A quality review checklist; five simple steps to a more successful review.

In 1985, our small firm in Boulder, Colorado, had its first peer review. The lessons we learned in the review improved our procedures and changed how we practiced.

That experience led me to become a peer reviwer. In this work, I have found most firms could improve efficiency and services through five simple steps that also are key to a successful review. This article explains each step and why firms now preparing to undergo quality review will find it worthwhile to take them.

ARRANGE FOR A

CONSULTING REVIEW

The most important preparatory step a firm can take is to get a consulting review--a confidential, high-spot review of quality control procedures and selected engagements that takes place before the official review. Consulting reviews performed by the American Institute of CPAs cost $500 plus expenses. Firms that join the AICPA private companies practice section can deduct one-half of the membership fee from the subsequent review fee. The consultation is confidential and very helpful in revealing, before the review, problems a firm might encounter in it. If our firm had had the consultation beforehand, we would have been better prepared and received fewer comments. This is true also of the firms I've reviewed.

USE THE GUIDES TO COMPILATION,

REVIEW AND AUDIT

Our firm adopted one of the available guides. While we made several modifications to the checklists and work programs it contained, it provided a starting point. Although many firms develop more than adequate guides internally, it is frequently difficult and expensive to keep them current. We found that ours were sadly out of date much of the time.

AVOID DISCLOSURE DEFICIENCIES

My experience as a reviewer has made me aware of some common disclosure deficiencies on client financial statements. It is interesting to note that most, if not all, are associated not with areas that are particularly complex but, rather, with simple oversights that often could have been avoided by using disclosure checklists. Typically, the disclosure inadequacies fall into one of five areas:

1. Accounting policy disclosures. The accounting policy note frequently fails to include all the required disclosures. These can include inadequacies in depreciation disclosure, basis for valuation of inventories and revenue recognition methods.

For depreciation, one must disclose the cost of the major classes of depreciable assets, accumulated depreciation in total or by class and the methods used. The amount of depreciation recognized in the period also must be disclosed. Although it is not required, disclosure of the average useful life or range of years of useful life by class of depreciable assets is a good idea.

In inventory, it's important to disclose the flow of cost assumption, such as first-in, first-out, and the valuation base, such as lower of cost or market. One firm wrote in the accounting policy note of a client's financial statement that the inventory was valued at cost. Thinking this was perhaps a departure from generally accepted accounting principles, I asked the engagement partner about it. We found the inventory was stated at the lower of cost or market, so the note was simply incorrect.

The method of recognizing income must be disclosed, particularly for long-term contracts, real estate transactions and lease arrangements. Since these methods are unusual and complex, appropriate disclosures must be provided.

2. Debt disclosures. The disclosures most often missed here include the nature of the debt, maturities, collateral, guarantees and interest rates on long-term debt. Maturities should be disclosed in the aggregate and for each of the next five years.

Contingency disclosures also are too often missed. When a loss contingency exists that is probable or estimable but not both, the nature of the contingency and an estimate of the loss generally must be disclosed. A loss contingency hat is estimable but not probable should be disclosed if the probability of a loss is reasonably possible. (See Financial Accounting Standards Board Statement no. 5, Accountingfor Contingencies, for guidance.)

3. Related-party disclosures. Since many CPAs work with small and medium-sized businesses, they often find transactions between the owners and the business that must be disclosed, such as rental of facilities when the owner is alos the landlord and borrowings from the business.

4. Pension disclosures. In contrast to the minimal disclosures required by Accounting Principles Board Opinion no. 8, Accounting for the Cost of Pension Plans, FASB Statement no. 87, Employers' Accounty for Pensions, mandates expanded disclosures. There must still be disclosure of the groups covered. In addition, the type of assets held in the plan, the funding policy and the components of pension expense must be disclosed. There also must be a reconciliation of the plan's funded status with the amounts reported on the employer's balance sheet. Checklists should comply with the new requirements.

