 would also generally apply to the
above-mentioned current liabilities. In addition, specific audit
procedures should be applied to these items as follows:

a. Withholding Taxes Payable

Income taxes withheld from employees pay and not remitted to the
BIR of the statement of financial position date constitute a liability to be
verified by the auditor.
The auditors should perform the following:
1. Review the adequacy of the withholding procedures and
determine accuracy of computation.
2. Determine the last remittance of withholdings taxes made before
the statement of financial position date. Review quarterly tax
returns to the BIR before the statement of financial position date.
3. Follow-up remittance subsequent to the statement of financial
position date.
b. Value Added Tax (VAT)

VAT on receipts constitutes current liabilities of the business until they

are remitted to the BIR. The auditor's responsibility includes verification
of the client's periodic tax returns and remittance. The auditor should
also test the reasonableness of the liability by a computation applying
the tax rate to total taxable receipts. Debits to the liability account for
remittances to the BIR should be traced to copies of the tax return and
should be vouched to the paid checks. Verify remittance of tax
subsequent to the statement of financial position date to the BIR.
c. Unclaimed Salaries and Wages

The auditor should analyze this account to determine that the

credits represent all unclaimed wages after each payroll
distribution, and the debits represent only authorized payments to
employees or transfer back to general cash funds through
approved procedures. Verify disposition of the account subsequent
to the statement of financial position date.
d&e. Customers’ Deposits; Liabilities under Trust Receipts

The auditor should obtain a list of the individual deposits and liabilities
under trust receipts and reconcile to the general ledger balance. If
amounts are substantial, or internal control procedures are considered
deficient, they should be confirmed by direct communication with
customers and appropriate financial institutions.
f. Accrued Expenses Payable

The approaches to auditing accrued liabilities are as varied as the

types of accrued liability accounts. Many can be tested by references
to the subsequent payment of the liability (accrued rent, utilities,
property taxes) while others must be estimated or calculated on the
basis of transactions in other accounts(accrued interest on the basis of
interest-bearing debt, outstanding and accrued royalties on the basis
of sales). The basic auditing steps for accrued liabilities.
1. Examine any contracts or other documents on hand that provide the
basis
2. Evaluate the accuracy of the detailed accounting records maintained
for this category of liability.
3. Test mathematical accuracy of the amounts of accrual set up by the
client.
4. Determine consistency in the treatment of accrued liabilities at the
beginning and end of the period.
5. Follow up actual payment or settlement subsequent to the statement
of financial position date.

Figure 17-2 shows a schedule of Accrued Liabilities

g. Pension Plan Accruals

Auditing procedures for the accrued liability for pension costs may
begin with a review of the copy of the pension plan in the auditor's
permanent file. The auditors should determine that the client's accrued
pension liability is presented in accordance with PFRS 715, including
consideration of service cost, interest cost, amortization of transaction
and service costs, and gains and losses on pension plan assets, In
auditing these amounts, the auditors wilI obtain representations from
an actuary and confirm the activity in the plan with the trustee.
h. Income Tax Payable

The auditor should analyze the Income Tax Payable account and vouch
all amounts to income tax returns, paid checks, or other supporting
documents. He should also verify the reasonableness of the tax liability
by reviewing the tax returns prepared by the client. The final balance in
the Income Taxes Payable account will equal the taxes on the current
year's income tax returns, less any payments thereon. Deferred Income
Taxes resulting from tax allocation should be classified as current
liabilities if they relate to current assets. Otherwise, deferred income
taxes are classified as long-term. Follow- up remittance to the BIR
subsequent to the statement of financial position date.
i. Provision for Product and Service Warranties

Review warranty agreements with buyers of goods and services and

determine whether expected warranty expense or liability is
recognized in the records of the entity. The provision for estimated
liability is usually based on historical experience of the level of
volumes, product mix and repair, and replacement cost.
j. Current Portion of Installment Note Payable

Inspect the copy of the installment note payable taking special

attention to the terms of payment. Determine the portion of the
long-term debt that is due within twelve months after the reporting
period and ensure that the client reclassifies such portion as current
liability.
Additional information includes the following:
1) Insurance policy data:
Туре Period covered Premium
Fire 12/31/X7 to 12/31/X8 P1,000
Liability 6/30/X7 to 6/30/X8 9,500
2) The postage meter was delivered in November and the balance due
was paid January Unused postage of P700 in the machine at Dec. 31,
20X7, was recorded as expense at time of purchase.
3) Bond discount represents the unamortized portion applicable to
bonds maturing in 20X8.
4) The P9,600 paid and recorded for advertising was for the cost of an
advertisement to be run in a monthly magazine for six-months, beginning in
December, 20X7. You examined an invoice received from the advertising
agency and extracted the following description: "Advertising services rendered
for store opened in November 20X7, P6,900."
5) Atlas has contracted to purchase New Stores and has been required to
accompany its offer with a check for P1,000 to be held in escrow as an
indication of good faith. An examination of paid checks revealed the check has
not been returned from the bank through January 20X8. Required: Assuming
that you have examined acceptable underlying audit evidence, prepare a
worksheet to show the necessary adjustment, corrections, and reclassification
of the items in the Prepaid Expense account. (AICPA Adapted)
Required:
Assuming that you have examined acceptable
underlying audit evidence, prepare a worksheet to
show the necessary adjustment, corrections, and
reclassification of the items in the Prepaid Expense
account. (AICPA Adapted)
Illustrative Audit 19-2: Audit of Current Liabilities
From the following information, prepare the current liabilities section of the
statement of financial position for the Drummand Company as of December 31,
20X7.

