Integration Auditing Theory and Practice Frederick Alfred D.

Abao, CPA
BSA – IV Handout 3

SUBSTANTIVE TEST OF SHAREHOLDERS’ EQUITY

 Audit Objectives
 Existence – All equity accounts or interest on the statement of financial position exist.
 Completeness – All equity interest that should have been recorded have been recorded and included in
the statement of financial position
 Valuation and allocation – The equity accounts are stated on the statement of financial position at the
appropriate amounts.
 Presentation and Disclosure – Equity accounts are properly classified, described and disclosed in the
financial statements, including notes, in accordance with applicable financial reporting framework.

 Substantive Procedures for Equity Transactions

 Obtain and verify equity reconciliation schedule
 Obtain and review board of director’s minutes of meetings, shareholders meeting, committee meetings
and articles of incorporation
 Review appropriateness of accounting for share-based payment transactions
 Analyze retained earnings and review appropriateness of dividends
 Review presentation and disclosure of equity items.

 Normally, few transactions but in large amount are involved in equity transactions. It is usually more efficient to
assess control risk at a high level and perform detailed substantive tests of transactions.

SHARE CAPITAL
Share capital refers to the paid-in capital representing the amount of the total par or stated value of the shares issued. It
represents the portion of authorized capital stock that has been fully paid.
 Subscribed share capital – portion of capital an investor agreed to purchase. This is added to the Share Capital.

 Subscription receivable – the unpaid portion of the subscription price. It is presented as current assets if collectible
currently, otherwise deducted from subscribed share capital.

 Reserves – equity items other than the total par or stated value of capital stock and the unrestricted retained
earnings.
 Share premium
 Revaluation surplus
 Retained earnings reserve / appropriated retained earnings
 Net changes reserve

 Unrestricted Retained Earnings – the accumulated corporate periodic earnings since inception of the enterprise.

 Contributed Capital – represents the amount invested or contributed by owners (Share capital and share premium).

 Legal Capital – portion of paid in capital which cannot be returned to stockholders in any form during the lifetime
of the corporation:
 In the case of par value share, legal capital is the aggregate par value of the shares issued and subscribed.
 In the case of no-par value share, legal capital is the total consideration received from shareholders
including the excess over the stated value.

TREASURY SHARES
Treasury shares are company’s own stock previously issued, reacquired but not cancelled.
 Reissuance
 at above cost, any difference shall be credited to share premium – treasury shares
  at below cost, any difference shall be debited to the following:
1. Share premium – treasury shares
2. Retained earnings

 Retirement
 at a perceived gain
Credit the difference between the “value of share capital at par plus share premium arising from original
issuance” and the “cost of treasury shares” is credited to share premium – treasury shares.

 at a perceived loss
Debit the difference to
 first, share premium – treasury shares
 Retained earnings

DONATED CAPITAL
Donations received from shareholders (part of Share Premium).
 If shareholder donated an asset, upon receipt should be credited to Donated capital.
 If entity’s own shares are donated, memo entry only upon receipt. Credit to donated capital when shares are
subsequently sold.

SHARE WARRANTS
Certificates that entitle the holder thereof to acquire shares at a certain price within a specified period.

 Right of preemption
 Upon issuance and expiration, memo entry only
 When exercised, credit to share capital and share premium (if any).

 Detachable warrants
 Issuance of Preference shares with share warrants
 Use relative fair value method (if both fair value are available)
 If only one class of security has available fair value, deduct the one with available fair value from
selling price and allocate the difference to security with unknown fair value.
 If fair value of both are not available, compute for the intrinsic value of warrant.

RETAINED EARNINGS
Represents cumulative amount of profits and losses, dividends and other capital adjustments.

 Dividends Out of Earnings

 Shares entitled to dividends – only shares issued and outstanding
Outstanding shares = No. of shares issued + No. of subscribed shares – No. of shares held as treasury

 Date of declaration is when retained earnings is to be charged and a liability account is to be set up (except
stock dividend).

 Forms of Dividends
 Cash Dividends
 Property Dividends
 Dividends payable is recorded at fair value of the assets to be distributed
 At the end of reporting period, review and adjust the carrying amount of payable to equity (if
necessary).
 Recognize gain or loss between the difference in the carrying amount of payable and assets to be
distributed.
 Liability dividends
 Share dividends
  Small dividend if less 20% of outstanding shares is declared. Charged retained earnings at fair value
or par value of shares, whichever is higher.
 Large dividend if 20% or more of outstanding shares is declared. Charged retained earnings at par
value.

