Plugdin Insights: How to prepare for your first audit
Plugdin Insights: How to prepare for your first audit
Read time: 9 minutes
The auditing process can be an intimidating procedure for younger businesses, particularly in the tech sector, where uncertainties about technological viability and commercial continuity are common. Tom Laird, expert in guiding businesses through their first and subsequent audits, discusses the various complexities to be aware of as a founder approaching your first audit.
How do you normally help a business prepare for their first audit?
The first thing to consider is why the business needs an audit. You're either undertaking an audit because you're mandated to have one by law, or because you’ve chosen to voluntarily. You might elect for a voluntary audit because an investor in your business wants it for their peace of mind – common for early stage or high growth businesses - or because you anticipate fundraising rounds in the near future.
If voluntarily undertaking an audit, the decision about which period you decide to have audited – and whether you're looking back or whether you're looking forward - is important. If your business has breached the statutory size criteria, that decision has been taken away from you, but you should seek to track this in advance to avoid the requirement for your first audit coming as a surprise.
"Whether its mandated or elective, it's important to consider the timing of an audit and how you prepare for it to ensure the business gets the most value from the process."
When I speak to start-ups and high-growth businesses, they are not always aware of what the business should seek to do, by way of preparation, in advance of that first audit. It’s really important, as a business, that you look to engage with your auditor early – and certainly before the year end you're having audited.
By way of example, if your business was intending or required to have your first audit at the end of the calendar year, you should absolutely engage in that process well in advance of that time. It's easy to think that because the audit is examining historical information, you should only engage with it near the end of the audit period, or subsequently.
The reason I say that is there's certain things that a business may want to do before its reporting (or balance sheet) date, which locks certain transactions and decisions taken in place. I encourage an up-front open dialog considering key judgements, accounting treatments and transactions, in advance of the reporting date to avoid unwelcome surprises arising from the first audit process.
What’s the key thing tech businesses should know before undertaking an audit?
The most significant part of the audit is examining the decisions taken by management of the business in connection with key judgements and choice of policies which effect the financial statements. How these decisions align with the requirements of accounting standards, and common practice in the sector, will be the key focus points of any audit.
In many high growth and developing businesses, the treatment of revenue will be the key consideration. Many tech businesses experiencing an audit for the first time may not actually have a significant amount of revenue, and therefore might have revenue accounting policies which are still evolving or consider only basic principles. However, if the revenue accounting is not well defined there is a risk policies may be inconsistent with accounting requirements, and could require adjustment. An audit can help identify and mitigate this risk early.
This is particularly relevant if talking to current or potential investors about your figures. Any business wants to avoid restating revenues and earnings figures because they were not wholly aligned to accounting standards or expected practice. My approach is to sit down with the CEO or CFO of the business and clearly identify what the business does, what value it provides to clients or customers, and how that value is delivered in practice. Discussing how revenue is ‘earned’, in advance of that first audit, can help ensure you’ve got the accounting right. This also provides comfort to the business, going into that first audit, that there shouldn’t be unpleasant surprises around such a key figure as reported revenues.
If you're only first looking at or discussing these factors after the balance sheet date, there are risks that the business may have to make changes to its accounting which may have been avoidable. Having these conversations early enough, particularly with advisors who are familiar with the sector, helps you to identify if there’s anything that may cause a problem.
Is it beneficial for businesses underneath the £10.2 million threshold to voluntarily have their first audit?
I think it depends on where the business is in its growth cycle, and on what they're looking for. Having an audit can provide significant comfort for potential incoming investors. Someone independent has come in and kicked the tires, so to speak, and reviewed policies, procedures and business controls. It will give current and potential investors more confidence.
"If you're getting into series A and B funding rounds after seed rounds, investors will often mandate a statutory audit is completed."
If the business is looking for, or has recently raised, a significant round of investment based on certain figures, but a first statutory audit subsequently changes those figures it can cause a serious headache, and unwelcome distraction, for the business.
What kind of costs can a business expect in preparation for an audit?
It varies significantly, but there is a ‘base cost’ of delivering a statutory audit, even for a very simple business, due to requirements of auditing standards. In London, the fee for an individual company audit will often start from £20,000. The price is altered by the complexity of the work involved; it's not necessarily the number of transactions or the size of revenue, it's how complex the business is.
These complexities can encompass several things. Is there a group and do you need to prepare consolidated group financial statements? Are there overseas subsidiaries? Do other auditors need to be involved? How complex are your activities and how standardised are your contracts with customers?
These are the key drivers of cost, driven by risk rather than basic size metrics. A business that has £50 million of turnover could easily have a lower audit fee than a business with £10 million of turnover, by virtue of the fact that the lower turnover business is much more complicated in its structure or audit risk.
