GAAP Audit

A GAAP audit is a critical process used to verify that a company’s processes align with generally accepted accounting principles (GAAP) when preparing financial statements. This type of audit ensures transparency, accuracy, and compliance in financial reporting.

Undergoing a GAAP audit builds trust, uncovers inefficiencies, and offers a clear picture of financial health for public, private, governmental, and non-governmental organizations. CPAs are there to help business owners prepare for (and to perform) GAAP audits in accordance with the relevant regulatory requirements.

What Is a GAAP Audit?

A GAAP audit is a formal review of a company’s financial statements that determines whether they follow the rules established by GAAP. Audits are often performed yearly. However, the frequency depends on the organization’s size, any established agreements, and relevant regulations.

The process provides interested parties, including investors, creditors, and regulators, with a detailed picture of the company’s financial position and assures them that the business is compliant with GAAP financial reporting standards.

GAAP sets out the standard way many U.S. businesses record and report their financial information. These accounting principles were laid out by the Financial Accounting Standards Board (FASB). They provide the framework for preparing financial statements used for reporting, including income statements, balance sheets, and cash flow statements.

An independent auditor, usually an independent accountant or certified public accountant with expertise in financial statement audits, carries out a GAAP audit and verifies that the business’s financial reporting process is accurate, complete, and consistent.

Are GAAP Audits a Legal Requirement?

GAAP audits aren’t universally required for U.S. companies. However, the U.S. Securities and Exchange Commission (SEC) requires publicly traded companies to prepare GAAP-compliant financial statements and have them audited by a Public Company Accounting Oversight Board (PCAOB)-registered firm.

Some private companies choose to have their financial statements audited, especially if stakeholders or investors request it.

Reasons to Request an External GAAP Audit

The reasons behind requesting an external GAAP audit will largely depend on whether the company is private, public, governmental, or non-governmental:

Private Companies

GAAP audits are useful for private companies for the following reasons:

• Obligations to lenders or creditors: Some banks and other lenders require GAAP-compliant financial statements and audits as a condition for ongoing funding or investment.
• Instilling internal confidence: A third-party audit offers the board of directors and any other interested parties peace of mind and confidence in the company’s financial position.
• Consistency: Adopting the consistent accounting rules set out by GAAP allows for parallel comparison with the financial performance of other companies. This is helpful both for attracting potential investors and internal decision-making.
• Fraud detection and prevention: An audit is an effective way to detect and prevent cases of fraud within an organization. Auditors will pinpoint potential areas of risk and suggest measures to mitigate them. This protects the company’s assets and reputation.
• Improving operational efficiency: Auditors often find areas of operational inefficiency in financial processes and controls. Putting their recommendations into practice will help to streamline operations and boost overall efficiency.
• To facilitate mergers or acquisitions: Significant business transactions like mergers and acquisitions often require audited financial statements, as they provide a clear picture of the company’s financial health. This is invaluable during the valuation and negotiation process.

Public Companies

SEC-registered public companies must prepare their financials in accordance with U.S. GAAP standards and have them audited by a PCAOB-certified auditor. However, as in private companies, an audit is also useful for public companies to provide objective third-party verification that their statements are accurate, compliant, and aligned with GAAP principles.

Governmental Organizations

GAAP is widely used in governmental accounting for both state and local governments. According to 2021 figures from the Governmental Accounting Standards Board, 100% of the states and 74% of the audited counties studied use GAAP (See page 5.).

This research cited access to lower borrowing costs as one of the main reasons why such a high percentage of governments choose to comply with GAAP. Other state and local governments use GASB (Governmental Accounting Standards Board) standards.

Nonprofits

Nonprofit organizations may also choose to undergo GAAP audits as a way to build donor trust. Others may be required to do so to fulfill requirements for private funding.

All non-federal nonprofits that expend $1 million or more in federal dollars in a single fiscal year must undergo a Single Audit. The audit must comply with both GAAP and Generally Accepted Government Auditing Standards (GAGAS).

How Does a GAAP Audit Work?

There are three main stages in the GAAP audit cycle before the auditors’ final report is issued:

1. Planning Stage

A robust audit planning stage is critical as it gives the independent auditors time to understand the business, the industry, and the operations and internal controls in place. Auditors typically meet the management of the company, review past financial statements, and identify any potential risk factors that could impact the accuracy of financial reporting.

