COLLEGE OF SCIENCE AND TECHNOLOGY

Cagamutan Norte, Leganes, Iloilo - 5003

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Email Address : svcst_leganes@[Link]

COO – FORM 12

SUBJECT TITLE: AUDITING AND ASSURANCE: CONCEPTS AND APPLICATIONS 1

INSTRUCTOR: JUVEN P. LAMERA, CPA
SUBJECT CODE: AUD1

PRELIM MODULE

Topic 1: CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

LEARNING OBJECTIVES:

At the end of this topic, the students are expected to:

1. Know the nature of conceptual framework

2. Identify the qualitative characteristics of accounting information.
3. Identify elements related to financial statements.
4. Know the requirements for the recognition of the elements of financial statements.

NOTES:

The Conceptual Framework for Financial Reporting

I. PURPOSE AND STATUS OF THE FRAMEWORK

The IASB Framework for the Preparation and Presentation of Financial Statements
describes the basic concepts by which financial statements are prepared. The
Framework serves as a guide to the FRSC in developing accounting standards and
as a guide to resolving accounting issues that are not addressed directly in Philippine
Accounting Standards or Philippine Financial Reporting Standards or Interpretations.
The purpose of the framework as outlined is to:

a) To assist the Board in the development of future IFRSs and in its review of existing
IFRSs
b) To assist the Board in promoting harmonization of regulations, accounting
standards and procedures relating to the presentation of financial statements by
providing a basis for reducing the number of alternative accounting treatments
permitted by
IFRSs
c) To assist national standard-setting bodies in developing national standards;
d) To assist preparers of financial statements in applying IFRSs and in dealing with
topics that have yet to form the subject of an IFRS
e) To assist auditors in forming an opinion on whether financial statements comply
with
IFRSs
f) To assist users of financial statements in interpreting the information contained in
financial statements prepared in compliance with IFRSs

Page 1 of 1
g) To provide those who are interested in the work of the IASB with information
about its approach to the formulation of IFRSs.

This Conceptual Framework is not an IFRS and hence does not define standards for
any particular measurement or disclosure issue.

Scope of the Framework:

• The Objective of general purpose financial reporting;

• Qualitative characteristics of financial information
• Underlying assumption
• The definition, recognition and measurement of the elements of the
financial statements
• Concepts of capital and capital maintenance.

The Objective of Financial Reporting

Ø The objective of general purpose financial reporting is to provide financial

information about the reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decisions about providing
resources to the entity. Those decisions involve buying, selling or holding
equity and debt instruments, and providing or settling loans and other forms
of credit.

Ø General purpose financial reports provide information about the financial

position of a reporting entity, which is information about the entity’s economic
resources and the claims against the reporting entity. Financial reports also
provide information about the effects of transactions and other events that
change reporting entity’s economic resources and claims.

Financial performance reflected by accrual accounting

Accrual accounting depicts the effects of transactions and other events and
circumstances on a reporting entity’s economic resources and claims in the periods
in which those effects occur, even if the resulting cash receipts and payments occur
in a different period.
II. Qualitative Characteristics of Useful Financial Information

These characteristics are the attributes that make the information in financial
statements useful to investors, creditors, and others. The Framework identifies
“fundamental” and “enhancing” qualitative characteristics:

Fundamental Characteristics

Relevance - Information in financial statements is relevant when it is capable of

making a difference in the decisions made by the users.

Ingredients of relevance:

• Predictive Value – Information can help users increase the likelihood of correctly
predicting or forecasting the outcome of certain events.

• Feedback Value – Information can help users confirm or correct earlier

expectations.

Note that the predictive and confirmatory roles of information are interrelated.

Materiality - Information is material if omitting it or misstating it could influence

decisions that users make on the basis of financial information about a specific
reporting entity. In other words, materiality is an entity-specific aspect of relevance
based on the nature or magnitude, or both, of the items to which the information
relates in the context of an individual entity’s financial report.

Faithful Representation - Financial reports represent economic phenomena in

words and numbers. To be useful, financial information must not only represent
relevant phenomena, but it must also faithfully represent the phenomena that it
purports to represent.

Ingredients of Faithful Representation

• Complete - A complete depiction includes all information necessary for a user to

understand the phenomenon being depicted, including all necessary descriptions
and explanations.

