The Audit and Its Alternatives
7 Pages
English
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The Audit and Its Alternatives

Downloading requires you to have access to the YouScribe library
Learn all about the services we offer
7 Pages
English

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The Audit and Its AlternativesSUMMER 2007STRIKING A BALANCE BETWEEN ASSURANCE AND COSTEvery year, Clifton Gunderson prepares hundreds of financial statements for organizations of all sizes in manyindustries. These documents are used by creditors, investors, regulators and others to help make importantdecisions based on the organization’s financial position and other aspects of its operations.The reliability and accuracy of financial statements is critically important, so many creditors and other users offinancial statements require that statements be independently audited. Clifton Gunderson also conducts hundredsof these audits each year, providing a professional opinion concerning the reliability of the information infinancial statements prepared by others.IS AN AUDIT REALLY NEEDED?Clients sometimes ask us if a traditional audit is the only way for a CPA firm to provide a third party withassurance as to the reliability of financial statements. Many are surprised to learn that the answer is “no.”An audit is not the solution for everyone. Different users of your financial statements may need different levels ofassurance depending on how they will use the statements. We can provide cost-effective solutions for all of thesesituations. In addition to the traditional annual audit, Clifton Gunderson can provide – • A financial statement review• “Agreed-upon procedures” applied to specified elements of your financial recordsSome organizations have completely ...

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The Audit and Its Alternatives S U M M E R2 0 0 7
STRIKING A BALANCE BETWEEN ASSURANCE AND COST
Every year, Clifton Gunderson prepares hundreds of financial statements for organizations of all sizes in many industries. These documents are used by creditors, investors, regulators and others to help make important decisions based on the organization’s financial position and other aspects of its operations.
The reliability and accuracy of financial statements is critically important, so many creditors and other users of financial statements require that statements be independently audited. Clifton Gunderson also conducts hundreds of these audits each year, providing a professional opinion concerning the reliability of the information in financial statements prepared by others.
IS AN AUDIT REALLY NEEDED?
Clients sometimes ask us if a traditional audit is the only way for a CPA firm to provide a third party with assurance as to the reliability of financial statements. Many are surprised to learn that the answer is “no.” An audit is not the solution for everyone. Different users of your financial statements may need different levels of assurance depending on how they will use the statements. We can provide cost-effective solutions for all of these situations. In addition to the traditional annual audit, Clifton Gunderson can provide – • Afinancial statement review • “Agreed-uponprocedures” applied to specified elements of your financial records Some organizations have completely replaced the annual audit with a financial statement review or additional agreed-upon procedures. The key consideration is that you provide the users of your financial statements with the level of assurance they need to be confident in the reliability of the information. Let’s look at the differences between an audit, a review and agreed-upon procedures. This may help you decide which level of assurance best fits your organization and the users of your financial statements.
WHAT LEVEL OF ASSURANCE DO I NEED? Third parties, like creditors, investors and regulators, need a degree of comfort that the financial statements they use to make decisions about your organization are reliable, transparent, and a fair representation of your operations, financial condition and cash flows. They may need to feel certain that— • Yourorganization will collect the entire amount reported as “accounts receivable” on the balance sheet. • Reportedrevenue includes only those sales made during the specified accounting period. • Theamount reported as “cash flows from operations” is an accurate presentation of the cash the organization received from normal business activities. • Thenotes to the financial statements include all disclosures necessary to keep the financial statements from being misleading. Each of our three alternatives offers processes and procedures that address these concerns individually and as a whole.
The Audit An audit of your financial statement provides the highest level of assurance possible to third party users. Current auditing standards require auditors to – “…plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.” As it relates to auditing standards, the term “reasonable assurance” means a high level of assurance (though not absolute assurance). If you read an auditor’s report, you will see that it concludes with the auditor providing an opinion on the financial statements. These opinions typically read – “In our opinion, the financial statements present fairly…the financial position of the entity as of year-end, and the results of its operations and its cash flows…” By performing an audit, we are able to provide financial statement users with a positive statement (“in our opinion”) about whether the financial statements are fairly presented. The Financial Statement Review
A review of your financial statements would be similar to an audit. The service encompasses the entire financial statements, and provides financial statement users with some level of assurance about the fairness of these statements.
Unlike an audit, a review provides only limited assurance. In fact, a standard review report will state that “[a review] is substantially less in scope than an audit.”
Where an audit results in an auditor making a positive statement of assurance, the limited scope of a review allows the CPA to express only negative assurance. This is presented in the review report in a statement such as –
“Based on our review, we are not aware of any material modifications that should be made to the financial statements…”
You will notice that the phrase “we are not aware of any material modifications” is a more passive, indirect statement when compared to the direct opinion expressed in an audit report.
Agreed-Upon Procedures
Agreed-upon procedures are much different than both an audit and a review.
