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July 1991

Professional competence and review engagements.

by Bailey, Larry P.

    Abstract- There are considerable differences between audit engagements and review engagements, and the public believes that a lower degree of competence is required to conduct a review than an audit. One difference is that audit engagements require enough evidence to be collected as a basis for offering an opinion on financial statements, while review engagements limit the data-collection process to the use of analytical procedures and inquiries. When performing a review engagement, CPAs must have as thorough an understanding of generally accepted accounting principles as they would if they were conducting an audit engagement, and they may need even greater evaluation skills when conducting a review engagement than they would if they were conducting an audit engagement.

The concept of a hierarchy of accounting services (audit, review, and compilation) and the attendant hierarchy of professional competence to match the specific service has some unwarranted implications for the profession, individual CPA firms, and the public. The implication for the public and the profession revolves around the recent suggestion that while "public accountants" should not be allowed to audit financial statements, they do have the necessary background to perform reviews and compilations. The consequences for a particular CPA firm is the possibility that the nature of review and compilation engagements is misunderstood to a degree that these engagements may be improperly staffed and monitored.

This article addresses the issue of professional competence and the performance of a review engagement. The similarities and differences between an audit engagement and a review engagement and what those similarities and differences mean in the context of professional competence are discussed. Also covered are the implications of misunderstanding the nature of a review engagement.

The Nature of a Review


As stated in SSARS 1, the nature of a review engagement entails the following:

"Performing inquiry and analytical

procedures that provide the accountant

witha reasonable basis for expressing

limited assurance that there

are no material modifications that

should be made to the statements in

order for them to be in conformity

with generally accepted accounting

principles, or, if applicable, with another

comprehensive basis of accounting."

Obviously, the nature of a review differs significantly from that of an audit engagement. First, an audit engagement requires the collection of sufficient competent evidential matter as a basis for expressing an opinion on the financial statements, whereas in a review engagement this process is generally limited to information obtained through the use of inquiries and analytical procedures. In addition, in a review engagement only limited assurance is expressed. However, in an audit engagement reasonable assurance is provided that the financial statements are prepared in accordance with generally accepted accounting principles (GAAP).

Do the significant differences between the nature of an audit and a review engagement automatically and consistently lead to the conclusion that a lesser degree of professional competence is needed to perform a review than an audit? This question can be answered to some degree by examining the accounting and evaluative skills needed to perform a review and an audit.

Basis for Financial Statement


In general, financial statements may be presented in accordance with GAAP, or other comprehensive basis of accounting (OCBOA) as described in SAS 62. Management is primarily responsible for selecting and applying the accounting principles that are in conformity with either GAAP or OCBOA. Does the nature of the financial statement service to be rendered by the accountant dictate the level of accounting expertise that must be possessed by the external accountant? Theoretically, the financial statements of an entity whether audited or reviewed would be identical.

SSARS 1 makes the following observation with respect to the external accountant's need to understand GAAP:

"The accountant should possess a

level of knowledge of the accounting

principles and practices of the industry

in which the entity operates...that

will provide him, through the performance

of inquiry and analytical procedures,

with a reasonable basis for

expressing limited assurance that

there are no material modifications

that should be made to the financial

statements in order for the statements

to be in conformity with generally

accepted accounting principles."

Thus, for example, if the client operates in an industry that is characterized by specialized accounting principles, the accountant must have an adequate understanding of those accounting principles. If, on the other hand, the client is in an industry for which there are no unique accounting principles, the accountant must have a thorough understanding of recent FASB pronouncements, and other authoritative pronouncements as well as GAAP. There is no suggestion in the promulgated standards or in practice that a lesser level of accounting expertise is acceptable for someone who performs a review as opposed to an audit engagement.

Evaluative Skills

Perhaps the most important criterion in determining the level of competence needed to perform a review relates to the requisite evaluative skills needed by the accountant. "Evaluative skills" refers to the accountant's ability to draw a conclusion about an assertion that appears in the financial statement based on evidential matter gathered.