• Neutral - A neutral depiction is without bias in the selection or presentation of

financial information. A neutral depiction is not slanted, weighted, emphasized,
de-emphasized or otherwise manipulated to increase the probability that financial
information will be received favorably or unfavorably by users

• Free from error means there are no errors or omissions in the description of the
phenomenon, and the process used to produce the reported information has been
selected and applied with no errors in the process.
Enhancing qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative

characteristics that enhance the usefulness of information that is relevant and
faithfully represented.

• Comparability is the qualitative characteristic that enables users to identify

and understand similarities in, and differences among, items.

• Verifiability - helps assure users that information faithfully represents the

economic phenomena it purports to represent. Verifiability means that different
knowledgeable and independent observers could reach consensus, although
not necessarily complete agreement, that a particular depiction is a faithful
representation.

• Timeliness - means having information available to decision-makers in time

to be capable of influencing their decisions.

• Understandability - Classifying, characterizing and presenting information

clearly and concisely makes it understandable.

The cost constraint on useful financial reporting

Cost is a pervasive constraint on the information that can be provided by financial

reporting. Reporting financial information imposes costs, and it is important that
those costs are justified by the benefits of reporting that information. There are
several types of costs and benefits to consider.

III. Underlying Assumptions (Postulates)

The Framework sets Going Concern as the only underlying assumption meaning,
financial statements presume that an enterprise will continue in operation indefinitely
or, if that presumption is not valid, disclosure and a different basis of reporting are
required.

The new FRSC conceptual framework mentions going concern as the only underlying
assumption (previously Accrual was included). However, it is widely believed that
inherent traits of the financial statements are the basic assumptions of:

• Accounting Entity. The business is separate from the owners, managers, and
employees who constitute the business. Therefore transactions of the said
individuals should not be included as transactions of the business.

• Time Period. Financial reports are to be prepared for one year or a period of
twelve months.

• Monetary unit. There are two aspects under this assumption

a. Quantifiability of the peso, meaning that the elements of the financial

statements should be stated under one unit of measure which is the Philippine
Peso.

b. Stability of the peso, means that there is still an assumption that the
purchasing power of the peso is stable or constant and that instability is
insignificant and therefore ignored.
IV. The Elements of Financial Statements

Financial statements portray the financial effects of transactions and other events by
grouping them into broad classes according to their economic characteristics. These
broad classes are termed the elements of financial statements.

The elements directly related to financial position and their definition according
to the framework are:

• Asset- A resource controlled by the enterprise as a result of past events and

from which future economic benefits are expected to flow to the enterprise.

• Liability- A present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits.

• Equity- The residual interest in the assets of the enterprise after deducting all
its liabilities.

The elements directly related to performance and their definition according to

the framework are:

• Income- Increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity
participants.

• Expense- Decreases in economic benefits during the accounting period in the

form of outflows or depletions of assets or incurrence of liabilities that result in
decreases in equity, other than those relating to distributions to equity
participants.

V. Recognition of the Elements of Financial Statements

Recognition is the process of incorporating in the financial statements an item

that meets the definition of an element and satisfies the following criteria
for recognition:

• It is probable that any future economic benefit associated with the item will flow
to or from the enterprise; and
• The item's cost or value can be measured with reliability.

Based on these general criteria:

• An asset is recognized in the statement of financial position when it is probable

that the future economic benefits will flow to the enterprise and the asset has a
cost or value that can be measured reliably.

• A liability is recognized in the statement of financial position when it is probable

that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation and the amount at which the settlement will
take place can be measured reliably.
• Income is recognized in the when an increase in future economic benefits related
to an increase in an asset or a decrease of a liability has arisen that can be
measured reliably. This means, in effect, that recognition of income occurs
simultaneously with the recognition of increases in assets or decreases in liabilities

• Expenses are recognized when a decrease in future economic benefits related to

a decrease in an asset or an increase of a liability has arisen that can be measured
reliably. This means, in effect, that recognition of expenses occurs simultaneously
with the recognition of an increase in liabilities or a decrease in assets.

Measurement of the Elements of Financial Statements

Measurement involves assigning monetary amounts at which the elements of the

financial statements are to be recognized and reported. The Framework
acknowledges that a variety of measurement bases are used today to different
degrees and in varying combinations in financial statements, including:
a. Historical cost
b. Current cost
c. Net realizable (settlement) value
d. Present value (discounted)

Historical cost is the measurement basis most commonly used today, but it is usually
combined with other measurement bases. The Framework does not include concepts
or principles for selecting which measurement basis should be used for particular
elements of financial statements or in particular circumstances. The qualitative
characteristics do provide some guidance in this matter.

