Practice Alert 2000-4
Quarterly Review Procedures for Public Companies

In December 1999, the Securities and Exchange Commission (SEC) adopted a rule that requires a company's independent auditor to review the company's interim financial information prior to the company filing its quarterly report on Form 10-Q or Form 10-QSB. In the SEC staff's view, this rule makes it a clear violation of the securities laws for a company to file such a quarterly report without having its auditor perform the review in advance of the filing. The rule was effective for all fiscal quarters ending on or after March 15, 2000. For further information, see the release entitled "Audit Committee Disclosure" at the SEC's Web site: www.sec.gov/rules/final/34-42266.htm. Because the SEC release also includes other new requirements not discussed in this Practice Alert, the PITF recommends that all auditors of SEC registrants review this release.

The professional standards and guidance for conducting interim reviews are set forth in Statement on Auditing Standards No. 71, Interim Financial Information (SAS 71). The objective of a review of interim financial information is to provide the auditor with a basis for reporting whether material modifications should be made for that information to conform with generally accepted accounting principles. SAS 71 states "To perform a review of interim financial information, the accountant needs to have sufficient knowledge of a client's internal control as it relates to the preparation of both annual and interim informationWhen the accountant has not audited the most recent annual financial statements, and thus has not acquired sufficient knowledge of the entity's internal control, the accountant should perform procedures to obtain that knowledge." Therefore, the first time a firm performs an interim review, the firm should acquire sufficient knowledge about the client's accounting and reporting practices for the purposes contemplated in the review by obtaining an understanding of internal control, including practices used for preparation of both annual and interim financial information.

The procedures for conducting a review of interim financial information should include:

• Inquiries concerning internal controls, especially changes in internal control since the most recent financial statement audit or review;
   
• Analytical review procedures over interim financial information;
   
• Reading the minutes of meetings of stockholders, the board of directors, and appropriate committees;
   
• Reading the interim financial information for conformity with generally accepted accounting principles;
   
• Inquiries of officers, executives, and other appropriate personnel;
   
• Obtaining written representations from management concerning its responsibility for the financial information, completeness of minutes, subsequent events, and other relevant matters;
   
• Obtaining reports from other auditors, if any, who have reviewed the interim financial information of significant components of the reporting entity.

All of the above procedures should be performed with consideration as to their impact on the preparation and presentation of interim financial information.

Suggested Procedures

The PITF has identified certain other procedures that should be considered in performing quarterly reviews. They are as follows (the auditor may want to consider developing a checklist of procedures):

• Read the Form 10-Q or 10-QSB, including management's discussion and analysis, to determine that such information is consistent with the interim financial statements (similar to a review under SAS No. 8 Other Information in Documents Containing Audited Financial Statements) and other information of which the auditor is aware. The auditor should consider reviewing all financial information in press releases and other documents filed with the SEC or other regulators. The company's Web site, the SEC's Web site, and other Internet sites are good sources for reviewing such information.
   
• Review and understand any restructuring charges taken in the current and prior quarters. Appropriate accounting guidance, e.g., EITF Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring), and SEC Staff Accounting Bulletin No. 100, Restructuring and Impairment Charges, should be considered when such charges are recorded.
   
• Review and understand any current or prior quarter extraordinary items.
   
• Consider tracing and agreeing financial statement amounts to the company's general ledger and other appropriate accounting records. For companies with simpler account structures, this is an easy way of avoiding classification or other errors. For companies with complicated account structures, this may be more difficult. In such instances, the auditor should consider the company's internal controls over accumulating and consolidating information, and the frequency of errors encountered during the annual audit, when performing these procedures. Additionally, all financial information should be independently recalculated and cross-referenced.
   
• Consider fraud risk factors. Inquire of management as to their understanding of the risk of fraud in the company and whether they have any knowledge of fraud that has been committed.
   
• Review the company's revenue recognition methods and determine compliance with generally accepted accounting principles. Additionally, the auditor may want to consider having the company's management confirm the absence of side agreements.
   
