ACCOUNTING & AUDITING

Assurance Services

Reviews of Interim Financial Information

By Thomas A. Ratcliffe

In November 2002, the Auditing Standards Board (ASB) issued Statement on Auditing Standards (SAS) 100, Interim Financial Information, which supersedes SAS 71. This guidance ratchets up the requirements associated with reviews of interim financial information and incorporates the SEC’s requirement for timely filings of interim financial information. SAS 100 also incorporates pertinent recommendations from the Public Oversight Board’s Panel on Audit Effectiveness Report and Recommendations. Additionally, SAS 100 incorporates recommendations from the AICPA’s Professional Issues Task Force that were included in Practice Alert 2000-4, “Quarterly Review Procedures for Public Companies.”

The SEC requires public companies to engage an independent accountant to review interim financial information before it is included on Form 10-Q or Form 10-QSB. SAS 100 contains the technical guidance related to these engagements. Although SAS 100 does not require the accountant to issue a report on the review of interim financial information, the SEC does require that the accountant’s review report be filed with the interim financial information if management stipulates that the information has been reviewed by the accountant.

On December 17, 2003, the Public Company Accounting Oversight Board (PCAOB) issued Auditing Standard 1, References in Auditors’ Report to the Standards of the Public Company Accounting Oversight Board. This standard revises wording that previously was contained in SAS 100; where a review report is issued on interim financial information of a public company, the PCAOB report wording must be used.

The objective of the review of interim financial information is to provide the accountant with a basis of communicating whether any material modifications would need to be made so that the information is presented in conformity with generally accepted accounting principles (GAAP). Utilizing the guidance in SAS 100, review engagements consist principally of performing analytical procedures and making inquiries of persons responsible for financial and accounting matters. These reviews do not contemplate testing of accounting records, testing controls, obtaining corroborating evidence in response to inquiries, or performing certain other audit procedures. And, very importantly, reviews of financial statements of reporting entities that are not public companies should still be performed under the Statements on Standards for Accounting and Review Services, not under SAS 100.

Performing the Review Engagement

The accountant should establish an understanding with the client, preferably in writing, regarding the services to be performed in a review engagement. Though not required, an engagement letter is very useful in documenting this understanding. If the accountant is a “successor accountant” related to the engagement, the provisions of SAS No. 84, Communications Between Predecessor and Successor Auditors, should be followed before the accountant accepts the engagement.

While a review engagement does not contemplate testing controls so that the effectiveness of controls can be evaluated, before performing the review engagement the accountant should have sufficient knowledge of the entity’s business, including internal controls as they relate to the preparation of both annual and interim financial information. The following knowledge should be helpful in identifying the types of material misstatements that could exist in the information (and the likelihood that these misstatements could occur); furthermore, this knowledge should be utilized in selecting the inquiries and analytical procedures that will be used in the review engagement:

In initial reviews of interim financial information, the accountant should perform procedures that will provide sufficient knowledge of the entity’s business and internal controls so that the overall objective of the review engagement can be accomplished. When the accountant has audited the entity’s financial statements for one or more annual periods, this knowledge of internal controls should already exist and simply will need to be updated; when the accountant has not audited the entity’s financial statements for one or more annual periods, this knowledge will need to be attained using SAS 55, Consideration of Internal Control in a Financial Statement Audit.

Procedures used in review engagements are generally limited to analytical procedures, inquiries, and other procedures that address significant accounting and disclosure matters related to the interim financial information. The specific analytical (and other) procedures performed and inquiries made should be tailored to the engagement based on the accountant’s knowledge of the entity’s business and internal controls. Analytical procedures should be used in review engagements to identify, and provide a basis for, inquiries about the relationships and individual items that appear to be unusual (i.e., that may indicate material misstatement). Such analytical procedures should include:

SAS 100 lists specific analytical procedures that may be utilized by the accountant in fulfilling the objectives of review engagements. Exhibit 1 summarizes these specific analytical procedures.

In addition to the specific guidance related to analytical testing contained in SAS 100, guidance in SAS 56, Analytical Procedures, may be useful in designing analytical tests. Importantly, expectations developed through analytical tests used in review engagements are typically less precise than those developed in a financial statement audit. Furthermore, in review engagements, the accountant is typically not required to corroborate responses from management. However, both the reasonableness and the consistency of these responses should be compared to the results of other review procedures, and to the accountant’s knowledge of the entity’s business and internal controls.

The following inquiries and other review procedures should occur in a review of interim financial information:

Many of these procedures can be performed before (or concurrent with) the preparation of the interim financial information. Furthermore, because the same accountant will also typically be engaged to perform the audit of annual financial statements, certain auditing procedures may be performed concurrently with the review of interim financial information.