REVIEW QUESTIONS

1. In an examination of shareholder’s equity, an auditor is most concerned that

A. Capital stock transactions are properly authorized.
B. Stock splits are capitalized at par or stated value on the dividend declaration date.
C. Dividends during the year under audit were approved by the shareholders.
D. Changes in the accounts are verified by a bank serving as a registrar and stock transfer agent.

2. In audit of a medium-sized manufacturing concern, which one of the following areas can be expected to require the
least amount of audit time?
A. Owner’s equity B. Assets C. Revenue D. Liabilities

3. When a corporate client maintains its own stock records, the auditor primarily will rely upon
A. Confirmation with the company secretary of shares outstanding at year-end.
B. Review of the corporate minutes for data as to shares outstanding.
C. Confirmation of the number of shares outstanding at year-end with the appropriate state official.
D. Inspection of the stock book at year-end and accounting for all certificate numbers.

4. When a client company does not maintain its own stock records, the auditor should obtain written confirmation from
the transfer agent and registrar concerning
A. Restrictions on the payment of dividends.
B. The number of shares issued and outstanding.
C. Guarantees of preferred stock liquidation value.
D. The number of shares subject to agreement to repurchase

5. The auditor is concerned with establishing that dividends are paid to client corporation shareholders owning stock as
of the
A. Issue date C. Record date
B. Declaration date D. Payment date

6. An audit program for the retained earnings account should include a step that requires verification of the
A. Fair value used to charge retained earnings to account for a two-for-one-stock split.
B. Approval of the adjustment to the beginning balance as a result of a write-down of an account receivable.
C. Authorization for both cash and stock dividends.
D. Gain or loss resulting from disposition of treasury shares.

7. During an audit of an entity’s shareholders’ equity accounts, the auditor determines whether there are restrictions on
retained earnings resulting from loans, agreements, or law. This audit procedure most likely is intended to verify
management’s assertion of
A. Existence C. Valuation
B. Completeness D. Presentation and disclosure

8. If the auditee has a material amount of treasury stock on hand at year-end, the auditor should
A. Count the certificates at the same time other securities are counted.
B. Count the certificates only if the company had treasury stock transactions during the year.
C. No count the certificates if treasury stock is a deduction from shareholders’ equity.
D. Count the certificates only if the company classifies treasury stock with other assets.

9. In performing tests concerning the granting of stock options, an auditor should

A. Confirm the transaction with the Securities and Exchange Commission.
B. Verify the existence of option holders in the entity’s payroll records or stock ledgers.
C. Determine that sufficient treasury stock is available to cover any new stock issued.
D. Trace the authorization for the transaction to a vote of the board of directors.
10. The auditor would not expect the client to debit retained earnings for which of the following transactions?
A. 4-for 1 stock split.
B. "Loss" resulting from disposition of treasury shares.
C. 1 for 10 stock dividend.
D. Correction of error affecting prior year's earnings.

11. A registrar/transfer agent system relating to capital stock is most likely used by:
A. A small, nonpublic company.
B. A large, publicly traded company.
C. All companies must use this type of system.
D. No companies use this system anymore.

12. An auditor obtains evidence of stockholders' equity transactions for a publicly traded company by reviewing the entity's:
A. Minutes of board of director’s meetings.
B. Registrar's record of interbank transfers.
C. Canceled stock certificates.
D. Treasury stock certificate book.

13. Company A does not employ an independent stock transfer agent, but rather issues its own stock and maintains its
stock records. When outstanding shares are transferred from one holder to another, the certificate of the selling
shareholder should be:
A. Canceled (generally by perforation) and attached to the certificate book.
B. Destroyed to prevent fraudulent reissuance.
C. Retained by the selling shareholder.
D. Sent to the state's registrar of investment securities.

14. In auditing retained earnings, the following item does not concern the auditor even if it was not approved by the board
of directors?
A. Issuance of convertible debt securities
B. Declaration of 20% share dividends
C. Issuance of redeemable preferred shares
D. Changes in retained earnings due to closing of net income

15. An auditor should trace corporate stock issuances and treasury stock transactions to the
A. Numbered stock certificates C. Articles of incorporation
B. Transfer agent’s records D. Minutes of board of directors
16. Which of the following procedures is least likely in the audit of capital stock?
A. Examine all outstanding stock certificates for completeness.
B. Account for the proceeds from stock issues.
C. Reconcile shares outstanding with the general ledger.
D. Evaluate compliance with stock option plans.

17. When auditing treasury shares, one objective of the auditor includes checking whether
A. Gain on reissuance of treasury shares is included in retained earnings.
B. Loss on reissuance of treasury shares is included in profit or loss.
C. Cash received from reacquisition of shares is received by the Board of Directors.
D. Retained earnings were restricted for the amount of issue price of the treasury shares.

