I've had several people ask me whether they need to have an audit performed prior to a business valuation. The short answer to the question is "no." However, let's explore the "whats" and the "whys" of financial statement analysis and valuation in a little more detail.
Types of financial statements
There are three types of financial statements issued by CPAs: audits, reviews, and compilations. An audit provides the highest level of assurance a CPA will give on an organization's financial statements. Audited financial statements provides the assurance that an organization's financial statements are free of material misstatement and are fairly presented based upon the application of generally accepted accounting principles (GAAP). During an audit, CPA's will test transactions, examine supporting documentation, complete inspections and evaluate a company's internal controls.
A CPA will also issue reviewed financial statements, which provide limited assurance on an organization's financial statements. During a review, inquiries and analytical procedures present a reasonable basis for expressing limited assurance that no material modifications to the financial statements are necessary to bring financial statements in conformity with generally accepted accounting principles. Think of it as a "does it make sense" analysis which may be useful when the organization needs some assurance about their financial statements, but not the higher level of assurance provided by an audit.
The third type of financial statement issued by a CPA is known as a compilation. A compilation provides no assurance that an organization's financial statements comply with GAAP. The CPA takes financial data provided by the company and puts them in a financial statement format. There are no testing or analytical procedures performed during a compilation.
Understanding financial statements
Understanding financial statements is easier when one considers the basis on which the financial statements are prepared. In reality, financial statements can be prepared any way a company likes. However, there are three ways to look at financial position (net worth) and income that are more common than others: cash basis, tax basis or accrual.
Many very small businesses concern themselves with cash flow and cash position and prepare their books accordingly. Cash basis financial statements record revenues when received and expenses when paid. This can be a good way of looking at things, particularly when it comes to figuring out whether a company made any money, but it ignores items that are paid for over time and can skew one's view of profitability and position.
Company financial statements
Others want to look at company financial statements based on how much they will pay in taxes, and therefore prepare their statements on that basis. They adjust financial statements such that they calculate net worth and income based on what they report to the IRS. This would include such things as tax depreciation that wouldn't be calculated the same way as with normal financial statements.
The third way, (and most correct way from a technical perspective), is to prepare accrual based financial statements in accordance with GAAP. Accrual accounting attempts to recognize all transactions of a business, regardless of whether such transactions occur in cash, that would impact the financial position or income of a company during a given period. For example, an accountant might "Accrue payroll expenses" at year end. The CPA is recording an estimate of what the payroll due and owing is, based on time spent by the workforce since the end of the last payroll cycle, but prior to the end of the year.
Comparative financial statements
When an audit is performed, the goal of the audit (and of the auditors) is to ensure the financials are prepared on a GAAP basis. Having an accountant prepare such comparative financial statements gives all parties involved more assurance that the financial statements are more accurate; this provides more "comparability" when analyzing one company's performance compared to another.
Is an audit necessary for a business valuation?
With that background, let's go back and answer the question. For most profitable, ongoing operating companies the business valuation approach is going to be primarily concerned with the amount of cash flow that business generates, and more specifically, the amount of cash flow it will generate in the future. Moreover, while historical results hopefully give some indication of what's possible in the future, the fact pattern and a solid projection of the future of the company are much more important in deriving an estimate of value.
As stated, accrual-based financial statements are the correct way to look at a business's financials statements and position, and this provides more confidence that the historical numbers analyzed are correct. However, an audit is not necessary for preparing a business valuation.
Audited financial statements
Having audited financial statements may affect how I do business valuation work, most notably because I may spend less time examining the data underlying what goes into the financial statements. Nor would I take the time to turn someone's financials into audited, GAAP financials before doing a business valuation.