Ultimate Guide to Financial Statement Review and Compilation

If you need a financial statement review or compilation, this guide will help you through the process. Reviewed financial statements can be required by regulation or because your bank asks for them. This Ultimate Guide to Financial Statements Review and Compilation is a handbook of useful facts.

You will see what major components are and why they are needed. Everything from the engagement letter to the management representation letter are covered. Along the way helpful links will take you to longer explanations and examples. Please use this directory of information and if you need help, contact us.

5 minute read

Format of this article:

1. General Info
2. Compilation
3. Compilation Design
4. Balance Sheet and Income Statement
5. Owner Equity and Cash Flow
6. The Notes
7. Review
8. Responsibility
9. Management Representation

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Who

Many banks will require a specific type of statement; compiled, reviewed or audited. However, you may encounter other demands from creditors, vendors or investors. For instance, companies that handle direct deposit and ACH payments, like Intercept, may require reviewed financials. This situation is not unusual and is becoming more a norm. As regulations on financial products become stricter and more complex, companies are shifting the burden on to you! Does it increase your cost of doing business? Yes, but you must play by their rules or go home.

Compliance

In order to help you comply with this ever-changing landscape, I’ll give you some paired down answers. By “paired down” I mean in as plain an English as I can. Some of the financial-speak in accounting is weird, complex and circular, if you know what I mean. As well, for SEO purposes, I must keep under three syllables per word when possible and not get verbose. Under 20 words per sentence and less than 150 per paragraph is the general rule. Man, this is gonna be hard. But we’ll get through it together. This article is not for the expert, it’s for regular business owners, NO accounting nerds allowed. I’ll be covering basics for non-public companies, including public company standards would be cumbersome due to increased regulations. Ooops, four syllables in regulations; but I stayed just under 150 for the paragraph, go ahead and check.

What are They?

Let’s begin with differences. The easy answer to the differences between compilation and review is in the assurance, or lack thereof, provided by each. In a compilation, no assurance is provided, the financial statements are compiled for use by management or a third party. In a review, the CPA determines whether they are aware of any modification that needs to be made to the financial statements, in order for them to be in conformity with GAAP. We have a whole group of acronyms to keep track of tasks we’re required to perform. It’s intense and done to provide assurance that a company’s financials are free from material misstatements and are fairly presented based upon application of GAAP.

Compilation

A financial statements compilation is not an assurance service. The service is not performed to provide an opinion like an audit. Nor is its function to provide limited assurance like a review. In this service an accountant is not required to verify the accuracy or completeness of the data. Financial information is delivered to the account for him to apply accounting and financial reporting expertise to assist management. The assistance is in helping management present the information and reporting in compliance with AR-C Section 80: Compilation Engagements. While performing this service the accountant does not seek to obtain or provide any assurance. This pertains to the financial statements being in conformity with the applicable reporting framework. If your statements are reported according to generally accepted accounting principles (GAAP), there isn’t assurance they meet this criterion.

Why?

This may sound counter to the intent of having a CPA perform the service. But a compilation is just the lesser of financial reporting options. Why then, you may ask, have this done? The answer lies in the use of these statements. The appropriate circumstances for this service are for seeking initial or lower amounts of credit where collateral is involved. While there is no assurance provided, many outside parties appreciate your involving a CPA for a formal report.

Some Examples

Let’s say your business needs a new front-end loader, or an addition to your current facility. Going to the bank with just your tax return is not going to cut it quite often. These days bankers are looking to see that you have the wherewithal to bring in some skilled help. That help is a CPA. Having a compilation performed by a CPA shows that you have a modicum of confidence in your financial position. As well, the bank has more faith in information that has been looked over by a CPA. In an alternative situation, you may be in the early stages of your business. In this situation compiled prospective information could help. By involving a CPA in the process, it adds a bit of reality to the data. A bank would be woe to just look at self-produced prospective financials.

