All of these could be reasons for you to “need” to have an audit done. Banks and investors will normally require an audit. If you are looking to go public, you need to have three years of audited financials.
One of the biggest stumbling blocks for companies seeking funding is the time and money it takes to get an audit completed, especially if they are not prepared for an audit. Usually, it is best for you to prepare to be audited from the beginning. Your business should already be ready for an audit. Just because you haven’t “needed” an audit, is no excuse for not having your financial house in order and doing things right. Doing things right will lead to more control and better information. Better information leads to better decisions, which will lead to higher profits and eventually a higher valuation. You have to have your financial house in order when you look for investment or a sale in order to maximize your valuation.
If you are going to get an audit, you are going to pay an outside CPA firm to audit your financial house and your goal is to get an “unqualified opinion”, sometimes called a “clean opinion”. Simply put, this means that the auditors audit your books and find nothing that will make investors uncomfortable about the numbers (nothing “materially misstated” in audit speak). So, what steps do you need to take in order to be prepared for your audit.
Accounting staff. Your accounting information is only as good as your accounting staff. That does not mean that you have to have a full staff of CPA’s, but you do need to have competent staff at all levels. Most companies are better off to have a part-time CFO and Controller until they are large enough to justify a full-time person in that position. The Controller is the main accountant for the company. The Controller must be well versed in GAAP and have several years of experience in actually closing the books of a company. A CPA is helpful, but not required. The Controller will supervise all of the accounting staff and insure that proper accounting is set up from the beginning and is consistent every month. The accounting staff will depend upon the size and complexity of the accounting for the company. Companies who have inventory or revenue recognition issues may have to have staff specifically for those issues. It may also be necessary to have larger Accounts Receivable or Accounts Payable staff, depending on the industry and number of transactions that flow through the accounting records. In any case, it is mandatory that your Controller is strong enough to build a strong accounting staff that is familiar with GAAP and with the highest of integrity. The Controller should also be familiar with reporting issues facing the company. These issues will also change depending on the company and will range from internal reporting, job costing and managerial accounting to external financial reporting, SEC reporting and other required reports. Companies with more strategic financial issues, especially those with large bank loans and investors should consider hiring a part-time CFO and as the company has over $30 million in revenue, should consider a full time CFO to be the strategic financial partner of the CEO and the Board.
Audit your balance sheet. All audits start with the balance sheet. It is critical that the company has a balance sheet approach to preparing financial statements. This means that every month the books are closed, the balance sheet accounts are reconciled and there is supporting documentation for each of the accounts. No exceptions!
Cash. It is amazing how many small companies don’t reconcile all of their cash accounts every month. It is critical that someone reconciles the general ledger to the bank statement as soon as possible after month end. For control purposes, this should be someone who does not have access to check signing, nor check preparation. This not only makes the statements more accurate, it is a good control on cash, which is the most easily stolen asset.
Accounts Receivable. If the company has customers who owe them money, it is necessary to have a subsidiary ledger of all accounts who owe them money. This subsidiary ledger must be reconciled to the general ledger every month. One of the hottest audit areas is the “Allowance for Doubtful Accounts”. This is an area where companies have been able to manipulate earnings in the past, so auditors will scrutinize this area very closely. You need to have some historical statistics to support the amount of allowance you are keeping on the books. If you are a new company with limited history to support your allowance balance, you still will be required to justify your number.
Inventory. Probably the most scrutinized item on any balance sheet is the inventory balance. Not only is it critical that you have accurate inventory records, but also any allowances that you have set up for purchase allowances, damage allowance, coop advertising allowance, etc., will all be scrutinized by auditors very closely. As with other allowances, this is an area where earnings management could be an issue. Many companies don’t realize that if they want an audit done, they need to have not only year-end inventory balances audited, but the beginning of the year balances need to be audited also. So, if a company wants an audit for December 31, 2009, it had better make sure the auditors review the inventory balance as of December 31, 2008. It is imperative that the company performs a physical inventory count at year end and beginning balances plus the auditor must participate in both inventory counts. Inventory is probably the biggest issue that will stop companies from getting an “unqualified opinion”. If a company doesn’t want to hold up its financing, then inventory MUST be properly accounted for.
