SUBSTANTIVE TEST

OF
SHAREHOLDERS’
EQUITY
Chapter 31
TOPIC OVERVIEW:

This chapter discusses the audit of shareholder’s equity, its objectives and
procedures as well as the management assertions relating to equity.
LEARNING OBJECTIVES
After studying this chapter you should be able to:

1. Identify the audit objectives for shareholders’ equity items and related
accounts.
2. Explain the primary substantive audit procedures for shareholders’ equity
items and related accounts.
3. Identify assertions addressed by audit procedures for shareholders’ equity
items and related accounts.
4. Differentiate audit of partnership, sole proprietorship, corporation and
other types of entity.
 INTRODUCTION

The financing cycle involves the activities of the company that are designed to
obtain capital funds (issuance and repayment of debt and equity, and payment of
interest and dividends).

Owners’ equity or shareholders’ equity may include preferred and common

shares, contributed surplus arising from the issuance of common and preferred
shares, and retained earnings from which dividends are paid.

Substantive Tests Focus: Changes in owners’ equity account.

 LEGAL CONSIDERATIONS

When auditing equity accounts of corporation, consideration should be given to

applicable laws to the entity being audited ( e.g., Corporation Code and Revised
Corporation Code of the Philippines and other applicable special laws).

The auditor also should review the articles of incorporation, the bylaws, and any
contracts and agreements.
Since auditors may not have the training and expertise needed fully to
understand the legal implications of the terms of such laws, regulations or
agreements, the auditor may request the entity’s legal counsel to assist in such
matters or may consult with any legal counsel employed by the auditor.

LEGAL CONSIDERATIONS
 AUDIT OBJECTIVES
When auditing the components of shareholder’s equity, the principal
objective for the substantive test is to determine the following:

Assertion Category Account Balances Audit Objectives

Existence All the equity accounts or interest on the

SFP exist.
Completeness All equity interest that should have been
recorded and included in the SFP.
Valuation and Allocation The equity accounts are stated on the
statement of financial position at the
appropriate amounts.
 Assertion Category Account Balances Audit Objectives

Presentation and Disclosure Equity accounts are properly classified,

described, and disclosed in the financial
statements, including notes in accordance
with the applicable financial reporting
framework.

AUDIT OBJECTIVES
 AUDIT OF SHAREHOLDERS’
EQUITY

After obtaining an understanding internal controls, they will often perform only
limited tests of controls. It is usually more efficient to assess control risk at a high
level and perform detailed substantive tests of transactions.

The auditors’ primary substantive procedures for equity transactions will

typically include the following:
1. Obtain and verify equity reconciliation schedule;
2. Obtain and review minutes of meeting, articles of incorporation, by-laws and
general information sheet (GIS);
3. Review the appropriateness of accounting for share-based payment
transactions;
4. Analyze retained earnings and review appropriateness of dividends; and
5. Review presentation and disclosure of equity items.

AUDIT OF SHAREHOLDERS’
EQUITY
 OBTAIN AND VERIFY EQUITY
RECONCILIATION SCHEDULE

In examining the appropriateness and proper authorization of equity

transactions, the auditor performs the following:

1. Obtain an equity reconciliation schedule (this might be similar to those

presented in the statement of changes in equity);
2. Agree to general ledger accounts;
3. Test movements from prior year end to current year end to verify proper
accounting for changes in equity;
4. Determine that changes in equity have been authorized by the Board of
Directors and appropriate officers; and
5. Determine completeness and compliance with applicable laws and regulations
including taxation issues.

OBTAIN AND VERIFY EQUITY

RECONCILIATION SCHEDULE
Treasury shares

For treasury transactions during the year, the auditors should:

1. Inspect the securities on hand and examine if it is under the name of the
corporation;
2. Determine whether the reacquisition or reissuance was authorized by the
BOD;
3. Determine the legal requirement on restriction of retained earnings acquiring
treasury shares; and

OBTAIN AND VERIFY EQUITY

RECONCILIATION SCHEDULE
4. Determine whether the price paid or received was in accordance with price
specified by the BOD. For non-cash consideration, determine whether it was
properly accounted for under applicable PFRS or not.

