Understanding Compilation, Review
and Audit
Reporting on Financial Performance
Almost every organization — whether it’s a privately held business, a
publicly owned corporation, or a nonprofit organization — must prepare reports on its
financial performance. Such reports help owners and managers make operating decisions,
enable creditors to evaluate loan applications, and provide individuals with information
to make investment decisions.
The accounting profession recognizes that different entities have different accounting
needs. Acknowledging these differences, the profession has developed standards that enable
CPAs to offer a range of financial statement services.
Diverse Accounting Services for Diverse Needs
A CPA may provide a client with three distinct services involving financial statements.
Each is designed to meet a different need.
A compilation is useful to small, privately held entities that need help in
preparing their financial statements. A review, on the other hand, may be
adequate for entities that must report their financial positions to third parties, such as
creditors or regulatory agencies. Reviewed financial statements may also be useful to
business owners who are not actively involved in managing their companies.
An audit is the third and most extensive service. An audit is appropriate for
entities that must offer a higher level of assurance to outside parties. An unqualified
opinion from a CPA after an audit provides reasonable assurance to outside parties that
the entity's financial statements fairly present its financial position and results of
operation in accordance with certain accounting principles.
COMPILATION
Preparing financial statements of
private entities based on information provided by the entity’s management.
Through compilation services, a CPA prepares monthly, quarterly, or annual financial
statements. However, he or she offers no assurance as to whether material, or significant,
changes are necessary for the statements to be in conformity with generally accepted
accounting principles, the cash basis, or the income tax basis of accounting. During a
compilation, the data is simply arranged into conventional financial statement form. No
probing is conducted beneath the surface unless the CPA becomes aware that the data
provided is in error or is incomplete.
However, before agreeing to perform a compilation, a CPA will take a "common
sense" look at the entity to decide whether the client needs other accounting
services, such as help in adjusting the accounting records.
Here’s what a compilation entails:
The CPA becomes familiar with the accounting principles and practices common to the
client’s industry, and acquires a general understanding of the client’s
transactions and how they are recorded.
After compiling the financial statements, the CPA is obliged to read them and consider
whether they are appropriate in form and free from obvious material errors. The CPA then
issues a standard report that says, in effect, that the financial statements were
compiled, but because they were not audited or reviewed, no opinion is expressed.
Compilation standards permit an accountant to compile financial statements that omit
footnote disclosures required by generally accepted accounting principles or another
comprehensive basis of accounting (cash or income tax). This is allowable as long as the
omission is clearly indicated in the report and there is no intent to mislead users.
However, when footnote disclosures have been left out, the CPA adds a paragraph to the
compilation report stating that management has elected to omit disclosures. This paragraph
lets the user know that if the financial statements contained this information, it might
affect the user’s conclusions.
A compilation is sufficient for many private companies. However, if a business needs to
provide some degree of assurance that its financial statements are reliable, it may be
necessary to engage a CPA to perform a review or an audit.
Here is an illustrative compilation report:
Accountant’s Compilation Report
Stockholders and Board of Directors
XYZ Company
We have compiled the accompanying balance sheet of XYZ Company as of December 31, 19X5,
and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with Statements on Standards for Accounting and Review Services
issued by the American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements information
that is the representation of management (owners). 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.
Able, Baker and Charlie, CPAs
February 15, 19X6
REVIEW
Inquiry and analytical procedures
applied to financial statements of private entities.
A private entity may engage a CPA to perform a review of its financial statements
and issue a report that provides limited assurance that material changes to the financial
statements are not necessary. With respect to reliability and assurance, a review falls
between a compilation, which provides no assurance, and the more extensive assurance of an
audit.
Before a review, the CPA may have to compile the financial statements; however, in all
cases, the financial statements are management’s statements, not the CPA’s.
Management must have a sufficient understanding of the financial statements to assume
responsibility for them.
Two other factors differentiate a review from a compilation — the CPA must remain
independent of the client during a review, and all appropriate footnotes must be included
in the reviewed statements.
