Understanding Audits

Years ago, a few board members of our co-op felt the management had let things go to such a state that neither the board nor perhaps management had an adequate grip on what was going on. They called for an audit.

The audit took place; but due to lack of understanding of an audit's potential and purpose, it did not solve the problems the board members were concerned about, which involved much more a mistrust of management's work and communications than the standards of the accounting work (though there were problems there, too). With better understanding and a little planning, a great deal more could have been had for all, including the membership.

What an audit is

The most important first step for a board of directors to take in order to make good use of a financial audit is to ensure that every board member understands both what the audit product is and what it is not. That is a reasonably easy thing to do.

The financial audit is a useful tool but has strict limitations established by the accounting profession. Put briefly, it is an examination of an enterprise's financial statements, performed in accordance with generally accepted auditing standards; the purpose of this examination is to enable the auditor to express an opinion on the "fairness" of the financial statements and their conformance with generally accepted accounting principles.

The final product of the audit is a brief standard opinion, followed by a compact set of financial statements with a short commentary on whether or not your accounting data was assembled following generally accepted accounting procedures, called GAAP. The financial statements will be accompanied by some footnotes and certain additional schedules. Lastly, a letter regarding financial management, with some editorial comments and suggestions, will be addressed to the board (not to management).

The financial statements will depend heavily on what the co-op's management hands the auditors. The auditors will do some limited sampling and testing to get a measure of confidence in your figures. Never will they assure you for certain that this or that line item is correct. Appreciate that limitation; their comments are on what management gives them to work with. The audit is a degree of verification of what the organization already is generating. The auditors' job is to assess and make limited adjusting entries to your existing accounting data, not to create an alternate set of financial statements.

Review or audit?

Another important planning decision for the board is to look at the financial audit as a choice among three alternatives: a compilation, a review, and an audit.

The compilation is assembling financials from fairly raw data. Whether well organized or on loose papers in a shoe box, no level of completeness can be assured. Presumably all of us are well beyond need for a compilation, having financial statements of our own to examine. The review, on the other hand, entails one of the more important decisions the board will make surrounding the topic of an audit. It is in the review that you may save thousands of dollars spent unnecessarily on an audit.

A review is everything an audit is except for a few specific items. With the review, you do not get an opinion as to whether the generally accepted procedures have been used. This is simply because the review leaves out the testing part of the full audit.

If you have some confidence in your financial statements on an ongoing basis, with what you believe is pretty reasonable management to board communications on the financial changes that occur over time, the extremely limited testing that goes on in an audit is not likely to break any news to you.

Audit testing is looking for big ticket items -- undisclosed lawsuits discovered from the lawyers instead of management, materially accurate valuation of inventory, the balances with major vendors that do not match the balances the co-op is booking -- and a few random looks at invoices paid and checks written throughout the year.

The review is thus somewhat more dependent on the validity of the information supplied by management. However, every balance sheet line is examined for internal integrity, and the entire income statement is reviewed for reasonableness.

Without going further into the technical details of these two, realize that this is one of your most important decisions in planning the "audit." Do you need an audit, or -- usually one third to one half less expensive -- a review?

You will find that banks and other lenders will usually accept having a review for most years and an audit on a periodic basis (e.g., every three years) -- so long as the bank can require an audit at any time, should they feel it is necessary.

Also, ensure that you are paying to have your annual inventory counts observed by your auditors; without this anchor, no "clean opinion" audit is possible.

Another important question in deciding between a review or an audit is, "who is the audience?" You must evaluate whether the members or other stakeholders in your co-op want the comprehensiveness of an audit. Usually the answer is "no," considering the extra cost. (Incidentally, a publicly traded security is a different animal than a co-op share, and by law must be audited.)

Choosing a firm

Upon deciding you will have a review or an audit, choose your auditor from the three general categories: national firm (highest cost, most prestige), regional/local firm (better price, totally competent), and sole practitioner (sometimes best price, should be competent, some limitations due to staff).