VI. Concepts of Capital

• Financial concept of capital - capital is synonymous with net assets of the

enterprise.
This is the concept of capital adopted by most enterprises. A financial concept
of capital, e.g. invested money or invested purchasing power, means capital is
the net assets or equity of the entity.

• Physical concept of capital – capital is regarded as the productive capacity

of the enterprise based on, for example, units of output per day.

Concepts of Capital Maintenance

• Financial capital maintenance – Under this concept, a profit is earned only

if the financial (or money) amount of the net assets at the end of the of the
period exceeds the financial (or money) amount of the net assets at the
beginning of the period, after excluding any distributions to, and contributions
from, owners during the period.

• Physical capital maintenance – Under this concept, a profit is earned only

if the physical productive capacity (or operating capability) of the enterprise
(or the resources need to achieve that capacity) at the end of the period
exceeds the physical productive capacity at the beginning of the period, after
excluding any distributions to, and contributions from, owners during the
period.
EXERCISES:

[Link] FRAMEWORK (Objective of Financial Reporting)

1. Which is a purpose of the Conceptual Framework?

a. To assist the IASB to develop IFRS based on consistent concepts.

b. To assist preparers to develop consistent accounting policy when no standard
applies to a particular transaction.
c. To assist all parties to understand and interpret IFRS.
d. Al of these can be considered a purpose of the Conceptual Framework

2. The Conceptual Framework provides the foundation for Standards that

a. Contribute to transparency by enhancing international comparability and

quality of financial information.
b. Strengthen accountability of management.
c. Contribute to economic efficiency by helping investors to identify
opportunities and risks across the world.
d. All of these.

3. The underlying theme of the Conceptual Framework is

a. Decision usefulness
b. Understandability
c. Timeliness
d. Comparability

4. The primary objective of financial reporting is to provide useful information to

a. Management
b. Capital Providers
c. Regulatory body
d. Government

5. An objective of financial reporting is to provide

a. Information about the investors in the entity.

b. Information about the liquidation value.
c. Information that is useful in assessing cash flow prospects.
d. Information that will attract new investors.

ANSWERS:

1. D
2. D
3. A
4. B
5. C
II. CONCEPTUAL FRAMEWORK (Qualitative Characteristics)

1. What are the qualitative characteristics of financial statements?

a. Qualitative characteristics are the attributes that makes the information

provided in financial statements useful to users.
b. Qualitative characteristics are broad classes of financial effects of transactions
and other events.
c. Qualitative characteristics are non-qualitative aspects of financial position and
financial performance.
d. Qualitative characteristics measure the extent to which an entity has
complied with all relevant standards and interpretation.

2. The fundamental qualitative characteristics are

a. Relevance and faithful representation

b. Relevance, faithful representation and materiality
c. Relevance and reliability
d. Faithful representation and materiality

3. The financial accounting information is directed toward the common needs of

users.

a. Relevance
b. Verifiability
c. Neutrality
d. Completeness

4. The economic substance of a transaction shall prevail over the legal form.

a. Form over substance

b. Substance over form
c. Relevance
d. Completeness

5. For information to be more useful, the linkage between the users and the
decisions made is

a. Relevance
b. Faithful representation
c. Understandability
d. Verifiability

ANSWERS:

1. A
2. A
3. C
4. B
5. C
III. CONCEPTUAL FRAMEWORK (Financial statements and reporting entity
underlying assumptions)

1. Combined financial statements provide financial information about

a. The parent and its subsidiaries

b. The parent
c. The subsidiaries
d. Two or more entities without a parent-subsidiary relationship

2. Which best describes the term going concern?

a. When current liabilities exceed current assets

b. The ability of the entity to continue in operation for the foreseeable future
c. The potential to contribute to the flow of cash and cash equivalents to the
entity
d. The expense exceed income

3. Which underlying assumption serves as the basis for preparing financial

statements at artificial points in time?

a. Accounting entity
b. Going concern
c. Accounting period
d. Stable monetary unit

4. What is the accounting concept that justifies the usage of accruals and
deferrals?

a. Going Concern
b. Materiality
c. Consistency
d. Stable monetary unit

5. The economic entity assumption

a. Is inapplicable to unincorporated business

b. Recognizes the legal aspects of business organizations
c. Requires periodic income measurement
d. Is applicable to all forms of business organizations

ANSWERS:

1. D
2. B
3. C
4. A
5. D
IV. CONCEPTUAL FRAMEWORK (Elements of financial statements)

1. It is an increase in asset or a decrease in liability that results in increase in

equity other than contribution from equity holders.

a. Asset
b. Liability
c. Income
d. Expenses

2. Which statement in relation to income is true?

a. Income encompasses both revenue and gain.

b. Revenue encompasses both income and gain.
c. Gain encompasses both income and revenue.
d. Income is technically the same as revenue.

