All companies are subject to financial audits, but why and when your company gets audited depends on its growth trajectory and finances. The Securities and Exchange Commission (SEC) requires public companies to submit quarterly and annual financial statements, and, depending on the particular circumstances, your own company’s requirements may be more rigid. Private companies, on the other hand, aren’t mandated by the SEC to conduct financial audits. However, many private companies elect to undergo regular audits to attract investors and lenders.
You don’t need to wait for a fundraising opportunity or for one of your investors to request an audit to prioritize audit preparation, though. Having a plan in place can help prevent bookkeeping errors and ensure your company is complying with accounting standards around stock-based compensation reporting, equity, and taxes.
What is a financial audit?
A financial audit is an evaluation of your company’s financial statements to assure investors, regulators, and other outside parties that your reported values are complete and accurate. If your company doesn’t follow the rules, you may have to pay a penalty.
There are three types of financial audits:
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IRS audits: The IRS performs financial audits based on random selection, but they also examine businesses that have a record of suspicious financial reporting. According to the IRS 2018 data book, in 2018 the IRS audited roughly 0.9% of corporation tax returns filed in 2017.
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Internal audits:These are conducted by someone within the company.
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Independent audits:These are conducted by a third party, typically a CPA firm.
Depending on your company’s financial goals and growth, you may want an independent audit to:
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Appeal to outside investors and gain their trust
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Satisfy a requirement from an insurance company
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Get a loan from a bank
What does the financial audit process look like?
Auditors abide by generally accepted accounting principles (GAAP)—guidelines that the Financial Accounting Standards Board (FASB) sets and enforces.
An auditor’s job is to review your company’s financial statements with GAAP in mind to test whether your company has calculated and reported its taxable income, losses, deductions, and expenses correctly.
If your company is voluntarily undergoing an audit, whether internally or independently, you’d simply hand over your financial documents to the party in charge of reviewing them.
If an auditor finds any inaccuracies in your company’s financial statements, they are obligated to let you know. If your company agrees with the auditor’s assessment, you can make the necessary change to your statements. However, if your company doesn’t agree and challenges the auditor’s assessment, then your auditor cannot sign off the report with a clean opinion, otherwise known as an unqualified opinion. Instead, they may choose to sign one of the following opinions:
A qualified opinion means the company’s financial records have not abided by GAAP in all areas.
An adverse opinion means the company’s financial records are not aligned with GAAP and are egregiously misstated.
A disclaimer of opinionmeans the auditor was unable to complete the report because of insufficient financial statements or a lack of cooperation from the company.
What do auditors look for?
Auditors typically evaluate a business’s bookkeeping and gather supporting documents to back their journal entries. Supporting documents could be bank statements, invoices, receipts, income statements, balance sheets, and confirmations from third parties. On occasion an auditor may even conduct a physical procedure, like visiting a shipping facility.
In addition to the above, there are three key areas auditors assess when auditing a private company:
1. Cap table and reports
A cap table is a record of your company’s ownership distribution. It lists all your company’s securities—including stock, convertible notes, warrants, and equity awards—as well as who owns them.
Using the information from your cap table, auditors perform tests and determine whether or not your valuation assumptions are compliant, your expenses are accurate, and the equity portion of your balance sheet is correct.
2. 409A
A 409A is an independent valuation of the fair market value (FMV) of your company’s common stock. The FMV determines the strike price for equity awards issued as compensation to founders, employees, board members, investors, and other parties. Your company needs a new valuation every year or whenever a material event occurs, such as a merger or funding round.
Auditors look at your company’s 409A valuation to determine whether or not you’ve priced your equity appropriately.
3. Stock-based compensation expense reporting (ASC 718)
ASC 718 is a set of rules outlined in the Accounting Standards Codification (ASC), which is written and enforced by the FASB. ASC 718 outlines the steps a company must take when reporting stock-based compensation on an income statement, including calculating the fair value of the stock option and amortizing the expense over time.
Audit preparation: Two important steps to take
The financial audit planning process requires careful bookkeeping and good organization. Follow these two steps to set your private company up for a successful audit.
1. Gather your documents
Make sure your financial statements and electronic records are organized and easily accessible at all times. That includes your company’s accounting records, such as journal entries and general ledgers, as well as your cap table, receipts, invoices, checks, bank statements, and financial statements.
If you don’t already have a system for updating and filing your financial records, consider investing in accounting software. Precise bookkeeping shows auditors you update your financial records regularly and accurately.
2. Upgrade your expense and compensation reporting
For late-stage private companies, tracking changes in equity compensation can be complicated, given the complex accounting principles and requirements. Fortunately, the right tool can simplify the process.
At Carta, we offer stock-based compensation expense reporting solutions that help you stay GAAP-compliant and audit-ready all year. Carta’s stock-based compensation expense reporting software integrates with your company’s cap table, so your expenses accrue automatically as you issue options. Plus, you can view and access expense or disclosure reports monthly, quarterly, or annually depending on what you need.
Our reporting software doesn’t just produce clean, accurate accounting; it also saves you time and hassle. With Carta, you don’t have to carve out time to prepare your financial records; they’re automatically updated—and ready to send to an auditor—whenever you need them.
DISCLOSURE: This publication contains general information only and eShares, Inc. dba Carta, Inc. (“Carta”) is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.