In all cases, several years of audited financial statements are required to go public. In the case of an acquisition, potential suitors will many times demand audited financial statements. If your books and financial statements have never been audited, can they be?

Audit Requirements
Audited financial statements are a requirement to go public. Three years of audited financial statements is the norm. For acquisitions, there is no firm requirement for audited financial statements. However, many companies will demand them. This is especially so if the acquiring company is a public company (or plans to be) and the acquired company has a material impact on the combined financial statements.

Any CPA can perform an audit. However, for companies going public, venture capitalists and underwriters usually want one of the "Big Five" CPA firms to do the audit.

An audit has two major goals. First, the auditor examines the numbers in company financial statements to determine that they are supported by records (e.g., bank statements, sales ledgers, invoices, checks, etc.). Second, the auditor makes sure that financial statements are prepared using the correct accounting rules, known as generally accepted accounting principles (GAAP).

Are You Ready?
So, can your company's books and financial statements be audited? In any sort of initial review, or "due diligence," a CPA must determine if your books can be audited. This determination is made based on the completeness of company accounting records. In some cases companies are found not to have records that will support an audit. For instance, a company may have old financial statements and tax returns, but no underlying accounting records. This can prevent an audit, and even prevent an IPO or acquisition.

In an initial review the auditor will also determine the potential adjustments necessary to bring company financial statements in line with GAAP. Sometimes these adjustments are so significant that the proposed offering or acquisition must be called off.

Common Problems

• An accounting firm that does not understand e-commerce. A problem for e-commerce start-ups is finding an accountant that understands the special needs of Internet-based companies. Start-ups often use local accounting firms that have a broad range of clients. If it is lucky, the start-up will have an accountant that understands the special rules for Internet-based companies. Unfortunately, many do not. The start-up should seek out firms with expertise in this area.
• Can sales be proven? In the world of e-commerce, where goods are both ordered and paid for using the Web, sales records may not be complete. Can your company prove sales by showing a stack of bank statements? Maybe. But how do you tell the difference between a sale, and the proceeds from a loan? Ordinarily, your company should have some kind of independent record of sales.
• Cash in the bank. If a company needs an audit going back three years, does it have all of its bank statements? Does the company have all of its cancelled checks? If not, you better order copies from the bank. This can take a while, so you had better order them now.
• Software costs. Internet-based companies employ a lot of software, some of which is purchased, and some developed internally. GAAP has special rules for software that determine when the costs are carried on the books as assets, and when they must be expensed. There are separate rules for software that will be sold to others, and software that is for internal use. A careful review must be made to determine that software has been properly accounted for. Most start-ups are haphazard in the rules they apply to software costs, so, expect some fairly large adjustments.
• Independent contractor versus employee. A typical practice of technology companies is the use of "independent contractors." These are workers that the company, rightly or wrongly, has elected not to treat as employees. As indicated by the well-known Microsoft Case, many of these independent contractors are really employees. Companies that make extensive use of independent contractors are at risk of these workers being reclassified as employees. The liability for unpaid payroll taxes and penalties can be a substantial "contingent liability" that may have to be disclosed in the audited financial statements. Companies that have, in the past, made extensive use of independent contractors should carefully reevaluate the treatment of these workers to determine whether there is a potential liability that must be disclosed on the books.
• Content costs. The creation of a Web site many times involves substantial cost for the creation of content. An online bookstore, for instance, may have thousands, or hundreds of thousands of pages of information describing the books it sells. Should the cost of creating this content be expensed or carried on the books as an asset? This is a difficult determination, and one that requires a detailed review of the types of costs incurred, and the expected useful life of the content.
• Inventory levels. If a company has an inventory, the auditors need some way to prove the amount of inventory at the end of each year. An inventory count that can be verified is the best proof of inventory. Where records of an inventory count are not available, it is still possible to prove inventory levels, however, it is very difficult and time consuming.
• Board minutes. Many start-up companies treat board meeting minutes as an afterthought, but these minutes are an important part of the corporate records. Important decisions, such as the issuance of stock or options, major loans, affiliations, and compensation should all be fully explained in the minutes.
• Are relationships documented? E-commerce is fluid, and relationships between companies come and go. Many times these relationships are not documented. Each key relationship should be documented by a contract or letter of understanding. Failure to do so puts the future of the company at risk, and this risk will have to be noted in the company financial statements.
• What is business? What is personal? Start-up companies are usually loose about where the money comes from to pay bills. Sometimes the company pays a bill for one of the owners. Sometimes one of the owners pays a bill for the company. This is not really a problem as long as these transactions are properly accounted for. However, many times an owner's personal expenses will inadvertently show up in "miscellaneous expenses." Sometimes the owner pays substantial expenses for the company without ever recording these expenses on the books.
• System security. An insecure system is a substantial risk to a company, and one that causes CPAs considerable concern. For instance, an Internet-based company might show sales growth of 1,000 percent per year, and might look like a wonderful investment. However, if that company's systems security is weak, its Web site, and associated databases, may be vulnerable to complete destruction in the form of a hacker, a virus or a disgruntled employee. E-commerce companies, especially those that are entirely Web based, are particularly vulnerable because so much value is contained in computer hard disks. Your company should make a detailed review of its systems security.
• Records in electronic form only. Many companies keep all of their accounting records in electronic form only. This is an unnecessary risk. When records are only in electronic form they are easily lost due to an accidental file erasure, a hard disk crash, a virus, or a change to a different type of accounting program. A company can easily lose access to electronic records if it changes accounting programs, bookkeepers, or computers. A company that needs an audit of three years worth of records, for instance, may have accessible records for only one or two years. For the third year the company may have only tax returns or internally prepared financial statements, which cannot be supported by full accounting records, and therefore, cannot be audited.

How to Get Ready for an Audit
If you plan to go public, plan to be audited. If you have several years of un-audited financial statements, you need to hire an accounting firm as soon as possible to get your records in shape. While you may eventually be audited by one of the "Big Five" CPA firms, you do not want to pay one of these firms to get your books in shape. Hire a firm that understands and has expertise in dealing with e-commerce companies. You should do this now. Time has a way of destroying records.