What are the keys to auditing equity correctly? In this post, we’ll answer this question, showing you how to focus on the important equity accounting issues.
In this post, we will cover the following:
Before we look at assertions, consider various potential equity accounts such as:
Certain types of equity accounts are used for certain types of entities. For example, you’ll find common stock in an incorporated business, net assets in nonprofits, and members’ equity in a limited liability corporation.
Then, the equity accounts used will depend upon what the entity does. Examples include:
So, it’s a must–before you determine the relevant assertions–that you understand the accounting for (1) the type of entity and (2) the particular equity-related transactions.
The primary relevant equity assertions (often) are:
When a company reflects equity on its balance sheet, it is asserting that the balance exists and that the equity transactions occurred. For example, if common stock is sold, the balance of the account is based upon the actual sale of stock and the monies received. The balance is not fictitiously or erroneously stated.
Equity instruments also have certain rights and obligations. For example, common stock provides rights to retained earnings. Also, some classes of stock provide voting privileges. Others do not.
Additionally, the classification of equity balances is important. Determining how to present equity is usually easy, but classification issues arise when an entity has equity instruments such as convertible stock. Classification is also relevant when there is a noncontrolling interest.
Keep these assertions in mind as you perform your transaction cycle walkthroughs.
Early in your audit, perform a walkthrough of equity to see if there are any control weaknesses. As you perform this risk assessment procedure, what questions should you ask? What should you observe? What documents should you inspect? Here are a few suggestions.
As you perform your equity walkthrough ask or perform the following:
As you perform your walkthroughs, also consider if there are risks of material misstatement due to fraud or error.
Theft seldom occurs in the sale of stock. If fraud occurs, it’s usually an intentional false equity presentation. Inflating an entity’s equity can make the organization appear healthier than it really is.
Additionally, mistakes can lead to errors in accounting for equity. Such mistakes may occur if the entity sells complex equity instruments. Understanding the rights and obligations of ownership interests is a key to proper accounting.
The directional risk for equity is that it is overstated (companies desire strong equity positions). So, audit for existence.
The primary risks for equity are:
As you think about these risks, consider the control deficiencies that allow equity misstatements.
In smaller entities, it is common to have the following control deficiencies:
Another key to auditing equity is understanding the risks of material misstatement.
In auditing equity, the assertions that concern me the most are existence, classification, and rights. So my risk of material misstatement for these assertions is usually moderate to high.
My response to the higher risk assessments is to perform certain substantive procedures: namely, a review of equity transactions. Why?
A company may desire to overstate its equity. Also, misclassifications occur due to misunderstandings about equity accounting.
Once your risk assessment is complete, you’ll decide what substantive procedures to perform.
My normal substantive tests for auditing equity include:
In light of my risk assessment and substantive procedures, what equity work papers do I normally include in my audit files?
My equity work papers normally include the following:
In summary, today we reviewed the keys to auditing equity. Those keys include risk assessment procedures, determining relevant assertions, performing risk assessments, and developing substantive procedures. The most important issues to address are usually (1) equity accounting (especially when there are more complex types of equity transactions) and (2) the classification of equity.
Look for my next post in The Why and How of Auditing.
If you’ve missed my prior posts in this audit series, click here.
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Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses.He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events.Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
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