Other Comprehensive Income (OCI)

For movements of OCI components, the auditor normally perform the following:
1. Unrealized gain or loss on financial asset at FVTOCI- this can be verified in
conjunction with the audit of the related investment by checking the change
in fair value of the investment;

OBTAIN AND VERIFY EQUITY

RECONCILIATION SCHEDULE
2. Effective portion of cash flow hedge- this can be verified in conjunction with
the audit of related derivative instrument;
3. Recognition or change in revaluation surplus- this can be verified in
conjunction with audit of related PPE accounts. Note that piecemeal realization of
revaluation surplus should be traced to the retained earnings account;
4. Translation gain or loss on foreign operation- the auditor normally verifies this
by inquiring to management the date of transactions affecting the balance
reported in the financial statement, obtaining the appropriate rate (e.g., closing
rate, historical rate, etc.) to be used; performing independent translation and
comparing it with the balance reported; and

OBTAIN AND VERIFY EQUITY

RECONCILIATION SCHEDULE
5. Actuarial gain or loss employee benefits - this can be verified in conjunction
with the audit of the related plan asset and the benefit obligation. Note that this
area is considered special in nature and the auditor may need the assistance of an
expert.

OBTAIN AND VERIFY EQUITY

RECONCILIATION SCHEDULE
 REVIEW MINUTES OF MEETINGS, ARTICLES OF
INCORPORATION, BY—LAWS AND GENERAL
INFORMATION SHEET (GIS)

When verifying minutes of the meetings, articles of incorporation, by-laws, and

general information sheet (GIS), the auditor should consider whether the
company maintains the shareholder records or the entity employs independent
registrar and stock transfer agent since this will affect the audit procedures to
be performed.
 INDEPENDENT REGISTAR AND STOCK
TRANSFER AGENT

Transfer agent- responsible for issuing and cancelling the entity's share or bond
certificates and for maintaining the record of share transfers.

Registrar- maintains the shareholders' register showing the names and addresses
of registered shareholders at any time.

Often the duties of both roles are assigned to the same party.
When these duties are performed by independent registrar and stock transfer
agent, the auditor ordinarily performs the following audit procedures:

1. Confirm the balance at year end and transactions during the year to the
independent registrar and agent;
2. Trace replies from the confirmation request to the corporate records; and
3. Agree the general ledger controlling accounts to the amount of stock issued as
reported by the independent registrar and stock transfer agent.

INDEPENDENT REGISTAR AND STOCK

TRANSFER AGENT
When sending confirmation request, it should be written under the client's
letterhead and be mailed by the auditors. Replies should also be sent directly to
the auditors to prevent manipulation by the client. The contents of the
confirmation request ordinarily include the following information:

1. The total number of each class of shares issued and outstanding reporting
date;
2. Details of any changes in this amount during the year;
3. The number of shares outstanding at the record date if dividends have been
declared;

INDEPENDENT REGISTAR AND STOCK

TRANSFER AGENT
4. The amount of any subscriptions receivable in respect of shares subscribed but
not issued;
5. Whether any shares are being reserved for future issuance (e.g. for share
options, convertible securities);
6. The amount of any unclaimed dividends; and
7. A list of principal shareholders for each class of share.

INDEPENDENT REGISTAR AND STOCK

TRANSFER AGENT
 WHEN THE ENTITY MAINTAINS THE
SHAREHOLDER RECORDS

When the entity acts as its own transfer agent and registrar, the auditor must
adopt alternative procedures to obtain evidence that is not available by direct
confirmation with outside parties. The auditor ordinarily performs the following
audit procedures:

1. Account for the share certificate numbers, both for unissued and cancelled
share certificates;
2. Check the details of share transactions during the year to minutes of the
directors' meetings to determine that the transactions have been properly
authorized;
3. Reconcile the stock ledger from the supporting documentations; and
4. Reconcile the shareholders ledger and share certificate book with the general
ledger.

WHEN THE ENTITY MAINTAINS THE

SHAREHOLDER RECORDS
 REVIEW APPROPRIATENESS OF ACCOUNTING
FOR SHARE-BASED COMPENSATION

Many corporations grant share options or other sim instruments to officers and
employees through incentive type compensation plans. When understanding the
client its environment including its internal control, the auditor must obtain an
overall understanding of how management uses share-based payments to
compensate employees, both currently and historically, and the process that is
undertaken to manage and administer awards-including the approval process.
Regardless of the assessment of the risk involving the process of granting share
based compensation, the auditor ordinarily performs the following audit
procedures:

1. Review minutes of meetings of the BOD or the remuneration committee to

determine if the grant dates designated for share options or other share-based
payments (particularly significant stock option grants to key executives) in the
entity's accounting records correspond to the actual date the appropriate
committee met and approved the respective grants;

REVIEW APPROPRIATENESS OF ACCOUNTING

FOR SHARE-BASED COMPENSATION
2. Inquire management, such as legal counsel, stock plan administrator and
human resource executives, regarding the completeness and accuracy of stock
option records, including the designated grant dates; and

3. Review the amounts provided as compensation expense if it is measured at fair

value and the amount is reasonable.

