Reviews of financial statements - SAS 71 vs. SSARSs.

Deciding when to apply SAS no. 71 and SSARSs can be difficult.

In May 1992, the American Institute of CPAs auditing standards board issued Statement on Auditing Standards no. 71, Interim Financial Information, to provide accountants with guidance on conducting a review of interim financial information, typically that of a public entity. Statements on standards for accounting and review services (SSARSs) also provide guidance on performing and reporting on a review. How do these standards differ?

APPLICABILITY

There are three major differences in the applicability of a SAS no. 71 and a SSARS review.

* Interim financial statements or information vs. annual financial statements.

* Financial statements vs. financial information.

* Public vs. nonpublic entities.

Interim vs. annual. SSARSs apply to both annual and interim financial statements, although they do not address issues unique to interim statements. SAS no. 71 applies only to interim financial statements or information, which includes financial statements or information for less than a full year or for a 12-month period ending on a date other than an entity's normal yearend. The disclosures necessary for interim financial information to be presented in accordance with the minimum disclosure requirements of Accounting Principles Board Opinion no. 28, Interim Financial Reporting, are considerably less extensive than those for annual financial statements that present financial position, results of operations and cash flows in conformity with generally accepted accounting principles.

Statements vs. information. An accountant may perform a SSARS review only on a financial statement (for example, a balance sheet) or a set of financial statements (for example, a balance sheet, income statement and statement of cash flows). Under SAS no. 71, an accountant may review interim financial information or financial statements. SAS no. 71 and its predecessor SASs permit reviews of interim financial information because the Securities and Exchange Commission requires certain public companies to include in their annual reports selected quarterly financial data that typically are not in financial statement form. Both the SEC and SAS no. 71 require the information to be reviewed unless it is marked to indicate it has not been.

Public vs. nonpublic. SSARSs provide guidance for the review of a nonpublic entity's financial statements. A nonpublic entity is any entity other than (1) one whose securities trade in a public market either on a stock exchange (domestic or foreign) or in the over-the-counter market, including securities quoted only locally or regionally, (2) one that makes a filing with a regulatory agency in preparation for the sale of any class of its securities in a public market or (3) a subsidiary, corporate joint venture or other entity controlled by an entity covered by (1) or (2). SAS no. 71 applies primarily to presentations of interim financial information by public entities (as did its predecessor, SAS no. 36, Review of Interim Financial Information, issued in April 1981).

When a public or nonpublic entity includes interim financial information in a note to audited financial statements, either the accountant should conduct a SAS no. 71 review of that interim information or the note should say a review has not been performed. In other words, SAS no. 71 applies, not the SSARSs. However, if a nonpublic entity goes public and a SSARS review of the entity's quarterly financial statements already has been performed, the accountant need not also perform a SAS no. 71 review of those statements.

Do SSARSs apply to a review of a public entity's financial statements? The answer is yes. A public entity that does not have its annual financial statements audited may engage an accountant to review its annual or interim financial statements in accordance with the SSARSs as stated in note 4 of SAS no. 26, Association With Financial Statements, and SSARS no. 7, Omnibus Statement on Standards for Accounting and Review Services - 1992.

A number of states have securities laws permitting public companies to raise a limited amount of capital without submitting audited financial statements to the state regulatory agency. For example, the Arizona Securities Act allows corporations that are not SEC reporting companies to raise up to $500,000 from the public every 12 months by filing Form U-7, Small Corporate Offering Registration Form. The act permits companies to submit with form U-7 financial statements that have been reviewed in accordance with the SSARSs.

At the federal level, regulation A of the Securities Act of 1933 exempts certain offerings from the act's registration requirements when the amount that will be received from the sale of securities during a 12-month period does not exceed $5 million. Exempt entities are not required to have their financial statements audited and many of them choose to have financial statements reviewed under SSARSs. Although many state regulatory agencies and the SEC permit qualifying entities to forgo an audit and auditing standards do not prohibit these public companies from having a SSARS review, practitioners should consider whether a review level of service will meet client and user needs - significant risk is involved in initial public offerings of securities, even small offerings.

