A company's first audit is a rehearsal for diligence

Many venture-backed companies meet their first financial statement audit at the same stage they meet their first institutional investors. The auditor arrives with a request list, often called the PBC list (prepared by client), and the finance team discovers how many signed documents live in inboxes rather than in a system. In our view, that first audit is the best rehearsal a company will get for diligence, and it should be run as one.

We believe the documents an auditor asks for and the documents an investor's counsel asks for overlap so much that a company which closes its audit cleanly has already built most of its data room. The reverse also holds: gaps that slow an audit will slow a round.

What the request list asks for

An audit request list covers the financial records, as expected, and much more. Auditors ask for the executed agreements behind the numbers: executive compensation and employment agreements, loan documents, board approvals, material contracts and the equity records that support the capital accounts. They also send questionnaires to management on fraud risk and on independence, which the right officers must review and sign.

Yet the hardest items are rarely the obvious ones. The last open lines on a request list tend to be the executed version of an agreement whose term sheet everyone remembers, or a signed copy of a document that was approved by email. A term sheet for a compensation arrangement is not the agreement, and an auditor will ask for the agreement, signed and dated by both parties.

Thus, we treat "executed and findable" as the standard for every material document. A copy that exists somewhere in an inbox does not meet it.

Inventory held by someone else

Companies that sell physical products add a layer the request list makes visible. Under the international auditing standard on specific audit evidence, ISA 501, an auditor whose client holds material inventory must obtain evidence about its existence and condition, generally by attending the physical count. Where a third party holds the inventory, the standard points to a confirmation from that party, an inspection, or other procedures, such as a report on the warehouse's controls.

Hence, a company that uses a third-party logistics provider should know, before the auditor asks, exactly where its inventory sits, under which agreement, and whether the provider can support a count or a confirmation on the auditor's timetable. Providers change and warehouses move. A company that cannot state the current address of its own stock in one message has found a gap that an investor will also find.

What's more, the IAASB is revising ISA 501, limited to inventory, together with ISA 505 on external confirmations, with the stated aim of reflecting current business practice and the use of technology. Companies with complex logistics should expect the questions to become more precise over time.

Questionnaires and signatures

Fraud and independence questionnaires look administrative, yet they are where audits stall, because they need the time of senior officers in the busiest weeks of the year. We find it works best to send them early, through an electronic signature platform, and to resend them without hesitation when they sit unsigned. An open questionnaire is a small item that can hold up the whole file.

Why the audit and the data room are the same work

An investor's diligence list and an auditor's request list are built for different purposes, yet the documents behind them are largely the same: the corporate records, the equity records, the material agreements, the compensation arrangements, the debt, the financial statements and the controls behind them. Investor rights agreements, such as the NVCA model, address the delivery of annual financial statements to major investors, so the audit report itself often becomes an item in the data room.

Thus, we recommend building the audit binder and the data room index together. Each request from the auditor maps to a row in the index, each row has a document or a named owner, and the folder structure lives in the company's own cloud. When the round comes, most of the room is already in place and every document in it has been checked by someone independent.

A practical sequence

For a company approaching its first audit with a raise on the horizon, we would follow this order:

1. Map the auditor's request list against a standard data room index, line by line.
2. Collect the executed version of every material agreement, and flag any that exist only as term sheets or drafts.
3. Confirm the location and custody of physical inventory, and the provider's ability to support a count or confirmation.
4. Send management questionnaires early, through an electronic signature platform.
5. Assign a named owner to every open item, and review the gap list weekly until it is empty.

None of these steps requires new systems. They require one person who owns the list and the authority to chase signatures.

Our view

We believe a company's first audit should be run as a diligence rehearsal, with the request list mapped to the data room index and every material document executed, signed and findable in one place. A company that does this closes its audit faster and enters its next round with most of the room already built and tested. Our view would change for a company whose investors have waived audited statements and which does not expect a priced round within the next year, although even then the document discipline costs little and saves time later.

Data Room is the offer we run for this work, and it sits inside Raise Ready.

Sources

1. International Auditing and Assurance Standards Board, ISA 501, "Audit Evidence: Specific Considerations for Selected Items", 2013 Handbook edition. iaasb.org
2. International Auditing and Assurance Standards Board, "ISA 500 Series" project page, covering the revision of ISA 501 and ISA 505. iaasb.org
3. National Venture Capital Association, Model Legal Documents. nvca.org

This article is general information, not accounting, legal or investment advice.