Auditing Equity: The Why and How Guide

Auditing equity is usually quite easy--until it's not

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.

how to audit equity

Auditing Equity — An Overview

In this post, we will cover the following:

  • Primary equity assertions
  • Equity walkthroughs
  • 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 various potential equity accounts such as:

  • 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. 

Then, the equity accounts used will depend upon what the entity does. Examples include:

  • Has the company purchased treasury stock?
  • Does a commercial entity have unrealized gains or losses on available-for-sale securities?
  • Does a nonprofit organization have 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.

The primary relevant equity assertions (often) are:

  • 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. 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.

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.

Walkthrough Questions and Actions

As you perform your equity walkthrough ask or perform the following:

  • What types of equity does the entity have?
  • 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.
  • Does the company have classes of stock? What are the rights of each?
  • 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 perform your 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 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.

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

The primary risks for equity are:

  1. Equity is intentionally overstated
  2. Misclassified equity 

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
  • A summary of equity activity (beginning balances plus new equity less equity distributions and ending balance)

In Summary

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.

SSARS 21: What Have We Learned?

SSARS 21 offers interesting alternatives for compilations and preparation of financial statements

SSARS 21 has been in existence since October 2014. What have we learned about this standard? 

(SSARS 22 and SSARS 23 were subsequently added, but most of the SSARS 21 guidance remains as originally issued.)

SSARS 21: What Have We Learned

Preparation of Financial Statements or Compilation Reports

Before SSARS 21, if an accountant created financial statements and submitted them to a client, he had to issue a compilation report. Now, using the Preparation of Financial Statements part of SSARS 21 (AR-C 70), an accountant can create and provide financial statements without a compilation report. Such financial statements can be provided to third parties such as banks–again with no compilation report. So, how have accountants responded to the option to provide financial statements to clients without a compilation report?

It has been my observation that many accountants continue to perform compilation engagements (rather than use the preparation option). Why? I think we are creatures of habit. We have issued compilation reports for so long that we’re comfortable doing so–and we continue to do the same. Also, as we’ll see in a minute, performing a compilation doesn’t take much additional time.

Some accountants, however, are using AR-C 70. They are issuing financial statements without a compilation report and stating that “no assurance is provided” on each page–or, as the standard allows, placing a disclaimer page in front of the financial statements.

Who Should Use the Preparation Standard?

So, who uses AR-C 70? Accountants with limited time. 

Suppose, for example, that a client wants a balance sheet and nothing else. You can create the balance sheet in Excel and put “no assurance is provided” at the bottom of the page. And you’re done–with the exception of obtaining a signed engagement letter. (Accountants should document any significant consultations or professional judgments, but usually, there are none.)

Can I Avoid the Engagement Letter?

You may be thinking, “Charles, I’m not sure I’m saving much time if I have to create an engagement letter.  Getting a signed engagement letter might even take more time than preparing the balance sheet.” Yes, that is true. So, is there a situation where the engagement letter is not required? Yes, sometimes.

Financial Statements as a Byproduct

You can provide the balance sheet to a client without obtaining an engagement letter if the statement preparation is a byproduct of another service (as long as you have not been engaged to prepare the financial statement). For example, if you’re preparing a tax return and create the balance sheet as a byproduct of the tax service, you are not required to obtain a SSARS engagement letter? Why? Because you have not been engaged to prepare the financial statement. The trigger for AR-C 70 is whether you have been engaged to prepare financial statements. 

QuickBooks Bookkeeping

The same is true if you provide bookkeeping services using QuickBooks in the Cloud. If you have not been engaged to prepare financial statements and the online software allows you to print the financial statements, you are not in the soup. That is, you are not following AR-C 70–because you have not been engaged to prepare financial statements. If your client asks you to perform bookkeeping service in a cloud-based accounting package (such as QuickBooks) and to prepare financial statements, you are engaged. Then you must follow AR-C 70 and obtain an engagement letter–and follow the other requirements of the standard.

