Compilations, reviews and audits: the skills required relative to public confidence.by Pendergast, Marilyn A.
Pressure is continuing from some quarters to drop the requirement that performance of review and compilation services be restricted to CPAs and other licensed accountants. In the mistaken notion that only limited skills are required for these services, proponents seek to persuade legislators to make this important and growing class of professional work available to a wider group who are neither adequately prepared nor subject to regulation. The authors point out the numerous phases of these services where professional skills are vital prerequisites to both reviews and compilations. They explode the myth that these services do not require the training equivalent to that of the CPA conducting an audit. Readers can help users of financial statements to understand the skills required by making this article widely available. Reprints may be obtained by writing to The CPA Journal.
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 business 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 entrusted with public funds.
The reliability of financial information is a responsibility 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 to which large grants are given 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 guides CPAs and other licensed public accountants has created a hierarchy of these services where 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 that 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 the engagement. The reasons for this become clearer when the characteristics of each engagement, which are summarized in the accompanying table, 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 is otherwise aware of, material errors in the financial statements and those errors are not corrected, the errors are disclosed in the accountant's report.
In general, financial statements that are to be distributed to external parties may be presented in accordance with GAAP or an other 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.
It is not unusual for a nonpublic company to prepare its financial statements on another comprehensive basis of accounting. However, that form of presentation does not reduce the level of knowledge that must be possessed or judgment exercised by an accountant. It should be noted that the only official guidance for evaluating the adequacy of disclosures in financial statements prepared in conformity with another comprehensive basis of accounting is contained in GAAS. In addition, financial statements prepared on a tax basis require that the accountant fully understand the complexity of the tax laws and related regulations and whether that guidance has been observed in the formatting of the external financial statements. Furthermore, if the company is an S Corporation, the accountant is faced with the added complexities associated with that type of tax entity.
To successfully compile, review, or audit financial statements, a pre- existing condition is that the external accountant 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 thorough 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 be performed beyond those explicitly set forth in the standards for reviews and compilations.
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, but rather, the preponderance of evidential matter 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 such 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 TABULAR DATA OMITTED of the financial statements that would be expected to conform to a predictable pattern based on the entity's experience.
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 capability of integrating comprehensive accounting standards with broad company characteristics can a useful compilation be performed.
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.
The application of GAAP to the preparation of financial statements is made irrespective of whether the statements are audited, reviewed, or compiled. Professional standards specifically state that the hierarchy of accounting principles established in SAS No. 69, The Meaning of "Present Fairly in Conformity with Generally Accepted Accounting Principles" in the Independent Auditor's Report, applies to financial statements that are reviewed or compiled by an external accountant.
GAAP requires adequate disclosures including appropriate notes, terminology, and statement formatting. Thus, 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 where 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 government 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, 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 may have 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 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 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 includes 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 prenumbered 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 it may be impossible or too costly to perform a review. Under this circumstance, the accountant may suggest 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 accounting problems 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.
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. 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 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 is lower than the likelihood associated with an audit. However, the fact the probability is lower in compilation and review engagements cannot be interpreted to mean 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. Because an accountant is not trained in law, it is not possible for the accountant to determine whether a particular act is illegal. An accountant also does not have a sufficient basis for recognizing possible violations of laws and regulations 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 concerning the known illegal act.
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. Nonetheless, professional standards do require the accountant to 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) on the financial statements.
Communication of Errors, Irregularities, and Illegal Acts
Professional standards require that in a review or compilation the accountant should establish an understanding with the client that "the engagement cannot be relied upon to disclose errors, irregularities, or illegal acts and that the accountant will inform the appropriate level of management of any material errors that come to his or her attention and any irregularities or illegal acts that come to his or her attention, unless they are clearly inconsequential." This responsibility can be achieved only by an accountant who is both informed of the meaning of various technical concepts included in the standard, and experienced enough to apply these concepts in the context of the specific review or compilation engagement circumstances.
