THE EXTERNAL AUDIT

Part 2—Preparing for the Audit

What does it take to be ready for the audit by the first day of fieldwork? CFOs can certainly expect a mountain of audit prep work at year-end, but I suggest you keep your “audit brain” on standby throughout the year.

A primary purpose of the audit is to ensure that your financial statements comply with generally accepted accounting principles (GAAP). Decisions are made throughout the year that involve GAAP in some way. Unexpected challenges and opportunities often have GAAP implications, but routine, everyday matters do, too. Let’s look at both.

Year-Round

The Out of the Ordinary

Hopefully, your CPA is a good resource for you throughout the year. The firm will not normally charge you extra for time spent answering questions, especially on matters that directly relate to your financial statements. They will be especially happy to help you with issues that could affect the audit.

Here are some examples.

  • Opening and closing programs: These actions usually entail adding and deleting cost centers.
    • Be prepared to explain your thought processes relating to changes in cost allocations; run your ideas past the auditors if you think it advisable.
    • Keep the functional expense statement in mind as you set up new cost centers. All cost centers must be tagged as program, M&G, or fundraising.
  • Buying or selling property: Journal entries can be complicated—your CPA can help with this.
  • Grants and bequests: consult with the auditors if questions like these arise:
    • Is the new grant conditional or unconditional?
    • Does a bequest notification trigger revenue recognition?
  • Starting up an investment account: The GAAP-required investment footnotes are extensive. You will have to maintain a monthly workpaper to track income and gains and losses. I recommend asking the auditors for the investment workpaper format that will give them the information they need for the footnotes.

The Day-To-Day

Even as you monitor your daily operations, the audit should be ever-present in your mind.

For example:

  • Bank reconciliations: For sure, the auditors will confirm your 12/31 cash balances with the bank. Everyone knows that timely bank reconciliations are an important job responsibility. But I have seen more than one occasion where a busy CFO let this slide with unpleasant consequences ranging from a belated discovery of bank fraud to an eleventh-hour scramble to complete a pile of bank recs. I will therefore risk your indignation when I remind you that completing your bank recs within a week or two of the close of the month is a best practice.
  • Year-end spending: If you have money to spend by the end of the year, plan to place orders and start repair projects early in the fourth quarter (or sooner). Make sure your managers remember that all computers, office supplies, etc., must be delivered, and repair work completed, by 12/31.
  • The auditors will assess your internal control procedures to assess risk of error and fraud; be vigilant in requiring proper authorizations and backup documentation for payments.
  • You will need to be able to find contracts and invoices quickly during fieldwork, so make sure your staff keeps up with organizing and filing year-round.

Year-End

Calendar-year CFOs spring into action at the start of the new year. Besides the month-end routines, we now have GAAP year-end entries, trial balance review, and a long list of tasks to complete for the auditors prior to the start of fieldwork.

Year-End Entries

As you prepare your year-end entries, here are a few thoughts about the areas that auditors concentrate on.

  • They will verify that total payroll expense reflects hours worked up to 12/31. The first payroll in January of next year will often include some days from December of the year under audit. You will need an accrual to correct that. (endnote).
  • They will look at your prepaid asset accounts to be sure that the balance as of 12/31 reflects contracted services that were paid for but have not yet been used.
  • Depending on the size and complexity of your receivables, your bad debt calculations may be of great interest to the auditors, so give careful thought to your estimates of receivables that are unlikely to be collected. If, for example, you have large pledges from a capital campaign outstanding, those that are unlikely to be paid may be a material amount.
  • If you have been recording capital purchases as expenses you will need to reclass them to your asset account and also record depreciation for the year.

Temporarily Restricted Revenues

The auditors will need detail on your temporarily restricted grant and contribution revenue. Hopefully you have taken my advice and sought guidance on how to record your grant awards. But, in addition, you may have other revenue that is classified as temporarily restricted. Say, for example, your food pantry generated all of its revenues from a dedicated appeal. Any surplus in the pantry cost center at 12/31 will be classified as temporarily restricted net assets on the balance sheet because the funding was clearly meant for the pantry and it was not all used. The auditors will need to know of any revenues that fall into this category. They will also want to know about contributions for any program that were specified to be used in the following year.

Trial Balance Review

The “trial balance” is the bible because it lists the final balance for every account in your general ledger starting with asset, liability, and net asset accounts (the balance sheet accounts). These are followed by revenues and expenses (the income statement statement accounts). I strongly recommend that you review all of the balance sheet account balances repeatedly up until the day you turn the trial balance over to the auditors. (Note that this process is not practical for the revenue and expense accounts; those account balances are verified by reviewing the individual cost center income statements.)

You might make the first pass at your balance sheet accounts when you think you are done with your year-end entries. You are almost certain to find small and infrequently-used accounts that need attention. A trick that I used to get my trial balance in order (and to help out the auditors) was to create a notebook (or a flash drive with pdf files) with documentation to prove out the balance of every balance sheet account, large or small. This is a pretty foolproof way to find errors and to know your accounts so well that you can confidently answer the auditors’ questions.

Final Review

The fieldwork team will be looking for anything that doesn’t pass GAAP muster and will inform you of any errors they find. This not at all unusual, but you can minimize the number of errors lying in wait for the auditors to find by thinking like an auditor. It is, of course, impossible to anticipate the auditors’ every move, but here are a few suggestions.

  • Look at large cash disbursements and cash receipts in the last two months of this year and the first two months of next year to ascertain that the associated expenses and revenues were recorded in the correct year.
  • Using your list of individual receivables and payables, add up the items on the list to verify that the totals agree to the accounts receivable and accounts payable balances on the trial balance.
  • Look for large outstanding checks on your bank reconciliation. I have seen auditors require that a large check amount be added back to cash on your balance sheet, the idea being that since the money did not leave the bank as of 12/31 it was still in your possession. Do all auditors look for this? I don’t know, but I can say that I have seen it.

In Sum: Keep a Positive Attitude

Closing the year out in a timely fashion and honing the accuracy of your financial records are important goals for CFOs whether they have an audit requirement or not. Your management, board, and the public all depend on high quality financial data. The annual audit provides guardrails to make sure that those goals take top priority.

Read on for some ideas on forging a strong relationship with the auditors that will pay off for everyone.

Endnote

Payroll accrual example: For the period of 12/30/x1 – 1/12/x2 your payroll was $1,562 for 14 days, but $250 was for the the last two days of December. Since the payroll was paid on 1/12/x2 the entire payroll ($1,562) was recorded as an expense of 20×2.

A journal entry as of 12/31/x1will be made to increase both payroll expense and payroll payable for 20×1 to reflect the two days in December.

A “reversing” journal entry as of 1/1/x2 will be made to decrease both payroll expense and payroll payable by $250.

The net effect is that the two days of expense are “moved” from 20×2 to 20×1.