1) Notes payable arising from the purchase of raw material, P114,000.

2) Notes payable-bank, due in 90 days, P60,000. (Collateral on this consists
of P80,000 in marketable securities).
3) Notes payable to officers, due on demand, P40,000.
4) Accounts payable arising from the purchase of raw materials, P88,000.
5) Cash balance with First Bank, P26,000; cash overdraft with College Station
Bank, P35,000.
6) Dividends in arrears on cumulative preference shares, P48,000.
7) Income tax withheld, P2,600.
8) Advance receipts on special jobs being manufactured to specification for
customers, P6,000.
9) Installment notes on equipment purchased, P40,000 of which P20,000 is due
in 20X8 and the balance in 20X6.
10) Accounts receivable credit balance, P3,600.
11) Estimated costs of meeting service requirement guarantees on products
produced and sold, P14,400.
12) One of the company's products exploded causing injury to a
customer's employee. The estimated claim is P4,800. The company has no
insurance to cover a loss of this nature.
13) Drummand borrowed P20,000 on the cash surrender value of its officer's
life insurance. Cash surrender value amounts to P80,000. Interest on this loan has
been paid to the statement of financial position date.
Solution Illustrative Audit Case 17-2
 Illustrative Audit Case 17-3
Friday Factory provides a 2-year warranty with one of
its products which was first sold in 20X7. In that year,
Friday spent P70,000 servicing warranty claims. At
year-end, Friday estimates that an additional P500,000
will be spent in the future to service warranty claims
related to 20X7 sales. Prepare Friday's journal entry to
record the P70,000 expenditure, and the December 31
adjusting entry.
 Solution Illustrative Audit Case 17-3

20X7 Warranty Expense 70,000

Cash, Inventory, etc. 70,000

12/31/X7 Warranty Expense 500,000

Estimated Liability Under Warranties 500,000
 Illustrative Audit Case 17-4
Summer Company offers a set of building blocks to
customers who send in UPC codes from Summer
cereal, along with P50.00. The blocks sets cost
Summer P110 each to purchase and P60.00 each to
mail to customers. During 20X7, summer sold
1,000,000 boxes of cereal. The company expects 30%
of the UPC codes to be sent in. During 20X7, 120,000
UPC codes are redeemed Prepare Summer's
December 31, 20X7, adjusting entry.
Solution Illustrative Audit Case 17-4
 Illustrative Audit Case 17-5
Melody Music Emporium carries a wide variety of musical instruments,
sound reproduction equipment, recorded music, and sheet music. Melody
uses two sales promotion techniques-warranties and premiums - to attract
customers.

Musical instruments and sound equipment are sold with one-year warranty
for replacement of parts and labor. The estimated warranty cost, based on
past experience, is 2% of sales.

The premium is offered on the recorded and sheet music. Customers

receive a coupon for each peso spent on recorded music or sheet music.
Customers may exchange 200 coupons and P20 for a CD player. Melody
pays P34 for each CD player and estimates that 60% of the coupons given
to customers will be redeemed.
 Illustrative Audit Case 17-5
Melody's total sales for 20X7 were P7,200,000 P5,400,000 from musical
instruments and sound reproduction equipment and P1,800,000 from recorded
music and sheet music. Replacement parts and labor for warranty work totaled
P164,000 during 2017. A total of 6,500 CD players used in the premium program
were purchased during the year and there were 1,200,000 coupons redeemed in
20X7.

The accrual methods is used by Melody to account for the warranty and
premium costs for financial reporting purposes. The balances in the accounts
related to The accrual method is used by Melody to account for the warranty and
premium
warranties and premiums on January 1, 20X7, were as shown below:

Inventory of Premium CD Players P39,950

Estimated Premium Claims Outstanding 44,800
Estimated Liability from Warranties 136,000
 Illustrative Audit Case 17-5
Required:

Melody Music Emporium is preparing its financial statements for the

year ended December 31, 20X7. Determine the amounts that will
be shown on the 20X7 financial statements for the following:

(1) Warranty Expense.

(2) Estimated Liability from Warranties.
(3) Premium Expense.
(4) Inventory of Premium CD Players.
(5) Estimated Premium Claims Outstanding.
Solution Illustrative Audit Case 17-5
Solution Illustrative Audit Case 17-5