Chapter 21: Evaluation of Audit Evidence and Completion of the Audit

Review Questions

1. In the final stage of the risk-based audit process, how shall the engagement partner or
sole practitioner know that sufficient appropriate audit evidence has been obtained to
support the conclusions reached for the auditor’s report to be issued.
In this final phase, the auditor performs the final audit procedures required to obtain
sufficient audit evidence to form the auditor’s opinion. The auditor also reports the audit
findings to the client. By performing the final audit procedures, the auditor is able to
conclude on the audit objectives, form an opinion and report audit findings. Completion
phase procedures may include the following:
 Performs final analytical procedures;
 Reads minutes of recent board and committee meetings; Inquiry of entity’s legal
counsel;
 Inquiry of client to identify commitments and contingencies;
 Makes final materiality judgments;
 Summarizes and evaluates the audit findings;
 Reviews the working papers;
 Reviews the financial statement presentation and disclosures for adequacy;
 Assess appropriateness of management use of going concern assumption;
 Considers subsequent events; and
 Obtains management representation letters.
The above procedures require the exercise of considerable professional judgment and thus
are generally performed by the more senior members of the engagement team.

2. Explain briefly the relevance of the following areas in connection with the final
evaluation of the audit evidence obtained:
a. Materiality - The auditor shall assess whether the amounts established for overall and
performance materiality are still appropriate in the context of the entity’s actual
financial results. If a lower materiality than that initially set is appropriate, the auditor
is required to determine:
i. Whether it is necessary to revise performance materiality; and
ii. Whether the nature, timing and extent of the further audit procedures remain
appropriate.
b. Risk - The auditor shall determine whether in the light of the audit findings the
assessed risks of material misstatement at the assertion level is still appropriate. If not,
the risk assessments would be revised and further planned audit procedures modified.
c. Misstatements - The auditor shall determine the effect in the audit of identified
misstatements and whether there is a need to perform additional audit procedures.
Revisions to the audit strategy and detailed audit plans may be required when:
 The nature of circumstances of identified misstatements indicate that other
misstatement(s) may exist that, when aggregated with known misstatements,
could exceed performance materiality; or
 The aggregate if identified and uncorrected misstatements comes close to or
exceeds performance materiality.
d. Fraud - The auditor through the performance of analytical procedures shall assess
whether previously unrecognized risks of material misstatement due to fraud are
 present. Also, he/she shall determine whether the identified misstatements are
indicatives of fraud.
e. Evidence - The auditor shall determine whether sufficient appropriate evidence has
been obtained to reduce the risks of material misstatement in the financial statements
to an acceptably low level. He/ She shall consider whether there is a need for further
procedures to be performed.
f. Analytical Procedures - The auditor shall assess whether the analytical procedures
performed at the final review stage of the audit:
 Corroborate the audit findings; or
 Identify previously unrecognized risks of material misstatement

3. In what instances will the auditor be required to revise the audit strategy and detailed
audit plans.
The auditor should modify the overall audit strategy and the audit plan as necessary if
circumstances change significantly during the course of the audit, including changes due to
a revised assessment of the risks of material misstatement or the discovery of a previously
unidentified risk of material misstatement.

4. Give and explain briefly at least 8 sources of misstatements of financial statements

items.
1. Related Party Transactions - sometimes involve contracts for goods or services that are
priced at less (or more) favorable terms than those in similar arm's
length transactions between unrelated third parties.
2. Subsequent Events Review - The subsequent events review is an important audit
procedure to be performed up to the date of the auditor’s report. Due to the dynamism of
the businesses environment, the procedures provided in this Practical Guidance are not an
exhaustive list. Auditors need to bear in mind the business environment that the company
is operating in and his/her risk assessment of the company so as to enable him/her to
design and perform the appropriate and adequate audit procedures for subsequent events
review. Auditors also need to ensure that the audit documentation prepared in respect of
the audit procedures performed is in accordance with the requirements in SSA 230(R)
“Audit Documentation”.
3. Letter of Inquiry/review of contingent liabilities - An auditor should never assume
company management has always disclosed all contingent liabilities. This is particularly
true with legal expenses and unsettled taxes. Auditors have the authority to review
all Internal Revenue Service, or IRS, reports for possible undisclosed tax liabilities. All
legal expenses are to be accompanied by supporting documents. An auditor may not
always be a sufficient legal authority on a specific topic to understand the likelihood of
the expense. Also, the legalese may be written to be intentionally obtuse. In such cases,
the auditor can review precedent or consult with an expert before making a ruling on
possible contingencies.
4. Evaluating going concern status - To make your final going-concern assessment, you
reconsider the company's ability to remain in business. To make this evaluation, you
check out negative financial trends and consider the effect that outside events have on the
continuing success of the company.
5. Management representations - letter issued by a client to the auditor in writing as part of
audit evidences. The representations letter must cover all periods encompassed by the
audit report, and must be dated the same date of audit work completion.
6. Perform final analytical procedures – Analytical procedures are performed as an
overall review of the financial statements at the end of the audit to assess whether they are
 consistent with the auditor's understanding of the entity. Final analytical procedures are
not conducted to obtain additional substantive assurance.
7. Review the minutes of stockholders and Board of Directors – Board meeting minutes are
more than a general accounting of board discussions; they serve as an official and
legal record of the meeting of the Board of Directors. Minutes are used in a variety of
ways including tracking progress, detailing future plans, and serving as a reference point.
8. Evaluating findings, formulating an opinion and drafting the audit report - When
completing the audit, the auditor must reconsider materiality and determine a material
amount to be used in evaluating the estimated misstatement in the financial statement. In
evaluating whether the statements are presented fairly, an auditor should aggregate any
uncorrected misstatement to be able to consider them in relation to the financial statement
as a whole. If audit risk increases due to numerous events and conditions while the audit
is being undertaken, the auditor should evaluate whether additional substantive procedures
need to be performed.

5. Give and explain at least 8 factors to consider in evaluating the sufficiency and
appropriateness of audit evidence.
1. Relevance and Reliability - The relevance of audit evidence refers to its relationship to
the assertion or to the objective of the control being tested. The relevance of audit
evidence depends on:
a. The design of the audit procedure used to test the assertion or control, in particular
whether it is designed to (1) test the assertion or control directly and (2) test for
understatement or overstatement; and
b. The timing of the audit procedure used to test the assertion or control.
The reliability of evidence depends on the nature and source of the evidence and the
circumstances under which it is obtained. For example, in general:
 Evidence obtained from a knowledgeable source that is independent of the company
is more reliable than evidence obtained only from internal company sources.
 The reliability of information generated internally by the company is increased when
the company's controls over that information are effective.
 Evidence obtained directly by the auditor is more reliable than evidence obtained
indirectly.
 Evidence provided by original documents is more reliable than evidence provided by
photocopies or facsimiles, or documents that have been filmed, digitized, or otherwise
converted into electronic form, the reliability of which depends on the controls over
the conversion and maintenance of those documents.
2. Materiality of misstatements – Is a misstatement in the assertion being addressed
significant, and what is the likelihood of it having a materially affect (individually or
combined with other potential misstatements) on the financial statements?
3. Management responses – Is management responsive to audit findings, and how effective
is the internal control in addressing risk factors?
4. Quality of information – Are the sources of available information reliable and appropriate
for supporting the audit conclusions?
5. Persuasiveness – Is the audit evidence persuasive or convincing?
6. Previous experience – What has been the previous experience in performing similar
procedures, and were any misstatements identified?
7. Results of performed audit procedures – Do the results of performed audit procedures
support the objectives, and is there any indication of fraud or error?
 8. Understanding the entity – do the evidences obtained support or contradict the results of
the risk assessment procedures (which were performed to obtain an understanding of the
entity and its environment, including internal control)?

6. Give examples of audit matters that should be communicated by the auditor to those
charged with governance.
The auditor should communicate the audit matter to those charged with governance
the effect of uncorrected misstatements related to prior periods on the relevant classes of
transactions, account balances or disclosures, and the financial statements as a whole.

Problems

Problem 1
The field work for the June 30, 20X7, audit of Tracy Brewing Company was finished
August 19, 20X7, and the completed financial statements, accompanied by the signed audit
reports, were mailed September 6, 20X7. In each of the highly material independent events (a
through i), state the appropriate action (1 through 4) for the situation and justify your
response. The alternative actions are as follows:
1. Adjust the June 30, 20X7, financial statements.
2. Disclose the information in a footnote in the June 30, 20X7, financial statements.
3. Request the client to recall the June 30, 20X7, statements for revision.
4. No action is required.
The events are as follows:
a. On December 14, 20X7, the auditor discovered that a debut that a debtor of Tracy
Brewing went bankrupt on October 2, 20X7. The sale has taken place April 5, 20X7, but
the amount appeared collectible at June 30, 20X7 and August 19, 20X7.
b. On August 15, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on August 1, 20X7. The most recent sale had taken place April 2, 20X6, and
no cash receipts had been received since that date.
c. On December 14, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on July 15, 20X7 due to declining financial health. The sale had taken place
January 15, 20X7.
d. On August 16, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on July 30, 20X7. The cause of the bankruptcy was an unexpected loss of
major lawsuit on July 15, 20X7, resulting from a product deficiency suit by a different
customer.
e. On August 6, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on July 30, 20X7, for a sale that took place July 3, 20X7. The cause of the
bankruptcy was major uninsured fire on July 20, 20X7.
f. On May 31, 20X7, the auditor discovered an uninsured lawsuit against Tracy Brewing
that had originated on February 28, 20X7.
g. On July 20, 20X7, Tracy Brewing settled a lawsuit out of court that had originated in
2014 and is currently listed as a contingent liability.
h. On September 14, 20X7, Tracy Brewing lost a court case that had originated in 20X6 for
an amount equal to the lawsuit. The June 30, 20X7, footnotes state that in the opinion of
legal counsel there will be a favorable settlement.
i. On July 20, 20X7, a lawsuit was filed against Tracy Brewing for a patent infringement
action that allegedly took place in early 20X7. In the opinion of legal counsel, there is a
danger of a significant loss to the client.
Answer:
a. 4 - The amount appeared collectible at the end of the field work.
b. 1 - The uncollectible amount was determined before end of field work.
c. 3 - Amount should have been determined to be uncollectible before end of field work, but it
was discovered after the issuance of the statements. The financial statements should have
been known to be in error on 8-20-06.
d. 2 - The cause of the bankruptcy took place after the balance sheet date, therefore the balance
sheet was fairly stated. Account may be written off as uncollectible at 6-30-06, but they are
not required to do so. Footnote disclosure is necessary because the subsequent event is
material.
e. 2 - The sale took place after the balance sheet date but, since the loss was material and will
affect future profits, footnote disclosure is necessary.
f. 2 - The lawsuit originated in the current year, but the amount of the loss is unknown.
g. 1 - The settlement should be reflected in the 6-30-06 financial statements as an adjustment of
current period income and not a prior period adjustment.
h. 4 - The financial statements were believed to be fairly stated for 6-30-06 or 8- 19-06.
i. 2 - The cause of the lawsuit occurred before the balance sheet date and the lawsuit should be
included in the 6-30-06 footnotes.

