Audit is not just an obligation

01 December 2022

Jan Macháč, Partner, Head of Audit, International Liaison Partner |

In my nearly 18 years as an auditor, my clients have repeatedly asked me what benefit an audit actually has for them. This question naturally is raised mainly by top management when negotiating the contractual terms for the audit of financial statements. Sometimes they themselves answer that it is simply an obligation, without apparently considering the added value for the business.

This opinion can be understood from a certain point of view, but not without reservations, where the audit concerns a smaller company that is actively managed by the owner himself, usually a sole owner, who is present on a daily basis and does not use any external sources of financing apart from the usual supplier loans ("purchase against invoice"). However, even in such a situation, the auditing of the financial statements is meaningful and relevant. The question may be whether it is necessarily within the scope of a full audit.

In assessing the benefits of a financial audit, it is good to start by remembering that it is a three-way relationship:

  • Management is responsible for preparing financial statements that present the company's financial position, financial performance and cash flows fairly.
  • The auditor is an objective and independent authority who reviews the accuracy of the financial statements and confirms in his or her opinion on whether they are unadulterated, reliable and can be depended upon with a high degree of certainty.
  • The user of the financial statements, as a source of information, is a third party outside the company. The audited financial statements serve as one of the input sources of information about the company and its actual financial condition. 

In a broader context, auditing can be said to help build a transparent and trustworthy business environment, and auditors thus act in the public interest.

The benefit of financial auditing to users of audited financial statements is clear from the above. The auditor is practising a profession for which he or she has the necessary qualifications, verification and authorisation.

But what value does an audit bring to the audited company and its management?

The usual argument is that banks, creditors or investors require audited statements from the company's management to have a credible basis for assessing potential risks and to decide whether and under what conditions they are willing to provide financing to the company.

But this is just one example of business cooperation in a free market where an audit provides some assurance.

Even if the company does not rely on external sources of financing or is not an issuer of traded securities, there are other business partners, such as suppliers or customers, who verify the credibility and assess the potential risks of their counterparty before doing business with them. Thus, their first steps often lead to the portal or to specialised company registers and databases, where they can view the latest available financial statements and get a better idea of whether the company has the prerequisites to meet its business obligations and will be able to pay invoices for products or services, finance its activities or reliably ensure supplies to its customers. They will certainly feel more secure if the available information is verified by an independent auditor and, if they have a choice, this can be (and often is) one of the parameters of the tender process.

One area where financial audits receive a lot of attention is corporate transactions, e.g. company mergers, acquisitions or sales. An analysis of the company's financial health can significantly influence both the price and terms, as well as the decision whether to proceed with the deal.

For larger transactions, the buyer usually carries out pre-acquisition due diligence, which includes a focus on financial reporting, for which an independent external advisor is usually engaged. If it is based on audited financial statements for the last few years, the advisor can rely on this data and then focus on assessing only specific risks and areas, which saves costs for the client.

If audited data is not available, this may be reflected in the terms of the transaction, for example directly in the purchase price in view of the perceived higher risk, or in the arrangements for post-acquisition price adjustments (which in turn increases the complexity of contracts, their negotiation and overall transaction costs).

Another example is a company or group of companies (concern) whose owner(s) have decided to hand over management to executive management. They only oversee the activities and operations, while the financial audit serves as an independent confirmation that they can trust the figures and data reported by the executive management. In our practice at BDO, we have also encountered a case where we discovered discrepancies in a company's financial statements during an audit and upon closer examination revealed financial misappropriation by management to the owners.

The financial statements are also relevant for company employees. People want to work for stable and trustworthy companies. In my own experience of interviewing job applicants at BDO, I often see the accounts of potential employers. Of course, my experience may be influenced by the fact that I meet people with an interest in accounting and finance. On the other hand, if a company is setting out to look for employees for a senior management position or even for its board of directors, consistency and caution will be required on both sides. Here again, the financial health of the potential employer and information about it can be expected to play a role in the decision.

So far, I have dealt with the topic only from the perspective of its final output, i.e. the auditor's report published together with the audited financial statements. However, it is "only" the result and a summary of the most important findings of the whole process, a kind of icing on the cake.

A financial audit is a complex process and in certain circumstances can also reveal a lot more information about the financial management of a company. This may then lead to further outputs, findings and recommendations that may be useful to the company's management and the persons charged with its governance.

At BDO, we prepare a summary of findings, additional findings and recommendations for our clients in the form of a management letter, which serves as a basis for discussion with management and also as a written output for the client. 

When I was thinking about some of the most common findings we come across with our clients, I thought it would be useful to do a little analysis of these findings and look more generally at the ones that are most often repeated. Together with my colleagues in our Prague BDO office in Chodov, we went through these letters over the past two years and came to some interesting conclusions, to which I have dedicated the following article.