18. Which of the following is correct in confirming shareholder’s equity items to independent registrar and stock transfer
agent?
A. The confirmation request should be written under the client’s letterhead and mailed by the Board of Directors.
B. Replies to confirmation request should be sent to the Board of Directors.
C. The confirmation request should be written
Problem 1
You have been assigned to the audit of Aguillon Inc., a manufacturing company. You have been asked to summarize the
transactions for the year ended December 31, 2004, affecting shareholders’ equity and other related accounts. The
shareholders’ equity section of Aguillon’s December 31, 2003, balance sheet follows:
Shareholders’ Equity

Contributed capital:
Ordinary share P2 par value, 500,000 shares authorized,
90,000 shares issued, 88,790 shares outstanding P 180,000
Paid-in capital in excess of par 1,820,000
Paid-in capital from treasury share 22,500
Total contributed capital P2,022,500
Retained earnings 324,689
Total contributed capital and retained earnings P2,347,189
Less: Cost of 1,210 shares of treasury share 72,600
Total shareholders’ equity P2,274,589
You have extracted the following information from the accounting records and audit working papers.
2004
Jan. 15 Aguillon reissued 650 shares of treasury share for P40 per share. The 1,210 shares of treasury share
on hand at December 31, 2001, were purchased in one block in 2001. Aguillon used the cost
method for recording the treasury shares purchased.

Feb. 2 Sold 90, P1,000, 9% bonds due February 1, 2005, at 103 with one detachable share warrant
attached to each bond. Interest is payable annually on February 1. The fair market value of the
bonds without the share warrants is 97. The detachable warrants have a fair value of P60 each and
expire on February 1, 2005. Each warrant entitles the holder to purchase 10 shares of Ordinary
share at P40 per share.

Mar. 6 Subscriptions for 1,400 shares of Ordinary share were issued at P44 per share, payable 40% down
and the balance by March 20.

Mar 20 The balance due on 1,200 shares was received and those shares were issued. The subscriber who
defaulted on the 200 remaining shares forfeited the down payment in accordance with the
subscription agreement.

Nov. 1 There were 55 share warrants detached from the bonds and exercised.

Dec. 31 Net income for the year is P600,000.

Questions- Based on the information above, answer the following questions:

1. The Ordinary Share at December 31, 2004 is:
A. P 215,000 B. P 204,000 C. P 191,000 D. P 183,500

2. The Additional paid capital in excess of par at December 31, 2004 is:
A. P 1,903,000 B. P 1,894,600 C. P 1,870,400 D. P 1,835,800

3. The APIC – treasury share at December 31, 2004 is:

A. P 22,500 B. P 13,000 C. P 9,500 D. P 0

4. The Ordinary Share Warrants Outstanding at December 31, 2004 is:

A. P 5,400 B. P 3,300 C. P 2,100 D. P 0

5. The Subscribed Ordinary Share at December 31, 2004 is:

A. P 2,800 B. P 2,400 C. P 400 D. P 0

6. The APIC – forfeited share at December 31, 2004 is:

A. P 0 B. P 3,520 C. P 3,920 D. P 5,280

7. The Treasury Share at December 31, 2004 is:

A. P 0 B. P 72,600 C. P 39,000 D. P 33,600
8. The Total Shareholders’ Equity at December 31, 2004 is:
A. P 2,984,309 B. P 2,659,620 C. P 2,384,309 D. P 2,059,620

Problem 2
You were engaged by Catacutan Company, a publicity held company whose shares are traded in the Philippines Share
Exchange, to conduct an examination of its 2004 financial statements. You were told by the company’s controller that there
were numerous equity transactions that took place in 2004. The shareholders’ equity accounts at December 31, 2003, had
the following balances:
Preference share, P100 par value, 6% cumulative; 15,000
shares authorized; 9,000 shares issued and outstanding P 900,000
Ordinary share, P1 par value, 900,000 shares authorized:
600,000 shares issued and outstanding 600,000
Additional paid-in capital 1,200,000
Retained earnings 3,198,000
Total shareholders’ equity P5,898,000

You summarized the following transactions during 2004 and other information relating tothe shareholders’ equity in your
working papers as follows:

 January 6, 2004 – issued 22,500 shares of ordinary share to Difficult Company in exchange or land. On the date
issued, the share had a market price of P16.50 per share. The land had a carrying value of P201,000, and an assessed
value for property taxes of P135,000.

 January 31, 2004 – Sold 1,350, P1,000, 12% bonds due January 31, 2006, at 98 with one detachable share warrant
to each bond. Interest is payable annually on January 31. The fair value of the bonds without the share warrants is
95. The detachable warrant entitles the holder to purchase 10 shares of ordinary share at P10 per share.

