A closer look - benefits of audits

Entrepreneur, June, 1996 by David R. Evanson

IF YOU GET an uncomfortable knot in your stomach when you hear the word "audit," then ponder this: Some business owners actually request audits--not from the IRS but from their accountants. Others, on the other hand, go through audits when they don't really need to. But knee-jerk reactions against audits keep many entrepreneurs from going through the process when it might do them some good.

Why such aversion to the highest level of accounting scrutiny? Well, even savvy business owners don't always get it right when it comes to the book work. Read on to learn how to sort it all out and save money in the process.

Paul Thrasher, a CPA from Halt, Jackson & Thrasher in Alexandria, Virginia, explains that the clearest way to view all this is to understand the three progressively elaborate voluntary accountancy reports that culminate with a full-fledged audit (we've included their average cost):

1. a compiled statement, or compilation ($2,500): Here, your accountant places your financial information, pretty much as given, into the standard format. Sure, he or she checks some numbers for a semblance of consistency--makes sure bank statements reconcile, etc. But when the smoke clears, the accountant will say only that in his or her opinion the statements conform with GAAP (generally accepted accounting principles). He or she includes a big disclaimer about the accuracy of the numbers you provided.

2. A review ($6,500): The next level of complexity adds more fact-checking but still relies on internal information supplied by you. In a nutshell, the accountant makes you go through the steps he or she would go through in a full-fledged audit.

What makes the review different than the compiled statement, Thrasher says, is that the CPA will question you further and analyze your numbers. While there's no physical review of canceled checks or validated cash-deposit receipts, the CPA "will press the client hard to make sure the client has done it right," says Thrasler.

The CPA also conducts an analysis to ensure that the numbers mesh. For example, in reviewing a manufacturing company, the accountant would look closely at, say, the cost of sales, inventory and revenues, which are related, for internal consistency and conformance to industry norms. Are cost of sales an acceptable percentage of sales? Is inventory an acceptable percentage of cost of sales? These are the kinds of questions a CPA will ask in an effort to uncover anomalies.

Accountants store many quantitative weapons in their quivers for this hunt, such as trend and predictive analysis. "If I know the cost of sales was 65 percent in each of the last four years, then in year five I'd expect it to be about the same," says Thrasher. If not, someone's made a boo-boo. That's when you get grilled and, typically, an error is uncovered.

When it's all over, your accountant offers an oblique appraisal, noting "that he or she did not see anything that suggests the financial statements are not as stated," says Thrasher. It's a kind of negative approval.

3. The big Kahuna--the audit ($10,000). Here your accountant wants to get more intimate. Got $2 million worth of widgets in the warehouse? She may want to see them. How much actually gets checked? "The trick is to find a way to look at just enough pieces of paper to reach a comfort level to sign on the bottom line," Thrasher says. Usually, that's a lot of pieces of paper.

It's easy to understand why. When the audit is over, your accountant stands behind your financial statements as being fairly presented. If someone relying on those statements later feels hurt or cheated, lawsuits can fly, and the accountant will be on the front line, Thrasher says. Lawsuits at smaller private accounting firms remain rare, at least compared with the frequency seen at larger, public companies these days. Still, they are frequent enough to force accountants to back themselves with pricey malpractice insurance--so don't be surprised if your everyday accounting firm doesn't handle audits.

So when should you actually go whole hog and get an audit? Typically, something external drives the need. Here is Thrasher's top-10 list of when audits are necessary:

1. You need bank financing. Banks often insist on an audit before considering lending because they like to lower their risk. Often, however, the point is negotiable (see "Saving Money on Audits," below).

2. You want to buy a business. Ideally, you'd like several years of audited statements and tax returns before making your decision. Even if the seller has audited statements, you'll often want your own CPA to customize the job by delving further into key areas, which vary by industry. That helps dredge up what financial statements alone cannot.

3. You want to sell your business. You'll probably want a series of audits so you can build a financial track record to make your business look its most attractive.

4. You want to go public. Similar to reason number 3, except that you have no choice in the matter.

5. You want to run a better business. Are you willing to spend thousands for a thorough financial review that includes copious suggestions from your CPA on how to make your business more efficient? Though a review may suffice, sometimes you need to go deeper.