CPA REVIEW SCHOOL OF THE PHILIPPINES AP-9501-3

Manila
AUDITING PROBLEMS CPA Review

AUDIT OF SHAREHOLDERS’ EQUITY

(Part 3 of 3)

PROBLEM 1 – Share-Based Compensation: Grant with Market Condition

At the beginning of year 1, an entity grants to a senior executive 30,000 share options. The grant
is conditional upon the executive remaining in the entity’s employ until the end of year 3.

The share options can be exercised if the entity’s share price increases from P20 at the beginning
of year 1 to above P30 at the end of year 3. If the share price is above P30 at the end of year
3, the share options can be exercised at any time during the next five years, i.e., by the end of
year 8.

The entity estimates the fair value of the share options on grant date to be P5 per option. This
estimate takes into account the following market condition:
The possibility that the share price will exceed P30 at the end of year 3, i.e., the share options
become exercisable; and
The possibility that the share price will not exceed P30 at the end of year 3, i.e., the share
options will be forfeited.

The following actual events occurred in years 1 to 3:

Year 1
The share price has increased to P24.
The entity’s estimate of the fair value of the options is P4 at the end of year 1. This takes
into account whether the market condition will be satisfied by the end of year 3.
Year 2
The share price has decreased to P22. However, the entity remains optimistic that the share
price target will be met by the end of year 3.
The estimated fair value of the share options is P3. Again, this estimate takes into account
the market condition noted above.
Year 3
The share price only reaches P28 by the end of year 3.
The estimated fair value of the share options is zero, as the market condition has not been
satisfied.

Based on the preceding information, determine the following:

1. Compensation expense for year 1

A. P50,000 B. P40,000 C. P60,000 D. P30,000

2. Compensation expense for year 2

A. P50,000 B. P40,000 C. P60,000 D. P30,000

3. Compensation expense for year 3

A. P50,000 B. P 0 C. P40,000 D. P30,000

4. Share options outstanding at the end of year 2

A. P70,000 B. P80,000 C. P90,000 D. P100,000

5. Cumulative compensation expense for the three-year period

A. P 0 B. P150,000 C. P100,000 D. P70,000

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CPAR - MANILA AP-9501-3 – AUDIT OF SHAREHOLDERS’ EQUITY

PROBLEM 2 – Share-Based Compensation: Grant with Performance Condition

On January 1, Year 1, Entity A grants share options to each of its 100 employees working in the
sales department. Each of these employees receives 10 share options. The share options will
vest on December 31, Year 3, provided that the employees remain in the entity’s employ. On
January 1, Year 1, fair value per option is P30.
On December 31, Year 1, it is expected that during the whole vesting period of three years, 10%
of the employees will leave entity A. On December 31, Year 2, this expectation is revised to 30%.
Finally, by December 31, Year3, 20% of the employees left entity A.
There is also a performance condition in addition to the service condition. According to the
performance condition, the options only vest if entity A’s sales revenue increases by at least
20% by December 31, Year 3. On December 31, Year 1 and on December 31, Year 2, it is
expected that this target will be met. However, the target is not met by December 31, Year 3.

Based on the preceding information, answer the following:

1. What amount of compensation expense should be recognized in Year 1?

A. P9,000 C. P10,000
B. P14,000 D. P 0

2. What amount of compensation expense should be recognized in Year 2?

A. P 0 C. P5,000
B. P9,000 D. P10,000

3. What amount of compensation expense should be recognized in Year 3?

A. P14,000 C. P9,000
B. P10,000 D. P 0

PROBLEM 3 – Share-Based Compensation: Share Appreciation Rights (SARS)

An entity grants 100 cash share appreciation rights (SARs) to each of its 500 employees, on
condition that the employees remain in its employ for the next three years.

During year 1, 35 employees have left. The entity estimates that a further 60 will leave during
years 2 and 3. During year 2, 40 employees have left and the entity estimates that a further 25
will leave during year 3. During year 3, 22 employees have left. At the end of year 3, 150
employees exercised their SARs, another 140 employees exercised their SARs at the end of year
4 and the remaining 113 employees exercised their SARs at the end of year 5.

The entity estimates the fair value of the SARs at the end of each year in which a liability exists
as shown below. At the end of year 3, all SARs held by the remaining employees vested. The
intrinsic values of the SARs at the date of exercise (which equal the cash paid out) at the end of
years 3, 4, and 5 are also shown below.

