According to Shakespeare’s Juliet, "That which we call a rose by any other name would smell as sweet." That may have been true in Shakespeare’s time but we imagine that there are more than a few master gardeners who would take exception to the statement today.
Just like different roses smell different, the accountant’s report you get on your monthly and annual financial statements mean different things. Since we are coming to the end of the year for many companies, we thought you might be interested in the differences in the three levels of service – compilation, review and audit – CPAs provide when issuing your year-end financial statements.
Much of the time, when a client asks what the differences are in the three levels of service, we generally joke and say something like “An audit costs three times as much as a review, which costs about twice as much as a compilation.” Fortunately, this tongue-in-cheek response draws more questions that allow us to explain the real differences, which are based on the amount of work performed to verify the financial statement balances.. So, now that we have given the tongue-in-cheek response, let’s get down to the real differences.
A compilation is considered the lowest level of service a certified public accountant can perform and report upon. The standard report includes the following wording:
“A compilation is limited to presenting in the form of financial statements information that is the representation of management. We have not audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or any other form of assurance on them.”
This standard language basically sums up what a CPA is supposed to do when compiling a set of financial statements. We are supposed to take the numbers you give us, put them into what would be considered a financial statement – balance sheet, income statement, etc. – add the necessary disclosures in notes to the financial statements and issue a report that basically says we haven’t done anything to verify the numbers on the financial statement.
Many times a CPA will prepare your compiled financial statements after preparing your tax return, and thus take more than just a passing glance at the numbers on your books, but the rules say we can’t look deeply into your accounts without issuing a different report. Accordingly, there is no way you or a banker should ever expect a CPA compiling your financial statements to pick up on any fraudulent transactions, especially if the fraud is well hidden. Sometimes in the course of preparing the statements we might see something that looks way out of whack and ask about it and sometimes that unexpectedly uncovers a fraud, but those instances are few and far between.
This may lead you to believe a compiled statement is of little value, but that’s not true either. Over the years, bankers have come to accept a lesser degree of work if a CPA reports on the financial statements. There may be many reasons for this, but the user of the financial statements at least has the comfort of knowing that the numbers are properly categorized to present meaningful information. Since we are required to report on departures from generally accepted accounting principles, bankers and other financial professionals have the comfort of knowing that we are not aware of anything wrong in the financial statements, even if we don’t flatly state so.
One more thing you should know about a compilation. In any other level of service, the CPA must be independent. Basically that means accountants cannot have any direct or material indirect financial stake in the business they report on that would affect their judgment on how financial statement transactions have been recorded. A CPA may, however, issue a compilation report on a business from which he or she is not independent, but the lack of independence must be included in the report.
Since we said that a review typically costs less than an audit and more than a compilation, we must be required to do more work to issue our report, right?
Of course that’s right, and once again, the standard report describes the basics:
“A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.”
Oops! There’s that “we do not express such an opinion” language again. If we aren’t going to tell you what we think of the numbers, isn’t that basically the same as a compilation? The answer is there is a vast difference between the two.
First, a compilation report does not give any assurance to the reader as to the reliability of the financial statement amounts. A review report, on the other hand, offers what we call limited assurance. Basically, our report states that we are not aware of any departures from accepted accounting principles.
Second, we must make appropriate inquiries of personnel about changes in the business environment, recording of transactions and the accounting principles underlying the financial statement. One such question might be to inquire about the proper valuation of inventories and provisions for obsolete inventory. One typically would not ask such a question in a compilation.
Not only must we ask general questions of company personnel, we are required to compare analytical ratios with both industry averages and prior operational results for things that look strange. We must then question appropriate personnel to determine the reason for unexpected differences and even the lack of variances when they are expected. This all means that we are required to have a good knowledge of the industry in which the client operates.
Finally, as we said earlier, we must be able to say we are independent from the client if we want to issue a report.
The audit is the highest level of service we can give with respect to financial statements. It encompasses all the procedures in both the compilation and the review but goes much further in verifying transactions. Typically, an audit will include confirming significant financial statement balances with third parties; it will require us to review the control systems in place to catch material financial statement errors; it will design tests to a) test check transactions to assured that transactions are properly recorded and b) catch material fraud.
In short, if there is an error that would affect a reader’s conclusions on the company’s financial health, we are supposed to find it. Obviously, then, the audit is the most valuable of the financial statement reports we provide and you can basically be sure there are no errors in the financial statements, right? Wrong! While it is true that we will do everything to root out material fraud, sometimes the only perfect way to guarantee we find all fraud is by looking at 100 percent of a company’s transactions. That’s just not cost effective. Why is it so hard to find fraud sometimes? The answer can be summed up in one word – collusion. If you have enough people working to hide a fraud, then it may be virtually impossible to catch.
We don’t want to leave you with the wrong impression. The vast majority of audits performed by CPAs produce results that you can rely on in assessing a company’s health. It’s not only our job to make sure the information you get is reliable; it’s also our passion. Most CPAs follow the rules and recognize that sacrificing their independence for one client is not worth the risk of losing their license and ability to serve other clients.
The depth of testing and understanding of business processes of a client required in an audit also offers our clients a valuable source of outside advice. Because we take the time to understand how the client’s system works, we also have the basis on which to make recommendations to enhance the profitability of our clients. This is where the true value of an audit comes in. Most times, we find that the way management thinks controls are working is not exactly accurate. As auditors, we are able to ask the questions and get the answers about the real workings of the company. This helps us help you maximize your efficiencies and minimize your loss risks.
And yes, we do issue an opinion on the financial statements. Assuming we find nothing drastically wrong, we will report that the financial statements are fairly stated in all material respects with the applicable accounting standards. Basically, this means we think you can rely on the financial information in assessing the health of the company. If we start an audit and find errors management won’t fix, we will report this to the user.
So, are you still convinced all accountants’ reports are the same and it’s best to go with the cheapest option? We hope this short discussion has convinced you to take a second look at the reasons you prepare annual statements and what you get out of your current level of service. A compilation may be just fine, especially if you have no outside reporting requirements. However, if you are experiencing fluctuations in profit margins and other significant financial ratios, it may be time to think about stepping up the level of service you get to gain some comfort that what you are seeing in your statements is really what’s going on in your business. If you have any questions, give us a call. We’ll be glad to discuss your business and the option that best fits your needs.
Have a great November and remember to keep our soldiers and others looking out for our safety in your prayers!