Understanding
Financial Statement Services
By J. Michael Barham, CPA
Almost
every organization – whether it is a privately held business, a publicly owned corporation,
or a nonprofit organization – must prepare reports on its financial
performance. Such reports help owners and managers make operating decisions,
enable creditors to evaluate loan applications, and provide individuals with
information to make investment decisions.
Recognizing that different entities have different
accounting needs, the accounting profession has developed standards that enable
CPAs to offer a range of financial statement services. CPAs may provide a
client with four distinct services involving financial statements – agreed-upon procedures, engagements,
compilations, reviews, and audits –
each designed to meet a different need.
So, what is the overriding difference among these
services? Quite simply, it is the level of assurance, as to reliability,
offered on financial statements. CPAs offer different levels of assurance according
to how strongly he or she believes, based on the extent of work done, that the
financial statements are free from material misstatement.
Therefore, the more the CPA knows about the financial
statements, the higher the level of assurance that can be offered. The reasons
for this become clearer when the characteristics of each engagement are
examined and compared.
Agreed-Upon
Procedures
An agreed-upon procedures engagement is one in which
a client engages a CPA to issue a report on procedures and findings based on
specific procedures performed related to a financial statement component or
other written assertion provided by the client.
Compilations
During a compilation, a CPA simply prepares the
financial statements of a private entity by arranging into the conventional
financial statement form the data and information provided by the entity’s
management. Through compilation services, a CPA prepares monthly, quarterly, or
annual financial statements, but offers no assurance as to whether material or significant
changes are necessary for the statements to be in conformity with generally
accepted accounting principles, the cash
basis, or the income tax basis of accounting.
In other words, no “beneath the surface” probing is
conducted unless the CPA becomes aware that the data provided is in error or is
incomplete.
Although in a compilation the CPA has limited
information about the company and a general understanding of the nature of the
entity’s business transactions, the possibility of identifying a problem in the
financial statements is based on the ability to use limited information to
identify a situation that appears to be inconsistent with the basic understanding.
After compiling the financial statements, the CPA is
obliged to read them and consider whether they are appropriate in form and free
from obvious material errors. The CPA then issues a standard report that says,
in effect, that the financial statements were compiled, but they were not audited
or reviewed, and no opinion is expressed. Compilation standards permit a CPA to
compile financial statements that omit footnote disclosures required by
generally accepted accounting principles or another comprehensive basis of
accounting (cash or income tax). This is allowable as long as the omission is
clearly indicated in the report and there is no intent to mislead users. However,
when footnote disclosures have been left out, the CPA adds a paragraph to the
compilation report stating that management has elected to omit disclosures. This
paragraph lets the user know that if the financial statements contained this
information, it might affect the user’s conclusions.
It is also important to note that each page of the
financial statements compiled by the CPA should include a reference such as “See
Accountant’s Compilation Report.”
A compilation may be sufficient for many private
companies; however, if a business needs to provide some degree of assurance
that its financial statements are reliable, it may be necessary to engage a CPA
to perform a review or an audit.
Reviews
A private entity, such as one that must report its
financial position to third parties, such as creditors or regulatory agencies,
may engage a CPA to perform a review of its financial statements and issue a
report that provides limited assurance that material changes to the financial
statements are not necessary in order for the statements to be in conformity with
generally accepted accounting principles.
Basically, a review consists of inquiries of management
and analytical procedures applied to financial statements. Keep in mind that
during a review, a CPA does not assess internal control risks, confirm balances
with banks or creditors, observe inventory counting, or test selected
transactions by examining supporting documents.
However, if the CPA becomes aware that information is incorrect,
incomplete, or unsatisfactory, he or she should perform the additional
procedures necessary to achieve limited assurance regarding the financial
statements.
The CPA must also remain independent of the client
and all appropriate footnotes must be included in the reviewed statements.