Year Fair Value Intrinsic Value

1 P14.40
2 15.50
3 18.20 P15.00
4 21.40 20.00
5 25.00
Based on the preceding information, answer the following:
1. What amount of compensation expense should be recognized in year 1?
A. P223,200 B. P211,200 C. P193,440 D. P194,400

2. What amount of compensation expense should be recognized in year 2?

A. P190,133 B. P222,993 C. P218,933 D. P234,433

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3. What amount of compensation expense should be recognized in year 3?

A. P272,127 B. P460,460 C. P225,000 D. P177,873

4. What amount of compensation expense should be recognized in year 4?

A. P280,000 B. P61,360 C. P218,640 D. P241,820

5. What amount of compensation expense should be recognized in year 5?

A. P241,820 B. P460,460 C. P40,680 D. P282,500

6. What amount of salaries payable should the entity report at the end of year 3?
A. P241,820 B. P 0 C. P413,333 D. P460,460

7. What amount of salaries payable should the entity report at the end of year 4?
A. P241,820 B. P 0 C. P413,333 D. P460,460

MULTIPLE CHOICE QUESTIONS

1. Tests in the audit of shareholders’ equity typically include all of the following, except
A. Determining that dividend declarations comply with debt agreements.
B. Verifying the authorization of dividends by inspecting the board of directors’ minutes of
meetings.
C. Tracing individual dividend payments to the capital stock records.
D. Reviewing the bank reconciliation for the imprest dividend account.

2. In an examination of shareholders’ equity, an auditor is most concerned that

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

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

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

5. Choose the correct statement.

A. When an entity does not maintain its own stock records, the auditor should obtain
written confirmation from the transfer agent and registrar concerning restrictions on the
payment of dividends.
B. When an entity does not maintain its own stock records, the auditor should obtain
written confirmation from the transfer agent and registrar concerning the number of
shares issued and outstanding.
C. When an entity does not maintain its own stock records, the auditor should obtain
written confirmation from the transfer agent and registrar concerning guarantees of
preference share liquidation value.
D. When an entity does not maintain its own stock records, the auditor should obtain
written confirmation from the transfer agent and registrar concerning the number of
shares subject to agreements to repurchase.

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CPAR - MANILA AP-9501-3 – AUDIT OF SHAREHOLDERS’ EQUITY

6. With respect to treasury shares, the auditor should not object to which of the following?
A. Restrictions on retained earnings have not been met.
B. Dividends have been paid on treasury shares.
C. The treasury share certificates have been destroyed.
D. Treasury shares are recorded at cost rather than par value.

7. A client company declared and paid a stock dividend. Its independent external auditor
should determine that
A. Shareholders received their additional shares by confirming year-end holdings with
them.
B. The stock dividend was properly recorded by means of a memorandum entry only.
C. The officers authorized the issuance of the stock dividend.
D. Appropriate amounts were transferred from retained earnings to share capital and share
premium.

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

9. Which of the following statements is correct?

A. When a company has treasury share certificates on hand, a year-end count of the
certificates by the auditor is always required.
B. When a company has treasury share certificates on hand, a year-end count of the
certificates by the auditor is required when the company classifies treasury shares with
other assets.
C. When a company has treasury share certificates on hand, a year-end count of the
certificates by the auditor is not required if the treasury share is a deduction from
shareholders’ equity.
D. When a company has treasury share certificates on hand, a year-end count of the
certificates by the auditor is required when the company had treasury share transactions
during the year.

10. In performing tests concerning the granting of stock options, an auditor should
A. Confirm the transaction with the Securities and Exchange Commission.
B. Verify the existence of option holders in the entity’s payroll records or stock ledgers.
C. Determine that sufficient treasury stock is available to cover any new stock issued.
D. Trace the authorization for the transaction to a vote of the board of directors.

11. The auditor does not expect the client to debit retained earnings for which of the following
transactions?
A. A 10% stock dividend.
B. An appropriation of retained earnings for treasury shares.
C. A large stock dividend.
D. A four-for-one stock split.

12. Where no independent stock transfer agents are employed and the corporation issues its
own stocks and maintains stock records, cancelled stock certificates should
A. Not be defaced, but segregated from other stock certificates and retained in a cancelled
certificates file.
B. Be destroyed to prevent fraudulent reissuance.
C. Be defaced and sent to the Secretary of the Department of Finance.
D. Be defaced to prevent reissuance and attached to their corresponding stubs.

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