• Perform appropriate analytical review procedures. Analytical review procedures provide a basis for inquiries regarding significant account balances and are, therefore, an integral part of the quarterly review. Analytical review procedures might include:
   
• Comparison of the financial information to the previous period and corresponding prior periods;
   
• Comparison of ratios and indicators developed from recorded amounts to expectations based on prior periods and industry averages. Examples of key ratios and indicators include: current ratio, receivable turnover or days sales outstanding, inventory turnover, depreciation to average fixed assets, debt to equity ratio, gross profit percentage and net income percentage;
   
• Comparison of financial information to budgets and forecasts;
   
• Comparison of financial information to that of others in the same industry;
   
• Vertical analysis of financial information in comparison to prior periods. Examples of vertical analysis include expenses by type as a percentage of sales, and assets by type as a percentage of total assets;
   
• Gross profit analysis by product line and business segment;
   
• Recalculating amortization of significant intangible assets;
   
• Analyze income tax balances. These procedures should include relating the provision for income taxes to pre-tax income, and relating current and deferred tax accounts to budgets and prior periods. Inquiries should be made regarding unusual rates and balances.

Significant account fluctuations that should be reviewed with additional emphasis include:

• Business combinations;
   
• Disposal of a segment of a business;
   
• Extraordinary, unusual, or infrequently occurring transactions;
   
• Litigation or the development of other contingencies;
   
• Changes in major contracts with customers or suppliers;
   
• Changes in accounting principles or the methods of applying them;
   
• Trends and developments affecting accounting estimates, such as allowances for bad debts and excess/obsolete inventories, warranty provisions, and unearned income.
   
• Consider reviewing non-standard journal entries. Standard journal entries include those journal entries processed in the normal course of business, such as sales, inventory purchases and cash disbursements. Standard journal entries are normally subject to the company's internal controls. Non-standard journal entries are those that are made outside the normal course of business, and might be made outside the company's internal control structure, such as the provision for bad debts, the provision for inventory obsolescence, and cut-off or period-end adjustments. Non-standard journal entries may pose increased risk to the auditor in that they might represent attempts by management to manage earnings and could be recorded in any general ledger account.
   
• Review and recalculate the company's earnings per share (EPS). The calculation should be compared with recent EPS calculations for consistency. Consideration also should be given to the effects of interim developments, such as the issuance of stock and granting of options. Such items may be found by reading minutes of meetings of the board of directors and the compensation committee.
   
• Inquire about compliance with debt covenants. If key financial requirements have been close to default level in the past, or there have been significant changes in relevant account balances, a review of the company's debt covenant calculations should be performed. If the calculations have not been performed at the end of each quarter, the auditor should consider insisting that the company require that such calculations be performed.
   
• Follow-up on material contingencies from prior audits and reviews. For example, when an auditor is informed during the annual audit that a significant account will be collected the next month, follow-up during the first quarter review would be appropriate.
   
• Consider reviewing details of significant transactions occurring in the last several days of the quarter.

Other Matters for Consideration

Issuance of Review Reports

In practice, a review report typically is not issued on interim financial information, although SAS No. 71 provides that a report may be issued. The SEC does not require, and most companies do not request, the issuance of a review report. However, the SEC does require that if a company includes a representation in their filing that the auditor has performed a timely review, the auditor's report on the review must accompany the interim financial information.

When a review cannot be completed within the 45-day SEC filing deadline, the auditor should suggest that the company delay the filing until the review is complete. SEC Form 12b-25, Notification of Late Filing, properly submitted to the SEC within one calendar day of the prescribed due date will extend the due date by five calendar days. Further extensions are not available. The SEC staff does not consider a Form 10-Q that is filed prior to the completion of the auditor's review to be timely filed or a complete document filing.

Concurring Partner Review

The AICPA SEC Practice Section requires involvement by the concurring partner reviewer in the conduct of a review performed on the financial statements of an SEC client's quarterly filings. Specifically, discussion with the concurring partner reviewer by the engagement partner on any matters identified during the review that involves a significant risk of material misstatement of the financial statements is required. The discussion should occur prior to the completion of the review and should be documented. It should be noted that a "significant risk of material misstatement to the financial statements" includes a material disclosure deficiency in the footnotes to the financial statements.

Coordinating the Review with the Annual Audit

The cost of conducting a review of interim financial information is a consideration for both the company and the auditor. However, if the review is properly planned and executed, it can assist and strengthen the annual audit. The quarterly review procedures should be tailored to take into consideration, among other things, the nature of the company's business and internal control structure. Some of the procedures performed during a quarterly review also might be necessary as part of the annual audit. Audit planning should partially evolve from the results of the quarterly reviews. Further, a review does not preclude the use of audit procedures.