Applying the standard of materiality in a review or compilation engagement requires that an accountant establish financial criteria (percentage of total assets, percentage of net income, etc.) in a manner so as to determine errors or misstatements that could have an impact on an external party's decision process. Likewise, determining what constitutes an inconsequential irregularity or illegal act requires an experienced accountant who can assimilate a variety of factors and, based on the circumstances in which they exist, reach a conclusion about their importance. To suggest that these concepts are somehow routine in a review or compilation is to significantly misunderstand the responsibilities imposed on the accountant by existing professional standards.
One dominant area of concern to external parties is the ability of the company to continue to exist. In an audit, the accountant observes complex professional standards when substantial doubts arise 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 concerning the uncertainty must be made.
In determining what constitutes adequate disclosure, the accountant is required to refer to the professional standards that apply to an audit engagement. Those professional standards require that matters such as the possible effects of conditions that are the basis for uncertainty, the presentation of information concerning recoverability or classification of assets and liabilities, and management's plans that deal with the conditions that lead to the going-concern problem be considered for disclosure. Even when the accountant believes management's strategies for dealing with a going-concern circumstance have been effectively addressed, professional standards nonetheless require the accountant to consider whether the principal conditions and events related to the uncertainty should be disclosed. These responsibilities imposed by existing standards require a considerable amount of expertise and are especially difficult to apply in a review or a compilation due to the limited nature of evidence available to the accountant.
Changing the Level of Service
A client may request the accountant change the current engagement from a review to a compilation. While that request may appear on its face to be straightforward, there are professional responsibilities that must be satisfied. These responsibilities include the evaluation of the basis for requesting the change and the determination of the additional effort required to complete the review engagement.
The purpose of the professional requirements is in part to reduce the possibility that an irregularity in the financial statements is not discovered by the accountant. The possibility that such a circumstance will not be identified is greater in a compilation engagement than in a review. For example, if the client is aware the financial statements are misstated, the strategy might be to reduce the level of service (e.g., from a review to a compilation) to reduce the possibility the error will be discovered.
Also, the professional standards have been constructed to reduce the likelihood the presentation of financial statements that omit substantially all disclosures is not abused. That is, under certain circumstances a client can present compiled financial statements that omit substantially all disclosures; however, if the client's objective is to mislead financial statement users by, for example, omitting a note that discloses information about noncancelable operating leases, then the accountant should refuse to issue a compilation report.
Again, what appears to be a simple concept, the changing of the level of an accounting service, potentially can have a detrimental effect on users. Only an accountant with a significant level of expertise can reasonably be expected to evaluate the circumstances and apply professional standards in a manner that will provide an acceptable level of protection to the financial community.
Practice Monitoring Program
In a practice monitoring program or peer review, an accounting firm's policies and procedures may be evaluated to determine whether professional standards are being observed in the financial statement services conducted by the firm. Participation in an AICPA practice monitoring program is a condition of AICPA membership.
Under an AICPA practice monitoring program, 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 have been followed.
For firms that perform only compilations or reviews, off-site reviews evaluate reports issued by them.
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 the AICPA practice monitoring program know their work will be exposed to an external evaluation. Therefore, 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 require accountants who perform audits under those standards participate in a recognized review program such as a practice monitoring program conducted by the AICPA.
The work of accountants not participating in these self-regulatory programs is evaluated by an external mechanism only when an engagement leads to litigation. While litigation can serve as a deterrent to unprofessional behavior, it is far better to have a practice monitoring program 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 to financial statements, can only be performed by a skilled professional.
This Article is a revision of an article by the same title that was published in the August 1992 issue of The CPA Journal. The revision principally reflects the provisions of Statement on Standards of Accounting and Review Services No. 7 issued in November 1992.
Larry P. Bailey, PhD, CPA, is Professor of Accounting at Rider University.
Marilyn A. Pendergast, CPA, is a partner of Urbach, Kahn & Werlin, P.C., a member of AICPA, and president of NYSS-CPA.
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