Reliable financial information in the form of financial statements is an essential ingredient to the functioning of today's society. In the commercial sector, investors and other owners, suppliers, and creditors need the information to evaluate the viability, soundness, and performance of the businesses in which they have invested or advanced funds. In the public sector, elected officials, regulators, administrators, contributors, and citizens need the information to evaluate the status and performance of entities that are entrusted with public funds.

The reliability of financial information is a function of the knowledge, judgment, and care of the preparer of the information. Absent any third-party involvement, users outside the entity generally have little or no way of evaluating the reliability of financial statements furnished to them.

CPAS and other licensed public accountants, as independent third parties, serve a vital role to society by providing assurance to users as to the reliability of financial statements based upon the services they perform.

The level of assurance required by users about the reliability of financial statements varies. For example, a shareholder who has little or no contact with a company demands a high level of assurance about the reliability of financial statements, as does a major lender in a commercial enterprise. The federal government requires a high level of assurance about the reliability of statements and other information from entities in which large grants are made to carry out public responsibilities. On the other hand, a commercial lender of relatively small amounts with ongoing contact or perhaps a security interest may feel the need for a lower level of assurance about the reliability of financial information it receives. And finally, owners active in a business may need little or no third-party assurance about the reliability of information of that business.

A final consideration is cost. The higher the level of assurance, the greater the effort, and the higher the cost.

To satisfy the need for varying levels of assurance about the reliability of financial statements, CPAS and other licensed public accountants provide three financial statement services - compilations, reviews, and audits.

Perception of Services

The professional literature that CPAS and other licensed public accountants are guided by has created a hierarchy of these services whereby an audit is considered the highest level of service, followed by a review and then a compilation. A common but serious misconception arising from this ranking of the three services is the notion that the level of competency needed to successfully conduct a particular engagement is dependent on the nature of the service. That is, an inference is made that a higher level of competence is needed to perform an audit than a review or compilation, and likewise a review will require more competence than a compilation engagement.

A closer examination clearly demonstrates while compilations and reviews are significantly different in scope from an audit engagement, the level of expertise needed to perform compilation and review engagements is indeed high. In fact, the difference among the three engagements is the assurance offered on the financial statements as to their reliability rather than the competence required to perform a particular service. The reasons for this become clearer when the characteristics of each engagement, which are summarized in Exhibit 1, are examined and compared.

Level of Assurance

An external accountant can offer different levels of assurance based on how strongly the accountant believes, based on the extent of work done, that the financial statements are free from material misstatement. The more the accountant knows about the financial statements, the higher the level of assurance that can be offered.

In an audit, the accountant obtains sufficient, competent evidential matter to a degree enabling the accountant to express reasonable assurance on the fairness of presentation of the financial statements. The level of assurance in an audit, while described as "reasonable assurance," is not absolute. Just as a physician can never be certain about the health of a patient, the accountant can never offer an absolute assurance about the financial statements.

The level of assurance offered in a review engagement by necessity cannot be as high as the level offered in an audit. In a review engagement, the accountant generally gathers evidence through inquiries and analytical procedures. The level of evidence collected and evaluated by the accountant is much less than in an audit. Therefore, in a review engagement, the accountant offers "limited" assurance. This limited assurance states the accountant is not aware of any material modifications that should be made to the financial statements.

In a compilation, any evidence the accountant obtains is incidental to the process of preparing the financial statements. However, if the accountant discovers or otherwise is aware of material errors in the financial statements and those errors are not corrected, the errors are disclosed in the accountant's report.

Professional Standards

In general, financial statements that are to be distributed to external parties may be presented in accordance with GAAP or another comprehensive basis of accounting; for example, an enterprise could prepare its financial statements on a cash basis or tax basis. Whatever the basis for presentation, the company, not the accountant, is responsible for selecting and applying the appropriate accounting principles.

To successfully compile, review, or audit financial statements, a preexisting condition is the external accountant must have an adequate understanding of the accounting principles, procedures, and methods used to prepare the financial statements. The accountant cannot evaluate something he or she does not understand! As noted earlier, there is no special or simplified accounting basis applicable to compiled or reviewed financial statements. The external accountant must therefore have a through understanding of increasingly sophisticated accounting rules.

