Clean books and records are vitally important when you sell your business. They verify your credibility as a seller and minimize the likelihood that purchase price will be negatively adjusted during diligence. If your company follows financial reporting guidelines as outlined by Generally Accepted Accounting Principles (GAAP), buyers have a higher level of confidence in your business and feel confident supporting a higher valuation. If your company deviates from GAAP (some ways include: inaccurate inventory costing, no accruals, no bad debt expense), buyers will be less likely to “trust” your financials and often require stronger indemnification provisions when you represent your financials.
As a business owner of a private company, you have the freedom to choose how your company reports financials annually, with either compiled, reviewed or audited financial statements. Pros and cons exist for each approach, from cost of the report to level of confidence in results.
So, which method is right for your company?
Compiled financial statements are the least expensive and least extensive type of financial report. Compilations are simply a converted copy of your company’s internal records prepared by an independent Certified Public Accountant (CPA) without any additional audit services provided (no checks for internal controls or review procedures performed). The CPA is not required to verify that financials are reported according to GAAP, or expected to offer opinions or suggestions for improvements (although, if the accountant observes any blatant fraud or misrepresentation, they are obligated to ask more questions or withdraw from the engagement). Compilations include a summary page from the CPA stating that they have not reviewed or audited the financial statements and do not provide assurance of their adherence to accounting standards. Since compilations do not offer any assurance that financials are accurate, most lenders, creditors and investors disregard their validity and mandate audited or reviewed financials at a minimum before making investment decisions.
Pros: Low cost. Less invasive.
Cons: No assurance that financials are accurate and according to GAAP.
Summary: Good for companies who want to spend less, but have organized financial statements assembled by an outside party.
Reviewed financial statements, also done by a CPA, cost more than compilations but less than an audit, and provide some (limited) assurance that company reports are accurate and adhere to GAAP. The accountant still does not check for internal controls or fraud risk, but does investigate areas like:
- Inconsistencies or deviations from GAAP
- Complex or one-time transactions impacting reported results
- Significant transactions and journal entries, especially those occurring near the end of an accounting period
The CPA also examines internal company accounting procedures to analyze methods for handling cash and receivables, inventory, fixed assets (capitalization and depreciation), accruals, classification of debts as long or short-term, stock issuance, revenue recognition and more. Reviewed financial statements reveal any areas significantly deviating from GAAP, and offer investors and lenders confidence in the financial health of the company under consideration.
Pros: Some assurance that financials are accurate and follow GAAP principles. Not the most expensive option.
Cons: More invasive and time-consuming than a compilation, and not the cheapest option. No check for internal controls or fraud risk.
Summary: Good for companies willing to invest a little more to know their financials are in line with standard accounting principles and gain credibility from outside groups.
A professional, comprehensive exam of a company’s financial records, processes and internal controls by a third-party auditor is the most expensive, yet most trusted, kind of financial report. In an audit, the independent accounting firm comes onsite to review financial files, run sample tests, affirm necessary checks for control are in place and verify that financials are in line with GAAP. Audits provide reasonable (but not absolute) assurance of clean financials, and lessen the likelihood of fraud.
The Securities and Exchange Commission (SEC) requires that all public companies audit their financials, but does not require private companies to do the same. In most purchases of even small, private businesses, however, buyers hire an independent accounting firm to perform some level of financial review during the diligence process to verify the accuracy of the provided financials.
Pros: High assurance that financials are accurate and according to GAAP, without fraud and appropriate internal controls are in place.
Cons: The most expensive option. Extremely invasive and time-intensive.
Summary: Required for public companies, and recommended for private companies looking for lender financing, investor capital, or who wish to sell soon.
So, what kind of financial reporting should my company practice?
The short answer, it depends on your goals. If you own a small to medium-sized, private company, it’s probably not in your company’s best interest (or necessary) to pay for an annual audit just for your own peace of mind. It is, however, valuable to hire an outside CPA to compile or ideally, review, your financials and check for basic accounting errors. What you see as minor decisions, such as how you calculate inventory or accrue (or don’t accrue) for bad debt, can have a significant impact on the way your financials are presented.
If your goal as a business owner is to reduce expenses, compiled financials are likely your solution. If, however, you’re planning to sell your business over the next 12-36 months, it might be worth spending a little more to have your financials reviewed or even audited to gain credibility and present your company in its best (and most accurate) light when you take it to market.