This article is written by the Chartered Professional Accounting firm of Edelkoort | Smethurst | Schein as our way of explaining some of the technicalities of accounting reports used by small businesses…starting from the basic reports all the way through some of the more complex reporting. And more importantly, explaining the key differences and the occasions when a particular format is required and when it is not. And by the way, yes, our firm does indeed provide the services required to prepare all of these reports. Please read on – we are sure it will all make sense. Also, we are a public accounting firm located in Burlington, Ontario, Canada, and this article is based on regulations in Canada, which may not be applicable to your situation if you are a reader outside of Canada.
Preface – why do small businesses fail? Two of the top five reasons often cited for small business failure are; poor management and lack of financial planning (see footnote 1). This in turn highlights the importance of good accounting reports and financial planning.
Compilations
Let’s start with the basics. Small businesses, and we mean every business from a one person shop, to a +50 person organization, needs to have a means of knowing the dollar value of their assets, such as their bank balance and property, and liabilities such as how much is owed for to suppliers and taxes. This is known as a Statement of Financial Position (also known as the ‘Balance Sheet’). They also need to track their sales to clients, as well as expenses to support their business, such as rent, employee costs and so forth. This is known as Statement of Operation (aka ‘Income Statement’). And finally, and perhaps most importantly, a ‘Statement of Cash Flow’ to explain where the money came from, and where it was spent.
Note – please take good care to track all of this in a format that works best for you – your accountant can suggest some tools for you to use, or if you need help, will figure out a way to get this ‘bookkeeping’ done for you on a monthly or quarterly basis – to keep you on top of the situation.
At the end of the year, all of this good work leads up to an accounting report known as a ‘Compilation’. The term compilation has a specific meaning in the accounting industry, although not well known by those who are not accountants. The specific meaning is as follows – you provide to your accountants all of the accounting data that has been recorded throughout the year, usually all tallied up for the entire year. Your accountant then assembles / compiles the data into the accounting reports mentioned above – Statement of Financial Position, Statement of Operations and Statement of Cash Flow. The compiled accounting reports are stamped with ‘Notice to Reader’ on the top of each report. The meaning of Notice to Reader (NTR for abbreviation) is to bring awareness to the users of these reports that the reports have not been audited. In other words, the paperwork and transactions underlying the ’NTR’ have not been examined. The accountant is relying solely upon the information provided by the business. Essentially there is a report attached to the financial statements stating the accountant has prepared the financial statements based on the information provided by management. Certain aspects of the financial statements will be relatively accurate, enough so that the accountant can comfortably state the financial statements are complete and not false or misleading. This is done mainly by verifying the accuracy of the information provided by management (such as bank reconciliations), and making sure the tax laws are abided by. By way of an analogy, this would be like a home inspector showing up to a house and issuing a report that says… “I can confirm the house has four walls, a roof, windows, doors and appliances. I’m only using the information made available to me and I haven’t done any inspections to verify the quality of the parts of the house”.
Having said that, there is a responsibility on the part of the accountant to ensure that the information is complete and not false or misleading. To meet this hurdle, the accountant will need to review your bank reconciliations and various other reports such as tax balances, and customer accountant balances. CPAs must follow CPA Ontario rules when preparing NTR statements to ensure that they meet the industry standards. In fact, NTRs prepared by our firm are subject to inspection by CPA Ontario – to make sure all the NTR rules have been adhered to.
So, that in a nutshell is a Compilation, or if you prefer – NTR. Nice and tidy accounting reports that a business needs to operate. They are also required to support the filing of income tax, sales tax, and payroll reports. Add on a budget or forecast to benchmark performance, and you have the basic tools to manage the financial affairs of your business. The best way for small businesses to approach this is to hire an accountant to get them on the right path – to explain the various reports required – and to set in motion a plan to have these completed – on time – so as to avoid any costly penalties. Your business will easily recoup any fees paid to an accountant for this advice. Small price to pay for peace of mind.
Review Engagements
Situations might arise where compiled / NTR financial statements just don’t fit the bill. Perhaps you are selling your business. Might be that you are trying to get additional financing from a bank. Could be there are key shareholders not directly involved with the business that need further analysis and assurance. In these situations, a further level of service would be required by the business and this is known as a review engagement.
A review engagement is considered negative assurance, meaning the accountant expresses an opinion that nothing has come to their attention that causes them to believe that the statements are not in accordance with the applicable financial reporting framework. A few items of note. First, unlike a compilation, with a review engagement the accountant is expressing an opinion, in other words providing further assurance – in this case not only are the financial statements assembled correctly (complete and not false / misleading), but that additional analytical work has been performed. Second, one of the biggest factors separating a review engagement from a compilation engagement is the last part of the sentence; “in accordance with the applicable financial reporting framework”. In Canada there are a number of financial reporting frameworks, the most applicable for businesses/organizations we see are Accounting Standards for Private Enterprises (ASPE) and Accounting Standards for Not for Profit Organizations (ASNPO). Accountants provide this level of service by reviewing the accounting policies and procedures, developing an understanding about the internal processes, the business as a whole and the financial reporting environment. From there the accountant can focus their attention on areas that are most susceptible to misstatement, and inquire about certain changes or how amounts were arrived at. Because the accountant isn’t providing positive assurance, the tools used to assess the business/organization are limited to inquiry, analytical procedures and discussions. Coming back to our home inspection analogy, the inspector would ask questions such as when was the roof repaired last, how old is the furnace, has there been any water damage. The inspector would look to the other houses in the neighborhood and compare attributes, new windows or roof on a neighboring house might indicate some significant repairs costs may be needed. Point is the inspector takes a better look around, gets to know the homeowners a little and looks for signs of trouble with the house.