REVIEW APPROPRIATENESS OF ACCOUNTING

FOR SHARE-BASED COMPENSATION
 ANALYZE RETAINED EARNINGS AND REVIEW
APPROPRIATENESS OF DIVIDENDS

Transactions in retained earnings normally consist of net income or loss,

dividends, appropriations in retained earnings and quasi-reorganizations, but
they may also include adjustments to opening retained earnings arising from
changes in accounting policy and prior period error corrections.
Audit procedures performed when auditing retained earnings may include the
following:

1. Check the opening retained earnings if they include prior year's adjusting
journal entries. For continuing auditor, opening balance of retained earnings
may be verified from the prior year working paper and ending balance of the
retained earnings presented on the prior year audited financial statements;

ANALYZE RETAINED EARNINGS AND REVIEW

APPROPRIATENESS OF DIVIDENDS
2. Check for proper authorization by appropriate official or the board of directors
for any movements in retained earnings, including dividend declaration other
than closing of net income or loss and any prior period adjusting entries to
retained earnings;
3. Check the propriety of entries related to transactions in retained earnings; and
4. Check for proper disclosure of restricted retained earnings.

ANALYZE RETAINED EARNINGS AND REVIEW

APPROPRIATENESS OF DIVIDENDS
When auditing dividends, the auditor should ensure whether the dividend has
been:

1. Properly declared in accordance with the requirements of the Revised

Corporation Code of the Philippines, for example, restricted retained earnings
should not be declared as dividends;

2. Properly authorized in accordance with the entity's procedures; and

ANALYZE RETAINED EARNINGS AND REVIEW

APPROPRIATENESS OF DIVIDENDS
3. Properly accounted for, in accordance with the requirements of the applicable
PFRSs, for example:
a. A debit to retained earnings account should be made at the date of declaration
b. Amount debited to retained earnings depends on the type of dividends (e.g.,
non-cash/property dividend, small and large share dividend, scrip dividends, etc.)
c. Dividend declared on redeemable preference share should be recorded as
finance cost, not as a deduction of retained earnings.
4. Complied with the requirements of applicable tax law and regulation (e.g.,
withholding tax- final or creditable)

ANALYZE RETAINED EARNINGS AND REVIEW

APPROPRIATENESS OF DIVIDENDS
 REVIEW FINANCIAL STATEMENT PRESENTATION AND
DISCLOSURE OF SHAREHOLDERS' EQUITY ITEMS

The auditor should check at a minimum whether disclosure includes the following
information: title of each issue, par or stated value, dividend rate, dividend on
preference shares, conversion and call provisions, number of shares authorized,
issued and in treasury shares, dividend in arrears of cumulative preference shares
and unissued shares reserved for share options or for conversions.
Redeemable Preference Share

When an entity has issued new instruments during the year, particularly if such
instruments have complex features, the auditor should consider the nature of the
instruments and examine management's assumptions in determining the
classification. A common example of instruments with complex feature is redeemable
preference shares. This instrument should be reported as a financial liability, rather
than as part of equity based on the substance of the instrument rather than its legal
form. In this case, the auditor should ensure that this item should not be part of
shareholders equity.

REVIEW FINANCIAL STATEMENT PRESENTATION AND

DISCLOSURE OF SHAREHOLDERS' EQUITY ITEMS
 APPENDIX
AUDIT OF PARTNERSHIPS, SOLE
PROPRIETORSHIPS AND OTHER TYPES OF AN
ENTITY

Although most audits conducted are on corporations, smaller business may

arrange for an independent audit for some business purpose, for example, in
obtaining a bank loan in which the bank requires audited financial statements
(AFS).
 PROCEDURES FOR THE AUDIT OF
PARTNERS' ACCOUNT

When auditing a partnership, the auditor should obtain basic understanding of

the provisions of the Civil Code and of the partnership agreement, which is
documented in the Articles of Partnership. Information in that document which
may be useful includes:

1. The basis for sharing profits (or loss, if any);

2. The basis for making drawings;
3. The levels at which capital must be maintained;
4. The basis for making loans to partners;
5. The conditions of withdrawal from the partnership; and
6. The conditions for making changes in the partnership agreement.

