WHAT ARE FINANCIAL STATEMENTS?
Financial statements are one of the tools a manager or owner can use to understand what is happening in the business. Financial statements help make informed management decisions to increase profitability and better secure the future. Many business owners pay their CPA good money to prepare financial statements, only to shove them in a drawer. All to often, they are not used for the purpose for which they were intended. With this in mind, we are launching a series of articles in an effort to give a useful approach to reading and understanding your financial statements.
WHAT ARE FINANCIAL STATEMENTS
Financial statements are the presentation of an entity's economic resources and obligations, and/or results of operations. They generally consist of the accountant's report, balance sheet, income statement, cash flow statement, footnotes, and supplemental schedules.
If the financial statements are associated with a CPA, there will be a letter in front of the financial statements. This is the accountants' report. As an informed reader of the financial statements the first step is to consider the accountant's level of assurance given in the accountants' report. There are three basic types of accountants' reports and levels of assurance. They are compilation, review or audit.
The accountant's report will also tell you what period of time the financial statements represent and the overall method of accounting used. If the financial statements for a business are prepared using "Generally Accepted Accounting Principles", they are prepared using accrual accounting. If the cash method or some other method is used, it will be disclosed in the accountant's letter. The letter will also disclose if there are significant departures from generally accepted accounting principles, or if parts of the financial information are not provided.
A compilation is the minimum level of service that a CPA can offer. No expression of assurance is expressed in a compilation. A compilation engagement can be thought of as the CPA drafting financial statements in the proper format, based on information provided by management. The CPA should be expected to have gained an understanding of the entity and to have read the statements to ascertain that the financial statements are free of obvious material errors.
Compilation reports are cost effective in situations where a company has minimal financial risk and when third party investors or creditors do not have great exposure. Another popular application for compilations is interim reporting.
VARIATIONS ON COMPILATIONS
Some compilation reports will omit the footnotes required by generally accepted accounting principles. In this case, the accountant's letter will have a paragraph stating that "substantially all of the disclosures" have been omitted.
Sometimes the accountant is not independent with respect to the entity. In this case, the accountant will issue a compilation report with an additional paragraph that acknowledges the lack of independence.
A review is the middle ground between a compilation and an audit. It is commonly used for semi-annual and annual reporting when there are significant financing or bonding considerations.
Like a compilation, a review requires the accountant to rely on information supplied by management. The accountant then performs inquiry and analytical procedures, in order to provide a reasonable basis for expressing limited assurance that there are no material modifications that should be made.
Audits are the highest level of assurance a CPA can give. The objective of an audit is to provide a reasonable basis for expressing an opinion regarding the financial statements taken as a whole.
All public companies are audited. In addition, most companies that have large financing or bonding requirements obtain annual audits. Also, many business owners insist on annual audits, because they value their accounting system and feel an annual audit is part of a good accounting system.
Procedures an accountant will employ during an audit include studying the entity's control structure, assessing control risk, testing of accounting records and obtaining corroborating evidential matter through inspection, observation and confirmation with third parties.
Note that an audit does not "guarantee accuracy", but provides reasonable assurance the financial statements are fairly stated in all material respects. Also note that the auditor does not attempt to detect fraud. It is an unfortunately common misconception that an auditor can be expected to find defalcation. It is always a possibility that an audit will discover fraud, but the procedures are not designed with this in mind.
After patiently assimilating the accountant's report, we are ready to plunge with wild abandon to the balance sheet. In Part 2 of this series we will discuss the the Balance Sheet.