I think firms of a certain size whether public or private should be required to have independent audits. I

Hi Gin:

Depending on the type of external auditor hired (whether small, Big N or government), the cost is obviously a key factor small companies must consider.

See below my thoughts:

Case for abolition of small company audits

• Shareholders: Benefit may not be worth the cost
• Banks and other institutions for lenders: Doubt over whether banks rely on audited financial statements more that unaudited ones
• Other payables: Limited reliance in practice as financial statements for wage negotiations
• Taxation authorities: little evidence whether reliance is placed on audited financial statements.
• Employees: Little evidence that employees make assessments of financial statements for wage negotiations
• Management: System review and management consultancy review would be of greater benefit with less or similar cost to an audit

Case against abolition of small company audits

• Shareholders: Provides reassurance to shareholders not involved in managing, Assists in fair valuation of share in unquoted companies
• Banks and other institutions for lenders: Banks may rely on audited financial statements for making loans and reviewing value of security.
• Other payables : Provides opportunity to assess strength of customers.
• Taxation authorities: Taxation authorities may rely on audited financial statements to calculate corporation tax and check returns
• Employees : Employees entitled to assess financial statements for wage negotiations and considering future viability of their employer
• Management : Useful independent check on accounting systems and recommendations for improving those systems

It seems that you can always argue a case for and against small company audits.

An audit can be quite expensive, esp. for a small company. By 'small', I mean a firm that employs fewer than fifty full-time employees. The fact that it is expensive doesn't mean it's a bad idea, however. The question I have, though, is why should such an SME get an audit?

I can see a variety of good reasons for getting an audit. A non-inclusive list is:

Of course, an audit is sometimes required--by a lender, for instance, or a regulator. But I think that's not the context in which you raise the question. 

Rather than an audit, I think many SMEs would benefit from two less-expensive services offered by audit firms:

• a review of their financial statements, and
• a soup-to-nuts assessment of their internal controls

A review is a notch down the services food chain from an audit. As such, a review is not nearly as comprehensive--and not nearly as expensive--as an audit. Unless there's a heckuva good reason for a smaller company to shoulder the cost of an audit, a review is the better choice.

In addition--and I'm speaking here as a former CFO of one firm and the ex-Controller of another--the internal controls of most SMEs that I've observed over the last 40+ years are just this side of dreadful. Let me give two examples.

#1. When I became the first-ever Controller of a non-public wholesaler and retailer of art supplies and engineering supplies, one of the first things I discovered was a Petty Cash operation being run out of a cash register at a large retail store the company operated in a metropolitan area in the southwest. In addition, it was also making cash advances to its salesmen from the cash registers. The chairman's solution to this gaping hole (one of many, but about the only one he knew about) was go give everyone lie-detector tests. Of course, even if one stipulates as to the reliability of those processes, it is notable that the company had never 'caught' a dishonest person. I confronted the chairman on that issue and asked him why, in his opinion, it hadn't happened. He didn't have a clue. I suggested that, to the extent there were any thieves on the payroll, they probably quit rather than subject themselves to the indignities of a 'polygraph'. I suggested that, rather than insulting the integrity of all of the honest people in the company (nearly 100 full-time employees), we should "run this place like a business." 

He didn't much like that, of course. The company had then been in business for 59 years. But I proceeded to slap a bunch of controls on processes that had never had them. From a cash register operation that was more than $15,000 SHORT the year before I got there, that same operation ended up $7.18 long (on about $7 million of retail sales) at the end of my first year there. I also tightened up expense reporting, mandated that each register begin each business day with the same amount of money in the same denominations, designated a Petty Cashier at each retail store with pre-numbered receipts, and made once-a-year advances to the outside sales people (they got reimbursed each month), requiring only that they 'settle up' the advance by December 31st of each year (in order for them not to be tagged by taxing authorities with either income or a non-interest-bearing loan). I set up a new chart of accounts stratified by internal departments (you should have heard the people in charge of those departments holler!); in a high-inflation year, expenses went down for each of those departments compared to the preceding year. I also dictated that invoices to our wholesale customers be sent out daily, rather than monthly (the practice when I got there). I did away with 'statements' for wholesale customers - no company that has a clue pays from a statement with invoice numbers on it. They pay from the invoices themselves.

Finally, in the Accounting Department under my direction, I converted the work week from 5 eight-hour days to 4 ten-hour days and staggered them; half the department worked Mon-Thurs., and the other half was there Tues-Friday. This resulted in departmental turnover of one person (whom I fired) vs. more than 200% annual turnover before I arrived.