Problem 2
In connection with his examination of Flowmeter, Inc., for the year ended December 31,
20X6, Flore, CPA, is aware that certain events and transactions that took place after December
31, 20X6, but before he issues his report dated February 28, 20X7, may affect the company’s
financial statements. The following material events or transactions have come to his attention:
1. On January 3, 20X7, Flowmeter, Inc., received a shipment of raw materials from
Laguna. The material had been ordered in October 2014 and shipped FOB shipping
point in November 20X6.
2. On January 15, 20X7, the company settled and paid a personal injury claim of a former
employee as the result if an accident that occurred in March 20X6. The company had
not previously recorded a liability for the claim.
3. On January 25, 20X7, the company agreed to purchase for cash the outstanding shares
of Porter Electrical Co. The acquisition is likely to double the sales volume of
Flowmeter, Inc.
4. On February 1, 20X7, a plant owned by Flowmeter, Inc., was damaged by a flood
resulting in an uninsured loss of inventory.
5. On February 5, 20X7, Flowmeter, Inc., issued and sold to the general public P2 million
in convertible bonds.
Required:
For each of the event or transactions just described, indicated the audit procedures that
should have brought the item to the attention of the auditor and the form of disclosure
required in the financial statements, including the reasons for such disclosures. Arrange your
answers in the following format:
Item No. Audit Procedures Required Disclosure and Reasons

Answer:
Item Audit Procedures Required Disclosure and Reasons
No.
1 Goods “in-transit” would be detected in the The receipt of the goods provides
 course of the auditor’s review of the year-end additional evidence with respect to
“cutoff” of purchases. The auditor would conditions that existed at the date of the
examine receiving reports and purchase balance sheet and hence the financial
invoices to make certain that the liability to statements should be adjusted to take into
suppliers had been recorded for all goods account such additional information.
included in inventory, and that all goods for
which the client was liable at year-end were
recorded in inventory.
2 Settlements of litigation would be revealed by The settlement of litigation would require
requesting from the company’s legal counsel a an adjustment of the financial statements
description and evaluation of any litigation, since the events that gave rise to the
impending litigation, claims, and contingent litigation had taken place prior to the
liabilities of which he has knowledge that balance sheet date.
existed at the date of the balance sheet being
reported upon, together with a description and
evaluation up to the date the information is
furnished. A review of cash disbursements for
the period between the balance sheet date and
completion of field work may also reveal
evidence of the settlement.

3 The purchase would normally be revealed in The purchase of a new business is not an
general conversations with the client and event that provides evidence with respect
would further be detected by reading the to conditions existing at the balance sheet
minutes of meetings of stockholders, directors, date; hence, it does not require adjustment
and appropriate committees. In addition, in the financial statements. However,
because the amount paid is likely to be such an event would normally be of such
unusually large in relation to other cash importance that disclosure of it is
disbursements, a review of cash disbursements required to keep the financial statements
for the period between the balance sheet date from being misleading. If the acquisition
and completion of field work is likely to is significant enough, it might be
reveal such an extraordinary transaction. advisable to supplement the historical
Moreover, because a purchase of a business statements with pro forma statements
usually requires a formal purchase agreement, indicating the financial results if the two
the letter from the firm’s legal counsel would firms had been consolidated for the year
probably have revealed the purchase. ending December 31, 2005. Otherwise,
disclosure in footnotes to the statements
would be adequate. Occasionally, a
situation of this type may have such a
material impact on the entity that the
auditor may wish to include in his report
an explanatory paragraph directing the
reader’s attention to the event and its
effect.
4 Inventory losses attributable to a flood would Losses attributable to floods subsequent
be brought to the auditor’s attention through to the balance sheet date do not provide
inquiries and discussions with corporate information with respect to conditions
officers and executives. Moreover, the auditor that existed at the balance sheet date;
would know the location of the plants and hence, it does not require an adjustment
warehouses of his client and upon becoming in the financial statements. However,
aware of any major floods in such a location, such an incident may be of sufficient
he would investigate to determine if his importance to require footnote disclosure.
client’s facilities had suffered any damage. Occasionally, a situation of this type may
have such a material impact on the entity
that the auditor may wish to include in his
report an explanatory paragraph directing
the reader’s attention to the event and its
effect.

5 The sale of bonds or other securities would Sales of bonds or capital stock are
require a filing with the SEC in which the transactions of the type that do not
auditor would presumably be involved. In provide information with respect to
addition, the sale would be revealed by conditions that existed at the balance
reading the minutes of directors’ and finance sheet date; hence, adjustment of the
committee’s meetings, by corresponding with financial statement is not required.
the client’s attorneys and by examining the However, such sales may be of sufficient
cash receipts book in the period subsequent to importance to require footnote disclosure.
the balance sheet date for evidence of Occasionally, a situation of this type may
unusually large receipts. have such a material impact on the entity
that the auditor may wish to include in his
report an explanatory paragraph directing
the reader’s attention to the event and its
effect.

Problem 3
In connection with your examination of the financial statements of Olars Mfg.
Corporation for the year ended December 31, 20X6, your review of subsequent events disclosed
the following items:
1. January 3, 20X7: The government approved a plan for the construction of an express
highway. The plan will result in the expropriation of a portion of the land owned by
Olar Mfg. Corporation. Construction will begin in late 20X7. No estimate of the
condemnation award is available.
2. January 4, 20X7: The funds for a P25,000 loan to the corporation made by Mr. Olars on
July 15, 20X6, were obtained by him by a loan on his personal life insurance policy. The
loan was recorded in the account “loan from officers”. Mr. Olars’ source of the funds
was not disclosed in the company records. The corporation pays the premiums on the
life insurance policy, and Mrs. Olars, wife of the president, is the beneficiary.
3. January 7, 20X7: The mineral content of a shipment of ore en route on December 31,
20X6, was determined to be 72 percent. The shipment was recorded at year-ended at an
estimated content of 50 percent by a debit to raw material inventory and a credit to
accounts payable in the amount of P20,600. The final liability to the vendor is based on
the actual mineral content of the shipment.
 4. January 15, 20X7: Culminating a series of personal disagreements between Mr. Olars,
the president, and his brother-in-law, the treasurer, the latter resigned, effective
immediately, under an agreement whereby the corporation would purchase his 10
percent share ownership at book value as of December 31, 20X6. Payment is to be made
in two equal amounts in cash on April 1, 20X7 and October 1, 20X7. In December, the
treasurer has obtained a divorce from his wife, who was Mr. Olars’ sister.
5. January 31, 20X7: As a result of reduced sales, production was curtailed in mid-
January and some workers were laid off. On February 5, 20X5, all the remaining
workers went on strike. To date the strike is unsettled.
6. February 10, 20X7: A contract was signed whereby Lopez Enterprises purchased from
Olars Mfg. Corporation all of the latter’s fixed assets (including rights to receive the
proceeds of any property condemnation), inventories, and the right to conduct business
under the name “Olars Mfg. Division”. The effective date of the transfer will be March
1, 20X7. The sale price was P500,000 subject to adjustment following the taking of a
physical inventory. The important factors contributing to the decision to enter into the
contract were the policy of the board of directors of Lopez Enterprises to diversify the
firm’s activities and the report of a survey conducted by an independent market
appraisal firm that revealed a declining market of Olars’ products.
Required:
Assume that the items described above came to your attention prior to completion of
your audit work on February 15, 20X7. For each item:
a. Give the audit procedures, if any, that would have brought the item to your attention.
Indicate other sources of information that may have revealed the item.
b. Discuss the closure that you would recommend for the item, listing all details that you
would suggest should be disclosed. Indicate those items or details, if any, that should not
be disclosed. Give your reasons for recommending or not recommending disclosure of
the items or details.

Answer:
1. The government’s approval of a plan for the construction of an express highway would have
come to the CPA’s attention through his inquiries of officers and key personnel, his examination
of the minutes of the meetings of the board of directors and stockholders, and his reading of local
newspapers. The details of the item would not have to be disclosed as a separate footnote because
all fixed assets of the corporation, including the right to the condemnation award, were to be sold
as of March 1, 2006 (see item 6).
2. It is improbable that the CPA would learn the source of the P25,000 unless it were revealed in a
discussion with the president or his personal accountant, or unless the auditor prepared the
president’s personal income tax return, in which case the interest charges would have led to his
investigation of the use to which the funds were put. Setting out the loan in the balance sheet as a
loan from an officer would be sufficient disclosure. The source from which the officer obtained
the funds would not be disclosed because it is the officer’s personal business and has no effect
upon the corporation’s financial statements. Indeed, disclosure of the funds’ source might be
construed as detrimental to the officer.
3. The additional liability for the ore shipment would have been revealed to the CPA in his scanning
of January transactions. His regular examination of 2001 transactions and related documents such
as purchase contracts would have caused him to note the time for subsequent follow up to
determine the final liability. In addition, the client’s letter of representation might have mentioned
the potential liability. The item would not require separate disclosure by footnote or otherwise
and would be handled by adjusting the financial statement amounts for purchases, ending raw
 materials inventory, and accounts payable by the amount of the additional charge, P9,064 {[(72 -
50) / 50] = 0.44; 0.44 x P20,600 = P9,064}.
4. The CPA might learn of the agreement to purchase the treasurer’s stock ownership through his
inquiries of management and legal counsel, examination of the minutes of the meetings of the
board of directors and stockholders and subsequent reading of the agreement. The absence of the
treasurer might also arouse the CPA’s curiosity. The details of the agreement would be disclosed
in a footnote because the use of company cash for the repurchase of stock and the change in the
amount of stock held by stockholders might have a heavy impact on subsequent years’ financial
statements. Usually, a management change, such as the treasurer’s resignation, does not require
disclosure in the financial statements. The details underlying the separation (personal
disagreements and divorce) should not be disclosed because they are personal matters.
5. Through inquiries of management, review of financial statements for January, scanning of
transactions, and observations, the CPA would learn of the reduced sales and of the strike.
Disclosure would not be made in the financial statements of these conditions because such
disclosure might create doubt as to the reasons therefore and misleading inferences might be
drawn.
6. The contract with Lopez Industries would come to the CPA’s attention through his inquiries of
management and legal counsel, his reading of the minutes of the meetings of the board of
directors and stockholders, and his examination of the contract. All important details of the
contract should be disclosed in a footnote because of the great effect upon the corporation’s
future. The factors contributing to the entry into the contract need not be disclosed in statements;
while they might be of interest to readers, they are by no means essential to make the statements
not misleading.

