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Reviewed Financial Statements vs. Audited

  

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The true cost of reviewed financial reporting may surprise you!

By George D. Shaw, CPA

In recent years many business owners have opted for reviewed financial statements rather than getting audited financial statements. The main reason is the desire to spend less for financial reporting. But there are other factors that business owners should consider when making the decision on getting reviewed rather than audited financial statements. In fact, the true cost of reviewed financial reporting may surprise you!

Accurate financial reporting is critical for business stakeholders who typically include shareholders, employees, vendors, financial lenders and other investors. They use the financial statements to help chart the course for the business, determine the value of a business, and to make decisions regarding creditworthiness.

The level of annual financial reporting that a small or middle market business presents is typically dictated by its banking agreements and the users of its financial statements.  In order to save costs, many business owners will often turn to their bank asking for permission to submit “reviewed” as opposed to “audited” financial statements for their annual reporting. In a recent discussion with several bank lender,s I noted that reviewed financial statements are not as reliable as audited and most of the lenders agreed with this assessment. I then asked the obvious question..why allow customers to do it then?  Answer: The lending market is very competitive on business loans and when other banks allow reviews and we demand audits, it is like we are charging an extra 1/4 of a point on the loan. In today’s competitive marketplace, most banks are willing to take the risk to gain market share.

While that helps us better understand why so many small and middle market businesses present reviewed financial statements, what about the impact on a future exit strategy for that middle market business owner?

A recent survey indicated that over 50% of privately owned businesses will have a succession or liquidity event in the next 5 years. There are also numerous studies indicating an increasing percentage of businesses that are owned by persons 55 years or older. In the buyer’s market, private equity firms are aggressively pursuing acquisitions today and have a lot of cash on the sidelines. Strategic buyers who are challenged with the prospects of organic growth are looking to acquisitions as a major component of their growth strategy. For a future seller, this all means that you need to be prepared for a liquidity event regardless of whether you are currently pursuing a transaction. Audited financial statements are an important part of being prepared for your exit strategy and contribute to increased value and purchase price.

Let me explain the potential economic impact of reviewed vs. audited financial statement reporting:

When a buyer or investor is interested in the purchase of a business, there is a process of due diligence related to the quality of earnings of the seller. The process involves a verification and analysis of the historical and forecasted profitability that a preliminary purchase price is based upon. The extent of the due diligence procedures typically increases with more sophisticated buyers who are serious buyers that a middle market seller would like to attract. My experience in performing due diligence analysis for private equity and strategic buyers on over 200 middle market transactions reveals that sellers of businesses who present reviewed financial statements have significantly more negative adjustments to earnings as compared to companies with audited financial statements. Due diligence adjustments are common in the areas of revenue recognition, accounts receivable reserves, inventory costing and obsolescence, and unrecorded liabilities.
 
Due diligence adjustments average approximately 10% of EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) when the preliminary purchase price calculation has been based upon reviewed financial statements.  If the business is generating $2m of EBITDA that is a decrease in EBITDA of $200k. When you apply an average transaction multiple of 6 times EBITDA, this results in a $1.2M reduction on the transaction price that could have been identified earlier or avoided altogether had audited financial statements been prepared.

For the business with $2m in EBITDA, the difference in cost between reviewed and audited financial statements is probably $40k annually depending upon the industry. That means an investment of $120k for audited statements (over three years) may have resulted in increased business value of $1.2m depending upon what the due diligence adjustments relate to. That is a good investment return!
 
Business owners also need to understand that after a Letter of Intent ("LOI") is signed, there is a shift in negotiating leverage to the buyer as due diligence begins. If the buyer's financial due diligence identifies negative adjustments to earnings, the transaction price will be decreased. Often times, those adjustments may relate to items that an audit would have uncovered and if properly reported in the years under review would not negatively impact the current years earnings. In order to keep potential audit adjustments out of the most recent EBITDA results, the business owner should present audited financial statements two to three years before a liquidity event. Plan ahead and don't wait for financial due diligence to flush out financial reporting issues.

There are also many other benefits to audited financial reporting including:

• Good financial discipline - the audit process focuses on best practices and compliance with current accounting standards when it comes to internal controls and financial reporting. As a result, your management and finance team will become aware of the best practices which need to be in place if they are not already implemented. These practices may allow them to improve upon the monthly interim financial reporting process which may help identify financial reporting issues earlier. Due diligence regarding the quality of earnings oftentimes includes a review of monthly trends in financial results. The best practices learned during an audit process will help ensure interim financial reporting is more timely and accurate.

• Fraud deterrent - while an audit is not designed to detect fraud, having auditors present (and making inquiries) at your offices provides a visual reminder that someone externally is examining the financial records. It increases the risk perception on being caught and this is important for middle market companies where the finance team may wear multiple hats.

• Comfort to stakeholders - as indicated earlier, bankers are more comfortable with audited financial reporting. Ask them yourself. If bankers have more confidence in your financial reporting and in how you manage the business, they are more willing to increase the bank loan size and leverage ratio if needed. This could be important if an attractive acquisition appears or you just need additional financing to support organic growth.

• Improve the business - a good audit should be able to provide you with ideas that help you improve the business. An audit allows the CPA to become more knowledgeable about your business and they will be in a better position to provide valuable advice during the lifecycle of your business. Ideas on improved internal controls, development of key financial metric reporting, succession planning, tax minimization, international expansion, operational improvement, employee incentive plans and M&A strategy are just some of the areas where a CPA can help you improve your business and increase its value.

• Accelerate transaction timelines - quality financial reporting and information will help avoid delays when pursuing a transaction. When transaction timelines are stretched longer due to poor financial information and surprises, there is an increased risk that the transaction will not close. You will also find that your costs for professional fees will increase when surprises and adjustments are uncovered. If the transaction ultimately fails it could prove to be very detrimental to the business. The longer a transaction timeline, the greater the risk that the deal will close. The cost of a failed transaction is significant to the business and improving surety of close is very important.

These are some compelling reasons for business owners to reassess presenting reviewed annual financial statement reporting. Based upon the economics, any business with EBITDA in excess of $1m should have audited financial statements. For many business owners, the time to act is now as you need to be prepared for all opportunities that may present themselves to you in this ever changing marketplace.

Contact George D. Shaw at gshaw@dgccpa.com or 781-937-5125 to learn more.