3. Which of the following criteria need not be satisfied for a liability to exist?

a. The entity has an obligation.

b. The obligation is to transfer an economic resource.
c. The obligation is a present obligation that exists as a result of a past event.
d. The settlement is expected to result in an outflow of economic benefit.

4. An economic resource could produce economic benefit if an entity is entitled to

all, except?

a. To receive contractual cash flows

b. To exchange economic resources with another entity on unfavorable terms
c. To receive cash by selling the economic resource
d. To extinguish a liability by transferring an economic resource

5. This new term refers to the statement of profit or loss and a statement
presenting other comprehensive income.

a. Income statement
b. Statement of comprehensive income
c. Statement of financial performance
d. Statement of financial position

ANSWERS:

1. C
2. A
3. D
4. B
5. C
V. CONCEPTUAL FRAMEWORK (Recognition and measurement)

1. An item is recognized in the financial statements if

a. It is probable that economic benefits will flow to or from the entity.

b. It meets the definition of an asset, liability, equity, income and expense.
c. The entity has ownership of such item.
d. It is probable that economic benefits will flow to or from the entity and that
the cost can be measured reliably.

2. Generally, revenue is recognized

a. At the point of sale

b. When cause and effect are associated
c. At the point of cash collection
d. At appropriate points throughout the operating cycle

3. Which of the following represents the least desirable choice of recognition of

revenue?

a. During production
b. When a sale occurs
c. When cash is collected
d. When production is completed

4. The write-off of a worthless patent is an example of which of the following

principles?

a. Associating cause and effect

b. Immediate recognition
c. Systematic and rational allocation
d. Objectivity

5. Which accounting principle is being observed when an accountant charges to

expense a cost that contributed to revenue during a period?

a. Revenue realization
b. Matching
c. Monetary Unit
d. Conservatism

ANSWERS:

1. B
2. A
3. C
4. B
5. B
VI. CONCEPTUAL FRAMEWORK (Presentation and disclosure concepts of capital)

1. The presentation and disclosure requirement achieves all of the following, except

a. An effective communication tool

b. More relevant and faithfully represented information
c. Understandability and comparability of information
d. Financial position, performance and cash flows

2. Financial capital is defined as

a. Net assets in monetary terms.

b. Net assets in terms of physical productive capacity.
c. Legal capital
d. Share capital issued and outstanding.

3. Under the financial capital concept, net income occurs when

a. The nominal amount of net assets at year-end increased.

b. The physical productive capital at year-end increased excluding equity
transactions with owners.
c. The nominal amount of net assets at year-end increased excluding equity
transactions with owners.
d. The physical productive capital at year-end increased.

4. The physical concept requires which measurement

a. Historical cost
b. Current cost
c. Fair value
d. Present value

5. Which statement regarding the term profit is true?

a. Is any amount over and above that required to maintain the capital at the
beginning of the period.
b. Is equal to income minus expenses.
c. Is the equivalent of net income under IFRS.
d. All of these statements are true about the term profit.

ANSWERS:

1. D
2. A
3. C
4. B
5. D

END OF TOPIC 1
Topic 1: AUDIT OF BASIC EQUITY TRANSACTIONS

LEARNING OBJECTIVES:

At the end of this topic, the students are expected to:

1. Learn basic entries on shareholder’s equity.

2. Understand the importance of entries in solving auditing problems.
3. Know how to use T-account.
4. Gain confidence in answering equity related problems.

NOTES:

I. Shareholders’ equity concepts

1. Corporation

A corporation is an artificial being created by operation of law, having the right

of succession, and the powers, attributes, and properties expressly authorized
by law or incident to its existence.

2. Shareholder’s equity or stockholder’s equity is the residual interest of owners in

the net assets of a corporation measured by the excess of assets over liabilities.