Problem 4
The following situations represent excerpts from the responses to audit inquiries of
external legal counsel of XYZ Co. during the annual audit of year 1 (“legal response”). For
each excerpt, select the most appropriate financial statement effect and audit response. Each
excerpt is independent. Responses may be used once, more than once, or not at all.
a. The client’s year-end is December 31, year 1.
b. The anticipated audit report date is February 15, year 2.
c. All amounts are material to the financial statements.
Financial Statement Effect Audit Response
1. No impact on financial statement 7. Legal responses is appropriately
amounts or notes. dated.
2. Disclosure in notes relating to nature 8. Update legal response.
of litigation, but no amount disclosed
3. Disclosure in notes relating to nature 9. Update audit report date.
of litigation, including loss amount.
4. Potential litigation settlement accrued
in financial statements.
5. Potential litigation settlement accrued
in financial statement, amount
disclosed in notes.
6. Verify amount due attorney is
recorded in financial statement
amounts.

Situations Financial Audit

 Statement Effect Response
Letter dated February 14, year 2: (a) No effect on (b) Legal
“I advise you that at and since December 31, year 1, I have financial response is
not been engaged to give substantive attention to, or statements or appropriately
represent, XYZ Co. in connection with any pending or notes dated
threatened litigation, claims, or assessment, nor am I
aware of any loss contingencies. No amounts were due to
this office for services provided at December 31, year 1.”
Letter dated January 21, year 2: (c) Verify amount (d) Update
“I advise you that and since December 31, year 1, I have due legal counsel legal
not been engaged to give substantive attention to, or is recorded in response
represent, XYZ Co. in connection with any pending or financial
threatened litigation, claims, or assessments, nor am I statements
aware of any loss contingencies. There were fees
outstanding of P3,675 due to this office for services
provided at December 31, year 1”
Letter dated February 26, year 2: (e) Disclosure in (f) Update
K Brosas v. XYZ Co: This matter commenced in notes relating to report date
December, year 1. The plaintiff alleges discrimination nature of
relating to his termination on November 17, year 1. The litigation, but no
company intends to defend this case vigorously. At this amount disclosed
time, we are unable to evaluated the likelihood of an
unfavorable outcome or estimate the amount or range of
potential loss.
Letter dated March 16, year 2: (g) Disclosure in (h) Update
J. Martin v. XYZ Co.: This matter commenced in March, notes relating to report date
year 2. The plaintiff alleges discrimination relating to his nature of
termination on November 17, year 1. The company litigation, but no
intends to defend this case vigorously. At this time, we are amount disclosed
unable to evaluate the likelihood of an unfavorable
outcome. The plaintiff is demanding P50,000.
Letter dated February 14, year 2: (i) Potential (j) Update
R. Red v. XYZ Co.: This matter commenced in November, litigation legal
year 1. The plaintiff alleges discrimination relating to his settlement not response.
termination on March 17, year 1. It is reasonably possible accrued in
that the case will be settled for approximately P35,000. financial
statement not
accrued in
financial
statement, amount
disclosed in
notes.
Letter dated February 14, year 2: (k) Potential (l) Update
L. Perez v. XYZ Co.: This matter commenced in litigation legal
November, year 1. The plaintiff alleges discrimination settlement response
relating to his termination on March 17, year 1. The case accrued in
is tentatively settled for P35,000 financial
statements.
Problem 5
For each of the account balances and associated assertions below, select the audit
procedure from the list provided that provides the most appropriate audit evidence for the
account assertion.
Account Assertion Procedure
Balances
1. Accounts Completenes a. Review confirmation of accounts receivable
receivable s balances and agree to accounts receivable sub
ledger.
b. Review list of accounts written-off during year.
c. Review schedule of bad debt expense.
d. Trace individual customer account transactions to
sales invoice.
e. Trace sales invoice and shipping documents just
before year-end to customer account transactions.
2. Inventory Valuation a. Examine invoices from suppliers.
and b. Examine invoices paid subsequent to year-end and
Allocation trace to subsidiary ledger.
c. Select items from inventory listing and locate the
items in the warehouse.
d. Select items located in the inventory warehouse
and trace to inventory listing.
e. Trace sales invoices and shipping documents just
before year-end to customer accounts.
3. Fixed Rights and a. Interview plant manager regarding fixed asset
assets Obligations additions during the year.
b. Recalculate partial year depreciation for fixed
asset acquisitions.
c. Trace fixed asset item to fixed asset master control
listing.
d. Vouch fixed asset acquisitions to purchase
invoices.
e. Vouch fixed asset acquisitions to related cash
disbursement.
4. Accounts Completenes a. Compare aging of accounts payable to prior
payable s periods.
b. Confirm accounts payable balance with suppliers.
c. Examine invoices paid subsequent to year-end and
trace to subsidiary ledger.
d. Trace individual payable transaction to purchase
order.
e. Vouch invoices for the purchase of suppliers to
receiving documents.
5. Cash Existence a. Agree bank statement to the subsidiary ledger.
b. Agree cash balance per the bank reconciliation to
the year-end bank statement.
c. Agree cash balance to online year-end bank
statement.
d. Recalculate bank statement balance including
interest receivable.
 e. Trace deposit per the bank statement to the cash
subsidiary ledger.

Answer:
1. Trace sales invoice and shipping documents just before year-end to customer account
transactions. - Testing for the completeness assertion asks the question, "Do the balances of
receivables contain all transactions for the period?" Tracing sales invoices and shipping
documents just before year-end to customer account transactions verifies that sales cut-off
procedures were performed correctly and that sales invoices and their associated accounts
receivable are recorded in the correct period.
2. Examine invoices from suppliers. - Testing for the valuation and allocation assertion asks the
question, "Is inventory valued at an applicable financial reporting framework, i.e., net
realizable value?" Examining invoices from suppliers verifies that the inventory was
purchased on a particular date at a specific price.
3. Vouch fixed asset acquisitions to purchase invoices. - Testing for the rights and obligation
assertion of fixed assets asks the question, "Does the client own the fixed assets?" Vouching
fixed asset acquisitions to purchase invoices verifies that the client purchased the fixed assets.
4. Examine invoices paid subsequent to year-end and trace to subsidiary ledger. - Testing for the
completeness assertion asks the question, "Do the balances of payables contain all
transactions for the period?" Examining invoices paid subsequent to year-end and tracing to
subsidiary ledger verifies that invoices were paid and recorded in the correct period.
5. Agree cash balance per the bank reconciliation to the year-end bank statement. -
Testing for the existence assertion asks the question, "Does the cash that the client has
recorded exist?" Performing or evaluating bank reconciliations for all accounts verifies that
the cash exists.
 Chapter 20: Audit of Other Accounts in the Statement of Profit or Loss
and Comprehensive Income

Exercises

Exercise 1
During 20X7, White Company determined that machinery previously depreciated over
a 7-year life had a total estimated useful life of only 5 years. An accounting change was made in
20X7 to reflect the change in estimate. If the change has been made in 20X6, accumulated
depreciation would have been P1,600,000 at December 31, 20X6, instead of P1,200,000. As a
result of this change, the 20X7 depreciation expense was P100,000 greater. The income tax rate
was 30% in both years. What should be reported in White’s statement of profit or loss and
comprehensive income for the year ended December 31, 20X7, as the cumulative effect on prior
years of changing the estimated useful life of the machinery?
a. P 0 b. P 280,000 c. P 300,000 d. P 400,000

Exercise 2
How should a change in accounting estimate that is recognized by a change in
accounting principle be reported?
Change in accounting estimate Change in accounting principle
a. No No
b. Yes Yes
c. No Yes
d. Yes No

Exercise 3
At the beginning of 20X8, Red Company discovered the following errors made in the
preceding 2 years:
2016 2017
Overstatement of ending inventory P 5,000 P 2,000
Omission of wages payable 700 800
Omission of allowance for doubtful accounts 1,300 1,700
Prepayment of insurance recorded as expense 500 200
Reported net income was P27,000 in 20X6 and P35,000 in 20X7. The allowance for
doubtful accounts had a zero balance at the beginning of 20X6. No accounts were written off
during 20X6 or 20X7. Ignore income taxes.
Required:
1. What is the correct net income for 20X6 and 20X7?
2. Prepare the adjusting entry in 20X8 to correct the errors.