Before I accepted the job in the first place, I asked for, and received, written assurance from the CEO that he would give me "full sway" over internal controls. He had no idea what I was talking about, but signed off on the memorandum anyway. Knowing I was the first-ever Controller in a company that had been in business for almost six decades, I never would have taken the job without that written assurance that I could make the changes that I suspected the company was going to require.

#2. We have a sometime client in the power-line construction space. They deploy four-person teams to work on electrical distribution systems for investor-owned utility companies and for electric co-operatives. These teams have 'small tools' that they use to do their work. The year before this company became our client, they had spent $1.9 million on such 'small tools'. . .out of revenue of just over $40 million. Given that they employed a field labor force of about 380 people, that worked out to about $5,000/employee/year. That's absurd, of course. But their CFO was slumbering soundly, so he'd never even thought about it.

I suggested to the chairman (second-generation owner w/90% of the stock) that the company issue 'small tools' through the team-leaders of each of the four-person teams and require them to sign a written document that (a) they were responsible for those tools, and (b) they could be held to account for them at any time with no advance notice. The chairman thought that was overkill, but I told him that I'd bet him 'whatever sum of money [he] was willing to lose' that doing what I recommended would reduce the small-tools expense by at least 90%. We agreed to bet $1,000. The following year, the total expense for 'small tools' was < $150,000. I required that the bet be paid in cash. He handed me ten crisp C-notes and said he thought he'd made a 'helluva great investment' for that money. I agreed with him. . .and then asked him if he'd ever thought about how many home tool shops he'd funded and also how many tools that he'd bought for his employees to sell to others and pocket the cash. He quit smiling then.

In closing, let me mention that there is a new trend in larger CPA firms: they are encouraging their auditors to go to work as Controllers, Accounting Managers, and CFOs of clients for several years. . .and then return to the CPA firm. Finally, someone has recognized what those of us who "have worked both sides of the desk" have known for years: outsiders don't know even 1% of what really goes on inside a company. I view the emerging trend as a huge step in the right direction. Clients will get much better accounting services from participating CPA firms, and the firms themselves will, over time, have few malpractice claims and also far lower malpractice insurance premiums.

I hope these comments are helpful.

This answer is based on US private companies. A private firm will rarely have an audit of their financial statements unless it is required. Banks require audits for certain lines of credit. Bonding companies may also require an audited financial statement. Contractual agreements could require a private company to have an audit. There are other areas that potentially require an audit but, rest assured that the majority of private firms will opt out of paying what they see as unnecessary accounting fees.

I believe in Canada private companies are require an audited financial statement. Don't know the exact rules.

Wow. Thanks folks for all your responses. So with all these in mind, do you think private firms still need the external auditors?

In US, SOX requires large nonprofits to have their financials audited, and their CEOs and CFOs to sign off the internal control statements. To ensure that they only trade with those vendors with a healthy financial position and a strong control system, many nonprofits have insisted on inspecting a copy of the vendors' audited reports. Trade and financial returns seem to out weight the costs of audits and SOX has done a good job not only for the registrants, but also those who wanted to trade with the registrants. Please share your thoughts.

Sole tradeship and partnership business do not require preparing financial statements and external audit by law. But for limited companies either private limited or public limited companies both require audited financial statemnts by Companies Act.  Private limited companies do not publish its financial statements and public limited companies publish their financial statements as per Companis Act. Now, the questions why the external audit is important. External audit is important for external stakeholders especially for minority shaeholders who do not have accesss to the accounts. In this case, a conflict of interest is created between management and extrnal shareholders. The primary objective of external audit is to minimise the conflict between them by issuing an audit report on financial statments. Thefore, it is very clear that the role of external audit is to protect the right of minority shreholders.  In my opinion, private firms either sole propritorship or partnership do not need external audit as they do not have such type of conflict of interest. Whenever conflict arise between two or more parties on the truthfulness of accounts, external audit can be a good solution for them.   

Independent auditors presence convey a positive message to investors, creditors, rating agencies and all other stakeholders so they hire to take the advantage of good reputation. 

I wasn't aware that 'large non-profits' had to be audited. There is a question on IRS Form 990, though, that asks if their statements were audited. It's a good idea for the big ones to be audited because they don't pay taxes. Audit fees are far less than the taxes they avoiding. It makes sense that they would do business with vendors whose statements are also audited. That way the NFPs don't have to worry (much) about subsidizing crooks.