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Design

For most of this article I will use standard examples. All examples will be based on basic financials. A balance sheet, income statement, owner’s equity statement, statement of cash flows and notes to them. Also, I will consider all information in accrual basis GAAP format. Situations vary and there are many examples, but I’m trying to stick to a repeating patter for ease. The compiled financial statements will include the above-mentioned financial statements and notes. In addition will be an accounts compilation report. The report gives a brief synopsis of what was done. And just as importantly the nuts and bolts of what a compilation has not done. Here are standards that are thrown in the report and a brief discussion of the financial statements.

The Report

The report covers several items that pertain to the work performed. First it must state that management is responsible for the accompanying financial statements and the related notes to them. In any service management is responsible for the financial statements in total. The accountant is responsible to review, compile or audit them, not develop or “create” them. Second, management is responsible for the financial statements to be in accord with the financial reporting framework. In this case, generally accepted accounting principles (GAAP). The CPA then states the purpose of their involvement which was to perform a compilation. This is done while stating the engagement was performed in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. Which is long form for, they operated with the standards of their professional responsibility.

Disclaimer

Third, the disclaimer. Here the CPA lets everyone know they did not audit or review the financial statements. They also state they were not required to perform any procedures to verify accuracy or completeness of the information. Last, the statement that they do not express an opinion, a conclusion, nor provide assurance on the financial statements. As mentioned earlier, a compilation is not used for high level financing or for gathering investors. This service is to show your business is being serious about its future and financial status. Just about anyone can get a car loan for 15 grand, with no more than a tax return. But securing a $200,000 loan for facility renovations requires more effort and proof.

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Balance Sheet

Of the financial statements, it is the foundation of where you are at financially at a point in time. Balance sheets are prepared after the income statement and sometimes viewed as more important (not my opinion, but others). The reason for this is that it shows what you have (assets), what you owe (liabilities) and the “balance” between these two things (equity, i.e. the leftovers). The balance sheet for a small business can contain a variety of items. Some analysts view a comparative balance sheet, current year and prior together, to see company performance over a period. This “assets based” view is a way to determine if a company is gaining equity (increasing in value). Equity is the difference between assets (the stuff you own) and liabilities (what you owe others). The difference is how much you have freed up for use (equity), if an individual, their net worth.

The top portion of a balance sheet are the assets and contain some of the following.  Cash, inventory, accounts receivable, equipment, property, stocks and anything of value to your business.  The balance sheet can cover a half page or several, depending on the company. For many small businesses it comprises one-half. The bottom portion of the balance sheet holds two items, liabilities and equity. The liability section holds the things you owe to others including the following. Accounts payable, payroll payable, short and long-term loans, bonds payable and any outflow of money you are responsible for. As with this section it can be similar in size to the asset portion. Last on the statement is the equity section. Equity includes the left over as a glommed amount for some small businesses. Alternately, it could be in the form of common or preferred stock owned by investors in larger companies.

Income Statement

This is one the financial statements that can tell quite a story. The balance sheet is a specific moment in time, the income statement is performance over a period of time. The sections of this form, at a minimum, are income and expenses: seems pretty simple to me. While some companies have far more going on in their income statement, we’re focusing on basics. The basic income statement will perhaps show several types of income. For example, these could include service income, sales of product income, interest income and investment income.  After the income comes the expenses. This portion is generally longer than the income portion. It seems that there are more ways to spend money than to earn it, cost control can be difficult. 

The income statement reports the excess of income over expenses. Or worse, the excess of expenses over income. It is a look at how your company has performed for the period. Standard income statements cover one year, usually a calendar or fiscal year. Publicly traded companies have quarterly information, but generally small business works on one year. This time frame is good for evaluating performance in making money and how thrifty one is with spending it. With any business, it’s not about how much you make, it’s about how much you save. The income statement can highlight the areas you need improvement. In comparative format, you can compare one year to another. Ratio analysis comes in handy with this. With it, you can see how much more you are spending by percent of income to a prior year. This can then be used for future period budgeting.