Answer:
Requirement (1)
20X7 20X6
Reported net income P 35,000 P 27,000
Subtract ending inventory overstatement (2,000) (5,000)
Add beginning inventory overstatement 5,000
Subtract wages payable when incurred (800) (700)
Add wages payable when expensed 700
Subtract bad debts * P1,700 – P1,300 (400)* (1,300)

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 Add back prepayments in year recorded as expense 200 500
Subtract prepayments in year expense is incurred (500) ________
Correct net income P 37,200 P 20,500

Requirement (2)
January 1, 20X8 Retained Earnings 4,300
Insurance Expense 200
Inventory 2,000
Wages Expense 800
Allowance for Doubtful Accounts 1,700

Problems

Problem 1
Rita Cruz, your staff assistant on the April 30, 20 X2, audit of Maxwell Company, was
transferred to another assignment before she could prepare a proposed adjusting journal entry
for Maxwell’s Miscellaneous Revenue account, which she had analyzed per the working paper
given on the next page. You have reviewed the working paper and are satisfied with Cruz’
procedures. You are convinced that all the miscellaneous revenue items should be transferred
to other accounts.
Required:
Draft a proposed adjusting journal entry at April 30, 20X2, for Maxwell Company’s
Miscellaneous Revenue account.
Maxwell Company
Miscellaneous Revenue
Year Ended April 30, 20X2
Account Number: 430 Q-
2
Date Description Reference Amount
May 8, 20X1, Proceeds of sale of scrap from Various CR P 58,430 Y
through April 7, manufacturing process (total of 12
20X2 monthly sales)
July 18, 20X1 Write-off old outstanding checks; GJ 7-4 11,000 Y
numbers 118 – P5,000; 214 – P4,000; 407
– P2,000
September 22, Recovery of previously written off CR 9-1 43,810 Y
20X1 account receivable from Wilson Company
February 6, 20X2 Cash proceeds from sale of machine, Cost CR 2-1 35,000 Y
of P100,000 and accumulated
depreciation of P80,000 as of February 6,
20X2, not removed from accounts.
April 28, 20X2 Refund of premium overcharge on fire Cr 4-1 6,000 Y
insurance policy no. 1856, for period
April 1, 20X2 – March 31, 20X3
April 30, 20X2 Balance per ledger P 154,240

Y - Traced to cash receipts journal or general journal; vouched to appropriate supporting

documents
R.A.K.

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 May 18,
20X2
Answer:
MAXWELL COMPANY
Proposed Adjusting Journal Entry
April 30, 20X2

Accumulated Depreciation: Machinery 80,000

Miscellaneous Revenue 154,240
Cost of Goods Sold 58,430
Unclaimed Checks 11,000
Allowance for Doubtful Accounts 43,810
Machinery 100,000
Gain on Sale of Machinery (3,500 - 2,000) 15,000
Unexpired Insurance (11/12 x 6,000) 5,500
Insurance Expense (1/12 x 6,000) 500

Problem 2
The Orange Corporation is in the process of negotiating a loan for expansion purposes.
The books and records have never been audited, and the bank has requested that an audit be
performed. Orange has prepared the following comparative financial statements for the years
ended December 31, 20X7 and 20X6:
Statement of Financial Position
As of December 31, 20x7 and 20X6
20X7 20X6
Assets
Current assets
Cash P 163,000 P 82,000
Accounts receivable 392,000 296,000
Allowance for uncollectible accounts (37,000) (18,000)
Trading Securities, at cost 78,000 78,000
Merchandise Inventory 207,000 202,000
Total Current assets 803,000 640,000
Fixed Assets
Property, Plant, and Equipment 167,000 169,500
Accumulated Depreciation (121,600) (106,400)
Total fixed assets 45,400 63,100
Total assets P 848,400 P 703,100
Liabilities and Shareholders’ Equity
Liabilities
Accounts Payable P 121,400 P 196,100
Shareholders’ Equity
Ordinary shares, par value P10, authorized 50,000 shares, 260,000 260,000
issued
and outstanding 20,000
Retained Earnings 467,000 247,000
Total Shareholders’ Equity 727,000 507,000
Total liabilities and shareholders’ equity P 848,400 P 703,000

Statement of Income

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 For the Years Ended December 31, 20X7 and 20X6
20X7 20X6
Sales P 1,000,000 P 900,000
Cost of Sales 430,000 395,000
Gross Profit 570,000 505,000
Operating Expenses 210,000 205,000
Administrative Expenses 140,000 105,000
350,000 310,000
Net income P 220,000 P 195,000
During the course of the audit, the following additional facts were determined:
1. An analysis of collection and losses on accounts receivable during the past 2 years
indicates a drop in anticipated losses due to bad debts. After consultation with
management, it was agreed that the loss experience rate on accounts receivable should
be reduced from the recorded 9.4% to 5%, beginning with the year ended December 31,
20x7.
2. An analysis of marketable securities revealed that this investment portfolio consistent
entirely of short-term investments in trading securities that were acquired in 20X1. The
total market valuation for these investments as of the end of each year were as follows:
December 31, 20X6 – P81,000; December 31, 20X7 – P62,000.
3. The merchandise inventory at December 31, 20X6, was overstated by P4,000 and the
merchandise inventory at December 31, 20X7, was overstated by P6,100.
4. On January 2, 20X6, equipment costing P12,000 (estimated useful life of 10 years and
residual value of P1,000) was incorrectly charged to Operating Expenses. Orange
records depreciation via the straight-line method. In 20X7, fully depreciated equipment
(with no residual value) that originally cost P17,500 was sold as scrap for P2,500.
Orange credited the proceeds of P2,500 to Property and Equipment.
5. An analysis of 20X6 operating expenses revealed that Orange charged to expenses a 3-
year insurance premium of P2,700 on January 15, 20X6.
Required:
1. Prepare the journal entries to correct the books at December 31, 20X7. The books for
20X7 have not been closed. Ignore income taxes.
2. Prepare a schedule showing the computation of corrected net income for the years
ended December 31, 20X7 and 20X6, assuming that any adjustments are to be reported
on comparative statements for the 2 years. The first items on your schedule should be
the net income for each year. Ignore income taxes. (Do not prepare financial
statements.)

Answer:
Requirement (1)
(1) Allowance for Uncollectible Accounts 17,400
Administrative Expenses (37,000 – 19,600) 17,400
To reflect reduction in loss experience rate.
(2) Unrealized Holding Loss on Trading Marketable Securities 19,000
Valuation Allowance 16,000
Retained Earnings 3,000
To reduce marketable securities to market valuation and correct prior year’s
profit.
(3) Retained Earnings 4,000
Cost of Sales 2,100
Merchandise Inventory 6,100

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 To adjust for overstatements in opening and closing inventories.
(4)
a. Equipment 12,000
Operating Expenses 1,100
Retained Earnings 10,900
Accumulated Depreciation: Equipment 2,200
To adjust for error in recording of equipment purchase in 2005 and related
depreciation for 2005 and 2006.
b. Accumulated Depreciation: Equipment 17,500
Equipment 15,000
Other Income 2,500
To adjust for misposting of equipment sale.
(5) Prepaid Expenses 900
Operating Expenses 900
Retained Earnings 1,800
To adjust for non-recognition of prepaid expense in 2005 and 2006.
(6) Ordinary Shares 60,000
Capital in Excess of Par 60,000
To adjust for capital contributed in excess of par value.

Requirement (2)
Orange Corporation
Computation of Corrected Net Income
For Years Ended December 31, 2006 and 2005
2006 2005
Debit (Credit) Debit (Credit)
Reported income P(220,000) P(195,000)
Change in accounts receivable loss experience rate (17,400) ---
Unrealized loss (gain) on marketable securities 19,000 (3,000)
Ending merchandise inventories overstated:
December 31, 2005 (4,000) 4,000
December 31, 2006 6,100
Misposting of equipment purchase:
Decrease in operating expenses – 2005 (10,900)
Increase in operating expenses – 2006 1,100
Misposting of proceeds of equipment sold (2,500)
Recognition of prepaid insurance ___ 900 (1,800)
Corrected net income P(216,800) P(206,700)

Problem 3: Correction of Income and Related Accounts

You have been engaged to review the records and prepare corrected financial
statements for the XOR Corporation. The books of account are in agreement with the
following statement of financial position:
XOR Corporation
Statement of Financial Position
December 31, 20X7
(In thousands)

Assets
Cash P 5,000

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 Accounts Receivable 10,000
Notes Receivable 3,000
Inventory 25,000
P 43,000
Liabilities and Capital
Accounts Payable P 2,000
Notes Payable 4,000
Share Capital 10,000
Retained Earnings 27,000
P 43,000
A review of the books of the corporation indicates that the following errors and
omissions had not been corrected during the applicable years:
December Inventory Inventory Prepaid Prepaid Accrued Accrued
31 Over-valued Under-valued Expense Income Expense Income
20X4 P- P 6,000 P 900 P- P 200 P-
20X5 7,000 - 700 400 75 125
20X6 8,000 - 500 - 100 -
20X7 - 9,000 600 300 50 150
The profits per the books are: 20X5, P7,500; 20X6, P6,500; and 20X7, P5,500. No
dividends were declared during these years, and no adjustments were made to retained
earnings.
Required:
Prepare a worksheet to develop the correct profits for the years 20X5, 20X6 and 20X7
and the adjusted statement of financial position accounts as of December 31, 20X7. (Ignore
possible income tax effects)

Answer:
XOR Corporation
Worksheet to Correct Net Profit and Balance Sheet Accounts
From 2005 to 2007
Net Profit Adjustments to Balance Sheet Accounts
Inventory Retained Prepaid Prepaid Accrued Accrue
2005 2006 2007 Earnings Expense Income Expense d
s s Income
Unadjusted P7,500 P6,500 P5,500 P25,00 P27,00 - - - -
Balance 0 0
Add (Deduct)
Adjustments
(1)
Overvaluation
of inventory
2005 (7,000) 7,000
2006 (8,000 8,000
)
(2)
Undervaluatio
n of inventory
2004 (6,000)
2005 9,000 9,000 9,000
(3) Prepaid
Expenses
omitted at end

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 of year
2004 (900)
2005 700 (700)
2006 500 (500)
2007 600 600 600
(4) Prepaid
income omitted
at end of year
2005 (400) 400
2007 (300) (300) 300
(5) Accrued
expenses
omitted at end
of year
2004 200
2005 (75) 75
2006 (100) 100
2007 (50) (50) 50
(6) Accrued
income omitted
end of year
2005 125 (125)
2007 150 150 150
Adjusted P(5,850 P5,550 P22,50 P34,00 P36,40 P600 P30 P50 P15
Amount ) 0 0 0 0 0

Problem 4
The statement of financial position below is submitted to you for inspection and review.
Sun Freight Company
Statement of Financial Position
December 31, 20X7
Assets
Cash……………………………………………………………….. P 45,050
Accounts Receivable……………………………………………… 112,500
Inventories………………………………………………………… 204,000
Prepaid Insurance………………………………………………... 8,800
Land, Buildings, and Equipment……………………………….. 376,800
P 747,150
Liabilities and Owners’ Equity
Miscellaneous Liabilities…………………………………………. P 3,600
Loan Payable……………………………………………………… 76,200
Accounts Payable…………………………………………………. 75,250
Share Capital……………………………………………………… 215,000
Paid-in Capital……………………………………………………. 377,100
P 747,150
In the course of the review, you find the data listed below:
a. The possibility of uncollectible accounts on accounts receivable has not been considered.
It is estimated that the uncollectible accounts will total P4,800.
b. P45,000 representing the cost of a large-scale newspaper advertising campaign
completed in 20X7 has been added to the inventories, since it is believed that this

