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Your Guide:

Getting your equity audit-ready

With Catie Wood Group Financial Controller, Beauty Pie
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Introduction

There are only two certainties in the life of a business once it reaches a certain scale: taxes, and audits.

Audits are a core part of any company’s lifecycle. They’re renowned for being stressful for businesses to address: after all, the purpose is to test the completeness and accuracy of financial statements and reporting. There can be serious consequences if an audit finds significant misstatements or inaccuracies in a business’s finances.

Auditors also seek to understand how companies handle equity and share plans. But equity data, spread across spreadsheets, contracts, software platforms and board minutes, is tough to handle.

Accounting for equity is a mix of art and science. It’s important for companies to have robust quantitative analyses of how share-based payments are represented on the balance sheet and in financial statements. At the same time, though, other elements like valuations often come down to subjective conversations and mutual agreements between the company, its auditors and other important stakeholders like tax authorities. So it’s vital for companies to be ready for audits as and when they arise.

Audits are a valuable opportunity to stress-test financial best practices, but they demand solid collaboration across business functions and a sound understanding of financial fundamentals. Don’t let equity hold you back from successful audits: get your equity and share plans audit-ready with this Ledgy guide.

Why do you need an audit?

Businesses are audited for a number of different reasons. The UK’s Companies Act (2006) states that businesses who fulfil two of the below three criteria must undergo a statutory audit:

Turnover of more than £10.2 million
Balance sheet total of more than £5.1 million
More than 50 employees

Audits offer several benefits for companies. A successful audit allows the company to enter into discussions with lenders or investors with an objective assessment of its financial structure and record-keeping. Audits also offer teams opportunities to rectify any gaps or inconsistencies in financial statements, and get a tighter grip on reporting processes.

Most audits are focused on a particular financial reporting period, such as the previous financial year. Larger, more complex companies may engage in interim audits, which assess a portion of the financial year. Interim audits allow companies to check in with auditors midway through the year, to ensure they are reporting activity accurately and to carry out valuable preparatory work ahead of fuller annual audits. Catie Wood, Group Financial Controller at beauty buyer’s club Beauty Pie, says that “An interim audit is usually shorter than a year-end audit, and doesn’t necessarily cover all areas of the financial statements. The year-end process is more in-depth: for a small-to-mid-sized company, it might take around a month from start to finish.”

Auditors thoroughly assess the company’s financial systems and processes in order to reconcile reported financial statements with the transactions and payments that make up a businesses’s revenues and costs.

Auditors test for a few important assertions. They seek to assert that reported transactions did occur; that recorded transactions are complete, and that data relating to recorded transactions are accurate. An audit will also draw conclusions on elements like the quality of presentation – essentially, whether the company’s relevant disclosures are clear and understandable.

Internal and external audits

Not all audits are the same. The purposes of internal and external audits are clearly defined by the Institute of Chartered Accountants for England and Wales (ICAEW), which says that external audits are designed to “report on the truth and fairness of financial statements”, while internal audits “are responsible for assessing the effectiveness of controls in mitigating risks”.

So in practice, how do internal and external audits differ?

Internal audit

An internal audit is carried out by an internal audit team – usually designated employees – and the results are not normally made public. Internal audits generally focus on internal controls and processes. They are scheduled in advance and company leadership is able to prepare records and statements ahead of the audit.

Internal audits generally seek to answer the following questions:

How effective are the company’s risk management controls?
Are the processes and systems that govern financial reporting and reconciliation working effectively?
What are the biggest risks to business continuity and financial reporting integrity?

External audit

An external audit is carried out by an independent third party. Any statutory audit, as described in the previous section, must be an external audit. External audits normally involve more preparation than an internal audit.

In an external audit, the auditors seek to establish answers to several important questions:

Do the company’s financial statements and reports add up, and are they compliant with relevant regulations?
Are assets, liabilities and equity interests properly classified and recorded?
Are the processes and systems that govern financial reporting and reconciliation working effectively?

In an external audit, the company’s balance sheet, profit and loss statements and cash flow statements are all assessed and reconciled with transaction data. With foresight of audit deadlines, companies can prepare to make sure the timing of the audit (whether it’s statutory or voluntary) does not create additional complexity. Remember key milestones, such as the date your balance sheet snapshot is recorded. Your balance sheet will necessarily ‘lock in’ certain payments, conversions and transactions. They can be corrected in subsequent financial statements, but good preparatory work will ensure that a business knows what the balance sheet will show before it’s finalised and reported.

Minimising equity headaches in an audit

In an audit, auditors aim to understand what transactions have taken place during the financial year – new grants, options that have been exercised, and so on – and reconciling those transactions with share-based payment reports.

There are several key considerations for equity and share plans in an audit, which affect the work of different teams – not just senior finance leaders. Valuations, corrections and internal controls can all throw up problems. Let’s look at these elements in more detail.

Three main equity risks in an audit

Valuations

“Valuations can make share plans a more complex piece of an audit as they often include an element of subjectivity,” says Catie.

Companies adhering to national or international accounting standards, such as IFRS 2, US or UK GAAP, need to fairly value shares and share options. If the value of a company’s equity is overstated or understated, this could cause problems for financial reporting down the line. For UK companies, the conversations with HMRC that lead to an EMI valuation are generally less in-depth than the valuation conversations that happen in an audit.

