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Oct 1989

Accountants' services on prospective financial information.

by Robertson, Jack C.

    Abstract- The performance of examination procedures for reporting on futures-oriented financial information should be based on an evaluation of a wide range of factors, including: the preparation of financial forecasts; the underlying assumptions of forecasts; and the conformity of forecasts' presentations within American Institute of Certified Public Accountants guidelines. The lack of public understanding of the role of accountants in the area of financial forecast examination has lead to vulnerability to the profession in the area of legal responsibility over the provision of future-information of financial forecasts, necessitating a policy encouraging: the clarification of the role of accountants in the area; the creation of a training program for accountants; and education of public users of futures-oriented financial information.

In 1985, the AICPA issued an authoritative statement, Financial Forecasts and Projections. In 1986, the AICPA also issued its implementation guidance, Guide for Prospective Financial Information. A Statement of Position (SOP), Accountants' Services on Prospective Financial Statements for Internal Use Only and Partial Presentations is soon to be released in draft form (see The CPA Journal, August 1989). However, these documents are only the source of general guidelines for auditors' responsibilities. These guidelines do not present details about applying each specific procedure in conducting accountants' services, nor do they address special difficulties that may arise. Only a few studies have been conducted to describe CPAS' experiences with prospective financial information services. Background

Prior to publishing the 1985 Statement and the 1986 Guide, the AICPA had issued other documents containing guidance on financial forecasts: SOP 75-4, Presentation and Disclosure of Financial Forecasts (1975); MAS Guideline 3, Guidelines for Systems for the Preparation of Financial Forecasts (1975); AICPA, Guide for a Review of Financial Forecast (1980); and SOP, Report on a Financial Feasibility Study (1982). The 1985 Statement and the 1986 Guide superseded all of these guidelines.

The 1980 AICPA Guide was published despite the existence of many practical and philosophical differences among practitioners. It pertained only to one form of prospective information-financial forecasts; and only to one type of accountant's service-independent review and reporting. The 1986 Guide distinguishes between the types of services the CPA may perform regarding forward-looking information: compilation, examination, and applying agreed-upon procedure services. The 1980 Guide was not enforceable under the AICPA Code of Professional Ethics. The 1985 Statement, which coincides with the 1986 Guide, was issued as a standard in the same series as the AICPA attestation standards, and it is enforceable.

The SEC, which historically prohibited including prospective financial information in prospectuses and reports filed with it, now permits the publication of such information under certain conditions. In 1979, the SEC adopted a safe-harbor rule for companies that issue prospective information. In 1981, the SEC amended its safe-harbor rule to cover projections contained in certain reports. Thus, the SEC encourages companies to prepare and disseminate forward-looking information. Description of the Sample

This study was conducted with a comprehensive questionnaire. Practicing CPAs from large firms were selected in the sample for this study. Large entities are more likely than small entities to provide prospective financial information. Thus, large CPA firms are assumed to be more frequently involved with such information. Ten of the largest national CPA firms were contacted and agreed to participate.

Of the 180 questionnaires, 101 provided usable responses, representing a 56% return. Table 1 summarizes the extent of respondents' experience with prospective financial information services. Slightly less than half of the respondents indicated they performed a compilation or an examination of the prospective financial information for at least one client in 1986. About one-third of the respondents indicated that they conducted engagements applying agreed-upon procedures to the prospective statements. It is interesting that about 15% of the participants indicated they performed examination services for more than five clients. Relative Cost-Chargeable Time

There are no published studies of the fees/chargeable hours for CPA involvement with prospective financial information. The survey participants were asked to identify average chargeable hours per client for each type of engagement (i.e., examination, compilation, and applying agreed- upon procedures), as shown in Table 2. As you would expect, in general the examination of prospective information requires more chargeable hours than either the compilation service or the applying agreed-upon procedures service: 45% of the respondents estimated more than 200 hours per client for the examination engagement, while most respondents considered less than 100 hours per client sufficient for both the compilation and the agreed-upon procedures engagement.

The study also analyzed how such chargeable hours were distributed over different levels of auditor experience in the firms. On average, senior staff accounted for 35.9% of the hours charged for services on prospective information; supervisor/manager accounted for 34.1%; and partners, (including review partners) for 17.2%. junior staff accounted for only 12.8%. This suggested that auditors' association with "soft data" such as prospective information requires more professional expertise and judgment than other limited assurance engagements.

