OCBOA Accounting and Auditing - CPAライセンス申請サ...

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OCBOA Accounting and Auditing

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Publish Date 7-2-2013

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Contents Chapter 1 - Other Comprehensive Bases of Accounting .................................... 14

OBJECTIVES .................................................................................................. 14 OVERVIEW ..................................................................................................... 14 Pure Cash Basis .............................................................................................. 15 Modified Cash Basis ........................................................................................ 15 Income Tax Basis ............................................................................................ 16 HISTORY OF OCBOA AND ACCOUNTING STANDARDS ............................ 16 DETERMINING WHETHER TO ISSUE OCBOA FINANCIAL STATEMENTS 17 BASIC FINANCIAL STATEMENTS ................................................................. 20 Economic Resources and Obligations ............................................................. 21 Changes in Economic Resources and Obligations .......................................... 21 Cash Flows ..................................................................................................... 21 Financial Statement Titles ............................................................................... 22 KEY ISSUES IN PREPARING OCBOA FINANCIAL STATEMENTS .............. 22 Recognition ..................................................................................................... 23 Measurement .................................................................................................. 23 Presentation .................................................................................................... 23 Disclosures ...................................................................................................... 24 Reporting ......................................................................................................... 24 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES ............................... 24

CHAPTER 2 ........................................................................................................ 29 OBJECTIVES .................................................................................................. 29 OVERVIEW ..................................................................................................... 29 THE AICPA CODE OF PROFESSIONAL CONDUCT .................................... 29 Form and Content ........................................................................................... 30 Rule 201: General Standards .......................................................................... 31 Professional Competence ............................................................................... 31 Due Professional Care .................................................................................... 31 Planning and Supervision ................................................................................ 32 Sufficient Relevant Data .................................................................................. 32 Rule 202: Compliance with Standards ............................................................ 32 Interpretations of Rules of Conduct ................................................................. 33 Ethics Rulings .................................................................................................. 33 OCBOA FINANCIAL STATEMENT GUIDANCE ............................................. 33 AU Section 623 ............................................................................................... 34 Financial Statement Titles ............................................................................... 34 Disclosures ...................................................................................................... 35 AU Section 623 Interpretation ......................................................................... 35 AR Section 100 and Related Interpretation ..................................................... 38 Technical Practice Aids ................................................................................... 39 STATEMENTS ON QUALITY CONTROL STANDARDS ................................ 41 Elements of a Quality Control System ............................................................. 41 Independence, Integrity, and Objectivity ......................................................... 42 Personnel Management ........................................................................................................ 42

Acceptance and Continuance of Clients and Engagements .................................................. 42

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Engagement Performance ..................................................................................................... 43

Monitoring ............................................................................................................................. 43

Administration of the Quality Control System .................................................. 43 Monitoring a Firm's System of Quality Control ................................................ 44 Inspection Procedures ........................................................................................................... 44

Pre‐Issuance or Post‐Issuance Review of Selected Engagements ......................................... 45

Practitioner-in-Charge ..................................................................................... 45 Personnel Management .................................................................................. 46 Competencies ................................................................................................. 46 Gaining Competencies .................................................................................... 47 Competencies Expected in Performing Accounting, Auditing, and Attestation Engagements .................................................................................................. 49 Interrelationship of Competencies and Other Elements of a Firm's System of Quality Control ................................................................................................. 50 The Relationship of the Competency Requirement of the Uniform Accountancy Act to the Personnel Management Element of Quality Control ....................... 50 History of Peer Review .................................................................................... 51 Objectives of Peer Review .............................................................................. 51 Strategies for Peer Review .............................................................................. 52 Philosophy at the Top ............................................................................................................ 52

Communicate the Philosophy ............................................................................................... 53

Identify a Coordinator ........................................................................................................... 53

Institute an Internal Inspection Process ................................................................................ 53

Prepare for the Recommendations ....................................................................................... 53

Peer Review Follow‐up .......................................................................................................... 54

Chapter 3 – Engagement Planning and Consideration ....................................... 55 OBJECTIVES .................................................................................................. 55 OVERVIEW ..................................................................................................... 55 CLIENT ACCEPTANCE AND RETENTION .................................................... 55 Ethical Considerations ..................................................................................... 56 Independence ........................................................................................................................ 56

Management Integrity........................................................................................................... 56

Professional Competency and Staff Availability .................................................................... 56

CLIENT ACCEPTANCE PROCEDURES ........................................................ 57 Evaluate Prospective Clients ........................................................................... 57 Interview the Prospective Client ...................................................................... 58 Read the Prospective Client's Financial Statements ....................................... 58 Develop a Preliminary Understanding of the Prospective Client's Accounting Records ........................................................................................................... 59 Contact Third Parties Familiar with the Prospective Client .............................. 60 Identify Intended Users of the Financial Statements ....................................... 60 Assess the Firm's Capabilities ......................................................................... 60 OTHER ENGAGEMENT ACCEPTANCE CONSIDERATIONS ....................... 60 Recognizing Danger Signs .............................................................................. 60 Valuable Lessons from Litigation ..................................................................... 61

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Documentation ................................................................................................ 62 INDEPENDENCE CONSIDERATIONS ........................................................... 62 Understanding the Nature of the Services ....................................................... 63 Evaluating the Client's Understanding of Its Responsibilities .......................... 64 Bookkeeping.................................................................................................... 65 Payroll and Other Disbursement ..................................................................... 65 Benefit Plan Administration ............................................................................. 66 Investment Advising and Investment Managing .............................................. 66 Corporate Finance Consulting and Advising ................................................... 66 Appraisal, Valuation, and Actuarial .................................................................. 67 Executive and Employee Search ..................................................................... 67 Business Risk Consulting ................................................................................ 67 COMMUNICATION WITH THE PREDECESSOR CPA .................................. 68 Audit Engagements ......................................................................................... 68 Compilation and Review Engagements ........................................................... 69 ESTABLISHING AN UNDERSTANDING WITH THE CLIENT ........................ 71 Audit Engagements ......................................................................................... 71 Engagement Letters ........................................................................................ 72 Other Engagement Letter Considerations ............................................................................. 73

Compilation and Review Engagements ........................................................... 73 Scope of the Engagement ............................................................................... 75 Identification of Financial Statements Presented ................................................................. 75

Identification of the Number of Reporting Periods............................................................... 76

Identification of Accounting Methods Used and Any Departures ........................................ 76

Footnote Disclosures Required ............................................................................................. 76

Presentation of Supplementary Information ........................................................................ 77

The Engagement Letter ......................................................................................................... 77

Other Documentation Methods ............................................................................................ 78

Chapter 4 - Primary Financial Statement Considerations ................................... 79 OBJECTIVES .................................................................................................. 79 PRIMARY FINANCIAL STATEMENTS ........................................................... 79 Economic Resources and Obligations ............................................................. 80 Changes in Economic Resources and Obligations .......................................... 80 Cash Flows ..................................................................................................... 80 Statement of Retained Earnings ...................................................................... 81 Comprehensive Income .................................................................................. 81 Presentation .................................................................................................... 81 FINANCIAL STATEMENT TITLES .................................................................. 82 Balance Sheet Title Alternatives ...................................................................... 83 Income Statement Title Alternatives ................................................................ 83 Statement of Cash Flows Title Alternatives ..................................................... 83 FINANCIAL STATEMENT CAPTIONS ............................................................ 84 Classified versus Unclassified Presentation .................................................... 84 OTHER PRESENTATION ISSUES ................................................................. 85 Consolidation Accounting ................................................................................ 85 Change from GAAP to OCBOA ....................................................................... 86

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REFERENCES IN THE FINANCIAL STATEMENTS ...................................... 86 References to the Notes .................................................................................. 86 References to Selected Information ................................................................ 87 References to the Accountant's Report ........................................................... 87 Management-Use-Only Financial Statements ................................................. 87 Placing the Reference ..................................................................................... 88 FINANCIAL STATEMENT DISCLOSURES .................................................... 88 Format of Disclosures ..................................................................................... 88 Title of Notes ................................................................................................... 88 Summary of Significant Accounting Policies ................................................... 89 Specific Disclosures ........................................................................................ 90 Cash basis .............................................................................................................................. 90

Tax basis ................................................................................................................................ 90

Interim Financial Statements ........................................................................... 91 Financial Statement Items ............................................................................... 91 Assets and Liabilities ....................................................................................... 92 Stockholders' Equity ........................................................................................ 92 Subsequent Events ......................................................................................... 92 Risks and Uncertainties ................................................................................... 93 Omission of Disclosures .................................................................................. 93 SUPPLEMENTARY INFORMATION ............................................................... 94 Reporting on Supplementary Information ........................................................ 95 FORM AND STYLE OF PRESENTATION ...................................................... 96 Title Page ........................................................................................................ 96 Accountant's Report ........................................................................................ 96

Chapter 5 - Cash and Modified Cash-Basis Financial Statements...................... 98 OBJECTIVES .................................................................................................. 98 OVERVIEW OF CASH-BASIS FINANCIAL STATEMENTS ............................ 98 Pure Cash Basis of Accounting ....................................................................... 98 Modified Cash Basis of Accounting ................................................................. 99 ISSUES TO CONSIDER IN CASH-BASIS FINANCIAL STATEMENTS ....... 100 Choosing the Appropriate Basis of Accounting ............................................. 100 Change in Basis of Accounting ...................................................................... 101 Change in Accounting Principle..................................................................... 101 Changes in Equity Accounts ......................................................................... 102 Statement of Cash Flows .............................................................................. 103 PURE CASH BASIS ...................................................................................... 103 Measurement and Recognition Considerations ............................................. 103 Cash and Cash Equivalents .................................................................................................. 103

Investments ......................................................................................................................... 104

Property, Plant, and Equipment .......................................................................................... 104

Debt ..................................................................................................................................... 104

Agency Transactions ............................................................................................................ 104

Income Taxes ....................................................................................................................... 104

MODIFIED CASH BASIS .............................................................................. 104 Acceptable Modifications ............................................................................... 105

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Modified Cash Basis versus GAAP ............................................................... 106 Measurement and Recognition Considerations ............................................. 106 Inventory ............................................................................................................................. 107

Non‐ Trade Receivables ....................................................................................................... 107

Investments ......................................................................................................................... 108

Prepaid Expenses ................................................................................................................. 108

Property, Plant, and Equipment .......................................................................................... 108

Depreciation ........................................................................................................................ 109

Current and Long‐Term Liabilities ....................................................................................... 109

Revenue ............................................................................................................................... 109

Income Taxes ....................................................................................................................... 109

DISCLOSURES IN CASH-BASIS FINANCIAL STATEMENTS ..................... 109 Recommendations ........................................................................................ 110 Basis of Accounting ....................................................................................... 110 Pure Cash Basis .................................................................................................................... 110

Modified Cash Basis ............................................................................................................. 111

Summary of Significant Accounting Policies ................................................. 111 Income Taxes ....................................................................................................................... 112

Consolidation ....................................................................................................................... 112

Inventory ............................................................................................................................. 113

Property and Equipment ..................................................................................................... 113

Commitments and Contingencies .................................................................. 114 Uncertainties ................................................................................................. 115 Subsequent Events ....................................................................................... 116 Asset Impairment .......................................................................................... 116 Changes in Accounting Principles or Estimates ............................................ 116 Investments ................................................................................................... 116 Property and Equipment ................................................................................ 117 Terms of Debt Agreements ........................................................................... 117 Restrictions on Assets and Equity ................................................................. 117 Employee Benefit Plans ................................................................................ 117 Income Taxes ................................................................................................ 117 Disclosures in Pure Cash-Basis Presentations ............................................. 117

Chapter 6 - Income Tax Basis Financial Statements ........................................ 119 OBJECTIVES ................................................................................................ 119 OVERVIEW ................................................................................................... 119 IRS ACCOUNTING METHODS .................................................................... 120 Inventories ..................................................................................................... 120 Exceptions ..................................................................................................... 121 Qualifying Small Business Taxpayer ............................................................. 121 Qualifying Taxpayer ...................................................................................... 122 Methods Permitted ........................................................................................ 122 C Corporations ..................................................................................................................... 122

S Corporations ..................................................................................................................... 122

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Partnerships ......................................................................................................................... 122

Sole Proprietorships ............................................................................................................ 122

ISSUES TO CONSIDER IN INCOME TAX BASIS FINANCIAL STATEMENTS ...................................................................................................................... 123 Nontaxed Entities .......................................................................................... 123 Nontaxable Revenues and Nondeductible Expenses .................................... 123 Tax Changes ................................................................................................. 124 Change in Basis of Accounting ............................................................................................. 124

Change in Tax Law or Accounting Principle ......................................................................... 124

Change in Fiscal Year ........................................................................................................... 125

Changes in Equity and Capital Accounts ............................................................................. 126

ACCRUAL METHOD ..................................................................................... 126 Safe Harbor Rule ........................................................................................... 127 Recurring Item Exception .............................................................................. 127 Revenue and Expense Measurement and Presentation Issues .................... 128 Revenues ............................................................................................................................. 128

Rental Income and Expense ................................................................................................ 128

Nontaxable Revenues and Nondeductible Expenses .......................................................... 129

Balance Sheet Measurement and Presentation Issues ................................. 129 Receivables .......................................................................................................................... 129

Inventories ........................................................................................................................... 129

Investments ......................................................................................................................... 130



Intangible Assets.................................................................................................................. 131

Liabilities .............................................................................................................................. 131

CASH METHOD ............................................................................................ 131 Constructive Receipt ..................................................................................... 131 Expenses ...................................................................................................... 132 Measurement and Presentation Issues ......................................................... 132 Inventories ........................................................................................................................... 132


DISCLOSURES IN INCOME TAX BASIS FINANCIAL STATEMENTS ......... 133 Recommendations ........................................................................................ 133 Basis of Accounting ....................................................................................... 133 Accrual Method ................................................................................................................... 134

Cash Method ....................................................................................................................... 134

Summary of Significant Accounting Policies ................................................. 134 Income Taxes ....................................................................................................................... 135

Consolidation ....................................................................................................................... 136

Inventory ............................................................................................................................. 136

Receivables .......................................................................................................................... 136

Depreciation ........................................................................................................................ 136

Start‐Up Costs ...................................................................................................................... 137

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Related- Party Transactions .......................................................................... 137 Commitments and Contingencies .................................................................. 138 Uncertainties ................................................................................................. 139 Subsequent Events ....................................................................................... 140 Asset Impairment .......................................................................................... 140 Changes in Accounting Principles or Estimates ............................................ 140 Investments ................................................................................................... 140 Property and Equipment ................................................................................ 141 Terms of Debt Agreements ........................................................................... 141 Restrictions on Assets and Equity ................................................................. 141 Employee Benefit Plans ................................................................................ 141 Income Taxes ................................................................................................ 141

Chapter 7 – Other Basis of Accounting ............................................................. 143 OBJECTIVES ................................................................................................ 143 INTRODUCTION ........................................................................................... 143 REGULATORY BASIS OF ACCOUNTING ................................................... 143 Insurance Companies ................................................................................... 143 Regulatory Basis versus Contractual Basis ................................................... 144 Insurance Companies ................................................................................... 144 Financial Institutions ...................................................................................... 148 Not-for-Profit Organizations ........................................................................... 148 Construction Contractors ............................................................................... 149 Prescribed Forms .......................................................................................... 149 OTHER BASES OF ACCOUNTING .............................................................. 150 Substantial Support ....................................................................................... 150 Definite Criteria .............................................................................................. 151 All Material Items ........................................................................................... 151 Price-Level Basis ........................................................................................... 151 Current Value Basis ...................................................................................... 152 Liquidation Basis ........................................................................................... 154 Agreed-Upon Basis ....................................................................................... 154 Incomplete Presentations ................................................................................................... 155

Presentation That Is not in Conformity with GAAP or OCBOA ...................... 158 Chapter 8 – Unique Entities .............................................................................. 162

OBJECTIVES ................................................................................................ 162 INTRODUCTION ........................................................................................... 162 PERSONAL FINANCIAL STATEMENTS ...................................................... 162 Issues to Consider in Personal Financial Statements ................................... 163 Ownership of Assets ............................................................................................................ 163

Choosing the Basis of Accounting ....................................................................................... 163

Basic Financial Statements .................................................................................................. 164

Cash Basis Financial Statements .................................................................. 165 Pure Cash ............................................................................................................................. 165

Modified Cash ...................................................................................................................... 165

Historical Cost Basis Financial Statements ................................................... 166 Establishing Historical Cost of Assets .................................................................................. 166

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Cash and Cash Equivalents .................................................................................................. 166

Life Insurance Policies ......................................................................................................... 166

Receivables .......................................................................................................................... 167

Business Interests ................................................................................................................ 167

Real Estate ........................................................................................................................... 167

Future Interests ................................................................................................................... 167

Income Taxes ....................................................................................................................... 168

Commitments ...................................................................................................................... 168

Other Liabilities ................................................................................................................... 169

Accounting Methods ........................................................................................................... 169

Receivables .......................................................................................................................... 170

