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For most small businesses, a financial audit is a distant concern. Companies House stipulates small companies must submit annual accounts each year, but for those meeting the small company criteria, these don’t need to have been audited.

Though financial audits have a reputation for being arduous (and a period the finance department dreads each year) they offer some valuable benefits to small and large companies alike.

What is a financial audit?

The objective of an audit

A financial audit, or an external audit, is a thorough independent scrutinisation of a business’s financial statements. Its purpose is to ensure the information presented in the financial statements is a fair and accurate representation of the performance and position of the business at the end of the relevant financial year, and that the way it is presented complies with the applicable accounting standards.

Many stakeholders – customers, suppliers, employees, lenders, and shareholders – rely on financial information to guide crucial decisions: whether to invest more in the company, accept a job offer, or issue a substantial bank loan. Inaccurate information can have catastrophic consequences, if for example, a company is unable to repay a loan they were offered on the grounds of an overstated balance sheet – the bank loses money, and the company is potentially pushed into administration.

An external financial audit differs significantly from an internal audit. The latter is carried out by employees of the company (or an external consultant if no internal audit department exists) to ensure compliance with laws and regulations and to improve the efficiency of business processes. The results of an internal audit are used by management to make informed changes relating to the business.

One large misconception surrounding financial audits is that they are performed to detect fraudulent activity and all errors present within the accounts. Audits do occasionally pick up instances of fraud and other misstatements (usually only those above a materiality threshold are flagged to the client) and may discourage illegal behaviour. But detection of fraud is not a primary objective of an audit: the responsibility for deterring and picking up fraud lies firmly with the management team.

What does an audit involve?

Audits are carried out by qualified auditors, generally working within public accounting practices. Procedures are carried out on individual balances in the financial statements that are higher than a specified threshold – referred to as materiality.

Materiality is calculated for a given company using a standardised formula applied to turnover, profit, or assets held. The exact parameter used depends upon the nature of the company and is determined by the auditor during the audit planning stages. Any balances over materiality are subject to rigorous testing procedures to ascertain whether they show a fair reflection of the actual performance or position of the company.

Assets held by the company are also physically verified during the audit. Properties, for example, are viewed in person and agreed to independent valuation reports and title deeds.

Towards the end of the audit, the financial statements are reviewed as a whole, to ensure they contain all the information they need to comply with relevant legislation and accounting standards.

After completion of the audit work, once the auditors and company directors have approved the financial statements, they are signed by both parties. The final accounts include a formal audit report that confirms to readers that the financial statements have undergone a rigorous independent review, which lends credibility to the information presented.

International audit standards

The International Auditing and Assurance Standards Board (IAASB) issues standards and regular updates – International Standards of Auditing (ISAs) – that guide auditors through the work they must complete during an audit. These cover a wide range of topics, from communication with management to reporting related party transactions. Each audit firm also usually has its own audit guidance and testing approach that its auditors are trained to use.

Does my business need an audit?

Small businesses are generally exempt from statutory audits. To be considered small, at least two of the three following criteria must be met in two of the last three years:

• an annual turnover of less than £10.2 million
• gross assets less than £5.1 million
• total employees less than 50.

However, even if these criteria are met, section 476 of the Companies Act allows shareholders holding 10% or more of the company shares (either as an individual or group of shareholders) to formally request an audit by writing to the company’s registered office address. The request must arrive at least one month before the end of the financial period they wish to be audited.

Some companies must undergo an audit by law. These include public companies, subsidiary companies within a group (unless they qualify for an exemption), insurance companies, and those in regulated finance or legal sectors. Many of these operate in a position of trust and require the assurance afforded by an audit. Some banks and lenders require an audit as part of their debt covenants to provide security over repayments – specifics will be set out in the loan agreement.

Charities

The thresholds for charities are slightly different to those for a private company. When a charity exceeds the following criteria, it must set up a financial audit:

• annual income over £1 million
• gross assets over £3.26 million and annual income over £250,000

Many charities undergo regular audits despite their size. Often, constitutional documents specify the need for an audit, or it is included in conditions set out by donors.

Other benefits of an audit

Improving business performance

A successful audit requires the audit team to have a full understanding of your business. To do this, they examine the processes and controls you have in place in relation to various areas: recording of financial information (which accounting software you use, who has access, who can post manual journals, who approves them?) cash transactions, processing of customer receipts and supplier payments, and asset acquisition and disposal.

External review of these provides an opportunity for non-bias feedback, which can highlight weaknesses or inefficiencies in your business. Addressing these could improve business performance and reduce the risk of errors (or fraud) making their way into financial information. A 2018 report from Deloitte supports this; high-quality audits were shown to create business insights, identify inefficiencies, and mitigate potential risks.

Improve credibility and increase stakeholder confidence

Proof of independent verification via an audit report lends credibility to a set of financial statements. Potential clients, investors, lenders, and suppliers are more comfortable with audited information compared to non-audited due to its higher reliability.

Preparing for a sale

Assurance over the state of a business can be useful when preparing for its sale. Audited financial information is more likely to result in a favourable selling price. Potential purchasers are inclined to agree to a price if they are comfortable that the information reflects the true (independently verified) performance of the business.

How to prepare for an audit

To set up an audit, you must first approach an accountancy firm licenced to audit. For new clients, certain checks are carried out before accepting the audit, including money laundering checks and client ID verifications. On acceptance, an engagement letter for signing will be issued that outlines the terms of the audit, and usually has an attached communications letter setting out the expected timeline and other relevant information. Often a request for information will also be provided, which includes a list of information needed to start the audit.

It is important to have all information ready by the agreed audit start date. Delays in providing it to the audit team could result in delay of the whole audit, and additional fees payable to the auditors if the delay impacts other client engagements.

How much does an audit cost?

The cost depends on the size of the business and the amount of work expected to be needed. Fees range from a few thousand for small single company audit to several tens of thousands for group audits with acquisitions and disposals to consider. The exact fee will be agreed upon before any audit work starts.

Sources

Anon 2022, Current Auditing Standards, Financial Reporting Council, viewed 26 July 2022 Auditors I Audit and Assurance I Standards and Guidance for Auditors I Current Auditing Standards I Financial Reporting Council (frc.org.uk)

Anon 2022, Audit exemption for private limited companies, GOV.UK, viewed 26 July 2022, Audit exemption for private limited companies – GOV.UK (www.gov.uk)

Anon 2019, Audit Value Survey, Deloitte, viewed 26 July 2022, Audit Value Survey | Deloitte US