SAS 31 establishes the framework for obtaining evidential matter in an audit engagement by classifying assertions (explicit or implicit) made by management in the financial statements into the broad categories of existence or occurrences, completeness, rights and obligations, valuation or allocation, and presentation and disclosure.

In an audit engagement, the accountant develops an audit strategy based on the assertions contained in the financial statements. For example, an implicit assertion included in the financial statements of a retailer is that inventory exists. In order to substantiate that assertion, the accountant could, among other things, observe the inventory count performed by the client.

The standards established by the SASs are not applicable to a review engagement; however, the conceptual framework established in SAS 31 would seem equally relevant to a review engagement. That is, the accountant considers implicit and explicit assertions contained in the client's financial statements and establishes review strategies using inquiry and analytical procedures to provide limited assurance concerning conformity with assertions. The difference in a review engagement when compared to an audit engagement is not the conceptual approach with respect to assertions, but rather the extent of evidential matter that should be collected. Logically, the level of assurance that can be offered when the evidential matter obtained is based on inquiries and analytical procedures is significantly different than the assurance to be offered when more persuasive evidential matter is gathered as part of an audit engagement.

However, the legitimacy and sufficiency of the evidential matter gathered should not be confused with the evaluative skills needed to provide limited assurance about the financial statements. The nature of a review engagement means the most of the activity requires a relatively high level of evaluative skills. This argument can be best demonstrated by examining the performance of analytical procedures in a review engagement.

SSARS 1 requires that the auditor design analytical procedures to identify relationships and individual items that appear to be unusual. SAS 56 offers the following insight into the nature of analytical procedures.

"A basic premise underlying the

applications of analytical procedures is

that plausible relationships among

data may reasonably be expected to

exist and continue in the absence of

known conditions to the contrary."

SAS 56 goes on to note that plausible relationships may be affected by such conditions as "specific unusual transactions or events, accounting changes, business changes, random fluctuations, or misstatements."

Analytical procedures obviously cannot be performed in a vacuum. That is, the auditor must have an adequate background to establish expectations concerning relationships. SSARS 1 recognizes the need for the accountant to acquire adequate understanding of the client. For example, the accountant should have an adequate knowledge of the accounting principles and practices of the industry in which the client operates and an understanding of the client's business. SSARS 1 concludes that an understanding of a client's business would include "general knowledge of the entity's production, distribution compensation methods, types of products and services, operating locations, and material transactions with related parties."

Thus, the accountant applies analytical procedures in the context of the fundamental characteristics of the client to evaluate assertions that appear or should appear in the financial statements. Unusual relationships or expectations that are anticipated but that do not exist would suggest to the accountant that the financial statements may be materially misstated and the accountant may conclude that it is necessary to perform other procedures to be in a position to express the limited assurance on the reviewed financial statements.

Prepare for the Unexpected

The key to the successful implentation of analytical procedures in a review engagement is the ability to recognize unexpected relationships, both quantitative and qualitative. To achieve this objective, a significant level of evaluative skills is often needed. To illustrate this contention, assume that a set of financial statements contains a material misstatement because a portion of the client's inventories is stated at a cost that exceeds replacement cost (lower of cost or market test). In an audit engagement, a staff auditor would likely identify the misstatement in the financial statements by following an audit program that includes one or more of the following procedures:

* Compare cost information per recent vendor invoices to cost data used to prepare the inventory summarization schedule;

* Compare cost information per vendor invoices processed after the end of the year to cost data used to prepare the inventory summarization schedule;

* Compare cost quotations received form vendors to cost data used to prepare the inventory summarization schedule; and

* Compare retail prices on sales invoices executed after the end of the year to retail prices in effect during the last quarter of the year.

The comparison required in the above procedures shoudl identify cost recover-ability problems. Once reported to appropriate firm supervisory personnel, it is reasonably likely that the material inventory error will be indentified.