In addition to having a thorough understanding of accounting principles, the external accountant must have a thorough understanding of auditing standards, i.e., the rigorous professional rules that must be followed in the conduct of an audit. These standards require a high degree of training and practical experience for their successful application. In addition to the obvious need to understand and apply auditing standards for the performance of audits, the same thorough understanding is necessary for the performance of compilations and reviews. In both types of engagements, professional standards are quite clear that when the accountant encounters an apparent problem it may be appropriate to perform procedures that would normally be performed in an audit. Only when a compilation or review engagement has "no problems" (an unlikely possibility) would no procedures beyond those explicitly set forth in the standards for reviews and compilations be performed.

Evidence Required and

Evaluative Skills

Perhaps the most important element in understanding the level of competence needed to successfully perform compilation and review engagements is identifying the evaluative skills needed in these engagements. Evaluative skills refer to the accountant's ability to draw a conclusion about an assertion in the financial statement, based on evidential matters.

In an audit engagement, the accountant develops an audit strategy based on the assertions in the financial statements. For example, an implicit assertion included in the financial statements of a retailer is that inventory exists. To substantiate that assertion, the accountant could observe the inventory count performed by the client. By physically seeing the inventory, the accountant is gathering evidence that supports the assertion that inventory exists.

While professional standards established for audit engagements are not directly applicable to compilation or review engagements, the basic logic is the same.

In a review engagement, the accountant's inquiries and analytical procedures are influenced by implicit and explicit assertions in the client's financial statements. The primary difference between a review engagement and an audit is not the conceptual approach with respect to assertions and substantiation of those assertions, but rather, the preponderance of evidential matter that is collected to evaluate financial statement assertions.

Specifically, the accountant uses inquiries and analytical procedures in evaluating financial statement assertions in a review engagement. For example, in a review engagement the accountant might ask the company's controller how inventory quantities and value were determined (an inquiry) and compare the inventory balance of the current year with that of the preceding year (analytical procedure).

The nature of the evidence gathered in a review engagement is that most of the auditor's 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, the accountant seeks to identify relationships and individual items in the financial statements that appear to be unusual. Generally the analytical procedures include the following techniques:

* Comparison of the financial statements with statements for comparable prior(s);

* Comparison of the financial statements with anticipated results, if available (for example, budgets and forecast); and

* Study of the relationships of the elements of the financial statements that would be expected to conform to a predictable pattern based on the entity's experience.

The performance of analytical procedures is based on the logic that plausible relationships among data may generally be expected to exist and those relationships should continue in the future unless other conditions arise that would be expected to change the expected relationship. Conditions that might change expected relationships include new governmental regulations, changes in operational and financing strategies, and the acquisition or disposition of a business segment.

In a compilation, the accountant obtains a general understanding of the company's business and reads the financial statements in the context of that understanding. While the level of evidence obtained in a compilation is minimal, the evaluative skills needed are significant. The accountant must be capable of dealing with very broad factors and relating those factors to specific items that appear in the financial statements. For example, if the accountant is aware the company, like others in the same industry, sells a product with a one-year product warranty, the accountant would read the financial statements with a certain expectation concerning the accrual of warranty costs for products sold but still under warranty. Only when an accountant has the capabilities of integrating comprehensive accounting standards with broad company characteristics can a useful compilation be performed.

GAAP Disclosure

Financial statements generally include a balance sheet, income statement, and statement of cash flows. However, to satisfy accounting standards, a variety of disclosures must be made in the financial statements, usually presented as part of the financial statement notes. These notes enable a company to present more completely and understandably its financial position and results of operations.

Reviewed and audited financial statements must include all appropriate notes required by accounting standards. Compiled financial statements must also include all appropriate notes. However, there is a provision in the reporting standards allowing compiled financial statements to omit all or substantially all notes if the accountant's report refers to the omission and the report is to be provided only to informed users. Thus, for all three services, the accountant must be aware of what constitutes adequate disclosure in the financial statements, including disclosures made in the notes. Even in situations whereby compiled financial statements do not include appropriate notes, the accountant must nonetheless understand required note disclosures to be able to determine whether their omission might be misleading to external parties.

Client and Industry Knowledge

Financial statement services cannot be successfully performed in a vacuum because those statements are affected by the basic characteristics of the company and the industry in which it operates. In an audit, the accountant 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, are used to plan the audit.