Generally the elements constituting shareholder’s equity with their equivalent

IFRS term are:

Philippine term IAS term

Capital stock Share capital

Subscribed capital stock Subscribed share capital
Common stock Ordinary share capital
Preferred stock Preference share capital
Additional paid capital Share premium
Retained earnings (deficit) Accumulated profits (losses)
Retained earnings appropriated Appropriation reserve
Revaluation surplus Revaluation reserve
Treasury stock Treasury reserve

3. Definition of terms

Capital stock or share capital is the portion of the paid in capital representing
the total par or stated value of the shares issued.

Subscribed share capital is the portion of the authorized share capital that has
been subscribed but not yet fully paid and therefore still unissued.

Ordinary share is so called because ordinary shareholders have the same rights
and privileges.

Preference share is so called because of the preferences granted to the

shareholders.

Additional paid in capital or share premium is the portion of the paid in capital
representing excess over the par or stated value.
 Retained earnings represent the cumulative balance of periodic earnings,
dividend distributions, prior period errors and other capital adjustment.

Revaluation surplus is the excess of revalued amount over the carrying amount
of the revalued asset.

Treasury shares are the corporation’s own shares that have been issued and
then reacquired but not canceled.

4. Accounting for share capital

a. Memorandum method – no entry is made to record the authorized share

capital. Only a memorandum is made for the total authorized share capital.
When share capital is issued, it is credited to the share capital account.
b. Journal entry method – the authorization to issue share capital is recorded by
debiting unissued share capital and crediting authorized share capital. When
share capital is issued, it is credited to the unissued share capital account.

5. Issuance of share capital

When share with par value are sold, the proceeds shall be credited to the share
capital account to the extent of the par value, with any excess being reflected as
share premium.

6. Issuance of share capital for noncash consideration

If share capital is issued for noncash consideration such as tangible property,

intangible property and services, the share capital is recorded at an amount
equal to the following in the order of priority:

a. Fair value of the noncash consideration received.

b. Fair value of the shares issued.
c. Par value of the shares issued.

7. Issuance of share capital for services

If shares are issued for services, the shares shall be recorded at the fair value of
such services or fair value of the shares issued, whichever is reliably
determinable.

8. Journal entries

v Issuance of shares at par value

Cash XX
Share capital XX

v Issuance of shares at more than par value

Cash XX
Share capital XX
Share premium XX
v Issuance of shares for noncash consideration

Noncash XX
consideration
Share capital XX
Share premium XX
(If any)

v Issuance of shares for services

Legal XX
expenses/
specific
expenses
Share capital XX
Share premium (If any) XX

v Subscription of shares at par value (no cash payment)

Subscriptions
receivable XX
Subscribed share capital XX

v Subscription of shares at more than par value (no cash payment)

Subscriptions
receivable XX
Subscribed share capital XX
Share premium XX

v Subscription of shares (partial payment)

Subscriptions
receivable XX
Cash XX
Subscribed share capital XX
Share premium (if any) XX

v Payment of previously subscribed shares

Cash XX
Subscribed share capital XX

v Issuance of previously subscribed shares

Subscribed XX
share Capital
Share capital XX

We used share capital account if we have only one type of share. But if we have
ordinary shares and preference shares, just replace the share capital with
specific type of shares.
II. Treasury shares, rights issue and share split

1. Treasury shares

Treasury shares are entity’s own shares that have been issued and then
reacquired but not canceled.

Three requisites to qualify as treasury shares:

a. The shares must be the entity’s own shares.

b. The shares must have been issued originally.
c. The shares are reacquired but not canceled.

Treasury shares is a deduction from shareholder’s equity.

2. Legal limitation of treasury shares

The company can acquire treasury shares only to the extent of retained
earnings.

3. Accounting for treasury shares

a. Cost method – the treasury shares is recorded at its cost.

b. Par value method – the treasury shares is recorded at its par value.

The cost method is used in accounting for treasury shares. Treasury shares shall
be recorded at cost, regardless of whether the shares are acquired below or
above the par or stated value.

4. Journal entries

v Acquisition of treasury shares

Treasury XX
shares
Cash XX

v Reissuance at cost

Cash XX
Treasury shares XX

v Reissuance at more than cost

Cash XX
Treasury shares XX
Share premium –
T/S

v Reissuance at below cost

Cash XX
a. Share premium –
T/S (if any) XX
 b. Retained XX
earnings
(if needed)
Treasury XX
shares

v Retirement of treasury shares

At loss – cost of the treasury shares exceeds the original issuance

Ordinary shares XX
Share premium -
issuance
(if determinable)
a. Share premium –
TS
b. Retained
earnings
Treasury XX
shares

At gain – original issuance exceeds cost of the treasury shares

Ordinary shares XX
Share premium -
issuance
(if determinable)
Treasury XX
shares
Share premium
- TS

5. Rights issue

Rights issue is granted to existing shareholders to enable them to acquire new

shares at a specified price during a specified period. Its Philippine term is “stock
right”

No entry is required when stock right is issued; only a memorandum entry is

made.

