Everything You Need to Know About Financial Statement Audits
If you mention that your business is undergoing an audit, most reactions will be something like, "uh-oh, that can't be good." But one type of audit – a financial statement audit – can be a truly collaborative process and can help companies achieve important goals.
Here, we explain what is involved in a financial statement audit and why it is nothing to fear.
1. A financial statement audit can provide benefits but is not pain-free. Especially if you're business is not well-prepared.
2. There are less thorough alternatives to a financial statement audit, but not all are useful.
3. Unlike an IRS audit, a financial statement audit is not adversarial in nature.
What is a financial statement audit?
In this type of audit, an independent public accounting firm or other qualified, unbiased third party evaluates the integrity of a company's financial records and statements. Although not combative, a financial statement audit is thorough and time-consuming, as the auditors typically:
- Examine financial statements and the underlying data (general ledger, etc.)
- Analyze business operations and processes
- Evaluate company assets for impairment and proper valuation
- Determine tax liability
- Ensure compliance with tax laws
The auditors obtain evidence to support (or refute) the financial statements by contacting major customers and/or suppliers, conducting a physical inspection, obtaining third-party confirmations, and doing independent analyses. In other words, it can be a demanding exercise.
Why obtain a financial statement audit?
Why do companies undergo a financial statement audit? An overly simplified answer is, "without an audit, a company could simply make up the numbers in its income statement and balance sheet – who would know?"
In other words, these audits are often mandated to protect shareholders and potential investors from unsubstantiated or even fraudulent claims about a company's financial position.
More specifically, companies obtain audits for various reasons:
1. To satisfy lenders and investors
To maintain a line of credit or prove compliance with loan covenants, a bank may require a company to undergo an annual audit that shows its financials are accurate and prepared according to GAAP.
For equity investors, the Investor Rights Agreement typically requires a company to provide financial statements audited by a Board-approved accounting firm, often annually. This gives current and potential investors confidence that the company's financials are accurate.
Although outright fraud is not common, it does happen. In one situation we encountered, a CEO had provided entirely fictitious numbers to investors and the Board. A red flag was that the CEO never provided an Income Statement and a Balance Sheet together and never offered a Cash Flow Statement. Regular audits would prevent this from happening.
2. When preparing a company for sale
To go public, companies must file an S-1 which requires audited financial statements. In a private sale, potential buyers will typically require two to three years of audited financials that conform to GAAP.
This benefits the seller and the buyer, as it makes the due diligence go much more smoothly than it otherwise would and can be used to support a proposed valuation.
3. In dealing with suppliers
Audited financials can convince new suppliers to extend trade credit by showing that a company pays its bills on time. Audited financials can also give current suppliers confidence when a customer seeks to substantially increase the quantities it orders on credit.
4. For valuations within Employee Stock Ownership Plans
ESOPs may require a company to provide audited financial statements, as the value of the options depends on the company's value. For privately held companies, valuations rely on methodologies that require robust financial statement data.
The end result: a complete financial statement audit gives creditors, investors, suppliers, and other interested parties the highest assurance regarding the accuracy of a set of financial statements.
Are there alternatives to a full-blown financial statement audit?
An increasingly popular alternative to a full audit is a Quality of Earnings (QofE) review, which shows that the company's stated revenues and expenses are correct and accurately stated. A QofE review can be faster and less expensive than an audit and greatly expedite the sale process.
Today, many buyers are satisfied with a due diligence review of a QofE statement; however, note that many accounting firms do not offer QofE services.
Other types of attest services:
- Compilation – A third party reviews the financial statements, along with some information from the company's general ledger, but does not attest to whether or not the values in the financial statements are accurate. A compilation may indicate to lenders and other third parties that a business has a relationship with a CPA.
Still, the report will state that the CPA did not audit or review the financial statements and therefore does not provide an opinion or assurance regarding their accuracy.
- Review of Financial Statements – more than a Compilation but less than a full audit. A Review provides "limited assurance" regarding the accuracy of financial statements. The auditor notes whether any material modifications would be needed to bring the financial statements into compliance with GAAP or some other financial reporting framework. This may suffice when a small business starts to grow and seeks more complex financing types.
We do not recommend spending much time or money on these reviews because, in our opinion, they offer little value, but many banks may be willing to "settle" for this.
What is the difference between a financial statement audit and an IRS audit?
A financial statement audit that shows compliance with Generally Accepted Audit Standards (better known as GAAS, which generates a lot of jokes) is quite different than an IRS audit.
Companies undergo a financial statement audit because doing so offers the important benefits described above. In contrast, an IRS audit has a different "attitude" – it assumes there are problems (or worse) in the company's books to be uncovered.
A financial statement audit also has a higher materiality threshold – in other words, the financial statements are expected to be materially correct. The IRS does not have a concept of "materiality" – even a minor error or discrepancy matters.
Think of a financial statement audit as a thorough physical exam with your doctor – it takes time and may be a bit unpleasant but can reveal things you should address to prevent significant problems in the future.
In contrast, an IRS audit is like an intrusive medical procedure that you cannot avoid, performed by a doctor who does not care about having a good bedside manner.
How can a company prepare for a financial statement audit?
Even though a financial statement audit is not adversarial, it is not a walk in the park. When G-Squared manages these audits for our clients, our first step is to make sure a company's books are appropriately closed according to GAAP. That necessary documents (bank statements, invoices, accounts receivable aging schedules, loan agreements, and more) are in good shape.
This is more than just verifying debits and credits – it takes an experienced team.
For example, we know what supporting information will be needed before an audit begins for a firm with complex revenue recognition rules.
We may also research specific GAAP and disclosure issues to help document how accounting principles apply to a company's particular circumstances.
Bottom line: G-Squared helps companies get ready for and get through a financial statement audit. We act as our client's finance team, handling the interactions with the auditors and making the process as painless as possible. In other words, you can continue to run your business while we handle the audit for you.
G-Squared Partners provides outsourced accounting services that provide companies with all of the benefits discussed above.