Should you, the owner of a privately held business, pay for an accountant or accounting firm to compile, review or audit your financial statements?
In cases where such is required by a governmental agency, lender or bonding company, the answer is pretty simple – you have to pay to play. But for the vast majority of business owners, it’s a choice. The correct answer to “should I” is not readily apparent. It’s a judgment call.
First, by way of review, the issue is one of “quality of financial statements.” Of course, by “financial statements” we mean your income statement, balance sheet and statement of cash flows. Generally, compiled statements are deemed to be of higher “quality” than company-prepared statements. Reviewed statements are viewed as higher quality than compiled, and audited statements are viewed to be of higher quality still. Here’s a description of each:
Company-Prepared Financial Statements: Also referred to as internally prepared and/or management statements, these have not been organized, reviewed or validated in any way by a certified public accountant (CPA). Of course, your accounting firm could have helped you set up your accounting system and the methods you use to keep your books and generate your statements. Or you could be an accountant yourself and your company-prepared statements are well-organized, prepared according to GAAP, and represent fairly in all respects the performance and financial condition of the business. But unless an accountant or accounting firm compiles, reviews or audits the statements, they are simply company-prepared and – given that no independent person of authority (i.e., certified public accountant) attests to their “quality” – investors and creditors have little way of knowing what methods were used to prepare them or how fair or accurate they are.
Compiled Financial Statements: These are financial statements that have been created by an accountant or accounting firm from the company-prepared statements. The firm simply took the information provided by the subject company and created financial statements that conform to how statements are supposed to be organized. “Supposed to look like” is dictated by GAAP. Compiled statements don’t carry any warranty or pledge of any kind by the accountant or accounting firm as to accuracy or whether or not the books were maintained or developed in conformity with GAAP. In essence, one could say compiled statements are just made to look pretty and professional. And, as we know, this is worth something since people judge a book by its cover.
Obtaining a compilation for a small or midsize private company might cost between $1,000 and $7,500, depending on the audit firm, geographic location and complexity of the subject business.
Reviewed Financial Statements: As the name implies, reviewed statements have been reviewed by an accountant or accounting firm. The extent of the review is limited, not nearly as thorough as a full audit. Reviewed statements should and will include a letter from whomever did the review. This letter will explain the extent of the review, notes about how or where the statements may deviate from GAAP, and any opinion or representation that the reviewer can provide about the statements. When reviewing reviewed statements, one should keep in mind that a review is limited and does not guarantee accuracy.
Obtaining a review for a small or midsize private company might cost between $4,000 and $20,000, depending on the audit firm, geographic location and complexity of the subject business.
Audited Financial Statements: Audited statements have undergone in-depth review and testing by a qualified third party. Similar to reviewed statements, they should be accompanied by a letter from the auditor. Among the important things revealed in the letter is the extent to which the auditor is able to render an opinion of the accuracy and fairness of the statements. An unqualified opinion means that the accountant has no reservations or concerns. As far as third-party assurances go, an unqualified audit opinion is the highest level of assurance about the quality of a firm’s financials. A qualified opinion means otherwise, so take caution.
The audit firm also issues a letter to management, which can be helpful to the owners and managers, and contain suggestions for improving accounting methods and processes.
Obtaining an audit for a small or midsize private company might cost between $7,000 and $50,000, depending on the audit firm, geographic location and complexity of the subject business.
Even GAAP Leaves a Wide Gap
Business owners, investors and creditors should keep in mind that two identical businesses could generate financial statements that look very different. Furthermore, both could receive unqualified audit opinions. How could this occur? Well, quite easily, really. GAAP allows considerable room for management to interpret and apply GAAP rules, primarily because many of the rules require management to assess situations and apply the rules accordingly. To be sure, different people see situations differently. One executive could deem a receivable highly collectable while another feels strongly that the account is at risk. The accounting would likely reflect the divergent views. Similarly, one firm could be aggressive in how it applies the rules – in an attempt to show maximum current income, for example – while another set of managers could be conservative and less motivated to maximize today’s book profit and/or equity.
Quality and Credibility of the Auditor
As we all learned in the 1990s, the credibility and quality of the audit firm is an all-important factor. Arthur Andersen audited the books of Enron (among others) and year after year issued unqualified opinions. We later learned that its accounting was an abomination. Those who relied on the statements, and trusted the opinion of the auditor, lost billions.
As another case in point, in a recent M&A transaction (i.e., business purchase/sale) that I was involved in, the selling company had an audit. All things being equal, the existence of an audit is a good thing to the extent it adds to one’s ability to rely on the statements to present a fair picture of the financial health and performance of the business. This was true in this case, but the buyer also noted that the audit firm was not one we recognized or could easily find much information about. Not even a Web site.
Then, early in due diligence, the buyer found that the cost of the audit was well below standard rates – another red flag. So the buyer conducted his own audit and found material deviations from GAAP. The auditor was a solo artist and old friend of the controlling shareholder of the selling company. In the end, there really was no audit conducted. Still, the books and records of the business were fairly well organized and buyer was able to assess the business, develop his own view of its performance and health, and eventually complete the purchase.
For the Business Sale?
I commonly hear business sellers say, “I got an audit because I was told buyers require it.” Well, I’ve worked on a lot of business purchase and sale transactions, and my experience is that selling firms do not need an audit. First, few small and midsize private companies have reviewed or audited statements. As such, buyers of small and midsize companies (along with their debt and equity sources) are used to dealing with company-prepared financials. Second, whether or not the selling firm has compiled, reviewed or audited statements, the buyer will have to investigate how the selling firm prepares its books. No buyer will just rely on the audit stamp as proof that the financials are “fair.”
And so, I would say that – for the business owner who wants to sell his or her business in the near future – reviewed and/or audited statements are a “nice to have,” not a “need to have.” The bigger issue is the overall health of your business and whether your books are kept according to GAAP and in a fair and reasonable manner. Buyers just want to know how much money the business is making. So long as you can help them get a pretty good feel for this, your accounting and financial statements will serve their purpose.
For General Principles?
For many businesses, there are no clear and convincing reasons to pay for improved financial statements such as a compilation, review or audit. And so, I think it comes down to personal preference. Some business owners like to do everything “first class.”
“We do things like the big boys,” I think I heard one business owner say as he proudly presented his audited financials.
To be sure, it’s not going to hurt. The question is what is the highest and best use of those dollars? In some cases, maybe it’s an audit? Or in some cases, one might be able to consider it more of a personal expenditure of the owner. Let’s say the audit has no real business purpose and the business owner would not pay for it unless there were excess profits to be had. So, in this way, the business owner could take the $50,000 out of the business as a return on investment or pay for the audit. The business owner can do whatever he or she wishes with his money – save it, buy a boat, give it to charity or buy an audit.
Do you have an opinion on these matters? If so, send them to firstname.lastname@example.org. We’ll share them in the next issue of The Business Owner.
Brent Johnson, assurance partner with HoganTaylor, contributed his expertise to this article.
This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2014.
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