Documentation

Accountants should prepare documentation related to the review of interim financial statements, tailored to the particular engagement. Generally, review engagement documentation will include review programs, results of analyses, memoranda, and letters of representation.

At the conclusion of the engagement, written representations should be obtained from management for all interim financial information presented and for all periods covered by the review. SAS 100 contains examples of two different representation letters: The short-form letter is used in conjunction with the representation letter received during the audit of the financial statements of the prior year, and the long-form letter is similar to the representation letter received during a financial statement audit and is a stand-alone letter that does not refer to the audit representation letter received. Exhibit 3 contains an example of a model short-form representation letter that may be utilized in review engagements.

During the performance of review engagement procedures, an accountant may become aware of matters indicating that material modifications must be made to the financial information to conform to GAAP, or may become aware that the entity filed Form 10-Q or Form 10-QSB before the completion of the review. In either of these circumstances, the matter should be communicated to the appropriate level of management as soon as practicable. If the matter involves fraud, it should be brought to the attention of the appropriate level of management. If the fraud involves senior management, or results in a material misstatement, it should be communicated directly to the audit committee under SAS 99, Consideration of Fraud in a Financial Statement Audit. If the matter involves possible illegal acts, an accountant should be assured that the audit committee is adequately informed, unless the matter clearly is inconsequential. SAS 54, Illegal Acts by Clients, contains helpful guidance.

The auditing technical literature guidance in SAS 61 (as amended), Communications With Audit Committees, also is important in review engagements. For example, the accountant should determine that the audit committee is informed about the process used by management to develop “sensitive” accounting estimates; about changes in accounting policies; and about any adjustments that, individually or in the aggregate, quantitatively or qualitatively, could have a significant effect on the financial information. Any uncorrected misstatements that are determined by management to be immaterial should be communicated to the audit committee.

Evaluating Engagement Procedures

A review of interim financial information is not designed to obtain reasonable assurance that the information is free of material misstatement. Based on the work performed in the engagement, however, an accountant may become aware of likely misstatements. A likely misstatement is the best estimate of the total misstatement in account balances (or classes of transactions) where review procedures have been performed. Likely misstatements identified in the performance of review procedures should be accumulated for the accountant’s evaluation. As in audit engagements, the accountant may designate (utilizing professional judgment) an amount below which misstatements are not to be accumulated. As in audit engagements, aggregated misstatements may be relatively small in amount and still have a material effect on the interim financial information for qualitative reasons.

Any misstatements in the interim financial information should be evaluated individually and in the aggregate, quantitatively and qualitatively, in determining whether it must be materially modified to conform with GAAP. The nature of the misstatements, the amount of the misstatements, the timing of the misstatements, materiality judgments made in conjunction with the current/prior-year audit, and the potential effect of the misstatements on future interim or annual periods are all factors to be considered.

The evaluation of uncorrected misstatements should also consider the appropriateness of offsetting a misstatement of an estimated amount with a misstatement of an item capable of precise measurement. An accumulation of immaterial misstatements could contribute to material misstatements in future periods.

Subsequent to the date of the review report or the completion of the review engagement procedures, an accountant may become aware of facts that existed as of the completion of the review engagement. Because of the variety of circumstances that might be encountered, the specific actions to be taken vary. The guidance in SAS 1/AU Section 561 (as amended by SAS 98), Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report, should be considered carefully.

Reporting Guidelines for Review Engagements

Because the PCAOB adopted interim auditing and related professional practice guidelines to incorporate the ASB review engagement literature, the performance standards for review engagements are still contained in SAS 100; however, as mentioned earlier, PCAOB Auditing Standard 1 revises the reporting standards associated with these review engagements. While there still is no guidance, from either the ASB or PCAOB, that would require the accountant to issue a report as a result of a review of interim financial information, the SEC does require that an accountant’s review report be filed with the information if management states (in any filing) that the information has been reviewed by an independent public accountant.

As mentioned earlier, while SAS 100 does not require an accountant to issue a report as a result of a review of interim financial information, the SEC does require that a review report be filed with the information if, in any filing, management states that the information has been reviewed by an independent public accountant. Each page of the interim financial information should be clearly marked to indicate that the information is unaudited.

SAS 100 contains several examples of review reports; in all cases, such reports must be modified to incorporate the new PCAOB requirements (an example is available at www.cpaj.com).

Effective Date

SAS 100 contains more detailed and extensive guidance than that found in SAS 71. SAS 100 is effective for reviews of interim financial information for fiscal years beginning after December 15, 2002. The provisions in SAS 100 could have been utilized in advance of the required effective date. The PCAOB reporting requirements became effective immediately upon approval (by the SEC) of the modifications to review report wording. The illustrative reports included in SAS 100 must be so modified to comply with the new PCAOB reporting requirements.