KNOWLEDGE BASE REQUIREMENTS

SAS no. 71 requires the accountant to gain sufficient knowledge of the entity's internal control structure (control environment, accounting system and control procedures), as it relates to the preparation of both annual financial statements and interim financial information, to perform a review of interim financial information. The accountant needs sufficient knowledge of the control structure to do the following:

* Identify potential material misstatements in the interim financial information and then consider the likelihood of their occurrence.

* Select the inquiries and analytical procedures that will provide the basis for reporting whether material modifications should be made for such information to conform with GAAP.

The accountant usually obtains the required knowledge by auditing the entity's most recent annual financial statements. If the accountant has not audited those statements and was engaged,to perform an interim review, he or she still must obtain the required knowledge to design effective review procedures. Although the SSARSs require the accountant to possess a level of knowledge of the accounting principles and practices of the industry in which the entity operates and an understanding of the entity's business, a SSARS review does not require obtaining an understanding of the internal control structure.

Some accountants believe the knowledge of the client's accounting practices required to perform a SSARS review is similar to the knowledge of the internal control structure required for a SAS no. 71 review. Others believe these knowledge requirements clearly are different since the SSARSs do not require knowledge of the control environment or control procedures. They also contend SAS no. 71 requires more detailed knowledge of the accounting system than a SSARS review does. We believe the SAS no. 71 knowledge requirements are clearly different from those of the SSARSs.

COMMUNICATION REQUIREMENTS

In performing a SSARS review, the accountant should establish an understanding with the client that the accountant will inform the appropriate level of management of any material errors that come to his or her attention and any irregularities or illegal acts, unless they are clearly inconsequential. Communication responsibilities for detected errors, irregularities and illegal acts under SAS no. 71 are similar to those of the SSARSs but SAS no. 71 requires the accountant to assure himself or herself the audit committee is adequately informed about such items.

SAS no. 71, however, sets communication responsibilities for other matters. In performing a SAS no. 71 review of interim financial information, the accountant may become aware of matters relating to the internal control structure that may be of interest to the audit committee. Such matters are referred to as reportable conditions. Specifically, these are matters coming to the accountant's attention that, in his or her judgment, should be communicated because they represent significant deficiencies in the design or operation of the internal control structure and could adversely affect the organization's ability to record, process, summarize and report financial data consistent with management's assertions in the interim financial information.

In many circumstances, this requirement merely accelerates the communication of a reportable condition since such conditions probably would come to the accountant's attention in performing the yearend audit. SAS no. 60, Communication of Internal Control Structure Related Matters Noted in an Audit, says the auditor also should consider matters coming to his or her attention relating to the reporting of interim financial information outside the entity in the communication required by that SAS.

In performing a SAS no. 71 review, the accountant also needs to consider whether any of the matters discussed in SAS no. 61, Communication With Audit Committees, as they relate to the interim financial information, should be communicated to the audit committee. The communications required by SAS no. 61 apply to entities that either have an audit committee or have otherwise formally designated oversight of the financial reporting process to an equivalent group (such as a finance committee or budget committee) and to all SEC engagements. The accountant should, for instance, determine the audit committee is adequately informed about a change in a significant accounting policy affecting the interim financial information or of any significant adjustments to the information.

When SAS no. 66, Communication of Matters About Interim Financial Information Filed or to Be Filed With Specified Regulatory Agencies - An Amendment to SAS No. 36, "Review of Interim Financial Information," was issued, the title of SAS no. 36 was changed (to Review of or Performing Procedures on Interim Financial Information) to alert accountants they may have certain additional responsibilities even when those procedures are less in scope than a review. Thus, SAS no. 71 was titled Interim Financial Information to indicate the broader nature of the services covered. The requirements of SAS no. 66 have been included in SAS no. 71 and are described in detail below.

The guidance in SAS no. 71 requiring certain communications, as described in step 11 of the review engagement checklist (see the exhibit on page 66), applies only under the following circumstances:

* The accountant is the auditor of record (the accountant's report accompanied an entity's most recent annual financial statements filed with a specified regulatory agency or the accountant has been engaged to audit an entity's annual financial statements for the current period as stated in a document filed by the entity with a specified regulatory agency).