To help run a smooth equity audit, companies can ‘show their working’ and present auditors with the methodology used to calculate valuations and share-based payments. Before the audit itself, getting a third party to independently check and verify the valuation can be a big time-saver.

“A recent funding round doesn’t always equate to a valuation you can use in your accounts,” says Catie. “The market can change very quickly, so getting another consultant or advisory firm to validate your approach prior to the audit can be helpful and make the audit smoother in the long run.”

Corrections and revisions

Part of the purpose of audits is to highlight any elements of a company’s financial reporting that might need additional explanation or clarification. This includes corrections to previous financial statements. For instance, companies may also need to deal with re-measuring (or ‘trueing up’) the fair value of share-based payments during the financial period in question. Under IFRS 2, there is no need to re-measure equity-settled transactions after the equity instrument is granted, but with cash-settled transactions, the liability is re-measured when there are material changes to fair value.

Corrections don’t mean a company has done anything wrong. common corrections can include repricing depreciating assets, or making adjustments to prior reporting based on recalculating forfeitures. But corrections also create new operational and financial overhead: lots of corrections mean an audit may take longer to complete, and the audit fees may rise accordingly.

Corrections to audits can create new operational and financial overhead. Audits may take longer to complete, 
and audit fees may rise as a result.

Internal communication and controls

Poor internal controls can make financial reporting errors more likely and audits trickier to execute.

Data sharing between teams is often a cause of confusion or delay in completing an audit. Key equity data on vesting, exercised options, new grants and more is often held within the HR or people function. This information needs to flow to the finance team on a regular basis including during an audit. If there is inadequate record-keeping, it’s more difficult for auditors to access the information they need.

Blending quantitative spreadsheet-based working papers with coherent policy documentation stands you in good stead to have constructive conversations with auditors, says Catie: “On top of the transaction information and financial reporting, it’s good to have a written ESOP policy document that covers details like vesting schedules, top-up policies, exercise prices and other key details of the plan.”

“It’s good to have a written ESOP policy document that covers details like vesting schedules, top-up policies, exercise prices and other key details of the plan.”– Catie Wood, Beauty Pie

Equity in your audit: key questions to answer

Companies may wish to begin from first principles when preparing equity plans for an audit, especially if it is the company’s first audit. It’s imperative to walk through your equity plans and clarify answers to the following questions. Some of these questions will be asked of the business directly by auditors, but delivering on the below will ensure the business can have constructive conversations with auditors, minimising additional workload during the busy audit period itself.

Which types of equity instrument are granted by the company?
Is there a log of equity-related transactions for the relevant period?
How many different share classes are in use? Are there particular conditions associated with the different share classes that affect distributions (such as liquidation preferences for preferred shares)?
Is there convertible debt on the cap table? If so, under what conditions does the debt convert into equity?
How many shares have been authorised by the board and issued to shareholders? How many are reserved for employees and other stakeholder groups, if any?
Who are the managers and/or authorities who approve equity issuance, new equity grants to different stakeholders, and handles cash transactions in/after a liquidity event?
Is there clear and reliable information on vesting schedules for different stakeholders, and on any conditions (time-based or performance-based) associated with vesting triggers?
Are all share certificates, share or option agreements and other documentation stored securely? Are relevant documents easy to find?
Are you recording share-based payments accurately? Equity-settled share-based payments are treated as equity entries, whereas cash-settled share-based payments are recorded as liabilities on the balance sheet.
Are you separating market and non-market performance conditions appropriately? (Market conditions are directly related to the share price, whereas non-market conditions like EBITDA or revenue targets are not specifically related to the share price).

Providing an auditor with answers to these questions at the outset will enable constructive dialogue and prevent equity and share plans from throwing up additional complications as the audit progresses.

Having a single source of truth for equity data helps companies and auditors understand what has happened in a given financial reporting period. To Catie, “your equity software almost functions as a second set of eyes so you can validate your calculations and assumptions before you share your work with the audit team.”

Using equity software in an audit streamlines work and minimises the risk of information being outdated, incomplete or inaccurate. With records and data stored in one place and updated in real time, teams have fewer version control or internal communication worries.

Summary

Preparing for an audit can be stressful. But doing proper diligence ahead of time increases the likelihood of getting a clean opinion from auditors (whether internal or external), and significantly reduces the risk of having an auditor highlight concerns or qualifications to your financial statements.

While equity is never the only component of an audit, it’s often one of the most complex elements. “It may be the case that you have a separate team of specialists working on your share-based payment charges and equity balances for the duration of the audit. Then, it all comes together at the end when financial statements are ready for approval,” says Catie. “The responsibility for managing the ESOP is shared between the finance, people and legal, teams, making it a real joint effort and a collaborative ongoing project.”

The lessons learned and the discipline acquired during the preparation phase are not only useful in the context of an audit. Getting financial reporting and processes in place adds value across business functions. And importantly, a successful audit empowers companies to advertise their robust, sound employee equity plans to investors and other stakeholders.

We’d like to thank Beauty Pie’s Catie Wood for providing her views on key audit lessons and best practices from their in-house and third-party perspectives. Learn more about Beauty Pie.

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