Levels of assurance: Compilations, reviews and audits
Financial statements help lenders evaluate an organization’s performance and determine its ability to repay debt. But all financial statements aren’t subject to equal levels of analytical procedures, inquiry or testing by an outside accounting professional.
In order of increasing level of rigor, CPAs offer three types of financial statements: compilations, reviews and audits. Which is appropriate for a given borrower depends on many factors, such as the needs of creditors or investors and the size, complexity and risk level of the organization.
CPAs bring assurance
How confident (or assured) are you that your borrowers’ financial reports are reliable, credible, relevant and timely? When CPAs are involved in financial statement preparation, you likely have greater peace of mind, knowing that the statements will comply with Generally Accepted Accounting Principles (GAAP). But it’s important to understand that, depending on the level of assurance selected, CPAs perform procedures of varying degrees of depth when evaluating a company’s assets, liabilities, revenues and expenses.
Compilations provide a minimalist approach
Compilations (or “comps”) rely on data provided by the borrower. They provide no assurance that financial statements are free from material misstatement and conform with GAAP. Instead, the CPA puts management’s financial information into a GAAP financial statement format. Footnote disclosures and cash flow information are optional and are often omitted from comps.
Comps may be appropriate for small, unsophisticated borrowers that need help accounting for, say, depreciation expense, warranties, or deferred tax assets and liabilities.
Reviews serve as a middle ground
Next are reviewed financial statements, which provide limited assurance that the statements are free from material misstatement and conform with GAAP. Like comps, reviews are based on internal financial data. Here, the CPA 1) applies analytical procedures to identify unusual items or trends in the financial statements, and 2) inquires about these anomalies, as well as the company’s accounting policies and procedures.
Reviewed statements always include footnote disclosures and a statement of cash flows. But the accountant isn’t required to evaluate internal controls, verify information with a third party or physically inspect assets.
Audits offer an opinion
An audit provides a reasonable level of assurance that a borrower’s financial statements are free from material misstatement and conform with GAAP. The SEC requires all public companies to have an annual audit, but larger, private firms also benefit from them, depending on their leverage and their bank’s risk assessment.
Audited financial statements are the only type of report to include an express opinion about whether the financial statements are fairly presented, in all material respects, in conformity with GAAP (or other comprehensive basis of accounting).
Beyond the analytical and inquiry steps taken in a review, auditors perform “search and verification” procedures. For example, auditors obtain written confirmations for accounts receivable, physically observe year end inventory counts, and randomly test sales transactions by examining contracts and other supporting documents. They also review internal control systems, tailor audit programs for potential risks of material misstatement and report on control weaknesses when they deliver the audit report.
Although audits provide the highest level of assurance, there are no absolute guarantees against “creative accounting” or inadvertent errors.
Lenders needn’t compromise on assurance
Not every borrower requires an audit. But the higher the level of assurance you require, the greater confidence you’ll have that your borrowers’ financial statements fairly present their financial health. After all, audits help reveal unintentional errors and omissions — and possibly even uncover fraud. The threat of being caught by external auditors may also cause would-be fraudsters to rethink their dishonest intentions.
If a borrower requests to downgrade the level of assurance in its financial statements, think beyond how it will save on audit fees and manhours. Consider the borrower’s strengths, weaknesses and long-term risks. Different borrowers require different levels of assurance.