An End to the Plain-Paper Debate?

With SSARS no. 8, ARSC seeks a conclusion to a decades-long problem.
BY GEORGE R. YOUNG AND J. RUSSELL MADRAY

EXECUTIVE SUMMARY
  • THE AICPA ACCOUNTING AND REVIEW SERVICES committee concluded more than 20 years of debate by issuing Statement on Standards for Accounting and Review Services no. 8, Amendment to Statement on Standards for Accounting and Review Services No. 1, Compilation and Review of Financial Statements in October 2000.
  • EFFECTIVE FOR FINANCIAL STATEMENTS submitted after December 31, 2000, the new statement makes two significant changes: It expands the communication options for accountants who submit unaudited financial statements of nonpublic entities and modifies the definition of submission of financial statements.
  • SSARS NO. 8 ALLOWS AN ABBREVIATED communication to replace the previous requirement for accountants to issue a compilation report. The statement permits accountants to submit financial statements not intended for third parties to members of client management who have knowledge of the company and who understand the limitations of the financial information.
  • THE APPLICABILITY OF SSARS NO. 1 DEPENDS on whether the accountant is “submitting” financial statements. SSARS no. 8 redefines this term as “presenting to a client or third parties financial statements the accountant has prepared either manually or through the use of computer software.” The new definition is broader than previously stated in professional standards.
  • BY INCORPORATING ADDITIONAL COMMUNICATION options, SSARS no. 8 increases flexibility for accountants who submit financial statements not intended for use by third parties. Accountants will still need to use professional judgment in deciding if they have presented financial statements to a client and whether SSARS no. 1 applies.
GEORGE R. YOUNG, CPA, PhD, is a retired partner of Tate & Young, CPAs, and an assistant professor of accounting at Florida Atlantic University in Ft. Lauderdale. His e-mail address is gyoung@fau.edu . J. RUSSELL MADRAY, CPA, is a member of the accounting and review services committee and a member of the faculty of Clemson University’s School of Accountancy and Legal Studies in Clemson, South Carolina. His e-mail address is mj@clemson.edu .

he AICPA accounting and review services committee (ARSC) has made the most substantive change to compilation requirements since it issued SSARS no. 1 in 1978. In October 2000 it issued Statement on Standards for Accounting and Review Services no. 8, Amendment to Statement on Standards for Accounting and Review Services No. 1, Compilation and Review of Financial Statements. The new statement, effective for financial statements submitted after December 31, 2000, expands the communication options available to accountants who submit unaudited financial statements of nonpublic entities and modifies the definition of submission of financial statements.

By issuing SSARS no. 8, ARSC may finally have brought more than two decades of debate on “plain-paper” financial statements to an end. Rather than make the wholesale changes once under consideration, ARSC added options that would let accountants use their professional judgment when deciding how best to meet client needs. (For more on the aim of the new statement see “ A New Approach to Compilations,” JofA, April00, page 36 .)

EXPAND AND REDEFINE

SSARS no. 8 brings about two significant changes. The first relates to the submission of unaudited financial statements not expected to be used by third parties, allowing an accountant to document limitations on the statements’ use by means of an engagement letter. The second change involves a redefinition of the term “submission” in an effort to clarify the applicability of SSARS no. 1.

Expansion of communication options. For years, clients have asked accountants to prepare (or help prepare) management-use financial statements in a format that does not necessarily follow GAAP but is nevertheless beneficial to management (financial forecasts, projections and information contained in tax returns are not considered financial statements for purposes of SSARS no. 1). SSARS no. 8 meets the needs of these clients by allowing an abbreviated communication to replace the compilation report.

Under SSARS no. 8, accountants can submit financial statements not intended for third parties to members of client management who “have knowledge” of the company and the limitations of the financial information. Such knowledge of the company lets users consider the statement’s impact in the context of other necessary information about the entity. Because third parties usually do not have such knowledge, management-use financial statements are not meant for their eyes.

