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.
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.
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.
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.
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.
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.
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