This article explores the benefits of being financially audited for entities not required by law or regulation to be audited.
Why are entities audited?
The majority of entities that obtain an independent audit of their annual financial statements are audited because they have to be.
Due to their type, and/or nature of operations, such as raising money from the general public, legislation or regulation specifies they must be audited. Other compulsions include a term in the entity’s Constitution or rules, or as a specific requirement of their funders. In all these cases the entity has no choice in the matter.
However, there are other very valid reasons that entities should consider an audit even if they are not compelled to. We explore some of the main ones below:
- A decision to adopt governance best practice
Good governance often involves seeking an independent and hence an objective perspective on matters of importance. The financial health of any entity is a key area of importance for governance. Without financial health, an organisation cannot hope to achieve its other aims, no matter how noble or well intentioned. Hence getting independent audit experts to assess the truth and fairness of the annual financial statements is recommended good governance. The results should provide comfort to the governing body, or if not; a wake up call to required actions.
- Management confidence
An audit by an objective independent audit expert can also assist management by giving them confidence in their existing financial systems and internal controls as well as sometimes identifying weaknesses and potential future improvements. Over time it is easy for systems and processes to continue as ‘they always have’ or become stagnant whilst businesses change. Often an audit is the only time management can receive feedback on systems which are based on good business practices followed by similar companies.
- Investor confidence
Many entities, especially companies, rely on a range of investors to fund their businesses. These can range from traditional shareholders to angel investors. Other forms of investor funding now includes such concepts as crowdfunding. Commonly these investors will not be actively involved in the day to day operations of the entity, nor will they have access to management’s financial reporting systems and regular reports to be able to assess progress. In addition to not having access, many will not want to have to be involved in that level of financial analysis to determine if they should continue to have confidence in the entity’s financial affairs.
- Loan funder confidence
Closely related to the above. If not already a specific requirement of bank funding, an independent audit of the financial statements can be a useful way to provide more confidence to existing or potential loan funders. As banks become more capital conscious, an audit can give you a better chance of keeping or extending funding.
- Building a financial history for future sale or expansion requiring funding
The sale value of most entities is a direct function of their financial performance, their financial potential (often assessed from past performance and forecasted results), including the value of their assets and liabilities. Most purchasers are primarily motivated by the future income and cash generating potential of the entity they are considering purchasing. As it is impossible to guarantee future financial performance, considerable reliance is usually placed on past performance as a proxy. This is because most investors will know what value they can add to a business however they will want to ensure that the starting base in which they operate from is in line with representations of current owners. An independent audit significantly improves the credibility of past financial performance and helps to remove concerns about management being motivated to present an overly rosy picture to potential purchasers. Having a history of audited financial statements can also significantly reduce purchaser due diligence time and effort. For particular types of investors, audited financial statements are often an expected pre-acquisition requirement. Where audits are not completed, this may result in multiple years of audits being conducted for the first time in addition to purchaser due diligence.
The audit process – what it does and doesn’t do
While very valuable due to the above reasons, an independent audit of annual financial statements by a suitably qualified statutory auditor is not a silver bullet though. Hence it is important to understand what is and isn’t involved.
It is primarily designed to allow the auditor to form an opinion on the truth and fairness of the annual financial statements. To get to this output this involves the auditor understanding the financial recording and reporting systems, assessing risks of misreporting, and then testing a sample of transactions, controls and balances to a certain level of materiality to be able to form their opinion.
However, this means that they do not test every transaction. Nor will they necessarily query the nature of expenditure if it appears to have been appropriately approved by management or the entity’s governing body in accordance with their constitution, systems and processes.
A common misconception is also that an audit effectively guarantees “100% correctness” of all transactions that have occurred in the organisation. It does not. Rather it provides a high but not absolute level of independent assurance over the truth and fairness of your annual financial statements. The primary responsibility for an organisation’s systems and internal controls and processes always remains with the governing body.
Audits also come at a cost for the professional’s expertise. As such in very small entities the cost of audit can seem disproportionately high versus the benefit.
Alternatives to audit
While auditors mostly perform audits of annual financial statements it is important to appreciate that that they can also perform a range of other independent assurance services using their skills and expertise. Hence their independent services may still be very useful to an entity for say an audit of the entity’s internal controls over financial reporting or for compliance against a specific requirement.
For the small to medium sized market here in New Zealand there is a growing trend of privately held companies voluntarily requesting a level of external assurance to help provide creditability to their financial results. If you would like to discuss your options
The team at RSM would be happy to discuss independent assurance services and how they may assist your entity.