Earnings per share (EPS) is a critical financial metric that is widely used to evaluate the performance and profitability of a company. It represents the amount of net income available for each outstanding share of stock.
As such, it is important for auditors to perform appropriate audit procedures to ensure that the EPS calculation is accurate and free from material misstatements.
Accounting Treatment:
Earnings per share is calculated by dividing the company’s net income by its weighted average number of outstanding shares of common stock.
The calculation of EPS requires the use of various accounting estimates, such as the determination of convertible bonds or options that are considered dilutive, and the calculation of the weighted average number of outstanding shares.
Audit Risks:
There are several audit risks associated with the calculation of earnings per share, including:
- Misapplication of accounting principles: This includes incorrect application of GAAP or IFRS in the calculation of EPS.
- Inadequate disclosure: This includes the failure to disclose important information about the calculation of EPS, such as the weighted average number of outstanding shares.
- Use of incorrect or inconsistent data: This includes the use of incorrect or inconsistent data in the calculation of EPS, such as incorrect calculation of the weighted average number of outstanding shares.
- Misrepresentation of earnings: This includes the manipulation of net income to increase the EPS.
- Underestimation of dilutive securities: This includes the failure to include all dilutive securities in the calculation of EPS.
- Misclassification of shares: This includes the incorrect classification of shares as outstanding for purposes of the EPS calculation.
- Inaccurate valuation of securities: This includes the use of inaccurate values for securities in the calculation of EPS.
- Inadequate controls over data: This includes the lack of appropriate controls over the data used in the calculation of EPS, such as the weighted average number of outstanding shares.
- Misapplication of the treasury stock method: This includes the incorrect application of the treasury stock method in the calculation of EPS.
- Inadequate documentation: This includes the lack of appropriate documentation supporting the calculation of EPS.
Audit Assertions:
The audit assertions for earnings per share include:
- Completeness: The calculation of EPS includes all relevant information.
- Accuracy: The calculation of EPS is accurate and free from material misstatements.
- Valuation: The value of securities used in the calculation of EPS is appropriate.
- Classification: The classification of shares as outstanding is appropriate.
- Presentation: The presentation of EPS is in accordance with GAAP or IFRS.
- Disclosure: The disclosure of information related to the calculation of EPS is adequate.
The auditor’s objective is to obtain sufficient appropriate evidence to support the audit assertions related to the calculation of earnings per share. This may involve performing a combination of test of controls, substantive audit procedures, and substantive analytical procedures.
The specific audit procedures performed will depend on the auditor’s overall audit strategy, the nature of the company’s business and financial reporting, and the level of risk associated with the EPS calculation.
Walkthrough Testing:
Walkthrough testing is a procedure that helps auditors gain an understanding of the process and procedures used by management in determining earnings per share (EPS).
During walkthrough testing, the auditor reviews the process flow of the calculations and discusses the methodology with the company’s management and finance team.
The auditor then traces the calculation of EPS back to its source data, such as financial statements and other relevant data, to verify the accuracy and completeness of the information used in the calculation.
Test of Control:
Test of control is a procedure that helps auditors assess the effectiveness of the company’s internal controls related to EPS calculation. The auditor identifies key controls, such as the segregation of duties, approval processes, and reconciliation procedures, and tests the operation of these controls.
For example, the auditor may observe or perform a walk-through of the calculation process, review the journal entries, or review the evidence of approvals.
The objective of the test of control is to assess the risk of material misstatement and to identify any deficiencies in the internal control system.
Substantive Audit Procedures:
Substantive audit procedures are audit procedures that are performed to test the accuracy and completeness of the financial information related to EPS.
These procedures can include, but are not limited to:
- Analytical procedures, such as reviewing the trends in the EPS calculation over time, and comparing the current year’s calculation to prior years.
- Re-calculation of EPS to verify the accuracy of the management’s calculation.
- Reconciliation of the EPS calculation to other financial statements, such as the balance sheet and the income statement.
- Testing the accuracy of the calculations of other relevant data, such as the number of outstanding shares.
The objective of substantive audit procedures is to obtain sufficient evidence to support the auditor’s opinion on the financial statements, including the EPS calculation.
The auditor must also evaluate the reasonableness of the accounting estimates used in the EPS calculation and consider whether the estimates are consistent with other financial data and industry practices.