Most banks require private limited liability companies to submit audited financial statements in support of a loan application. Because of this, private firms should be audited or subject to an independent review

@Onesimus Ayaya: In the United States, few banks would require that, unless the loan amount was substantial.

The Company's Act demands so. Additionally private companies holding funds on behalf of the public in fiduciary capacity would be required to do so under regulatory/supervisory directives. Those wishing to list on the stock exchange or raise debt finance would find it easy to do so if they are properly audited. Adhering to best practice principles and corporate governance would also demand auditing otherwise it is just a necessary evil.

This week, our country passed a new company law categorizing small companies as those with turnover of USD 500,000 and assets of USD 200,000. Immediately the local Professional Accounting Institute raised issues around this matter. These thresholds are considered high and more companies will fall under the small companies with the consequences:

1. Small companies are not audited hence no one will rely on their financial statements and so they will have reduced access to funding from banks hence the economy will not grow. The cost of lending may also go up because of higher perceived risks.

2. Revenue authorities will not have reliable information to levy tax hence government tax target will be lost and the government will be starved of resources to run the country. Audits are not mandatory in small companies so incomes declared by owners may not be reliable.

3. It will be difficult to tell the financial health of these entities.

4. Other consequences are that auditors will have reduced market because their services will not be required or less of their services will be required.

5. The institute recommended small companies to have turnover of at least US 50,000, 10 times lower than the government threshold.

From these arguments, we can say that small companies need independent assurance on their financial health to acquire financing and legitimacy. Audits may also lower risk perception to enable them acquire capital at better terms. Generally, business is a long value chain, and by small firms creating business for auditors, the multiplicity effect in terms of employment and cash flows are felt in the economy.

So yes, they should be audited by different standards such as IFRS for  SMEs

To answer your question “Do you think private firms still need external auditors?”

The answer to this question in the US is: it depends. What I mean is: what is the obligation of the private company to the public? The US has adopted additional taxes for the affordable health care act on all companies. Public entities are statutorily required to have an audit, should private entities that pay into the health care act have to also have an audit? It would be an interesting issue posed to US private closely held companies that would certainly cause a hot debate.

I think private firms, similar to public companies, need to have external independent auditors. This will strengthen the the firm's internal control and its governance mechanisms in general. Moreover, this will enhance the confidence in the firm's accounting and financial information by its investors, creditors, and its stakeholders at large.

Just my thoughts but David Mathuva's thought are impressive. I'll take a different perspective in my thoughts:  Audits are expensive and most often directed at outside investors and/or creditors. Management gets little value from an audit.   I cannot imagine a company voluntarily agreeing to be audited. The audit might be a waste of the company's money.  Thus the only way to get a company to agree to an audit is for an outside force to require it.  Two typical ways that happens in the USA are:

1) In order to be listed as a publicly traded company on a US stock exchange is by having audited financial statements.

2) A bank or other investor/creditors makes an audit a condition of obtaining the financing. 

I am aware of no legal forces in the USA that would require private companies to be subject to an audit.  That audit might be viewed as an unnecessary tax or governmental influence. Also, the US Federal Government has no role in regulating US provide companies. The US Security and Exchange Commission only deals with publicly traded companies.

The Bottom line here: a corporate officer might say "Audits are expensive and I get little out of it. I will do it only if forced to do so.:

Jim Carroll

Professor - Georgian Court University

Lakewood, NJ

Well said! USA private companies are only interested in the value added. Private companies in the USA would certainly not have a pure voluntary audit.

Good question and great answers. I would like to add that the answer to your question depends on the financial reporting importance awareness, as well.  Therefore, I think that economies in growth should enforce independent audit for all business entities, except maybe micros. Adherence to almost all legal requirements impose expenses, so I do not think that audit fees are good enough excuse. The importance of both public and private companies is the same for the growth of the economy, financial institutions, investors and other stakeholders (academics for sure).

What's wrong with letting markets decide this question?? Why bring the heavy, one-size-fits-all, overreaching, hyperexpensive sledgehammer of government into this?

If banks won't lend to companies that don't have audited statements, fine. Either the companies can find other sources of financing and do without. If investors won't put their money into public companies with unaudited financials, fine. They shouldn't. If enough investors refuse to invest, the stock price will sink to such a low level that the company will be taken over.

My point is this: Why are audit firms entitled to a government-mandated annuity?? IMHO, they are not. Markets provide far better, far less expensive answers to these kinds of questions than bureaucrats ever could.