As you can imagine, it takes more time for an accountant to complete the analytical additional work required with a review engagement, and as a result you can expect to pay higher fees as compared to NTRs. However, often it cannot be avoided. As an example, banks usually insist on a review engagement to support sizeable bank loans. Remember, Compiled / NTR financial statements do not offer any type of assurance. The accountant assembles the reports and ensures that they are complete and not false or misleading, but the accountant does not need do any further analytical work as they would in a review engagement.
Audited Financial Statements
The highest level of service is an audit. The purpose of the audit is to provide reasonable assurance that the financial statements are free of material misstatement and that they are prepared in accordance with an accounting frameworks such as Accounting Standards for Private Enterprises (ASPE) and Accounting Standards for Not for Profit Organizations (ASNPO). The auditor examines the prepared financial statements to see if there are any significant (“material”) errors in the statements, and as a result of the examination provides an auditors’ report. Contained in the report is the auditor’s opinion on whether or not the financial statements are presented fairly. It is a common misconception that the auditor examines all of the transactions that comprise the financial statements – this is not the case. The auditor performs the examination on a test basis only and therefore does not provide any guarantees – only reasonable assurance.
Audited financial statements are required in various situations. For instance, all publicly traded entities such as companies listed on a stock exchange in Canada, require annual audits. Charitable and Not for Profit organizations, as well as condominium boards require audits as well. Private corporations whose operations have become complex and have multiple shareholders often require audits. Essentially any organization mandated by regulations, or which have stakeholders who require the most robust level of assurance from an independent audit firm, may require an audit. And, by the way, audits can extend beyond financial statements and can include such areas as internal controls, value for money to name a few.
As mentioned, audits offer the highest level of assurance but do not offer guarantees – only reasonable assurance. Management is responsible for generating the financial statements – the role of the independent auditor is to review these statement and to provide an opinion on them.
An audit employs a number of techniques, tools and tests so that the auditor can deliver an appropriate audit opinion. The auditor can reach a qualified or unqualified opinion; most businesses and organizations seek an unqualified opinion whereby the auditor reports the financial statements are presented fairly in accordance with the applicable financial reporting framework. A qualified opinion is one when the auditor, aside from one aspect of the financial statements, reports that the financial statements are presented fairly. By the way, most often charities and not-for-profit organization see qualified opinions in their audit reports when they collect cash donations. Cash is the most difficult to audit due to lack of controls and paper trail, therefore cannot be properly audited. As a result, a qualified opinion often accompanies these audit reports.
The primary ‘tool’ of the auditor is to examine on a test basis, a sample of transactions, and to extrapolate the findings of the sample to the entire population of transactions. It would not be practical or possible to review all of the transactions. The review of samples is known as ‘substantive testing’, and this is a very time consuming part of any audit. The size of the sample to be reviewed, will also dictate the time and fees associated with completing an audit. The smaller the sample size, the less time to audit. The size of the sample will be influenced by several factors including the internal controls in place within the organization. Strong internal controls will mean the auditor can rely upon the controls within the organization to ensure that transactions are approved and processed in accordance within company policy, which in turn reduces the amount of substantive testing. Clearly a win-win for organizations is to ensure that they have a strong system of internal controls in place – doing so will ensure that their operations are running efficiently and effectively, and that the annual audit is completed quicker. For additional information regarding internal controls, please click here to refer to the companion article on our web-site.
Coming back to our home inspection analogy, in the case of an audit, the inspector would conduct a detailed review several components in the house. For instance – a few water taps and faucets located throughout the house would be randomly selected and reviewed to determine if there are any leaks and the quality of the brand being used. This would provide assurance on the plumbing. Similarly, a sample of roof shingles would be reviewed, as well as the maintenance records of the HVAC system. You get the point – the inspector would physically review a sampling of each major component throughout the house, and provide an overall opinion, in writing, on whether there are any significant issues which would impact the sale price of the house.
In terms of fees, since there is more time required to complete an audit, you can expect higher fees for an audit, as compared to compilations and review engagements.
Summary
We hope you enjoyed reading this article and find it to be useful. It is a very broad overview of the different types of accounting reports and assurance services provided by public accountants. Our firm can provide the full array of services to your organization – from Compilations, Review and Engagements, all the way to Audits. On an annual basis your accountant should review with you the type of reporting appropriate for the business – we can assist with this if you require. Keep in mind that both review engagements and audits must be completed by licensed public accountants. This is a key point – assurance work, such as review engagements and audits, must be done by a CPA firm registered in public practice, AND, bear the title ‘licensed public account’ (LPA). The reason for this pertains to the fact that assurance services are considered ‘public accounting services’, and require additional training and experience. This in turn gives the public confidence that the reports will be prepared by qualified accountants, and adhere to strict standards. This is all laid out in the Ontario Public Accountancy Act of 2004. The firm of Edelkoort, Smethurst and Schein, CPAs, LLP is a firm with the LPA designation, and we can prepare audit and review engagements. Not many small firms can offer this type of service. And, of course we can provide strategies for implementing strong internal controls and financial reporting. Please give us a call – we would be delighted to hear from you. Best wishes!
Footnotes
1) Forbes Magazine – September 2013.