Business Interests ................................................................................................................ 170

Income Taxes ....................................................................................................................... 170

Disclosures in Personal Financial Statements .............................................. 170 Recommendations ........................................................................................ 171 Basis of Accounting.............................................................................................................. 171

Summary of Significant Accounting Policies ................................................. 172 Other Disclosures .......................................................................................... 172 Personal Financial Statement Engagement Issues ....................................... 173 Accepting the Client ............................................................................................................ 173

Understanding the Client's Accounting Records ........................................... 175 Consider Obtaining a Representation Letter ................................................. 177 Audit of Personal Financial Statements ......................................................... 177 Reporting Standards ..................................................................................... 177 NOT-FOR-PROFIT ORGANIZATIONS ......................................................... 179 Issues to Consider in Not-for-Profit Financial Statements ............................. 179 Fund Accounting .................................................................................................................. 179

Statement of Functional Expenses ...................................................................................... 180

Cash-Basis Financial Statements .................................................................. 180 Pure Cash ............................................................................................................................. 180

Modified Cash ...................................................................................................................... 181

Pledges ................................................................................................................................ 181

Investments ......................................................................................................................... 181


Net Assets ............................................................................................................................ 182

FAS-117 ........................................................................................................ 182 Income Tax Basis Financial Statements ....................................................... 183 Accounting Methods ........................................................................................................... 184

Pledges ................................................................................................................................ 184

Grants Receivable ................................................................................................................ 184

Investments ......................................................................................................................... 184

Grants Payable ..................................................................................................................... 184

Deferred Revenue ............................................................................................................... 185

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Net Assets ............................................................................................................................ 185

Contributions ....................................................................................................................... 186

Depreciation ........................................................................................................................ 187

Taxes .................................................................................................................................... 187

FAS-117 ........................................................................................................ 187 Disclosures in Not-for-Profit Financial Statements ........................................ 187 Basis of Accounting.............................................................................................................. 188

Summary of Significant Accounting Policies ................................................. 188 Tax Exempt Status ............................................................................................................... 189

Pledges ................................................................................................................................ 189

Investments ......................................................................................................................... 190

Deferred Revenue ............................................................................................................... 190

Net Assets ............................................................................................................................ 190

Donated Services ................................................................................................................. 191

Donated Materials, Equipment, or Facilities ....................................................................... 191

Functional Expenses ............................................................................................................ 192

Chapter 9 - Auditing OCBOA Financial Statements .......................................... 193 OBJECTIVES ................................................................................................ 193 INTRODUCTION ........................................................................................... 193 AUDIT PROCEDURES ................................................................................. 193 AUDIT REPORTS ......................................................................................... 195 Auditor's Standard Report ............................................................................. 197 TYPES OF AUDIT OPINIONS ...................................................................... 197 Unqualified Opinion ....................................................................................... 197 Qualified Opinion ........................................................................................... 198 Adverse Opinion ............................................................................................ 198 Disclaimer of Opinion .................................................................................... 198 Conditions Precluding an Unqualified Opinion .............................................. 199 Scope Limitations .......................................................................................... 199 Qualified Opinion Due to a Scope Limitation ...................................................................... 200

Disclaimer of Opinion Due to a Scope Limitation ................................................................ 200

Departures from the OCBOA......................................................................... 201 Qualified Opinion Due to a Departure from the OCBOA .................................................... 201

Adverse Opinion Due to a Departure from the OCBOA ...................................................... 202

Accounting Changes ............................................................................................................ 202

Lack of Independence ................................................................................... 203 Unqualified Audit Reports with Explanatory Language Added ...................... 204 Substantial Doubt about the Entity's Ability to Continue as a Going Concern204 Reissued Reports and Going‐Concern Matters ................................................................... 205

Reliance on Third‐Party Funding ......................................................................................... 206

Lack of Consistency in Accounting Principles or in the Method of Their Application ..................................................................................................... 206 Modification to the Standard Auditor's Report as a Result of a Lack of Consistency ................................................................................................... 207

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Emphasis of a Matter .................................................................................... 207 Change from GAAP to OCBOA ..................................................................... 208 Part of the Audit is Performed by Other Auditors........................................... 208 REPORTING ON COMPARATIVE FINANCIAL STATEMENTS ................... 208 REPORTING ON INFORMATION ACCOMPANYING THE BASIC FINANCIAL STATEMENTS .............................................................................................. 209 Reporting on Voluntary Additional Information .............................................. 209 DATING OF THE AUDITOR'S REPORT ....................................................... 210 Events Occurring after Completion of Fieldwork but before Issuance of Report ...................................................................................................................... 210 Effect of Subsequent Events Requiring Adjustment of the Financial Statements .............. 211

Effect of Subsequent Events Requiring Disclosure .............................................................. 211

Methods Available for Dating the Auditor's Report for a Subsequent Event ..................... 212

RESTRICTING THE USE OF AN AUDITOR'S REPORT .............................. 212 Circumstances Requiring Reports to Be Restricted ...................................... 213 Specified Parties in Restricted-Use Reports ................................................. 213 Restricted-Use Report Language .................................................................. 214

Chapter 10 - Compiling and Reviewing OCBOA Financial Statements ............ 215 OBJECTIVES ................................................................................................ 215 INTRODUCTION ........................................................................................... 215 COMPILATION ENGAGEMENT PROCEDURES ......................................... 215 Traditional Compilations ................................................................................ 216 Knowledge of the Industry .................................................................................................. 216

Knowledge of the Client ...................................................................................................... 217

Necessity to Perform Other Accounting Services................................................................ 217

Awareness Concerning Information Supplied ..................................................................... 217

Reading the Financial Statements ....................................................................................... 218

Management-Use-Only Compilations ............................................................ 218 Understanding with the Client ............................................................................................ 218

Third Parties ........................................................................................................................ 219

Management‐Use‐Only Compilation Program .................................................................... 220

REVIEW ENGAGEMENT PROCEDURES ................................................... 220 Accounting Principles and Practices ............................................................. 220 Analytical Procedures .................................................................................... 221 Inquiries ......................................................................................................... 221 Types of Inquiries ................................................................................................................ 221

Other Review Procedures ............................................................................. 223 Management Representations ...................................................................... 224 Documentation .............................................................................................. 225 REPORTING STANDARDS .......................................................................... 225 Compilation Reports ...................................................................................... 225 Review Reports ............................................................................................. 226 Association with Financial Statements .......................................................... 227 Financial Statement Legends ........................................................................ 227 Report Address ............................................................................................. 228

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Report Date ................................................................................................... 228 Report Signature ........................................................................................... 229 Reporting on a Single Financial Statement ................................................... 229 MODIFICATIONS TO THE STANDARD REPORT ....................................... 230 Lack of Independence ................................................................................... 230 Departures from the OCBOA......................................................................... 230 Report Modification Is Adequate ........................................................................................ 231

Report Modification Is Inadequate ..................................................................................... 231

Restricted Use Financial Statements ............................................................ 232 Omission of Substantially All Disclosures ...................................................... 232 Inclusion of More than a Few Disclosures ..................................................... 234 Scope Limitations .......................................................................................... 234 Uncertainties ................................................................................................. 235 Uncertainties Related to Going Concern ....................................................... 236 Change in Accounting Principles ................................................................... 238 Change in an Accounting Principle (Correction of an Error) ............................................... 239

Supplementary Information ........................................................................... 239 Supplementary Information ................................................................................................ 240

Presentation of Supplementary Information ...................................................................... 240

Supplementary Information Prepared by the Client ........................................................... 241

Emphasis of a Matter .................................................................................... 242 REPORTING ON COMPARATIVE FINANCIAL STATEMENTS ................... 243

GLOSSARY ...................................................................................................... 244

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Chapter 1 - Other Comprehensive Bases of Accounting

OBJECTIVES At the end of this section, the student should be able to:

Recognize what the term OCBOA means. Identify the three basis of accounting that are recognized and the types of

organizations that would use each type. Indicate the different reasons why OCBOA financial statements are

beneficial to clients and why they might be used by a CPA.

OVERVIEW The term" other comprehensive bases of accounting" (OCBOA) refers to bases of accounting other than generally accepted accounting principles (GAAP). The primary guidance for OCBOA financial statements is SAS-62 (AU 623) (Special Reports). Unlike GAAP, there is no standard-setting organization for OCBOA. Instead, preparers and accountants have interpreted the audit guidance in AU 623 for purposes of preparing OCBOA financial statements. AU 623.03 states that "an independent auditor's judgment concerning the overall presentation of financial statements should be applied within an identifiable framework." Ordinarily, that framework is provided by GAAP; but AU 623 allows a comprehensive basis of accounting other than GAAP to be used. AU 623.04 recognizes the following OCBOAs:

• The basis of accounting that a reporting entity uses to comply with the requirements or the financial reporting provisions of the governmental regulatory agency under whose jurisdiction the entity is included • The basis of accounting that the reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements • The cash receipts and disbursements basis of accounting, and modifications of the cash basis that have substantial support, such as recording depreciation on fixed assets or accruing income taxes • A definite set of criteria having substantial support that is applied to all material items appearing in financial statements, such as the price-level basis of accounting

NOTE: The Statements on Auditing Standards (SAS) promulgated by the AICPA's Auditing Standards Board are codified in the AICPA Professional

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Standards, Volume 1, as AU sections 100 through 900. The Statements on Standards for Accounting and Review Services (SSARS) are codified in the AICPA Professional Standards, Volume 1, as AR sections 50 through 600. The Statements on Standards for Attestation Engagements (SSAE) are codified in the AICPA Professional Standards, Volume 1, as AT sections 101 through 701. References in this book to AU sections, AR sections, and AT sections refer to these AICPA standards.

Pure Cash Basis Under the cash receipts and disbursements basis of accounting ("pure cash basis"), only transactions that increase or decrease cash and cash equivalents are reflected in the financial statement. The pure cash basis recognizes all cash disbursements as expenses and all cash receipts as revenues. In practice, the pure cash basis of accounting is rare. Entities that use the pure cash basis of accounting typically have the following characteristics:

• They are not profit-oriented • Their operations are simple • Their accounting and finance functions are unsophisticated • There is only one major activity • Capital expenditures and long-term debt are not significant

Entities that use the pure cash basis of accounting can include school activity funds, civic ventures, trusts and estates, political action committees, and political campaigns.

Modified Cash Basis The modified cash basis of accounting is described by AU 623.04 as the pure cash basis incorporating modifications that have substantial support. These modifications generally include the recognition of certain transactions on an accrual basis, as entities would recognize them under GAAP. However, the appropriate modifications and the extent of those modifications are not clearly defined in the literature. Entities that use the modified cash basis of accounting generally possess the following characteristics:

• They are profit-oriented • They distribute profits as collected (e.g., through bonuses and retirement plan contributions)

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• They have significant inventory and credit arrangements with vendors • They make material capital expenditures or incur material amounts of debt • Their operations are somewhat sophisticated, and accounting for them may be complex

Examples of entities that use the modified cash basis of accounting are professional associations of doctors, lawyers, and CPAs.

Income Tax Basis The income tax basis of accounting is typically based on federal income tax laws. However, income tax laws generally do not address financial statement presentation or disclosure considerations. Typically, entities that use the tax basis of accounting are either

• Profit-oriented enterprises (such as small closely held companies for which conversion to GAAP would be costly) • Partnerships whose partnership agreements require the use of the tax basis of accounting • Not-for-profit organizations seeking relief from the requirements of FAS-116 and FAS-U7

HISTORY OF OCBOA AND ACCOUNTING STANDARDS The AICPA has commissioned several studies to examine the problem of standards overload. In 1976, the AICPA's Committee on GAAP for Smaller and/ or Closely Held Businesses recommended that the FASB distinguish disclosures required by GAAP from those that merely provide additional data. The committee also recommended that the AICPA develop a method of reporting on financial statements where some or all footnote disclosures are omitted. In 1981, the Special Committee on Accounting Standards Overload was given the following charge: To study accounting standards overload and to consider alternative means of providing relief from accounting standards which are found not to be cost effective, particularly for small, closely held businesses, and to report thereon to the board of directors. The committee recommended the use of the income tax basis of accounting as an alternative to GAAP financial statements for small businesses for the following reasons:

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• Taxpaying entities already must maintain records of the tax basis of assets and liabilities. Preparing tax basis financial statements would eliminate the need to also maintain records of the GAAP basis of assets and liabilities. • Most financial statement users recognize and understand the tax basis of accounting. • Many users are satisfied with financial statements prepared on the tax basis; those who need more information are generally able to require GAAP statements. • Few measurement guidelines need to be established.

The committee also recommended minimum disclosure, measurement, and reporting guidelines for income tax basis financial statements. In addition, in 1983 the FASB issued a special report entitled "Financial Reporting by Privately Owned Companies: Summary of Responses to FASB Invitation to Comment" that summarized the responses to a FASB Invitation to Comment issued in 1981, which included questionnaires tailored to three groups: (1) managers of private and small public companies, (2) users of financial statements of those companies, and (3) public accountants who served those companies. The report did not draw any conclusions or make any recommendations concerning accounting standards.

DETERMINING WHETHER TO ISSUE OCBOA FINANCIAL STATEMENTS OCBOA financial statements are beneficial to clients for many reasons. One of the major benefits is that some clients can understand OCBOA financial statements better than GAAP financial statements. It is not uncommon for the owner / manager of a privately held company to fully understand the measurement issues represented in tax returns but have little grasp of the measurement and disclosure complexities in GAAP financial statements. Another major advantage: Because accountants do not need to consider the measurement requirements of GAAP, the OCBOA financial statements can often be prepared on a more timely and cost-efficient basis. For cash-basis financial statements, many of the measurement principles associated with GAAP simply do not exist; for tax-basis financial statements, the CPA has already addressed the measurement issues in the tax returns. It is estimated that CPAs can save up to 20% to 30% or more in certain cases because of the reduced time and cost in preparing and reporting on OCBOA financial statements.

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In advising clients about the use of an OCBOA, accountants should consider the following issues:

• Does the entity have inventory? (If so, the pure cash basis may not be helpful.) • What basis of accounting does the entity use in preparing its income tax return? (If the accrual basis is used, preparing financial statements on the same basis makes sense.) • Is the entity highly leveraged? (Lenders may require GAAP financial statements.) • Are there outside investors? (GAAP financial statements may provide information required by such users.) • Does the entity's cash flow parallel its income and expenses? (The pure cash basis may be appropriate.) • Does the entity anticipate going public? (If so, the entity will need a history of GAAP financial statements.) • Was the entity formed for tax purposes? (If yes, the owners are probably interested in the tax effects of transactions and the income tax basis would be appropriate.) • Is the entity subject to bonding requirements? (Most bonding companies only accept GAAP financial statements.)

OCBOA financial statements may be prepared for any entity that is not required, contractually or otherwise, to issue GAAP financial statements. As a practical matter, OCBOA financial statements may be considered anytime the following conditions are met:

• The users of the financial statements-those who are internal as well as those who are external to the entity-understand an OCBOA presentation and find it relevant to their needs. • It is cost-effective to prepare OCBOA financial statements. • The operations of the entity are conducive to an OCBOA presentation.

The AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements lists the following characteristics of entities that should consider issuing cash- or tax-basis financial statements: General Condition

Specific Characteristic

User needs: third parties •The entity has no third-party users of the financial statements (e.g., the entity is a small closely held business with no third-party debt).

•The entity's debt is secured rather than unsecured.

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•The entity's creditors do not require GAAP financial statements.

User needs: owners and managers •The owners and managers are closely involved in the day-to-day operations of the business and have a fairly accurate picture of the entity's financial position

•The business's owners are primarily interested in cash flows (e.g., a professional corporation of physicians that distributes its cash-basis earnings through salaries, bonuses, and retirement plan contributions).

• The owners are primarily interested in the tax implications of transactions (e.g., partners in a partnership who are concerned about the tax effects of transactions that will be reflected on their personal tax returns).

Cost-effective • The entity's cost of complying with GAAP would exceed the benefits (e.g., a small construction contractor would be required to account for long-term contracts using the percentage-of-completion method and would be required to compute deferred taxes).

• The entity is not subject to Internal Revenue Code rules that would require it to prepare its tax return on the accrual method of accounting (If the entity is required to use the accrual method for income tax purposes, the differences between a tax-basis presentation and GAAP might not be sufficient to provide substantial cost savings.)

Operations • Capital expenditures and long-term financing are not significant to the entity.

As the foregoing table indicates, understanding the needs of the financial statement users is the most important step in helping clients decide whether to issue OCBOA financial statements.

Note: Financial statement users may be more inclined in certain situations to accept OCBOA financial statements if the client also provides additional information outside the basic financial statements. For example, a lender

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might accept tax-basis financial statements from a borrower if the borrower also provides the lender with an aged listing of receivables.

OCBOA financial statements should not be issued if the results will be misleading. AU 623.09 includes the following guidance:

The auditor should apply essentially the same criteria to financial statements prepared on an other comprehensive basis of accounting as he or she does to financial statements prepared in conformity with generally accepted accounting principles. Therefore, the auditor's opinion should be based on his or her judgment regarding whether the financial statements, including the related notes, are informative of matters the may affect their use, understanding, and interpretation.