First of all, an audit or review covers an entire set of financial statements. Agreed-upon procedures are much narrower in scope, usually focusing on an isolated part of your accounting records. For example, agreed-upon procedures can be performed just on accounts receivables or just on inventory balances.
Another difference is that an audit or review results in the CPA expressing some level of assurance. An agreed-upon procedures report does not provide any assurance. Instead it is presented as a report of the procedures performed and the CPA’s findings. Users of this information must then draw their own conclusions about what the findings mean.
Financial statements that have been audited or reviewed are suitable for a general audience and therefore can be distributed widely, without restriction. Agreed-upon procedures reports should be used only by the parties who have agreed that the procedures are suitable for their purposes. Distribution of an agreed-upon procedures report is restricted to these parties.
HOW DO I EVALUATE THE DIFFERENT TYPES OF ENGAGEMENTS?
Because the three types of engagements provide different levels of assurance, the scope of these engagements and the nature of the procedures vary dramatically. These differences can have a large impact on the amount of work the CPA is required to perform and the cost of the engagement.
SCOPE OF THE ENGAGEMENT Professional requirements in two areas have a significant impact on the scope of an engagement– • Understandingthe organization, its industry, business strategies and competition • Evaluatinginternal control The Audit As we said earlier, an audit provides third parties with the highest level of assurance, but not absolute assurance. Providing absolute assurance would be too costly, since the auditor would have to examine every transaction and every journal entry made during the year. The audit team would have to understand your operations well-enough to actually run the business. Determining which procedures to perform requires an auditor to exercise a great deal of judgment. These judgments are based on an assessment of the risk that your financial statements could be materially misstated. A risk assessment must be performed to determine what might cause an error in your accounting system or in the preparation of your financial statements. An auditor is also required to have a reasonable basis for his or her risk assessments. This comes from the auditor’s understanding of your operation. Professional auditing standards require an auditor to obtain – • Anoverall understanding that spans many aspects of your operations and management activities • Anin-depth understanding of each of these areas Auditing standards also recognize that your internal controls will have a significant bearing on the risk of an accounting error going undetected. As a result, an auditor must evaluate the design of your accounting system and the related controls that management has put into place. To make this evaluation, an auditor must perform a significant array of procedures. Simply making inquiries of your personnel is not enough. An auditor must supplement these inquiries with other procedures such as reading documentation, observing operations, or testing controls. An auditor should perform these same procedures every year to update his or her understanding and evaluation of internal control. The Financial Statement Review Since a financial statement review provides only limited assurance about your financial statements than an audit, the requirements are much less stringent than for an audit. For review engagements, the CPA’s understanding of your business should include a general understanding of your organization, its operating characteristics, and the nature of its assets, liabilities, revenues, and expenses. This typically involves a general knowledge of your production, distribution, and compensation methods, types of products and services, operating locations, and material transactions with related parties. Review standards go on to say that this “general” understanding and knowledge typically can be obtained through the CPA’s experience and through inquiries of personnel. In other words, the CPA’s breadth and depth of understanding about the entity is significantly less for a review than for an audit.
A CPA performing a review is also not required to evaluate or otherwise obtain an understanding of your accounting system or related internal control.
Agreed-Upon Procedures
When performing agreed-upon procedures, a CPA performs only the procedures that have been agreed to by the third party users of the information. The CPA should have adequate knowledge of the specifically defined subject matter of the engagement, but is not required to have expansive knowledge of the entity or its internal control.
If a CPA were engaged to perform agreed-upon procedures relating to accounts receivable balances and related accounting records, he or she would only have to be knowledgeable about those records and the nature of the transactions that affect receivables. He or she would not have to be knowledgeable about other aspects of your business, such as payroll, or internal control.
THE NATURE OF THE CPA’S PROCEDURES
A CPA might perform many procedures to gather evidence about whether your financial statements or accounting records are accurate. Each of these procedures provides a different degree of reliability. For example, physically observing and counting inventory held at year-end is a more reliable source of evidence than other types of procedures.
Since an audit is performed to provide a high level of assurance about the financial statements, a CPA will perform a number of procedures that are designed to produce highly reliable evidence. These procedures include obtaining confirmations from customers, banks, and lenders; comparing individual transactions to underlying supporting detail; or inspecting physical assets.
When performing a review, the CPA’s procedures consist mainly of an analysis of financial and non-financial information and inquires of management. These procedures result in reliability that is consistent with the limited level of assurance being provided.
In an agreed-upon procedures engagement, the CPA does not choose the procedures to be performed. Instead, the third party user of the financial information must decide which procedures are best suited for its purpose. Those procedures may be as extensive or as limited as the outside party user determines.
