Financial audit essentials: What every SMB needs to know

Love them or hate them, routine independent financial audits are essential for all types of businesses and organizations. Outside auditors provide an independent and objective assessment of a company’s financial statements and internal controls. Since third-party auditors aren’t company employees, the auditors provide an impartial and unbiased opinion of the financial statements and provide greater assurance to stakeholders, such as shareholders, creditors and regulators.

Arguably, audits can help companies increase their revenue and margins, improve their customer experience, decrease costs, improve working capital and improve efficiency. Sound fantastical? I’ll explore this a bit later. For now, let’s delve into the audit process and ways you can make this easier for all involved.

Choosing the right external auditor is a critical decision and will affect the entire process. If you’re not yet collaborating with an auditor or are looking to find a new one, here are some things to consider as a pragmatic buyer of their professional services:

• Ensure that the auditor is appropriately licensed, certified, and registered with the relevant professional bodies. A CPA license is the most common credential for auditors. If you’re company is public, ensure the audit firm is registered with the Public Company Accounting Oversight Board (PCAOB). The PCAOB inspects registered firms to ensure they comply with auditing standards and requirements. While it’s not required for an auditor to be registered with the American Institute of Certified Public Accountants (AICPA), it’s a valuable credential.
• Consider an auditor who has experience in your industry. They’ll be better equipped to understand the nuances of your business and to provide more relevant insights.
• Look for an auditor with a strong reputation. Check their record for accuracy.
• Ensure that the auditor is independent and free from any conflicts of interest. This is essential for ensuring the audit integrity.
• Evaluate the team that will be working on the audit. Look for experienced, knowledgeable and professional auditors who have a history of delivering quality results.
• Seek an auditor who takes a risk-based approach to the audit. They’ll focus on areas most likely to contain significant risks or material misstatements.
• Choose an auditor who communicates clearly and effectively. They should be able to explain complex financial information in a way that is easy to understand.
• Finally, review the fee structure to ensure it’s transparent and reasonable.

Your choice of an outside audit team should bring expertise, credibility, transparency and compliance to the process. External auditors have specialized knowledge and expertise in financial reporting, auditing standards and regulations, enabling them to identify potential issues and provide valuable insights to the company. They provide credibility to the financial statements by providing an independent and unbiased opinion on the financial health of the company. They offer transparency to stakeholders by reporting any potential issues, discrepancies or weaknesses in the internal controls of the company, which helps stakeholders make informed decisions. And they ensure that the financial statements comply with accounting standards, regulations and laws, which reduces the risk of fines, penalties or legal issues for your business.

Audits and Privately Held Companies

Public companies face regulatory requirements that necessitate independent audits. These requirements don’t apply to privately held companies, but there are several reasons why periodic independent audits make sense when you consider the following risk factors:

• An independent audit can identify weaknesses in the internal controls of the business, which might lead to theft, financial losses and other issues.
• Fraud and embezzlement might go unnoticed for longer periods, leading to significant financial loss.
• Inaccuracies or errors in the financial statements could mislead stakeholders and result in wrong business decisions.
• Noncompliance with financial reporting requirements, accounting standards and regulations can lead to fines, penalties and legal issues.
• The credibility of the financial statements may be questioned, negatively affecting the reputation of the business and harming relationships with stakeholders.
• Financial institutions, investors, and other stakeholders may require independent financial audits to make informed decisions about the business. Without independent audits, it will make it more difficult to obtain financing or attract investors.

Think back to my earlier point about how audits can help companies increase their revenue and margins, improve their customer experience, decrease costs, improve working capital and improve efficiency. Mitigating the risks listed above will help your company achieve these goals.

Privately held firms are not required by law to undergo external audits. However, there are some exceptions to this, depending on the industry, ownership structure and other factors. For example, if a privately held firm has debt financing or other agreements that require audits, then it may be required to undergo external financial audits. Also, if a privately held firm is a subsidiary of a publicly traded company, it may be subject to audit requirements as part of the parent company’s regulatory obligations.