The foregoing statement indicates that the auditor has a responsibility to determine whether the financial statements are misleading. The AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements states that the accountant should consider whether OCBOA financial statements could be misleading whenever the following conditions are present:

• The entity has substantial unfunded obligations, commitments, and contingent liabilities that would not be recorded on the cash or tax basis. • The entity has delayed paying accounts payable and other current liabilities not shown on a cash-basis statement. • The financial statements have been compiled with substantially all disclosures omitted.

BASIC FINANCIAL STATEMENTS By default, generally accepted accounting principles are applicable when a CPA conducts an audit, compilation, or review of and reports on any financial statement. A financial statement may be, for example, that of a corporation, a consolidated group of corporations, a combined group of affiliated entities, a not-for-profit organization, a governmental unit, an estate or trust, a partnership, a proprietorship, a segment of any of these, or an individual. The term "financial statement" refers to a presentation of financial data, including accompanying notes, derived from the accounting records and intended to communicate an entity's economic resources or obligations at a point in time or the changes therein for a period of time in conformity with a comprehensive basis of accounting. The following financial presentations are examples of financial statements:

• Balance sheet

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• Statement of income • Statement of comprehensive income • Statement of retained earnings • Statement of cash flows • Statement of changes in owners' equity • Statement of assets and liabilities (with or without owners' equity accounts) • Statement of revenues and expenses • Statement of financial position • Statement of activities • Summary of operations • Statement of operations by product lines • Statement of cash receipts and disbursements

In an OCBOA presentation, the basic financial statements typically present financial position and results of operations as measured under the OCBOA, descriptions of accounting policies, and notes to the financial statements. However, an exception to this exists for entities that use the pure cash basis of accounting. Under the pure cash basis of accounting, a statement of assets, liabilities, and equity is needless because the cash balance is the only item that appears. Consequently, entities using the pure cash basis of accounting present a single statement titled "Statement of Cash Receipts and Disbursements."

Economic Resources and Obligations By definition "financial statements" are a presentation of financial data intended to communicate an entity's economic resources or obligations on a specific date. When GAAP financial statements are prepared, a financial statement of this nature is referred to as a "balance sheet" or "statement of financial position."

Changes in Economic Resources and Obligations By definition "financial statements" are a presentation of financial data intended to communicate changes in an entity's economic resources or obligations. When GAAP financial statements are prepared, a financial statement of this nature is referred to as an "income statement" or "statement of operations."

Cash Flows FAS-95 (Statement of Cash Flows) states that "a business enterprise that provides a set of financial statements that reports both financial position and results of operations shall provide a statement of cash flows for each period for which results of operations are provided." However, Interpretation No. 14 of SAS-

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62 (AU 9623.94) states that "a statement of cash flows is not required" in presentations using the cash, modified cash, or income tax basis of accounting.

Note: Whether a statement of cash flows is necessary for a basis of accounting established by a governmental regulatory agency depends on the specific requirements established by the agency.

Although a statement of cash flows is not required in cash, modified cash, or income tax basis presentations, if a presentation of cash receipts and disbursements is presented in a format similar to a statement of cash flows, or if the entity chooses to present a statement of cash flows (for example in a presentation on the accrual basis of accounting used for federal income tax reporting), the statement should either conform to the requirements for a GAAP presentation or communicate their substance.

Financial Statement Titles When OCBOA financial statements are prepared, it is inappropriate to use titles that would normally be associated with GAAP financial statements. AU 623.07 addresses the issue of OCBOA financial statement titles. Terms such as "balance sheet," "statement of financial position," "statement of income," "statement of operations," "statement of cash flows," and similar unmodified titles are generally understood to be applicable only to financial statements that are intended to present financial position, results of operations, or cash flows in conformity with GAAP. Consequently, CPAs should modify such titles to ones that are appropriate for OCBOA financial statements. Care must be exercised in titling OCBOA financial statements so that readers of the statements will not infer that OCBOA financial statements are prepared in accordance with GAAP. For example, cash-basis financial statements might be titled" statement of assets and liabilities arising from cash transactions" or "statement of revenue collected and expenses paid," and a financial statement prepared on a statutory or regulatory basis might be titled "statement of income-statutory basis."

KEY ISSUES IN PREPARING OCBOA FINANCIAL STATEMENTS A basis of accounting (including an OCBOA) is a framework for determining what information is presented in the financial statements and related notes and how it is presented. However, many issues arise in practice for which there is no authoritative guidance. These issues are summarized as follows.

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Recognition Recognition deals with when an item should be reported in the financial statements. Transactions should be recognized in the financial statements based on the basis of accounting used. More specifically, an item and the information about it should be recognized in the financial statements when the following four criteria are met:

1. Definition: The item meets the definition of an element of a financial statement. 2. Measurability: The item has a relevant attribute that can be reliably measured. 3. Relevance: The information about the item may make a difference to financial statement users. 4. Reliability: The information is representationally faithful, verifiable, and neutral.

For example, cash-basis financial statements recognize transactions when cash is received or paid. Tax-basis financial statements recognize transactions when they would be recognized in the entity's tax return.

Measurement "Measurement" is how an item is quantified. The item must have a relevant attribute that can be quantified monetarily with sufficient reliability. Some items that meet the definition of a financial statement element are not measurable. Cash-basis financial statements measure an item based on the amount of cash received or paid. Tax-basis financial statements measure items based on amounts that would be reported in the entity's tax return. Recognition and measurement issues for cash-basis financial statements are addressed in Chapter 5, "Cash and Modified Cash-Basis Financial Statements." Recognition and measurement issues for income tax basis financial statements are addressed in Chapter 6, "Income Tax Basis Financial Statements."

Presentation Although transactions are recognized and measured according to the OCBOA, they are generally presented in the financial statements according to GAAP presentation guidelines. That is, revenues and expenses (measured in accordance with the OCBOA) are presented in a statement of income and assets, liabilities, and equity (measured in accordance with the OCBOA) are presented in a statement of financial position.

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Financial statement form and style considerations are discussed further in Chapter 4, "Primary Financial Statement Considerations."

Disclosures Some information is better provided, or can only be provided, by notes to the financial statements, by supplementary information, or by other means. A common misconception about OCBOA financial statements is that the requirements for disclosure are significantly different from those for GAAP financial statements. According to AU 623.09, OCBOA financial statements should include all informative disclosures that are appropriate for the basis of accounting used. Thus, the disclosures required for OCBOA financial statements are essentially the same as those required for GAAP financial statements. Specifically, informative disclosures can be classified in the following categories:

• Summary of significant accounting policies • Financial statement items • Presentation requirements • Other information

Disclosure issues relevant to each basis of accounting are discussed further in the pertinent chapters throughout this book.

Reporting Certain modifications must be made when reporting on OCBOA financial statements. The statement titles in the reports must reflect the OCBOA statement titles. Audit reports must disclose the basis of presentation, refer to the note that describes the basis, and include a statement that the basis is a comprehensive basis of accounting other than GAAP. When compiled financial statements omit substantially all disclosures, the compilation report must reflect OCBOA titles and disclose the basis of accounting. Other compilation and review reports must reflect the OCBOA statement titles. Chapter 9, "Auditing OCBOA Financial Statements: Procedures and Reporting," discusses audit reports on OCBOA financial statements in further detail. Chapter 10, "Compiling and Reviewing OCBOA Financial Statements: Procedures and Reporting," discusses compilation and review reports on OCBOA financial statements in further detail.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

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Because OCBOA refers to a comprehensive basis of accounting other than GAAP, it is important to understand what is meant by the term "GAAP." What is GAAP? The phrase generally accepted accounting principles is a technical accounting term that encompasses the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. It includes not only broad guidelines of general application, but also detailed practices and procedures. Those conventions, rules, and procedures provide a standard by which to measure financial presentations. Generally accepted accounting principles GAAP are concerned with the measurement of economic activity, the time when such measurements are to be made and recorded, the disclosures surrounding this activity, and the preparation and presentation of summarized economic information in the form of financial statements. GAAP develops when questions arise about how to best accomplish those objectives - measurement, timing of recognition, disclosure, or presentation. In response to those questions, GAAP is either prescribed in official pronouncements of authoritative bodies empowered to create it, or it originates over time through the development of customary practices that involved when authoritative bodies fail to respond. Thus, GAAP is a reaction to and a product of the economic environment in which it develops. As such, the development of accounting and financial reporting standards has lagged the development and creation of increasingly intricate economic structures and transactions. There are two broad categories of accounting principles-recognition and disclosure. Recognition principles determine the timing and measurement of items that enter the accounting cycle and impact the financial statements. These are quantitative standards that require economic information to be reflected numerically. Disclosure principles deal with factors that are not always numeric. Disclosures involve qualitative information that is an essential ingredient of a full set of financial statements. Their absence would make the financial statement misleading by omitting information relevant to the decision making needs of the reader. Disclosure principles complement recognition principles by explaining assumptions underlying the numerical information and providing additional information on accounting policies, contingencies, uncertainties, etc., which are essential to fully understand the performance and financial condition of the reporting enterprise. Who Created GAAP? From time to time, the bodies given responsibility for the promulgation of GAAP have changed, and indeed more than a single such body has often shared this

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responsibility. GAAP established by all earlier standard-setting bodies, to the extent not withdrawn or superseded, remains in effect at the present time. These bodies are:

• Committee on Accounting Procedure • Accounting Principles Board • Financial Accounting Standards Board (FASB) • American Institute of Certified Public Accountants (AICPA) • Emerging Issues Task Force (EITF) • Other sources • Accounting Standards Codification

The Hierarchy of GAAP after Codification On July 1, 2009, the FASB Accounting Standards Codification became the single official source of authoritative, nongovernmental US generally accepted accounting principles (GAAP). It superseded all extant FASB, AICPA, EITF, and related literature. After that dale, only one level of authoritative GAAP existed, excluding the guidance issued by The Securities and Exchange Commission (SEC). All other literature is nonauthoritative. In effect, therefore, the formerly five-level US GAAP hierarchy was compressed to two levels. The Codification did not change GAAP, but rather introduced a new structure—one that is organized into an easily accessible, user-friendly online research system. The Codification reorganizes the large number of discrete US GAAP pronouncements into roughly 90 accounting Topics, and displays all Topics using a consistent structure. Also included in the Codification is relevant SEC guidance, which follows the same topical structure, used throughout the Codification. This represents a departure from past practice, since it was not previously included in official GAAP guidance, (although it obviously was binding on publicly held reporting entities, and was to be given some consideration as "category E" hierarchy literature even by nonissuers). To increase the utility of the Codification for public companies, relevant portions of authoritative content issued by the SEC and selected SEC staff interpretations and administrative guidance are being included for reference in the Codification. The sources include Regulation S-X, Financial Reporting Releases (FRR) / Accounting Series Releases (ASR), Interpretive Releases (IR), and SEC staff guidance in Staff Accounting Bulletins (SAB), EITF Topic D. and SEC Staff Observer comments. The Codification does not. however, incorporate the entire population of SEC rules, regulations, interpretive releases, and staff guidance, such as content related to mailers outside of the basic financial statements, including Management's Discussion and Analysis (MD&A), or to auditing or independence matters.

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The Codification includes all category A-D GAAP issued by accounting standard setters, including pronouncements issued by the FASB, EITF, the Accounting Standards Executive Committee (AcSEC), the Accounting Principles Board, etc., to the extent still binding on financial reporting practice. The source of materials used to create the Codification is the as-amended versions of those original accounting standards. Therefore, the Codification does NOT identify as sources any documents that solely amend other standards. For example, FAS 149 was an amendment of FAS 133. so the content of FAS 149 is included through the as-amended version of Statement 133. Similarly, a great deal of literature (FASB statements, technical bulletins, and interpretations, as well as scores of EITF Issues, etc.) amended the venerable lease accounting standard, FAS 13, and those also are no longer referenced. The Codification content is arranged within Topics, Subtopics, Sections, and Subsections. Topics represent a collection of related guidance. Topics reside in four main areas as follows:

• Presentation - Topics relating only to presentation matters: they do not address recognition, measurement, and derecognition matters. Examples of these topics are-income statement, balance sheet, and earnings per share.

• Financial Statement Accounts—The Codification organizes topics into a financial statement order, including assets, liabilities, equity, revenue, and expenses. Topics include, for example, receivables, revenue recognition, and inventory.

• Broad Transactions - These topics relate to multiple financial statement accounts and are generally transaction-oriented. Topics include, for example, business combinations, derivatives, and nonmonetary transactions.

• Industries - These topics relate to accounting that is unique to an industry or type of activity. Topics include, for example, airlines, software, and real estate.

Subtopics represent subsets of a topic and are typically identified by type or by scope. For example, operating leases and capital leases are two separate subtopics of the leases topic, distinguished by type of lease. Each topic contains an overall subtopic that generally represents the pervasive guidance for the topic, which includes guidance that applies to all other subtopics. Each additional subtopic represents incremental or unique guidance not contained in the overall subtopic. Sections represent the nature of the content in a subtopic for example, recognition, measurement, and disclosure. The sectional organization for all subtopics is the same. In a manner similar to that used for topics, sections correlate closely with sections of individual International Accounting Standards.

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Sections are further broken down into subsections, paragraphs, subparagraphs, depending on the specific content of each section.

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CHAPTER 2 - AUTHORITATIVE GUIDANCE FOR PREPARING AND REPORTING ON OCBOA FINANCIAL STATEMENTS


Recognize the purpose of The Code of Professional Conduct and the responsibilities that CPAs have to follow the Code when performing their professional responsibilities.

Identify the four parts of The Code of Professional Conduct. Recognize the guidance that is provided by The Code of Professional

Conduct when preparing OCBOA financial statements.

OVERVIEW Individual CPAs and CPA firms follow standards that were specifically established to provide guidance in preparing and reporting on OCBOA financial statements; others applicable standards are general in nature. The standards discussed here include the AICPA Code of Professional Conduct, SAS-62 (AU 623), SSARS-1 (AR 100), and Statements on Quality Control Standards (SQCSs).

THE AICPA CODE OF PROFESSIONAL CONDUCT The AICPA Code of Professional Conduct provides guidance for the CPA in conducting his or her professional practice. A CPA must observe all of the rules and interpretations in the Code of Professional Conduct. The Code of Professional Conduct is made up of two sections: (1) the Principles and (2) the Rules. The Principles provide the framework for the Rules, which govern the performance of professional services by CPAs. The Council of the AICPA is authorized to designate bodies to promulgate technical standards under the Rules. The Code of Professional Conduct was adopted by the membership of the AICPA to provide guidance and rules to all members-those in public practice, industry, government, and education-in the performance of their professional responsibilities.

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Compliance with the Code of Professional Conduct, as with all standards in an open society, depends primarily on members' understanding and voluntary actions, secondarily on reinforcement by peers and public opinion, and ultimately on disciplinary proceedings, when necessary, against members who fail to comply with the Rules. The Code applies to all services performed by a practitioner while holding him- or herself out as a CPA. According to the Code, a practitioner holds out as a CPA if he or she informs others of his or her status as a CPA or AICPA-accredited specialist. This includes, for example:

• Oral or written representation to another regarding CPA status • Use of CPA designation on business cards or letterhead • The display of a certificate evidencing the CPA designation • Listing as a CPA in local telephone directories

The Code also applies to other people in the practitioner's firm. Ethics Interpretation No. 505-2 states that

A member may be held responsible for compliance with the rules by all persons associated with him or her in the practice of public accounting whom the member has the authority or capacity to control.

A member shall not permit others to carry out on his or her behalf, either with or without compensation, acts which, if carried out by the member, would place the member in violation of the rules.

Form and Content The Code of Professional Conduct consists of four parts: (1) principles, (2) rules, (3) interpretations, and (4) rulings. Principles of professional conduct provide the framework for the Code’s specific rules. Rules of conduct govern the performance of professional services. The AICPA Council establishes the rules and can designate bodies to establish technical standards under the rules. The rules consist of the following:

• Rule 101: lndependence • Rule 102: lntegrity and Objectivity • Rule 201: General Standards • Rule 202: Compliance with Standards • Rule 203: Accounting Principles • Rule 301: Confidential Client Information • Rule 302: Contingent Fees • Rule 501: Acts Discreditable • Rule 502: Advertising and Other Forms of Solicitation • Rule 503: Commissions and Referral Fees

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• Rule 505: Form of Organization and Name

Rule 201: General Standards Rule 201 of the Code, which is reproduced below, is concerned with general standards, including guidance on organizational structure, that a CPA must observe in the performance of all professional services:

A member shall comply with the following standards and with any interpretations thereof by bodies designated by Council:

A. Professional Competence. Undertake only those professional services that the member or the member' s firm can reasonably expect to be completed with professional competence. B. Due Professional Care. Exercise due professional care in the performance of professional services. C. Planning and Supervision. Adequately plan and supervise the performance of professional services. D. Sufficient Relevant Data. Obtain sufficient relevant data to afford a reasonable basis for conclusions or recommendations in relation to any professional services performed.

