The term “assurance” refers to how much confidence lenders and other 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. Here’s how the three levels of assurance — compilations, reviews and audits — measure up.
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. Here, an accountant 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.
AICPA Statement on Standards for Accounting and Review Services (SSARS) No. 21 recently reduced 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.
There’s another type of service that accountants offer that provide no assurance: Prepared financial statements follow many of the same guidelines as compiled financials. The basic difference? Preparation 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.
Accountants have been preparing financial statements for years, but SSARS 21 now provides official guidance 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.
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, the accountant isn’t required to evaluate internal controls, conduct substantive testing and confirmation procedures, 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.
Audits are seen by many as the “gold standard” in financial reporting. They provide reasonable assurance that the statements are free from material misstatement and conform to GAAP.
Though there’s no level of assurance that provides an absolute guarantee against material misstatement or fraud, a lot of work goes into preparing audited financial statements. In addition to performing analytical procedures and conducting inquiries, auditors:
- Evaluate internal controls,
- verify information with third parties (such as customers and lenders),
- observe inventory counts,
- physically inspect assets, and
- assess other forms of substantive audit evidence.
Public companies are required by the Securities and Exchange Commission to have their financial statements audited. In addition, many lenders require larger private companies to be audited. But audits aren’t necessary for everyone.
Moving up (and down) the assurance chain
Choosing the right level of assurance comes down to: 1) the complexity of your operations, 2) the abilities of your in-house personnel to accurately report financial results that conform to GAAP, and 3) your stakeholders’ expectations. Though larger companies have more sophisticated finance and accounting departments, the nature of their transactions and their reliance on outside financing often necessitate an audit.
Over time, manufacturers may decide to change their level of assurance. For example, a growing firm might upgrade from a review to an audit to attract public company financing. Or a stable midsize firm might decide to downgrade from an audit to a review, and then hire a CPA to perform certain agreed-upon procedures to evaluate accounts receivable and inventory on a quarterly basis. Discuss these options with your CPA to find the level of assurance that suits your business’s current needs.