It can be a challenging conversation for businesses who need an audit for the first time. However, simply because a business hasn’t had an audit before, it doesn’t mean that it will be inexpensive.
What common misconceptions are there about being audited for the first time?
Many people aren't necessarily aware that the first time a business has an audit, the opening balance sheet always has to be considered. If, for example, you're going to have an audit for the first time on the 31st December 2019, your auditor also has to audit your figures from the start of that period, which would be the 1st January 2019. Some businesses who have grown quickly and might be lacking a full finance team may not realise that the audit encompasses so much, and that the opening balance sheet must be considered with the same rigor as the closing balance sheet. This is another reason why engaging early with your auditor is a positive thing to do.
In addition, for some people there is still a misconception that an audit is a literal box-ticking exercise, where the auditor will come in to just tick off contracts, expenses etc. I’ve already highlighted that an audit is a broader assessment of a business’ approach to key policies and judgements. This means senior people within the business need to have their input. For audits of tech companies and similar businesses, it’s likely to involve a discussion with the CTO, or equivalent, to understand the technology and if it, and related transactions, are being accounted for correctly. Different stakeholders in the business need to buy into the audit process to ensure the business gains the most value from it.
What is the main evaluation criterion for an audit?
One of the key things for high growth and developing tech businesses to think about is ‘going concern’. It is a requirement of the UK Companies Act for the directors to consider the basis of preparation of the financial statements, and the use of the ‘going concern’ basis. This is the assumption that the business will continue to trade for a period of at least 12 months from the date you sign the financial statements – which may be six to nine months after the reporting date.
Going concern is prominent in the public eye at the moment, as well as the role of directors and also auditors. There have been a number of significant corporate failures recently; and while businesses like Carillion are of very different scale to the businesses I’m talking about here, all businesses are held to the same standards under UK law. There is also currently significant focus on this area from investors and regulators.
"For a young, growing business, it's quite possible, or likely, that the business knows it will need more cash or funding to get through the next 12 to 18 months."
It may well be part of the current business plan that there's going to be another funding round, and the financial statements will need to disclose this, alongside what uncertainties exist in connection with this. The audit report will have to refer to it as well.
There are numerous examples in the market of how that appears, and sophisticated investors are used to such disclosures, as long as it's part of the current plan for that business. They will expect to see it in many cases. The language can however appear stark to those unfamiliar with it, with refence to a ‘material uncertainty’ often being mandated by auditing standards. It is a fundamentally important part of the audit to not just consider the historical financial information and consider what the businesses future looks like and how that will be funded. This again is another area I recommend discussing early with your auditor.
What kind of uncertainties might a tech business specifically encounter?
Following on from the above regarding going concern, tech businesses often encounter funding cycle challenges, as well as uncertainties relating to developing and maintaining talent to ensure the business can continue to grow. Many commercial risks may not necessarily find their way directly into the financial statements, however the need for successful fundraising for the business for both growth and working capital, is often reliant on audited financial information. As a result, the financial statements remain an important document for the business’ future growth.
Considering financial risks, I am increasingly seeing international tax risks effecting more clients. It's very common for high growth tech businesses to go international very early in their life cycle, and are often attracted to certain markets, the US being a prime example. There has been a huge amount of movement in certain tax laws and legislation around the world, particularly in areas such as sales taxes.
Businesses selling internationally, even if they're not selling physical goods, and even if they're selling remotely, can be subject to local overseas tax requirements. The penalties of non-compliance can also be severe. This is a very quickly changing and evolving area; and digital and other technological goods are changing the landscape of various taxes, even where no physical goods are involved. An audit must assess potential tax risks and any potential liabilities that may arise from non-compliance, including penalties which may apply. With this in mind it is important that both your audit and tax advisors understand your business, the sector, and are aligned to avoid tax risks creating unexpected financial reporting and audit issues.
Any final advice for tech businesses thinking about their first audit?
It’s important to ensure you have a realistic timeline for your audit, particularly noting that the business’ first audit may take a little longer to complete, and the timeline has to be one your stakeholders support. It’s also vital to make sure that the team within the business supporting the audit have the time to adequately prepare, to avoid the process becoming inefficient or impacting the day to day operations of your finance team.
A key factor to consider is timing, as I mentioned before. There are certain actions – usually types of transactions or critical decisions – that can’t be changed if you haven’t completed them by your statutory year-end. If these aren't completed in time, you could effectively lose an opportunity, and unwanted accounting implications may arise as a result, and I would therefore always encourage businesses to speak to an audit firm as early as possible.
Thinking about undergoing an audit, or just finished your first audit and have some thoughts? Let us know your tips and concerns about the process by emailing firstname.lastname@example.org.