Professional Competence The professional competence standard under Rule 201 is similar to the first standard of generally accepted auditing standards (GAAS), which requires that an audit be performed by someone having adequate technical training and proficiency as an auditor. "Adequate technical training" means that the CPA is thoroughly familiar with financial accounting standards, with procedures relevant to the performance of a particular engagement (ie., audit, review, compilation, or attestation), and with professional engagement standards. "Proficiency" refers to practical experience. That is, a CPA in charge of a particular engagement should have sufficient practical experience to execute the engagement successfully in accordance with professional standards.

Due Professional Care The general standard of due professional care requires CPAs to perform engagement in a manner appropriate for a professional accountant. If due professional care is not exercised, an entity that sustains a financial loss may have grounds for bringing legal action against the CPA.

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Due professional care can be evaluated only in the context of a specific engagement. For this reason, CPAs must approach each engagement with the appropriate degrees of skepticism and creativity. Skepticism means that the CPA approaches the subject matter of the engagement with an inquisitive mind. Creativity on the part of the CPA facilitates the successful performance of an engagement. Regardless of the number of standards promulgated, the CPA must approach each engagement as unique and be prepared to respond in a meaningful way to the issues that arise from the procedures.

Planning and Supervision All professional engagements need proper planning and supervision to be effective. The planning and supervision standard under Rule 201 is similar to the first standard of fieldwork of GAAS, which requires that the work be adequately planned and that assistants be properly supervised. Proper planning allows the CPA to understand the needs of the client and the demands of the engagement. In addition, adequate planning requires that the CPA firm consider the staffing requirements and assign personnel whose technical training and proficiency match the demands of the specific engagement. In fact, determining whether appropriate staff are available for an engagement is an important element in determining whether an engagement should even be accepted. Staff accountants for an engagement should be properly supervised. As part of its organizational structure, an accounting firm should implement an adequate system of review and supervision for all engagements. The appropriate level of supervision on an engagement depends in part on the complexity of the engagement and the technical proficiency and experience of the assistants.

Sufficient Relevant Data Before a CPA can issue a report, he or she must collect sufficient relevant data to support the report's conclusions. The sufficient relevant data standard under Rule 201 is similar to the third standard of fieldwork of GAAS, which requires practitioners to obtain sufficient competent evidential matter as a basis for expressing an opinion on financial statements. As part of determining whether to accept a particular engagement, the CPA should establish procedures to determine whether the prospective client has an adequate accounting system.

Rule 202: Compliance with Standards

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Rule 202 of the Code of Professional Conduct, addresses compliance with standards that CPAs must observe in the performance of all professional services:

“A member who performs auditing, review, compilation, management consulting, tax, or other professional services shall comply with standards promulgated by bodies designated by Council.”

The AICPA has charged the Accounting and Review Services Committee (ARSC) with establishing professional standards for compilation and review engagements for nonpublic entities and the Auditing Standards Board (ASB) with establishing professional standards for audit engagements for nonpublic entities. The AICPA has recognized the Public Company Accounting Oversight Board (PCAOB) as the body responsible for establishing professional standards for audit engagements for public entities. Statements on Standards for Accounting and Review Services (SSARS), Statements on Auditing Standards (SAS), and Statements on Standards for Attestation Engagements (SSAE) and related interpretations have been issued under the authority established by Rule 202.

Interpretations of Rules of Conduct Interpretations of Rules of Conduct are interpretations that have been adopted (after exposure to state societies, state boards, practice units, and other interested parties) by the AICPA's professional ethics division's executive committee. The Interpretations of Rules of Conduct provide guidelines on the scope and application of the Rules but they are not intended to limit the scope or application of the Rules. A CPA who departs from these guidelines has the burden of justifying his or her departure should there be a disciplinary hearing.

Ethics Rulings Ethics Rulings are formal rulings made by the AICPA's professional ethics division's executive committee after exposure to state societies, state boards, practice units, and other interested parties. Ethics Rulings summarize the application of Rules of Conduct and Interpretations to a particular set of factual circumstances. CPAs who depart from Ethics Rulings in similar circumstances will be requested to justify their such departures.

OCBOA FINANCIAL STATEMENT GUIDANCE The primary guidance for OCBOA financial statements is found in SAS-62 (AU 623) (Special Reports). AU 623 and its related interpretations address the general definition of the term "other comprehensive bases of accounting,"

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financial statement titles, and financial statement disclosures. In addition, AU 623 provides guidance for the auditor's report. SSARS-1 (AR 100) (Compilation and Review of Financial Statements) and its related interpretations contain additional guidance concerning compilations and reviews of OCBOA financial statements. Finally, AICPA Technical Practice Aids (TPAs) provide guidance for several OCBOA preparation and reporting circumstances.

NOTE: Although SAS-62 is an audit standard, SSARS-1 specifically references SAS-62 as authoritative guidance for compiling and reviewing OCBOA financial statements.

AU Section 623 AU 623.03 states that "an independent auditor's judgment concerning the overall presentation of financial statements should be applied within an identifiable framework." Ordinarily, that framework is provided by GAAP and the auditor's judgment in forming an opinion is applied accordingly; however, AU 623 allows comprehensive bases of accounting other than GAAP to be used. AU 623.04 recognizes the following OCBOAs:

• The basis of accounting that a reporting entity uses to comply with the requirements or financial reporting provisions of a governmental regulatory agency whose jurisdiction the entity is under (for example, insurance companies use a basis of accounting pursuant to the rules of a state insurance commission) • The basis of accounting a reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements • The cash receipts and disbursements basis of accounting, and modifications of the cash basis that have substantial support, such as recording depreciation on fixed assets or accruing income taxes • A definite set of criteria having substantial support that is applied to all material items appearing in financial statements (such as the price-level basis of accounting)

Unless one of the foregoing descriptions applies, the CPA is not allowed to audit, review, or compile the financial presentation.

Financial Statement Titles AU 623.07 also addresses the issue of financial statement titles. Terms such as "balance sheet," "statement of financial position," "statement of income," "statement of operations," "statement of cash flows," and similar unmodified titles are generally understood to be applicable only to GAAP financial statements. Accordingly, CPAs should modify the titles of OCBOA financial statements. For

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example, cash-basis financial statements might be titled" statement of assets and liabilities arising from cash transactions" or "statement of revenue collected and expenses paid," and a financial statement prepared on a statutory or regulatory basis might be titled "statement of income-statutory basis."

Disclosures When reporting on OCBOA financial statements, the financial statements, including the accompanying notes, should include all informative disclosures that are appropriate for the basis of accounting used. Notes accompanying OCBOA financial statements should include a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from GAAP. However, the effects of the differences between GAAP and the OCBOA used need not be quantified. In addition, AU 623.10 states that when the financial statements contain items that are the same as or similar to items in GAAP financial statements, similar disclosure should be included. For example, income tax basis financial statements and modified cash basis financial statements usually reflect depreciation, long-term debt, and owners' equity. Thus, the disclosures for depreciation, long-term debt, and owners' equity in OCBOA financial statements should be comparable to those in GAAP financial statements. The CPA should also consider disclosures related to matters not specifically identified on the face of the financial statements, such as

• Related-party transactions • Restrictions on assets and owners' equity • Subsequent events • Uncertainties

AU Section 623 Interpretation In 1998, the Auditing Standards Board issued Interpretation No. 14 of SA5-62 (AU 9623.94) (Evaluating the Adequacy of Disclosure and Presentation in Financial Statements Prepared in Conformity with an Other Comprehensive Basis of Accounting). Interpretation No. 14 of SAS-62 (AU 9623.94) states that the discussion of the basis of accounting, required by AU 623.10, may be brief and only needs to describe the primary differences from GAAP. For example: "The accompanying financial statements present financial results on the accrual method of accounting used for federal income tax reporting." To further illustrate, if several items are accounted for differently from how they would be under GAAP but only

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the differences in the depreciation calculation are significant, a brief description of the depreciation differences is all that is necessary. The remaining differences need not be described. Also, quantifying the differences is not required. Interpretation No. 14 of SAS-62 (AU 9623.94) also states that if OCBOA financial statements contain elements, accounts, or items for which GAAP would require disclosure, the OCBOA financial statements should either

• Provide the relevant disclosure that would be required for those items under GAAP or • Provide information that communicates the substance of that disclosure.

In order to provide information that communicates the substance of a GAAP disclosure, the CPA may substitute qualitative information for some of the quantitative information required by GAAP. For example, disclosing the repayment terms of significant long term borrowings may sufficiently communicate information about future principal reduction without providing the summary of principal reduction during each of the next five years that would be required for a GAAP presentation. Similarly, disclosing estimated percentages of revenues, rather than the amounts that GAAP presentations would require, may sufficiently convey the significance of sales or leasing to related parties. GAAP disclosure requirements that are not relevant to the measurement of an element, account, or item are not required. The following examples illustrate this situation:

• FAS-115 (Accounting for Certain Investments in Debt and Equity Securities) requires disclosure of fair-value information for debt and equity securities reported in GAAP presentations. This disclosure is not relevant when the basis of presentation does not adjust the cost of such securities to their fair value. • FAS-87 (Employers' Accounting for Pensions) requires disclosure of information about contributions to defined benefit plans based on actuarial calculations in GAAP presentations. This disclosure is not relevant in income tax or cash-basis financial statements.

Interpretation No. 14 of SAS-62 (AU 9623.94) states "If GAAP sets forth requirements that apply to the presentation of financial statements, then OCBOA financial statements should either comply with those requirements or provide information that communicates the substance of those requirements. II The substance of GAAP presentation requirements may be communicated using qualitative information and without modifying the financial statement format. AU 9623.93 provides the following examples:

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1. Information about "the effects of accounting changes," "discontinued operations, II and "extraordinary items" may be disclosed in a note to the financial statements without following the GAAP presentation requirements in the statement of income, without using those terms, or without disclosing the net-of-tax effects. 2. Instead of showing expenses by their functional classifications, the income tax basis statement of activities of a not-for- profit organization may present expenses according to their natural classifications and a note to the statement may use estimated percentages to communicate information about expenses incurred by the major program and supporting services. A voluntary health and welfare organization could take such an approach instead of presenting the matrix of natural and functional expense classifications that would be required for a GAAP presentation. Alternatively, if information has been gathered for the IRS Form 990 matrix, which is required for such organizations, it could be presented, either in the form of a separate statement or in a note to the financial statements. 3. Instead of showing the amounts of, and changes in, the unrestricted and temporarily and permanently restricted classes of net assets, which would be required for a GAAP presentation, the income tax basis statement of financial position of a voluntary health and welfare organization could report total net assets or fund balances, the related statement of activities could report changes in those totals, and a note to the financial statements could provide information (using estimated or actual amounts or percentages) about restrictions on those amounts and any deferred restricted amounts, describe the major restrictions, and provide information about significant changes in restricted amounts.

Under the cash basis, the modified cash basis, or the cash method used for income tax reporting, a presentation consisting entirely (or mainly) of cash receipts and disbursements is often included. According to AU 9623.94, these presentations do not have to conform to the requirements for a statement of cash flows that would be included in a GAAP presentation. A statement of cash flows is not required in OCBOA presentations. However, according to AU 9623.94, if cash receipts and disbursements are presented in a format similar to a statement of cash flows, or if the entity chooses to present a statement of cash flows, for example in a presentation on the accrual basis of accounting used for federal income tax reporting, the statement should either conform to the requirements for a GAAP presentation or communicate their substance.

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Finally, AU 9623.95 states that if GAAP would require disclosure of other matters, the CPA "should consider the need for that same disclosure or disclosure that communicates the substance of those requirements." Examples are

• Contingent liabilities • Going-concern considerations • Significant risks and uncertainties

However, the disclosures need not include information that is not relevant to the basis of accounting. For example, SOP 94-6 (Disclosure of Certain Significant Risks and Uncertainties) is not relevant in a pure cash-basis presentation, because the pure cash basis has no estimates.

AR Section 100 and Related Interpretation SSARS-1 (AR 100) (Compilation and Review of Financial Statements) provides the following definition of a "financial statement":

A presentation of financial data, including accompanying notes, derived from accounting records and intended to communicate an entity's economic resources or obligations at a point in time, or the changes therein for a period of time, in accordance with generally accepted accounting principles (GAAP) or a comprehensive basis of accounting other than GAAP.

AR 100.04, footnote 6, refers to AU 623.04 for the definition of the term "comprehensive basis of accounting other than generally accepted accounting principles." SSARS-1 (AR 100) states further that "reference to GAAP in this statement includes, where applicable, another comprehensive basis of accounting (OCBOA)." Thus, SSARS specifically sanctions the compilation or review of OCBOA-based financial statements; however, SSARS provides only minimum guidance for a compilation or review of financial statements prepared in accordance with OCBOA. The most extensive guidance on OCBOA financial statements in the SSARS is found in Interpretation No. 12 of SSARS-1 (AR 9100.41) (Reporting on a Comprehensive Basis of Accounting Other than Generally Accepted Accounting Principles). Interpretation No. 12 states that "when financial statements are prepared in accordance with a comprehensive basis of accounting other than generally accepted accounting principles, the footnotes ordinarily would state the basis of presentation and describe how that basis differs from generally accepted

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accounting principles." It further notes that if such disclosures are made, the standard forms of compilation and review reports included in AR 100 can be used (modified as necessary to appropriately identify the accompanying financial statements). Interpretation No. 12 of SSARS-1 (AR9100.41) also states that when an accountant compiles and reports on financial statements that are presented in accordance with an OCBOA and the financial statements omit substantially all disclosures, AR 100.17 requires disclosure of the basis of accounting. This disclosure may be in an attached footnote or in a note on the face of the financial statements. If a disclosure is not made as part of the financial statements, the accountant's compilation report must be modified. For example, the following sentence could be added to the first paragraph of the standard compilation report: "The financial statements have been prepared on the accounting basis used by the Company for federal income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles." Interpretation No. 12 of SSARS-l (AR 9100.41) also provides examples of appropriate compilation and review reports for OCBOA financial statements.

Technical Practice Aids Inquiries and replies based on selected practice problems received by the staff of the Technical Information Service are published each year in the AICPA's Technical Practice Aids (TPAs). The replies to practitioner's inquiries are not official positions of the AICPA or any of its committees. TPAs are codified into the AICPA Professional Standards, Volume 2, as TIS Sections 1100 through 9500. References in this book to TIS Sections refer to that codification. The following are summaries of the inquiries and replies that relate to OCBOA financial statements: • TIS Section 1300 (Statement of Cash Flows)

- TIS 1300.10 (Comprehensive Basis of Accounting Other than Generally Accepted Accounting Principles) addresses whether a statement of cash flows is required in OCBOA financial statements.

• TIS Section 1500 (Financial Statements Prepared under an OCBOA)

- TIS 1500.04 (Terminology for OCBOA Financial Statements) addresses the use of GAAP financial statement titles and captions within OCBOA financial statements.

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- TIS 1500.05 (Substantial Support for Modifications in Cash Basis) addresses what modifications of the cash basis have "substantial support" under AU 623.

• TIS Section 6950 (State and Local Governmental Units)

- TIS 6950.22 (State Accounting Differs from GAAP) Addresses whether reports on financial statements conforming to the state accounting guide requirements are considered special reports under AU 623.

• TIS Section 9030 (Accounting Changes)

- TIS 9030.10 (Change from Generally Accepted Accounting Principles [GAAP) to an Other Comprehensive Basis of Accounting [OCBOA) or from OCBOA to GAAP) addresses how a change in accounting basis should be accounted for and reported in the financial statements and how the change impacts the auditor's or accountant's report.

• TIS Section 9110 (Special Reports)

- TIS 9110.07 (Statement of Cash Receipts and Disbursements) addresses the appropriate language to use for audit, review, and compilation reports on a statement of cash receipts and disbursements. - TIS 9110.08 (Statutory Basis Financial Statements Differ from GAAP) addresses how the accountant should report on financial statements if he or she knows they will be distributed to third parties other than a regulatory agency.

• TIS Section 9150 (Compilation and Review Engagements)

- TIS 9150.09 (Application of SSARS 3 to Certain Companies Required to File with Regulatory Bodies) addresses whether SSARS-3 (Compilation Reports on Financial Statements Included in Certain Prescribed Forms), paragraph 2 (AR 300.02), precludes an accountant from using the alternative form of report illustrated in SSARS-3 when unaudited financial statements are included in a form prescribed by a regulatory body concerned with the sale or trading of securities (such as the National Association of Securities Dealers or the New York Stock Exchange). - TIS 9150.10 (Review of Financial Statements Included in a Prescribed Form) addresses whether an accountant can perform a review of financial statements included in a prescribed form that are presented on a basis other than generally accepted accounting principles.

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- TIS 9150.12 (Use of Other Comprehensive Basis of Accounting (OCBOA) for Interim Financial Statements and Generally Accepted Accounting Principles (GAAP) for Annual Financial Statements) addresses the reporting implications when a client uses OCBOA for interim financial statements and GAAP for annual statements.

