So what went wrong at Enron? Liabilities were hidden in special "off balance sheet" companies that US accounting standards permitted. The company also took profits in the first year on long-term ventures, although in some cases these projects had not even started. Essentially, managers focused on short-term gain rather than the long-term health of the company.
Could it happen here? UK financial reporting standards would have helped prevent the accounting treatment used. In addition, UK auditing bodies are considering proposals for increased independence of auditors that should help prevent spectacular collapses such as Enron, and also to heighten the role of the auditor in large and small businesses.
While the Registrar of Companies accepts internally produced abbreviated accounts, other interested parties prefer to see financial reports reviewed by an external organisation. Above all, the annual external audit lends credibility to the company's financial statements. This is an important factor for stakeholders that want to protect their investment; that is, shareholders (particularly where different from management), creditors, lenders, suppliers and potential investors, as well as employees and regulators.
A company's bankers often require audited accounts to assist reviews of overdraft facilities and may offer a preferential rate to those that provide externally audited accounts. Similarly, suppliers may also want to see audited accounts before agreeing lines of credit or increasing limits.
Although an audit typically analyses information from the previous year to give a snapshot of the financial position of a business, its real value comes in providing information that can be applied to help improve the future management and efficiency of the organisation.
An audit should begin by understanding the activities of the organisation and its key information processes. To make this easier, keep your auditor up to date about the firm's developments, and not just on financial matters. The greater the auditor's understanding of a business, the greater the value of the audit.
Since an audit involves a thorough inspection of your business, get your auditor to review an aspect that could lead to savings
The annual audit should identify any sources and causes of risk arising through error (unintentional mis-statement), fraud (intentional mis-statement) or business failure. An audit should also assess management controls – and, if necessary, test them – to see whether they can be relied upon to reduce risks to an acceptable level.
Agree your expectations of the audit before it begins. Discuss those expectations with the auditor, agreeing potential improvements, respective responsibilities and the time scale.
It is also wise to agree the fee in advance and any variations to the work to be carried out.
Check exactly what information is required by the auditor: after all, it is much more efficient (and cheaper) for you to provide it than for the auditor to hunt for it. On a practical level, bank accounts should agree with cash books, and purchase and sales ledgers should add up. If there are any discrepancies, explain them: don't wait for the auditor to raise queries. You will find it useful to keep working papers such as VAT calculations, PAYE and NIC payments. Similarly, keep any calculations for work in progress as this can be a sizeable figure for many firms in the building sector working on medium- to long-term projects.
Since an audit involves a thorough inspection of a business it is usually possible, with relatively little extra planning, to get the auditor to review an aspect of your business that could potentially lead to considerable savings. Typical areas might be time recording systems, billing, efficient remuneration and credit control. Discuss such extra work at the outset and negotiate the fee.
Chris Pomroy is a partner at chartered accountant Smith & Williamson, specialising in business services. Email: firstname.lastname@example.org