A common question we receive at LRZ Consulting is whether a company should have their finances externally audited. This involves an independent examination of a business’ financial statements (typically by a CPA firm), determining if they’re represented fairly and accurately. In simpler terms, it’s a stamp of approval. It also typically allows parties to feel more comfortable relying on these financial statements to make a significant decision (i.e. a bank considering providing a loan, or an investor valuating a company).
If you’re considering an external audit of your company’s financial statements, here are four factors to take into account:
Does a legal or contractual obligation exist?
The first and most obvious question that needs to be addressed is whether a legal, contractual, or statutory obligation to obtain an audit exists. Some examples of this include a company that:
- Has a bank loan and the agreement requires the company to submit audited financial statements to the lender on an annual basis within 90 days of year-end
- Is publicly traded and is required to obtain an audit under SEC regulations
- Operates under a partnership agreement which requires an annual audit
- Is a non-profit and receives $2M annually in federal funds through grants, so under the Single Audit Act is required to obtain an audit
If your organization is legally required to get an audit, then the decision has already been made for you; it’s time to figure out what kind you need (i.e. if you require a Single Audit as a non-profit, or need additional procedures performed as a result of SEC oversight) and any deadlines associated. For those without a contractual right, the decision whether to obtain an audit becomes subjective, based on the goals and other circumstances surrounding the company. Let’s touch on a few of those key decision points next.
Who are the statements intended for?
The next questions you’ll want to ask is who are the audited financial statements intended for and who would they would benefit? Key management or internal owners that have access to these audited financial statements would undoubtedly benefit, for example. They’d likely be reviewing the statements on a periodic basis, but relying on the accounting personnel preparing the statements for accuracy. Since audits require an independent third-party (usually a CPA firm), they can serve as a way of corroborating this work by the internal accountant. Similarly, knowing that the financial records will be looked at by an external party can deter the internal accountant from performing any fraudulent activity. (Note that while an audit isn’t designed to detect fraud and provides no assurance that fraud hasn’t occurred, it still can serve as a strong deterrent and/or help uncover fraud that’s already occurred.)
Other stakeholders you could have an audit done for are inactive owners or investors who may need a similar assurance that the financial results of the company can be relied on. This is a greater need when there are multiple investors or owners, or when the entity is a joint venture between two parties and one is responsible for managing financial statements. The inactive partners, investors, or other parties may want confirmation that the statements are accurate, and an external audit would be a way to achieve this. If the company is on a bad trajectory but finances don’t accurately represent that, an audit may uncover this and save investors a lot of money before the business goes deeper into a hole.
Another group that may want an external financial statement audit is non-profit organizations. Depending on the non-profit charter and a few other factors it may not be required, but if they’re receiving large contributions from the public and want to continue to do so, an audit could be extremely beneficial. Most big donors will want to ensure that the non-profit they’re potentially donating to is using their funds as promised, and an audit would provide that comfort.
Am I preparing for a change in ownership or another significant event?
You may not currently have any external parties that need to see audited statements, and you may have decided that it isn’t worth the cost to do one solely for internal purposes. But if your business will be going through a significant change in the future, it would help to be proactive and have audited financial statements readily available. Some “significant” business changes would include:
- The sale of a business or of partial ownership of a business
- A capital raise to bring on new investments
- Obtaining a line of credit or loan from a financial institution
In many cases, a financial statement audit is not required to achieve one of these outcomes. However, the external parties involved in a potential sale, capital raise, loan, or other major event will likely be evaluating your financial statements during their due diligence procedures, so an audit makes your statements (and therefore your company) immediately more reputable. This could simplify the sale or loan process and may bring additional parties into the mix that may not have been interested prior to the company having readily available audited financial statements.
Are lower levels of assurance sufficient for my needs?
A financial statement audit isn’t the only type of external evaluation that companies experience; there are various levels of assurance and various functions that can be performed surrounding financial statements. Two primary options beyond an audit are a financial statement review or compiled financial statements. We won’t go into the details of the level of assurance provided with each, but at a high level, an audit provides the highest level of assurance, followed by a review, then a compilation. All three result in a set of issued financial statements and a report from the external accountant, but the review and compilation reports will explain that fewer steps were performed by the external accountant and there’s less assurance being provided.
If you have any other questions, or need assistance in deciding whether to obtain a financial statement audit, please contact LRZ Consulting. (Note: since we don’t perform any of the services discussed, we guarantee you’ll receive an unbiased assessment of your company’s needs).