STATEMENTS ON QUALITY CONTROL STANDARDS The statements on Quality Control Standards (SQCSs) are a framework for quality control in a CPA firm that applies to both the functional and technical aspects of all types of accounting and auditing engagements. The following SQCSs have been issued by the Auditing Standards Board:

• SQCS-1 (System of Quality Control for a CPA Firm) (superseded by SQCS-2) • SQCS-2 (System of Quality Control for a CPA Firm's Accounting and Auditing Practice) • SQCS-3 (Monitoring a CPA Firm's Accounting and Auditing Practice) • SQCS-4 (System of Quality Control for a CPA Firm's Accounting and Auditing Practice) • SQCS-5 (The Personnel Management Element of a Firm's System of Quality Control-Competencies Required by a Practitioner in Charge of an Attest Engagement) • SQCS-6 (Amendment to SQCS-2)

The standards established by the SQCSs apply to a firm's accounting and auditing practice, which SQCS-2 defines as follows:

Accounting and auditing practice refers to all audit, attest, accounting and review, and other services for which standards have been established by the AICPA Auditing Standards Board or the AICPA Accounting and Review Services Committee under Rules 201 or 202 of the AICPA Code of Professional Conduct.

The SQCS are codified in the AICPA Professional Standards, Volume 2, as QC sections 20 through 40. References in this book to QC sections refer to that codification.

Elements of a Quality Control System The fundamental elements of a quality control system are

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• Independence, integrity, and objectivity • Personnel management • Acceptance and continuance of clients and engagements • Engagement performance • Monitoring

Although these elements are discussed separately here, an effective system of quality control recognizes that all of the elements are interrelated.

Independence, Integrity, and Objectivity The CPA firm should establish policies and procedures to reasonably assure that personnel are independent. For example, a firm may periodically distribute a client list to personnel and have them acknowledge whether they have a financial interest in or whether any of their relatives hold a key position with a listed client.

Personnel Management

A CPA firm should establish policies and procedures related to personnel management that encompass "hiring, assigning personnel to engagements, professional development, and advancement activities." The quality control standards specifically state that policies and procedures should be designed to reasonably assure that the following are achieved:

• Those who are hired by the firm possess the appropriate characteristics to enable them to perform competently. • Work is assigned to personnel within the firm who have the degree of technical training and proficiency required in the circumstances. • The firm's personnel participate in general and industry specific continuing professional education and other professional development activities that enable them to fulfill assigned responsibilities and satisfy applicable continuing professional education requirements of the AICPA and regulatory agencies. • The firm selects personnel for advancement who have the qualifications necessary to fulfill the responsibilities they will be called on to assume.

Acceptance and Continuance of Clients and Engagements

Policies and procedures should be in place to determine whether the firm should continue to be associated with clients and prospective clients. These policies and procedures should be designed to assess the integrity of a client's management. For example, a firm may require a thorough investigation of the integrity of the principals associated with any existing and prospective clients. Although the firm

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must be concerned with the integrity of management, the evaluation performed by the firm does not vouch for the integrity of management. The SQCS also require that policies and procedures be established to provide reasonable assurance that the following objectives related to an engagement are achieved:

• The firm undertakes only those engagements that it can reasonably expect to complete with professional competence. • The firm appropriately considers the risk associated with providing professional services in the particular circumstances.

Engagement Performance

Quality control policies and procedures should be designed to reasonably assure that an engagement is performed in a manner that satisfies "professional standards, regulatory requirements, and the firm's standards of quality." These policies and procedures should encompass all phases of the engagement from its initial acceptance to the preparation of the accountant's report. An integral part of engagement performance is consultation, which ranges from referring to authoritative literature to holding discussions with personnel who have expertise relevant to the engagement.

Monitoring

Policies and procedures should be established to determine whether the firm is observing its quality control policies and procedures.

Administration of the Quality Control System Once they are established, policies and procedures can achieve their objectives only with an effective system of administration. SQCS-2 lists the following as elements that should be considered in the design of an effective system of administration: • Assignment of responsibilities… The responsibility for the design and maintenance of quality control policies and procedures should be assigned to a competent individual along with adequate authority to administer the quality control system. • Communication A firm must communicate its quality control policies and procedures (as well as changes to those policies and procedures) to its personnel on a timely and comprehensive basis.

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• Documentation of quality control policies and procedures The specific policies and procedures related to the documentation of quality control policies and procedures adopted by a firm are dependent on the characteristics of the firm and its practice.

NOTE: SQCS-2 does not require that quality control policies and procedures be documented, only that the documentation requirements be a reflection of the "size, structure, and nature of the practice of the firm." In addition, the standard states that "although communication is ordinarily enhanced if it is in writing, the effectiveness of a firm's system of quality control is not necessarily impaired by the absence of documentation of established quality control policies and procedures."

• Documentation of compliance with quality control policies and procedures Firm personnel must document their compliance with the quality control policies and procedures established by the firm. The specific form of documentation is dependent on the characteristics of the firm and its practice.

NOTE: Although SQCS·2 does not require a listing of the specific quality control policies and procedures used by a firm, the standard does require documentation that policies and procedures were observed.

Monitoring a Firm's System of Quality Control SQCS-2 specifically states that monitoring a firm's system of quality control encompasses the following:

• Relevance and adequacy of the firm's policies and procedures • Appropriateness of the firm's guidance materials and any practice aids • Effectiveness of professional development activities • Compliance with the firm's policies and procedures

Although the specific procedures that constitute effective monitoring of a firm's system of quality control depend on "the firm's management philosophy and the environment in which the firm practices," SQCS-3 states that such procedures may include (1) inspection procedures and (2) pre-issuance or post-issuance review of selected engagements.

Inspection Procedures

The inspection procedures adopted as part of a firm's monitoring activity should be designed to determine whether firm personnel are in fact observing the firm's quality control policies and procedures. Inspection procedures should include the review of administrative and personnel records, review of working papers, and conversations with firm personnel. In addition, SQCS-3 notes, inspection

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procedures may encompass: (1) a periodic summarization of weaknesses discovered as part of the monitoring process, (2) recommendations to eliminate or minimize the occurrence of such weaknesses in the future, (3) communication of weaknesses and related recommendations to appropriate firm management personnel, and (4) follow-up procedures conducted by appropriate firm management personnel to ensure that recommendations are implemented on a timely basis.

Pre-Issuance or Post-Issuance Review of Selected Engagements

Monitoring procedures could include a review of an engagement either before or after the report is issued. Review procedures are considered inspection procedures if they meet the following criteria:

• The review is sufficiently comprehensive to enable the firm to assess compliance with all applicable professional standards and the firm's quality control policies and procedures. • Findings of such reviews that can indicate the need to improve compliance with or modify the firm's quality control policies and procedures are periodically summarized, documented, and communicated to the firm's management personnel having the responsibility and authority to make changes in the policies and procedures. • The firm's management personnel consider on a timely basis the systemic causes of findings that indicate improvements are needed and determine appropriate actions to be taken. • On a timely basis, the firm implements such planned actions, communicates changes to personnel who might be affected, and follows up to determine that the planned actions were taken.

For reviews to be considered monitoring procedures, they must be conducted by reviewers who "are not directly associated with the performance of the engagement" -with one exception: If a firm has a "limited number of qualified management-level individuals," a post-issuance review may be conducted by the person with final responsibility for the engagement. Although SQCS-3 allows this exception, it notes that reviewing one's own work is generally not as effective as a review performed by someone who was not associated with the engagement. For this reason, SQCS-3 suggests that a firm consider hiring someone outside the firm to perform inspection procedures.

NOTE: Although a peer review is not a substitute for a firm's monitoring procedures, SQCS-3 states that a peer review that satisfies the standards established by the AICPA may substitute for "some or all of [the firm's] inspection procedures for the period covered by the review."

Practitioner-in-Charge

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QC Section 20 (System of Quality Control for a CPA Firm's Accounting and Auditing Practice) provides that a CPA firm must have a system of quality control for its accounting and auditing practice that should encompass the following elements:

• Independence, integrity, and objectivity • Personnel management • Acceptance and continuance of clients and engagements • Engagement performance • Monitoring

Personnel Management Personnel management encompasses hiring, assigning personnel to engagements, professional development, and advancement activities. Accordingly, policies and procedures should be established to provide the CPA firm with reasonable assurance that

• Those who are hired possess the appropriate characteristics to enable them to perform competently. Examples of such characteristics include meeting minimum academic requirements established by the firm, maturity, integrity, and leadership traits. • Work is assigned to personnel having the degree of technical training and proficiency required in the circumstances. • Personnel participate in general and industry-specific continuing professional education and other professional development activities that enable them to fulfill assigned responsibilities and satisfy applicable continuing professional education requirements of the AICPA and regulatory agencies. • Personnel selected for advancement have the qualifications necessary for fulfillment of the responsibilities they will be called on to assume.

QC Section 40 clarifies the requirements of the personnel management element of a firm's system of quality control. In light of the significant responsibilities of individuals who supervise the performance of accounting, auditing, and attestation engagements and sign (or authorizing an individual to sign) the accountant's report on such engagements, a CPA firm's policies and procedures should be designed to provide a firm with reasonable assurance that the responsible individuals possess the kinds of competencies that are appropriate given the circumstances of individual client engagements. For purposes of QC Section 40, such individuals are referred to as "the practitioner-in-charge of an engagement.

Competencies

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Competencies are the knowledge, skills, and abilities that qualify a practitioner-in-charge to perform an accounting, auditing, or attestation engagement. A firm is expected to determine the kinds of competencies that are necessary in the individual circumstances of an engagement. Competencies are not measured by periods of time, because such a quantitative measurement might not accurately reflect the kinds of experiences gained by a practitioner in any given time period. Accordingly, for the purposes of QC Section 40, a measure of overall competency is qualitative rather than quantitative.

Gaining Competencies A firm's policies and procedures ordinarily require the practitioner in- charge of an engagement to have gained the necessary competencies through recent experience in accounting, auditing, and attestation engagements. In some cases, however, a practitioner in- charge will have obtained the necessary competencies through disciplines other than the practice of public accounting, such as in relevant industry, governmental, and academic positions. If necessary, the experience of the practitioner-in-charge should be supplemented by continuing professional education (CPE) and consultation. The following are examples:

• A practitioner-in-charge of an engagement whose recent experience has consisted primarily of providing tax services may acquire the competencies necessary in the circumstances to perform a compilation or review engagement by obtaining relevant CPE. • A practitioner-in-charge of an engagement who did not have any experience in auditing the financial statements of a public company and only possessed recent prior experience in auditing the financial statements of nonpublic entities may develop the necessary competencies by obtaining relevant CPE related to SEC rules and regulations and consulting with other practitioners who possess relevant knowledge related to SEC rules and regulations. • A practitioner-in-charge of an engagement who did not have any experience in auditing the financial statements of a public company but possessed prior public accounting practice experience in auditing financial statements of nonpublic entities and who also has relevant experience as the controller of a public company may have the necessary competencies in the circumstances. • A practitioner-in-charge of an engagement whose actual experience consists of performing review and compilation engagements may be able to obtain the necessary competencies to perform an audit by becoming familiar with the industry the client operates in, obtaining continuing

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professional education relating to auditing, and/or using consulting sources during the course of performing the audit engagement. • A person in academia might obtain the necessary competencies to perform accounting, auditing, or attestation engagements by (1) obtaining specialized knowledge through teaching or authorship of research projects or similar papers and (2) a rigorous self-study program or by engaging a consultant to assist on such engagements.

Regardless of the manner in which a particular competency is gained, a firm's quality control policies and procedures should be adequate to provide reasonable assurance that a practitioner-in-charge of an engagement possesses the competencies necessary to fulfill his or her engagement responsibilities. The nature and extent of competencies established by a firm that are expected of the practitioner-in-charge of an engagement should be based on the characteristics of a particular client industry, and the kind of service being provided. For example, the following should be considered:

• The competencies expected of a practitioner-in-charge of an engagement to compile financial statements would be different from those expected of a practitioner engaged to review or audit financial statements. • Supervising engagements and signing or authorizing others to sign reports for clients in certain industries or engagements such as financial services, governmental, or employee benefit plan engagements, would require competencies that are different from what would be expected in performing attest services for clients in other industries. • The practitioner-in-charge of an engagement to audit the financial statements of a public company would be expected to have certain technical proficiency in SEC reporting requirements; a practitioner-in-charge who is not assigned to the audits of public companies would not need to be proficient in this area. This would include, for example, experience in the industry and appropriate knowledge of SEC and ISB rules and regulations, including accounting and independence standards. • The practitioner-in-charge of an attestation engagement to examine management's assertion about the effectiveness of an entity's internal control over financial reporting would be expected to have certain technical proficiency in understanding and evaluating the effectiveness of controls. A practitioner in- charge of an attestation engagement to examine investment performance statistics would be expected to have different competencies, including an understanding of the subject matter of the underlying assertion.

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Competencies Expected in Performing Accounting, Auditing, and Attestation Engagements In practice, the kinds of competency requirements that a firm should establish for the practitioner-in-charge of an engagement are necessarily broad and varied in both their nature and number. However, the CPA firm's quality control policies and procedures should ordinarily address the following competencies for the practitioner-in-charge of an engagement. Firms' policies and procedures should also address other competencies as necessary in the circumstances. The following is a list of competencies that could be included:

1. Understanding of the Role of a System of Quality Control and the Code of Professional Conduct Practitioners-in-charge of an engagement should possess an understanding of the role of a firm's system of quality control and the AICPA's Code of Professional Conduct, both of which play critical roles in assuring the integrity of the various kinds of accountants reports. 2. Understanding of the Service to be Performed Practitioners-in charge of an engagement should possess an understanding of the performance, supervision, and reporting aspects of the engagement, which is normally gained through actual participation in that kind of engagement under appropriate supervision. 3. Technical Proficiency Practitioners-in-charge of an engagement should possess an understanding of the applicable accounting, auditing, and attest professional standards, including those standards directly related to the industry in which a client operates and the kinds of transactions in which a client engages. 4. Familiarity with the Industry To the extent required by professional standards applicable to the kind of service being performed, practitioners-in-charge of an engagement should possess an understanding of the industry in which a client operates. In performing an audit or review of financial statements, this understanding would include an industry's organization and operating characteristics sufficient to identify areas of high or unusual risk associated with an engagement and to evaluate the reasonableness of industry-specific estimates. 5. Professional Judgment Practitioners-in-charge of an engagement should possess skills that indicate sound professional judgment. In performing an audit or review of financial statements, such skills typically include the ability to exercise professional skepticism and identify areas requiring special consideration, including, for example, the evaluation of the reasonableness of estimates and representations made by management and the determination of the kind of report necessary in the circumstances.

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6. Understanding the Organization's Information Technology Systems Practitioners-in-charge of an audit engagement should have an understanding of how the organization is dependent on or enabled by information technologies, and the manner in which information systems are used to record and maintain financial information.

Interrelationship of Competencies and Other Elements of a Firm's System of Quality Control The competencies described above are interrelated, and gaining one particular competency may be related to achieving another. For example, familiarity with the client's industry interrelates with a practitioner's ability to make professional judgments relating to the client. In establishing policies and procedures related to the nature of competencies needed by the practitioner-in-charge of an engagement, a firm may need to consider the requirements of policies and procedures established for other elements of quality control. For example, a firm would consider its requirements related to engagement performance in determining the nature of competency requirements that assess the degree of technical proficiency necessary in a given set of circumstances.

The Relationship of the Competency Requirement of the Uniform Accountancy Act to the Personnel Management Element of Quality Control The Uniform Accountancy Act (UAA) is a model legislative statute and related administrative rules that the AICPA and the National Association of State Boards of Accountancy (NASBA) have designed in order to provide a uniform approach to the regulation of the accounting profession. CPAs are required to follow not the provisions of the UAA itself but rather the accountancy laws of the licensing jurisdictions in the United States governing the practice of public accounting, which may have adopted the UAA in whole or in part. The UAA provides that "any individual licensee who is responsible for supervising attest or compilation services and signs or authorizes someone to sign the accountant's report on the financial statements on behalf of the firm shall meet the competency requirements set out in the professional standards for such services." A firm's compliance with QC Section 40 is intended to enable a practitioner who performs these services on the firm's behalf to meet this competency requirement; however, QC Section 40's applicability is broader than what is required by the UAA because the definition of an accounting and auditing practice in quality control standards encompasses a wider range of attest engagements

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History of Peer Review The AICPA Peer Review Program (PRP) was put in place to monitor the profession and establish a layer of public protection by identifying CPA firms that have inadequate systems of quality control, detecting nonperformance in accordance with professional standards in all material respects, imposing remedial action to correct deficiencies, and improving firms' accounting and auditing practices. The practice-monitoring programs are the AICPA's former SEC Practice Section peer review program, which in 2004 was supplanted by the Public Company Accounting Oversight Board's (PCAOB) inspection program, and the AICPA's PRP. The AICPA's PRP requires a peer review of each firm's accounting and auditing practice every three years. Since its inception, the PRP program has been amended several times to expand its reach and strengthen its effectiveness. The PRP continues to evolve in response to changing market needs:

• 1977: Voluntary AICPA peer review program established. • 1988: AICPA bylaw approved requiring all AICPA members active in the practice of public accounting to be associated with a firm that is enrolled in an AICPA-approved practice monitoring program. • 2000: AICPA bylaw amendment approved requiring individual CPAs to enroll in an AICPA-approved practice-monitoring program if they perform compilation services in firms or organizations not eligible to enroll in such a program. • 2001: AICPA Standards for Performing and Reporting on Peer Reviews revised to include three different tiers of peer reviews: (1) System, (2) Engagement, and (3) Report Reviews.

