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What Makes a Good or Bad Audit Committee? Observations from the Auditor’s Side

Angel Insights Blog

Friday, March 06, 2015 

What Makes a Good or Bad Audit Committee? Observations from the Auditor’s Side

By: Jeff Solomon, CPA, CVA, Managing Partner, Katz Nannis + Solomon, PC

Early stage investors are often asked to sit on boards, and many sets of investment terms require that outside investors sit on the key board committees.  But what’s involved in being on an Audit Committee, and how do you do it right?  Let’s take a look at examples of an effective working relationship with the auditor and the types of questions you should be asking your auditors when you meet to add value to the governance process and to the company you represent:

Company risks-what should the audit committee be made aware of?

Obviously, risks are not just from the financial side of the business but will also include overall business risks, possibly due to the industry the company operates in or the types of information (technology risk) they are touching. Most audit committees do not bring this up-they don’t ask their auditors what they think are the company’s risks, how they got comfortable with these risks, and how they adapted their audit approach to address risk. For example consider a client that has a SaaS based business that its customers use to handle sensitive health records or one that touches customer credit cards. These companies have more risk than others. One of the best boards I’ve worked with has a “technology risk task force” that discusses these types of risks, and brings me in to all their discussions.

What are the estimates used by management or the policies that the auditors feel bear discussion?

The audit committee should know and discuss each year the accounting policies management has adopted and make sure they are in agreement with those decisions. These policies are used in the preparation of the financial statements and are crucial to understanding the company’s financial picture.

How is revenue recognized?

With many of our clients, due the fact that they are technology based, revenue recognition on multiple element arrangement contracts can be quite complex.  Understanding the types of revenues, terms and practices specific to the company and the relevant accounting is imperative for the audit committee to understand.  Also, other complex issues such as warranty reserves or percentage completion should be discussed with the auditors. They should also review the company’s written revenue recognition policy annually to make sure it makes sense and is in conformity with Generally Accepted Accounting Principles.

How is stock compensation or other liability or equity instruments valued and accounted for?

The complexities surrounding various instruments that could be either equity or liabilities (such as warrants) can be quite complex. In addition, understanding how the company determined the fair value of its common stock as a basis for calculating the stock compensation charge for options should be discussed. You should feel free to ask your auditor how the company accounted for these arrangements, and whether a 409a valuation study was undertaken by the company.

Are the accounting systems adequate for the future?

There are a multitude of accounting packages and interrelated modules that companies can use to handle their accounting and overall CRM needs. Many companies start off with something simple such as QuickBooks, but as the business grows and complexities mount, the audit committee should assess, along with management, whether the current package is adequate. Selecting and implementing a fully integrated package can take months and, so this discussion should happen at least once a year. Once implementation begins, the audit committee should follow and understand the implementation timetable and overall costs.

How good are the accounting team’s capabilities? Is staffing adequate?

Quite often in the startup world, a company will grow and become quite complex very quickly. A bookkeeper may be adequate early on, but the audit committee should ask the auditor how the team is doing, including their strengths and their weaknesses.  Is it time to bring in a CFO with great operating experience? What would the company gain by doing so and what is the cost by not doing so? It’s not uncommon to also find that the team is understaffed due to the company’s desire to keep overhead low.

Are there good controls in place and are there steps that can be taken to improve controls?

The audit committee should review the auditor’s adjustments made during the audit and the scope of the errors found.  You should ask your auditor what they consider to be material. A discussion about controls, authorizations, signatures on checks and management review of transactions should also be discussed. Obviously, a proper segregation of accounting duties is always desirable to insure proper oversight. You should review your auditor’s written management letter of recommendations and ask them questions after management has had a chance to respond to the letter in writing. In addition, you should urge all companies to have written accounting policy manuals that the audit committee can periodically review.

Is there one single thing you can do as an audit committee member that will help the most?

It is the simple things that matter here.  Just being involved and paying attention delivers great value. We urge all members of audit committees to read the financials and ask questions about the conduct of the audit.

Communication is the goal.  A formal executive session at least once a year is always a good practice so the auditors and the audit committee can have a direct one on one discussion. They should also meet and discuss company activities during the year, not just at the delivery of the audit report. In order to do your job, you need to ask your auditors questions.  Having committee members with good financial backgrounds is important, but I have been in many meetings where members were not very financially savvy, but participated and asked good probing questions.  Help your auditors make your audit committee and company better by, as Bill Belichick says, “just doing your job”.

Jeff can be reached at Katz, Nannis + Solomon is a boutique CPA firm in Boston focusing on early stage tech based and entrepreneurial businesses and their owners.

Tags: Exits

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