SSARS no. 1 defines a third party as anyone other than someone in management who knows the type of procedures the accountant applied and the basis of accounting and assumptions he or she used to prepare the statements. Note that this is a definition by exception. ARSC chose not to define “third parties,” but instead to define who is not a third party.

The starting point is to assume everyone is a third party. To not be considered a third party, a person must meet two requirements. He or she must

Be a member of management.

Have sufficient knowledge about the business to put the financial statement information in the proper context.

For guidance on determining whether a person is a member of management, CPAs should refer to FASB Statement no. 57, Related Parties. It defines members of management as those “responsible for achieving the objectives of the enterprise and who have the authority to establish policies and make decisions by which those objectives are to be pursued.” Management normally includes members of the board of directors, the chief executive officer, chief operating officer, vice-presidents in charge of principal business functions (such as sales, administration or finance), and others with similar policymaking duties. The statement adds that “persons without formal titles also may be members of management.”

Who Is a Third-Party User?

In the graphic above, circle C represents all potential users of an entity’s financial statements (company management, employees, banks, bonding companies, creditors, shareholders, vendors and customers). Circle B represents all members of management. All parties in circle C, other than those in circle A, are considered third-party users. These parties, including the members of management in circle B who are not in circle A, are third-parties because they lack the requisite knowledge of the business to adequately use the statements. Use of compiled financial statements not accompanied by a compilation report should be restricted to knowledgeable members of management represented by circle A.

Does this mean accountants must make judgments about management’s knowledge of its own business? Although some judgment is involved in this determination, a CPA can rely on management’s representation that it has the necessary knowledge to put the information in the proper context.

Here are some examples of third parties under SSARS no. 8. In all cases, the companies are small, closely held businesses.

ABC Co. is owned and managed by its sole shareholder, John. Absent evidence to the contrary, John has the requisite knowledge of his business and would not be considered a third party.

KML Co. is managed by one of its 10 shareholders, Jane. The other nine live out of state and are not involved in managing the business. Absent evidence to the contrary, Jane has the requisite knowledge of the business and would not be considered a third party. The other nine shareholders, however, would be considered third parties.

The XYZ Co. management team consists of a president, Joe; controller, Mary; operations manager, Sue; and sales manager, Jim. Joe, Mary, and Sue are all involved in the company’s financial operations and are knowledgeable about the accounting principles and practices being used. Jim, on the other hand, has no finance background and is not involved in financial decisions. Joe, Mary, and Sue would not be considered third parties. Jim, although a member of management, does not have the requisite knowledge of the business’ accounting practices and would be considered a third party.

Members of management who are considered third parties (for example, Jim, in XYZ Co. above) can be “brought into the loop”—removed from third party status. This process involves educating them about the accounting principles and practices of the business, thereby allowing them to put the information in the proper context. Other members of management or the accountant could undertake this educational process.

Even though use of financial statements is restricted to knowledgeable members of management, accountants still must comply with compilation performance standards. These standards require the accountant to know accounting principles and industry practices, as well as share a general understanding of the client’s business transactions, the form of its accounting records and other information specific to the client so the accountant can competently compile the client’s financial statements. The accountant must ask for additional or revised information if he or she encounters data that appear incorrect or incomplete and must withdraw from the engagement if the client does not provide the necessary answers. The accountant also should read the financial statements to make sure they are free of obvious presentation errors, mathematical and clerical mistakes and misapplication of accounting principles.

For Management Use Only

Financial statements produced under SSARS no. 8 are intended to be restricted to “management use,” not “internal use.” Internal use implies that anyone who is an owner or employee of the client is an intended user. SSARS no. 1, as amended, requires that SSARS no. 8 financial statements be restricted to management use only.

Under SSARS no. 8, an accountant who compiles financial statements not intended for third-party use now has two communication options:

Issue a compilation report as required before SSARS no. 8 (paragraphs .11 to .19 of amended SSARS no. 1, as amended).

Document in an engagement letter, preferably signed by management, the services to be performed and the limitations on the use of the financial statements. (Appendix D of SSARS no. 1, as amended, includes an illustrative engagement letter.)