The approach in a review engagement is similar to an audit in that the accountant obtains an understanding of the company's organization, its operating characteristics, and the nature of its assets, liabilities, revenues, and expenses. The difference between the audit approach and the review approach is a matter of degree and not of kind. In a review, the accountant is exposed to less specific information about the company but yet must plan an appropriate review engagement based on the information known. For this reason a review requires an equal ability to relate basic characteristics of the company to specific investigative techniques.

The approach in a compilation engagement is similar to both an audit and a review, except the accountant obtains only a general understanding of the nature of the entity's business transactions. In a compilation the accountant has limited information about the company, but again 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.

The ability to go from the general to the specific is in part determined by the educational background of an accountant. The more narrowly educated, the less likely that the person can function in a less structured professional environment. The profession has recognized the need to have better educated accountants by requiring that by the year 2000 those who take the CPA examination must have had 150 hours of formal education. The education will include not only training in accounting but also exposure to less technical courses that will enhance the ability of the accountant to evaluate broad issues.

Understanding of Internal

Control

Internal control relates to the design of policies and procedures that reasonably ensure a company's financial statements are appropriately prepared. Internal control features range widely from segregation of duties and responsibilities to use of pre-numbered documents. The better designed and executed an internal control structure, the smaller the likelihood that material errors and irregularities will occur in the financial statements. In an audit, adequate understanding of the company's internal control structure is obtained to plan audit strategies and procedures.

While there is no specific requirement to understand and evaluate a company's internal control structure in a review, the accountant is required to develop some understanding of the company's accounting system, which by definition is an element of the internal control structure. This understanding is obtained through inquiry and results in identifying journals and ledgers used, determining the manner by which information is processed, and understanding the level of sophistication of accounting personnel.

In a review, one purpose of obtaining information about the company's accounting system is to determine whether an accounting system is so deficient that it may be impossible or too costly to perform a review. Under this circumstance, the accountant may suggest that other accounting services are needed, such as data processing services, basic systems design, and routine adjusting journal entries. Significant expertise is needed by an accountant to obtain a limited understanding of a company's accounting system and then be able to anticipate the accounting problems that are likely to arise in the review if basic features of an adequate accounting system are not in place.

When an accountant performs a compilation engagement, the understanding of a company's internal control structure is much less than that demanded in either an audit or review. However, some understanding is nonetheless required. Specifically, in a compilation the accountant obtains a general understanding of the company's business transactions, the form of its accounting records, and the stated qualifications of accounting personnel. Thus, the accountant must properly determine the interrelationship between the types of transactions executed, the accounting records used to capture those transactions, and the capabilities of employees responsible for recording transactions. The expertise needed in this phase of a compilation engagement is not inconsequential. For example, if a company is involved in an industry characterized by significant sales returns, a licensed accountant would immediately recognize the possible need for the company to provide some system of estimating future returns. The design of the procedures would be dependent on return policies established by the company and the applicable accounting rules.

Independence

The foundation for the performance of financial statement services is the independence of the individual performing the service. If the business community collectively perceived that accountants are not truly independent, then public confidence would be lost and society would have to find someone else to fill the profession's current role. The need exists in a sophisticated business environment and someone must fill it.

The concept of independence is equally applicable to compilations, reviews, and audits. in an audit, if the accountant is not independent, the accountant's report must specifically state that the accountant is not independent and provides no assurance in the report. For a review, the accountant is prohibited from issuing a report when the accountant is not independent. In a compilation engagement, a report may be issued but the accountant must specifically state that the accountant is not independent.

Thus, in all three financial statement services the accountant must be aware of what constitutes independence. The AICPA and state boards of accountancy have promulgated broad as well as specific guidelines as to what constitutes a lack of independence. For example, the AICPA has issued numerous rules and interpretations and well over 100 detailed rulings.

Detection of Errors

and Irregularities

Errors refer to unintentional misstatements or omissions in financial statements. Irregularities are intentional misstatements or omissions ranging from incorrectly processing accounting data to misapplication of an accounting principle.

The accountant designs an audit to provide reasonable assurance that material errors and irregularities will be discovered. In a review, the accountant is expected to detect material errors that would be reasonably expected to be discovered based on the use of review procedures. In a compilation engagement the accountant is expected to discover only obvious material errors that come to the attention of the accountant during the reading of the financial statements in the context of the company's characteristics.