* The accountant is engaged to either (1) assist the entity in preparing its interim financial information or (2) perform any of the procedures described in steps 4 through 9 of the review engagement checklist (see exhibit) on interim financial information other than merely reading the information.

If the accountant, as a result of performing the services described in the second bullet point above, becomes aware of matters causing him or her to believe interim financial information that has been filed or is to be filed with a specified regulatory agency is probably materially misstated, he or she has certain obligations to discuss the matters with the appropriate level of management as soon as practicable.

If in the accountant's judgment management does not respond appropriately within a reasonable period of time, he or she should inform the audit committee of the matter as soon as practicable. If in the accountant's judgment the audit committee does not respond appropriately within a reasonable period of time, he or she should evaluate whether to

* Resign from the engagement related to the interim financial information.

* Remain the entity's auditor or stand for reelection to audit the entity's financial statements.

REPORTING REQUIREMENTS

Is the accountant required to report? An accountant need not report on a SAS no. 71 review of a public company's stand-alone interim financial information unless the client has engaged the accountant to do so. In contrast, whenever an accountant has reviewed financial statements under the SSARSs, he or she must report on those statements.

As stated previously, interim financial information sometimes is included in a note to audited financial statements. When it is, SAS no. 71 requires the accountant to perform a review unless the information is marked to indicate a review has not been performed. Some accountants incorrectly interpret SAS no. 71 as requiring the review report to be attached or to be added to an audit report under the circumstance described above. However, the accountant should be silent in the audit report about the review unless the interim financial information

* Does not appear to be presented in conformity with GAAP.

* Has not been reviewed and does not contain an indication to that effect.

* Is not presented as required by item 302(a) of SEC regulation S-K.

The SSARSs do not set any requirements for a review's timeliness. Similarly, neither the SEC nor SAS no. 71 requires timely review of interim financial information. However, most publicly traded entities are required to file with the SEC on form 10-Q quarterly interim financial information within 45 days of the end of the quarter; there is no requirement a review report is to be included. If there is an indication such a review was made, the review report should be included.

The SEC requires most public entities to include selected quarterly financial data in their annual reports filed with the SEC. Both the SEC and SAS no. 71 specify that when a public entity includes interim financial information in its audited financial statements or in a document including those financial statements, a review - timely or otherwise - must be performed.

How do the SAS no. 71 and the SSARS review reports differ? SSARS no. 7 revises the SSARS review (and compilation) report(s) to clarify the standards referred to in those reports are SSARSs. In contrast, the SAS no. 71 review report contains a more generic reference to "standards established by the AICPA." The standards differentiate the review services since the SAS no. 71 review performance standards are more stringent than those for a SSARS review.

As required by the SSARSs, the accountant's review report must indicate the financial statements are the "representation of management." Similarly, SAS no. 71 amended the SAS no. 36 review report to include a statement that management is responsible for the interim financial data.

SIGNIFICANT DIFFERENCES

A SSARS review and a SAS no. 71 review have several significant differences. The SSARSs and SAS no. 71, by clarifying authoritative guidance, should make it clear when each standard applies.

EXECUTIVE SUMMARY

* BOTH STATEMENT ON Auditing Standards no. 71 and statements on standards for accounting and review services (SSARSs) provide guidance on conducting a review of financial information. The authors believe, however, there are major differences between a SAS no. 71 and a SSARS review.

* SSARSs APPLY TO BOTH annual and interim financial statements. SAS no. 71 applies only to interim financial statements. Accountants may perform a SSARS review only on a financial statement or statements. SAS no. 71 permits a review of interim financial information or statements. SSARSs applies primarily to the review of a nonpublic entity's financial statements; SAS no. 71 applies to interim financial information of public entities.

* SAS NO. 71 REQUIRES the accountant to gain sufficient knowledge of an entity's internal control structure to perform a review of interim financial information. Some believe the knowledge necessary to perform a SSARS review is similar to the knowledge required by SAS no. 71.

