AUDIT OF EQUITY

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.

Auditing Equity — An Overview

In this post, we will cover the following:

✓ Primary equity assertions

✓ Equity walkthroughs
✓ Equity-related fraud and errors
✓ Directional risk for equity
✓ Primary risks for equity
✓ Common equity control deficiencies
✓ Risk of material misstatement for equity
✓ Substantive procedures for equity
✓ Common equity work papers

Primary Equity Assertions

Before we look at assertions, consider that equity comes in a variety of forms including:
• Common stock
• Paid in capital
• Preferred stock
• Treasury stock
• Accumulated other comprehensive income
• Noncontrolling interests
• Members’ equity (for an LLC)
• Net assets (for a nonprofit)
• Net position (for a government)

❖ Certain types of equity accounts are used for certain types of entities. For example, you’ll find:
a. common stock in an incorporated business;
b. net assets in nonprofits; and
c. members’ equity in a limited liability corporation (LLC).

❖ The equity accounts used depend upon the type of entity and what occurs within and outside the organization.
Examples include:
• Has an incorporated company purchased treasury stock?
• Does a commercial entity have unrealized gains or losses on available-for-sale securities?
• Does a nonprofit organization have donor-restricted contributions?
• Does a government have restricted net position?

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:
• Existence and occurrence
• Rights and obligations
• Classification

❖ 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.

Equity 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:

✓ What types of equity does the entity have? What are the rights of each class?
✓ How many shares are authorized? How many shares have been issued?
✓ Does the company have any convertible debt?
✓ Has the company declared and paid dividends?
✓ Are there any state laws restricting distributions?
✓ Does the company have accumulated other comprehensive income?
✓ Inspect ownership documents such as stock certificates.
✓ Read the minutes to determine if any new equity has been issued.
✓ Is the entity attempting to raise additional capital?
✓ Has the company sold any additional equity ownership?
✓ Is there a noncontrolling interest in the company?
✓ Does the company have stock compensation plan?
✓ For a nonprofit, are there any restricted donations?
✓ For a government, is the net position restricted?
✓ For a limited liability corporation, are there differing classes of ownership?

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.

Equity-Related Fraud and Errors

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?

Directional Risk for Equity

The directional risk for equity is that it is overstated (companies desire strong equity positions). So, audit for
existence.
Primary Risks for Equity
Primary risks for equity include:
1. Equity is intentionally overstated (fraud)
2. Misclassified equity (error)

As you think about these risks, consider the control deficiencies that allow equity misstatements.

Common Equity Control Deficiencies

In smaller entities, it is common to have the following control deficiencies:
1. One person performs two or more of the following:
✓ Approves the sale of equity interests,
✓ Enters the new equity in the accounting system,
✓ Deposits funds from the sale of the equity instruments
2. Accounting personnel lack knowledge regarding equity transactions

Another key to auditing equity is understanding the risks of material misstatement.

Risk of Material Misstatement for Equity

❖ In auditing equity, the assertions that concern me the most are existence, classification, and rights. So
the risk of material misstatement for these assertions is usually moderate to high.

❖ The 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.

Substantive Procedures for Equity

Normal substantive tests for auditing equity include:
1. Summarizing and reviewing all equity transactions
2. Reviewing all equity accounts for proper classification
3. Agreeing all beginning of period balances to the prior period’s ending balances
4. Reviewing equity disclosures for compliance with the requirements of the reporting framework
(e.g., IFRS)
In light of risk assessment and substantive procedures, what equity work papers are normally included in audit
files?

Common Equity Work Papers

The equity work papers normally include the following:
1. An understanding of equity-related internal controls
2. Documentation of any equity internal control deficiencies
3. Risk assessment of equity at the assertion level
4. Equity audit program
5. A copy of (sample) equity instruments
6. Minutes reflecting the approval of new equity or the retirement of existing equity
7. A summary of equity activity (beginning balances plus new equity less equity distributions and ending
balance)

Ref: https://cpahalltalk.com/auditing-
equity/#:~:text=Auditing%20equity%20is%20usually%20one,year%20profits%20and%20owner%20distributions.
TEST YOUR SELF

1. In an examination of shareholder’s 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.

2. In audit of a medium-sized manufacturing concern, which one of the following area can be expected to require the
least amount of audit time?
a. Owner’s equity b. Assets c. Revenue d. Liabilities

3. 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.

4. When a client company does not maintain its own stock records, the auditor should obtain written confirmation from
the transfer agent and registrar concerning
a. Restrictions on the payment of dividends.
b. The number of shares issued and outstanding.
c. Guarantees of preferred stock liquidation value.
d. The number of shares subject to agreement to repurchase

5. The auditor is concerned with establishing that dividends are paid to client corporation shareholders owning stock
as of the
a. Issue date c. Record date
b. Declaration date d. Payment date

6. An audit program for the retained earnings account should include a step that requires verification of the
a. Fair value used to charge retained earnings to account for a two-for-one-stock split.
b. Approval of the adjustment to the beginning balance as a result of a write-down of an account receivable.
c. Authorization for both cash and stock dividends.
d. Gain or loss resulting from disposition of treasury shares.

7. Where no independent stock transfer agents are employed and the corporation issues its own stocks and maintains
stock records, cancelled stock certificates should
a. Be defaced to prevent issuance and attached to their corresponding stubs.
b. Not be defaced, but segregated from other stock certificates and retained in a cancelled certificates file.
c. Be destroyed to prevent fraudulent reissuance.
d. Be defaced and sent to the secretary of finance.

8. 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 wriiten 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.

9. Which of the following statements id 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 the 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. The retained earnings account would be debited for the following transactions, except
a. A two-for-one stock split.
b. A 5% stock dividend.
c. A 70% stock dividend.
d. An appropriation of retained earnings for possible decline in value of investments.

11. Which of the following statements is correct?

a. An independent auditor should determine that the company officers authorized the issuance of the stock dividend.
b. An independent auditor should determine that the stock dividend was properly recorded by a memorandum entry
only.
c. An independent auditor should determine that the stock dividend was recorded by transferring appropriate
amounts from the retained earnings to share capital and share premium.
d. When a company declared and paid stock dividend, an independent auditor should determine that shareholders
received their additional shares by confirming year-end holdings with them.

ANSWERS: A, A, D, B, C, C, A, B, A, A, C

Believe in yourself!
Have faith in your abilities!
Without a humble but reasonable confidence in your own powers
you cannot be successful or happy.
– Norman Vincent Peale (Author)