Audit

By the fifth bridge a business's statements have been checked many times. A bookkeeper closes them monthly. An outside accountant has reviewed them for years. A lender's credit analyst has read two years of packs reconciled to them, and a quality-of-earnings team may have been through them for an earlier transaction. Nobody suspects them.

Even so, a yield buyer, particularly an institutional one, will often insist on audited statements before it capitalizes the payout, or commission audit-level work of its own and discount the yield until that work is done. Suspicion has nothing to do with it. A capitalized yield multiplies every dollar of distributable cash by a large number, and the buyer wants an independent opinion on the dollar before it multiplies.

Audit supplies the opinion. It puts the numbers coverage is computed from under an independent audit, so the coverage a yield buyer capitalizes rests on statements an auditor has opined on.

A run of audited years

The most recent fiscal years, in an unbroken run, should be audited by an independent accounting firm, each with an unqualified opinion.

A review and an audit are different engagements. In a review, the accountant asks questions, performs analytical procedures and gives limited assurance that nothing came to their attention suggesting the statements are materially wrong. In an audit, the firm tests the underlying records, confirms balances with banks and customers, observes the inventory count, examines the controls, and gives a positive opinion that the statements are fairly presented. A yield buyer relies on the second.

Moving from review to audit takes a year of preparation. The firm performs an audit-readiness assessment, the findings are closed, and the first audit is engaged for a year whose opening balances can themselves be audited. That last point is easy to miss and expensive to get wrong. The auditor has to be satisfied about the balances at the start of the first audited year, and if the inventory at that date was never observed, the opinion may have to be qualified. Planning the first audit a year ahead lets the business arrange for the opening count to be observed.

The same firm is then kept year after year, so that opening balances and accounting policies carry forward without restatement. A change of auditor, especially in the years before a sale, raises a question a buyer will ask.

Coverage tested, not just the statements

Each year the coverage schedule and the distribution history are tested under agreed-upon procedures, by the auditor or another independent firm.

An audit opinion covers the statements. It says nothing about a ratio the business computes from them. Coverage is the figure a yield buyer will capitalize, so it is tested on its own, under procedures written to the definition in the distribution policy: the auditor recomputes each quarter's coverage from the audited statements, checks it against the schedule and reports any exception. The procedures are engaged alongside the audit, so the coverage schedule a buyer reads has been tested by the same firm against the same statements.

A management letter, closed

Every point in each year's management letter should be closed, or have a dated remediation, before the next audit begins.

The management letter is the auditor's list of weaknesses found during the audit that did not affect the opinion: a control that was not operating, a reconciliation done late, a policy not followed. Each point goes to a named person with a date and is tracked in the board pack until it is closed. A buyer reading several years of management letters cares less about how many points there were than about whether the same points recur. A point that appears three years running tells the buyer that the business does not act on what its auditor tells it.

How a buyer's team uses the audit

A yield buyer with audited years in hand does not repeat the auditor's work. Its quality-of-earnings team reads the audit files, which the auditor will usually release under an access letter, and spends its time on the questions an audit does not answer: whether the earnings are sustainable, whether the adjustments in the coverage figure are reasonable, whether the forecast is credible. The buyer starts from a settled set of figures and skips the work of first establishing what the figures are.

That changes the shape of the transaction as well as its price. Diligence is shorter and cheaper. Representations and warranties insurers, where the buyer uses them, take more comfort from audited statements and exclude less. A buyer with no audited statements to rely on will often ask for more protection in the purchase agreement, a larger escrow or a longer survival period for the seller's warranties, which the seller carries for years.

None of this is value in the framework's sense, because none of it changes the business's cash. It is still why the owners of a business heading for a yield buyer pay for the audit.

What it costs, and what it does to value

An audit costs materially more than a review, and the extra cost comes out of distributable cash.

In the illustration, an audit and agreed procedures costing $45,000 a year more than the review they replace, capitalized at a 9 percent yield, take $500,000 off the value of the payout. That loss is real value, and the framework counts it.

The audit's benefit the framework does not count as value. The audit reveals the coverage figure and leaves it unchanged. The probability a buyer assigns to the payout falling short moves only because the evidence improved, and verification reveals value without creating it. Audited statements admit buyers whose mandates require them and remove a buyer's diligence haircut. Both are price and certainty, and they sit in the price column. Where an audit adjustment changes the cash flow itself, the change belongs to Coverage Management.

So the driver carries no rank. It is worked because the buyer at this anchor will not buy without it, or will pay much less. The cost goes into the budget the payout ratio was sized against, so it never reaches the owners as a surprise deduction after the fact.

What has to be in place first

The business needs a budget for the audit and the agreed procedures, placed in the budget the ratio was sized against, because an audit costs materially more than a review. It needs a finance lead who can support an audit, producing schedules, reconciliations and evidence on the auditor's timetable without the owner. And it needs the coverage definition from Coverage Management, since the agreed procedures test against it.

Knowing that it works

The driver is tracked by the audited fiscal years on hand against the run a yield buyer will expect; by audit adjustments each year, by count and value, which should fall as the business learns what the auditor looks for; and by management letter points still open, counted at each board meeting.

The owner can be tested by meeting the audit partner without the finance lead, asking what the partner would want fixed before a buyer's team arrives, and recording the answer; and by reading the agreed-procedures report and saying which coverage figures were tested and whether any exceptions were found.

Why it slips, and what holds it

The audit tends to slip back to a review in a quiet year, when the cost looks unnecessary and no buyer is in sight. A single unaudited year breaks the run, and the next buyer will want consecutive audited years.

Both decays are answered in documents the owner cannot quietly change. The audit requirement is written into the distribution policy, so a year without an audit stops distributions under the policy until one is completed. And the board, not management, approves the audit engagement, so dropping the audit to save cost has to be a minuted board decision with the independent member present.