Private companies typically do not audit their books unless an outside party requires it. Audits are a material expense and require great effort.
The bank is typically the first party to require an audit; outside investors are usually next to ask for an audit, either before investing or as a condition of their investment.
Having worked with almost 100 private companies, the author cannot recall a single case of a company choosing to be audited if not required to do so.
The first audit can be quite difficult if the company’s accounting practices are not consistent with GAAP- Generally Acceptable Accounting Principles. This is often the most grueling part of professionalizing the accounting function of a private company. A first-year audit may be a Balance Sheet only audit since the accountant would need to audit the beginning balance sheet of the previous year to opine on the income statement. When given a choice, consider doing a Balance Sheet audit only for the first year and then the entire financial statement the second year. The second and third years tend to run smoother.
A private company without a functioning board can conduct an audit without having an Audit Committee. Companies form boards to help ownership and management deal with increasing size, complexity, and risk. The Audit Committee is typically the first subcommittee to be formed.
The Audit Committee is responsible for making sure the financial statements are understandable and reliable, internal controls are effective, policies on ethics & fraud are understood and enforced, as well as overseeing litigation and regulatory matters. It also selects & manages the relationship with the public accounting firm and communications with any internal auditors on staff.
When first forming an Audit Committee, what are the key issues to think about from an ownership perspective?
Here are the key questions the author recommends be asked:
Who is the audience for the audit?
Most private companies do not follow GAAP accounting. One benefit of being private is that you can craft your statements to enhance decision-making. But variations from GAAP will need to be negotiated with the auditors. These discussions will be a balance between accounting inertia, management preferences, and the auditor’s requirements. The goal is to get a clean opinion.
If you are doing an audit, you are doing it for a reason. Who is asking for it, and what are their needs? While it doesn’t change the audit process, knowing your audience will help in resolving the open issues.
Do you have a "Unqualified Opinion", also known as a clean opinion?
An audit includes several documents: the audited financial statement; the auditor’s opinion letter to the audit committee; and, a management representation letter. Each piece needs to be examined by the committee. Once the numbers are confirmed, understanding the letters and how to interpret them is where the committee needs to lean in. The goal is to have a clean opinion from the auditor.
A clean opinion means the audit team believes the financial statements are reasonably stated- i.e., free of material misstatement. Audits are not designed to detect, and in fact in most cases do not detect fraud.
Anything other than a clean opinion needs to be investigated and weighed. Auditors are typically cautious and specific in their wording, so a slight change in wording needs attention.
Did management cooperate?
Audit Committees are the critical element in the governance system that keeps management accountable. Otherwise, there could be no real oversight of the executive team.
In most private companies, there are only a few people who work directly with the auditors. The people running the business are usually the same as the people who own the business.
A key function of the Audit Committee is to work with the outside auditor to assess if management is cooperative with the audit process. It may seem odd for the auditor to report back to the people they investigated, but that is how it works. Having outsiders on the Audit Committee is a good way to protect investors. If you are a sizable owner who is not active in the business, then you may want to be on the Audit Committee, as that is the best way to protect your investment.
Are there any exceptions of consequence?
Are there reasons to be concerned with how the numbers are put together? Were there any surprises? Were they material? Remember the auditor’s opinion means the statements are materially correct, not that the auditor will catch every error. Understanding the definition of what the auditor considers material is crucial to understanding the audit. The Audit Committee must get a list of proposed adjustments and adjustments that were considered but not made. If the amount of a single account is off, or the total the financial statements are off without an adjustment, then that adjustment needs to be understood.
Once the issues are understood, the committee needs to apply judgment to resolve differences and attempt to move to a clean opinion.
Don't skip executive session
Once the audit process is completed, there should be an executive session to discuss any possible concerns the auditors may have had with the management team. Was the CFO uncooperative? Was there any suspicious activity? What can we do better?
This is the time for the committee to probe, ask tough questions, and listen closely for both what is said, and more importantly, what might not be said. This is the time for outsiders to step up since they are often more able than insiders to ask uncomfortable questions.
In long-term relationships, the executive session tends to be perfunctory since everyone knows each other, and the audit process does not vary much year to year. That is a sign of success.
Where to start?
Developing an effective audit committee requires effort, and you may not have a ready roadmap. Like many things in business, it helps to have a checklist. This list is a starting point to develop a more thorough list customized to the needs of your organization.
A great audit process has no surprises; it just needs to get done. But it should give owners comfort that their assets are being managed properly, and appropriate safeguards are in place.
Note: The original version of this article was published in Forbes.com in Feb. 2023. A number of enhancements have been added in this version for PDA.
ABOUT BURCE WERNER
Bruce Werner is the Managing Director of Kona Advisors LLC, which provides governance and advisory services to middle market businesses. His range of assignments includes board formation, strategy, finance, M&A, succession planning and all facets of family business consulting. Mr. Werner is an experienced outside director, having served on numerous boards during periods of growth, restructuring and crisis management.
He writes and speaks on ownership and governance issues impacting the middle market.
Bruce's second book titled "Navigating Private Company Governance" will be released in the fall of 2023, and is available at www.BruceWerner.com
You can reach Bruce at 847-910-2025 or [email protected].