Which of the following procedures would not be performed in a review of financial statements of a nonpublic company?

By Frank Milone, CPA, Founding Partner, Assurance & Advisory Services
Mar 05, 2014

As a company grows and matures, it will likely eventually need the assistance of a certified public accounting firm (CPA firm) to provide some level of assurance on its financial statements. A management team’s discussions often result in the following question: Should we have an audit or review performed? The answer is more complicated than most people think.

When making a decision on the level of service you want a CPA firm to provide, you need to understand the level of assurance that comes with each report. This is critical to determining whether the service requested meets your needs as an organization, or meets the expectations of the users of your financial statements (i.e., bankers, investors or vendors), who most often drive these requests. A CPA firm can perform three levels of service on a company’s financial statements: compilationreview and audit.

Compilations

A compilation refers to the preparation of a company’s financial statements, using data provided by the company itself. There is no assurance on the figures presented in the financial statements, as the CPA firm performs no testing, inquiry or analytical procedures on the figures. It should also be noted that the CPA firm does not need to be independent to perform this level of service. A compilation is the lowest cost option for a company, as it takes the least amount of time for a CPA firm to perform.

When should a company consider a compilation? This level of service should be used only in the simplest situations, generally when management needs assistance in presenting the company’s financial information in the form of financial statements. A compilation, however, is often not a viable option for a company, as it provides little value. Many users of a company’s financial statements, especially investors and bankers, will most often require that some assurance is given by a CPA firm on the figures presented in the financial statements. Which leads us to the main question: Audit or review?

Reviews

When considering audit versus review, the conversation often leads to the cost factor. A review costs less than an audit and, as a result, is often viewed as the preferred option, especially for early-stage, high-growth companies with limited operating capital. The problem is that a review provides only limited assurance and is substantially narrower in scope when compared with an audit, as the CPA firm designs and performs analytical procedures, inquiries and other procedures only as deemed necessary based on its understanding of the industry and client. A review does not include an investigation of the entity’s internal control system or its risk of fraud, which could be an area of interest for bankers and investors who are lending/providing

money to a growing company. More important, a review does not include the testing of accounting records or other procedures that would normally be performed in an audit. This limitation is important to understand – a common misconception is that a review is a first step that can be easily transitioned into an audit in the following year. It is not. Ultimately, a review is a very effective option for companies that are comfortable with the limited assurance given in the report and expect to stay at the review level for a period of time.

For example, if a company engages a CPA firm to perform a review for the 2012 fiscal year and for 2013 decides to move to an audit, the firm will be required to perform audit procedures on the 2012 balance sheet in order to issue its audit report for fiscal year 2013. The company may ask, “Why do you need to look at 2012 again? You already did that work last year.” If this discussion takes place after the review has been delivered, clearly the client did not understand the assurance limitations of the review, and its CPA firm did not advise the company correctly.

In order to issue an opinion on the 2013 income statement, the CPA firm must audit both the 2012 and 2013 balance sheets to ensure proper cutoff of revenue and expenses. Because only review-level procedures were performed in 2012, the CPA firm is required to perform testing of accounting records and other audit-related procedures on the 2012 balances. These additional procedures on the 2012 balance sheet will likely increase the costs of the first-year audit, and when combined with the fee paid for the review for 2012, could ultimately result in higher costs over the two- year period ending in 2013.

The lesson here is that a company should hold an in-depth discussion in advance of the CPA firm’s initial engagement to ensure that there is sufficient value in performing a review, or determine whether a different option, like an initial balance sheet audit for 2012, would be better in the long run.

Let’s look at another example that demonstrates how a change from a review to an audit without proper understanding of the limitations of review procedures and proper planning can lead to an increased workload and increased costs. This example focuses on a manufacturing company that holds inventory.

For the year ending December 31, 2012, the manufacturing company hires a CPA firm to do a review on its financial statements. The CPA firm performs typical analytical review procedures, evaluates ratio trends and does inquiry procedures to determine if the financials have any material misstatements. For the year ending December 31, 2013, the company’s bank determines that the company needs to provide audited financial statements, based upon the size of the debt facility it now has outstanding.

The company now engages its CPA firm to perform an audit for 2013. A standard audit procedure for inventory is the observation of the company’s inventory counting procedures at the end of each year. The CPA firm observes the company’s physical inventory count as of December 31, 2013, but, because the firm was not required to observe the inventory count as of December 31, 2012, under the review engagement,  it must now perform alternate procedures to audit the inventory on hand as of December 31, 2012. As a result, the CPA firm requires the company to roll back the inventory unit counts from December 31, 2013, to support the inventory units on hand as of December 31, 2012, so that the movement can be tested back to supporting documentation. This alternate auditing procedure is time consuming for the company and the auditor, but because of the need to audit the balance as of December 31, 2012, and the inability to rely on the review procedures, it must be performed.

With proper planning and discussions with its bank and CPA firm, the company could have better facilitated the switch from a review to an audit. Its CPA firm could have observed the company’s physical inventory count in 2012 in preparation for the switch to the audit in 2013.

