If Not an Audit, Which Level of “Assurance” is Appropriate?
January 12, 2016
Audits are seen by many as the “gold standard” in financial reporting. But this level of assurance isn’t necessary for every business. In some cases, management may prefer to downgrade to a less expensive service. When a borrower wants to downgrade its financial statements, it’s important for lenders to understand the key differences between reviews, compilations and preparations, including how these services have changed under the American Institute of Certified Public Accountants’ (AICPA’s) recent Statement on Standards for Accounting and Review Services (SSARS) 21.
The term “assurance” refers to how much confidence stakeholders have that a company’s financial statements will be reliable, informative and in conformity with U.S. Generally Accepted Accounting Principles (GAAP) or another financial reporting framework. Higher levels of assurance require more in-depth procedures performed by the CPA when evaluating a company’s financial statements.
Audits provide reasonable assurance that the statements are free from material misstatement and conform to GAAP. Other services provide lower levels of assurance.
Borrowers who can get by with a slightly lower level of assurance than an audit may issue reviewed financial statements. Reviews provide limited assurance that the statements are free from material misstatement and conform to GAAP. They start with internal financial data. Then, the accountant applies analytical procedures to identify unusual items or trends in the financial statements. He or she will also inquire about any anomalies and evaluate the company’s accounting policies and procedures.
Reviewed statements require footnote disclosures and a statement of cash flows. But, unlike in an audit, the accountant isn’t required to evaluate internal controls, verify information with a third party or physically inspect assets.
SSARS 21 calls for review reports to contain emphasis-of-matter (and other matter) paragraphs when CPAs encounter significant disclosed (or undisclosed) matters that are relevant to stakeholders.
Next, compiled financial statements provide no assurance that they’re free from material misstatement or that they don’t require material changes to conform to GAAP. The CPA simply puts management’s data into a financial statement format that conforms to GAAP (or another framework). Footnote disclosures and cash flow information are optional in compiled financial statements.
SSARS 21 changes the length of compilation reports. Instead of the previous standard three-paragraph statement, compilation reports are now only one paragraph long, unless the company follows a special-purpose framework (such as income tax basis or cash basis). In those cases, an extra paragraph is needed.
For years, accountants have been performing financial statement “preparations” as a type of nonattest service. Now there’s official guidance under SSARS 21 for accountants to follow. Prepared financial statements are often used by owners who formerly relied on management-use-only financial statements, which have been eliminated under SSARS 21.
Preparations provide no assurance and usually omit most of the disclosures required under the financial reporting framework. In fact, the requirements for preparation and compilation engagements are very similar. The main difference between the two services is the report: Prepared statements don’t require the CPA to include a report; instead they simply contain a disclaimer on every page that no level of assurance has been provided.
No service offering provides an absolute guarantee that a borrower’s financial statements are free from material misstatement and conform to GAAP. Clever fraudsters sometimes get away with creative accounting shenanigans — and errors may go undetected.
Some borrowers need more oversight than others. Deciding on which level of assurance is acceptable requires lenders and borrowers to discuss these options with the company’s accountant.
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