| 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
W hile 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.
|
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
T he 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.
|
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.
| |
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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