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 campaign will benefit sales of 20X8. It is also found that inventories include
merchandise of P16,250 received on December 31 that has not yet been recorded as a
purchase.
c. The books show that land, buildings, and equipment have a cost of P556,800 with
depreciation of P180,000 recognized in prior years. However, these balances include
fully depreciated equipment of P85,000 that has been scrapped and is no longer on
hand.
d. Miscellaneous liabilities of P3,600 represent salaries payable of P9,500, less noncurrent
advances of P5,900 made to company officials.
e. Loan payable represents a loan from the bank that is payable in regular quarterly
installments of P6,250.
f. Tax liabilities not shown are estimated at P18,250.
g. Deferred income tax liability arising from temporary differences totals P44,550. This
liability was not included in the statement of financial position.
h. Share capital consists of 6,250 shares of preference 6% share, par P20 and 9,000
ordinary shares, stated value P10.
i. Share capital had been issued for a total consideration of P283,600, the amount received
in excess of the par and stated values of the shares being reported as paid-in capital.
j. Net income and dividends were recorded in paid-in capital.
Required:
Based on the above information, compute for the following:
1. Accounting receivable (net):
a. P107,700 b. P112,500 c. P114,500 d. P113,000
2. Land, buildings, and equipment (net):
a. P378,800 b. P556,800 c. P376,800 d. P386,800
3. Inventories:
a. P204,000 b. P198,000 c. P159,000 d. P195,000
4. Total current assets:
a. P320,000 b. P330,550 c. P310,250 d. P312,450
5. Current portion of long-term debt:
a. P25,000 b. P51,200 c. P0 d. P76,200
6. Preference shares:
a. P215,000 b. P90,000 c. P125,000 d. P68,800
7. Paid-in capital in excess of par and stated value:
a. P68,600 b. P90,000 c. P377,000 d. P87,000
8. Retained Earnings:
a. P180,000 b. P190,650 c. P180,650 d. P179,650
9. Total assets:
a. P703,250 b. P705,250 c. P710,250 d. P703,000
10. Total current liabilities:
a. P114,250 b. P134,250 c. P138,375 d. P200,000

Answer:
1. a P107,700 (P112,500 – P4,800)
2. c P376,800
3. c P159,000 (P204,000 – P45,000)
4. a P320,550
5. a P25,000
6. c P125,000
7. a P68,600

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 8. d P179,650
9. a P703,250
10. a P144,250 (P9,500 + P25,000 + P16,250 + P18,250 + P75,250)

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 Chapter 19: Audit of Owners’ Equity

Review Questions

1. What audit procedures may be employed to establish the (a) existence or occurrence
and (b) rights and obligations of shareholders’ equity balances?
(a) Procedures applicable to the existence or occurrence of shareholders’ equity
balances are:
(1) Obtain schedules of shareholders’ equity accounts and reconcile to the general ledger
balances,
(2) review authorizations and terms of share issues,
(3) confirm shares outstanding with registrar on share and transfer agent,
(4) inspect share certificate book, and
(5) inspect certificates of shares held in treasury.
(b) Procedures applicable to rights and obligations are:
(1) make inquiries of legal counsel, and
(2) review articles of incorporation and by-laws.

2. List the procedures that are required in vouching dividend payments.

In vouching dividend entries, the auditor should:
(a) establish that preferential or other rights of shareholders and any restrictions on dividend
distributions have been recognized,
(b) establish the number of shares outstanding on the date of record and verify the accuracy
of the total dividend declaration by recalculation,
(c) ascertain the propriety of the entry to record the declaration, and
(d) trace dividend payments to canceled checks and other documentation.

3. What procedures are used in determining whether there is proper statement

presentation and disclosure of shareholders’ equity items?
The procedures consist of:
(a) review minutes of board of directors’ and shareholders’ meetings for share options and
dividends restrictions, and
(b) Evaluate financial statement presentation and disclosure for shareholders’ equity accounts.

Exercises

Exercise 1
The Earla Company was incorporated July 10, 20X7, with an authorized capital as follows:
1. Ordinary shares, Class A, 20,000 shares, par value P25 per share
2. Ordinary shares, Class B, 100,000 shares, par value PS per share
The share capital account in the general ledger is credited with only one item in the year
20X7. This represents share capital sold for cash, at par, as follows:
1. Class A, 12,000 shares
2. Class B, 60,000 shares
The sum of open certificate stubs in the share certificate books at December 31, 20X7
indicates that 82,000 shares were outstanding.
Required:
a. State possible explanations for this apparent discrepancy.
 b. State the procedures you would perform to determine the cause of the discrepancy.

Answer:
a.
1) Certificates may have been surrendered in exchange for others without attaching the
surrendered certificates to the stub book.
2) The excess certificates may have been issued under proper authority for services or
for property and not recorded in the financial books.
3) They may have been issued improperly in exchange for cash, services or property, or
without consideration. The impropriety might result from oversight or from fraudulent
design.
4) The error may have occurred because an item which should have been posted to the
share capital account was not in fact so posted.
5) An error may have occurred in entering the number of shares issued on the certificate
stub.
b.
1) Make a quick inspection of open stubs to determine whether they provide a ready clue
to the reason for difference, e.g., one certificate issued for 10,000 shares. If so,
investigate the facts regarding its issue.
2) If a quick inspection fails to provide a clue, refer to a list of shareholders supporting
the entries in the cash receipts book for the 72,000 shares originally sold. Check this
list item by item against stubs for shares originally issued and mark the stubs so
checked. Then check returned certificates attached to stubs against new stubs issued in
exchange for those certificates, marking the new stubs. Prepare a list of unmarked
stubs. This should total 10,000 shares and serve to identify the outstanding certificates
with respect to which shares are not recorded in the general ledger.
3) If errors are found in the number of shares issued, as shown by stubs in the share
certificate book after comparison with the cash receipts entries, it may be necessary to
circularize the original shareholders to determine how many shares were actually
issued.
4) If it is found that excess shares have been issued, inquiry should be made of
responsible officers with respect to the circumstances in which they were issued. The
answers obtained should be substantiated by appropriate evidence, e.g., resolutions of
the board, etc.

Exercise 2
You are engaged in doing the audit of a corporation whose records have not previously
been audited by you. The corporation has both an independent transfer agent and a registrar
checks that there is no over issue of shares. Signatures of both are required to validate
certificates.
It has been proposed that confirmations be obtained from both the transfer agent and the
registrar as to the shares outstanding at statement of financial position. If such confirmations
agree with the books, no additional work is to be performed as to share capital.
Required:
If you agree that obtaining the confirmations as suggested would be sufficient in this
case, give the justification for your position. If you do not agree, state specifically all additional
steps you would take and explain your reason for taking them.

Answer:
 The proposal for the limitation of procedure is not justified by the stated facts. Although the
transfer agent and the registrar know the number of shares issued, they do not necessarily know the
number of shares outstanding. Furthermore, the audit of share capital includes more than determining
the number of shares outstanding. For example, the auditor must determine what authorizations exist
for the issuance of shares, what assets were received in payment of shares, how the transactions were
recorded, and what subscription contracts have been entered into. Confirmation from the registrar
could not help in determining these things. In addition to confirmation from the registrar, the audit of
share capital might include the following procedures for which the purposes are briefly indicated:
(1) Examine the corporation charter to determine the number of shares authorized and the
special provisions relating to each class of shares if more than one class is authorized.
(2) Examine minutes of shareholders’ and directors’ meetings to determine authorization for
appointments of the registrar and the transfer agent, and to determine authorization for the issuance
or reacquisition of shares.
(3) Examine provisions relating to share capital in the corporation law of the state of
incorporation to determine any special provisions such as, for example, those relating to the issuance
of no-par shares.
(4) Analyze the share capital accounts to obtain an orderly picture of share transactions for
use as a guide to other auditing procedures and as a permanent record.
(5) Trace the consideration received for share capital into the records to determine what
consideration has been received and how it has been recorded.
(6) Examine and schedule treasury shares and review entries for treasury shares to determine
the existence of treasury shares, as authorized, and to determine that a proper record has been made.
(7) Review registrar’s invoices and cash disbursements to determine that original issue taxes
have been paid.
(8) Compare dividends with shares outstanding at dividend dates to determine that dividends
have been properly paid and also to substantiate the shares outstanding.
(9) Review subscription and option contracts, etc., to determine the facts in regard to
subscriptions and options and to determine that these facts have been properly recorded and that they
are adequately disclosed.

Exercise 3: Correction of Errors: Statement of Financial Position Preparation

Talisay Corporation presented the following statement of financial position for
December 31, 20X7:
Assets
Current Assets P30,000
Treasury shares (at market; cost = P15,000) 14,000
Fixed Assets 56,000
Total Assets P100,000
Liabilities and Shareholders’ Equity
Current Liabilities P20,000
Ordinary Shares subscribed (500 shares) 10,000
Long-Term Debt 8,000
Total Liabilities 38,000
Shareholders’ Equity
Ordinary Shares (4,000 shares issued) 18,000
10% Preference Shares (1,000 shares issued) 12,000
Less: Share subscriptions receivable (4,000)
Reserve for depreciation 16,000
Earned surplus 20,000
Total liabilities and shareholders’ equity P100,000
 Your investigation of Talisay Corporation’s financial records indicates that all
authorized shares have been either issued or subscribed. In addition, the par values for the
ordinary and preference shares are P2 and P10, respectively. The treasury share was originally
purchased when the market price was P20 per share. During 20X7, 250 treasury shares were
resold for P25 per shares. A “gain on treasury share transactions” was credited for the
difference between the original cost and the selling price. Furthermore, the excess of cost over
market of the treasury shares at the end of the period was recognized as an unrealized loss on
the 20X7 income statement. You also discovered that the City of Makati donated land with a
market value of P9,000 to Talisay during 20X7. Share subscriptions receivable are due six
months from December 31, 20X7.
Required:
Revise the December 31, 20X7, statement of financial position for Talisay Corporation
as it should be presented according to financial reporting standards.

