Audited Financials for Investors: Audit, Review or Compilation

Do startups need an audit, and do VCs require audited financials?

No federal tax rule requires a private US corporation to have its financial statements audited. The requirement comes from a contract or a securities rule: the investor rights agreement, a loan agreement, or the exemption used to sell shares. Read that clause first. It says which statements, for which period, by what date, and whether they must be audited, reviewed or only prepared by management. Have the company's lawyer read it with you.

A case is not simple when the clause asks for an audit of a year already closed, when equity, stock compensation or revenue was never booked on the accrual basis, when the company has a foreign parent or subsidiary, or when a crowdfunding or non-accredited offering is planned.

Gather:

• The investor rights agreement, loan agreement or offering documents
• Trial balances for each year the audit or review will cover, and the year before
• Bank and card reconciliations for every account
• The cap table, option ledger and signed equity documents
• Revenue and vendor contracts
• The Form 1120s already filed

Audit vs review vs compilation: what is the difference?

An audit gives an opinion; a review gives limited assurance; a compilation gives none. The AICPA's comparison sets out the three levels.

A lender may accept a review; investors who ask for "audited" statements mean an audit. On the tax return, reviewed or compiled statements do not count as audited either: the Schedule UTP instructions say so expressly.

When do securities rules require reviewed or audited financial statements?

Two exemptions startups use set statement requirements by size. Regulation Crowdfunding ties the level to the amount raised; a Regulation D Rule 506(b) offering does so only when a buyer is not an accredited investor.

Regulation Crowdfunding. The level depends on the target offering amount plus amounts sold under the exemption in the preceding 12 months (17 CFR 227.201(t)). Include the maximum amount you will accept if it exceeds the target.

If reviewed or audited statements already exist, the issuer must provide them instead of the lower level. The statements must follow US generally accepted accounting principles and cover the two most recent fiscal years, or the period since inception if shorter. A review report with modifications, or an audit report with a qualified, adverse or disclaimed opinion, does not meet the rule. After the raise, each annual report needs statements certified by the principal executive officer, or the reviewed or audited ones if they exist (17 CFR 227.202).

Rule 506(b) with a non-accredited buyer. If any buyer is not an accredited investor, the company must give that buyer financial statement information a reasonable time before the sale (17 CFR 230.502(b)). For offerings up to $20,000,000, the statements follow Regulation A's Tier 1 rules and need not be audited, but an audit obtained for another purpose must be used. Above that amount, Tier 2 rules apply and audited statements are required (Form 1-A, Part F/S). Sales only to accredited investors carry no such requirement.

What usually triggers a first audit?

A first audit usually starts because a document or a deal requires it, not because the company reached a size. Common triggers:

• An investor rights clause in a priced round that calls for audited annual statements
• A loan or venture debt covenant that requires reviewed or audited statements
• A crowdfunding raise above the review tiers, or a 506(b) sale to a non-accredited buyer
• A buyer's diligence for an acquisition
• A board or lead investor that asks for an audit when the clause is optional

The clause decides the deadline. When it calls for audited statements within a set number of days after year-end, count back from that date.

Can our bookkeeper or tax preparer also audit our books?

Usually the auditor or reviewer is a separate, independent CPA firm, and a common setup keeps the books and tax returns with one firm and the audit with another. Under the SEC's independence rule, an accountant who maintains or prepares a client's accounting records is not independent (17 CFR 210.2-01(c)(4)). Regulation Crowdfunding accepts independence under either the SEC rule or the AICPA's rules (Instruction 10 to 227.201(t)).

The AICPA's code allows an auditor of a private company to provide some other services only under conditions meant to protect independence, including that management takes responsibility for the books and the results. Whether a given firm may do both depends on those rules and the auditor's own assessment. Ask the auditor, in writing, which services it can still provide.

What does a first audit need from the books?

A first audit needs accrual-basis books that tie to outside evidence at both the start and the end of the year. An audit opinion covers the year's results, so the auditor also has to be satisfied with the opening balances; when the prior year was never audited, that generally means testing the prior year's closing balances too.

How to prepare for a first financial audit: in what order?

Fix the balances the auditor tests first, then the judgment areas, then the statements. The order:

1. Read the clause and agree which years and which statements are covered.
2. Reconcile every bank, card and loan account for the opening and closing dates.
3. Close each year on the accrual basis with a clean cutoff.
4. Tie equity to the cap table and signed documents.
5. Book stock compensation from the first grant.
6. Prepare the income tax provision.
7. Draft the financial statements and notes, and write down the revenue and other accounting policies.
8. Collect support for large balances: contracts, loan documents, fixed asset invoices.

Readiness time depends on how much of this is already done. Reconciled accounts, equity that ties to the cap table, a clean cutoff and a provision prepared before fieldwork shorten it; missing years, unbooked equity and a subsidiary abroad lengthen it. For the monthly reporting that keeps the books audit-ready, see monthly financials for investors and the board.

Does an audit change our Form 1120?

An audit does not change the tax rules, but it can change what the Form 1120 reports and which schedules apply. Schedule L shows the balance sheet per books, which the Form 1120 instructions say should agree with the books and records, and Schedule M-1 or M-3 starts from book income. Adjustments booked during the audit flow into those schedules.

An audit does not by itself move the return to the accrual method. A corporation whose average annual gross receipts for the three prior years are $32,000,000 or less can generally use the cash method (Publication 538); a change of method has its own rules, covered in switching from cash to accrual. Stock compensation expense changes book income, but the tax deduction follows the holder's taxable income, so the two rarely match (stock compensation). When an audit adjustment shows a filed return used a wrong figure, ask whether that return needs correcting.

Example

These examples are illustrative; figures are in US dollars.

Lender asks for a review, investors for nothing

A company takes a $3,000,000 venture loan that requires reviewed annual statements within a set period after year-end. The investors' documents ask only for unaudited statements. The company closes its books on the accrual basis, and an outside CPA firm, independent of the company and separate from its bookkeeper, performs the review. If the investors later ask for an audit of the next year, the reviewed year-end balance sheet becomes the opening balances the auditor tests.

Series B requires an audit of last year

The Series B investor rights agreement requires audited statements for the year just ended. The company has never been audited, so the auditor also tests the balances at the start of that year. The company first ties equity to the cap table, books stock compensation for every grant since its first one, and prepares the income tax provision; then the auditor starts fieldwork.

Raising on a crowdfunding platform

A company plans a $1,500,000 Regulation Crowdfunding raise, its first. The amount is above the reviewed tier for a first offering, so it needs audited statements under US generally accepted accounting principles for its two most recent fiscal years. Its earlier compiled statements do not meet the rule.

Different for you?

• Your books are behind or on the cash basis: start with cleaning up the books before a raise and get startup accounting help.
• The auditor wants a tax provision: see the income tax provision for a first audit.
• Stock compensation was never booked: see catching up on stock compensation expense.
• The round just closed and equity does not tie: see recording a priced round.
• Customers prepay annual plans: see deferred revenue for subscriptions.
• Your Canadian company sits under a Delaware parent: see investor financials after a Delaware flip and get cross-border tax help.
• Your company is Canadian and needs year-end statements for its T2: see year-end financial statements for a corporation.
• The audit is for a raise or a sale and the deadline is close: get startup accounting help to plan the order of work.