Before the release of SSARS no. 8, written documentation of services was not required (although it was and still is encouraged) because the compilation report was used to inform users of the service performed.

The engagement letter the accountant prepares should document:

The nature and limitations of the services to be performed.

That a compilation is limited to presenting, in the form of financial statements, information that is the representation of management.

That the accountant will not audit or review the financial statements.

That the accountant will not provide an opinion or any other form of assurance on the financial statements.

That management is knowledgeable about the nature of the procedures applied and the basis of accounting and assumptions used in preparing the financial statements.

Management’s representation and agreement that the financial statements are not to be used by third parties.

That the engagement cannot be relied upon to disclose errors, fraud or illegal acts.

In addition, the engagement letter should make other applicable statements, such as

That substantially all disclosures required by GAAP or an other comprehensive basis of accounting (OCBOA) are omitted (including omission of the statement of cash flows, if applicable).

That material departures from GAAP or OCBOA exist and the effects of these departures on the financial statements may not be disclosed.

That the accountant is not independent.

A reference to any supplementary information.

In addition to documenting the agreement that third parties are not to use the financial statements, the accountant may also document an agreement indicating the client’s intent to limit use of the statements to specific personnel. Accountants may rely on management’s assertion that it does not expect third parties to use the financial statements, unless contradictory information comes to its attention. In addition, ARSC says accountants may include financial statements not intended for third parties in personal financial plans as long as they believe no third party will use those financial statements.

If the accountant does not think he or she has reached an understanding with the client, the accountant should not perform the engagement. If, subsequent to performing the engagement, the accountant becomes aware that third parties are using the financial statements, he or she should discuss the unintended use with the client and advise the client to request the financial statements be returned. If the client does not comply with this advice, the accountant should, after carefully considering whether consulting with an attorney is appropriate, notify the third parties that the information was not intended for their use.

Accountants should notify third-parties in writing or orally. If the accountant decides to use oral notification, he or she should document in the client’s file the date of notification and the name of the person to whom the accountant spoke. To reduce the likelihood of third-party reliance on these financial statements, each page should be marked with a phrase such as “Restricted for management use only” or “Solely for the information and use by the management of [ name of entity ] and not intended to be and should not be used by any other party.”

Peer review. In general, any firm or individual that performs audits, reviews, compilations or other attestation engagements is subject to peer review. However, financial statements compiled for management use only do not include a report, theoretically placing them outside the purview of peer review. Accordingly, the Peer Review Board has determined that if compilation of financial statements issued with an engagement letter (financial statements not intended for third-party use), not with a report, is the only accounting and auditing service the firm performs, the AICPA would not require the firm to enroll in an Institute-approved practice monitoring program. If a firm is already enrolled in such a program and performs these engagements, they would be included in the definition of the firm’s accounting and auditing practice and would be within the scope of peer review.

Redefinition of submission. SSARS no. 1 says, “This statement sets forth the performance and communication requirements when an accountant submits unaudited financial statements of a nonpublic entity to his or her client or third parties.” Since the applicability of SSARS no. 1 depends on whether the accountant is submitting financial statements, the definition of “submission” is important. SSARS no. 8 redefines submission as “presenting to a client or third parties financial statements that the accountant has prepared either manually or through the use of computer software.” Previously, submission was defined as generating financial statements, either manually or by use of computer software or modifying financial statements by changing account classifications, amounts and disclosures.

The new definition is shorter and replaces the word “generated” with “prepared,” eliminating a reference to a more rigid and clerical task. When accountants present financial statements they are not required to generate financial statements. The new definition, then, is broader than previously stated in professional standards.

SSARS no. 8 does not define the term prepared. Rather, accountants must use professional judgment to determine if they have prepared a financial statement. In making this judgment, a CPA has to consider the difference between mere bookkeeping services (such as adjustments, corrections or accruals) and financial statement preparation. To prepare financial statements you must use your knowledge, education and experience to create statements that would not have existed otherwise. In other words, if a client’s bookkeeper competently prepares the client’s financial statements and all you do is slightly modify a couple of items, you probably haven’t prepared the financial statements. On the other hand, if the client gives you an unadjusted trial balance and you make all of the adjustments necessary to convert the information into financial statements, most likely you have prepared those statements.

