Role of Auditors in SME Finance
Role of Auditors in SME Finance
WHO IS AN AUDITOR?
Auditing is the analysis of the financial accounts/records and procedures of an organization by a qualified accountant as an auditor.
This is essential in order to gain a fair perspective of a company’s working from the company’s financial statements. Audited statements form the basis by which investors, creditors, bankers, and business partners assess the credibility of the business for investment, creditworthiness, and business association.
The purpose of conducting financial audits is to express an opinion of the auditor on the financial statements based on their audit.
In determining the financial health of an organization as to how efficient and effective it is, the management may require the auditors to take up separate assignment to report specifically on such matters.
Likewise, separate assignment may be taken up by auditors with separate agreed upon procedures (AUP) to conduct audit of non-financial areas.
This is generally done by the consulting division of the auditors. However, in taking up audits of non-financial areas or AUP, a conflict check is done to ensure that the independence of the auditors is not compromised.
Owners of small and medium-sized enterprises believe that their accounts are less complex than those of larger organizations. They are wary of seeking the services of qualified auditing professionals unable to visualize the cost-effectiveness of the auditing fee expenditure.
AUDITING FOR SMES
Auditing supports owners of the small business self-assess the sustainability, risks, and growth potential of their business.
The advantages for a business audit are:
- Develop internal controls in the business.
- Identify business challenges and potential opportunities for greater efficiency and results.
- Identify potential financial risks in the business.
- Analyze and understand your firms’ financial data.
SME owners must overcome their hesitations about the role of auditors by including in the scope of auditor’s report the following:
- Scope the auditing work carefully to ensure cost-effectiveness of the exercise. This is achieved by scoping the management report to be prepared as a part of the audit.
- The report must prepare a trend analysis of financial performance of the company; and how the key operational benchmarks are trending, depicting a degree of management control on company performance.
- The report must focus on quality of cash flow as an outcome and controllable variables like staff, marketing and other productive resources.
- The report must benchmark and assess the productivity of marketing, HR, and other capital resources as applicable.
- The report must review and give feedback on internal working procedures and controls.
- Auditors must review and assess legal and statutory compliances.
- The management report is a must.
CONTENTS OF AN AUDIT REPORT
An auditor mainly prepares two types of reports:
- Financial Audit Report
- Management Report
Ideally, an SME should ask the auditor to prepare both the reports. The financial audit report and the management report serve as essential tools for a bank to evaluate a company’s financial strength.
Contents of a financial audit report
- Report on the financial statements
The auditor audits the financial statements of the company which comprise of the statement of financial position, statement of comprehensive income, statement of changes in equity and statement of cash flows for the year then ended and provides a summary of significant accounting policies and other explanatory information.
- Management’s responsibility for the financial statements
Management is responsible for the preparation of financial statements that give a true and fair view in accordance with International Financial Reporting Standards or any other globally recognized international standards. For internal control, it is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.
- Auditor’s responsibility
The auditor’s responsibility is to express an opinion on the financial statements based on the audit.
The auditor conducts audit in accordance with the International Standards on Auditing or Generally and accepted Auditing Standards. Those standards require that they comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. The auditor considers internal control relevant to the entity’s preparation of financial statements that give true and fair view in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements.
- Basis of Opinion
The auditor’s report is only an opinion on whether the information presented is correct and free from material misstatements. The auditor provides his opinion whether the financial statements give a true and fair view of the financial position of the company.
- Report on other legal and regulatory requirements
The auditor verifies that the financial statements comply with the applicable provision of the law and the company’s articles of association..
Contents of audited financial statements
- Statement of financial position
- Statement of comprehensive income
- Statement of changes in equity
- Statement of cash flows
- Notes to the financial statements
Contents of the management report
An auditor prepares an additional management report only at the request of the company’s management. This report expresses an opinion on the effectiveness of the establishment’s internal control.
- Describe in general the development of the business identifying any significant changes in the business.
- Describe the dominant business segment
- Principal products produced and services rendered
- Domestic versus export
- Methods of distribution
- Percentage of total revenue contributed by each segment
- Any new developments – description of new product and segment or products and segments dropped
- The sources, availability and underlying contracts of raw materials or services
- The practices of the company relating to working capital items
- Significant amounts of inventory to meet rapid delivery requirements of customers
- Assure itself of a continuous allotment of goods from suppliers;
- Where the registrant provides rights to return merchandise;
- Where the registrant has provided extended payment terms to customers.
- Dependence of the company or segment upon a single customer, or a few customers, the loss of any one or more of which would have a material adverse effect on the company or segment.
- Amount of backlog orders
- Competitive conditions in the business
- The principal methods of competition (e.g. price, service, warranty or product performance) may be identified
2.Discussion and Analysis of Financial Condition
- Provide information with respect to liquidity, capital resources and results of operations
- Identify any known demands, commitments, or uncertainties that may cause liquidity increasing or decreasing in any material way.