If a written agreement does not exist, the auditor may consider obtaining
representation letter from the partners to confirm their accounts to obtain
satisfaction that the partnership has run its affairs in accordance with the
understanding among the partners.

PROCEDURES FOR THE AUDIT OF

PARTNERS' ACCOUNT
 PROCEDURES FOR THE AUDIT OF SOLE
PROPRIETORSHIPS

When auditing the financial statements of a proprietorship, the auditor normally

will not find formal documents establishing the basis for changes in the capital
assigned to the business. Under such circumstances, the auditor should ensure
that:

1. Changes in the capital accounts are approved by the proprietor

2. Personal transactions of the proprietor should not be included in that of the
proprietorship in accordance with accounting entity assumption, and
3. The nature of the transactions is appropriately disclosed in the financial
statements.
 PROCEDURES FOR THE AUDIT OF OTHER TYPES
OF ENTITY

Other types of entity, for example, trusts, mutual societies, or entities

incorporated under specific statute, will have equity accounts that are unique to
that type of entity. When auditing these entities, the auditor should obtain an
understanding of the nature of the equity accounts and determine that the equity
transactions have been made in accordance with the relevant legislation,
document of incorporation, or applicable financial reporting framework.
 SUMMARY OF AUDIT PROCEDURES CLASSIFIED PER
ASSERTION
Assertion Category Primary audit procedures
Existence  Obtain and verify equity reconciliation schedule.
 Obtain and review board of director’s (BOD)
minutes of meetings, shareholders meeting,
committee meetings and articles of incorporation.
 Review appropriateness of accounting for share-
based compensation
 Analyze retained earnings and review
appropriateness of dividends.
 Assertion Category Primary audit procedures
Completeness  Obtain and verify equity reconciliation schedule.
 Obtain and review board of director’s (BOD)
minutes of meetings, shareholders meeting,
committee meetings and articles of incorporation.
Valuation and Allocation  Obtain and verify equity reconciliation schedule.
 Review appropriateness of accounting for share-
based compensation
 Analyze retained earnings and review
appropriateness of dividends.

SUMMARY OF AUDIT PROCEDURES CLASSIFIED

PER ASSERTION
 Assertion Category
Rights and Obligations
Presentation and Disclosure
SUMMARY OF AUDIT PROCEDURES CLASSIFIED
PER ASSERTION
Primary audit procedures
 Review appropriateness of accounting for share-
based compensation
 Obtain and review board of director’s (BOD)
minutes of meetings, shareholders meeting,
committee meetings and articles of incorporation.
 Analyze retained earnings and review
appropriateness of dividends.
 Review financial statement presentation and
disclosure of shareholders’ equity items.
 EXHIBIT 2: SAMPLE AUDIT PROGRAM- SHAREHOLDERS’
EQUITY (SHARE CAPITAL & DIVIDENDS)
Audit objective/ Audit Procedure Comments
Possible
misstatement
Share Capital
Existence & Verify share transactions to minutes of
Completeness Board of Directors’ meetings or
shareholders’ meetings. Share cert no.
14344 should be
Trace the transfer of shares to the cancelled
shareholder register
 Audit objective/ Audit Procedure Comments
Possible
misstatement
Share Capital
Existence & Reconcile the total number of shares
Completeness outstanding to the general ledger
Share cert no.
For disposals of shares, ensure that the 14344 should be
relevant share certificates are cancelled. cancelled

Account for & inspect any unissued share

certificates in the share certificate book.
 Audit objective/ Audit Procedure Comments
Possible
misstatement
Share Capital
Valuation Ensure that the value of the shares issued
is correctly taken up in the financial
statements. No issue of new
shares
Trace the proceeds from the issue of new
shares to supporting documents (e.g., cash
receipt documents).
 Audit objective/ Audit Procedure Comments
Possible
misstatement
Share Capital
Disclosure Ensure proper disclosure in the financial
statements, as follows:
(a) No. of shares authorized. No exceptions
(b) No. of shares issued & fully paid. noted.
(c) Par value per share.
(d) No. of shares outstanding at the
beginning & the end of the period.
 Audit objective/ Audit Procedure Comments
Possible
misstatement
Dividends
Existence and Verify the amount disbursed with the
valuation amount authorized by the Board of
Directors No exceptions
noted.
Recompute the dividend by multiplying
the number of shares outstanding on the
record date by the amount/rate of dividend
approved by the BOD. This amount
should agree to the dividend amount in the
financial statements.