Despite having obtained a working knowledge of the
industry in which the entity operates and acquiring information on essential
aspects of the organization, including operating methods, products and
services, and material transactions with related parties prior to performing a
review, the CPA is exposed to less specific information about the company, but still
must plan an appropriate review engagement based on the information known.
For this reason, a review requires equal ability to
relate basic characteristics of the company to specific investigative techniques.
Before performing a review, the CPA may have to compile the financial
statements. However, the financial statements are management’s statements, not the
CPA’s, and management must have a sufficient understanding of the financial statements
to assume responsibility for the statements. As a matter of fact, written
representations are required from management for all financial statements and
periods covered by the CPA’s review report.
The CPA will then make inquiries concerning such
financial statement related matters as accounting principles and practices,
record-keeping practices, accounting policies, actions of the board of
directors, and changes in business activities. Analytical procedures designed
to identify relationships and unusual items or trends in the financial
statements that may need explanation will then be applied by the CPA.
Essentially, a review is designed to ascertain
whether the financial statements “make sense” without applying audit-type
tests.
Therefore, in a review engagement, the CPA offers
“limited” assurance. This limited assurance states the CPA is not aware of any
material modifications that should be made to the financial statements.
In many instances, a review – with its limited
assurance – may be adequate for a business or its creditors. By necessity, the
level of assurance offered in a review engagement is not as high as the level
offered in an audit.
If more assurance is necessary, the organization may
need to engage a CPA to perform an audit.
Audits
Of the financial statement services that a CPA can
provide to a client, an audit is the most extensive. An audit is appropriate
for entities such as public or private companies that must provide, to outside
parties, the highest level of assurance that the financial statements are
presented fairly in conformity with generally accepted accounting principles. In
an audit, the CPA obtains sufficient, competent evidential matter somewhat enabling
the expression of reasonable assurance as to the fairness of presentation of
the financial statements.
The level of assurance in an audit, while described
as “reasonable assurance,” is not absolute.
In an audit, the CPA obtains an understanding of such
factors as the accounting principles used in the company’s industry, types of
products, distribution systems, compensation methods, rate of technological
change, and extent of governmental regulations. These, as well as other factors
including an assessment of internal
controls, are used to plan the audit which is planned and performed with an attitude of professional skepticism; that
is, the auditor designs the audit to provide “reasonable assurance” that
material errors or fraud are detected. However, fraud concealed through forgery
or collusion may not be found because the auditor is not trained to catch
forgeries, nor will customary audit procedures detect all conspiracies.
To gather evidence on the reliability of the
financial statements, the CPA performs “search and verification” procedures. In
an audit, the CPA generally confirms balances with banks or creditors, observes
inventory counting, and tests selected transactions by examining supporting documents.
In addition, the CPA contacts sources outside the client organization to gather
information that may be more objective than that obtained from internal sources.
For example, the CPA usually obtains written confirmation from a client’s customers
about amounts owed to the client at a specific date. By accumulating this type
of evidence, the CPA tries to reduce the risk that the financial statements
will be materially misstated.
The auditor then issues a report stating that the
financial statements are presented fairly, in all material respects, in
conformity with generally accepted accounting principles.
In an audit, as in a review, the CPA must be
independent of the client and the financial statements must contain all
required footnotes.
Although an unqualified opinion from a CPA after an
audit provides reasonable assurance to outside parties that the entity’s financial
statements fairly present its financial position and results of operation in
accordance with certain accounting principles, an audit does not provide a
guarantee of absolute assurance.
Professional
Standards
Just as a physician can never be certain about the
health of a patient, the CPA can never offer an absolute assurance about the
financial statements. As independent third parties, CPAs serve a vital role to
society by providing assurance to users as to the reliability of financial statements
based upon the services they perform.
It is important that users recognize that each of these
financial statement services – agreed-upon procedures engagements, compilations,
reviews, and audits – fulfill a distinct need.
This article was
originally published in the
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