The likelihood of discovering material errors and irregularities in compilation and review engagements are lower than the probability associated with an audit. However, the fact that the probability is lower in compilation and review engagements cannot be interpreted to mean that a lower level of competence is expected of someone who performs reviews and compilations. The financial statements can only be read in an intelligent and effective manner if the accountant has an adequate background in financial reporting standards.

Detection of Illegal Acts

Illegal acts arise from violations of laws or governmental regulations. An audit is planned to detect illegal acts that have a direct and material effect on the financial statements. As an example, in a commercial organization the auditor selects appropriate procedures to reasonably determine whether there have been violations of the IRC and related regulations. In a government entity, the auditor selects procedures to test compliance with the important provisions of major grant documents. Because an accountant cannot practice and is not trained in law, it is not possible for the accountant to perform direct tests to determine whether violations have occurred that have an indirect effect on the financial statements.

In a review, an accountant is responsible only for discovering illegal acts that would reasonably be expected to be identified through inquiries, analytical procedures, and other procedures the accountant may deem appropriate in a particular engagement. In a compilation engagement, the accountant does not test for the occurrence of illegal acts; however, if the accountant is aware of such matters the accountant reads the financial statements to determine whether there are obvious errors or omissions with respect to the known illegal act.

While in both compilation and review engagements, the accountant's responsibility for the detection of illegal acts is significantly less than the responsibility in an audit, professional standards do require that the accountant be aware of the possibility of their occurrence. For example, in a review engagement an accountant may have discovered through inquiry that the company had a significant inventory writedown that arose from chemicals leaching into the ground. The accountant would likely extend the inquiries to determine whether the company has evaluated the situation to identify violations of environmental laws or regulations that would have a direct and material effect (i.e., potential fines and penalties).

Going Concern Considerations

One dominant area of concern to external parties is the ability of the company to continue to exist. In an audit, the accountant observes involved professional standards when substantial doubt arises about the company's ability to continue as a going concern. Likewise, in compilations and reviews, if the accountant becomes aware of similar doubts about the company's continuation, an evaluation of the adequacy of disclosures relating to the uncertainty must be made. In making such an evaluation, the accountant uses guidance provided in auditing standards.

Practice Monitor - Peer

and Quality Review

In a practice monitoring program or peer review, an accounting firm's policies and procedures are evaluated to determine whether professional standards are being observed in the financial statement services conducted by the firm. The AICPA has two practice monitoring programs - one for the Division For CPA Firms referred to as Peer Review and one for all other firms with AICPA members called Quality Review. It is a condition of AICPA membership that a firm belong to one of the two programs.

In a Peer or Quality Review an accounting firm that performs audits is subject to an on-site evaluation. During that activity, the review team evaluates practices related to compilation, review, and audit engagements. The evaluation includes the inspection of working papers for specific clients to determine whether professional standards, many of which have been discussed earlier in this article, have been followed.

For firms that perform only compilations or reviews, Peer and Quality Reviews include the evaluation of compilation and review reports issued by the firm.

Any professional group that provides a service to the public needs to be subject to some policing mechanism to determine whether the public is being properly served. Accountants that are subject to Peer or Quality Reviews know that their work will be exposed to an external evaluation and, thus, there is an incentive to provide for an effective system of policies and procedures that reasonably ensure professional standards are followed in all financial statement services.

Government Auditing Standards issued by the U.S. General Accounting Office requires accountants that perform audits under those standards participate in a recognized review program such as the Peer and Quality Reviews conducted by the AICPA.

The work of accountants not participating in these self-regulatory programs only becomes evaluated by an external mechanism when an engagement leads to litigation. While litigation can serve as a deterrent to unprofessional behavior, it is far better to have a mechanism, such as Peer or Quality Review, that can identify substandard service at a point before the public is damaged or before society is forced to provide an expensive legal forum for assessing damages.

IT MAY LOOK EASY, BUT ...

The compilation or review of financial statements seems easy when there are no problems. That logic simply does not hold up to close scrutiny. Compilation and review engagements, if performed in a manner that adds value of financial statements, can only be performed by a skilled professional.

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