| EXECUTIVE
SUMMARY |
 SSARS NO. 10,
PERFORMANCE OF REVIEW ENGAGEMENTS,
effective for reviews of
financial statements for periods ending
on or after December 15, 2004, amends
SSARS no. 1, Compilation and Review
of Financial Statements, by
introducing new requirements for
performing such services. CPAs MUST APPLY THEIR
KNOWLEDGE OF FINANCIAL and other
factors affecting the broad economy, the
client’s entire industry and the
client’s company. Together these
three kinds of information provide the
basis for developing expectations
necessary to measure the reasonableness
of the client’s financial
statements.
MANAGEMENT’S WRITTEN
REPRESENTATIONS and staff’s
oral statements made during discussions
with the CPA complete the picture of the
client’s business situation and help
ensure it’s accurately reflected in
the entity’s financial statements.
FRAUD IS A MAJOR NEW FOCUS
of SSARS no. 10, which requires
accountants to obtain specific
representations from management
concerning its knowledge of any actual
fraud or suspected fraud affecting the
entity, involving management or others
and potentially having a material effect
on the financial statements. SSARS no. 10
also requires CPAs to obtain
management’s acknowledgement of its
responsibility to prevent and detect
fraud.
IN MAY 2004, THE ARSC ALSO
ISSUED SSARS no. 11, Standards
for Accounting and Review Services, which
establishes a SSARS hierarchy that
describes the relative authority of
various publications. SSARS themselves
have the most authority, interpretive
publications have the next greatest
weight and other publications have the
least.
|
| J. RUSSELL MADRAY, CPA, is
president of Madray Group Inc., an
accounting and auditing technical
consulting practice. He also is a senior
lecturer at Clemson University’s
School of Accountancy and Legal Studies
in Clemson, South Carolina. His e-mail
address is russ@madray.com. |
 n
issuing Statement on Standards for Accounting and
Review Services (SSARS) no. 10, Performance
of Review Engagements, the AICPA accounting
and review services committee (ARSC) has
introduced the most significant changes in review
engagement requirements since it released its
first statement in 1978. This article gives
practitioners and members in industry a look at
the changes, which take effect for reviews of
financial statements for periods ending on or
after December 15, 2004.
By the
Numbers
Reviews provide limited
assurance that a client’s financial
statements are free from material
misstatement.
Source: PCPS/Texas Society
of CPAs National MAP Survey of 3,052
firms, 2003.
|
SSARS no. 1, Compilation
and Review of Financial Statements, has long
been the source of information on procedures
applicable to a financial statement review. But
practitioners said they needed new and more
comprehensive direction on several topics, such
as inquiries, analytical procedures and
documentation requirements. The new statement,
which the ARSC issued in May 2004, amends SSARS
no. 1 by providing guidance on
 Analytical procedures,
including specific instruction on how CPAs should
compare client financial data with their existing
expectations based on their understanding of the
entity and the industry in which it operates.
(See “Testing for Reasonability.”)
Questions that accountants
should consider directing to management,
including specific ones about its knowledge of
any actual or suspected fraud that could have a
material effect on the financial statements, or
of transactions occurring or recognized near the
end of the reporting period.
Statements in the
representation letter required from management to
confirm its oral responses to the CPA’s
inquiries about fraud.
Documentation requirements.
Testing
for Reasonability
SSARS no. 10 does not
introduce methods for evaluating the
reasonableness of the financial
information management provides during a
review engagement. CPAs always have been
able to use a variety of analytical
procedures for this purpose, from simple
comparisons to complex models involving
many relationships and data elements.
Instead, SSARS no. 10 reinforces the
appropriateness of using such methods and
introduces a requirement that accountants
document the analytical procedures they
use during a review. These procedures
compare key financial data with
information from prior periods or with
benchmark budgets and forecasts from the
entity’s industry; with nonfinancial
information that may be financially
significant; or with any combination of
these. The three types of analyses
accountants most commonly perform are Trend
analysis, a comparison of a
current recorded amount with the prior
year balance or with balances from two or
more periods. For example, practitioners
often contrast monthly sales totals for
the current year and preceding year.