Audits

An audit provides the highest level of assurance that the financial statements are free from material misstatement. Under an audit, the CPA firm is required to obtain an understanding of the client company’s internal controls and assess the fraud risk. It is also required to corroborate figures and disclosures included in the financial statements by obtaining audit evidence through inquiry, physical inspection, observation, third-party confirmation, examination, analytical procedures and other procedures. As a result of the work required to be performed, the audit is usually substantially higher in cost than a review. Audits are usually required by banks, creditors and outside investors that want the assurance level provided by the auditor’s opinion. Audits are also best practice prior to selling a company, as they will ensure that the financial information presented is materially accurate and can withstand financial due diligence.

Choosing an audit or a review is mainly a question of your needs and the needs of your creditors and investors. Should cost be considered? Yes, but it should not be the driving factor. Proper planning and discussions with your board of directors, investors, creditors and a qualified CPA firm should yield the right decision for your company – one that will fulfill your needs in the most cost-effective manner.

For a helpful summary and comparative overview of a compilation, review and audit, you can also visit the AICPA website.

There are a variety of non-audit services that CPAs perform for companies. Understanding what these services entail helps to ensure you are in compliance for any type of client engagement.

Melissa O’Neil, CPA, has been engaged by a non-public company, Caldwell, Inc., to review the financial statements of the most recently completed fiscal year.

  • What sources should O’Neil consult in order to prepare for this review?
  • What are the required procedures that O’Neil must perform?
  • What information should the review report contain?
  • What should O’Neil do if she finds there was a material departure from GAAP?

Just do response each posted # 1 to 3 down below only.

Posted 1

When O'Neil prepares to review the financial statements for Caldwell, he should review the companies policies and procedures along with inquiring if another CPA has completed the same task in the past. A previous review would be very beneficial to O'Neil because it would serve as a template for her own review plus it would highlight any past issue there were. A flowchart of the business would also be beneficial because she would be able to understand how data and information flows through the company. O'Neil will need to perform procedures on items deemed material and analyze those records. She will also need to follow up with management on any inconsistencies found. The report will review company procedures and detail any deficiencies that were found. This report will be used as a tool for the company to correct any procedures O'Neil feels are not within proper boundaries. Any material departure from GAAP would be documented in the report.

Posted 2

Hello Class,

It is different from publicly traded companies, nonpublic companies may or may not require having an annual audit; it depends on the size of the company. Nonpublic companies that do not have an annual audit may engage CPAs to review their annual or interim financial statements under Statements on Standards for Accounting and Review Services (SSARS) (Whittington & Pany, 2016, p. 747). There are several sources O’Neil should consult the company in order to prepare for the review. First, O’Neil should make inquiries to take a look over the Caldwell Inc.’s policies and standards to understand the management’s honesty and integrity including any disagreement over accounting principles. Next, provide engagement letter to establish a clear understanding with the managers and specifying the objectives and limitations of engagements, management’s and accountant’s responsibilities. Ensure the client is willing to provide necessary accounting information. In addition, understanding the company's industry, including its operations and organization structure are important to help O’Neil design review procedures.

According to Whittington & Pany, the required procedures include four steps: “(1) perform analytical procedures, (2) make inquiries of management and others within the organization (3) perform other procedures considered necessary, and (4) obtain representations from management relating to the financial statements” (2013, p. 748).

The review report information should contain any misstatements that O’Neil may have found during the review and whether the material modifications should be made to the financial statements. Also, any significant deficiencies, unusual matters, and the review procedures performed should be included in the report. The responsibilities of both client and accountant and the accountant’s conclusion of her review should include in the report as well (Whittington & Pany, 2016, p. 749).

If O’Neil found a material departure from GAAP, a modification report to address the issue must be taken place. She also needs to communicate to the audit committee regarding any adjustments made during the review (Whittington & Pany, 2016, p. 751).

Posted 3

Good morning classmates,

Melissa O’Neil, CPA, has been engaged by a non-public company, Caldwell, Inc., to review the financial statements of the most recently completed fiscal year.

  • What sources should O’Neil consult in order to prepare for this review? The screening process is the first step that the CPA will want to do before taking on the non-public company for review. The CPA will want to inquire if the company had previously been reviewed by other CPA’s in the past, and if so, was there a reason why they did not use that CPA again. They will also want to obtain an understanding of the client and the industry that they operate in. Lastly, they want to ensure that the company is ethical and the CPA will want to review if the non-public company is using generally accepted accounting principles, and if their financial statements are prepared to conform with GAAP. In order to do that, they are going to need financial statements, and confirmations from outside sources to help ensure that GAAP is being used and followed.
  • What are the required procedures that O’Neil must perform? Below are the required procedures that would be performed for a non-public company:
  1. Perform analytical procedures
  2. Make inquiries of management and others within the organization
  3. Perform other procedures considered necessary
  4. Obtain representations from management relating to the financial statements (Pany & Whittington, 2016, p. 746)
  • What information should the review report contain? The review report that the CPA will issue looks similar to an audit report. It will have an opening paragraph explaining what the CPA did in the review, what management’s and the accountant’s responsibilities are and were, and then the accountant’s conclusion of the review. Because this is not a full audit, the CPA will be unable to express an opinion on the financial statements, and this will be mentioned in the review report.
  • What should O’Neil do if she finds there was a material departure from GAAP? Any material departure from GAAP is to be reported in a paragraph in the review. It would reference the material difference, what GAAP says how it should be reported, and then how management is actually reporting it.