In summary, the auditors' association with prospective financial information, particularly the examination service, requires more time and professional expertise than any other service (except the basic audit itself. Based on the average chargeable hours performed by different levels of accountants, the most probable average chargeable fees per client could be estimated to be in the range between $9,000 and $37,000 as shown in Table 3. CPAs' Perceptions on Competence and Reliability

Obvious limitations underlie prospective financial information. One of these is that a CPA's evaluation of the assumptions driving the future-oriented data may be limited by his or her expertise. Thus, the accounting profession is seriously concerned with an unreasonable degree of responsibility and legal liability1. We analyzed CPAS' general perceptions concerning their competence.

More than 90% of the respondents agreed with the statement that compilation and agreed-upon procedures services on prospective data are within the normal field of competence of a public accountant. For examination services, however, approximately 25% of the respondents indicated that they disagreed with this statement.

The respondents who answered that association with prospective information is not within the normal competence of CPAs, cited the following reasons:

* Prospective information contains future uncertainties sufficient to disqualify the auditor from an opinion on the information.

* An auditor cannot obtain sufficient reliable data to confirm hypothetical assumptions.

* The users of prospective information may expect that the auditor's examination adds more assurance than a public accountant can reasonably intend. Therefore, risks of lawsuit are too high.

* There is not enough authoritative literature to establish the standards.

Participants were also asked how much more reliable to external users they believed prospective information would be if it were examined rather than compiled. The views on the degree of reliability as a result of public accountants' association were split three ways. About 40% of the respondents thought that examined prospective information would be somewhat more reliable to external users than compiled information; about 33% of the respondents thought not much better; fewer than 30% thought examined information would be significantly better than compiled information.

In summary, most CPAs believed the examination service for prospective financial information is well within the normal field of competence of a CPA. However, many practitioners nevertheless believe that examined prospective information would not be much more reliable to external users than compiled information. Several Factors Influencing the Extent of Examination Services

The extent to which examination procedures are performed should be based upon the accountant's consideration of several factors, one of which is the likelihood of misstatements. Audit-based knowledge and/or knowledge based on a study of internal accounting controls might be helpful in evaluating the risk of misstatements in prospective data2. Participants were asked whether a comprehensive study of internal accounting controls as well as audit-based knowledge were required as a basis for CPAs' examination engagements. The responses were split into two groups: one group of respondents (about 50%) agreed with the importance of recent audit-based knowledge, but another group of respondents (about 30%) disagreed. The remaining 20% took the neutral position. A similar split result occurred with regard to the importance of a study of the relevant internal controls; 23% agreed, 29% disagreed, and about 30% took the neutral position.

In addition, participants were asked about the comparative influence several key factors would have on their decision concerning the scope of the accountant's examination of prospective information. Seven factors in the Guide were selected and presented to the participants. As shown in Table 4, all factors listed in this study were influential. No significant differences were noted. Of those factors, however, competence and experience of management personnel was regarded as the most influential. Among the factors which should be considered in obtaining knowledge of the entity's business, patterns of past performance for the entity or comparable entities was ranked relatively high. The Specific Procedures

The practitioners were asked to indicate the types of procedures used for compilation and examination work on prospective financial disclosures. To obtain insight into each practice, a list of the broad categories of procedures was presented. The results are summarized in Table 5. In performing compilations, 32.6% of total chargeable hours were spent on inquiring of management and others. Checking mathematical accuracy of computations and reading the underlying assumptions accounted for 27.3% and 21.6%, respectively. Other procedures included overall review and assembling the data. In performing examinations, however, reading the underlying assumptions and inquiring of management and others accounted for about 26% each. Checking mathematical accuracy of computations accounted for 18.8%. The typical other procedures included evaluating and determining the reasonableness of the underlying assumptions.

An examination of a financial forecast is a professional service that involves: 1) evaluating the preparation of the financial forecast; 2) evaluating the support underlying the assumptions; and 3) evaluating the presentation of the financial forecast for conformity with AICPA guidelines. The specific procedures listed in the Guide were selected and presented to the participants. Table 6 shows the responses related to procedures to evaluate assumptions. Overall, more than 85% of the respondents placed strong emphasis on such procedures as tracing certain assumptions to the supporting data, analyzing the historical plan, and determining conformity with external sources. By contrast, the procedure of considering alternative approaches to the development of the assumptions was given only moderate emphasis (the lowest of the procedures for evaluation of assumptions).

