First-Year Financial Statement Audits Warrant Careful Preparation

Private companies generally don’t have an audit requirement for their financial statements unless it’s a contractual requirement because of the terms of a debt or equity financing. But companies may choose to be audited when raising additional capital or if they’re looking to be acquired.

Numerous accounting rules issued over the past several years have made it more challenging for all companies to complete an audit—especially for those completing a first-year audit. It’s not uncommon to miss the original completion timeline. And in some cases, those audits may not be completed at all.

Having the right resources and preparation can increase the chances of a successful financial statement audit. Companies can take several steps to get ready for a first-year audit.

Reconciliations, Underlying Support

Companies should reconcile their general ledger accounts to the underlying support—such as bank statements, account detail, and calculations—of each reporting period as part of the financial statement close process. They should emphasize the reconciliations and underlying support for the year-ends that will be presented on the balance sheet under audit.

Common issues throughout this process include the following:

• Accounts not being reconciled
• Insufficient underlying support
• Large and unsupported reconciling items
• Inappropriate cutoff—expenses aren’t accrued for goods or services received, or prepaid goods or services are expensed before they’re received
• Property and equipment being expensed instead of capitalized

As part of the financial statement close process, companies should ensure the underlying support is complete, accurate, and in accordance with generally accepted accounting principles, or GAAP. This should also include the reviewer testing reconciliations and underlying support on a sample basis.

Technical Accounting

Accounting for certain areas and transactions may be complex, such as debt and equity instruments, revenue recognition, stock-based compensation, provision for income taxes, and business combinations. Audits often encounter several common issues resulting from misapplication of GAAP.

Debt and equity instruments. Embedded features in debt and equity instruments sometimes aren’t identified or aren’t accounted for correctly. Freestanding financial instruments issued with preferred stock instruments are inappropriately concluded to be embedded, and warrants are recorded to equity but should be liabilities.

Also, modifications to debt and equity instruments may not be identified or accounted for correctly. Valuations supporting debt and equity instruments may be inaccurate.

Revenue recognition. This happens when performance obligations are incorrectly identified, and the contract term didn’t consider renewal and/or termination provisions.

Stock-based compensation. This may happen when the grant date fair value is inaccurate or when modifications to stock-based compensation aren’t identified or aren’t accounted for correctly.

Business combination and asset acquisitions. If incorrectly evaluated, contingent consideration is identified as consideration transferred versus compensation. Consideration transferred inappropriately excludes liabilities paid at closing.

Companies should refresh their accounting evaluation for such complex areas and transactions in accordance with GAAP and prepare accounting memorandums as support for the audit. This exercise frequently uncovers significant errors in historical accounting.

Valuations

Valuations record various accounting transactions, including grants of stock-based compensation and issuance of debt and equity instruments. They are also used to record business combinations, which use complex methodologies and significant unobservable inputs and are typically key audit areas. Valuations generally require the assistance of a specialist to withstand the scrutiny of an audit.

Common valuation issues that arise during the audit may include the improper use or selection of valuation methodologies when valuing grants of stock-based compensation or valuing debt and equity instruments. This could happen when companies rely on software system-driven valuations, which generally don’t have support from a specialist to ensure the methodologies and significant unobservable inputs are appropriate.

Companies should be careful of over-relying on software system-driven valuations. They should have a specialist review them and make any necessary updates if material to the financial statements prior to a first-year audit.

Financial Statements

Preparing the financial statements, including footnotes, can take much more time than expected.

Incorrect current versus long-term presentation; non-cash expenses missing from the cash flow statement; cash flows presented net as opposed to gross; data for footnotes not being readily available; and missing disclosures are among the common issues encountered during the preparation of financial statements or identified by auditors.

Companies should prepare the draft of the financial statements early to help identify data and footnotes required and have the auditors begin their review to help meet internal or external timelines.

Advantages of Outsourcing

One of the primary advantages of using a third-party provider to prepare for an audit is their significant expertise with technical accounting and financial reporting and valuation matters. They also will use best practices as much as possible during the process.

Companies should consider the following when choosing a provider: Does the provider have the relevant capabilities and the resources to meet deadlines? Will the project leader maintain a high level of involvement in the project to ensure high-quality and timely deliverables?

By carefully evaluating these factors, companies can select a third-party provider that can assist companies with getting ready for the audit by:

• Reviewing and uplifting account reconciliations and underlying support
• Evaluating complex areas and transactions and preparing the related technical accounting memorandums to support the audit
• Reviewing and uplifting valuations used to record accounting transactions
• Drafting GAAP compliant financial statements and related footnotes

This will minimize any audit risks, enhance the efficiency of the financial statement audit, increase likelihood of meeting the timelines, and free up the finance department to continue with day-to-day accounting work.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Brad Burch is managing director in Stout’s accounting and reporting advisory practice.

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