Ratio analysis, a
proportion calculated for the current
period measured against a related or
similar one for a prior period, an
industry standard or a budget. The four
major types of ratios measure liquidity,
profitability, leverage and activity. For
example, by calculating an
inventory-turnover ratio, which compares
the cost of sales to average inventory,
the CPA may be able to identify inventory
misstatements.
Model-based procedures, which
use client operating data and relevant
external data, such as industry-specific
and general economic information, to
develop an expectation for a recorded
amount. These procedures also evaluate
financial data for reasonableness. For
example, the number of employees can be
used to determine average wages or
vacation pay per employee. Because
nonfinancial operating data often are
generated and maintained outside of the
accounting department, comparisons
involving such data can offer an
independent check on the reasonableness
of related financial information.
|
EXAMINE, MEASURE, APPRAISE
Analytical
procedures provide a basis for the limited
assurance CPAs provide in the review report and
may identify financial statement items that
appear to be materially misstated. The techniques
for conducting an analysis fall into two
categories: developing expectations—although
this term was introduced in SSARS no. 10, SSARS
no. 1 introduced the concept it
represents—and evaluating results.
Developing
expectations. In review engagements
CPAs develop expectations by identifying and
considering relationships they reasonably could
assume might exist, given their understanding of
the entity and the industry in which it operates.
Expectations developed by a CPA in a review
ordinarily are less encompassing than those
developed in an audit, and in a review, it
isn’t necessary to corroborate
management’s responses with other evidence.
Although SSARS no. 10 does not provide guidance
on how to deal with the highly judgmental nature
of this process, practitioners must be able to
assimilate a wealth of information into a series
of logical and internally consistent conclusions
(see “Key
Factors in a Financial Relationship”).
Key
Factors in a Financial Relationship
While SSARS no.
10 requires CPAs to document the items
they consider in developing expectations
relating to the financial statements, it
does not say how they should formulate
those expectations. In my view, to
perform this function properly CPAs need
to be aware of
The
general economy. Financial
conditions establish the background for
developing expectations. CPAs should stay
abreast of trends in the regional and
national economy, which can have a
significant effect on the client and
ultimately on its financial statements.
If interest rates rise steadily, for
example, a practitioner would expect the
client’s interest costs to be higher
than they were a year ago, assuming the
amount of debt outstanding is relatively
stable and its maturity short term.
The
client’s entire industry. CPAs
can evaluate industry trends to formulate
more detailed expectations. Examples
include the economic cycle and maturity
of the client’s industry, the pace
of technological change in the industry
and relevant government regulations. If
the client’s industry is at the low
point of an economic cycle, the CPA would
expect excess operating capacity to
create significant volume variances that
would affect the client’s gross
profit margin and overall profitability.
The
client’s company. CPAs
should make inquiries to develop a
general understanding of the
client’s organization and operating
characteristics and the nature of its
assets, liabilities, revenues and
expenses. They should become familiar
with the client’s production
methods, distribution system and products
and services. A practitioner may have
developed such knowledge during prior
review engagements and by providing other
services for the client. Based on prior
engagements, for example, the CPA may be
aware the client often makes costing
errors when pricing certain raw
materials.
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Evaluating
results. CPAs do this by comparing
the recorded amounts—or ratios developed
from them—with the expectations they’ve
developed. The practitioner’s knowledge of
the client and the industry in which it operates
is essential to interpret the results of the
analytical procedures and to determine when a
difference from an expected amount is
significant. For example, it’s important for
CPAs to know whether fluctuations from previous
periods resulted from changed conditions, such as
major increases in product selling price,
inventory obsolescence or changes in credit
policy. It’s equally crucial to identify
when a value should have fluctuated but did not,
such as when a company’s gross profit
percentage remained substantially the same even
though its raw material costs increased
significantly while its prices stayed flat. The
AICPA’s annual Audit Risk Alert
series is a good source of up-to-date information
on economic and industry trends that can help
CPAs make such evaluations accurately. For titles
in the series, see “AICPA Resources.”
