Auditing equity is easy, until it’s not.
Auditing equity is usually one of the easiest parts of an audit. For some equity accounts, you agree the year-end balances to the prior year ending balance, and you’re done. For instance paid-in-capital seldom changes. Often, the only changes in equity are from current year profits and owner distributions. And testing those equity additions and reductions in equity takes only minutes.
Nevertheless, auditing equity can be challenging, especially for businesses that desire to attract investors. Such companies offer complicated equity instruments. Why? The desire to attract cash without giving away (too much) power. And this balancing act can lead to complex equity instruments.
Regardless of whether a company’s equity is easy to audit or not, below I show you how to focus on important equity issues.
In this post, we will cover the following:
Before we look at assertions, consider that equity comes in a variety of forms including:
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.
The equity accounts used depend upon the type of entity and what occurs within and outside the organization. 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.
Primary relevant equity assertions include:
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. In other words, the balance is not fraudulently 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 convertible stock (is it debt or equity?). Another example of a classification issue is noncontrolling interests (how much of the profits go to this account?).
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 ask the above questions, consider examining equity-related information such as stock certificates, receipts from new equity issuances, general ledger accounts, related journal entries, minutes, and stock compensation plan documents. Don’t just ask questions. Observe equity controls (see below) and inspect sample documents.
As you perform 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 happens, it’s usually a false equity presentation. Why? Inflating equity makes the organization appear healthier than it really is.
Additionally, mistakes lead to errors in equity accounting. Such mistakes might occur if the entity sells complex equity instruments.
So, what is the greater risk for equity? An overstatement or an understatement?
The directional risk for equity is that it is overstated (companies desire strong equity positions). So, audit for existence.
Primary risks for equity include:
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, we’ve 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.
Now that we’ve reviewed the audit of transaction areas, it's time to shift gears. Next we'll look at how to wrap up the audit.
This post concerning how to audit equity is one of several articles in my audit series: The Why and How of Auditing.
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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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