On the other hand, in a review engagement the identification of the material inventory problem through the use of analytical procedures (in conjunction with other review procedures) would more likely require the skills of an experienced and perceptive accountant.

The difficulty of identifying the inventory problem described above through the use of analytical procedures occurs because of a dynamic or unstable environment (for example, costs are changing due to technological changes in the industry), the effect is limited to the balance sheet (as long as no adjustment has been made the income statement is not affected) and management must take the initiative to identify the problem and then to make the adjustment based on the lower of cost or market analysis.

It is likely that the inventory error will be discovered by the accountant only if the accountant is familiar with the client's industry and is aware of the pace of technological or consumer taste changes occurring within the industry.

Other analytical procedures might indentify the problem but the success of those procedures would likely be related to the length of the period affected by the problem. For example, the computation of comparative gross profit percentages would identify the problem only if the sales prices of inventory were affected (lower sales prices) for a period during the year, thus creating a significantly lower gorss profit percentage. Again, as noted earlier, if the error is confined to the balance sheet, the problem may be relatively difficult to identify through the use of analytical procedures.

What are the implications to the CPA firm and to the public of the argument that review engagements represent a professional service that requires a relatively high level of accounting and investigative skills?

Implications for the CPA Firm

Statement on Quality Control Standards 1 is applcable to review engagements and requires that a CPA firm design a quality control system that will reasonably assure that professional standards applicable to review engagements are observed. The specific elements of quality control policies and procedures that should be considered in the context of review engements are briefly discussed below.

Staff Assignments. While some review engagements may take on a characteristic of being routine, those responsible for assigning personnel should recognize those review engagements that require a high level of professional training and proficiency. For example, review engagements with the following characteristics would require the attention of seasoned accountants:

* The client is in an industry that has overcapacity and is going through a period in which weaker participants are going out of business at an above average rate;

* The client is involved in complex transactions that are unique to the industry;

* The client has exhinited a lack of cooperation with the accountant in discussing issues fundamental to the industry; or

* The client lacks a level of accounting expertise sufficient to recognize important accounting issues relevant to the preparation of financial statements that are in accordance with GAAP or OCBOA.

These are just some scenarios that the individual responsible for the assignment of personnel should take into consideration in determining who should participate in review engagements. Assigning personnel on the basis of a perception that an audit engagement is more difficult than any review engagement is a strategy fraught with risk.

Staff Supervision. Timely and meaningful supervision should be an integral part of the engagement. There can easily be a tendency to reduce the requirements for proper supervision of the review engagement. Thus, the CPA should establish quality control policies, and procedures for supervision of review engagements that include:1) the use of appropriate forms, checklists, and programs; 2) the requirement for timely reviews on site as well as in the office by the technical review department; and 3) the preparation of appropriate working papers, including the documentation of disagreements among staff personnel and the eventual resolution of disagreements.

Professional Development. In some CPA firms, professional development is skewed to audit engagements. For example, discussion of new accounting standards may emphasize how audit strategy should be modified to the exclusion of discussion of the implication of the new standards in review engagements.

In many colleges and universities, auditing courses provide only a superficial discussion of review engagements. This means that CPA firms should include as part of their initial training of onew staff personnel a fairly detailed discussion of review engagements taught by personnel who understand the risks related tho this type of professional service.

Implications for the Public

The profession should guard agains the perception by the public that a review engagement is not as demanding as the performance of an audit engagement.

This misconception has been manifested in some states by the introduction of legislation that would allow public accountants who are not certified to review (and complie) financial statements. If state legislatures and public administrators fully understand the demands of review engagements it would be difficult, if not impossible, for other parties to make a forceful and persuasive argument that review engagements should not be the sole domain of CPAs. As suggested earlier in this articel, the successful performance of a review engagement requires understanding GAAP and their applications equal to that of an audit engagement. Also, the evaluative skills required are ofthen equal to and sometimes higher in review engagements than audits.

Larry P. Bailey, PhD, Professor of Accountancy, Rider College

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