After applying a specific
analytical procedure to the client’s
financial information, CPAs should compare the
actual results with their original expectations
of what that outcome should be. It is essential
to do this, in my opinion, by means of objective
analysis—by evaluating the results of the
analytical procedure to determine whether the
result is consistent with the
expectation—rather than by relying on
rationalization, that is, searching for
conditions that support a result without
identifying which conditions are the most
important, most logical and most relevant to the
evaluation.
The ARSC also created an issues
paper, Analytical Procedures in a Review
Engagement, that explains certain
requirements related to analytical procedures in
review engagements, including the development of
expectations and the documentation of analytical
procedures in such engagements.
GETTING
MORE FROM MANAGEMENT
The inquiry
process is a fundamental technique used to
collect information relevant to the financial
statements. It should be evolving and ongoing.
SSARS no. 10 gathers the inquiries the accountant
should consider performing in one place in a
logical sequence, and adds new ones—most
notably concerning fraud.
Practitioners should consider
making inquiries to management concerning the
following matters, most of which are introduced
in SSARS no. 10:
The preparation of the
financial statements in conformity with
consistently applied generally accepted
accounting principles (GAAP) or an other
comprehensive basis of accounting (OCBOA).
The entity’s
accounting principles and practices, methods
followed in applying them and the procedures for
recording, classifying and summarizing
transactions and accumulating information for
disclosure in the financial statements.
(Previously discussed in AR100.28.)
Unusual or complex
situations that may have an effect on the
financial statements.
Significant transactions
occurring or recognized near the end of the
reporting period.
The status of uncorrected
misstatements identified during the previous
engagement.
Questions that have arisen
in the course of applying the review procedures.
Events subsequent to the
date of the financial statements that could have
a material effect on the financial statements.
Management’s knowledge
of any actual or suspected fraud that affects the
entity and involves management or others where
the fraud could have a material effect on the
financial statements.
Significant journal entries
and other adjustments.
Communications from
regulatory agencies.
Actions taken at meetings
of shareholders, the board of directors,
committees of the board or comparable gatherings
that may affect the financial statements.
(Previously discussed in AR100.28.)
Although the inquiry process is
straightforward, its success depends on how it is
followed. A related critical factor not within
SSARS no. 10’s scope is the importance, in
my opinion, of CPAs’ knowing what questions
to ask and how to effectively pursue a particular
line of inquiry. The quality of the review
engagement is reduced dramatically when a
practitioner performs inquiries in a mechanical
fashion and accepts responses without thoroughly
evaluating them. For example, a practitioner who
is aware of major recent changes in the
client’s business activities or structure
would be remiss in not probing further if the
client said there had been no such modifications.
Many of the questions typically
found on engagement checklists apply to almost
all review engagements. CPAs typically ask such
questions in a formal manner when they interview
appropriate client personnel and record their
responses directly in the documentation. But the
inquiry should consist of more than this rather
rigid process; it also should take the more
dynamic form of a dialogue between the CPA and
the client’s management. As practitioners
become aware of circumstances, facts or
relationships, they may find it logical and
appropriate to pose follow-up questions to the
client.
For example, the CPA may ask
management to provide more information about a
recent acquisition that the company made and how
it recorded the transaction, and then change the
focus of the questioning based on the
client’s responses, if applicable. Or when a
relative of the company’s owner is a company
subcontractor, the CPA might inquire about the
types of services the relative provides and how
he or she is compensated.
An
All-SSARS Lineup
The
accounting and review services committee
(ARSC) in May issued SSARS no. 11, Standards
for Accounting and Review Services, which
establishes a SSARS hierarchy and informs
practitioners of the appropriate
publications’ relative authority.
The statement, which took effect upon
issuance, also addresses a technical
correction to SSARS no. 2, Reporting
on Comparative Financial Statements. SSARS
no. 2 currently provides guidance to be
followed when the financial statements of
a prior period were compiled or reviewed
by a predecessor accountant whose report
is not presented, and the successor
accountant has not compiled or reviewed
those financial statements. SSARS no. 11
also amends SSARS no. 2 to conform with
the guidance found in SAS no. 58, Reports
on Audited Financial Statements, as
amended, which states that a successor
auditor may name the predecessor auditor
if the predecessor auditor’s
practice was acquired by, or merged with,
that of the successor auditor.