Objectives of Peer Review Firms that perform engagements under the Statements on Auditing Standards (SASs), Government Auditing Standards (Yellow Book) and/ or examinations of prospective financial information under the Statements on Standards for Attestation Engagements (SSAEs) must undergo a System Review, in which independent peers periodically evaluate their system of quality control. These reviews are system and compliance-oriented, with the objectives of evaluating whether

• The reviewed firm's system of quality control for its accounting and auditing practice is designed to meet the requirements of the Quality Control Standards established by the AICPA. • The reviewed firm's quality control policies and procedures are being complied with to provide the firm with reasonable assurance of complying with professional standards.

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Firms that perform compilations (except as noted below) or review services under SSARSs and/ or services under the SSAEs not included in system reviews must undergo an Engagement Review. The objectives of an engagement review are to provide the peer reviewer with a reasonable basis for expressing limited assurance that

• The financial statements or information, and the related accountant's report on the accounting and review engagements and attestation engagements submitted for review, conform in all material respects with the requirements of professional standards; and • The reviewed firm's documentation conforms with the requirements of SSARSs and the SSAEs applicable to those engagements in all material respects.

Firms that only perform compilation engagements under SSARS where the firm has compiled financial statements that omit substantially all disclosures undergo peer reviews called Report Reviews. The objective of a Report Review is to enable the reviewed firm to improve the overall quality of its compilations that omit substantially all disclosures. The reviewer provides comments and recommendations based on whether the submitted financial statements and related accountant's reports conform with the requirements of professional standards in all material respects.

Strategies for Peer Review The integration of peer review into a CPA firm's practice should be viewed as an opportunity to improve the profession. A negative attitude toward peer review impedes the growth and development of a firm. Although each firm must adopt its own strategies for implementing peer review, the following guidelines are helpful for firms that are just beginning to address the issue.

Philosophy at the Top

If the key partners and other supervisory personnel of the firm approach the peer review process with a positive attitude, the firm will have an excellent opportunity for growth and improvement. The starting point for developing a positive attitude is the initial planning for a peer review. Someone, presumably the managing partner, should embrace the concept and meet with key personnel. During the meeting, he or she should make it clear that peer review is an opportunity and not a necessary evil. Perhaps the best strategy for a successful peer review is to show how peer review fits into the firm's overall plans for development. For example, the managing partner may show how peer review could generate a valuable assessment of current policies and procedures, provide insight into the level of

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staff expertise, and afford an opportunity to talk candidly with an outside professional about the strengths and weaknesses of the firm.

Communicate the Philosophy

Once the key personnel of the firm have developed a consensus about the peer review process, it is important to communicate that position to the staff-both formally and informally. The formal aspect would include a staff meeting and a memorandum. Perhaps more important, however, are informal, sincere expressions of support by top management; that is, in day-to-day conversations with staff, key personnel fully explain and stress the benefits of peer review.

Identify a Coordinator

The CPA firm should assign one individual the responsibility of coordinating the peer review of the firm. The selection of a coordinator sends a signal to other staff members that the firm is fully committed to the peer review process. Thus, the coordinator should be highly competent and committed to the project. Once the coordinator is identified, an internal review should begin. The coordinator, perhaps with assistants, should begin to catalog policies and procedures related to the nine quality control elements. If policies and procedures are vague, it may be necessary to develop a list of perceived policies and procedures and submit those to key personnel in the firm for confirmation or modification. Next, existing forms, checklists, programs, and other similar documents should be identified. If documentary forms appear to be out of date or inappropriate, new forms should be designed with appropriate feedback from staff.

Institute an Internal Inspection Process

An ongoing internal inspection process should be started before an external peer review is conducted. An internal inspection is essential to a well-designed quality control system. In addition, a CPA firm that is comfortable with the internal inspection process will be better able to take full advantage of an external peer review.

Prepare for the Recommendations

The peer review process is by nature somewhat contentious, so key personnel of the firm must encourage the attitude that the results are recommendations, not criticisms. It is crucial that the firm be enthusiastic about the recommendations and see them as an opportunity to strengthen the firm. If the peer review team is competent, that is exactly what the firm will receive: an opportunity to grow.

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Peer Review Follow-up

Once the external peer review is completed, the CPA firm should be prepared to make the best use of the peer evaluation. This response should be orchestrated by the coordinator, and it may include staff meetings as well as individual assessment conferences with staff members. The firm should be prepared to read, evaluate, and implement the' recommendations of the peer review team as quickly as possible; delayed response decreases the likelihood that the full benefit of the process will be achieved. Finally, the peer review should be seen as a continuous process, not something to be endured every three years. Firm members should meet periodically to discuss quality control issues (including peer review). At every opportunity, key personnel of the firm should remind the staff that the key to growth is quality work and that a strong quality control system will benefit the firm as a whole and the staff members individually.

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Chapter 3 – Engagement Planning and Consideration


Identify the ethical considerations related to independence of a CPA. Indicate the recommended procedures for accepting clients. Recognize the accepted guidelines related to communication with

predecessor CPAs. Identify the recommended guidelines and procedures for establishing an

understanding with a client for retaining services and documenting the scope of the engagement.

OVERVIEW Some of the procedures a CPA should perform as part of accepting an engagement are broad in nature. These broad procedures apply to the structure that should be in place within an accounting firm to be used in its evaluation of each prospective engagement, and they should take into consideration relevant portions of the AICPA Code of Professional Conduct and the firm's quality control system. Other procedures are directed at each prospective client; for example, evaluating the integrity of the prospective client, determining who will use the financial statements, and determining the level of service required. In addition, procedures should be in place to ensure that the CPA and the client establish, preferably in writing, a clear understanding of the services to be performed. This chapter discusses these concepts in detail.

CLIENT ACCEPTANCE AND RETENTION Rule 201 of the AICPA Code of Professional Conduct specifically states that the CPA should "undertake only those professional services that the member or the member's firm can reasonably expect to be completed with professional competence." This standard does not necessarily preclude a CPA firm from accepting an engagement that the firm is not fully qualified to execute at the time of acceptance. On the contrary, SSARS-1 (AR 100) (Compilation and Review of Financial Statements) states that a CPA could accept a compilation or review engagement in an industry that the CPA has no experience in as long as the CPA obtains the necessary expertise before the engagement is completed.

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Ethical Considerations

Independence

Although an accountant may have adequate technical training and proficiency to conduct the engagement, he or she must be also without bias with respect to the client. As noted in SAS-95 (AU 150) (Generally Accepted Auditing Standards), the second general standard states that "in all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors." The auditor must be independent both in fact and in appearance. The accountant must also be independent in order to perform a review engagement. Also, even though an accountant may compile financial statements when he or she is not independent, he or she must state that he or she is not independent. Therefore, as a preliminary step before the engagement is accepted, the accounting firm should make inquiries of its professional staff to determine whether there is any relationship between a staff member and the client that might impair the firm's independence. See the "Independence Considerations" section later in this chapter for a more detailed discussion of independence considerations.

Management Integrity

An auditor is required to plan and perform an audit with an attitude of professional skepticism. In other words, the auditor neither assumes that management is dishonest nor assumes unquestionable honesty. In difficult audit areas that are subject to an increased level of professional judgment, the auditor should recognize the increased importance of factors that bear on management integrity. Management integrity has been found to be lacking in the great majority of significant accountants' liability cases. The following are some of the questions that the auditor should consider asking:

• Are there significant disagreements or lawsuits between the owners? • What is the reputation of top management and/or majority owners in the business community? • Is any significant litigation pending against the entity? • Is there high turnover in key financial positions? • Does top management lack the experience necessary to operate the business?

Professional Competency and Staff Availability

A prospective client may be in an industry that is not familiar to the accountant, may have a sophisticated accounting system that requires a high level of expertise, or may be subject to stringent requirements imposed by regulatory agencies (e.g., the Securities and Exchange Commission) that the accountant is not familiar with. When determining whether an engagement should be

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accepted, the accountant should assess the level and quality of staffing needed to complete the engagement. The level of staffing needed is based on the size and complexity of the engagement. The accountant should make preliminary estimates of the number of staff hours needed to complete the engagement and the period of time during which the engagement will be executed. The accountant must determine whether appropriate skilled personnel will be available at the proper time to work on the engagement.

CLIENT ACCEPTANCE PROCEDURES SQCS-2 (System of Quality Control for a CPA Firm's Accounting and Auditing Practice) states that an accounting firm should establish procedures to determine whether a client should be accepted, rejected, or retained and whether to perform a specific engagement for that client. SQCS-2 highlights the fact that the accountant should exercise due professional care in the initial contact with, and evaluation of, prospective clients and in determining whether to continue client relationships. The purpose of the quality control requirement is to minimize the probability of a CPA associating with a client whose management lacks integrity. When making client acceptance and continuance decisions the accountant should carefully take the following steps:

• Evaluate prospective clients • Identify intended users of the financial statements • Assess the firm's capabilities • Consider the firm's independence

NOTE: The presentation of client acceptance procedures in this chapter is quite extensive, and may be more elaborate than is necessary for all engagements. Depending on the risk assessment and the size of the client, the CPA may need only meet with the client, look over the client's records, obtain a copy of the current financial statement and tax return, and speak with the intended third-party user.

Evaluate Prospective Clients After the initial contact by a prospective client but before the terms of the engagement are negotiated, the CPA should evaluate the prospective client. This screening process should determine whether the prospective client fits with the type of practice that the accounting firm is developing. The following are the more basic steps that should be taken relevant to the screening process:

• Interview the prospective client • Read the prospective client's financial statements • Develop a preliminary understanding of the form of the prospective client's accounting records

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• Perform a preliminary evaluation of staff competencies • Contact third parties familiar with the prospective client

Interview the Prospective Client After the prospective client initially contacts the CPA, arrangements should be made for the two parties to meet. The meeting gives the CPA the opportunity to speak directly with key management personnel or owners to get a feeling for the skill level of personnel and the types of personalities in the client's company. Other areas that should be explored during the interview are:

• Why the prospective client wants financial statements compiled, reviewed, or audited

• What limitations, if any, the prospective client may impose on the engagement • A brief history of the prospective client, including identification of the principals involved and the management team • A summary of turnover of key personnel, including financial staff • Identification and description of pending or threatened litigation • How accounting policies are established and what recent changes have been made to accounting principles • Any conflict of interest between the accounting firm and the prospective client

When communicating with the prospective client and the predecessor accountant, the CPA should discuss the possible existence of related-party transactions. Although information about potential related-party transactions might not affect whether an engagement is accepted, it will alert the CPA to the issue so that subsequent engagement planning will include consideration of related-party transactions.

Read the Prospective Client's Financial Statements The initial meeting with the prospective client affords the CPA an opportunity to read prior financial statements. The financial statements can provide some idea of the sophistication of the prospective client's financial personnel. If the financial statements appear to be incomplete or erroneous, the CPA and the prospective client should discuss what other accounting services must be performed before an engagement can commence. Although the potential client and expected users of the financial statements may want an audit, certain factors (e.g., a fire that destroyed accounting records) might preclude the auditor from auditing the entity and expressing an opinion on the financial statements. The auditor should inquire of the prospective client about the availability of documents to substantiate the transactions recorded in the accounting records. Therefore, the client's accounting system must provide

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sufficient evidence to support the transactions that have occurred. The accounting system should also ensure that all transactions that should be recorded have in fact been recorded. If the auditor has concerns about the accounting system, he or she may conclude that it is unlikely that sufficient competent evidence will be available to support an opinion on the financial statements. The auditor should determine whether the accounting records include at least the following information:

• A description of the types of transactions in sufficient detail to permit appropriate classification in the financial statements. The accounting records generally need to indicate only broad classes of transactions (such as sales, cost of sales, payroll). The transactions should be described in a manner that permits the recording of monetary value in the financial statements. • The period in which the transactions occurred to permit the recording of transactions in the appropriate accounting period.

The form and degree of detail of accounting records maintained by the client depends primarily on the nature of the client's business, its size, and its organizational structure. A formalized and complex accounting system or sophisticated internal controls are not necessarily required for a business to be auditable. Many small businesses do not have elaborate or computerized accounting systems on adequate segregation of duties, but they do have the basic elements of accounting records and are therefore auditable. New engagements usually require the auditor to perform special procedures.

Develop a Preliminary Understanding of the Prospective Client's Accounting Records Although, unlike standards for audits, standards applicable to a compilation or review engagement do not require the CPA to understand and evaluate the client's internal control, the CPA should develop some understanding of the prospective client's accounting records. Ordinarily, this understanding includes identification of the types of journals and ledgers used, the manner in which data are processed (manually, by machine, or electronically), the use of outside data processing services, and the training and level of education of the client's accounting personnel. A basic understanding of the prospective client's accounting records should alert the CPA to whether additional accounting services are needed before a compilation or review engagement can be performed. In some instances, the accounting records may be so poorly designed and maintained that the CPA will decide that a compilation or review engagement cannot be performed or that the potential for encountering problems is so great that it would be better not to accept the engagement.

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Contact Third Parties Familiar with the Prospective Client The CPA should also consider contacting other parties familiar with the prospective client, including other accountants (including the predecessor CPA), bankers, the prospective client's attorney, and other business associates. In making such contacts, the CPA must be careful not to breach any confidential relationships between the prospective client and other parties. It is a good idea for the CPA to get the prospective client's permission before beginning any discussions with third parties.

Identify Intended Users of the Financial Statements As part of client acceptance, the CPA should determine the purpose of the report, which might be intended for use by management, governmental regulatory authorities, or external parties such as banks and other creditors. Although the specific engagement procedures do not depend on the users of the financial statements, the CPA should assess the risk associated with each engagement-whether the final users of the statements are internal or external parties.

Assess the Firm's Capabilities Once the CPA has discussed the engagement with the prospective client and identified the users of the report, the next step is to assess the firm's ability to complete the engagement successfully. Beyond having the prerequisite expertise, the CPA firm should consider a number of other factors. Initially, the CPA firm should determine whether staff members are available for the prospective engagement. If it appears that the engagement will involve two or more offices of the firm, all offices involved must have the capacity to perform the engagement. In order to satisfy the standard of due professional care in the engagement, adequate resources must be at the firm's disposal. The firm must also consider whether the CPA handling the engagement will need to obtain training and/or technical materials for a specialized industry that he or she has had little or no exposure to.

OTHER ENGAGEMENT ACCEPTANCE CONSIDERATIONS

Recognizing Danger Signs Screening prospective and existing clients is a valuable component of an accountant's malpractice-defense program. Warning signs of potentially troublesome clients are as follows:

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• Financial or organizational difficulty • Involvement in suspicious transactions • Lack of cooperation by key management and accounting personnel • Fee and time pressures • Refusal to sign engagement and representation letters.

Valuable Lessons from Litigation As a result of the persistent and significant allegations CPAs have faced in litigation, the following reminders are offered:

• CPAs should exercise great care in deciding to accept and equally importantly-to retain clients. For example, a CPA should consider having discussions with the prospective client's banker, legal counsel, and key personnel before accepting the client. Similarly, the CPA should carefully evaluate a continuing client's request for new levels of service in light of the firm's expertise and ability to deliver those services.

• The CPA should evaluate high turnover in key management positions, which can result in poor recordkeeping, weak internal controls, and increased risk. • The CPA should be realistic in assessing the risks associated with an engagement. For example, weak internal controls coupled with an aggressive management team or questionable management integrity greatly heighten risk. • The CPA should determine whether there is adequate board oversight of the client environment. For example, when a company gets into financial difficulties and shareholders and creditors learn that top executives treated airplanes and vacation homes as personal entitlements, they are quick to blame the CPA. Such abuse is likely to be controlled and minimized if the client has an effective oversight board. • The CPA firm and its staff should possess adequate training, competence, and proficiency to complete the engagement in accordance with professional standards. All engagement team members should try to evaluate the significance of the issues they face. This is even more important for supervisory personnel, particularly engagement partners. If the client operates in a specialized industry, the CPA should be knowledgeable about the specific requirements and issues facing the industry. • The CPA should allocate adequate time and effort to high risk, complex, and unusual transactions. The time records and summaries should be complete and accurate.

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• The CPA should adequately document in the workpapers the work performed and the conclusions reached, including why certain factors were considered more relevant and persuasive than others in reaching the conclusions. In general, the workpapers for an audit must demonstrate that the standards of fieldwork were achieved and that the accounting records agree or reconcile with the financial statements being reported on. • The CPA should obtain timely representations and confirmations from management (in an audit or review), client legal counsel, and other third parties (in an audit).