ANALYZING THE COST-BENEFITS OF ASSURANCE SERVICES
When choosing which type of assurance service (or combination of services) is right for your organization, you should avoid generalizations about which type of service is “the best.” Instead, users of financial statements must determine – • Whatlevel of assurance they are comfortable with • Whetherit makes sense to accept a lower level of assurance to reduce costs The key to choosing the appropriate assurance service is to match the level of assurance provided with the needs of the financial statement user. In some cases, financial statement users may want a high level of assurance about your entire organization that a CPA provides by performing an audit. However, in other cases, a user may not need such a high level of assurance. Here are three scenarios to illustrate the cost-benefit analysis. Note how determining the appropriate level of assurance depends on the needs of the financial statement user, and not the needs of the organization.
Scenario One ABC Company is a privately-held, family-owned and operated manufacturing company that has been in business for 40 years. The company has an unsecured revolving line-of-credit with a bank that it has been doing business with since its inception. ABC has been highly profitable for the past few years and easily meets its debt covenants. Management of the company is stable and experienced, and the industry in which it operates is relatively stable. In this scenario, the bank is the primary financial statement user. Periodically, it will have to make decisions about whether to renew the line of credit and at what terms. The bank uses ABC’s financial statements to help make these decisions, and it will need some assurance as to the reliability of the statements. The degree of assurance the bank will require should be commensurate with its risk. In this case, the bank has other information about the company that it can partially rely on to assess that risk, including – • Pastexperience with the company • Ahigh level of profitability • Knowledgeof and confidence in the company’s management team • Therelative stability of the company and the industry in which it operates Given these circumstances, the bank may determine that the risks it faces with regard to ABC’s line of credit are less than the risks it faces with other organizations, so it may not require ABC to submit audited financial statements every year. Instead, the bank’s needs could be served by a financial statement review. Scenario Two If scenario one is changed slightly, the bank could reach a different conclusion. Suppose that the bank had little or no experience in working with ABC. Or, suppose that ABC operates in a relatively dynamic industry, the company itself is expanding and changing, and it has come close to violating some of its debt covenants. Under these circumstances, the bank is much more exposed to risk, and it would be ill-advised to loosen its requirement for an annual audit. Because of all the unknowns about the borrower, the bank will place a great deal of reliance on the accuracy of the financial statements. The bank will need the highest level of assurance as to the fairness of the statements. Scenario Three Assume the same facts as scenario one except the line of credit is larger and secured by ABC’s inventory. In this case, the bank’s risk is narrowly focused on the valuation of the company’s inventory. Although it will want to monitor the overall health of the company, it will be most concerned about the value of its collateral.
Under these circumstances, the bank may agree to an annual financial statement review, supplemented by an agreed-upon procedures directed at ABC’s inventory. Obtaining a full set of financial statements is important, because these will help the bank monitor the overall condition of ABC. For this purpose, having the financial statements reviewed will provide some assurance as to their reliability.
Agreed-upon procedures will allow the bank to establish the reliability of the information about inventory. In some ways, the agreed-upon procedures relating to inventory may be more helpful to the bank than a complete set of audited financial statements. For example, the bank may request the CPA to physically count inventory every quarter, rather than the once-a-year count normally performed for an audit.
CHALLENGING THE COVENTIONAL WISDOM
The annual financial statement audit is not going away any time soon. In many cases, an audit provides a crucial service to creditors, investors, regulators and other third party financial statement users who need a high level of assurance from an independent party. Many financial statement users may automatically assume that they need the highest level of assurance possible. But the high level of assurance provided by an audit may not always be warranted.
Recent changes to the auditing standards require auditors to perform more extensive and costly procedures than they have in the past. As the cost of obtaining a high quality audit increases, organizations should talk to the users of their financial statements and challenge the conventional wisdom to see whether a lower cost alternative to the audit would be more suited to their situation.
A SUMMARY OF THREE DIFFERENT ASSURANCE SERVICES Audit ReviewAgreed-Upon Procedures Level of Assurance and Reporting Level of assuranceHigh, DirectModerate, IndirectLimited to procedures performed Subject matter of reportFinancial StatementsFinancial StatementsSpecific subject matter Opinion – “the financialNegative assurance –Report of Nature of assurancestatements present“Nothing came to ourprocedures performed fairly...” attentionto indicate...”and findings Distribution of reportNo restrictionNo restrictionRestricted Required Procedures Understanding In-depthunderstanding Generalunderstanding Generalunderstanding of the entityof a broad rangeof a narrower rangeof the subject matter of mattersof mattersof the report
Internal control
Nature of procedures Procedures
Relative cost
Evaluation of internal control design required
Extensive, highly reliable
Most expensive
No requirements
Primarily analytical procedures and inquiries
Less expensive than an audit
No requirements
Defined by user – may be extensive or limited
Varies, but typically much less than an audit