Compilation Engagements – Considerations for Lenders and Investors
I have often said that having bad information is usually worse than having no information at all. Relying on bad information can cause an individual or organization to charge ahead when they should proceed with caution. Over the past decade I have witnessed creditors and investors rely increasingly on tax returns, QuickBooks reports or even stated income to make financial decisions in the small business arena. While it is understandable that the cost of a review or audit can be prohibitive in many small business financing situations, discounting the value a CPA can bring to the table in a compilation engagement is often done so at the peril of the lender or investor. I have seen millions lost as a result of this poor decision.
Although a compilation is far less in scope than a review or an audit engagement, if the compilation is conducted correctly, the procedures employed can uncover errors or omissions that could prevent poor financial decisions on the part of users. As such, I highly encourage lenders and investors to develop an understanding of the standards that apply these engagements, so they can place sufficient weight on the information contained therein.
What is a Compilation Engagement?
In a compilation engagement a CPA helps a company’s management present financial information in the form of financial statements using a comprehensive basis of accounting. Compiling financial statements is not synonymous with preparation, although it is not unusual for a CPA to do both. If the CPA’s involvement with the bookkeeping or accounting becomes too significant, however, their independence will be impaired. This does not prevent the CPA from completing the compilation, but they are required to disclose their lack of independence in the compilation report.
The CPA begins by developing an understanding of the industry in which the client operates, including the accounting principles and practices that are generally used, and the manner in which the financial statements are presented. The CPA is required to obtain a general understanding of the client’s organization, its operating characteristics and the nature of its assets, liabilities, revenues and expenses. She should become familiar with the accounting principles and practices used by the client in measuring, recording, and disclosing all significant accounts and disclosures in the financial statements. This should include any differences between practices and principles employed by the company compared with normal practices employed in the industry.
The CPA is required to read the financial statements and consider whether they are free from obvious material errors, which include mistakes in the preparation of financial statements, arithmetical or clerical errors, mistakes in the application of accounting principles, including inadequate disclosure.
Be Careful with Quickbooks Reports
An Accounting Information System (AIS) is a lot more than software – it also includes the policies and procedures used to record accounting information. QuickBooks and other similar accounting packages provide a cost effective checkbook and document management system for small businesses, but it is not an AIS in and of itself.
The danger here is that using these accounting packages an unsophisticated user can produce something that looks like a financial statement. I would encourage extreme caution in relying on these reports. Although properly implemented accounting software can improve the consistency and reliability of the financial information, the controls in these accounting packages are very weak. Prior to working with QuickBooks I had never seen an accounting system that allowed you to reconcile your checking account without balancing it. There is nothing preventing a user from altering or deleting posted transactions and I regularly find unreported liabilities and overstated assets on the reports my client’s present to me.
As part of the compilation engagement the accountant should become familiar with the procedures being employed to record transactions. Although the compilation engagement is not designed to provide assurance that these problems have been resolved, obvious issues are often uncovered and corrected before compiled financial statements are presented.
Don’t Ignore the Compilation Report
Too often I see bankers and investors flip past the compilation report without giving it a second thought. This is a bad idea. When a CPA compiles financial statements for third party use they are required to issue a compilation report. Our profession is very specific about the format and contents of this report and with good reason.
The compilation report will indicate the basis of accounting, the periods being presented and the scope of management and the CPA’s responsibilities. If the company is electing to omit disclosures, which many small businesses do, the CPA must include a separate paragraph noting the omission and they have to put users on notice that this could impact their conclusions about the financial health of the company. The CPA should indicate if their independence has been impaired and may choose to bring important matters to the attention of users, such as a deviation from standard accounting principles or an uncertainty about the company’s ability to continue as a going concern.
It is very important to consider the basis of accounting used to prepare the financial statements. It is not unusual for a company to be profitable using accrual accounting and have a loss using the tax basis of accounting, or vice versa. Although it is usually less expensive to produce cash or income tax basis financial statements, accrual accounting will produce reports that are a fairer representation of the company’s performance and will improve comparability with other similar companies.
Limitations of a Compilation Engagement
A compilation is not an audit or review. The CPA does not employ procedures designed to provide any assurance on the accuracy of the information. So unlike an audit, the CPA does not perform analytical procedures, assess the risk of misstatement or test controls or accounting records using audit procedures. However, as a result of knowledge gained from prior engagements, inquiries and procedures, or by reading the financial statements, the CPA may become aware that the information supplied by the entity is incorrect, incomplete, or otherwise unsatisfactory. In these situations, the CPA is required to obtain revised statements before issuing her compilation report.
It’s possible that prospective clients may look elsewhere for financing when loans become contingent on the production of accurate financial reports, but a lender should consider carefully whether this is the kind of business they are looking for. Even audited financial statements issued by the world’s top accounting firms frequently have material errors and require restatement. I will leave to your imagination what lies beneath the QuickBooks reports produced by your average small business entrepreneur.
While a compilation provides no level of assurance, it does indicate that the financials have been presented by someone that is trained in the art of accounting. CPA’s in public practice are keenly aware that the survival of their business is dependent on the public’s continued reliance on their good name. Few are willing to be associated with a work product that is subpar.
Benjamin R. Podraza, CPA, MST
January 24, 2013