AP-12: Audit Program for Equity

Company Balance Sheet Date

The company has the following general ledger accounts that will be classified in the equity caption
of the balance sheet.

General Ledger Number Description or Brief Purpose of the Account

Audit Program for Equity

Company Balance Sheet Date

Audit N/A Workpaper

Objectives Performed Index
Audit Procedures for Consideration by
FINANCIAL STATEMENT ASSERTIONS

E/O Existence or occurrence. V/A Valuation or

allocation.
C Completeness. P/D Presentation
and disclosure.
R/O Rights and obligations.
 AUDIT OBJECTIVES

A. Equity transactions are authorized and recorded correctly

as to account, amount, and period, and the equity section of the
balance sheet is properly described and disclosed in accordance
with accounting standards and legal requirements (assertions E/O,
C, R/O, V/A, and P/D).
IDENTIFICATION CODES

The letters preceding each of the above audit objectives, i.e., A, B,

etc., serve as identification codes. These codes are presented in the
left column labeled “Audit Objectives” when a procedure
accomplishes an objective. If the alpha code appears in a bracket,
e.g., [A], [B], etc., the audit procedure only secondarily
accomplishes the objective. If an asterisk precedes a procedure, it is
a preliminary step or a follow up step that does not accomplish an
objective.

BASIC PROCEDURES

* 1. Inspect the articles of incorporation, bylaws, partnership

agreement, member agreement, etc., and extract matters of audit
interest.
Practical Considerations:

¯ Much of this information may already be available in the prior

year’s workpapers.

¯ Before the auditor starts vouching transactions, it is important

to be aware of all agreements or other documents that affect equity.

* 2. Read the directors’ or partners’ minutes and note equity

transactions authorized.

A 3. Obtain or prepare an analysis of transactions in equity

accounts and perform the following procedures:

a. Determine the number of shares of stock issued and

canceled and compare quantities with the stock certificate book.

b. Determine that the method used to cancel shares is

adequate to prevent reissuance.
 c. Identify the number of shares held in treasury, examine
certificates, and determine that the company’s name is on the
certificates.
Practical Considerations:

¯ These steps should provide the auditor with support for the
number of shares issued and outstanding as disclosed in the
financial statements.

¯ These procedures should not be time-consuming. If a

significant volume of transactions occurs, sampling might be used.
(See Chapter 4.)

¯ It would be efficient to prepare a permanent schedule for

posting of the changes in all capital stock accounts each year.

A 4. Using the analysis of equity accounts, perform the

following procedures:

a. Examine supporting documents for significant transactions

affecting paid-in capital, contributed capital, or treasury stock.
Document the items tested.

b. From a comparison with directors’ minutes, determine that

such transactions have been authorized.

c. Determine that significant entries are accounted for in

accordance with GAAP.

d. Include in the current or permanent workpaper files

abstracts or copies of significant agreements or other documents
examined to evaluate appropriate accounting.
Practical Considerations:

¯ The auditor should consider whether such transactions are in

accordance with the company’s charter, applicable state
regulations, partnership agreement, or other relevant documents.

¯ Normally a small business has very few material equity

transactions. However, if equity transactions are numerous,
vouching all equity transactions is impractical. In that case, the
auditor should vouch only individually significant transactions or a
sample of transactions. (See Chapter 4.)

¯ SAS No. 96, Audit Documentation, requires documentation of

substantive tests of details involving inspection of documents to
include identification of the items tested. The authors believe items
tested can be identified by listing the items; by including a detail
schedule in the workpapers, such as an analysis of equity accounts,
on which the items are identified; or by documenting in the
workpapers the source and selection criteria. For example:

¯¯ For tests of significant items, documentation may describe the

auditor’s scope and the source of the items (for example, all
treasury stock purchases greater than $5,000 from the 20X2 stock
certificate book).

¯¯ For haphazard or random samples, documentation should

include the identifying characteristics of the items (for example, the
specific stock certificate numbers, check numbers, etc.).

¯¯ For systematic samples, documentation may indicate the

source, starting point, and sampling interval (for example, a
selection of dividend checks from the dividend check register for
the period 1/1/X2 to 12/31/X2, starting with check number 2150
and selecting every 100th check thereafter).

SAS No. 96 is effective for audits of financial statements for

periods beginning on or after May 15, 2002, with early application
permitted.

¯ The step explained previously regarding authorization of

transactions in the directors’ minutes provides evidence regarding
completeness of such transactions actually reported in these
accounts.

¯ Accounting for certain equity transactions can be complicated

and small business auditors may not frequently encounter complex
equity transactions. When auditing equity transactions, therefore, it
may be necessary to consult other accounting and auditing
professionals. If consultation is necessary, see Step 19 of the audit
program for other general procedures at AP-1b. In addition, PITF
Practice Alert 2000-01, Accounting for Certain Equity
 Transactions, provides accounting guidance for several forms of
equity transactions that may require scrutiny by the auditor.