SSARS no. 1 does not define the term presenting. Again, you need to use professional judgment to determine if you have presented financial statements to a client. Obviously, physically presenting printed statements qualifies. Other situations, especially those involving electronic presentation (via e-mail, for example), should be carefully considered when determining whether SSARS no. 1 applies.

The exhibit on below may help determine if you have submitted financial statements.

The flowchart in appendix A, Compilation of Financial Statements, of amended SSARS no. 1 provides guidance in determining whether (and how) SSARS no. 1 applies. If an accountant submits financial statements not exempted from SSARS no. 1, a compilation report is required if he or she reasonably expects a third party to rely on the statements. Only if the accountant reasonably expects the financial statements will not be used by third parties does he or she have the option of using an engagement letter.

INCREASED FLEXIBILITY

SSARS no. 8 incorporates additional communication options for accountants who submit financial statements not intended for use by third parties, while leaving the service of compiling financial statements for third party users untouched. While this new standard allows the accountant and client more options, some observers believe it doesn’t go far enough. SSARS no. 8 doesn’t create new reporting options for financial statements presented to third parties, nor does it add a new level of service similar to Florida’s assembled financial statements (for details, see “We’ve Seen the Future and It’s Florida,” JofA, Sept.98, page 13).

Although redefining submission of financial statements solves the majority of problems that have plagued accountants for decades, the age-old applicability issue may not have been laid to rest. The new definition hinges on an interpretation of the word “prepared,” a term not clearly defined in the professional standards. ARSC acknowledges that practitioners still need to use their professional judgment when deciding whether SSARS no. 1 applies to a particular situation. One thing appears certain: Although it may not be a panacea for all reporting problems, the new standard does meet a need by increasing flexibility in reporting on the unaudited financial statements of nonpublic companies.

When Financial Statements Are Submitted
Scenario Financial Statements Submitted? Reasoning
1. Using client information, the CPA prepares financial statements in the CPA’s office for use in preparing a corporate income tax return and the financial statements are not given to the client.

No.

The financial statements are not presented to the client and the information contained in a tax return is not considered a financial statement.
2. Same scenario as number 1, except that the accountant gives the client a copy of the financial statements along with the income tax return.

Yes.

The financial statements are prepared by the accountant and presented to the client.
3. Same scenario as number 1, except the accountant gives the client a copy of the adjusting journal entries and trial balance along with the income tax return.

No.

A trial balance is not a financial statement.
4. At a client’s office, the CPA makes material adjustments to the client’s accounting database, prints the adjusted financial statements and takes the financial statements with him or her.

No.

The accountant is providing bookkeeping services but is not “preparing” financial statements. Material modifications no longer constitute a submission of financial statements. In addition, the accountant did not “present” the financial statements to the client.*
5. Same scenario as number 4, except that the CPA also prints a copy of the financial statements and presents them to the client.

No.

The accountant is providing bookkeeping services but is not “preparing” financial statements. Material modifications no longer constitute a submission of financial statements. Although the financial statements were presented to the client, the accountant did not prepare them.*
6. The client sends the CPA a disk containing information from the client’s accounting database. The CPA makes adjustments to the disk and returns it to the client.

No.

The accountant is providing bookkeeping services but is not “preparing” financial statements. Material modifications no longer constitute a submission of financial statements.*
7. The CPA accesses the client’s accounting database by modem and makes material modifications to the database.

No.

The accountant is providing bookkeeping services but is not “preparing” financial statements. Material modifications no longer constitute a submission of financial statements.*
*In each scenario, a certain amount of professional judgment is involved. If you believe that by making material adjustments you have, in fact, prepared financial statements (by using your knowledge, experience and education you have gone beyond providing mere bookkeeping services) and you believe you have presented them to the client or others, you should comply with SSARS no. 1.

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