Auditors look for areas where misstatements could occur due to human error or fraud. This information will shape how the team tailors the audit to each business. The team will also develop a formal plan for the audit. This will detail the audit timeline, its scope, and the resources required.

2. Evidence Collection

Auditors gather evidence to determine whether financial statements have been prepared in line with GAAP principles. Evaluating the reliability of a company’s financial processes takes many different forms depending on the nature of the business and the strength of its internal controls. Auditors may conduct evaluations, including:

• Reviewing bank balances and transactions with financial institutions
• Physically checking inventory
• Going over invoices
• Matching revenue transactions to their supporting documents

3. Evaluation and Analysis

The auditors will then analyze the data they’ve collected. They will determine whether their findings indicate that the company complies with GAAP standards and that their financial statements don’t present evidence of material misstatement.

This stage also involves a detailed analysis of any data that shows inconsistencies or unusual patterns. These could include significant changes in margins or cash flow issues. Finally, the auditors must decide if any misstatements could jeopardize the overall fairness or accuracy of the company’s financial statements.

The GAAP Audit Report

The culmination of the audit process is the GAAP audit report. The report comes with an opinion letter, which offers a final evaluation of the audit. There are four possible outcomes:

• Unqualified Opinion: A positive outcome that states that the company’s records are compliant with GAAP guidelines.
• Qualified Opinion: Auditors found no evidence of fraud, but have some concerns about the company’s financial records.
• Adverse Opinion: Financial records that are inaccurate or misleading will receive an adverse opinion.
• Disclaimer Opinion: Companies that provide insufficient financial records to the auditors to make a qualified judgment on their accuracy will receive a disclaimer opinion.

How to Prepare for a GAAP Audit

The best way to prepare for a GAAP audit is to ensure your financial records are accurate, compliant, and readily available. Doing the groundwork before the audit will facilitate a streamlined process and a faster resolution. The following steps will prepare you for the demands of a GAAP audit:

1. Understand the scope of the audit: Full or limited audits will require different levels of scrutiny. Find out which financial statements will be audited and by whom.
2. Update your financial records: Ensure the following records containing key financial data are accurate and up to date:
   – General ledger
   – Trial balance
   – Bank statements and reconciliations
   – Payroll records
   – Inventory records
   – Fixed asset register and depreciation schedules
   – Any records detailing loans or leases
3. Review Compliance with GAAP Principles: Some of the key principles characterizing GAAP include:
   – Revenue recognition
   – Expense recognition and accruals
   – Inventory valuation
   – Capitalization vs expensing
4. Close Books Properly: Review all your books, and reconcile your accounts and financial statements. Prepare all the supporting documentation required to back up your claims.
5. Resolve Pressing Issues Proactively: Consult your CPA about any urgent issues and adjust errors before the audit begins.

GAAP vs GAAS vs GAGAS

These different acronyms sound similar, but they refer to very different aspects of accounting and auditing. The following table lays out the main differences between GAAP, GAAS, and GAGAS:

Example

Let’s imagine a nonprofit organization that receives federal grants is audited by an independent CPA. In this case, GAAP, GAAS, and GAGAS would all apply at different points:

1. The nonprofit would need to prepare its financial statements according to GAAP principles.
2. The independent auditor would then follow GAAS principles to carry out an annual financial statement audit.
3. The audit must also comply with GAGAS, as the nonprofit receives federal funds.

Audit vs Review

It’s also important to differentiate between an audit and a review. A review is a shorter process that doesn’t require deep testing or external confirmation. It looks primarily for material misstatements or red flags based on the scope of the work performed, but it doesn’t result in an auditor’s opinion or guarantee accuracy.

Streamline the GAAP Audit Process

Following GAAP principles is a great way to build stakeholder confidence and meet regulatory obligations in your business. A GAAP audit takes this to the next step and is instrumental for many companies to secure investment, uncover inefficiencies, and make better financial decisions.

Proper preparation for a GAAP audit is critical to streamline the audit process and ensure your business is ready. Work with a CPA with experience in financial statement audits for a smooth and successful process.