In my opinion, large non-profit making organisation needs financial audit as they collect funds not only from memebrs but also from different quarters of the society and even sometimes they collect funds from foreign countries. The executive commitee is the highest authority to oversee the activities of management. This type of organisation should provide assurance to fund providers that they are using the funds very sincerely and efficiently. Therefore, they prepare financial statements that must be certified by an external audit, for them. Using external audit in certifying the statements will increase their reputation in terms of transparency as wll as accountability. Consequently,  they can grow up and take more responsibilities for society.

As far as some degree of public interesest is at stake, I think so.

Thanks Dr. Pugliese, but we need to define what constitutes `public interests'.

Gin

in my pov, private firm can be the subject to independent audit in term of internal auditing, just to make sure the private entity is operating at it best, or the external auditing for the best ideal practice. as far as the cost didn't surpass the benefit from the audit process it self

The practice varies from country to country. Some jurisdictions require private companies to be subjected to an independent review by a qualified accountant/auditor. In addition, banks have respect for audited financial statements and insist on having audited financial statements accompany loan applications. This being the case, firms interested partnering with banks and other parties (other than owners) should be subjected to independent review/audit as a matter of annual accountability routine.

Onesimus,

Thanks for your response. Does your country require non listed firms to have their financial statements audited? If so, please share.

Gin

Without repeating what has been said, many jurisdictions still focus audit on public interest entities which differ from country to country but generally include entities whose transferable securities are admitted to trading on a regulated market, Credit institutions, Insurance or entities designated so by the government.

Yes,In some countries, non-listed companies are required to be audited because the company law says that auditors report is required both for listed and unlisted, meaning all registered companies should be audited. However, many small companies do not comply and enforcement is a problem. At the end of the day, it is only listed companies that are compliant with audit requirement. In my view an audit should be imposed on all registered companies. There are some companies in Africa or other parts of the world registered solely for the purpose of corruption. Inflated and irregular purchases with government entities go through such companies. It might be interesting to see how an audit of such companies can help the government in curbing corruption and how accounting standards are used to define revenue and expenses in such situations. How do such companies report in and out payments? Do they show them as income or expenses and what do the auditors say?

Thanks Erick for sharing your experiences and inputs. Interestingly many firms pay audit fees as a camouflage and for protecting its images.

Other colleagues, please share your views and thoughts on the real values of having audits for SME. I look forward to reading your insights. Thanks

I am not confident an audit would uncover this type of corruption. A Fraud audit would be the answer.

Dear all,

Thanks for your inputs. From the feedback, it seems that there is little or no increment value of private firms hiring independent auditors, after all most, if not all, the audit reports go to the board members and family members.

Also, should private firms be subject to independent audits? If so, recommend thresholds and criteria that could justify for waiving or exempting an audit.

Please share your thoughts,

Gin

Gin, is your question "If so, should all private firms be subject to independent audits"? (You omitted the 'be' from your question, so, before I reply, I want to make sure I'm answering the right question. Thanks in advance for your help here, sir.

Thanks Professor Miller. I have edited the text.

Best regards

Gin

Thank you, Gin. And please call me 'Warren' - I'm neither 'Professor Miller' (I'm not an academic) nor 'Mr. Miller' (Mr. Miller was my Dad!)

As the former Controller of one non-public and the ex-CFO of another, I can attest that non-public enterprises get audits for a variety of reasons. In no particular order of importance, those include:

1. Regulators require audited statements (banks, for example)

2. Lenders require them.

3. A vendor might require it (this is rare, however).

4. The company may have restive shareholders, and an audit is an attempt to reassure them about the financial statements that the company is reporting.

5. A non-public company might have grown to a size and reach that the founder(s) never envisioned, so its Board believes an annual audit is a good thing.

6. A non-public company may be considering putting itself up for sale, and it wants to reassure potential buyers that its reported financials can withstand an audit.

One important consideration in deciding whether to have an audit in circumstances outside those that I listed above is the cost: Audits are really, really expensive. That is why savvy non-public companies that are not required to have an audit often opt for a 'review' of their financial statements instead. A review is a step down from an audit in its scope and the level of assurance that the audit firm provides, but it's a far bigger step down in terms of cost.

As a matter of long-standing practice, we routinely recommend to our non-public clients that have more than twenty or so employees that they consider getting a review. But we also advise them to insist that whatever CPA firm they hire to conduct the review commit in advance to issuing a 'management letter' that is substantive, esp. in its focus on possible enhancements to internal controls.