Current liabilities. The issues related to accounts payable, accrued payroll and accrued expenses can also be an issue for most growing companies. It is critical that there is a clean cut off and that all of the expenses are included in the proper time frame. Auditors will perform what is called a “test for unrecorded liabilities”, which will look at all checks cut after year end to make sure they were recorded in the proper period.
Deferred Revenue. Many companies don’t even know they have a deferred revenue issue. If a company receives money up front for services to be performed in the future, they have deferred revenue. The money must be put on the books as a liability until the service is performed. This is a HUGE issue with software, technology and businesses who collect money up front.
Equity. Behind inventory, the equity of a company will usually be the next most scrutinized area on the balance sheet. It is critical that all capital contributions are properly recorded and for the proper amounts. Stock options, warrants and other equity compensation are areas that have been abused in the past, so a company needs to have an expert in FASB 123r and IRS 409A help them prepare the correct accounting of these issues before they have a chance to blow up with cheap stock issues, large compensation issues and tax issues that can be avoided.
Internal controls. Auditors have always put significant weight on internal controls. If the auditor can rely more on internal controls, then the amount of testing can also be reduced and potentially reduce the cost of the audit. After Sarbanes Oxley was passed as legislation, auditors are now required to do more of a review of internal controls. The size of the company will dictate how in depth the internal controls can be. Auditors will be looking to make sure there is a proper “segregation of duties”, which means employees with access to assets, do not have access to records. So, simple controls over cash as mentioned earlier are a great control for cash. Individuals who prepare and sign checks should not reconcile the accounts. The internal controls in place should do two main things for the company:
Protect the assets of the company and;
Insure the accuracy of the financial statements.
Policies and procedures. Accounting policies and procedures need to be put in place for the entire company. These procedures need to be in written form and include GAAP rules for all of those that are specific to the company. This will include procedures for handling cash, inventory and fixed assets plus the revenue recognition policies. There should be policies in place prohibiting personal use of company assets and expenses. It is also critical that these policies are the same for everyone in the company from the CEO to the receptionist. If it is not proper for the receptionist to run through personal expenses, then the CEO should not be allowed to do so either. This type of commitment to policies will insure the strength of the accounting records. Policies and procedures should include detailed job descriptions of all of the accounting staff as well as other staff. Internal controls should also be documented as part of the procedures.
Month end close checklist. Each member of the accounting team should have a month end checklist to follow. This checklist will insure that financial records are prepared consistently month after month. It will also insure that the nothing is forgotten and that the records are complete. The checklist should include such items as auditing the balance sheet every month and insuring that reconciliations are completed. Normal adjusting journal entries such as depreciation and amortization expense, month end accruals and revenue recognition should be captured in the checklist and should be used as a guide for insuring proper accounting. The Controller is the main individual responsible for insuring that the checklist is followed and that it is complete each month.
Once a company has put the proper staff in place, audited all of its balance sheet accounts, developed internal controls and put in proper policies and procedures, then the audit will be easy. Each month end should be a mini audit of the accounts to insure that the year end and quarter end statements are proper. Companies should get in the habit of preparing the statements that are required in an audit, which always includes a balance sheet, an income statement and a statement of cash flows. The year- end audit will require significantly more reporting, such as footnotes to the financial statements, but if the above steps are taken, then the audit will go much smoother and should cost significantly less than normal first year audits will cost.
If a company is unsure if it is really ready for an audit, then it may be worth hiring a firm that has significant experience in managing audits for companies. An audit should not be something that a company should fear, but an audit should be a chance for the company prove that it is a financially strong company and that its accounting procedures and policies are proper and in place.
—By JB Henriksen, CPA – Advanced CFO