Audit of SHE Concepts

NOTES FOR AUDIT IN SHE
 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.
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
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:
 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:
 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
 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, 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.
Substantive Procedures for Equity
My 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., GAAP)
In light of my risk assessment and substantive procedures, what equity work papers do I
normally include in my audit files?
Common Equity Work Papers
My equity work papers normally include the following:
 An understanding of equity-related internal controls
 Documentation of any equity internal control deficiencies
 Risk assessment of equity at the assertion level
 Equity audit program
 A copy of (sample) equity instruments
 Minutes reflecting the approval of new equity or the retirement of existing equity
 A summary of equity activity (beginning balances plus new equity less equity
distributions and ending balance)
 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.
 Stockholders’ equity represents the claim that the corporation’s shareholders have to the
company’s net assets. As an auditor you have to account for net assets. Stockholders’
equity has three common components: paid-in capital, treasury stock, and retained
earnings.
 Paid-in capital: Paid-in capital represents money that shareholders invest in a business.

There are some subcategories:
o Common and preferred stock: Common and preferred stock show ownership in
a corporation. What’s the difference between the two? As the names imply,
preferred stock represents a higher rung on the ownership ladder than common
stock. Common stock represents residual ownership, which means that owners of
common stock have a claim on any remaining net assets only after preferred
stockholders’ claims are paid. Because of this characteristic of common stock,
preferred stock shows traits of both debt and equity.
o Liquidation: 1st: Paid all the creditors. 2nd: Preferred stockholders get back the
money they’ve invested in the company, plus any cash dividends owed to them.
3rd: Any funds left over are then distributed to the common stockholders.
o Common stockholders have voting rights, which preferred stockholders usually
don’t have.
o Additional paid-in capital: Additional paid-in capital is the excess of what
shareholders pay to buy stock over the stock’s par value. Par value is what’s
printed on the face of the stock certificate. Additional paid-in capital is shown on
the balance sheet as a component of owner’s equity.
 Treasury stock: Treasury stock must be recorded on the balance sheet as a contra
stockholders’ equity account. Contra equity account has a debit balance.
NOTES: It is not appropriate to record any sort of gain or loss on treasury stock
transactions. Per generally accepted accounting principles (GAAP), this is a balance sheet
transaction that affects stockholders’ equity and cash.
 Retained earnings: Retained earnings show a company’s total net income or loss from
the first day it is in business to the date on the balance sheet you’re auditing.
NOTES: Items other than net income or loss can affect retained earnings. Paying
dividends and correcting prior period errors are two of the most common events that
increase or decrease retained earnings.
DEFINITION OF TERMS:
Outstanding Shares
 The number of outstanding shares is an integral part of shareholders' equity.

 It is the amount of company stock that has been sold to investors and not repurchased by
the company.
 It represents the total amount of stock the company has issued to public investors,
company officers, and company insiders, including restricted shares.
 It includes the par value of common stock, as well as the par value of any preferred
shares the company has sold.
 Outstanding shares are also an important component of other calculations, such as the
calculations for market capitalization and earnings per share (EPS).
Additional Paid-in Capital
 Amount of money paid for shares of stock above the stated par value, known
as additional paid-in capital (APIC).
 This figure is derived from the difference between the par value of common and preferred
stock and the price each has sold for, as well as shares that were newly sold.
 APIC only occurs when an investor buys shares directly from a company.
 It represents the additional amount an investor pays for a company's shares over the face
value of the shares during a company's initial public offering (IPO).
 You can find the APIC figure in the equity section of a company's balance sheet.
Retained Earnings
 When a company retains income instead of paying it out as a dividend to stockholders, a

positive balance in the company’s retained earnings account is created.
 A company often uses retained earnings to pay off debt or reinvest in the business.
 When a corporation buys back some of its issued and outstanding stock, the transaction
affects retained earnings indirectly.
 The cost of treasury stock must be subtracted from retained earnings , reducing amounts
the company can distribute to stockholders as dividends.
 Net income/ Net Loses is directly affect the entity’s retained earnings.
 Net Income increases retained earnings.
 Net Loss decreases retained earnings.
 Dividend payments made during the year to entity’s shareholders would make the
accumulated earnings decrease.
 If the declaration is not made and the board of directors, as well as authority, is not
approved yet, the dividend is not qualified for the deduction.
 When a company repurchases and reissues its stock, it debits the treasury stock contra-
asset account and credits cash for the cost to repurchase the stock. When the company
subsequently reissues the stock, if the reissue price is more than the original stock cost,
the proceeds made from the sale of the reissued stock are credited to the additional
treasury stock account. The company does not increase retained earnings from the
proceeds of the sale by crediting the retained earnings account. (Reissue price greater
than original price)
 When the company buys back and reissues the stock for less than the original cost, the
difference between the two prices is debited to the additional paid-in-capital account
until it reaches a zero balance. The amount remaining after the account reaches zero is
debited to retained earnings. It is only under these circumstances when treasury stock
transactions affect retained earnings. If there were no remaining balance after the
account reached zero, there would be no debit or decrease to retained earnings.
(Reissue price less than original price)
Treasury Stock
 The number of shares that have been repurchased from investors by the company.
 A company will hold its own stock in its treasury for later use.
 It might sell the stock at a later date to raise capital or it might use it to prevent a hostile
takeover.
 Treasury stock is a contra account. DEBIT- normal balance.
 This figure is subtracted from a company's total equity, as it represents a smaller number
of available shares for investors once it is repurchased.
 A company lists its treasury stock as a negative number in the equity section of its
balance sheet.
 Treasury stock can also be referred to as "treasury shares" or "reacquired stock."
 When a corporation buys back some of its issued and outstanding stock, the transaction
affects retained earnings indirectly.
Share Premium
 Difference between the par value of a company’s shares and the total amount a company
received for shares recently issued.
 It is credited for money paid, or promised to be paid, by a shareholder for a share, but
only when they pay more than the cost of a share.
 It is a reserve that cannot be distributed.
 It is usually utilized to pay off equity expenses, which include underwriter fees.
 The account can also be used in the issuance of bonus shares and for costs or expenses
related to this issuance.
 Same as to Additional Paid in Capital (APIC)

Audit of SHE Concepts

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Audit of SHE Concepts

Uploaded by

Copyright:

Available Formats

NOTES FOR AUDIT IN SHE

Auditing Equity — An Overview

In this post, we will cover the following:

 Primary equity assertions

 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

 Accumulated other comprehensive income

 Members’ equity (for an LLC)

 Net assets (for a nonprofit)

 Net position (for a government)

 Has an incorporated company purchased treasury stock?

 Does a commercial entity have unrealized gains or losses on available-for-sale

 Does a nonprofit organization have donor-restricted contributions?

 Does a government have restricted net position?

 Existence and occurrence

 Rights and obligations

 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.

 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?

 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

 Accounting personnel lack knowledge regarding equity transactions.

 An understanding of equity-related internal controls

 Documentation of any equity internal control deficiencies

 Risk assessment of equity at the assertion level

 Equity audit program

 A copy of (sample) equity instruments

 Paid-in capital: Paid-in capital represents money that shareholders invest in a business.

 The number of outstanding shares is an integral part of shareholders' equity.

 When a company retains income instead of paying it out as a dividend to stockholders, a

You might also like