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Statement of Owner’s Equity

Owner’s equity; the excess of assets over liabilities in a small business, or stock equity in a large. Or a morph of many items. Often this statement is half a page. Its purpose is to show three items, the opening balance, additions and ending balance. The opening balance is the amount of equity from the last years balance sheet. Again, for larger companies this could involve a lot of moving parts; painfully, mind-numbing calculations from Hades. For our purposes, let’s not go there. Our calculation is sweetness and light; excess of assets over liabilities. The next part is the inclusion of the net from the income statement. The net income, or loss, is now added to or subtracted from, the prior years equity. This results in the current years ending equity amount. The statement of owner’s equity is the Stephen Baldwin of the family, so let’s move on.

Statement of Cash Flows (Indirect Format)

The most difficult to produce, work with and understand of the financial statements, is also the most informative. Pounding out these babies is time consuming, mind boggling and frustrating. Nevertheless, the cash flow statement shows you where your cash came in and out during the year. It does this by presenting your starting cash amount and then adding or subtracting increases and decreases in account balances to it. It’s a little confusing but stick with me on this. This statement has three parts; operating, financing and investing. I’m not going to try and fully explain this in a 150-word paragraph, or a 1500 one for that matter. Instead, I’ll break out the sections in separate paragraphs and be as succinct as possible.

Operating Cash Flows

The first section of the statement is usually used by every business. This is where your cash flow from operations is broken out. In this area we add and subtract non-cash movements that the business has to/from net income. Depreciation expense is a non-cash expense. In other words, to claim it, you do not pay out any cash. You add this amount back into your cash column. Remember, your starting net income had depreciation subtracted from it on the income statement. Increases in assets are subtracted from net income and decreases are added to it. The reverse is applied to liability accounts.

Example

Here’s how it works with an inventory example. You start the year with $100 in inventory, purchase $500 worth and end the year with $200 in stock. Also, you start year one with zero dollars in the bank. Year one net income is $1,000. At year end, your bank account shows $900. If you had income of $1,000 added to your start of zero, why do you only have $900 cash at year end?

What happened?

The inventory you hold increased. This means that you purchased $100 more in product than you used (expensed). $100 start + $500 purchase – $200 end = $400 expense. Your net income only accounts for the amount you expensed $400. However, you spent cash that net income isn’t recognizing. Net income is higher than the actual cash you hold. This being the case you subtract the excess $100 from net income. Now your net income matches your cash on hand. Click here for a full blown example. In this way your business can get a better picture of its cash flow. While net income is $1,000, you only have $900 available for use.

Investing Cash Flows

This is where your company accounts for cash changes in the following items. Purchases of property and equipment, purchases of businesses, investments in securities and other “investment” related activities. Also included are changes from loans to others (others borrowing), but not loans taken from others (your borrowing). This part is a little more straight forward than the operating section. If you buy a truck and capitalize it, it increases assets. But there was no expense on the income statement, so you subtract this amount from net income. Likewise, if you sell a piece of land, your assets decrease with out showing net income. This amount is added to net income to reach ending cash on hand. There are many factors that go into this calculation though. Things like gain or loss on the sale, depreciation balance and other factors make this a bit more complex than it appears.

Financing Cash Flows

These are items that affect cash flow that include the following. Issuing debt and repaying it, like company bonds or taking a bank loan, issuing stock in the company and buying it back. When you take out a loan from the bank, your cash increases, but this money does not show up on your income statement. The statement of cash flows accounts for this by adding loans taken to the net income to arrive at year end cash. In the reverse, as you repay a loan, the cash outflow is not recognized by the income statement. This amount needs to be subtracted from net income to arrive at ending cash. Similarly cash moves when you issue stock in your company. When investors buy your stock, you receive cash, but it doesn’t show in net income. These amounts are added to net income to arrive at your ending cash balance.

There are a lot of moving parts to a cash flow statement. It’s not a topic you should expect to fully grasp in just a few minutes. Hopefully though this intro has given you a bit more insight that you had prior.

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Notes to Financial statements

The notes to financial statements are where various items that affect the company are listed. The first part is a summary of significant accounting policies. Many things can end up in this section and they pertain to how the company accounts for various items. The following are included in this area of the financial statements. The basis of accounting used by the company be it GAAP or some other acceptable framework, like tax basis. Tax basis accounting is when you use accounting based on your reporting to the IRS, in the US. The nature of company operations provides a brief overview of what you do. Next, a discussion of how estimates are used in the financial statements. For example, estimates are used to determine amounts that may not be collected from customers. Estimates can differ from actual results and this must be stated.