The more you can build a relationship with your auditing company, the more useful they can be to you. A firm of some size is useful in limiting turnover, but that can work both ways. Check the prospect of working with the same individuals for several years in a row. Doing so will build efficiencies in the many rote stages of the audit in ensuing years. You want to review this topic because it impacts the quality of reporting you will have with the firm, in that their experience with you will pay off. Turnover is no more helpful with your external professional staff than with internal staff.

The last point on selecting firms is to get bids. This can save you thousands of dollars again. Make sure it happens. Do not necessarily just take the lowest bid, of course, but keep your purpose in mind. If all you are doing is getting an audit to satisfy the bank, do not overbuy. Most of the research on selecting a firm may be done by management, but keep in mind that the board is retaining the audit for a report on how it finds management's books. The auditing firm does not work for management.

While you are still in the planning stage, anticipate the report that you will get. With no input from you, it will be a very compact set of financial statements that merge into one line the many lines (especially expenses) which you are accustomed to seeing. For the most part this is good, as they are showing you the big picture. But if you want to see their edition of any particular lines in your income statement, in particular, instruct management to have them break out their report to the degree you want. Think ahead to how much you want to be able to compare, line for line, to your internally generated reports. Do not wait on this until you get your bound copy in your board packet.

Perhaps the last planning item, and again an important one for cost, is determining when you want your report back. Depending on when your fiscal year ends, and on how long you can wait to get the results, you can save a lot of money. Most CPAS, in any size firm, have the heaviest demand after calendar year ends. Again, if the bank is the only reason you are having this done, or if you are fairly confident the results will be what you expect, you can wait as long as your loan papers permit to try to bypass the first quarter, the highest priced part of the year. This is another point to have negotiated, both with your lender and your examiners.

Once the board or its committee has selected your auditing firm, it is up to them and management to do their work together.

Reading the audit

When you get your report back, you will first be greeted by the cover letter. If you asked for an audit, you want to see the standard letter that says your co-op was found to be keeping its records in accordance with GAAP. Just that phrase. The rest is both courtesy and a thorough restatement of the limitations of the work, again emphasizing that they are examining your books and that all systems in place are the responsibility of management.

If the GAAP phrase is not there, your task is to find out why not. The number of possibilities are too great to pursue here, but be confident that you understand why you may not have gotten a "clean opinion," as it is called.

Be confident that you understand each note at the end of the report. Simply use them as an outline to ask questions, one by one, on any you do not understand. Among the significant items you will usually find here are fundamentals, usually in Note #1, describing some elementary characteristics of your accounting. Review them as though part of your board manual.

Then look for the several notes that might be labelled or construed as commitments. These are obligations of the co-op, stated in words, not only numbers, and there should not be any that you do not know about. These commitments could include straightforward items, such as loans and contracts, and encompass the more unusual, such as lawsuits or other litigation pending. The latter, of course, do not show on your income statements. Similarly, you will find lease obligations for the coming years, a useful reminder of the stability of your premises or the price escalators you may soon be facing.

When you have gotten comfortable with the cover page, the financial statements themselves, and the notes to the financials, look to the management letter. You may need to take it up as an entirely separate agenda item.

This letter, as mentioned, is addressed to the board, and is perhaps the most interesting part of the audit, especially when things are relatively smooth. This is because it is in this letter that the auditors (in a review or an audit) get to exercise their more editorial senses and attempt to convey to the board the various changes they think would be helpful for management to institute in the accounting systems to strengthen them or bring them into compliance with GAAP. Sometimes they merely seek changes that are simply convenient to audit, so do not necessarily take all of them too seriously.

Keep in mind that the auditors are still commenting on the accounting system and its contents, not on the co-op's management or other parts of the organization. However, as with most specifics in a review or audit, this letter is negotiable in scope; many firms are capable of supplementing an audit in this fashion. But realize that you may be broadening the auditing firm's work out to a management audit, not a financial audit, which is all we have been discussing here. A good accounting firm will distinguish between the two. If a management audit is what you need, plan ahead to get a firm capable of delivering that, but separate it from the financial audit.

In summary, plan ahead to get a financial audit that will have the fewest surprises and be the greatest pleasure to read, as its contents will be the closest to what you expect and can easily read. Save your co-op some cash by making use of reviews as extensively as possible; the binders are just as impressive.

See other articles from this issue: #022 April - June - 1989