- Describe any commitments for capital expenditures, the general purpose of such commitments and the sources of funds needed to fulfill such commitments.
- Describe known changes between equity, debt and any off-balance sheet financing arrangements.
- Describe any trends or uncertainties that have had or that may have a material favorable or unfavorable impact on revenues or income from operations.
3.Transactions with owners and management
- Identify and list any transactions or any currently proposed transactions (sales, services, and procurement), in which any of the following persons had, or will have, a direct or indirect material interest, naming such person and indicating the person’s relationship to the company.
- Any owner or officer of the company.
- Any member of the immediate family of any of the foregoing persons.
- Identify any persons who are indebted to the company – nature of the person’s relationship with the company, the amount of indebtedness outstanding, and the nature of the indebtedness transaction, in which it was incurred.
- Describe briefly any material pending legal proceedings, other than ordinary routine litigation incidental to the business (and against any director, officer or any owner of record).
- The name of the court in which the proceedings are pending.
5.Disagreements with Accountants on Accounting and Financial Disclosure
- Describe briefly the impact of risk factors (listed below) on revenue, margins, and costs.The audited financial statements will generally contain a note on the exposure and management of following risks: credit risks, liquidity risks and market risks (including currency risks, cash flow interest rate risks and fair value interest rate risks). Examples of such risks include- Changes in market demand, ability to expand sales, changes in credit terms to customers, competitive market conditions, fluctuations in foreign currency exchange rates, availability of products, services, & raw materials, the mix of products and services, customer base and sales channels, timing of shipments of products and delivery of services under contracts and global economic conditions.
AUDITORS AND SME FINANCE
It is important to obtain independent advice when considering financing options. The type of finance and sought should match the needs of the business. Advisers (auditors and / or consultants) can help SME businesses establish whether they need to raise finance or whether their needs can be addressed in and other ways such as better financial management.
Small businesses can consider using Advisers (auditors and / or consultants), who provide financial and business growth services, to develop a funding proposal for presentation to banks.
Advisers (auditors and / or consultants) assist small firms become ready for working with banks.
Advisers (auditors and / or consultants) assist SMEs in the following areas:
- Assessing the suitability of bank capital as a source of funds for the business.
- Matching business needs of capital with different products and services of the banks.
- Maintaining proper books of account.
- Efficient management of cash flow.
- Efficient management of payables and collections.
- Present to the SME owner an independent assessment of the business as a ‘management report,’ and included in the audited annual report of the business, covering – general development of the business,analysis of financial condition, transactions with owners and associate companies, legal proceedings with material impact on the business, disagreements if nay with accountants on financial disclosure,and business risk factors.
- Preparing an application for bank finance.
- Help SME maintain the accounts for appropriate business decision making.
- Help SME efficiently manage and monitor cash flow, stocks, trade debtors, and creditor repayment period.
- Ensure proper utilization of funds borrowed from banks.
- Prepare half-yearly audited financial statements for submission to banking institution.
- Update the financial institution on any changes in business.
The suggested scope of work is recommended for consideration by SME owners. It is a guideline. It is not mandatory. The scope of engagement of the SME and the Advisers (auditors and / or consultants) is a professional relationship that should be determined with a clear service expectations defined by the business.
SELECTING AN AUDITOR
Presented hereunder are criteria that an SME can typically use to assess suitability of auditing firms.
- Experience and industry knowledge of the auditing firm.
- Experience in performing the required work for other similar companies.
- Written proposal presented by the firm delineating how it intends to handle the auditing services.
- Audit quality standards adopted.
- Consistency in application of auditing and accounting policies and their application across clients.
- Compatible personality of company and audit firm.
- The independence of the auditor.
- Fee proposal – what it includes and excludes.
- The balance of quality, price, and scope of services.
- Non-audit services to be provided and expertise therein. Non-audit services should not compromise and independence with respect to the audit services. As a consultant ‘preparing an application’ for banking and using is and another an audit report is one thing and ‘representing the SME’ for negotiating with banks for a loan is another thing. Representation should be discouraged.
GOOD vs. BAD FINANCIAL STATEMENTS
While preparing the auditor’s report, an auditor verifies and confirms the company’s financial statements and with the internal accounting records. The key objective of an audit is to provide an independent and examination of the financial statements produced by management. Detailed review of these records and adds credibility to the financial statements of an organization.
Accounts receivable ageing is disclosed separately in the audited financial statements, as required by and the International Financial Reporting Standards (IFRS) or any other globally recognized international and standards. The financial statements should clearly highlight the quality and aging of accounts and receivable.