Regardless, we need to be clear about the intended service.

Compilation Engagements

In most compilations, the accountant prepares the financial statements and performs the compilation engagement. Notice these are two different services: (1) preparing the financial statements and (2) performing the compilation. It is possible for your client to create the financial statement and for you (the accountant) to perform the compilation, though this is rare. If you do both, the preparation of financial statements is not performed using AR-C 70. So what standard should you follow for the preparation of the financial statements. There is none. You are just performing a nonattest service. Then you’ll perform the compilation engagement using AR-C 80.

So, the question at this point is whether you should prepare financial statements using AR-C 70 or create the financial statements and perform a compilation using AR-C 80. (Technically, the choice is the clients, but you are explaining the differences to them.)

Additional Time for Compilations

How much extra time does it take to perform a compilation engagement after the financial statements are created? Not much. You are only placing a compilation report on your letterhead (rather than stating that “no assurance is provided” on each page or providing a disclaimer that precedes the financial statements). 

What other procedures are required for a compilation (versus providing the financial statements under AR-C 70)? You are reading the financial statements to see if they are appropriate. And since you just created the statements, that shouldn’t take much time. 

Regardless, both AR-C 70 and AR-C 80 require signed engagement letters. So if you’ve been engaged to prepare financial statements or perform a compilation, there is no getting around the requirement for an engagement letter.

Is a Preparation or a Compilation Service Best?

So which is better? Using AR-C 70 (Preparation of Financial Statements) or AR-C 80 (Compilation Engagements)? It depends. 

Some banks desire a compilation report, so in that case, of course, you are going to–at the request of the client–perform a compilation engagement.

Also, some CPAs feel safer issuing a compilation report that spells out (in greater detail than a preparation disclaimer) what is done and what is not done. We don’t know yet whether a preparation service creates greater legal exposure than a compilation. But we will with time. After a few years of using SSARS 21, I think our insurance companies will tell us whether one service creates more exposure than another. So far, I have not seen any such studies. Why? SSARS 21 has been in use only a couple of years.

Another factor to consider is peer review. The AICPA standards do not require a peer review if you only provide financial statements using AR-C 70. But check with your state board of accountancy; some states require peer review, regardless.

For the most efficient way to issue financial statements, click here.

SSARS 21 Book

You can purchase my five-star rated SSARS 21 book on Amazon. Click here. The book provides sample financial statements using AR-C 70 and AR-C 80.

(Note: SSARS 23 has changed the supplementary information language; see it here. The book focuses on preparation of financial statements and compilation engagements. It does not cover review engagements.)

How CPAs Can Use the Evernote App on Their iPhones

Here is a series of videos showing how you can use the Evernote app on your cell phone

How can CPAs use the Evernote app on their iPhones? Evernote is one of the most valuable tools that an accountant or CPA can use. You just have to know what it can do and how to use it–and it’s not that hard (I promise).

Here’s an Evernote short-course. See the four videos below for demonstrations of how the iPhone Evernote app will work for you.

Using iPhone Evernote app

1. An Evernote Overview

This video provides an overview of the Evernote app on an iPhone. You’ll see how easy it is to create and search notes.

For more information, see my post Evernote for CPAs. This post provides a printable summary of how you can create and use notes.

2. How to Add a New Note

This video shows you how to add a new note to your Evernote library.

3. How to Add Audio and Photograph File to Evernote

This video demonstrates how to add audio files or photographs to your Evernote library. You can start a new file in seconds. Click here to see how.

For additional tips regarding how to add new notes, see Seven Ways to Feed Evernote.

4. Using the Search Bar

After you’ve used Evernote for a while, you may have several hundred files. Then you may find it more challenging to find the needle in the haystack. But Evernote provides a powerful search bar that enables you to find what you need.

Here are additional Tips on Searching Your Evernote Account.

You can download your Evernote iPhone app here