6. Share split

Share split may be in the form of:

a. Split up or share split proper – it is a transaction whereby the original shares

are called in for cancellation and replaced by a larger number accompanied by
a reduction in the par or stated value.

b. Slit down or reverse share split

Is the reverse of split up. It is a transaction whereby the original shares are
canceled and replaced by a smaller number accompanied by an increase in
the par value or stated value.
 Illustration:
Number of shares Par value Share capital
10,000 P100 P1,000,000
Split up 5 for 1 50,000 P 20 P1,000,000
Split down 1 2,000 P500 P1,000,000
for 5

Share split is recorded by a memorandum entry only.

III. Dividends and quazi-reorganization

1. Dividends

Dividends are distribution of earnings or capital to the shareholders in proportion

to their shareholdings.

2. In accounting for dividends, three dates are essential:

a. Date of declaration – is the date on which the board of directors authorize the
payment of dividends to shareholders.
b. Date of record – is the date on which the stock and transfer book of the
corporation will be closed for registration. Only those shareholders registered
as f such date are entitled to receive dividends. No entry is required on this
date but a list of the shareholders entitled to receive dividends is made.
c. Date of payment – is the date on which the dividend liability is to be paid.

3. Types of dividends

a. Cash dividends
b. Property dividend
c. Liability dividend in the form of scrip or bond
d. Share dividend

4. Journal entries

a. Cash dividend

Date of Retained earnings XX

declaration:
Cash dividend XX
payable
Date of record No entry
Date of payment: Cash dividend XX
payable
Cash XX

b. Property dividend

Date of declaration: Retained earnings XX

Property dividend XX
payable
Reporting period:
To recognized the
Increase in dividend Retained earnings XX
payable (if any)
Property dividend XX
payable

Reporting period:
 To recognized the
decrease in dividend Property dividends XX
payable (if any) payable
Retained earnings XX
Reporting period:
To recognized the
impairment loss (if any) Impairment loss XX
Specific asset XX
declared
as dividends
Date of payment:
To recognized the
increase of
dividend payable (if Retained earnings XX
any)
Property dividend XX
payable
Date of payment:
To recognized the
decrease of
dividend payable (if Property dividend XX
any) payable
Retained earnings XX
Date of payment:
To record the settlement
of Property
property dividend dividend payable XX
payable
Loss (if any)
Specific asset
declared as XX
dividends
Gain (if any)

c. Liability dividend

Scrip

Date of Retained earnings XX

declaration:
Scrip dividend XX
payable
Date of record No entry
Date of payment: Scrip dividend XX
payable
Interest expense
Cash XX

Bonds

Date of Retained earnings XX

declaration:
Bond dividend XX
payable
Date of record No entry
Date of payment: Bond dividend XX
payable
Bonds payable XX
 d. Share or stock dividend

Small share dividend

• less than 20%
• recorded at fair value

Date of Retained earnings XX

declaration:
Share dividend XX
payable
Share premium XX

Date of record No entry

Date of payment: Share dividend XX
payable
Share capital XX

Large share dividend

• 20% or more
• recorded at par value

Date of Retained earnings XX

declaration:
Share dividend XX
payable
Date of record No entry
Date of payment: Share dividend XX
payable
Share capital XX

5. Quasi-reorganization

Quasi-reorganization is a permissive but not a mandatory procedure under which

a financially troubled entity restates its accounts and establishes a “fresh start” in
accounting sense.

Quasi-reorganization is also called corporate readjustment and may be

accomplished thru:

a. Recapitalization
b. Revaluation of property, plant and equipment.
Exercises:

1. Ocean Company was organized at the beginning of the current year and was
authorized to issue share capital 100,000 shares of P50 par value.

The following transactions occurred during the year in connection with the
share capital:

a. The incorporators subscribed for 25% of the authorized share capital at

par value.
b. The incorporators paid 25% on their subscription.
c. Full payment was received on 15,000 shares originally subscribed.
d. Land with fair value of P600,000 was acquired upon issuance of 10,000
shares. The market value of the share at this time is P55.
e. Cash subscription to 5,000 shares at P60 per share was received.
f. Issued 2,000 shares to the legal counsel in payment for his P100,000 bill
for organization services.

