ACCOUNTING: Private-company audits make a comeback, but not for all

October 27, 2008

In recent years, Sarbanes-Oxley Act regulations have been a moving force in increasing the emphasis on improved internal controls, governance and accountability in the public markets.

The Securities and Exchange Commission has always required audits

for publicly traded companies, but the primary users of private companies' financial statements-banks and other lending institutions-have been slow to mandate audits.

With the recent turmoil in credit markets and increasingly tight credit requirements for closely held business loans, the audit appears to be coming back into vogue.

Many banks and lenders have historically relied on either a compilation or review of their borrowers'financial statements to satisfy their internal credit documentation and analysis requirements. However, as credit tightens and bank underwriting departments become more aware of the nature and scope of compilations and reviews, they are beginning to understand that these CPA services often have only limited value.

A compilation of financial statements provides very little, if any, assurance regarding the credibility of the underlying data used to create the financials. Likewise, a review-which includes the steps performed in a compilation-offers no assurance on the credibility of the underlying data, other than that obtained through what CPAs call their "inquiry and analytical review procedures."

Notably, neither a compilation nor review includes any evaluation or testing of the businesses' internal controls-which are central to preparing reliable interim financial statements.

Banks and other lenders have been hesitant to require audits from their borrowers, primarily because of the perceived cost of the audit versus the benefit that the bank will receive.

The lack of an audit requirement has become a competitive advantage in many situations, and since reviewed financial statements look like those that are audited, settling for a review is a simple and competitively-sound decision.

The cost of a review ranges from 40 percent to 60 percent of the cost of an audit, but that does not take into account the benefit received from both the bank and the customer.

An audit includes an evaluation of the entity's internal controls by the auditor for the purpose of determining whether the controls can be relied upon. If so, it reduces the scope of the auditor's testing of balances and disclosures in the financial statements.

This is a valuable benefit because these controls also are used to prepare interim financial statements that are submitted to the bank throughout the year to monitor the loan.

Additionally, from the customer's perspective, an audit provides valuable insight into the inner workings of the business, its basic controls, potential areas for fraud and recommendations for improvements in processes, procedures and controls. Although the benefits to the customer are difficult to quantify, business owners who have been stung by fraud or misappropriation of assets will confirm that the value is substantial.

Banks and other lenders are starting to take their cue from the not-for-profit sector, where audits have now become the norm instead of the exception.

Recent Internal Revenue Service changes to the Form 990 informational tax return and ongoing pressures from Congress to clean up the industry have resulted in an increasing awareness of the value of an audit. In fact, most large foundations and other institutional donors won't even consider a grant request from an organization that has not been audited.

Right now, private companies represent the only major market area that has not jumped on the audit bandwagon, but some progress is being made. Banks and other lenders need to get ahead of the curve and begin requiring audits in situations where loan repayment is dependent on factors other than simple collateral recovery.

Based on the recent events in the not-forprofit sector, the sooner this evolution takes place, the less likely it will be that government and oversight organizations will become actively involved.

Alerding is managing director of Alerding Co. LLC, an accounting and consulting firm specializing in entrepreneurial businesses. He can be reached at P.O. Box 90170, Indianapolis, IN 46290-0170; 569-4181, ext. 223; malerding@alerdingandco.com
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