A 5. Obtain an analysis of transactions affecting the retained

earnings (or equivalent) account for the period and perform the
following procedures:

a. Test the schedule for clerical accuracy and relate the

beginning and ending balances to the trial balance.

b. Reconcile changes in retained earnings to net income for

the period and other appropriate transactions included.

c. Obtain detailed lists of dividends paid during the year.

Select the largest individual transactions for testing if there is a
significant quantity of dividends paid (normally there will be only a
few payments made as dividends in a small business). Document
the items tested.
Practical Considerations:

¯ The auditor should be aware of unusual transactions posted to

the retained earnings account that might indicate improper
accounting or use of the tax method of accounting. These
transactions should be identified for potential adjustments, if
appropriate.

¯ Small businesses typically have few dividend transactions. If

there are dividends, they can be tested easily without significant
expenditures of time.

¯ It is also important in this step to determine the authorization

of dividend payments or other types of entries that might affect
retained earnings accounts.

¯ If the company is an S corporation, more detailed retained

earnings classifications may be presented. See Guide to
Compilation and Review Engagements and Guide to Preparing
Financial Statements. These companion books can be ordered from
Practitioners Publishing Company at (800) 323-8724.

A 6. Obtain an analysis of transactions affecting other

comprehensive income for the period, relate the beginning and
 ending balances to the trial balance, and review the propriety of
classifications. Agree activity to testing performed in other audit
areas.
Practical Consideration:

¯ For example, changes in accumulated other comprehensive

income related to unrealized gains and losses on available-for-sale
securities should be tested in conjunction with the procedures
performed to audit investments.

A 7. Obtain copies of all company agreements associated with

rights or restrictions on any equity accounts, including any buy-sell
agreements or related options to buy company stock. Perform the
following procedures:

a. Determine the nature of the agreement or provision and its

effect on the company’s equity.

b. Determine the appropriate accounting treatment for any

transactions that might be the result of such agreements.

c. Include in the current or permanent workpaper files

abstracts or copies of significant agreements examined to evaluate
appropriate accounting. Summarize the provisions of the
agreements for disclosure.

d. Determine the amount of equity balances that are restricted

due to provisions in such agreements, and summarize such amounts
for disclosure in the financial statements.
Practical Considerations:

¯ If practical, a schedule for the permanent file should be

prepared presenting a continuing analysis of provisions of such
agreements and their effect on the corporation.

¯ Such agreements also can be identified in other types of

entities such as partnerships and proprietorships.

¯ In unusual cases in which small businesses have stock option

plans, warrants, stock rights, stock redemption, and conversion
privileges, or other types of complicated equity agreements, the
auditor should consider the need for procedures (such as, inquiries
 of management or review of plan documents) to determine the
appropriate accounting and disclosure requirements for these
agreements.

* 8. Consider the need to apply one or more additional

procedures. The decision to apply additional procedures should be
based on a consideration of whether information obtained or
misstatements detected by performing substantive tests or from
other sources during the audit alter your judgment about the need to
obtain a further understanding of control activities, the assessed
level of risk of material misstatements (whether caused by error or
fraud), and on an evaluation of whether the basic procedures have
been sufficient to achieve the audit objectives. Attach audit
program sheets to document additional procedures.
Practical Considerations:

¯ Certain common additional procedures relating to the

following topics are illustrated following this program:

¯¯ Significant number of shareholders.

¯¯ Independent registrar or stock transfer agent.

¯¯ Stock option plan.

¯¯ Additional procedures in response to fraud risk assessment.

¯ Practitioners may refer to PPC’s Guide to Fraud Investigations

for more extensive fraud detection procedures if it is suspected that
the financial statements are materially misstated due to fraud.

* 9. Consider whether procedures performed are adequate to

respond to identified fraud risk factors. If fraud risk factors or other
conditions are identified that require an additional audit response,
consider those risk factors or conditions and the auditor’s response
in connection with the performance of Step 11 in AP-1b.
Practical Consideration:

¯ Specific responses to identified fraud risk factors are addressed

in individual audit programs. In connection with evaluation and
other completion procedures in AP-1b, the auditor considers the
need to perform additional procedures based on the results of
procedures performed in the individual audit programs and the
 cumulative knowledge gained from performing those procedures.

* 10. Consider whether the results of audit procedures indicate

reportable conditions in internal control and, if so, add to the memo
of points for the communication of reportable conditions. (See
section 1504 for examples of reportable conditions, and see CX-18
for a worksheet that can be used to document the points as they are
encountered during the audit.)
CONCLUSION

We have performed procedures sufficient to achieve audit

objectives for equity, and the results of these procedures are
adequately documented in the accompanying workpapers. (If you
are unable to conclude on any objective, prepare a memo
documenting your reason.)

Additional Audit Procedures for Equity

Instructions: Additional procedures will occasionally be necessary on some small
business engagements. The following listing, although not all-inclusive, represents
common additional procedures and their related objectives.

Significant Number of Shareholders

A If the company has more stockholders than normally found in a

small business, apply the following additional procedures to the
stock certificate book:

a. Reconcile the number of shares outstanding with certificate

stubs and certificates representing unissued, retired, or treasury
shares.

b. Examine unissued shares.

 c. Check the numerical sequence of stock certificates.

d. Obtain a representation from the corporate secretary on the

shares issued and outstanding.