5. Income tax disclosures. Disclosure of the amounts and expiration dates of net operating loss carryforwards and other large unusual deductions or credits occasionally are absent from the reports. The reasons for significant variations in the customary relationships between income tax expense and pretax accounting income also must be disclosed. Similarly, the nature of significant differences between pretax accounting income and taxable income must be disclosed.

When FASB Statement no. 96, Accounting for Income Taxes, goes into effect, further disclosures will be required.

Most if not all of the disclosure deficiencies cited would have been prevented through the use of disclosure checklists. In each instance, the firm either wasn't using a checklist at all or was using one that was out of date.

ENSURE COMPLIANCE WITH SSARSs

In compilations and reviews, many firms had not incorporated the requirements of the AICPA statements on standards of accounting and review service (SSARSs) into their work programs. Our firm had a problem with documentation, as has every firm I've reviewed. Documentation in workpapers is one critical area in a review. For example, SSARS no. 1, Compilation and Review of Financial Statements, suggests the need for documentation of the understanding of the engagement with a compilation or review client. An engagement letter serves that purpose. In addition, SSARS no. 1 requires a CPA performing a review to make inquiries about meetings of stockholders and directors, subsequent events, unusual matters discovered during the review and other matters. One way to ensure all these steps are taken is to use work programs to document these inquiries. When a firm lacks documentation, the reviewer must judge whether the proper inquiries were made.

SSARS no. 1, paragraphs 24 and 27, requires performance of analytical procedures in a review engagement. Too often, compliance with this requirement is not documented or is performed superficially. The analytical procedures performed on an engagement depend to a great extent on conditions. The decision about what analytical procedures to use should be made by a manager or partner. I often find that, as a substitute, reviewed firms conduct a number of audit procedures in the belief that standard audit procedures fulfill the analytical review requirement. This approach has many pitfalls, including the chance the firm will be responsible for doing an audit when a full audit has not been performed.

REVIEW KWORKPAPERS

FOR COMPLETENESS

Many problems in reviews involve lack of documentation that can be helped by using oneof the guides to compilation, review and audit. For instance, one technical accounting problem is lack of documentation regarding the need for compensated absence liabilities. Also, tax lives can be used in the depreciation calculation for both tax and book urposes. the materiality of the difference between economic lfie depreciation and tax depreciation must be documented.

Common planning and systems-related documentation deficiencies are

1. Preliminary judgments about materiality levels are not indicated. (See Statement on Auditing Standards no. 47, Audit Risk and Materiality in Conducting an Audit, for guidance.

2. Anticipated reliance on internal controls is not shown.

3. There is no documentation that consideration was given to the entity's control environment, accounting system and control procedures.

4. A summary of the CPA's evaluation of the internal control and its effect on the audit procedures is not included.

While most audit engagements are done well, they could be done more efficently. Corrections of the inadequacies discussed above will lead to reductions in the other audit procedures and, therefore, to a more efficient audit.

CPAs are taught to perform audits in a certain manner and their habits often are difficlt to change. Many of the audit advances in the past few years have introduced more efficient approaches. These advances are, however, sometimes expressed in terms that are new and therefore possibly difficult to grasp. For instance, the auditor's assessment of inherent risk and control risk is new language, not a new audit consideration. This is compounded by a lack of intermediate and advanced continuing professional education courses appropriate for partner-level practitioners.

RENEWED CONFIDENCE

Our review certainly helped our firm. We were initially reluctant to adopt checklists, work programs and concurring review, but our hesitation was based on habit. Our problems weren't attributable to a lack of knowledge but, rather, to failure to implement the necessary procedures. These procedures ensure that the appropriate steps are performed on compilation and review engagements and that the proper disclosures are made.

Our review also gave us more confidence in ourselves and our firm. When we met with prospective clients, we didn't hesitate to mention that we, too, had been audited. Our renewed confidence, combined with our determination to market our success, led to more referrals. Our review gave us a significant return on our investment.

R. K. McCABE, CPA, DBA, a professor of accounting at California State University-Fullerton, is a former member of the Colorado Society of CPAs quality review board and was chairman of the board's peer review committee. He is a quality review consultant at Clifton, Gunderson & Co. and a former partner of McCabe & Associates.