Here’s what a review entails:
The CPA obtains a working knowledge of the industry in which the entity operates
and acquires information on key aspects of the organization, including operating methods,
products and services, and material transactions with related parties.
The CPA will then make inquiries concerning such financial statement-related matters as
accounting principles and practices, recordkeeping practices, accounting policies, actions
of the board of directors, and changes in business activities. Then the CPA will apply
analytical procedures designed to identify unusual items or trends in the financial
statements that may need explanation. Essentially, a review is designed to see whether the
financial statements "make sense" without applying audit-type tests.
Keep in mind that during a review, a CPA does not confirm balances with banks or
creditors, observe inventory counting, or test selected transactions by examining
supporting documents. However, in many instances, a review—with its limited assurance
—may be adequate for a business or its creditors. If more assurance is necessary, the
organization may need to engage a CPA to perform an audit.
Here is an illustrative review report:
Accountant’s Review Report
Stockholders and Board of Directors
XYZ Company
We have reviewed the accompanying balance sheet of XYZ Company as of December 31, 19X5,
and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with Statements on Standards for Accounting and Review Services
issued by the American Institute of Certified Public Accountants. All information included
in these financial statements is the representation of the management of XYZ Company.
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.
Based on our review, we are not aware of any material modifications that should be made
to the accompanying financial statements in order for them to be in conformity with
generally accepted accounting principles.
Able, Baker and Charlie, CPAs
February 15, 19X6
AUDIT
Includes such procedures as confirmation
with outside parties, observation of inventories, and testing selected transactions by
examining supporting documents.
A public or private company may engage a CPA to audit its financial statements and
to issue a report that provides the highest level of assurance that the financial
statements are presented fairly in conformity with generally accepted accounting
principles.
In an audit, as in a review, the CPA must be independent of the client and the
financial statements must contain all required footnotes.
Here’s what an audit entails:
To gather evidence on the reliability of the financial statements, the CPA performs
"search and verification" procedures. In an audit, the CPA generally confirms
balances with banks or creditors, observes inventory counting, and tests selected
transactions by examining supporting documents. In addition, the CPA contacts sources
outside the client organization to gather information that may be more objective than that
obtained from internal sources. For example, the CPA usually obtains written confirmation
from a client’s customers about amounts owed to the client at a specific date. By
accumulating this type of evidence, the CPA tries to reduce the risk that the financial
statements will be materially misstated.
The auditor then issues a report stating that the financial statements are presented
fairly, in all material respects, in conformity with generally accepted accounting
principles.
An audit is planned and performed with an attitude of professional skepticism; that is,
the auditor designs the audit to provide "reasonable assurance" that material
errors or fraud are detected. However, fraud concealed through forgery or collusion may
not be found because the auditor is not trained to catch forgeries, nor will customary
audit procedures detect all conspiracies.
An audit provides a reasonable level of assurance that the financial statements are
free of material errors and fraud. An audit does not, however, provide a guarantee of
absolute assurance.
Here is an illustrative audit report:
Independent Auditor’s Report
Stockholders and Board of Directors
AU Company
We have audited the accompanying balance sheet of AU Company as of December 31, 19X5,
and the related statements of income, retained earnings, and cash flows for the year then
ended. These financial statements are the responsibility of the Company’s management.
Our responsibility is to express an opinion on these financial statements based on our
audit.
We conducted our audit in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of AU Company as of December 31, 19X5, and the
results of its operations and its cash flows for the year then ended in conformity with
generally accepted accounting principles.
Able, Baker and Charlie, CPAs
February 15, 19X6
What Services Do You Need?
Compilation CPA prepares financial statements from
information provided by management.
A compilation is useful when limited in-house capabilities for preparing financial
statements exist.
Review CPA applies inquiry and analytical procedures to
financial statements provided by management to determine if they are reasonable.
A review provides limited assurance that no material changes need to be made to the
financial statements.
Audit CPA examines financial statements by conferring with
outside parties, completing physical inspections and observations, and testing selected
transactions by examining supporting documents.An audit provides the highest level of
assurance that the financial statements fairly represent the entity's financial position
and results of operation in accordance with generally accepted accounting principles.