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DIAGNOSING MISSTATEMENTS
A review
engagement provides limited assurance the
financial statements require no material
modifications to conform to GAAP or an other
comprehensive basis of accounting. Misstatements
could be intentional, thus constituting fraud, or
unintentional, the result of error. The ARSC
determined that the issue of fraud should be
addressed in a review engagement; SSARS no. 10
therefore requires specific inquiries about fraud
and specific written representations from
management about it.
SSARS no. 10 requires the
accountant to obtain from management written
representations for all financial statements and
periods covered by the accountant’s review
report (see “Your Signature, Please,” below). The contents will depend
on the circumstances of the engagement and the
nature and basis of presentation of the financial
statements, but SSARS no. 10 requires specific
representations from management on the following
matters:
Management’s
acknowledgement of its responsibility to prevent
and detect fraud.
Management’s knowledge
of any known or suspected fraud affecting the
entity, involving management or others, where the
fraud could have a material effect on financial
statements.
The ARSC issued an
interpretation (www.aicpa.org/members/div/auditstd/interp_ar_9100_26.htm) of SSARS no. 10 to provide guidance on
the steps CPAs should follow to perform the
required communication when, during a compilation
or review engagement, they suspect fraud or an
illegal act may have occurred.
Your
Signature, Please
SSARS no. 10 requires
that the representation letter be signed
by those members of management whom the
accountant believes are responsible for
and knowledgeable—directly or
through others in the
organization—about the matters
covered in the letter. Normally, this
would be the CEO and CFO or others in
equivalent positions. Even if the current
management was not present during all
periods covered in the accountant’s
report, the accountant should obtain
their written representations on all such
periods. |
GET IT IN WRITING
Documentation is
the principal record of the procedures performed
and the conclusions reached in performing the
review. The ARSC determined that SSARS no. 1
didn’t provide enough specific documentation
guidance for practitioners. The guidance now
requires the documentation to describe
Matters covered in the
practitioner’s inquiries.
Analytical procedures
performed.
Significant expectations
that otherwise were not readily determinable from
the documentation of the work performed and
factors considered in the development of those
expectations.
Results of the comparison
of the expectations to the recorded amounts or
ratios that are developed from the recorded
amounts.
Any additional procedures
performed in response to significant unexpected
differences arising from the analytical
procedures and the results of such procedures.
Unusual matters—such
as significant journal entries that were made on
the last day of the accounting period for no
apparent business purpose—the practitioner
considered during the performance of the review
procedures and their disposition.
The management
representation letter.
SSARS no. 10 does not preclude
CPAs from supporting their review reports by
means in addition to the review documentation.
This may be written documentation contained in
other engagement files (for example, compilation
files) or quality control files (for example,
consultation files) or oral explanations when the
accountant finds it necessary to supplement or
clarify information contained in the
documentation. Oral explanations should not be
the principal support for the work performed or
the conclusions reached.
 |
PRACTICAL
TIPS TO REMEMBER |
|
 CPAs should
know how to develop expectations
by identifying and considering
relationships they reasonably can
expect to exist, based on their
knowledge of the entity and its
industry.
Practitioners also must use that
knowledge to contrast the values
recorded in the client’s
financial statements—or
ratios based on those
values—with the expectations
they have developed during the
review.
A
CPA’s inquiries during a
review should be sufficiently
flexible and open-ended to
identify any inconsistencies
between expectations and results
and resolve any inconsistencies
to the extent possible and
appropriate.
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LOOKING AHEAD
It has been more
than 25 years since the ARSC issued SSARS no. 1.
With the issuance of SSARS no. 10, practitioners
now are required to raise the issue of fraud.
Will this change raise the bar of a review
engagement, as some practitioners predict, and
lead to a better understanding by management of
their responsibilities, and therefore, to
higher-quality engagements? One thing is
certain—as the profession enters a new era
of scrutiny by the public and regulators, it is
imperative that practitioners and management
understand their respective roles and
responsibilities.
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