Practical Consideration:

¯ These additional procedures are necessary only when the

auditor is concerned about fraud in sales of shares.

Independent Registrar or Stock Transfer Agent

A In the rare case when the small business uses an independent

registrar or stock transfer agent, confirm the following with the
registrar or transfer agent:

a. The number of shares authorized.

b. The number of shares issued and outstanding.

c. Unbilled registrar or transfer agent fees to the date of audit.

Stock Option Plan

A If the company has a stock option plan, perform the following

procedures:

a. Review the provisions of the plan, compare dollar values to

market quotations, and determine any necessary disclosures.

b. For compensatory plans, determine that compensation

expense is computed in accordance with APB Opinion No. 25 or
Statement of Financial Accounting Standards No. 123, as
appropriate, and is recognized over the period the related services
are performed.
Practical Considerations:

¯ Stock option plans can be accounted for under APB Opinion

 No. 25, Accounting for Stock Issued to Employees, or SFAS No.
123, Accounting for Stock-Based Compensation. Companies that
account for stock option plans using APB Opinion No. 25 are
required to disclose pro forma net income (and earnings per share,
if presented) as if the fair value based method of accounting
prescribed by SFAS No. 123 had been followed.

¯ APB Opinion No. 25 can only be used to account for stock

options issued to employees.

¯ If a plan is noncompensatory, compensation expense is not

recorded under either APB Opinion No. 25 or SFAS No. 123.

¯ In practice, most companies account for stock options issued to

employees using APB Opinion No. 25. Under APB Opinion No.
25, companies typically do not record compensation expense
related to fixed stock option and purchase plans because the fair
value of the stock to be issued is seldom higher than the option or
purchase price at the measurement date.

¯ For nonpublic companies, pro forma disclosures as if the fair

value based method of accounting had been followed should be
estimated using the minimum value method prescribed by
Statement of Financial Accounting Standards No. 123. Using the
minimum value method, compensation expense that would have
been recorded is determined using the current stock price, exercise
price, risk-free interest rate, life of the option, and expected future
dividends.

¯ The FASB issued Interpretation No. 44, Accounting for Certain

Transactions Involving Stock Compensation—an interpretation of
APB Opinion No. 25, to provide guidance with regard to the
definition of employee and the scope of APB Opinion No. 25.

Additional Procedures in Response to Fraud Risk Assessment

A If the auditor, based on his or her consideration of fraud risk

factors, decides to modify procedures related to equity transactions,
the following procedures may be performed:

a. Confirm shares held with all stockholders.

 b. Confirm dividends received with all stockholders.

Additional Audit Procedures for Equity

Beginning Balance in Initial Audit
Company Balance Sheet Date

Audit N/A Workpaper

Objectives Performed Index
Audit Procedures for Consideration by

Instructions: Additional procedures will be necessary in an

initial audit. These procedures are applied to opening balances
depending whether you are relying on your review of a
predecessor’s work or placing no reliance on a predecessor’s audit.
(Section 1803 discusses considerations when replacing a
predecessor auditor, including a discussion of what the term
reliance means when used in this program.) These procedures may
be applied in conjunction with the basic procedures applied to the
ending balance. The asterisks preceding the procedures indicate
that they are an intermediate step in achieving audit objectives for
the ending balance.

* 1. If a predecessor’s audit of the prior period’s financial

statements is to be relied on:

a. Scan the predecessor’s workpapers for equity accounts

from the inception of the business or for a reasonable period such
as the last five years; consider whether the predecessor’s
procedures included examination of authorization and supporting
documentation for all significant transactions; compare closing
amounts of the prior period with opening balances.
Practical Consideration:

¯ Supporting documentation for changes in retained earnings

would normally include income statements or tax returns for the
change due to income or loss.

b. Consider whether the scanning of the predecessor’s

 workpapers has identified any necessary disclosures, such as
preferred stock dividends in arrears, or the need for modification of
reported equity amounts, such as a misapplication of GAAP in the
charges to retained earnings or owners’ capital.
Practical Consideration:

¯ A change in state law may require restructuring of equity

accounts even though no errors have been made in prior periods’
financial statements.

* 2. If no reliance on a predecessor is planned or possible:

a. Obtain or prepare an analysis of all equity accounts from

the inception of the business, or for a reasonable period such as the
last five years, and perform the following procedures.

(1) Test clerical accuracy.

(2) For all significant transactions, compare to director’s

minutes for the relevant period to determine authorization and
inspect supporting documentation. Document the items tested.

(3) Vouch changes in retained earnings or capital due to

income or loss to income statements or tax returns.

(4) Compare the closing balances of the prior period to the

opening balances of the current period.

b. Consider whether the procedures applied have identified

any necessary disclosures, such as preferred stock dividends in
arrears, or the need for modification of reported equity amounts,
such as a misapplication of GAAP in the charges to retained
earnings or owner’s capital.
Practical Consideration:

¯ A change in state law may require restructuring of equity

accounts even though no errors have been made in prior periods’
financial statements.