Required:Prepare journal entries to record the transactions using the

memorandum method.

2. Aroma Company reported the following shareholder’s equity:

Ordinary share capital, 50,000 P5,000,000

shares, P100 par
Share premium 200,000
Retained earnings 2,000,000

Subsequently, the following transactions, among others occurred:

a. Treasury shares of 5,000 were acquired at P160 per share.

b. Assuming treasury shares were reissued for P1,000,000.
c. Assuming the treasury shares were reissued for P700,000.

Required: Prepare journal entries to record the transactions.

3. On December 31, 2017, Zebra Company showed the following shareholders’

equity:

Share capital, P100 par, 100,000 authorized,

50,000 shares issued. P5,000,000
Share premium 1,000,000
Subscribed share capital 10,000
Retained earnings 2,000,000
Subscription receivable 4,000
Treasury shares, 6,000 at cost 600,000

On December 31, 2017, Zebra Company declared a cash dividend of P30 per
share to shareholders of record on January 15, 2018 and payable on January
31, 2018.

Required: Prepare journal entry on December 31, 2017, January 15, 2018 and
January 31, 2018.
4. Your audit client, Argao, Inc., is a public enterprise whose shares are traded
in the over-the-counter market. At December 31, 2019, Argao had 3,000,000
authorized shares of P10 par value ordinary share, of which 1,000,000 shares
were issued and outstanding. The stockholders’ equity accounts at December
31, 2019 had a following balances:

Ordinary share P10,000,000

Share premium 3,750,000
Retained earnings 3,250,000

Transactions during 2020 and other information relating to the stockholders’

equity accounts were as follows:

• On January 2, 2020, Argao issued at P54 per share, 50,000 shares of P50
par value, 9% cumulative convertible preference share. Each share of
preference share is convertible into two shares of ordinary share. Argao
had 300,000 authorized shares of preference share. The preference share
has a liquidation value equal to its par value.

• On February 1, 2020, Argao reacquired 10,000 shares of its ordinary share

for P16 per share.

• On April 30, 2020, Argao sold 250,000 shares (previously unissued) of P10
par value ordinary share to the public at P17 per share.

• On June 15, 2020, Argao declared a cash dividend of P1 per share of

ordinary share, payable on July 15, 2020, to stockholders of record on July
1, 2020.

• On November 10, 2020, Argao sold 5,000 shares of treasury share for P21
per share.

• On December 15, 2020, Argao declared the yearly cash dividend on

preference share, payable on January 15, 2021, to stockholders of record
on December 31, 2020.

• On January 20, 2021, before the books were closed for 2020, Argao became
aware that the ending inventories at December 31, 2019 were understated
by P150,000 (after tax effect on 2019 net income was P90,000). The
appropriate correction entry was recorded the same day.

• After correcting the beginning inventory, net income for 2020 was
P2,250,00.

QUESTIONS:

Based on the above and the result of your audit, determine the following as
of December 31, 2020:

a. Share premium
b. Un-appropriated retained earnings
c. Treasury share
d. Total stockholders’ equity
e. Ordinary shares outstanding

END OF TOPIC 2
 COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]

Topic 2: AUDIT OF SHARE BASED COMPENSATION

LEARNING OBJECTIVES:

At the end of this topic, the students are expected to:

1. Understand the concept of share-based compensation.

2. Know the recognition and measurement of share options;
3. Know the recognition and measurement of share appreciation rights;

NOTES:

1. Share based compensation plan

Share based compensation plan is a compensation arrangement established by

the entity whereby the entity’s employees shall receive shares of capital in
exchange for their services or the entity incurs liability to the employees in
amounts based on the price of its shares.

Compensation plans are a common feature of employee remuneration for

directors, senior executives and other key employees.

2. Types of share-based compensation plan

a. Equity settled – the entity issues equity instruments in consideration for

services received, for example, share options

b. Cash settled – the entity incurs a liability for services received and the liability
is based on the entity’s equity instruments, for example, share appreciation
rights.

3. Share rights (vs) Share warrant (vs) Share option

Share rights are granted to existing shareholders to enable them to acquire new
shares at a specified price during a specified period.

Share warrants are granted to enable the holders to acquire equity shares at a
specified price during a definite period.

Share options are granted to officers and key employees to enable them to
acquire shares of the entity during a specified period upon fulfillment of certain
conditions at a specified price.