From here the notes could explain any number of the following: Transactions with related parties, subsequent events (things that happened after the year-end), financing activities, lines of credit and notes payable, etc. Some companies only have one or two pages of notes, while others a dozen or so. While this overview was brief, it serves to give you the basics. Many organizations, such as the AICPA, provide detailed documents on all these items.

What’s Involved

A compilation is the least intrusive of the three main services for financial statements.  You can expect to meet with the CPA once and probably email and phone will suffice from there. Most documents and data can be sent e-mail and for the most part there isn’t much back and forth. Due to the limited procedures involved, the CPA should be able to perform the service fairly quickly. This of course depends on the time of year. Obviously, the middle of tax season isn’t when speedy service will happen. More than likely you will be asked routine clarity questions. Also, you will provide all documents in order for the service to take place.

Many compilations are performed with a financial statement preparation. In this case the CPA does help prepare and format the statements. However, management is responsible for the statements. Any prep work should be reviewed and approved by management. the CPA is not required to be independent in a compilation of financial statements, . This means that if your CPA performs other accounting services for you, such as payroll or bookkeeping, they can still perform the service. This is not the case with a financial statement review or audit.

Uses

The uses of these financial statements is varied but limited. Often, they are used to obtain small amounts of financing. Things like heavy equipment financing and equity lines of credit are common uses. Vehicle loans may fall into this category if your levels of financing are getting high. Internal management use is another use for complied financial material. Quite often management alone is not capable of producing the level of information that a CPA can. Last, a compilation could be used to attract new investors. Many small businesses do not have access to bank financing as readily as large ones. This leaves them in a position to go to friends, family or strangers to acquire funds. In these cases, it may be helpful to have compiled financial statements to show how you are operating.

Costs

This can vary to a great degree. A small business with one revenue stream and limited expenses might pay less than $1,000. A midsized small business with several revenue streams, heavy accounts receivable and payable with lots of assets, could be in the $2,000 range or more. With price variations of this nature, it helps to contact a CPA for an estimate of your needs. 

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Review

Where a the last service provided no assurance on the financial statements, a review provides limited assurance. Per AR-C Section 90 the objective of a review of financial statements is to obtain limited assurance. Limited assurance is used as a basis for the CPA to report whether he is aware of any material modifications that should be made to the financial statements, for them to be in accordance with the applicable financial reporting framework. This explanation is a bit winding. In essence the accountant is performing actions that lead him to make a proper assessment of the financial statements. Limited assurance is not absolute, nor is it providing an opinion like an audit. Limited assurance is that the accountant is not aware of things. This is achieved through inquiry and analytical procedure. But not through document inspection, confirming with outsiders or other process commonly used with an audit.

In a review, assistance is provided to management to be in compliance with AR-C Section 90: Review of Financial Statements. Preparation is quite often performed in conjunction with a review. In this way the accountant can aid management in its report of items properly.

Design

This section will not contain a repeat on the breakdown of the financial statements already done above. Instead of rehashing the balance sheet and income statement, etc. I will stick to the report. Now, assume that the rest of the financial statements are included.

Review Report

In the review report the accountant expresses his limited assurance on the financial statements. The title of the report must clearly state that the accountant is independent. If the accountant is not independent or independence is compromised during the review, he cannot perform the service. Compromising is if the account is a related party to the entity or provides to it other services, not including tax work. The report must state that the entity was reviewed, the statements reviewed, and the period covered by the review. Included is a statement that a review includes applying analytical procedures to management’s financial data and making inquiries. It must state that a review is substantially less in scope than an audit. And that the objective of an audit is to express an opinion accordingly he does not express an opinion.

Management

Also included is“Management’s Responsibility for the Financial Statements”. It should explain that management is responsible for the financial statements preparation and fair presentation. Including the design implementation and maintenance of internal control relevant to these things. Management is also responsible that the statements are free from material misstatement whether due to fraud or error.