Getting Audit-Ready

How should you prepare for a financial audit? Here are some steps to follow:

1. Gather all relevant financial documents such as bank statements, receipts, invoices and financial statements. Organize them in a clear and easily accessible manner.
2. Review financial statements to ensure their accuracy and completeness, identifying any errors, discrepancies or unusual transactions requiring additional explanation.
3. Address any issues identified in the financial statements review. Correct any errors, reconcile accounts and provide additional documentation to support any unusual transactions.
4. Schedule a meeting with the auditor to discuss the audit process and ask any questions. Provide the auditor with relevant information and access to appropriate personnel.
5. Prepare supporting documentation for all financial transactions. This may include contracts, purchase orders and other relevant documentation.
6. Identify any potential areas of concern that the auditor may focus on, such as significant transactions, related-party transactions and nonroutine transactions.
7. Document internal controls, including policies and procedures, to demonstrate that the business has appropriate controls in place to prevent and detect errors or fraud.
8. Train colleagues on the audit process and their role in supporting the audit. This includes educating colleagues on the importance of accurate record-keeping and the need to provide timely and accurate information to the auditor.

Many of these steps can be streamlined with technology, and we’ll look at that a bit later.

In addition to following the steps I’ve outlined above, there are several things you can do before an audit to make sure it goes smoothly, which include:

• Conducting regular internal audits of your financial records to identify any potential issues before an external audit takes place. This helps to identify and correct any errors or discrepancies before they become a problem.
• Ensuring that all receipts, invoices, bank statements and other financial documents are properly filed and easily accessible.
• Following generally accepted accounting principles (GAAP).
• Hiring a professional accountant to maintain accurate financial records and ensure that your financial statements are prepared in accordance with GAAP.
• Staying informed about any changes to accounting and financial reporting requirements.
• Timely tax filings and tax payments.
• Being open and honest with your auditor. If you have any concerns or questions, raise them with the auditor as soon as possible. This will help to build trust and ensure that the audit process runs smoothly.

How often should you undergo an external audit? It depends on several factors, such as the size of the business, its industry, regulatory requirements and stakeholder expectations. Publicly traded companies are required to undergo an annual independent financial audit. For privately held companies, the frequency may vary based on their individual circumstances. It should be based on a careful assessment of the risks and requirements of the business.

Audit Steps

A typical independent financial audit follows these steps:

1. The first step in the audit process is planning. The auditor meets with company leaders and gets an in-depth understanding of the business, its operations and any risks involved. This includes a review of the prior year’s financial statements and audit report to identify areas of potential concern to plan the audit.
2. The auditor assesses the risks of material misstatement in the financial statements by analyzing the company’s internal controls, financial transactions and other relevant factors. This helps the auditor to identify areas that require further examination and to determine the extent of the audit procedures that need to be performed.
3. The auditor evaluates the company’s internal controls to determine if they are designed and operating effectively to mitigate the risk of material misstatements in the financial statements.
4. The auditor performs substantive procedures to obtain evidence to support the financial statements. This includes reviewing the company’s accounting records, confirming balances with third parties and performing analytical procedures.
5. The auditor evaluates the results of the audit procedures and identifies any issues or findings which require further examination or disclosure in the audit report.
6. The auditor issues a report with opinions as to whether the financial statements are presented fairly in all material respects in accordance with accounting principles.
7. After the audit report is issued, the auditor follows up with company executives to ensure that any issues identified during the audit have been adequately addressed.

Audits: What Can Go Wrong

I’ve posited some thoughts around getting ready for a smooth independent audit, so let’s spend some time looking at factors that make the process less pleasant. First off, if the auditor doesn’t spend the time needed to plan, it will handicap the auditor’s understanding of the company’s operations, processes and internal controls. This can result in the auditor not identifying areas of potential risk or performing inadequate audit procedures. This is a major red flag! Make sure all the needed people and resources are available on your end to prevent this from occurring and insist that it does.