Answer:
Based on the limited data made available in the problem, the Balance Sheet is presented as
follows:
Talisay Corporation
Statement of Financial Position
December 31, 20X7
Assets
Current assets (including share subscriptions receivable) (30,000 + 4,000) P 34,000
Noncurrent assets
Land (From City of Manila; at market value) 9,000
Other fixed assets (net of accumulated depreciation of P16,000)
(16,000 from reserve for depreciation; 56,000 – 16,000) 40,000
Total assets P 83,000
Liabilities and Stockholders’ Equity
Current liabilities P 20,000
Long-term liabilities 8,000
Total liabilities P 28,000
Stockholders’ equity
10% Preference shares (P10 par value; 1,000 shares authorized,
issued, and outstanding) P 10,000
Ordinary shares (P2 par value; 4,500 shares authorized [ordinary
shares + shares subscribed], 4,000 shares issued, and 3,250 outstanding) 8,000
Ordinary shares subscribed (500 shares) 1,000 a
Share Premium (preference) 2,000
Share Premium (ordinary) 20,250 b
Donated capital 9,000
Retained earnings 19,750 c
Less: Treasury shares (750 shares at cost) (15,000) d
Total liabilities and shareholders’ equity P 83,000
a. 500 shares x P2 par value = P1,000
b. Amount on issued ordinary shares [P18,000 - (4,000 x P2)] P10,000
Amount on subscribed ordinary shares [P10,000 - (500 x P2)] 9,000
P19,000
Sale of treasury shares (250 x P25) P 6,250
Cost of treasury shares sold (250 x P20) ( 5,000) 1,250
P20,250
 c. P20,000 - P1,250 (improper gain) + P1,000 (improper loss) P19,750
d. P15,000 total cost  P20 cost per share = 750 shares

Exercise 4: Preparation of Shareholders’ Equity Section

Hope, Inc., a manufacturer of restaurant and kitchen equipment, was incorporated in
20X3. Its share is publicly held. The shareholders’ equity section of the statement of financial
position at September 30, 20X7, follows:
P2 Cumulative redeemable preference shares (P15 par value;
500,000 shares authorized, 4,000 shares issued and outstanding) P60,000
Ordinary shares (P10 par value; 1,000,000 shares authorized,
110,000 shares issued and outstanding) 1,100,000
Retained Earnings 622,000
Total shareholders’ equity P1,782,000
Hope’s share capital transactions during fiscal 20X8 were as follows:
1. On January 2, 8,000 preference shares were issued in exchange for land with an
appraised value of P100,000. Six months ago, 1,000 shares of Hope preference were
exchanged “over the counter” for P14 per share. (Preference Shares)
2. On January 17, 4,500 ordinary shares were sold to Torn Santos at P25 per share.
(Ordinary Shares)
3. On September 14, Hope purchased dissident shareholder Santos’ 4,500 shares at P27
per share. The shares are to be held at treasury shares and accounted for at cost.
(Santos violently opposed Hope’s business strategy and Hope’s management decided to
eliminate his interest.) (Treasury Shares)
4. On September 28, Hope contracted with Kathryn Reyes for the sale of 10,000 previously
unissued shares at P25 per share to be issued when the purchase price is fully paid. At
September 30, only P195,000 had been paid. Reyes agreed to pay the balance on or
before November 3, 20X8. (Ordinary Shares Subscribed, at par)
5. On September 30, Hope redeemed 4,000 preference shares according to the issue
agreement. The shares were redeemed at P18 per share. (Preference Shares)
6. A cash dividend of P2 was declared on the preference shares on March 11, and paid on
March 30.
7. A cash dividend of P1.50 per share was declared on September 15, and payable October
11.
8. Hope’s net income for fiscal year 2018 was P250,000.
Required:
Prepare the shareholders’ equity section of the statement of financial position for the
year ended September 30, 20X8. This statement should be supported by the following
schedules, presented in the order given:
a. Changes in preference shares account.
b. Changes in ordinary shares account.
c. Calculation of paid-in capital in excess of par.
d. Changes in retained earnings.

Answer:
Hope, Inc.
Shareholders’ Equity
As of September 30, 2007
P2 Cumulative redeemable preference shares (P15 par value;
500,000 shares authorized; 8,000 shares issued and
outstanding) P 120,000
Ordinary shares (P10 par value; 1,000,000 shares authorized,
114,500 shares issued, 110,000 shares outstanding) 1,145,000
Ordinary shares subscribed, 10,000 shares 100,000
Paid-in capital in excess of par (ordinary) 217,500
Discount on preference shares (20,000)
Retained earnings 671,000
Treasury shares (4,500 shares at cost) (121,500)
P2,112,000
(a)
Preference Shares Schedule
# of Shares Amount
Balance 9/30/06 4,000 P 60,000
Shares issued to purchase land 8,000 120,000
Shares redeemed (4,000) (60,000)
Balance 9/30/07 8,000 P120,000

(b)
Ordinary Shares Schedule
# of Shares Amount
Balance 9/30/06 110,000 P1,100,000
T. Santos 4,500 45,000
Balance 9/30/07 114,500 P1,145,000

(c)
Paid-in Capital Schedule
Amount
Balance 9/30/06 -0-
Sale to T. Santos [4,500 x (P25 - P10)] P 67,500
Subscription by K. Reyes [10,000 x (25 - P10)] 150,000
P217,500

(d)
Retained Earnings Schedule
Amount
Balance 9/30/06 P622,000
Net income 250,000
Preference shares redemption [4,000 x (P18 - P15)] (12,000)
Cash dividend – ordinary (110,000 x P1.50) (165,000)
Cash dividend – preference (12,000 x P2) (24,000)
P671,000

Exercise 5: Preparation of Statement of Financial Position After Quasi-Reorganization

Adverse financial and operating circumstances warrant that Baguio Company undergo
a quasi-reorganization at December 31, 20X8. The following information may be relevant in
accounting for the quasi reorganization.
1. Inventory with a cost of P215,000 is currently recorded in the accounts at its market
value of P200,000.
2. Plant assets with a fair market value of P700,000 are currently recorded at P875,000 net
of accumulated depreciation.
 3. A creditor agrees to extend the maturity date of a loan for five years, although interest
as originally stated must continue to be paid.
4. Individual shareholders contribute P600,000 to create additional paid-in capital to
facilitate the reorganization. No new shares are issued, although control of a majority of
the company’s outstanding shares passes to the company’s creditors.
5. The par value of the ordinary share is reduced from P25 to P15.
6. Immediately before the events described above, the shareholders’ equity section appears
as follows:
Ordinary shares (P25 par value; 100,000 shares
authorized and outstanding) P2,500,000
Paid-in capital in excess of par 1,750,000
Retained earnings (deficit) (750,000)
Total shareholders’ equity P3,300,000
Required:
Prepare the shareholders’ equity section of Baguio Company’s statement of financial
position after the quasi-reorganization.

Answer:
Baguio Company
Shareholders’ Equity
December 31, 2007

Ordinary shares (15 par value; 100,000 shares authorized,

and outstanding) P1,500,000
Paid-in capital in excess of par 2,425,000 *
Retained earnings (from Dec. 31, 2007) -0-___
Total Shareholders’ Equity P3,925,000

* Original balance P1,750,000

Reduction of par value of ordinary shares (P10 x 100,000) 1,000,000
Additional contribution 600,000
Elimination of deficit (925,000)**
Paid-in capital in excess of par P2,425,000
** Original deficit P750,000
Loss on revaluation of plant assets 175,000
Deficit to be eliminated P925,000

Exercise 6: Determination of Correct Retained Earnings Balance

The Retained Earnings account of Paranaque Company follows:
Date Item Dr. Cr.
7-01-2017 Balance P48,500
3-31-2017 Dividends paid P20,000
12-31-2017 Net income for the year 32,400
4-01-2018 Premium on share capital 15,000
6-30-2018 Gain on sale of treasury shares 10,000
9-30-2018 Dividends declared 30,000
12-31-2018 Net income for the year 45,100
Appraisal increase of land 30,000
Balance 131,000
P181,00 P181,10
 0 0
The corrected balance of Retained Earnings as at December 31, 20X8 should be:
a. P76,000 b. P106,000 c. P131,000 d. None of these

Answer:
Retained Earnings before adjustments P 131,000
Add (Deduct) Adjustments:
(a) Premium on share capital credited to retained earnings (P 15,000)
(b) Gain on sale of treasury shares incorrectly charged (10,000)
(c) Appraisal increase of land incorrectly credited to Retained Earnings (30,000)
Total adjustments P(55,000)
Retained Earnings after adjustments P 76,000

Exercise 7
The A4 Corporation has been operating successfully for several years. It is authorized to
issue 24,000 shares of no-par ordinary share and 6,000 shares of 8% P100 par preference
share. The Contributed Capital section of its January 1, 20X7 statement of financial position is
as follows:
8% preference shares, P100 par P210,000
Ordinary shares, no par 207,000
Premium on preference shares 18,900
P435,900
Part a. A shareholder has raised the following questions:
1. What is the legal capital of the corporation?
2. At what average price per share has the preference share been issued?
3. How many ordinary shares have been issued (the ordinary share has been issued at an
average price of P23 per share)?
Part b. The company engaged in the following transactions in 20X7:
March 2 Received a subscription to 400 shares of the 8% preference share. The total
subscription price is P122 per share and the contract requires a P10 per share
down payment. The remaining balance must be paid within 60 days or the share
subscription is defaulted. In the case of default, 20% of the down payment on the
defaulted shares is forfeited, and the remainder is returned to the defaulting
subscribers.
April 3 Sold 900 ordinary shares for P33 per share.
April 13 Issued 400 ordinary shares in exchange for land. The share is currently selling at
P34 per share.
May 1 Received remaining subscription balance (from March 2) owed on 350
preference shares and issued the shares.
May 4 Returned 80% of their down payment to defaulting subscribers and canceled the
related account balances.
June 1 Reacquired 500 ordinary shares at P37 per share. The company uses the cost
method to account for treasury shares.
October 19 Issued for P27,000 a combination of 500 ordinary shares and 100 preference
share. The ordinary and preference shares are currently selling for P35 and P125
per share, respectively.
November 16 Reissued the 500 treasury shares at P39 per share.
December 31 Distributed an P8 per share dividend on all preference shares outstanding and a
P2 per share dividend on all ordinary shares outstanding on this date (debit
Retained Earnings and credit Cash for each dividend).
Required:
Prepare the contributed capital section of the December 31, 20X7 statement of financial
position.

