Growing a startup comes with a potentially heady mix of near-endless opportunities surrounded by countless pitfalls. While the freedom that comes with scaling up the business is exciting, sometimes it’s nice to know you’re on the right track as verified by outside sources.
Enter: a financial audit. This tool gives you a way to validate that your company is following proper accounting practices and that your books are accurate. Whether you’re facing an external trigger (like an audit request from an investor or bank) or you’re ready to have an outside expert look over your books, your startup can probably benefit from an audit.
That’s not to say that audits aren’t burdensome. Fortunately, though, taking some steps to prepare now makes this whole process a lot easier. Here’s your checklist to get ready for your startup’s first financial audit.
#1: Adhere to GAAP
Aligning your books with national standards makes the audit run much more smoothly, and limits the amount of rework you’ll need to do during it. For U.S.-based companies, that means adhering to generally accepted accounting principles (GAAP).
As a startup, aligning with GAAP usually means starting with accrual-based accounting. This means recognizing revenue as you actually earn it, rather than as customers pay it. In other words, if a customer pays for you for an annual subscription, this part of GAAP means recording one-twelfth of that annual fee in each of the twelve months for which that subscription is active.
Accrual accounting can be somewhat complicated, especially for software as a service (SaaS) companies, so we have a guide to help you better understand it.
There’s another similar component of GAAP that’s relatively new and applies to many startups: lease accounting. As of 2022, all U.S. companies need to adhere to Accounting Standards Codification (ASC) 842. That means that all year-long leases need to be reported over 12 months on your balance sheet.
If you don’t implement proper accrual-based and lease accounting using GAAP now, you’re probably going to be dealing with cutoff errors during your audit. These occur when revenue or expenses are recorded in the wrong period, and they can be a big headache during an already burdensome process.
#2: Account for stock-based compensation
This piece technically falls under the GAAP umbrella as well, but because it’s such a key part of many startup’s accounting, we want to specifically call it out.
Granting equity in your company gives you a valuable way to scale up without immediately increasing your overhead. Any stock your company has issued needs to be accounted for during your audit, though.
And this isn’t just an audit-specific to-do. You should already be accounting for your stock-based compensation in your annual income statement because this is a requirement from the Financial Accounting Standards Board.
Calculating this compensation means using the latest financial reporting value that you have for your company (e.g., your 409A valuation), so be sure you have that number. Then, apply it to calculate your equity compensation. Finally, make sure that the resulting expense is properly allocated across your income statement.
#3: Organize your documents
When you hire an auditor, they’ll give your startup a provided-by-client (PBC) list. This names documents you need to hand over to them. Doing some legwork now should get you to the point where you have the majority of the required paperwork ready to go.
Usually, auditors will use the PBC list to ask for:
- Your income statement
- Your balance sheet
- Your cash flow statement
- Your capitalization table
- A list of fixed assets
- Bank account statements
- Payroll
- Details to support accounts receivable and payable (invoices, proofs of payment)
- Key contracts
- Your org chart
If your startup has completed a 409A valuation, have that paperwork handy, too.
#4: Nail the timing
Startups aren’t under the same annual audit requirements as public companies. That doesn’t mean that you can or should skip the financial audit, though.
In some cases, the audit will get triggered by a request or requirement from a third party, like:
- A potential investor asking to see the results of one
- Hitting a certain revenue threshold as specified in someone’s investor rights agreement (IRA)
- An acquiring company requiring it as a term of the acquisition
- A financial institution mandating one before it will issue financing like a business loan
In other cases, your startup may determine that an audit benefits the company as a due diligence measure. Many companies undertake an audit to prepare for a fundraising round or an initial public offering (IPO), for example.
If none of these other makers apply to your startup, we have a general rule of thumb about when to consider an audit. Generally, if you’ve hit $4 million in annual revenue, it’s time.
Many companies choose to start the audit the quarter after their fiscal year ends so they can relatively neatly audit the previous year’s financial statements.
#5: Find the right partner
The auditor you choose will directly impact how smoothly and successfully the audit goes.
Usually, startups benefit from choosing smaller firms. While a Big Four auditor can certainly complete the process for you, smaller companies often have more flexibility on their processes. This can make it easier to navigate your first audit.
As you seek out the right auditor, ask about their experience with tech companies. You may want to ask them about their history of working with other companies like yours, since tech firm accounting requires specialized expertise.
Whether external forces have your startup preparing for an audit or you see the benefit of undertaking one yourself, you stand to gain a lot. Getting an outside partner to take a thorough look at your books early on helps you refine your accounting practices. This means you can correct issues before they grow — and before you have years of bookkeeping to rework.
If you want help preparing for an upcoming audit — or keeping your books audit-ready over time — we’re here. Contact our accountants at ShayCPA and we can help you align with GAAP as you create the necessary financial reporting and keep it accurate. We have extensive expertise helping tech startups satisfy investor expectations and ASC requirements so they can grow.
