The Financial Controls Audit That Banks and Investors Actually Care About
When a bank assesses your company for additional credit or a major client inquires about your financial operating procedures, they’re not just examining your books. They want validated evidence that what you’re providing relative to financial reporting actually works.
Unfortunately, this is where many business owners get confused. They think, “As long as I have clean books and an accountant, I’m all set.” But in reality, if you as a business provide services that affect the financial reporting of another entity, e.g., you’re a payroll company or a loan servicer or a claims administrator, you need something called a SOC 1 audit.
What’s Different About This Audit
A SOC 1 report is not about your company finances. It’s meant to validate that your internal controls will not impede the ability of another company to file accurate financial statements.
For example, you’re a payroll company and you process other companies’ payroll. If your payroll solutions over-calculate paychecks or apply incorrect tax withholdings, the other company will find its financial reports unreliable. Its auditors can’t sign off on numbers they can’t trust coming from your system. So, before they work with (or continue working with) you, they need to know from an external party that your controls work.
This is not the same as an audit into your company’s finances. This is a SOC 1 looking only at the controls that would apply to other companies’ financial statements. It’s more focused but much more detailed about those particular operations.
Why Banks and Investors Don’t Take No For An Answer
Banks don’t ask for these reports because they want to hassle clients. They ask for them because they’ve seen enough unfortunate circumstances between companies and their service providers with insufficient controls in place.
Not too long ago, a benefits administration company coded something wrong in their system and miscalculated retirement contributions for six months for thousands of employees from multiple companies. When that error came to light, companies had to restate their annual financials. One or two received regulatory action due to contribution overages, and a couple lost investor sentiment just before anticipated funding rounds.
That benefits administration company went out of business in under twelve months.
It’s memories like this that linger for banks and investors. When they want to extend credit or invest resources into a company that utilizes third-party service providers, they like to see current SOC 1 reports by those providers. Otherwise, it’s a no-go.
What Gets Tested
The basics of a SOC 1 audit test controls related to financial reporting. But what does that mean?
Auditors will take a look at how information flows through your systems and whether or not the segregation of duties exists (can one person create an invoice and pay it, or does someone else have to approve it?). They will check whether access controls are available as described. They will assess whether reconciliations are done timely and reviewed by someone.
For many service organizations attempting to get these controls in place, working with a reputable soc 1 audit firm USA helps determine gaps before the official audit starts.
The testing is specific. For example, if you say you reconcile accounts every day, the auditor will confirm it happened every day during the testing period (if that’s possible). If you say that transactions need two approvals, they’ll sample those transactions to ensure two people approved them.
Where organizations sometimes fail at this stage is having policies in place but then not sticking to them. That daily reconciliation might have happened on Mondays until everything got busy and then was changed to weekly. The system might fail to acknowledge the second approval requirement because it exists in “emergency situations” that occur too often.
These are the types of things auditors find. It’s their job.
The Two Styles You Should Know
There are two SOC 1 report types, and choosing the wrong one wastes time for everybody involved.
Type 1 reports are point-in-time assessments where an auditor looks at your control at one moment in time and determines it’s appropriately designed. This is cheaper and quicker to obtain but only validates existence on that one day it was present and looking good, but it doesn’t show that that control has been operating effectively since.
Type 2 reports look at a window of time (typically, six to twelve months) where an auditor tests whether the control has operated correctly for that entire time. Did reconciliations happen daily as they were supposed? Did access prevention save unnecessary changes? This is where Type 2 reports provide so much more credibility because they show consistent effort instead of just one good day.
Most banks and serious investors want Type 2 reports. They’ve learned enough about controls that magically work in front of an auditor at one moment but never again during normal operating hours to know better. The longer time frame for testing on the Type 2 report makes it much more difficult to have falsified working controls.
When They Become Required
There are certain industries where this is non-negotiable – payroll companies, third-party retirement administrators, mortgage servicers, claims processors – if you’re in one of these industries and don’t have a valid SOC 1 report, you’re going to lose business – and therefore gain highly regulated and observed marketplace standing.
However, there are overlaps where companies working outside of these industries still need the reports. For example, Software-as-a-Service applications that bill clients for clients need them. Data centers that host financial applications need them as well as some HR platforms that process transactions going into financial statements for clients.
The problem is that many companies fail to understand their necessity until a huge client asks for a SOC 1 – and then they’re scrambling to create controls and find an auditor while the client is on hold.
Getting your first SOC 1 takes four to six months from start to finish. That includes time documenting controls, addressing gaps during the pre-planning meeting for audit approval and subsequent testing time. Companies that wait until the last minute often scramble between a loss of clients or asking clients for an extension until compliance is achieved.
The Cost Nobody’s Talking About
SOC 1 audits aren’t cheap – you can expect fees from $15K to $50K or more depending on operational complexity and the number of controls involved.
But when it’s all said and done, that cost becomes a mere rounding error when you compare it to potential revenue you can’t obtain due to lack of report. One contract alone could be worth $500K annually for one client who requires a SOC 1. Losing that client because you don’t have the report doesn’t make sense.
And the audit often reveals unintended consequences of actual control weaknesses that would have caused significant issues down the line. Realizing your reconciliation procedure has gaps is way better than someone becoming aware when client data gets corrupted due to possible litigation.
Making It Worth More Than Paper
Companies use their SOC 1 reports as sales tools. When vying for new business through comparison opportunities, presenting a clean Type 2 report gives credibility that competitors without SOCs can only dream.
Companies even provide notice on their website they are SOC compliant, they include them in request-for-proposal responses and pitch decks alike – showing prospective clients even current clients know working with you won’t create compliance headaches related to auditing.
Conversely, if you’re required to have a SOC 1 and you’re trying to skate by without one, clients and prospects will see the shortcut you’ve taken – and since these reports are commonplace in relevant industries either applicants will know you’re naive or careless.
SOC 1 Reports matter because banks and investors care about success stories but also success metrics instead of entities with service providers whose controls failed them along the way – for their bottom line depends on appropriately functioning finances not just linked through systems but also through expected resource allocation.