Financial workflows

A guide to financial audits for startups

Written By

Myoung Kang, Interim CFO for Startups

Graphic illustration of magnifying glass looking at line chart | Guide to financial audits for startups | Mercury
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Navigating the financial waters of a startup can be a simultaneously dynamic and daunting task. As your startup begins to gain traction, secure new investments, and scale operations, the question of financial audits becomes increasingly pertinent — so feeling confident about when and how to approach your company’s preparation for a successful audit is critical. In this guide, we'll explore when a startup should consider getting audited — including the primary trigger points that prompt the decision — as well as what’s involved in a typical financial audit, the range of auditor options, and how early finance teams can best prepare for successful financial audit.

What is the purpose of a financial audit?

A financial audit essentially entails a close examination of a company’s financial records and transactions, with the primary goal of confirming the accuracy and integrity of your financial statements and accounting practices, and their compliance with GAAP. And, of course, by confirming that your records paint a truthful picture of your startup's financial position, the audit ends up being an important component — if not a prerequisite — of everything from raising capital and building your credibility with stakeholders (e.g., investors, lenders, customers) to risk management (e.g., an audit might bring to light inadequate financial controls or tax non-compliance).

Keep in mind that financial audits, while possible to conduct proactively, are also often required in compliance with regulatory requirements or contractual obligations, so it’s important to understand your startup’s unique position and expectations around audits — beyond simply doing it for the purposes outlined above.

What is involved in a typical financial audit?

Financial audits are typically conducted annually by an independent, third-party firm, and are typically undertaken as part of a regulatory or stakeholder requirement.

After an engagement letter is signed, the audit team will ask for key contracts, the organization chart, company policies, and process flow documentation to better understand the business. The audit starts with a PBC “Provided by Client” list. This includes the trial balance and how they are mapped to the balance sheet and income statement. The auditor will then calculate materiality to determine a threshold to determine the level of detail to test based on what a user of the financial statements would consider to be a material difference.

For income statement accounts, the auditors will request detail listings to make sample selections, where they will request supporting invoices, contractors, payments, and other supporting documentation to prove the transaction is accurate. This is why it is critical to ensure you are categorizing all transactions properly throughout the year. In addition, the auditors will test the balance sheet by requesting balance sheet reconciliations such as bank reconciliations, accounts receivable, fixed assets, accrued expenses, and equity. Recording transactions on an accrual basis in accordance with US GAAP is critical as cutoff errors are one of the most common audit adjustments. A cutoff error is when a transaction is recorded in the wrong period which often happens if the cash activity was in a period after the service was performed.

What’s the right time for your startup to consider getting audited?

In a lot of cases, the specifics of when you’ll need to be audited will be clearly laid out for your company. Unlike public companies, private companies aren’t required by the IRS to perform an annual audit, and your startup’s audit requirements will instead be determined by investors. Most startups will have an investor rights agreement (IRA) that will establish the appropriate trigger point for an audit (e.g., a particular revenue threshold), the required cadence of auditing consolidated financial statements (e.g., X days after the fiscal year-end, usually in the range of 120–180 days for earlier stage companies), and, in some cases, any requirements about the logistics of the audit (e.g., requiring the company to retain a recognized accounting firm approved by the board of directors).

Again, audits are generally a good practice for ensuring your finances and accounting practices are in good shape, so companies don’t — and shouldn’t — necessarily wait to be held to a contractual requirement to undergo an audit. And even in those cases, where an audit isn’t required by investors or some outside regulatory body, $4M in revenue is a common trigger point in a lot of IRAs is usually a good rule of thumb, even for a voluntary audit. Auditors can help you identify shortcomings in your accounting practices earlier on, resulting in less accumulation of accounting “tech debt”.

Audits do require a material amount of time, work, and coordination so be mindful to weigh whether it makes sense for your company and its trajectory. Even if you outsource accounting, you can still complete an audit but expect to take on a lot more work yourself given your outsourced accountants are primarily focused on closing the books.

How to find the right auditor to work with?

As a rule of thumb, companies in the earlier stages can typically be fine working with a regional or small local firm. These smaller firms can be a better fit in the earlier stages because they typically have lower fees but can still provide assurance. As you scale, though, you may want to go with a mid-tier or Big Four firm, since your accounting will become more complicated. Larger firms typically have broader experience across more complex accounting topics and greater resources. They also provide a different level of external validity. Your goal should be to find a firm that will be able to scale with your company over at least a few stages of growth for the sake of consistency.

When working with a non-Big Four, make sure to do reference checks, and to consider industry specialization and familiarity with your particular business model. If you’re a SaaS company, look at a firm closely to make sure that they’ve worked with other SaaS companies in the past. And more importantly, have they worked with other SaaS companies that have grown fast or scaled through product-led growth? If your company is focused on enterprise sales, then you’ll want a firm that can recognize and analyze enterprise contracts. Think about domain, but think about your go-to-market strategy too, and find a firm that aligns in each category.

Once your company scales to a series C stage and beyond, that’s when it makes sense to work with a Big Four firm on all audits going forward. If you’re considering going public, you will want three years of audited financial statements under the auditor that takes you public, so you’ll want to keep that in mind and be forward-thinking when considering when to switch over to a Big Four firm for your company’s audits.

How can early finance teams set the company up for a successful audit?

One of the best tips for having a successful audit is to make sure your financial hygiene is in good shape well before it’s time to get audited. Build out your company’s financial reporting and accounting workflows around best practices from the beginning, establishing a consistent GAAP month-close process, reconciling bank accounts, maintaining detailed balance sheet schedules, and ensuring that your cap table is well-monitored.

And as you prepare to do an audit — especially for the first time — it’s worth paying close attention to revenue. There are a lot of cases where revenue isn’t captured correctly, a big example being in the case of discounts or promo codes that impact average sales price. This can be particularly true for younger startups that might have grown rapidly and had a lot of changes in a relatively short period of time. So that’s where you end up catching a lot of errors and needing to issue a restatement to remedy the inaccuracies.

Another area to pay close attention to is equity. You want to ensure your cap table is accurate to understand the true ownership of the company. This will be important if you are raising equity in future rounds. In addition, there are often reporting requirements on owners with more than a 25% stake.

Other good practices for ensuring a successful audit might include securing a 409A valuation from a reputable firm to determine the fair market value of your company’s common stock, and ensuring that your tech stack is SOC2 compliant, which can show a commitment to financial integrity and security.

Something else to consider is investing in the auditor relationship so they understand your business and upcoming changes that’ll result in financial reporting impact (e.g. new revenue streams, new products, geographic expansion, etc.) — the fewer surprises during the audit process, the smoother it’ll go. Audits are most successful when they’re not viewed as just an annual task, but instead a deep relationship to build with the auditors who can also become your thought partners on accounting during the early stages of a startup.

Written by

Myoung Kang, Interim CFO for Startups

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