Answer:
Requirement (1) Part a
1. The legal capital is P417,000 (P210,000 + P207,000).
2. The average issuance price of the preference share is P109 per share [(P210,000 + P18,900)
 2,100 shares].
3. The number of ordinary shares issued is 9,000 shares (P207,000  P23).
Requirement (2) Part b
A4 Corporation
Contributed Capital Section of the Balance Sheet
December 31, 2006

Contributed Capital
8% Preference shares, P100 par (6,000 shares authorized,
2,550 shares issued and outstanding) P255,000
Ordinary shares, no par 24,000 shares authorized,
10,800 shares issued and outstanding) 266,050 *
Premium on preference shares 27,850 
Additional paid-in capital from share subscription default 100
Additional paid-in capital from treasury shares 1,000
Total contributed capital P550,000

* P207,000 + P29,700 + P13,600 + P15,750 = P266,050

 P18,900 + P8,800 – P1,100 + P1,250 = P27,850

The above schedule is supported by the following entries for the transactions that occurred in
2006:
2006
March 2 Cash (P10 x 400) 4,000
Subscriptions Receivable (P112 x 400) 44,800
Preference Shares Subscribed (P100 x 400) 40,000
Premium on Preference Shares 8,800
April 3 Cash (P33 x 900) 29,700
Ordinary Shares, no par (900 shares) 29,700
April 13 Land (P34 x 400) 13,600
Ordinary Shares, no par (400 shares) 13,600
May 1 Cash (P112 x 350) 39,200
Preference Shares Subscribed (P100 x 350) 35,000
Subscriptions Receivable 39,200
Preference Shares, P100 par 35,000
May 4 Preference Shares Subscribed (50 x P100) 5,000
Premium on Preference Shares (50 x P22) 1,100
Subscriptions Receivable (50 x P112) 5,600
Cash (50 x 0.8 x P10) 400
Additional Paid-in Capital from Share Subscriptions Default 100
June 1 Treasury Shares – Ordinary 18,500
Cash (500 x P37) 18,500
October 19 Cash 27,000
Ordinary Shares, no par (500 shares) 15,750*
Preference Shares, P100 par 10,000
Premium on Preference Shares 1,250
* Ordinary shares: P27,000 x (500 x 35 / [(500 x 35) + (100 x 125)]) = P15,750
Preference shares: P27,000 x (100 x 125) / [(500 x 35) + (100 x 125)]= P11,250
P27,000
November 16 Cash (P39 x 500) 19,500
Treasury Shares 18,500
Additional Paid-in Capital from Treasury Shares 1,000
December 31 Retained Earnings 21,600*
Cash 21,600
* Ordinary dividends: (9,000 + 900 + 400 + 500) x P2 = P21,600
December 31 Retained Earnings 20,400*
Cash 20,400
* Preferred dividends: (2,100 + 350 + 100) x (0.08 x P100) = P20,400

Exercise 8
Partner Corporation’s post-closing trial balance at December 31, 20X7 was as follows:
Debit Credit
Accounts Payable (L) P290,000
Accounts Receivable (A) P550,000
Accumulated depreciation – building and equipment (A) 200,000
Additional paid-in capital – ordinary shares (SHE)
In excess of par value 1,560,000
From sale of treasury shares 250,000
Allowance for doubtful accounts (A) 30,000
Bonds Payable (L) 400,000
Building and Equipment (A) 1,100,000
Cash (A) 220,000
Ordinary share capital (P1 par value) (SHE) 150,000
Dividends payable on preference shares – cash (L) 4,000
Inventories (A) 620,000
Land (A) 380,000
Investment in equity securities (at market ) @ FVOCI (A) 285,000
Trading equity securities (at market) (A) 215,000
Preference shares (P50 par value) (SHE) 500,000
Prepaid Expenses (A) 40,000
Retained Earnings (SHE) 231,000
Treasury Shares – ordinary (at cost) (SHE) 180,000
Unrealized decrease in value of investment in securities – OCI 25,000
(SHE)
Totals P3,615,00 P3,615,00
0 0
At December 31, 20X7 Partner had the following number of ordinary and preference
shares:
Ordinary Preference
Authorized 500,000 50,000
Issued 150,000 10,000
 Outstanding 140,000 10,000
The dividends on preference shares are P4 cumulative. In addition, the preference share
has a preference in liquidation of P50 per share.
Required:
Prepare the shareholders’ equity section of Partner’s statement of financial position at
December 31, 20X7.

Answer:
Partner Corporation
Shareholders’ Equity
December 31, 2006
Share capital
Preference shares, P4 cumulative, par value P50 per share;
authorized 50,000 shares, issued and outstanding
10,000 shares P 500,000
Ordinary shares, par value P1 per share; authorized 500,000
shares, issued 150,000 shares, and outstanding
140,000 shares 150,000
Total share capital P 650,000
Additional paid-in capital – ordinary
In excess of par value 1,560,000
From sale of treasury shares 250,000
Total paid-in capital P2,460,000
Retained earnings 231,000
Accumulated other comprehensive income (loss)
Unrealized decrease in value of available for sale securities (25,000)
Total paid-in capital, retained earnings, and accumulated other
comprehensive income (loss) P2,666,000
Less: Treasury shares, 10,000 shares at cost (180,000)
Total shareholders’ equity P2,486,000

Problems

Problem 1
On January 1, 20X7, Del-V Company had a retained earnings balance of P206,000.
During 2017, the following events occurred:
1. Treasury shares (ordinary) was acquired at a cost of P14,000. The law requires a
restriction in retained earnings in an equal amount. The company reports its retained
earnings restrictions in a note to the financial statements.
2. Cash dividends totaling P9,000 and share dividends totaling P6,000 were declared and
distributed.
3. Net income was P58,000.
4. Two thousand shares of callable preference shares were recalled and retired at a price of
P150 per share. This share has originally been issued at P130 per share.
5. A material error in net income for a previous period was corrected. This error
correction decreased retained earnings by P12,600 after a related income tax credit of
P5,400.
Required:
1. Prepare a statement of retained earnings for the year ended December 31, 20X7.
2. Prepare a note to disclose the restriction of retained earnings.
Answer:
Requirement (1)
Del-V Company
Statement of Retained Earnings
For Year Ended December 31, 2006

Retained earnings, as previously reported, January 1, 2006 P206,000

Less: Correction of overstatement of previous
net income (net of P5,400 income tax credit) (12,600)
Adjusted retained earnings, January 1, 2006 P193,400
Add: Net income 58,000
P251,400
Less: Cash dividends P 9,000
Share dividends 6,000
Reduction due to retirement of preference shares 40,000 (55,000)
Retained earnings, December 31, 2006 (See Note A) P196,400

Requirement (2)
Note A: Retained earnings are restricted in the amount of P14,000, the cost of the ordinary
shares being held as treasury shares.

Problem 2
RICY Corporation has experienced a net loss for a number of years. On the advice of
the board of directors, a new management team was appointed. Furthermore, the corporation
has agreed to a quasi-reorganization and to the revaluation of certain statement of financial
position account balances, subject to shareholder approval. The RICY statement of financial
position on December 31, 20X7 contained the following information prior to the
reorganization:
Current Assets P20,000 Liabilities P30,000
Property and equipment 110,000 Ordinary shares, P10 par 100,000
Less: Accumulated Additional paid-in capital
Depreciation (30,000) on ordinary shares 40,000
Retained Earnings (deficit) (70,000)
Total Assets P100,000 Total Liabilities and Shareholders’ Equity P100,000
The following information is relevant to the quasi-reorganization as approved by the
shareholders:
1. Property and equipment is determined to have a fair value of P45,000.
2. Current assets contain inventories overstated by P6,000.
3. Current assets contain uncollectible accounts receivable of P3,000.
4. Par value of ordinary shares is to be reduced to P1 per share as approved by the state of
incorporation.
Required:
1. Prepare journal entries to record the quasi-reorganization.
2. Prepare the statement of financial position of RICY Corporation immediately following
the quasi-reorganization. Include a note to accompany retained earnings.

Answer:
Requirement (1)
a. Write-down of property and equipment
 Retained Earnings (P80,000 – P45,000) 35,000
Accumulated Depreciation 35,000
b. Write-down of inventories
Retained Earnings 6,000
Current Assets (inventories) 6,000
c. Write-down of accounts receivable
Retained Earnings 3,000
Current Assets (accounts receivable) 3,000
d. Change in par value of ordinary shares
Ordinary Shares, P10 par 100,000
Ordinary Shares, P1 par 10,000
Additional Paid-in Capital on Ordinary Shares 90,000
e. Elimination of retained earnings deficit
Additional Paid-in Capital on Ordinary Shares 114,000
Retained Earnings * 114,000
* P114,000 = P70,000 deficit + P35,000 + P6,000 + P3,000

Requirement (2)
RICY Corporation
Balance Sheet
December 31, 2006

Current assets P 11,000

Property and equipment 110,000
Less: Accumulated depreciation (65,000)
Total assets P 56,000

Liabilities P 30,000
Ordinary shares, P1 par 10,000
Additional paid-in capital on ordinary shares 16,000
Retained earnings (see Note A) 0___
Total liabilities and shareholders’ equity P 56,000

Notes to Financial Statements

Note A: Retained earnings as of December 31, 2006 has a zero balance due to a quasi-
reorganization on that date. At that time, net assets were revalued, the par value of ordinary share
was reduced from P10 to P1 per share, and a P114,000 deficit was charged against additional paid-in
capital.

Problem 3
JTC Company has P80,000 available to pay dividends. It has 2,000 shares of 10% P100
par, preference shares and 30,000 shares of P10 par ordinary share outstanding. The
preference shares is selling for P125 per share and the ordinary share is selling for P20 per
share.
Required:
1. Determine the amount of dividends to be paid to each class of shareholder for each of
the following independent assumptions:
a. Preference share is non-participating and non-cumulative.
b. Preference share is non-participating and cumulative. Preference dividends are
two years in arrears at the beginning of the year.
 c. Preference share is fully participating and cumulative. Preference dividends are
one year in arrears at the beginning of the year.
d. Preference share is participating up to a maximum of 15% of its par value and is
non-cumulative.
2. For 1(a), compute the dividend yield on the preference share and the ordinary share.