Quality of accounts receivable- An analysis of receivables usually begins with an evaluation of the financial strength of the borrower’s customer base. In general, the greater the number of financially and sound companies, better is the quality of the customer base. As the receivable base shifts toward and smaller companies, financially weaker companies, or both, the risk increases that the borrower will not be able to collect the amounts it is owed.
A receivables concentration of one account or a few large accounts is often referred to as “single-party” risk. If the “single party” takes its business elsewhere or its financial condition deteriorates, the borrower’s business could be compromised.
Aging of accounts receivable- Audited financial statements categorizes a company’s accounts and receivable according to the length of time an invoice has been outstanding. An aging schedule is a way of finding out if the customers are paying their bills within the credit period prescribed in the company’s credit terms.
Accounts receivable turnover ratio & days in receivables ratio is an important measurement of management efficiency. These two ratio’s give lenders a decent appraisal of a company’s ability to collect on credit.
Accounts receivable aging is a critical management tool as well as an analytic tool that helps determine and the financial health of a company’s customers, and therefore the health of their business.
Financial statements should also provide a clear picture of the company’s inventory management.
An auditor verifies the salability of the inventory, makes sure that the inventory reflected on the balance sheet actually exists and that the balance sheet includes all inventory owned by the company.This includes all raw materials, supplies, inventory in transit, inventory the company may have on consignment with another business, and inventory stored off the premises.
An auditor ensures that inventories are stated at cost or net realizable values, whichever is lower.
Further, as part of audit procedures, an auditor ensures that slow/non-moving inventories are adequately provided for. The auditor reviews the company’s policies and procedures for managing the inventory. An auditor also notes any obsolete or damaged inventory and reduces its valuation to its net realizable value.
Inventory turnover ratio & days in inventory ratio are the key ratios that determine how efficiently the company is utilizing the inventory to generate sales revenue. A high inventory turnover ratio indicates excess inventory and perhaps low sales.
Trade and other payables
An auditor reviews the schedule of creditors at the balance sheet date. This schedule should match and with the total of the general ledger. An accounts payable aging schedule will help the auditor to determine how well the company is paying their accounts payable. Accounts Payable Aging Reports are used to reveal patterns of delinquency and identify points where payment efforts should be concentrated. Looking at the schedule allows the auditor to spot problems in the management of
payables early enough to warn the business from any major trade credit problems. An auditor also reviews the liabilities at the end of the previous year for any possible unrecorded liability.
Property, Plant & Equipment
An auditor reviews the schedule of property, plant and equipment at the balance sheet date showing
the cost, or valuation, of each category of asset and related depreciation:
- At the beginning of the period
- At the end of the period
- In respect of additions and disposals in the period.
Cash and Bank Balances
Audited financial statements detail a schedule of cash balances and all bank accounts operating during the year, listing balances at the end of the period.
The schedule should agree to the total of the general ledger. An auditor reviews the bank reconciliation statement as at the balance sheet date. The balances in the reconciliation statement should agree with the general ledges & the bank statement.
Transactions with related parties
An auditor evaluates a company’s identification and disclosure about its relationships and transactions with related parties that are material to the financial statements.
The objective is to ensure that an entity’s financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances with such parties.
If there have been transactions between related parties, the auditor discloses the nature of the related party relationship as well as information about the transactions and outstanding balances necessary for an understanding of the potential effect of the relationship on the financial statements.
These disclosures would be made separately for each category of related parties and would include:
- the amount of the transactions
- the amount of outstanding balances, including terms and conditions and guarantees
- provisions for doubtful debts related to the amount of outstanding balances
- expense recognized during the period in respect of bad or doubtful debts due from related parties. Examples of the kinds of transactions that are disclosed if they are with a related party
- purchases or sales of goods
- purchases or sales of property and other assets
- rendering or receiving of services
- transfers of research and development
- transfers under license agreements
- transfers under finance arrangements (including loans and equity contributions in cash or in kind)
- provision of guarantees or collateral
- commitments to do something if a particular event occurs or does not occur in the future, including executory contracts (recognized and unrecognized)
- settlement of liabilities on behalf of the entity or by the entity on behalf of another party
Loans and advances to promoters / owners
SME entrepreneurs can depict a bolstered picture of their balance sheet by disbursing loans and advances to themselves.
In this way, there is no affect on the reserves and surplus of the company. Therefore, the balance sheet of the company looks strong irrespective of the fact that the money has actually been paid out to the promoters.
It is also pertinent for the auditor to analyze whether the owners have pledged their shares in the company to other banks / financial institutions against a personal debt / loan.
The annual report of the company should make an adequate disclosure of the afore-stated factors. The auditor has to check and comments as to whether adequate disclosure has been made or not.
Good Balance Sheet – Good Balance Sheet
Bad Balance Sheet- Bad Balance Sheet