Documentation The acceptance of an engagement should be well documented. The documentation should clearly show that the necessary preengagement planning procedures were properly completed. The documentation also should include copies of communications with the client, memoranda of the exchanges of information between the predecessor and successor accountants, and other pertinent information concerning pre-engagement planning. Once an engagement is accepted, the professional relationship between the client and the CPA should be evaluated annually. This evaluation is critical in determining whether clients may be developing into potential risks to the CPA's practice. The requirement of periodic evaluation of client retention is explicitly mandated by SQCS-2. Therefore, the CPA should continue to evaluate the integrity of management and should periodically determine his or her ability to service the client.

INDEPENDENCE CONSIDERATIONS AR 100.19 states that a compilation report can be issued even if there is an impairment of independence; however, under this circumstance the compilation report must state that the CPA is not independent. Thus, before accepting the engagement the CPA should evaluate a prospective client to determine whether there is an independence problem. If there is an independence problem, the CPA and the prospective client should discuss the situation and the prospective client should understand the format of the compilation report that will be issued (that is, that it will contain a reference to a lack of independence). The reporting responsibilities for a CPA in a compilation engagement differ significantly from the reporting responsibilities in a review or audit engagement. In a compilation engagement in which the CPA is not independent, the CPA may issue a compilation report noting his or her lack of independence. In a review or

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audit engagement, the CPA is prohibited from issuing a review report or audit opinion if he or she is not independent. Determining independence is a matter of professional judgment, and CPAs should use the guidelines found in the AICPA Code of Professional Conduct. The Code provides guidance in Rule 101 (Independence), Interpretations of Rule 101, and Ethics Rulings on Independence. Rule 101 is a summary of guidelines for determining independence on the basis of Interpretations of Rule 101. In May 1999, the AICPA Professional Ethics Executive Committee revised Ethics Interpretation 101-3 and issued a new Interpretation 101-3 (Performance of Other Services) that provides numerous examples of various types of services being performed in today's practice environment and the impact such services have on accountants' independence. In June 2003, the Professional Ethics Executive Committee adopted significant revisions to Interpretation 101-3 (renamed "Performance of Nonattest Services"), which became effective on December 31, 2003. The revised AICPA rules clarify the general requirements for performing nonattest services, adding a new pre-engagement documentation requirement. In addition, more restrictive rules apply to certain services such as financial information system design and implementation and appraisal, valuation, and actuarial services. The new rules became effective on December 31, 2003, and incorporated a one-year transition period for services under contract as of that date, provided that the engagement is completed by December 31, 2004, and the accountant was in compliance with pre-existing independence requirements. One of the key principles underlying the AICPA rules on nonattest services is the accountant may not serve-or even appear to serve-- as a member of a client's management. For example, the accountant may not

• Make operational or financial decisions for the client • Perform management functions for the client • Report to the board of directors on behalf of management

NOTE: The AICPA reminds CPAs that state societies, state boards of accountancy, and state regulatory agencies may have additional requirements for assessing whether independence has been compromised.

Understanding the Nature of the Services A CPA should discuss with the client the nature of the compilation, review, or audit engagement (attest engagement) and other services (nonattest services)

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the client has requested the CPA to perform. This discussion should include (1) the objectives and limitations of the attest engagement and (2) the responsibilities of both the CPA and management. Interpretation 101-3 states that it is preferable that this understanding be part of the engagement letter and that it be made clear that the CPA "will not perform management functions or make management decisions."

Evaluating the Client's Understanding of Its Responsibilities It is not sufficient to document an understanding of the services in an engagement letter. The CPA should also evaluate the client to determine whether management has an understanding of its responsibility to

• Designate a management-level individual or group of individuals to be responsible for overseeing the services being provided • Evaluate the adequacy of the services performed and any findings that result • Make management decisions, including accepting responsibility for the results of the other services • Establish and maintain internal controls, including monitoring ongoing activities

The determination of whether the CPA's independence is impaired because of the performance of other services in an attest engagement is a matter of professional judgment. However, Interpretation 101-3 provides general guidance by listing services that would impair independence in an attest engagement:

• Authorizing, executing, or consummating a transaction or otherwise exercising authority on behalf of a client • Preparing source documents or originating data, in electronic or other form, evidencing the occurrence of a transaction • Having custody of client assets • Supervising client employees in the performance of their normal activities • Determining which recommendations of the CPA should be implemented • Reporting to the board of directors on behalf of management • Serving as a client's stock transfer or escrow agent, registrar, or general counsel or its equivalent

A CPA may perform a variety of services that are not part of an attest engagement. Some of the more common services are • Bookkeeping • Payroll and other disbursement • Benefit plan administration • Investment advising and investment managing

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• Corporate finance consulting and advising • Appraisal, valuation, and actuarial • Executive and employee search • Business risk consulting • Information system design, installation, or integration

Bookkeeping Routine bookkeeping activities, such as recording properly approved transactions or preparing financial statements from a trial balance, do not impair independence. However, Interpretation 101-3 notes that the following activities do impair independence in a compilation or review engagement:

• Determining or changing journal entries, account coding or classification for transactions, or other accounting records without obtaining client approval • Authorizing or approving transactions • Preparing source documents or originating data • Making changes to source documents without client approval

The AICPA independence rules prohibit accountants from acting as client management in all circumstances. Accordingly, an accountant may provide bookkeeping services provided that the client effectively oversees the services and, among other things, performs all management functions and makes all management decisions in connection with the services. For example, if an accountant is engaged to provide bookkeeping services that will result in a set of financial statements, the client must:

• Approve all account classifications • Provide source documents to the accountant so he or she can prepare journal entries • Take responsibility for the results of the accountant's services (e.g., financial statements) • Establish and maintain internal controls over the accountant's bookkeeping activities

Payroll and Other Disbursement Activities such as processing approved payroll information and making electronic payroll tax payments, "assuming the client has made arrangements for its financial institution to limit such payments to a named payee," do not impair independence. When activities include authorizing payments, cosigning client

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checks, maintaining custody over a client's cash account, or approving vendor invoices for payment, the CPA assumes the role of management and thus impairs his or her independence.

Benefit Plan Administration Benefit plan administrative duties may include communicating summary plan data to a plan trustee or preparing participant statements based on data provided by management. Interpretation 101-3 notes the following activities that impair independence in a compilation or review engagement:

• Making disbursements to participants • Serving as a fiduciary as defined by ERISA • Making policy decisions related to the plan

Investment Advising and Investment Managing A CPA may develop expertise in investment planning and management, and independence is not impaired when the CPA's activities include recommending an asset allocation strategy to the client and transmitting approved investment transactions to a broker. Activities that do impair independence include executing transactions and assuming custody over investment assets.

Corporate Finance Consulting and Advising Clients seeking compilation or review engagements often have limited expertise in corporate finance. The CPA's performance of activities such as assisting in the development of corporate strategies or participating in transaction negotiations is acceptable if the CPA does not assume a managerial role. Interpretation 101-3 notes the following activities that impair the CPA's independence:

• Negotiating on behalf of the client or its owners with potential investors and sources of capital • Distributing private placement memoranda or offering documents to potential investors • Acting as an underwriter, broker, agent, distributor, or guarantor regarding client securities • Soliciting investors or promoting client securities • Maintaining custody of client securities

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Appraisal, Valuation, and Actuarial A CPA may be hired to perform services related to the appraisal or valuation of accounts or the determination of actuarial valuations. However, the CPA should have the expertise necessary to perform these services and the work product should be carefully considered by the client. The CPA cannot assume responsibility for determining amounts that appear in the financial statements, because that role belongs strictly to management. Interpretation 101-3 illustrates this guidance in the following descriptions of acceptable services:

• Testing the reasonableness of the value placed on an asset or liability included in a client's financial statements by preparing a separate valuation of that asset or liability • Performing a valuation of a client's business when all significant matters of judgment are determined or approved by the client and the client is in a position to make an informed judgment on the results of the valuation

If a CPA determines a valuation based on his or her judgment but it is not approved by the client, the CPA's independence is impaired.

Executive and Employee Search Often a CPA is able to provide valuable services in the recruitment of employees. These services do not impair independence if they include activities such as screening prospective employees based on client-approved criteria or recommending a job description to the client. The hiring or firing of employees are activities that do impair independence.

Business Risk Consulting A CPA can assist the client in activities such as assessing business risk and recommending strategies to manage risk without impairing independence. Information System Design, Installation, and Integration CPAs typically develop strong information systems skills, and Interpretation 101-3 has identified the following related activities that do not impair independence:

• Installing or integrating a client's financial information system that was not designed or developed by the accountant (e.g., an off-the-shelf accounting package) • Assisting in setting up the client's chart of accounts and financial statement format with respect to the client's financial information system

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• Designing, developing, installing, or integrating a client's information system that is unrelated to the client's financial statements or accounting records • Providing training and instruction to client employees on an information and control system

Activities that do impair independence include designing or developing a client's financial information system, making other than insignificant modifications to source code underlying a client's existing financial information system, supervising client personnel in the daily operation of a client's information system, and operating a client's local area network (LAN) system.

NOTE: When a CPA is offered employment by a client or seeks employment with a client during an engagement, in order to prevent the impairment of independence the CPA should remove himself or herself from the engagement until the employment offer is rejected or employment is no longer being sought.

COMMUNICATION WITH THE PREDECESSOR CPA

Audit Engagements In evaluating a potential client that has been audited previously by another auditor, the predecessor auditor is a primary source of information about the client. SAS-84 (AU 315) (Communications between Predecessor and Successor Auditors) requires the successor auditor to communicate with the predecessor auditor. However, Rule 301 of the AICPA Code of Professional Conduct prohibits an auditor from disclosing confidential information except when the client agrees to the disclosure. To reconcile the requirements of AU 315 with Rule 301, the successor auditor should ask the prospective client to grant permission to discuss the impending engagement with the predecessor auditor. If the successor auditor cannot obtain required information from the predecessor auditor because of client restrictions, the successor auditor should carefully consider the implications of such restrictions in evaluating whether to accept the engagement. The initiative for communicating rests with the successor auditor, and the form of the communication between the successor auditor and the predecessor auditor may be oral or written. The main objective of such communication is to find out any information that is relevant to deciding whether to accept the client. Therefore, the questions raised by the successor auditor should be sufficiently specific to help determine whether the engagement should be accepted. AU 315.09 states that matters subject to inquiry should include

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• Information that might bear on the integrity of management • Disagreements with management over the application of accounting principles, auditing procedures, or other similarly significant matters • Communications to audit committees or others with equivalent authority and responsibility (e.g., board of directors or the owner in a small business) regarding fraud, illegal acts by clients, and internal-control-related matters • The predecessor auditor's understanding of the reasons for the change of auditors

The successor auditor should request the client to authorize the predecessor auditor to allow a review of the predecessor's working papers. The predecessor auditor may wish to request a consent and acknowledgment letter from the client to document this authorization in an effort to reduce potential misunderstandings about the scope of the communications being authorized. AU 315.11 also states that, ordinarily, the predecessor auditor should permit the successor to review working papers, including documentation of planning, internal control, audit results, and other matters of continuing accounting and auditing significance such as the working paper analyses of balance sheet accounts and those relating to contingencies. The extent, if any, to which a predecessor auditor permits access to the working papers is a matter of professional judgment. Before permitting access to the working papers, the predecessor auditor may wish to obtain a written communication from the successor auditor as to the use of the working papers.

Compilation and Review Engagements SSARS-4 (AR 400.02) (Communication between Predecessor and Successor Accountants) provides the following definitions:

• Successor accountant An accountant who has been invited to make a proposal for an engagement to compile or review financial statements and is considering accepting the engagement, or an accountant who has accepted such an engagement. • Predecessor accountant An accountant who (1) has reported on the most recent compiled or reviewed financial statements or was engaged to perform but did not complete a compilation or review of the financial statements and (2) has resigned, declined to stand for reappointment, or been notified that his or her services have been, or may be, terminated.

The successor accountant may (but is not required to) communicate with the predecessor accountant (with the prospective client's permission) to determine whether a compilation or review engagement should be accepted. AR 400.05 notes that the inquiries "should be specific and reasonable regarding matters that

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will assist the successor accountant in determining whether to accept the engagement" and may include areas of inquiry such as the following:

• Management (owner's) integrity • Disagreements concerning accounting principles, the performance of engagement procedures, or "similarly significant matters" • Management cooperation with requests for additional or revised information • Fraud or illegal acts • The reason for the change of accountants

Generally the predecessor accountant should respond promptly and fully with inquiries posed by the successor accountant except in the case of unusual circumstances such as litigation. When the response is limited, the predecessor accountant should inform the successor accountant of this. The successor accountant may also request, with the client's permission, a review of the predecessor accountant's working papers. AR 400.08 notes that the predecessor accountant should determine which working papers should be made available to and copied by the successor accountant. AR 400.08 notes that the predecessor accountant may decide to request a written communication from the successor accountant before allowing access to working papers.

NOTE: If the successor accountant discovers during the engagement that the financial statements compiled or reviewed by the predecessor accountant might have to be revised, the successor accountant should request that the client inform the predecessor accountant of this possibility.

AR 400.11 states that if the client refuses to inform the predecessor accountant of the matter or is not satisfied with the predecessor accountant's response to the notification, the successor accountant should consider the impact (including withdrawal from the engagement or consultation with legal counsel) of such developments on the current engagement.

NOTE: Interpretation No. 1 of SSARS-4 (AR 9400.01) states that the standards established by AR 400 apply only when the successor CPA is contemplating the acceptance of a compilation or review engagement. If the CPA has not been engaged to report on an entity's financial statements but has been requested to provide written advice (1) on the application of accounting principles to specific transactions, (2) on the type of report that may be rendered on a client's financial statements, or (3) to intermediaries about the application of accounting principles not involving facts or circumstances of a particular principal, the standards established by SAS-50 (AU 625) (Reports on the Application of Accounting Principles)

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should be observed. It should be noted that AU 625 applies to oral advice as well.

ESTABLISHING AN UNDERSTANDING WITH THE CLIENT

Audit Engagements SAS-83 (AU 310) (Establishing an Understanding with the Client) requires the auditor to establish an understanding with the client regarding the services to be performed for each engagement. Such an understanding reduces the risk of either the auditor or the client misinterpreting the needs or expectations of the other party. The understanding should include the objectives of the engagement, management's responsibilities, the auditor's responsibilities, and the limitations of the engagement. The auditor should document the understanding in the working papers, preferably through a written communication with the client. If the auditor believes that an understanding with the client has not been established, he or she should decline to accept or perform the engagement. AU 310.06 states that an understanding with the client regarding an audit of the financial statements usually includes the following matters:

• The objective of the audit is the expression of an opinion on the financial statements. • Management is responsible for the entity's financial statements. • Management is responsible for establishing and maintaining effective internal control over financial reporting. • Management is responsible for identifying and ensuring that the entity complies with the laws and regulations applicable to its activities. Management is responsible for making all financial records and related information available to the auditor. • At the conclusion of the audit, management will provide the auditor with a letter that confirms certain representations made during the audit. • The auditor is responsible for conducting the audit in accordance with generally accepted auditing standards. Those standards require that the auditor obtain reasonable, rather than absolute, assurance about whether the financial statements are free of material misstatement, whether caused by error or by fraud. Accordingly, a material misstatement might remain undetected. An audit is not designed to detect error or fraud that is immaterial to the financial statements. If for any reason the auditor is unable to complete the audit or is unable to form or has not formed an opinion, he or she may decline to express an opinion or decline to issue a report as a result of the engagement. • An audit includes obtaining an understanding of internal control sufficient to plan the audit and to determine the nature, timing, and extent of audit

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procedures to be performed. An audit is not designed to provide assurance on internal control or to identify reportable conditions. However, the auditor is responsible for ensuring that the audit committee or others with equivalent authority or responsibility are aware of any reportable conditions that come to his or her attention. • Management is responsible for adjusting the financial statements to correct material misstatements and for affirming to the auditor in the representation letter that the effects of uncorrected misstatements resulting from errors or fraud aggregated by the auditor during the current engagement and pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the financial statements taken as a whole.

In addition to the foregoing required matters, AU 310.07 states that an understanding with the client may also include other matters, such as the following:

• Arrangements about the conduct of the engagement, such as timing, client assistance regarding the preparation of schedules, and the availability of documents • Arrangements regarding involvement of specialists or internal auditors, if applicable • Arrangements involving a predecessor auditor • Arrangements regarding fees and billings • Any limitation of or other arrangements regarding the liability of the auditor or the client, such as indemnification of the auditor for liability arising from knowing misrepresentations to the auditor by management • Conditions under which access to the auditor's working papers may be granted to others • Additional services to be provided relating to regulatory requirements • Arrangements regarding other services to be provided in connection with the engagement

The auditor may communicate the understanding with the client and the foregoing matters in an engagement letter to the client. Although it is not required by generally accepted auditing standards, the use of engagement letters is a common and sound business practice.