Answer:
Requirement (1)
Preference Ordinary
a. Preferred dividend (2,000 x 0.10 x P100) P20,000
Remainder to ordinary (P80,000 – P20,000) P60,000
Total P20,000 P60,000

b. Dividends in arrears (2 x 2,000 x 0.10 x P100) P40,000

Current preferred dividend (2,000 x 0.10 x P100) 20,000
Remainder to ordinary (P80,000 – P60,000) 20,000
Total P60,000 P20,000

c. Dividends in arrears (1 x 2,000 x 0.10 x P100) P20,000

Current preferred dividends 20,000
Ordinary proportional share (0.10 x 30,000 x P10) P30,000
Remainder shared * (P80,000 – P70,000) 4,000 6,000
Total P44,000 P36,000
* Preference: P10,000 extra dividend x (2,000 x 100) / [(2,000 x 100) + (30,000 x 100)] = P4,000
* Ordinary: P10,000 extra dividend x 300,000 / 500,000 = P6,000

d. Preference dividend P20,000

Ordinary proportional share (0.10 x 30,000 x P10) P30,000
Preference extra (0.05 x P200,000) 10,000
Ordinary extra (0.05 x P300,000) 15,000
Remainder to ordinary (P80,000 – P75,000) 5,000
P30,000 P50,000

Requirement (2)
Dividend yield = Dividends per share / Market Price per share
Preference share: (P20,000 / 2,000) / P125 = P10 / P125 = 8%
Ordinary share: (P60,000 / 30,000) / P20 = P2 / P20 = 10%

Problem 4
Trading on the Equity Analysis Presented below is information from the annual report
of Empire Plastics, Inc.
Operating income P532,150
Bond interest expense 135,000
397,150
Income taxes 183,432
Net Income P213, 718

Bonds Payable P1,000,000

Ordinary Shares 875,000
Retained Earnings 375,000
Required:
Is Empire Plastics, Inc. trading on the equity successfully? Explain.
Answer:
Rate of return on equity:
P213,718 / (P875,000 + P375,000) = P213,718 / P1,250,000 = 17.1%
Rate of interest paid on bonds payable:
P135,000 / P1,000,000 = 13.5%
Emporia Plastics, Inc. is trading on the equity successfully, since its return on ordinary share
equity is greater than interest paid on bonds.

Problem 5: Shareholders’ Equity Section of the Statement of Financial Position

The following is a summary of all relevant transactions of MLA Corporation since it
was organized in 20X5.
In 20X5, 15,000 shares were authorized and 7,000 ordinary shares (P50 par value) were
issued at a price of P57. In 20X6, 1,000 shares were issued as a share dividend when the share
was selling for P62. Three hundred ordinary shares were bought in 20X6 at a cost of P66 per
share. These 300 shares are still in the company treasury.
In 20X5, 10,000 preference shares were authorized and the company issued 4,000 of
them (P100 par value) at P113. Some of the preference share was reacquired by the company
and later reissued for P4,700 more than it cost the company.
The corporation has earned a total of P610,000 in net income after income taxes and
paid out a total of P312,600 in cash dividends since incorporation.
Required:
Prepare the shareholders’ equity section of the statement of financial positon in proper
form for MLA Corporation as of December 31, 20X6. Account for treasury shares using the
cost method.

Answer:
MLA Corporation
SHAREHOLDERS’ EQUITY
December 31, 2007

Paid-in Capital:
Preference shares, P100 par value
10,000 shares authorized, 4,000 shares issued & outstanding P400,000
Ordinary shares, P50 par value
15,000 shares authorized,
8,000 shares issued 7,700 shares outstanding 400,000 P 800,000
Additional Paid-in Capital:
Paid-in capital in excess of par— preference 52,000
Paid-in capital in excess of par— ordinary 61,000
Paid-in capital from treasury shares— preference 4,700 117,700
Total Paid-in Capital 917,700
Retained Earnings: 235,400*
1,153,100
Less cost of treasury shares (300 shares—ordinary) 19,800
Total Shareholders’ Equity P1,133,300
*P610,000 – P312,600 – (P62 X 1,000 shares)
Problem 6: Issuance of Bonds and Warrants
Odyssey, Inc. has decided to raise additional capital by issuing P170,000 face value of
bonds with a coupon rate of 10%. In discussions with investment bankers, it was determined
that to help the sale of the bonds, detachable share warrants should be issued at the rate of one
warrant for each P100 bond sold. The value of the bonds without the warrants is considered to
be P136,000, and the value of the warrants in the market is P24,000. The bonds sold in the
market at issuance for P152,000.
Required:
(a) What entry should be made at the time of the issuance of the bonds and warrants?
(b) If the warrants were non-detachable, would the entries be different? Discuss.

Answer:
(a) Basic formulas:
Value of bonds without warrants / (Value of bonds without warrants + Value of warrants) X
Issue price = Value assigned to bonds
Value of warrants / (Value of bonds without warrants + Value of warrants) X Issue price =
Value assigned to warrants
P136,000 / (P136,000 + P24,000) X P152,000 = P129,200 Value assigned to bonds
P24,000 / (P136,000 + P24,000) X P152,000 = 22,800 Value assigned to warrants
P152,000 Total
Cash...................................................................... 152,000
Discount on Bonds Payable.................................. 40,800 (P170,000 – P129,200)
Bonds Payable.......................................... 170,000
Paid-in Capital—Share Warrants............. 22,800
(b) When the warrants are non-detachable, separate recognition is not given to the warrants. The
accounting treatment parallels that given convertible debt because the debt and equity
element cannot be separated.
The entry if warrants were non-detachable is:
Cash...................................................................... 152,000
Discount on Bonds Payable.................................. 18,000
Bonds Payable.......................................... 170,000

Problem 7: EPS with Convertible Bonds and Preference Shares

The Simmy Corporation issued 10-year, P5,000,000 par, 7% callable convertible
subordinated debentures on January 2, 20X7. The bonds have a par value of P1,000 with
interest payable annually. The current conversion ratio is 14:1, and in 2 years it will increase
into 18:1. At the date of issue, the bonds were sold at 98. Bond discount is amortized on a
straight-line basis. Simmy’s effective tax rate was 35%. Net income in 20X7 was P9,500,000,
and the company had 2,000,000 shares outstanding during the entire year.
Required:
(a) Prepare a schedule to compute both basic and diluted earnings per share.
(b) Discuss how the schedule would differ if the security was convertible preference share.

Answer:
Requirement (a)
Net income for year P9,500,000
Add: Adjustment for interest (net of tax) 234,000*
P9,734,000

* Maturity value P5,000,000

 Stated rate X 7%
Cash interest 350,000
Discount amortization [(1.00 – .98) X P5,000,000 X 1/10] 10,000
Interest expense 360,000
1 – tax rate (35%) X 0.65
After-tax interest P 234,000

P5,000,000/P1,000 = 5,000 debentures

Increase in diluted earnings per share denominator:
5,000 X 18 = 90,000
Earnings per share:
Basic EPS P9,500,000 ÷ 2,000,000 = P4.75
Diluted EPS P9,734,000 ÷ 2,090,000 = P4.66

Requirement (b)
If the convertible security were preference shares, basic EPS would be the same assuming
there were no preference dividends declared or the preference was noncumulative. For diluted EPS,
the numerator would be the net income amount and the denominator would be 2,090,000.

Problem 8
You are engaged in the audit of Phoenix, Corp., a new client, at the close of its first fiscal
year, April 30, 20X1. The accounts had been closed before the time you began your year-end
filed work.
You review the following stockholders’ equity accounts in the general ledger:
Capital Stock
5/1/X0 CR1
500,000
4/28/X1 J12-5
50,000

Paid-in Capital in Excess of Stated Value

5/1/X0 CR1
250,000
2/2/X1 CR10
2,500

Retained Earnings
4/28/X1 J12-5 4/30/X1 J12-12
50,000 800,000

Treasury Stock
9/14/X0 CP5 2/2/X1 CR10
80,000 40,000

Income Summary
4/30/X1 J12-13 4/30/X1 J12-12
5,200,000 6,000,000
4/30/X1 J12-14
800,000
Other information in your working paper includes the following:
1. Phoenix’s articles of incorporation filed April 17, 20X0, authorized 100,000 of non-par
value capital stock.
2. Directors’ minutes include the following resolutions:
4/18/X0 Established P50 per share stated value for capital stock.
4/30/X0 Authorized issue of 10,000 shares to an underwriting syndicate for P75 per
share.
9/13/X0 Authorized acquisition of 1,000 shares from a dissident holder at P80 per
share.
2/01/X1 Authorized reissue of 500 treasury shares at P85 per share.
4/28/X1 Declared 10 percent stock dividend, payable May 18, 20X1, to stockholders of
record May 4, 20X1.
3. The following costs of the May 1, 20X0, and February 2, 20X1, stock issuances were
charged to the named expensed accounts; Printing Expense, P2,500. Legal Fees,
P17,350; Accounting Fees, P12,000; and SEC Fees, P150.
4. Market values for Phoenix Corp. capital stock on various dates were
9/13/X0 P78.50 2/02/X1 P85.00
9/14/X0 P79.00 2/28/X1 P90.00
5. Phoenix Corp.’s combined federal and state income tax rates total 55 percent.
Required:
a. Prepare the necessary adjusting journal entries at April 30, 20X1.
b. Prepare the stockholders’ equity section of Phoenix Corp.’s April 30, 20X1, balance
sheet.

Answer:
Requirement (a)
The first journal entry would be to charge the costs to stock issuances to the
appropriate account heads. Costs such as printing expenses, legal fees, accounting fees and the
SEC filing fees should be charged to the paid-in-capital in excess of stated value. Direct costs
incurred to sell shares, such as underwriting costs, accounting and legal fees, printing costs,
and taxes, should reduce the proceeds received from the sale of the shares. To record the
journal entry, debit paid-in capital in addition of stated value and credit the individual costs
accounts with respective amounts as below:
Dat Account Title Debit Credit
e
Paid-in Capital in addition of stated value 32,00
0
Printing Expense 2,500
Legal Fees 17,350
Accounting Fees 12,000
SEC Fees 150
To assign the costs of May 1, 20X0 and February 2, 20X1 to
paid-in capital account