That is because in all but one instance in the last 25 years, the management letters we've read when we first arrived on the scene of a new client are silly and non-substantive. More than anything, they try to suck-up to the CFO because they know that, in most cases, the CFO is the key participant in the decision-making process, and they don't want to offend that person.

In more than a few cases--and I'm speaking figuratively here--they have done the internal-controls equivalent of talking about the client's hairstyle. . .when its feet were on fire. You just cannot imagine some of the trivial and non-substantive counting-paper-clips management letters I've read, esp. in situations where, I later found out, there were gaping holes in a firm's system of internal controls.

One example: the internal threshold for capitalizing (for accounting purposes) capital expenditures, especially for laptop computers. The problem with such expensing is that, even when the IRS will accept it, expensing tends to remove individual accountability for possessing and maintaining the laptop in good working order. Laptops are fungible and can develop 'legs' - when an employee with a company laptop leaves the company, the laptop often does, too.

Another: a sometime client of ours generated $40 million in annual revenues when we arrived on the scene in 1994. As a matter of policy, they expensed all purchases of 'small tools'. Well, believe it or not, they were spending 5% of revenue on 'small tools'. I immediately believed that some employees were using the company's 'small tools' to support their own home workshops. The CFO was sound asleep, so I recommended to the CEO (and 90% owner) that he implement a policy that required the more than 90 'team leaders' (the company delivered its services through four-person teams) to keep a running inventory of the tools that had been assigned to them AND to turn in to their division general managers tools that were worn out and needed to be replaced.

The results: last year that company generated more than $250 million in revenues. The total outlay for 'small tools' was less than $800,000!

We advise all of our clients to embrace a key practice: DON'T TEMPT EMPLOYEES. Don't. Most can resist temptation, but some cannot. Sometimes they might even have an understandable, if still unacceptable, reason - a terminally ill family member, for instance, or a large uninsured loss of some kind. It is management's responsibility not to tempt their subordinates. That is a key aspect of how they fulfill their own responsibilities to safeguard the company's assets.

Sorry to be so long-winded, Gin. I hope these comments are helpful and constructive, Gin.

Thanks Warren for your inputs.

Others, please share your views and thoughts.

Best regards,

Gin

Dear readers,

The bottom line of private audits is just a waste of resources.

There seem to be no incremental benefits or returns to both the firm and stockholders unless the audit report is meant for a specific purpose [M&A, loan application, family disputes], apart from the middlemen [the auditors themselves].

Please continue to share your thoughts.

Gin.

I disagree 100%, Gin. An absolute statement like that is untrue. Most non-public companies lack strong systems of internal controls. An audit will highlight that fact because samples will be larger and the cost of the audit will be notably higher than it would otherwise be if strong internal controls were present.

Of course, an audit is not the only way of assessing the strength of internal controls. A periodic review of internal controls by an outside CPA firm will accomplish the same thing.

If some level of attestation is required, we tend to recommend to our clients that they have their financial statements reviewed, rather than audited. For one thing, lenders usually find a review to be sufficient. For another, a review is much less expensive than an audit. However, a review will not probe into internal controls nearly so deeply as an audit will.

Thanks Warren for your inputs.

Others, please share your thoughts and suggestions.

Gin

@Warrren D Miller: The context (amount of loan, jurisdiction, etc) become important im making a call on the matter. South Africa corporate law requires an independent review for closely held companies. Unfortunately, banks request for audited financial statements that are accompanied by solvency and liqudity testing reports completed by a registered auditor

Dear Professor Ayaya,

This is an interesting development on banks requesting for closely held firms to submit their audited accounts before granting any loans and facilities. Are small and medium sized firms subject to similar requirements? Please share. Thanks

Gin

Yes, and to governance

Independence in appearance is necessary in order for financial statement users to place value on the audit report. Independence in fact must be present for an auditor to be truly objective in evaluating whether a set of financial statements is presented in accordance with GAAP.

Yes. Avoiding an audit or independent review will limit the firm from accessing credit from the financial system of a country. Banks value independently verified financials.

As the former Controller of one company and ex-CFO of another, I always recommend to our SME clients that they consider getting their financial statements 'reviewed' by a CPA firm. In the USA, the cost of a review is a fraction of the cost of an audit, but it's still an 'attest service' that gives some assurance that a competent and independent outsider has examined the financial statements and felt comfortable enough to issue a form of assurance about them.