CEP Auditing Principles & Procedures 3 — Questions and Answers
Question 1: An equity auditor is testing whether Section 16 officers filed Form 4s timely. What is the standard filing deadline after a reportable transaction?
- 10 calendar days
- Two business days (Correct answer)
- 30 calendar days
- The next quarterly filing date
Correct answer: Two business days
Under SEC rules, Section 16 insiders must file Form 4 within two business days of a reportable transaction such as a grant, exercise, or sale.
Question 2: When auditing an ESPP, which condition must be satisfied for the plan to qualify as a Section 423 plan?
- Participation must be limited to full-time employees only
- All employees of the company must be offered equal rights and privileges (Correct answer)
- The offering period cannot exceed 27 months
- The discount cannot exceed 5% of fair market value
Correct answer: All employees of the company must be offered equal rights and privileges
A Section 423 ESPP requires that all employees be granted equal rights and privileges under the plan, though employers may exclude certain categories under IRC rules.
Question 3: An auditor notes that a performance award payout exceeded the plan's per-person annual grant limit. What is the most significant risk?
- The employee owes additional payroll taxes
- The excess award may not be deductible under the plan's Section 162(m) provisions (Correct answer)
- The transfer agent will reject the share delivery
- The plan automatically converts the excess to stock appreciation rights
Correct answer: The excess award may not be deductible under the plan's Section 162(m) provisions
Performance award payouts exceeding the stated per-person limit may jeopardize the deductibility of the excess compensation under Section 162(m).
Question 4: Which sampling method is most appropriate when auditing a large volume of routine option exercises with expected low error rates?
- Judgmental sampling of largest grants only
- Statistical random sampling (Correct answer)
- Complete population testing
- Sampling only terminated employee exercises
Correct answer: Statistical random sampling
Statistical random sampling provides a defensible, unbiased selection for high-volume, low-complexity transactions and allows auditors to project error rates to the population.
Question 5: A company uses a 10b5-1 plan to allow executives to sell shares. When auditing insider transactions, what key feature must the auditor verify?
- That the plan was adopted during an open trading window when the insider lacked material non-public information (Correct answer)
- That the plan was approved by the SEC before adoption
- That the executive sold no more than 1% of shares outstanding per quarter
- That the plan was filed on Form S-8
Correct answer: That the plan was adopted during an open trading window when the insider lacked material non-public information
A valid 10b5-1 plan must be adopted at a time when the insider did not possess MNPI and during an open trading window to provide an affirmative defense against insider trading claims.
Question 6: During a post-merger equity audit, the auditor must verify that assumed options were repriced to maintain economic equivalence. Which formula governs the adjustment?
- Exchange ratio multiplied by pre-merger shares, divided by exercise price
- Pre-merger exercise price divided by the exchange ratio; shares multiplied by the exchange ratio (Correct answer)
- Post-merger stock price minus pre-merger stock price, applied to all outstanding grants
- Target company's 52-week high used as the new exercise price
Correct answer: Pre-merger exercise price divided by the exchange ratio; shares multiplied by the exchange ratio
Treasury regulations require that assumed options adjust the share number by the exchange ratio and divide the exercise price by the exchange ratio to preserve the intrinsic value.
Question 7: When an auditor reconciles equity compensation expense under ASC 718, which component is NOT included in the fair value calculation for a standard stock option?
- Expected term of the option
- Expected stock price volatility
- Current dividend yield
- Current market price of the underlying stock relative to the exercise price after vesting (Correct answer)
Correct answer: Current market price of the underlying stock relative to the exercise price after vesting
ASC 718 uses a grant-date fair value model (Black-Scholes or lattice), which does not include post-grant stock price movements; the key inputs are term, volatility, risk-free rate, and dividend yield.
CEP Auditing Principles & Procedures 3
An equity auditor is testing whether Section 16 officers filed Form 4s timely.
What is the standard filing deadline after a reportable transaction?