4. Share options

Typically, share options are granted to officers and key employees as part of
their remuneration package, in addition to a cash salary and other employee
benefits.

Page 23 of 23
Measurement of compensation

a. Fair value method - this means that the fair value is equal to the fair value of
the share options on the date of grant.
b. Intrinsic value method – this means that the compensation is equal to the
intrinsic value of the share options.

5. Recognition of compensation – share options

The following accounting procedures should be observed in the recognition of

compensation expense:

a. Vest immediately – the entity shall recognize the compensation as expense in

full with corresponding increase in equity.
b. Do not vest immediately – the entity shall recognize compensation as expense
over the service period or vesting period.

6. Journal entries for share options

Vest immediately
Date of grant
(2019):
Salaries – share XX
options
Share options outstanding XX
2020: No entries
2021: No entries
Exercise date
(2022):
Cash XX
Share options XX
outstanding
Ordinary share capital XX
Share premium XX

Do not vest
immediately
Date of grant
(2019):
Share options XX
outstanding
Share options outstanding XX
2020:
Salaries – share XX
options
Share options outstanding XX
2021:
Salaries – share XX
options
Share options outstanding XX
 Exercise date
(2022):
Cash XX
Share options XX
outstanding
Ordinary share capital XX
Share premium XX

7. Share appreciation rights

A share appreciation right entitles an employee to receive cash which is equal to

the excess of the market value of the entity’s share over a predetermined price
for a stated number of shares.

A share appreciation right entitles an employee to a cash payment equal to the

increase in the price of a given number of shares over a given period.

Share appreciation right creates a liability.

8. Measurement of compensation – share appreciation rights

The compensation is based on the fair value of the liability at the reporting date
and shall be remeasured at every year-end until it is finally settled.

Any changes in fair value are included in profit or loss.

The fair value of the liability is equal to the excess of the market value of share
over a predetermined price for a given number of shares over a definite vesting
period.

9. Recognition of compensation – share appreciation rights

a. If the share appreciation right vests immediately, the compensation is

recognized immediately on the date of the grant.
b. If the share appreciation right does not vest until the employee completes a
definite vesting period, the compensation is recognized over the service or
vesting period.

[Link] entries for share appreciation rights

Example:

Service period – January 1, 2019 to December 31 2022

Exercise date – January 1, 2023

December 31,
2019
Salaries XX
Accrued salaries payable XX
2020:
Salaries XX
Accrued salaries payable XX
2021:
Salaries XX
Accrued salaries payable XX
 2022:
Salaries XX
Accrued salaries payable XX
January 1, 2023:
Accrued salaries XX
payable
Cash XX

If there is a drop in the market value of share that needs reversal, the journal
entry is:

Accrued salaries XX
payable
Gain on reversal of share appreciation XX
right

Exercises:

1. On January 1, 2017, Marie Company granted 100 share options to each 300
employees, conditional upon the employees remaining in the entity’s employ
during the vesting period.

The share options will vest over a three year period. The fair value of each share
option is P50.

By the end of 2017, 20 employees have left and based on a weighted average
probability, a further 10 employees will leave during the vesting period.

By the end of 2018, only 8 employees have left and a further 32 employees will
leave during 2019.

By the end of 2019, only 25 employees left the entity.

Required:

Compute the compensation expense for 2017, 2018 and 2019 as a result of the
share option.

2. Pure company adopted a share option plan that granted options to key executives
to 30,000 ordinary shares with P10 par value.

The options were granted on January 1, 2017 and were exercisable 2 years after
date of grant if the grantee was still an employee of the entity.

The options expired three years from the date of grant. The option price was set
for P30 and the market price at the date of the grant was also P30 a share.

The fair value of the share options cannot be measured estimated reliably.

The share market prices are P45 on December 31,2017, P50 on December
31,2018 and P55 on December 31, 2019. All of the options were exercised on
December 31, 2019.

Required:

Prepare journal entries relating to the share option plan using the intrinsic value
method.
3. On January 1, 2017, Magna Company offered the chief executive officer share
appreciation rights.

The terms are predetermined price P100, 10,000 shares, vesting period 3 years
and expiration date December 31, 2019.

The share appreciation right is to be paid on the date of exercise.

The share appreciation rights were exercised on December 31, 2019.

Share price
January 1,2017 100
December 31, 2017 95
December 31,2018 112
December 31,2019 125

Required:

Prepare journal entries in connection with the share appreciation rights.

END OF MODULE.