Compilations, Reviews, and Audits
$15,000, $30,000, and $60,000.
That’s typically my pat answer when someone asks me about the difference between compilations, reviews, and audits, respectively. And I’m dead serious when I say it.
Quick Overview of the Three Reports
Compilations require less time and effort for the CPA firm to issue. And that means the price tag is lower too.
So, guess which reporting format I prefer when negotiating with bankers after they start pushing for CPA-issued financial statements? Do I even need to answer that one?
If I get push-back from bankers, I suggest full-disclosure compiled financial statements as an option. While there are still no assurances that the numbers are free of material errors or omissions, the disclosures make the reporting look (and even feel) more “official”. Believe me, it just does.
True, CPA firms will charge more to add the disclosures, but if you have a strong financial team on board, the accounting staff can help write or draft the note disclosures with CPA guidance.
If that’s not the case, you are only looking at a higher one-time cost in the initial year of the compiled financial statements. The cost should drop the following year since the disclosures do not need to be created from scratch, just updated.
Reviews cost more. Reviews require more time to complete. Reviews start eating into accounting staff time when their year-end schedules are already stretched.
I will also add that as a KPMG alum, I’m finding the line between a review and an audit somewhat blurred.
My win-loss record of getting the reporting downgraded to a compilation is higher with bankers than it is with insurance underwriters.
If you are a general contractor or sub-contractor, and your client base requires surety bonds, in many cases, the underwriter will require a review at a minimum. If you are one of the lucky ones with a great balance sheet sitting on a strong equity position, the underwriter may accept just compiled financials. But good luck on that one.
Finally, audits require much more CPA fieldwork at your office, and you will feel it more so in your wallet. In return, you get a report that you will probably not read nor will your banker (that’s not sarcasm).
My Biggest Frustrations with Audits
The big check you write to the CPA is only part of the cost to fund this non-value activity. As mentioned earlier, your accounting staff needs ample time to prep for these audits. Additionally, there is a fair degree of babysitting in terms of answering questions, updating schedules, and resolving issues raised by the auditors.
Audit reports are not easy to read. That’s why my clients do not read them. And the bankers that I work with? At least I have a few admitting they prefer our internal financials over the audited statements.
In short, the audited statements are adding next to no value. Yet, the audit requirement still remains in many bank covenants because, well, “because that’s just the way it is.”
The Ultimate Option to Reviews and Audits
I gave the answer away by leaving out compilations.
The best way to eliminate the review and audit requirement from a bank is to develop trust over time.
If you continue to pump out report after report each and every month without your bank prodding you to do so, that can be a huge score in terms of building trust and confidence in the numbers. Additionally, I find it helps to do the following with your banker:
1. At least annually, walk the banker through the month-end closing process (mine are very detailed with as many as 100 steps). When my bankers see the closing process of my clients, they are awed. In short, the detailed process of closing is like a mini audit each and every month.
No, it’s not an audit, but it’s similar in that every balance sheet account is reconciled and P&L balances are reviewed for reasonableness.
2. Tie-out (reconcile) the internal statements to the year-end tax return and show the output to the banker. Most bankers get it. They know that their clients are not likely to lie on their tax returns. Accordingly, an easy-to-read reconciliation between the financials and the tax return is a strong option to a full-disclosure audit.
3. As a kicker, I’ve also suggested that the bank bring in its own people to conduct agreed-upon procedures for certain balance sheet accounts like accounts receivable or inventory. Coupled with a full-disclosure compilation, agreed-upon procedures are a great low-cost alternative to reviews and audits.
4. Regarding agreed-upon procedures, I also recommend about 10-12 fraud-related steps that are never performed in most financial audits. All findings by the CPA firm go directly to the bank. I’ve never understood why more CPA firms don’t do this. Is a value-adding activity for bankers and business owners.
Wait a Minute, I’m Selling My Company–Don’t I Need an Audit?
The short answer is, “No.” The longer answer is “Absolutely, no way.”
My peers view me as a contrarian on this topic as many CFOs think an audit is crucial for getting a business sold.
I do not agree. Most strategic buyers (even financial buyers) will perform their own due diligence. Plus, if there are questions with the numbers, there are probably issues elsewhere in the underlying company that is being acquired.
I turned to my friend, Larry Reinharz for an outside opinion on this topic. Larry is a Managing Director for Woodbridge International, a leading M&A firm with offices around the country.
Larry agrees with my position that business sellers do not gain any advantages by subjecting themselves to full-scope audits. According to Larry, most of the businesses they sell do not have audited financial statements. What these businesses do have is growth, an enviable bottom line, and demand by a short, but meaningful list of qualified buyers.
Mark, don’t get me wrong. Audited financial statements prepared by a reputable CPA firm will only help sell a company! However, it is not the most important aspect of exit planning.The most important aspect is that the company continues to grow revenues and profits, keeps up the sense of urgency, and builds a healthy backlog.
My favorite story Larry tells is one where the seller company had audited financials but …
Yeah, ironically we were selling a company a number of years ago that was owned by a CPA, and he had audited financial statements prepared by a reputable CPA firm. We marketed the company, obtained multiple offers, held management meetings, negotiated Letters of Intent and the client executed a Letter of Intent with the buyer of his choosing. The buyer then went into financial due diligence and discovered fraud–the owner was overstating his inventory in order to obtain financing.
Ouch. Or should that be whoops?
Remember my comment above about agreed-upon procedures? Valuable. Audited financials – not valuable.
The next time a banker requires an audit based on your current lending situation, ask about options. I truly believe a full-disclosure compilation with bank-driven, agreed-upon procedures is a winning combination. The cost is reasonable, and the time commitment from your staff will be manageable.
The important thing to know is your options. You just need to ask.
One more thing. When your buddy who is an audit expert says, “As your business grows, you need audited financials.” Just smile and say, “Yeah, right.”