Finding Material Changes to Debt or Equity
If your audit client has material debt or equity transactions after the balance sheet date, you must disclose the debt or equity in your audit report as well. This type of subsequent event may include the following circumstances:
Borrowing new money, paying off debt, or changing the terms of existing debt: For example, the client issues new bonds or changes the date that a loan needs to be paid off.
Converting debt to equity: Some companies use convertible securities to raise operating capital. These securities start off as debt (bonds) but can be turned into equity (stock) under some circumstances, which are spelled out in the issuance of the bonds.
Declaring dividends: Dividends are income paid to a corporation’s owners based on their proportionate ownership. Stock dividends are extra shares of stock that each shareholder of record gets (the number depends on how many shares each one already owns).
Having significant equity transactions: The company may issue new stock or create a stock split, which involves dividing one share of stock into two or more shares. A company takes this step if it believes that the trading price of its stock is too high. A stock split artificially reduces the price.
For example, if a company’s stock is trading for $100 and the company thinks this high price adversely affects the average investor’s desire to purchase the stock, the company may issue a 4-for-1 split to get the stock price down to $25 per share. Every outstanding share is now equal to four shares.
Material debt or equity changes require disclosure in the financial statements. Here’s an example of a note to the financial statements disclosing bonds that were paid off by issuing preferred stock:
During this period, the Company retired all its callable Series A bonds. The funds used to retire the bonds were obtained from the issuance of Series B preferred stock. Total extraordinary gain from the transaction sale was $200,000, and we recognized a pretax gain of $150,000.
An extraordinary item is an event that’s both unusual and infrequent. For example, you wouldn’t consider hurricane losses in Florida unusual or infrequent, but losses sustained by the Florida fern industry because of a blizzard would be.