AP-12:

Company

Audit Program for Equity

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 Audit Objectives Audit Procedures for Consideration FINANCIAL STATEMENT ASSERTIONS E/O Existence or occurrence. allocation. C Completeness. and disclosure. R/O Rights and obligations. AUDIT OBJECTIVES V/A P/D Valuation or Presentation Balance Sheet Date N/A Workpaper Performed Index by

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 years 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. 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 companys 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.

* A

(See Chapter 4.) It would be efficient to prepare a permanent schedule for posting of the changes in all capital stock accounts each year. 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 companys 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 auditors 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. 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. 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. 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 companys 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 PPCs 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 auditors 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 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 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 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 Compensationan 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 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 Audit Objectives Audit Procedures for Consideration 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 predecessors work or placing no reliance on a predecessors 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 predecessors audit of the prior periods financial statements is to be relied on: a. Scan the predecessors workpapers for equity accounts from the inception of the business or for a reasonable period such as the last five years; consider whether the predecessors procedures included examination of authorization and supporting documentation for all significant transactions; compare closing amounts of the prior period with opening balances. Balance Sheet Date N/A Workpaper Performed Index by

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 predecessors 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 directors 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 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.