Likewise, if the auditor does not have a thorough understanding of the business and its operations, it can lead to a failure to identify material misstatements in the financial statements or overlook important information.

If the auditor relies too heavily on the company’s internal controls, this can lead to a failure to identify material misstatements in the financials as internal controls can be circumvented or overridden. The auditor must perform substantive testing in addition to evaluating the internal controls. That’s one of the reasons why a rock-solid audit trail is critical. As well, if the auditor doesn’t document the audit work sufficiently, this can lead to missing evidence establishing the audit results.

Finally, if the auditor has a bias towards the company or its management, it can result in a failure to identify material misstatements in the financial statements. Likewise, if the auditor lacks independence or the appearance of independence, it can result in a lack of credibility and erode stakeholders’ trust in the financial statements.

Those are some issues that must be understood when dealing with an auditor. Additionally, there are some areas where audits can get messy if not managed properly, especially around revenue recognition, receivables and consolidations. Let’s explore each of these a bit further.

Revenue recognition can get complicated. Determining the appropriate timing of revenue recognition can be difficult, particularly for long-term contracts or contracts with multiple deliverables. Auditors might review contract terms, assess the risks and rewards of ownership, and evaluate the progress of the contract to ensure that revenue is recognized at the appropriate time. The auditor might evaluate the company’s pricing policies, sales contracts and other supporting documentation to judge the accuracy of the revenue amount recognized. As well, auditors might assess the company’s policies and procedures for recognizing returns and allowances and calculate the adequacy of the related reserves, and auditors may need to review the company’s disclosures to ensure that they comply with the applicable accounting standards and regulations.

Receivables can be another messy area. Receivables should be recorded at their net realizable value, which is the amount the company expects to collect after accounting for any expected losses. The aging schedule should provide a breakdown of the receivables by the number of days outstanding, and auditors may need to evaluate the reasonableness of the aging categories used by the company. Auditors may need to confirm a sample of the company’s receivables with its customers to ensure that the amounts are accurate and collectible, and they may need to review the company’s cut-off procedures for recording receivables to ensure that the receivables are recorded in the appropriate period.

Consolidations can also create some issues. Auditors need to identify all related entities, including subsidiaries, joint ventures and other entities that are required to be consolidated under the applicable accounting standards. They must review the intercompany transactions between the company and its related entities to make certain these are appropriately eliminated in the consolidated financial statements.

Smoother Audits

When your auditor asks for additional information, you need to be able to provide it quickly to keep the audit moving forward. Wading through file cabinets, consulting multiple spreadsheets or exporting and importing data from another computer program will slow down your audit and make it more costly.

Audits can be a source of stress for even the most well-organized finance teams. It can often cause you and your team to lose hours to days as you go back through transactions in question, examine the compliance of the entry maker and look for old supporting documentation.

A modern cloud financial-management platform organizes transactions so you and your auditors can easily trace transactions from the financial statements to the general ledger to the subledger to the supporting documents, and back again. Using an accounting system that is purpose-built to manage and demonstrate the accounting path will set the stage for both you and your auditor to have a positive audit experience. By establishing a clear and complete audit trail from transaction to reporting and reconciliation, auditors will be able to evaluate your organization’s accounting processes easily and effectively.

A smooth audit starts by giving auditors access to the information they need. Audit-ready dashboards will provide auditors read-only access to reports and drill down into underlying transactions. Each record offers auditors the level of traceability needed to give them a complete understanding of when the record was created, who created it and whether it was edited and by whom. An ability to attach documents to a transaction allows you to keep your backup documentation with the transaction, making it accessible to the auditors with a click.

A modern cloud financial-management platform can provide access to real-time financial data to everyone in your organization that needs it, including your outside auditor. Your team can still work at the same time the auditor is working, minimizing distractions and keeping your team focused on achieving your business goals.