 February 22, 2004 – Purchased 7,500 shares of its own ordinary share to be held as treasury share for P24 per share.

 February 28, 2004 – Subscriptions for 21,000 shares of ordinary share were received at P26 per share, payable 50%
down and the balance by March 15.

 March 15, 2004 – The balance due on 18,000 shares was received and those shares were issued. The subscriber
who defaulted on the 3,000 remaining shares forfeited the down payment in accordance with the subscription
agreement.

 April 30, 2004 – Declared a dividend of inventory to ordinary shareholders. The inventory had a carrying value of
P910,000: fair value on relevant dates were:
Date of declaration (April 30, 2004) P950,000
Date of record (May 15, 2004) 900,000
Date of distribution (May 31, 2004) 920,000

 August 30, 2004 – Reissued 3,000 shares of treasury share for P20 per share.

 September 14, 2004 – There were 945 warrants detached from the bonds and exercised.

 November 30, 2004 – Declared a cash dividend of P2 per share to all ordinary shareholders of record December 15,
2004. The dividend was paid on December 30, 2004.

 December 15, 2004 – Declared the required annual cash dividends on preference share for 2004. the dividend was
paid on January 15, 2004.

 January 8, 2005 – Before closing the accounting records for 2004. Catacutan became aware that no amortization
had been recorded for 2003 for a patent purchased on July 2, 2003. The patent was properly capitalized at P480,000
and had an estimated useful life of eight years when purchased. Catacutan is subject to 32% regular corporate
income tax. The appropriate correcting entry was recorded on the same day.

 Adjusted net income after tax for 2004 was P1,860,900.

Questions
Based on the foregoing and the result of your audit, answer the following :

1. By how much should the retained earnings be decreased as a result of the property dividend declaration on April 30,
2004?
A. P 950,000 B. P 920,000 C. P 910,000 D. P 0

2. How much is the total dividends declared on preference and ordinary share in 2004?
A. P 2,294,900 B. P 2,263,900 C. P 2,254,900 D. P 2,200,900

3. Preference share at December 31, 2004 is

A. P 1,500,000 B. P 954,000 C. P 900,000 D. P 0

4. Ordinary share at December 31, 2004 is

A. P 640,500 B. P 645,450 C. P 649,950 D. P 652,950

5. How much is the total additional paid-in-capital as of December 31, 2004

A. P 2,163,300 B. P 2,178,220 C. P 2,765,600 D. P 2,774,000

6. The adjusted balance of retained earnings on December 31,2004 is

A. P 2,783,600 B. P 2,774,000 C. P 2,771,600 D. P 2,743,600

7. How much is the total shareholders’ equity on December 31, 2004?

A. P 6,376,850 B. P 4,271,550 C. P 4,232,550 D. P 4,194,350

Problem 3
With your representation, as Managing Partner of the Sy Pee Ey & Co., your firm was engaged in the audit of the Fortitude
Company at the close of the company’s first year of operations on December 31, 2005. The company closed its books prior
to the time you began your year-end fieldwork.
Your audit and review showed the following stockholders’ equity accounts in the general ledger:

Common Stock
08/30/05 CD P550,000 01/02/05 CR P6,000,000
12/29/05 J 545,000

Retained Earnings
12/29/05 J P 545,000 12/01/05 CR P 287,500
12/31/05 J 4,000,000

Income Summary
12/31/05 J P26,000,000 12/31/05 J P30,000,000
12/31/05 J 4, 000,000

Based on the other working papers submitted by your audit staff, the following additional information was forwarded:
From the Articles of Incorporation of Fortitude Company:
 Authorized capital stock – 150,000 shares
 Par value per share – P100
From the board of directors’ minutes of meetings, the following resolutions were extracted:
 01/02/05 – authorized the issuance of 50,000 shares at P120 per share.
 08/30/05 – authorized the acquisition of 5,000 shares at P110 per share.
 12/01/05 – authorized the re-issuance of 2,500 treasury shares at P115 per share.
 12/29/05 – Declared a 10% stock dividend, payable January 31, 2006, to stockholders on record as of January 15,
2006. The market value of the stock on December 29, 2005 was P130 per share.
Based on the above and the result of your audit, determine the adjusted balances of the following as of December 31, 2005.
A B C D
1. Capital stock 5,995,000 5,545,000 5,000,000 5,475,000

2. APIC 1,012,500 1,000,000 1,155,000 965,000

3. Total retained earnings 3,525,000 3,572,500 3,382,500 3,512,500

4. Treasury stock 250,000 550,000 275,000 -

5. Total stockholders’ equity 10,012,500 9,215,000 9,737,500 9,262,500