Chapter 8
What the accountant’s report tells you

All financial statements prepared by outside independent accounting firms must contain an accountant’s report. This generally one-page report contains standardized wording mandated by the accounting profession’s regulatory body. That’s why they say “in accordance with standards . . . issued by the American Institute of CPAs.” It is designed to let any reader know what the accountant did and did not do to prepare the report. The monthly or quarterly reports prepared by your internal accountant are not required to have an accountant’s report.

Why is the accountant’s report important? Bankers and other lenders know that each time an accountant places his name on a report, his reputation is on the line. An accounting firm would not remain in business long if it gained a reputation of helping management play fast and loose with the numbers. More immediately, the firm would fail its periodic reviews and lose its license to practice.

While you certainly would never do such a thing, on occasion a company’s management, under pressure from lenders and investors to perform well, takes steps to ensure the company shows a profit when, in fact, it lost money.

An outside accountant’s job is to make sure that your accounting practices are appropriate and that various estimates follow sound judgment — even if the bottom line is not good. Bankers, lenders and regulators rely on your choice of a reputable accounting firm to help ensure that you follow the rules. It’s far too easy for the internal accountant to do what the boss wishes instead of what may be right.

Three types of accounting reports are common — the compilation, the review and the audit. Almost everyone thinks accountants perform audits, but for many small companies they only perform compilations or reviews. Reviews and compilations give companies lower-cost alternatives to the expensive auditing report process.

A compilation report means that the accountant compiled, or pulled together, numbers from your accounting system into a set of financial statements. This involves very little detailed testing or systems review work compared with reviews or audits. A compilation assignment (often called an engagement by your accounting firm) for a small trucking company might take 25 to 50 man-hours to complete. Reviews involve more procedures and might take 100 man-hours. Audits involve even more procedures and might take 200 man-hours or more.

Compilations can be quite extensive or quite simple, depending on the level of sophistication of your accounting team and software. Each company establishes the level of detail in its contract with the accounting firm, and the bank often mandates the level of detail.

In general, however, the accountant does very little verification of the numbers beyond checking to see that you have followed basic accounting principles. The outside accountant wants to ensure that you have:

• reconciled bank accounts;
• written off accounts receivable bad debts;
• reasonably computed and reconciled fixed-asset depreciation records;
• adjusted loan accounts to agree with bank billings; and
• scanned the P&L accounts for potential errors.

The accountant’s responsibility in a compilation is to read your reports and question you if anything unusual pops up. The accountant seems to take very little responsibility for the ultimate accuracy of the financial statements in the report. In fact, he pointedly says it is not audited or reviewed, to alert the reader to the limited level of his involvement.

A review report means that the accountant performed a more detailed examination of your statements and your accounting policies than in a compilation, but less than in an audit. Lenders (or silent investors) often require a review to achieve a greater comfort level than a compilation provides.

In addition to the procedures performed for a compilation, the outside accountant places your numbers in a multi-year computer analysis program or spreadsheet and evaluates changes from year-to-year. He computes certain financial ratios and evaluates these and their trends over time. Lastly, he or one of his staff spend a lot of time asking questions about your accounting policies and practices. The accountant is trying to compare your basic practices with those expected of all companies. He points out anything you aren’t doing but should, and adjusts numbers, if necessary.

The objective in the review report is to give “negative assurance” — to state that the accountant found nothing wrong with the statements.

A sample review report is shown on the right.

An audit report means that the accountant subjected the company’s records and accounting practices to a very thorough examination. In addition to all of the procedures for a compilation and a review, an audit includes additional procedures, such as direct verification of selected numbers through independent contact with vendors and customers. For other transactions, the accounting firm pulls a sample of the detail behind transactions — almost as if an IRS audit were taking place.

In a compilation, if you tell the accountant that the accounts receivable is $350,000, he probably will accept that and move on.
He might just check to see that you have a listing of customer balances that adds up to that total. In a review, he compares the number in several ways with other numbers in your report, perhaps computing ratios such as the average age of the accounts
. He also questions your accounting practices in this and many other areas. In an audit examination, the accountant not only does all the above, he actually writes many of your customers and asks them to confirm that they really owe as much as you say. If there are discrepancies, he will want a good explanation.

Lenders usually require audits when the loan amount tops $5 million. Because the lender has so much to lose, its interest in the accuracy of your financial numbers is especially high.

But audits have their limitations. The outside accountant selects only a small sample of transactions for verification. To verify each transaction would simply be too costly. Determined dishonest management can hide much from auditors. It’s fraud, of course, to do so, but occasionally you read how outside accountants fail to catch it. Even with the expression of an opinion regarding the fairness of presentation, the accountant’s report discusses the limitations of the audit process.
A sample audit report is shown on the left.

One last point: Audits are not findings that the company is financially sound. You can post an enormous loss and still get a clean audit opinion. The auditors are simply saying that we looked at everything, and, indeed, you had one big loss!

In Summary
When reading financial statements, it’s important to know what type of work the accounting firm did in helping prepare the reports. The three basic types of reports are compilations, reviews and audit examinations. Each involves more work than the previous.