In relation to procedures to evaluate the preparation and presentation of financial forecasts (Table 7), respondents placed very strong emphasis on the following three procedures: 1) consistency among assumptions 66%); 2) reflection of the assumptions in the forecast 65%); and 3) conformity of the assumptions actually used with the listed ones (66%). Tracing the amounts of historical data from the books to the final forecast (the last procedure in Table 7) was emphasized the least. The Accountant's Report

The study also analyzed the accountants' practice of reporting on the compilation and the examination of prospective financial information. The authoritative standards indicate the specific circumstances in which an accountant should modify the standard compilation or examination report. The participants were asked to indicate whether they have ever modified their standard reports due to such specified reasons. Their responses showed the following:

1. Overall, a relatively small number of the respondents have modified the standard compilation/examination report. Fewer than 10% of the respondents have modified the compilation report, while 11% have modified the examination report due to at least one reason.

2. Modifications of compilation reports have been required as a result of the omission of footnote disclosures.

3. Specific reasons for qualifying the opinion in an examination report included: a) failure to present all elements required; b) a lack of basis in assumptions; and c) unlikely assumptions intended for internal purposes only.

There is serious concern among the respondents that prospective information may be accorded unwarranted credibility as a result of CPA association, and that an unreasonable degree of responsibility and legal liability may be assumed by the practitioner. Therefore, they believe it is of great importance for CPAs to communicate clearly the limitations and the results of association with prospective information. The majority of the respondents (85%) agreed that readers of the accountant's report were provided enough information about the scope and limitations of the accountant's work to be able to judge the reliability added to prospective statements. Considering the basic limitations in such soft data, this percentage is higher than one would expect.

Of those expressing disagreement with this statement, the typical comments were:

9 Additional description is needed to make the readers comprehend that the report is not their "insurance" policy.

o The public does not fully understand what this report means. Therefore, more emphasis should be placed on educating the public than expanding the report.

9 "Examination" suggests the same degree of assurance as an "audit."

In the standard language of accountants' reports, negative assurance" wording is ordinarily used to convey assurance at a lesser level than the positive assurance" intended in an audit report. However, the prospective information standard requires use of positive assurance language in an examination report (e.g., ". . . the financial forecast is presented in conformity with AICPA presentation guidelines . . ."). Nevertheless, 51% of the respondents preferred the negative assurance language in an examination report, and 15% preferred a no assurance" report form, while 31% preferred the positive assurance required by the standard. These responses indicate that practitioners are not yet comfortable with the level of assurance required in an examination service and would prefer to report less assurance to users. Summary and Recommendations

The sample selection methods reported were not randomly based. Accordingly, it is not appropriate to present statistical measurements of significant differences among various responses or to analyze the data in any way that suggests a random sample generalizable to the total population of CPAs who deal with prospective financial information. The findings in this study, however, provide some evidence of CPAS' views and contribute to communication and description to others interested in such CPA involvement.

In addition to specific responses shown in the tables, several problem areas were also revealed. The CPAs mentioned what they felt was a lack of public understanding of CPAs' roles in performing services on prospective financial information. Such public expectations raise serious legal responsibility concerns for practitioners involved with "soft" future-oriented information. The uncertainty involved in financial forecasts causes CPAs to desire expanded disclosures in their reports or in notes to the forecast presentation. In addition, they mentioned their own problems related to the prospective information standards. Typical comments were: "This is a difficult area to service clients at a reasonable cost due to the complexity of the reporting requirements;" and "The requirements to be fulfilled by accountants to issue financial forecasts are extremely rigorous." Based on the findings and analysis of this study, the following recommendations are responsive to CPAS' needs:

1. The accounting profession should develop and conduct an education program for public users and managers regarding the accountants' services on prospective financial information.

2. The accounting profession should develop comprehensive and in- depth professional training programs for accountants' services on prospective financial information.

3. The accounting profession should make an effort to clarify and refine the accountant's role and responsibility in conducting various services examination, compilation, agreed-upon procedures) on prospective financial information.

4. The accounting profession should develop more specific guidelines to determine the nature and extent of various technical procedures used in conducting various services on prospective financial information.

5. The accounting profession should make the compilation and examination reports more understandable to public users and managers.

New practices evolve over lengthy periods, especially when large numbers of practicing accountants begin to deal with a small but growing demand. The above recommendations reflect many activities already being pursued by the accounting profession. However, we believe the breadth and depth of education, training, and technical activities will need to be greater to enable CPAs to have widespread expertise and "professional comfort" when dealing with prospective financial information services.

1 There are two basic limitations involved in CPAs' association with forecasts: a) the attainability of a forecast by its nature not susceptible of independent verification, and b) a public accountant's evaluation of the assumptions that underlie a forecast may be limited by his expertise.

2 Analysis of existing authoritative standards for limited assurance engagements indicates there are ambiguities regarding the required bases of knowledge and the study of internal accounting control for review engagements. SSARS 1, for example, indicates that a review does not contemplate a study and evaluation of internal control.

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