by Bryce Welker, founder of Crush The CPA Exam
You are sure to be happy when your business reaches a Series B financing round because it usually means your company has a higher valuation. However, that can make the auditing process much more complicated than it was before. You must be aware of the standards your company has to meet to pass its first external audit so you can implement the right procedures and maintain the correct documentation.
Don’t know where to begin? Well, check out the following crucial things you need to know about your first external audit for Series B.
Your Records Must Conform to GAAP.
For your business to pass its first external audit, you must maintain your company’s records according to GAAP, which stands for Generally Accepted Accounting Principles. The Financial Accounting Standards Board establishes these standards. The principles provide guidance on how to correctly record transactions across all possible business events. Before your financial statements can be filed with the SEC or distributed outside of your business, an external auditor must ensure your records adhere to GAAP. A certified public accountant (CPA) will perform the audit. A CPA will affirm to the IRS that your company’s financial statements are truthful once he or she has audited bank statements and other documentation to eliminate any errors. CPAs are the most highly-qualified type of accountant to perform an external audit for Series B given the rigorous examination process.
There are three main areas of GAAP that are commonly the most problematic for companies undergoing their first Series B external audit. These are:
- Revenue Recognition issues.
- Share-based Compensation.
- Accounting for Income Taxes.
Accounting for Income Tax.
According to Audit Analytics, accounting for income tax is one of the most common areas for accounting inaccuracies and failing control requirements. That is because tax laws are incredibly complicated, and tax calculations incorporate all of your company’s other transactions. They are, therefore, the last thing to address when preparing your financial statements. GAAP requires the representation in financial statements of the tax results for every one of your business transactions. You may want an Enrolled Agent (EA) to help with your tax returns. An EA is slightly different from a CPA in that they are authorized by the US Treasury to represent you before the IRS for various tax related matters.
This accounting principle determines the exact conditions in which revenue is recognised and accounted. Typically, income becomes recognised when a specific significant event has happened, and the amount of revenue is reversible. Determining and implementing a consistent representative policy can be more challenging than it sounds.
For example, should you recognise revenue if you have a signed service contract, but you have not yet collected all of the data required to onboard a client to a software system? Because revenue recognition rules are relatively broad, they frequently require interpretation before application. The more you discuss and document your company’s policies, the more you will understand the policies and the more likely you can apply the policy properly. Common errors in first-time audits of revenue recognition practices typically fall into two categories:
- The improper adherence to your agreed company policy.
- The improper interpretation of revenue recognition’s rules in setting your company policy.
Start-ups, investor-backed businesses and high-growth companies heavily use share-based compensation. That can affect your first-time audit in two main ways: with stock option expensing and 409A Valuations.
Stock Option Expensing.
When you want to issue financials that are GAAP compliant, you need to expense your stock options. Even if something is not a cash transaction, you still need to cost it. Do not be tempted to use a simple rule-of-thumb process for this and do not entirely ignore the issue. You should begin expensing stock options as soon as your business has full-time employees. Valuing stock options can involve tricky maths, so if you do not have a corporate finance background, it can be best to get an accountant to advise you about stock option expensing.
409A Valuations .
Private companies that have no liquid market for their shares can generally find the value through a 409A valuation. To ensure your 409A valuations pass the external audit:
Create or pay for a valid 409A valuation whenever you grant stock options.
Make your 409A valuation defensible by selecting a 409A valuation company that can help you navigate complex issues.
Bryce Welker is an active speaker, blogger, and tutor on accounting and finance. As the Founder of Crush The CPA Exam, he has helped thousands of candidates pass the CPA exam on their first attempt.