For example, if a company has a well-controlled means of processing a high volume of transactions, the auditor may choose an audit strategy that is control reliant. Inquiries regarding changes in the control environment would be particularly important during a review of interim financial information. In addition to these procedures, some of the tests of the control system can be performed as part of the quarterly review. This provides added support that the control system is functioning properly and may reduce the amount of testing required during the year-end portion of the annual audit.

If a company uses the percentage-of-completion method of accounting for long-term contracts, a review of significant contracts and related discussions regarding estimates to complete with appropriate company personnel could be performed during the quarterly review. This should reduce the amount of time needed to review contracts at year-end and could alleviate potentially embarrassing and costly revenue recognition issues from surfacing at year-end. In addition, if a company had a significant business combination or restructuring, the auditor may want to perform audit procedures at a quarter-end to help streamline the year-end audit.

Auditors are reminded that APB No. 28, Interim Financial Reporting, requires disclosure of significant fourth quarter items and adjustments in a note to the annual financial statements.

Communication with Audit Committees

SAS No. 90, Audit Committee Communications (SAS No. 90), clarifies that the accountant performing the quarterly review should communicate to the audit committee or be satisfied, through discussions with the audit committee, that matters described in SAS No. 61, Communication With Audit Committees (SAS No. 61), have been communicated to the audit committee by management when they have been identified in the conduct of interim financial reporting. For instance, the accountant should determine that the audit committee is informed about the process used by management in formulating particularly sensitive accounting estimates or about a change in a significant accounting policy affecting interim financial information. SAS No. 90 further requires the accountant of an SEC client to attempt to discuss with the audit committee the matters described in SAS No. 61 prior to the filing of the Form 10-Q or 10-QSB.

When the auditor becomes aware of a probable misstatement due to a departure from GAAP, he or she should discuss the matters with the appropriate level of management as soon as possible. If management fails to appropriately respond in a reasonable period of time, the auditor should inform the audit committee or equivalent as soon as practicable. This communication may be oral or written and should be documented in the working papers. If the audit committee fails to appropriately respond in a reasonable period of time, the auditor should consider whether to resign from the review and the audit.¹ In such circumstances, the auditor should consider consulting with his or her attorney to, among other reasons, determine if he or she has any responsibility to report fraud under Section 10A of the Securities Exchange Act of 1934.

Timing

As previously mentioned, the SEC requires that a company's auditor review the financial information included in the company's Form 10-Q or 10-QSB prior to the company's filing with the SEC. Many of the required review procedures can be performed prior to or simultaneously with the company's preparation of the quarterly financial statements. For example, it may be practical to begin reading applicable minutes and update the understanding of the company's internal control environment prior to the end of an interim period. Also, certain basic analytical procedures and inquiries may be completed prior to the end of the period (e.g., as of the end of the second month of a quarter) if the company has strong internal controls. The auditor also should, if at all possible, schedule the same personnel to the quarterly reviews who have been and will be assigned to the annual audit.

Some companies will want to issue their press release prior to the completion of the review. Under these circumstances, the auditor should attempt to perform as much of the review as possible, prior to the release of earnings. Nonetheless, the auditor should not be publicly associated with the press release.

Summary

For all fiscal quarters ending on or after March 15, 2000, the SEC requires that the interim financial information included in a company's Form 10-Q or Form 10-QSB be reviewed by the company's independent auditor prior to being filed. A company that files its quarterly report without having its auditor perform a quarterly review is, in the SEC staff's view, in violation of the securities laws, and an auditor with a client who does this should consider discussing the matter with the company's audit committee and the company's legal counsel. Guidance for conducting such reviews can be found in the SAS No. 71.

One of the primary reasons the SEC has mandated the above requirement is to minimize large year-end adjustments to quarterly financial statements that historically have been uncovered in the annual audit process. The PITF believes the suggested procedures listed in this Practice Alert will assist in the timely identification of material accounting issues, and they should reduce the likelihood of quarterly restatements.

¹Auditors are reminded of their responsibilities for disclosure to audit committees under SAS No. 82, Consideration of Fraud in a Financial Statement Audit, and SAS No. 54, Illegal Acts by Clients