* BOTH SSARSs AND SAS no. 71 provide guidance on the communication accountants are required to have with the board of directors audit committee (or its equivalent) regarding irregularities and illegal acts, as well as problems with the internal control structure.

* AN ACCOUNTANT IS NOT required to report on a SAS no. 71 review of a public company's stand-alone interim financial information. Under SSARSs, however, a report is required whenever the accountant has reviewed financial statements.

Review engagement checklist

1 . Establish with the client a clear understanding of the nature of the engagement.

2. Obtain a sufficient knowledge of the internal control structure as it relates to both annual and interim financial information.

3. If the internal control structure contains significant deficiencies, consider whether it's practicable to perform the review engagement.

4. Apply inquiries and analytical procedures that provide a basis for reporting whether material modifications should be made to the interim financial information to conform with generally accepted accounting principles.

* Inquiries ordinarily are made about the internal control structure and significant changes therein that potentially affect the preparation of interim financial information.

* When analytical procedures are applied, recorded amounts should be compared with expectations developed by the accountant. (The accountant may find the guidance in Statement on Auditing Standards no. 56, Analytical Procedures, useful in performing a review of interim financial information.)

* The accountant ordinarily is not required to corroborate management's response to inquiries made in investigating unexpected deviations, provided the response is consistent with the results of other inquiries and other analytical procedures.

5. Read the minutes of meetings of stockholders, the board of directors and board committees to identify actions that may affect interim financial information.

6. Read the interim financial information to consider whether it conforms with GAAP.

7. Obtain reports of other accountants, if any, who have reviewed significant components, subsidiaries or other investees.

8. Inquire of officers and other financial and accounting executives about

* Conformity of interim financial information with GAAP.

* Changes in the entity's accounting practices.

* Questions about matters identified above.

* Subsequent events.

9. Obtain written representations from management. (Refer to SAS no. 19, Client Representations, for guidance.)

10. If the accountant becomes aware of information that leads him or her to question whether the interim financial information conforms with GAAP, make additional inquiries or apply other procedures to obtain limited assurance.

11. If the accountant becomes aware of matters that cause him or her to believe the interim financial information filed or to be filed with the SEC, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp., Federal Reserve System or the Office of Thrift Supervision is probably materially misstated, discuss the matter with the appropriate level of management as soon as practicable.

* If management does not respond appropriately within a reasonable period of time, inform the audit committee (or others with equivalent authority and responsibility). Communication may be oral (but documented) or written.

* If the audit committee does not respond appropriately within a reasonable period of time, evaluate whether to (a) resign from the engagement and (b) remain the entity's auditor or stand for reelection as auditor.

12. If the accountant becomes aware of irregularities or illegal acts, the audit committee should be informed about the matters unless they are inconsequential.

13. If the accountant becomes aware of reportable conditions (significant deficiencies in the design or operation of internal control structure related to financial reporting), report these conditions to the audit committee.

14. Consider whether any matters described in SAS no. 61, Communication With Audit Committees (if applicable), that affect interim financial information should be communicated to the audit committee. Matters to consider include

* The auditor's responsibility.

* Initial selection of and changes in significant accounting policies or their application.

* The process used by management to formulate significant accounting judgments and estimates.

* Significant adjustments.

* Responsibility for other information.

* Disagreements with management.

* Consultation with other accountants.

* Major issues discussed with management before retention.

* Difficulties encountered in performing the engagement.

15. Document the performance and results of the review procedures. (See SAS no. 41, Working Papers, for further guidance on working papers.)

16. If engaged by the client to issue a review report and the scope of the review has not been restricted, the accountant may issue a review report.

17. If a review report is issued, modify the report for material departures from GAAP. An uncertainty, a going-concern matter and a lack of consistency do not require a report modification.

18. If subsequent to the date of the review report the accountant becomes aware facts existed at the report date that might have affected the report had he or she been aware of them, consider the guidance in SAS no. 1, Codification of Auditing Standards, section 561, "Subsequent Discovery of Facts Existing at the Date of the Auditor's Report."