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Responsibility

A section titled “Accountant’s Responsibility” should include the following items. This reports that the accountant performed the review in accordance with Statement on Standards for Accounting and Review (SSARS). The accountant believes his procedures provide a reasonable basis for his conclusion. A section with appropriate heading about whether the accountant is aware of any material changes that should be made to the financial statements for them to be in accordance with the applicable reporting framework. And should identify the country of origin of those principles. The signature of the CPA and their firm must be included. As well, the city and state where the accountant practices should be noted. Again, this is not a be all and end all list, just a basic overview.

Implementation

The CPA should design and implement appropriate procedures to provide limited assurance in the review. The accountant should understand the industry, the entity under review or attain competence by the review. Some analytical procedures include comparing financials statements to comparable information, prior year or related business type. When relevant, he compares financial and non-financial data for plausible relations. They also perform ratio analysis of recorded amounts compared to expected. Any anomalous results or oddities should bring about an inquiry of management. Question about operations, management knowledge of fraud, unusual/complex transactions and many other items should be addressed. The CPA should read the financial statements and consider any information relevant to them that could cause them not to conform to the applicable reporting framework.

Interaction

In a review there is a good deal more contact between the CPA and management. However, there will more inquiry and contact with management. It is normal to have at least one sit down interview to go over the majority questions of importance. After this, the questions that come up along the way can be handled in a quick email or phone call. When the inquiry and analysis are finished, the CPA assess evidence .The accountant determines whether limited assurance has been obtained..

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Management Representation

The last piece of the review is the management representation letter. A written letter, from a member of management with financial duty, is required . Some of the items that management must include in the letter are the following. That he has fulfilled its duty for the preparation and fair presentation of the financial statements. Within the applicable reporting framework. Management is accountable for internal control relevant to the financial statements. It is also managements duty to prevent and detect fraud. Management states that it has provided all relevant data, provided access and respond truthfully to inquiries. Management states that it has reported fraud to the accountant including claims, suspected acts and incidents of it. That management has disclosed all known actual or possible litigation. This provides a good basis, though there are other items. 

Uses

The uses of a financial statements review go further than a compilation. Since a review provides limited assurance, it is more valuable to creditors and investors. Use a review to provide a bank increased comfort for loans you are seeking or already have. Many lines of credit contain covenants that require yearly financial statements review. Some vendors may also ask for reviewed financial statements before providing large or increased lines of credit. These situations are not unusual and with a quick growing economy, you may find yourself needing reviewed statements. In some conditions, the bank will set up the review. Banks want to be sure that a CPA is truly impartial. The company assumes this cost. Some reviews don’t include all the financial statements. They may just include one particular statement or a specific account.

Costs

The costs for a financial statement review are grater than lesser services, but still lower than an audit. In a generic sense a review could average around $5,000. That’s not to say that yours could be less, or more. Procedures and inquiries take time, as such they increase the cost. If you are in need of a financial statement review, click here for a free consultation.

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The Bottom Line

Financial statement work comes in various forms. Auditing is too large to cover in this article. I may revisit this function in the future. For now remember to consult a pro when making decisions that affect the future of your business. Going it alone will not suffice as your business grows. It will lead to wasted time, money and resources. Also see our Ultimate Guide to Crowdfunding Financial Statement Review.

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Ernest L Tomkiewicz CPA has been called by some “the best affordable accountant and CPA” in New Hampshire. He has worked as an accountant and auditor for decades providing services to Massachusetts and New Hampshire. Saint Joseph’s College in Maine has conferred upon him a Master’s degree in Accountancy as part of his educational background.

His experience was broadened under the direction of Diane B Rohde CPA PLLC, where he worked for many years. Ernest has membership in the American Institute of Certified Public Accountants, the Association of Certified Fraud Examiners, the New Hampshire Society of Certified Public Accountants and the Greater Concord Chamber of Commerce.

In addition to being a certified public accountant he is also a certified fraud examiner. To learn more or subscribe to his social network, use these links: Facebook, LinkedIn, Twitter.