Did You Know You Need These 20 Items to Prepare for an Audit and Other Debt Covenants?

“The first step in preparing for an audit is ensuring your organization has the right expertise and experience to handle the infinite number of data requests,” William Webster emphasizes at the start of this conversation.

Preparing for an audit is significant for any business, especially when debt covenants are involved. Debt covenants are agreements between the institution and its lenders that the company will operate according to the financial rulebook and guidelines. Failing to comply can lead to severe consequences, such as the conversion of debt to equity, which can be catastrophic for the company and investors, potentially leading to loss of control and dilution of ownership. 

We spoke to seasoned experts William Webster and Ankush Sharma, who have decades of experience in finance and have worked with numerous businesses. They shared their insights on how businesses can effectively prepare for an audit and ensure continuous compliance with debt covenants. 

First Steps in Preparing for an Audit 

Adding an outsourced accounting expert on an ad-hoc basis can keep audit costs down significantly. Suppose auditors cannot get comfortable around internal controls. In that case, they will have to perform significantly more substantive and analytical procedures which can cause audits to double or triple in price,” Will shares. 

Ankush underscores the importance of timeliness and responsiveness. “Most of the time, audits get negative opinions or are delayed because the requested data was either not provided or received late. The Big 4 teams operate in a very time-bound manner. Suppose they are not kept engaged and provided the data in time. In that case, there is a significant risk of defaulting on covenants. Auditors do not sign off on reports until satisfied with the responses received.” 

An Expert’s Checklist 

Ankush outlines a long list of documents that should be organized before going for the first audit. The top 20 items that auditors typically ask for include: 

1. Financials for the last three years 
2. General ledger, AP, and AR aging reports
3. Balance sheet reconciliations
4. Bank and credit card statements and their reconciliation
5. Fixed asset listing
6. Vendor bills
7. List of top 10 customers and vendors
8. Contracts related to customers, vendors, employees, and leases
9. Deferred revenue waterfall and deferred commission schedule
10. Inventory roll-forward schedules and inventory reports for all warehouse and 3PL locations
11. Supporting documents to validate the beginning balances of the audit period
12. Policy documents like fixed asset policy, purchase policy, T&E policy, and employee handbook
13. Standard operating procedures for various functions like order to cash, procure to pay, record to report
14. Accounting memos (e.g. ASC 606 and ASC 842 implementations)
15. Cap table
16. 409A reports
17. Equity reconciliation
18. List of contingencies for customer dispute, litigation, etc.
19. Going entity concern analysis
20. Listing of payments made within 30 days of the accounting period close (this is called data for subsequent testing)

He also advises business owners to respect the critical nature of these documents as they establish a clear and accurate financial picture for auditors. 

Strengthening Internal Controls 

“If it’s your first time getting ready for an audit, adding an outsourced controller can help unburden the existing accounting team and naturally create separation of duties,” William notes. An outsourced controller can assist with tasks such as preparing financial statements, managing the audit process, and ensuring compliance with accounting standards and regulations. 

Ankush further states that preparing in advance helps keep the necessary items ready and gives the accounting team ample time to compile the additional information requested by the auditors. “An outsourced controller with experience in audit management can ease a significant burden on the client team.” 

In the subsequent years, Ankush suggests that continued support from an outsourced team can help the accounting team focus on their daily deliverables, ensuring compliance with board, department, and external covenants. 

Common Challenges and Proactive Solutions 

The common challenges most businesses face, as stated by Ankush, are: 

1. Lack of staff
2. Lack of preparedness
3. Lack of experience

The best way to address these challenges is to engage experts early — preferably two to three months before the auditors knock on the business’s door. “Businesses can either hire employees, which is a recurring commitment to finance and accounting costs or leverage outsourced controllers and teams who can support the audit for a short period. The latter comes with significant cost savings in recruiting and retaining the team,” he adds. 

Ankush stresses the importance of early engagement and strategic use of outsourced experts to manage the audit process effectively. 

Maintaining Continuous Compliance 

Maintaining continuous compliance with debt covenants and ensuring audit readiness requires a hands-on approach. Here are some strategies Ankush suggests businesses implement: 

1. Regular Updates and Review: SOPs should be documented, reviewed, and meticulously updated to reflect evolving business environment and operations changes. 
2. System Upgrades: Outdated processes, applications, and systems should be replaced promptly to avoid exposure to risks, such as cyber-attacks. “The processes help in implementing the controls across the organization, preventing the risk of frauds and increasing the confidence level of the auditors,” he notes. 
3. Internal Controls: Strong internal controls are your business’s shield, preventing fraud and ensuring accurate financial reporting. They are critical for audits and debt covenant compliance, giving you the security and protection you need in the financial landscape. 
4. Engage Experts Early: Appointing outsourced experts early in the audit process can help address potential issues before they become mountainous problems. 

Staying vigilant of these practices is paramount for businesses, particularly family-owned ones looking to raise external capital or those that have recently secured external investments. As Ankush points out, outdated processes might not suffice as the business grows, necessitating continuous growth and adaptation. 

Bottom Line 

Preparing for an audit and ensuring compliance with debt covenants are complex but easily attainable tasks with the right approach and expert resources. Businesses can navigate these challenges effectively by leveraging William and Ankush’s industry knowledge. From assembling the right team and organizing critical documents to strengthening internal controls and perpetuating continuous compliance, these expert-forward strategies will help businesses survive and excel in the audit process. 

Want to be audit and debt covenant-ready? Don’t miss this opportunity to learn from the best in the business at our Escalon Webinar!

Register now for our webinar on June 26, 2024, at 2:00 PM ET / 11:00 AM PT.

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About Ankush Sharma

Ankush Sharma is a seasoned financial professional with over 18 years of experience at Escalon Services. He has a passion for innovation and a proven track record of helping businesses grow. Throughout his career, Ankush has honed his skills in process improvement, change management, and implementing cutting-edge financial systems. His passion for innovation and measurable results makes him an invaluable asset to Escalon Services and its clients. To know more about Ankush’s background, visit our website.

About William Webster

William Webster started his career working with a family office in Kansas City and has spanned stints at companies like Ernst & Young, PitchBook Data, and Tegus. He’s passionate about ensuring that small business owners can achieve the dreams they’ve set for themselves as they grow their companies. Further, his experience ensures that he has the interests of everyone, from investors to business owners, when looking to broker deals. To know more about William’s background, visit our website.

Disclaimer: This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal, or accounting advice in this article. If you would like to engage with Escalon, please get in touch with us here.