Engagement Letters The engagement letter is intended to achieve the following primary objectives:

• Document the contractual duties agreed to by the auditor and the client • Explain the auditor's and the client's responsibilities

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• Explain the nature of the services to be rendered by the auditor and establish that the financial statements are the responsibility of the client • Avoid misunderstandings with the client and the auditor's staff • Protect the auditor from legal liability

The engagement letter is normally addressed to the board of directors, the audit committee, the partners, the proprietor, or the chief executive officer. The engagement letter should identify the period under audit, describe the financial statements that will be audited (e.g., balance sheet, statement of operations, statement of cash flows), and state the type of report the auditor expects to issue. In addition, the auditor should mention that in the event of unforeseen circumstances or conditions, the client will be notified in writing about the revised terms of the engagement. For example, the auditor may be unable to express an opinion on the financial statements without extensive additional procedures because the internal controls were found to be ineffective or because of the poor condition of the accounting records.

Other Engagement Letter Considerations

The auditor may wish, and in some cases may be required by law, regulation, or audit contract, to confirm in writing with the client that the auditor might be required to provide a regulator with access to the audit documentation. In such circumstances, the auditor may use language such as the following in the engagement letter:

The audit documentation for this engagement is the property of [name of auditor] and constitutes confidential information. However, we may be requested to make certain audit documentation available to [name of regulator] pursuant to authority given to it by law or regulation. If requested, access to such audit documentation will be provided under the supervision of [name of auditor] personnel. Furthermore, on request, we may provide copies of selected audit documentation to [name of regulator]. The [name of regulator] may intend, or decide, to distribute the copies or information contained therein to others, including other governmental agencies.

Compilation and Review Engagements A compilation or review engagement may be performed for a client who lacks a high degree of accounting sophistication. For this reason, it is important that the CPA and the client reach an understanding on what service(s) will be performed.

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AR 100.05 states that, preferably, the understanding with the client be in writing and include the following:

• A description of the scope and the limitations of the compilation or review engagement • A description of the compilation or review report that the CPA expects to issue • A statement that the compilation or review engagement cannot be relied upon to disclose errors, fraud, or illegal acts • A statement that the CPA will inform the appropriate level of management about any material errors, evidence, or information that comes to his or her attention during the performance of compilation or review procedures that fraud or an illegal act may have occurred. The CPA need not report any matters regarding illegal acts that may have occurred that are clearly inconsequential, and he or she may reach agreement in advance with the entity on the nature of any such matters to be communicated.

IMPORTANT: Whether an act is, in fact, fraudulent or illegal is a determination that is normally beyond the CPA's professional competence. A CPA, in reporting on financial statements, presents him- or herself as one who is proficient in accounting and compilation or review services. The CPA's training, experience, and understanding of the client and its industry may provide a basis for recognition that some client acts coming to his or her attention might be fraudulent or illegal. However, the determination of whether a particular act is fraudulent or illegal would generally be based on the advice of an informed expert qualified to practice law, or it may have to await final determination by a court of law.

The client should also understand that, in a review engagement, the CPA must receive a representation letter from the client in order for the review to be performed at all. Although the understanding with the client is not required to be in writing, it should be documented adequately in the compilation or review workpapers. If the understanding is in writing, the best form of documentation is an engagement letter. If the understanding is not in writing, other documentation methods may be used to summarize the understanding between the client and the CPA. Documenting the understanding with a client is discussed in more detail later in this chapter in the section entitled "Engagement Letters."

NOTE: Under certain circumstances the CPA may be able to accept an engagement in which compiled financial statements are not distributed to third parties. This type of compilation engagement is sometimes referred to as a "management-use-only compilation engagement." For these engagements, the understanding with the client must be documented in writing.

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Scope of the Engagement Before accepting a compilation or review engagement, the CPA should make clear to the prospective client the scope of the engagement as the CPA perceives it. Once the CPA has a clear picture of the necessary scope of the engagement, he or she can design specific compilation and review procedures.

NOTE: Reaching an understanding with a client does not imply that the client determines the scope of the compilation or review engagement. The understanding between the CPA and the client simply facilitates the execution of a successful compilation or review engagement. When a CPA cannot perform the procedures deemed appropriate in a compilation or review engagement, no compilation or review report can be issued. NOTE: The concept of a scope limitation in a compilation or review engagement differs from a scope limitation in an audit engagement. In an audit engagement, a CPA may encounter a scope limitation (not imposed by the client) and may decide to express either an unqualified opinion (assuming the scope limitations are not significant) or a qualified opinion.

The type of financial statement presentation a client requires for a compilation or review engagement identifies the specific reporting responsibility of the CPA with respect to the compiled or reviewed financial statements. This encompasses such factors as

• Identification of financial statements presented • Identification of the number of reporting periods • Identification of the accounting methods used and departures, if any • Footnote disclosures required • Presentation of supplementary information

Identification of Financial Statements Presented

An engagement is permitted to consist of the compilation or review of only one financial statement. For example, the CPA may be asked to compile or review only the statement of assets, liabilities, and equity. In planning an engagement in which only one financial statement is compiled, the CPA may need to recognize the interrelationship of the financial statements. That is, where appropriate, the CPA should consider events, transactions, and balances that appear on the other financial statement (or statements) in determining whether the compiled or reviewed financial statement appears to be free from obvious material errors. Furthermore, the compilation or review of one financial statement does not relieve the client of the requirement to present relevant notes and other disclosures to support the statement.

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Identification of the Number of Reporting Periods

Financial statements are often presented on a comparative basis. SSARS-2 (AR 200) (Reports on Comparative Financial Statements) requires the CPA (or CPAs) involved in the engagement(s) to report on all financial statements presented on a comparative basis in a compilation or review engagement. When financial statements are presented for more than one period, the engagement must be adequately planned so that the reporting responsibilities with respect to all the financial statements are satisfied. In a continuing engagement, the CPA updates the compilation or review report on the previous year's financial statements. For this reason, information contained in the current compilation or review engagement should be considered for possible implications for the current and previous year's financial statements. In a noncontinuing engagement, the reporting responsibility for the previous year's financial statements may rest with either the successor CPA or the predecessor CPA. If the successor CPA, on the basis of the understanding with the client, assumes responsibility for compiling or reviewing the previous year's financial statements, the scope of the compilation or review procedures must be expanded to include the previous year's financial statements. If the predecessor CPA has agreed to reissue the previous year's compilation or review report, procedures should be established to ensure that there is proper communication between the successor CPA, the predecessor CPA, and the client. The client can grant permission to the successor CPA or the client can make the contact. In the current report, the successor CPA need only refer briefly to the predecessor CPA's reissued report when the previous year's report is not presented. Once an understanding between the three parties has been reached, the successor CPA should be alert to matters he or she discovers during the current engagement that may have implications for the previous year's compilation or review report. These should be communicated to the predecessor CPA. In addition, the successor CPA may wish to give the predecessor CPA a draft of the current year's and previous year's financial statements on a comparative basis and a preliminary draft of the successor CPA's compilation or review report.

Identification of Accounting Methods Used and Any Departures

Clearly, the CPA will want to identify the basis of accounting used and any departures from that method.

Footnote Disclosures Required

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The CPA should consider the level of footnote disclosure anticipated in the preparation of the client's financial statements. Generally, it is assumed that financial statements will include adequate disclosures. Nonetheless, some clients may wish to avoid the additional cost of preparing the required disclosures. AR 100.16 provides a special compilation reporting format for when a client elects to omit substantially all disclosures. Compilation reports can also include "selected" disclosures. No similar reporting format is allowed in a review engagement. Thus, before an engagement is accepted, the client should be informed that only a compilation report can be issued when the client elects to omit substantially all disclosures.

Presentation of Supplementary Information

Basic financial statements typically present financial position and results of operations as measured under the OCBOA and supporting information. The supporting information consists of notes, descriptions of accounting policies, and additional material specifically identified as being part of the basic financial statements. "Supplementary information" is financial and nonfinancial information not required to be included as a part of the basic financial statements. Because the user of the financial statements might confuse required information and supplementary information, the CPA should have a clear understanding of what information constitutes supplementary information. When the financial statements in a compilation or review engagement are accompanied by supplementary information, the CPA should state the degree of responsibility, if any, he or she is taking with respect to the supplementary information.

The Engagement Letter

SSARS do not require that the accountant obtain an engagement letter to formalize the understanding with a client. However, to avoid a misunderstanding with the client and to reduce exposure to liability risk, the CPA should prepare an engagement letter before accepting a compilation or review engagement. (If no letter is obtained, this fact should be documented.) These procedures should be repeated for each subsequent compilation or review engagement with the client. The CPA should be sensitive to any circumstance that would require a change in a subsequent engagement letter. For example, if a client acquires a subsidiary whose financial statements are compiled by another CPA, the engagement letter should be revised to describe the CPA's responsibility for reporting on the consolidated entity.

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The following elements are ordinarily covered in an engagement letter:

• A description of the nature of the service to be performed and the limitations of the service • A description of any additional services to be performed, such as tax return preparation or bookkeeping services • An indication of the time period covered by the engagement • An example of the report the accountant expects to render • An indication of the frequency with which the service will be rendered, especially when different services will be rendered with different frequencies • An indication of the client's responsibilities during the engagement, such as responsibility for the preparation of account analyses • Fees for the service and billing arrangements • A statement that the engagement cannot be relied on to disclose errors, fraud, or illegal acts • A statement that the CPA will inform the appropriate level of management about any material errors, evidence, or information that comes to his or her attention during the performance of compilation or review procedures that fraud or an illegal act may have occurred. The CPA need not report any matters regarding illegal acts that may have occurred that are clearly inconsequential, and he or she may reach agreement in advance with the entity on the nature of any such matters to be communicated.

Although most compilation and review engagement letters include the same basic text, the CPA should word the letter carefully to conform to the individual characteristics of each engagement. This letter sets forth our understanding of the terms and objectives of our engagement and the nature and limitations of the services we will provide. In addition, it would be necessary to omit the bottom section of each letter, which requests the client to sign the engagement confirmation letter.

Other Documentation Methods

If the understanding with the client is not documented in an engagement letter, the understanding should be documented in the compilation or review workpapers. The documentation can take a variety of forms, including a checklist or questionnaire or a memorandum based on the discussions with the client. The workpaper documentation should state the basic understanding with the client.

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Chapter 4 - Primary Financial Statement Considerations


Differentiate the different types of financial statements. Indicate how OCBOA financial statements should be presented per

Interpretation No. 14 of SAS-62. Recognize what titles are appropriate and inappropriate for OCBOA

financial statements. Identify what informative disclosures that are appropriate for the basis of

accounting used for OCBOA financial statements. Identify what items and disclosures must be included on OCBOA financial

statements. Recognize how supplementary information must be presented in form and

style.

PRIMARY FINANCIAL STATEMENTS The term "financial statement" refers to a presentation of financial data, including accompanying notes, derived from the accounting records and intended to communicate an entity's economic resources or obligations at a point in time or the changes in an entity's economic resources or obligations for a period of time in conformity with a comprehensive basis of accounting. The following financial presentations are examples of financial statements:

• Balance sheet • Statement of income • Statement of comprehensive income • Statement of retained earnings • Statement of cash flows • Statement of changes in owners' equity • Statement of assets and liabilities (with or without owners' equity accounts) • Statement of revenues and expenses • Statement of financial position • Statement of activities • Summary of operations • Statement of operations by product lines • Statement of cash receipts and disbursements

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A financial statement may be, for example, that of a corporation, a consolidated group of corporations, a combined group of affiliated entities, a not-for-profit organization, a governmental unit, an estate or trust, a partnership, a proprietorship, a segment of any of these, or an individual. In an OCBOA presentation, the basic financial statements typically present financial position and results of operations as measured under the OCBOA, descriptions of accounting policies, and notes to the financial statements. However, an exception to this exists for entities that use the pure cash basis of accounting. Under the pure cash basis of accounting, a statement of assets, liabilities, and equity is needless because the cash balance is the only item that appears. Consequently, entities using the pure cash basis of accounting present a single statement titled "Statement of Cash Receipts and Disbursements."

Economic Resources and Obligations The term "financial statements" refers to a presentation of financial data that is intended to communicate an entity's economic resources or obligations on a specific date. When GAAP financial statements are prepared, a financial statement of this nature is referred to as a "balance sheet" or "statement of financial position."

Changes in Economic Resources and Obligations The term "financial statements" refers to a presentation of financial data related to changes in an entity's economic resources or obligations. When GAAP financial statements are prepared, a financial statement of this nature is referred to as an "income statement" or "statement of operations."

Cash Flows FAS-95 (Statement of Cash Flows) states that "a business enterprise that provides a set of financial statements that reports both financial position and results of operations shall provide a statement of cash flows for each period for which results of operations are provided." However, Interpretation No. 14 of SAS-62 (AU 9623.94) states that "a statement of cash flows is not required" in presentations using the cash, modified cash, or income tax basis of accounting.

NOTE: Whether a statement of cash flows is necessary for a basis of accounting established by a governmental regulatory agency depends on the specific requirements established by the agency.

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Statement of Retained Earnings APB-9 (Reporting the Results of Operations) states that the statement of income and the statement of retained earnings (separately or combined) are designed to reflect, in a broad sense, the "results of operations." Therefore, to present results of operations under GAAP, changes in retained earnings must be disclosed. Based on Interpretation No. 14 of SAS-62 (AU 9623.90), OCBOA financial statements also should disclose the changes in retained earnings when results of operations are presented. This disclosure can be made in a separate financial statement, in the notes to the financial statements, or as part of another basic statement (such as the income statement or balance sheet).

Comprehensive Income According to FAS-130 (Reporting Comprehensive Income), all business entities that have any component of comprehensive income must display information about comprehensive income in a financial statement having the same prominence as the other basic financial statements. The four components of other comprehensive income are:

1. Unrealized gains and losses arising from investments in marketable securities classified as "available for sale" (FAS-115 [Accounting for Certain Investments in Debt and Equity Securities]) 2. Foreign currency translation adjustments and gains and losses from certain foreign currency transactions (FAS-52 [Foreign Currency Translation]) 3. Minimum pension liability adjustments (FAS-87 [Employers' Accounting for Pensions]) 4. Unrealized gains and losses arising from certain derivative transactions (FAS-133 [Accounting for Derivative Instruments and Hedging Activities])

However, these components of other comprehensive income generally do not occur in tax: or cash-basis financial statements.

Presentation Presentation relates to how items are presented and described in the financial statements. Interpretation No. 14 of SAS-62 (AU 9623.90) offers broad guidance on how OCBOA financial statements should be presented, stating that OCBOA financial statements should either comply with GAAP presentation requirements or provide information that communicates the substance of those requirements. The "substance" of GAAP presentation requirements may be communicated by

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using qualitative information and without modifying the financial statement format. For example, an entity preparing GAAP financial statements would present discontinued operations, extraordinary items, or accounting changes on the face of the income statement in accordance with APB-30 (Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions). In an OCBOA presentation, information about these items could be provided in a note to the financial statements without modifying the format of the actual statements. Interpretation No. 14 of SAS-62 (AU 9623.94) also provides the following examples of how OCBOA financial statements can communicate the substance of GAAP presentation requirements without strictly following GAAP:

• Instead of showing expenses by their functional classifications, the income tax basis statement of activities of a not for- profit organization could present expenses according to their natural classifications, and a note to the statement could use estimated percentages to communicate information about expenses occurred by the major program and supporting services. A voluntary health and welfare organization could take such an approach instead of presenting the matrix of natural and functional expense classifications that would be required for a GAAP presentation. Alternatively, if information has been gathered for the IRS Form 990 matrix, which is required for such organizations, it could be presented, either in the form of a separate statement or in a note to the financial statements. • Instead of showing the amounts of, and changes in, the unrestricted and temporarily and permanently restricted classes of net assets, which would be required for a GAAP presentation, the income tax basis statement of financial position of a voluntary health and welfare organization could report total net assets or fund balances, the related statement of activities could report changes in those totals, and a note to the financial statements could provide information, using estimated or actual amounts or percentages, about restrictions on those amounts and any deferred restricted amounts, describe the major restrictions, and provide information about significant changes in restricted amounts.

FINANCIAL STATEMENT TITLES AU 623.07 addresses the issue of OCBOA financial statement titles. When OCBOA financial statements are prepared, it is inappropriate to use titles that normally would be associated with GAAP financial statements. Terms such as

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"balance sheet" "statement of financial position" "statement of income" "statement of operations" and "statement of cash flows" and similar unmodified titles are generally understood to be applicable only to financial statements that are intended to present financial position, results of operations, or cash flows in conformity with GAAP. Consequently, CPAs should modify titles such as the foregoing to titles that are appropriate for OCBOA financial statements. Care must be exercised in titling OCBOA financial statements so that readers of the statements will not infer that OCBOA financial statements are prepared in accordance with GAAP. For example, cash-basis financial statements might be titled "statement of assets and liabilities arising from cash transactions" or "statement of revenue collected and expenses paid" and a financial statement prepared on a statutory or regulatory basis might be titled "statement of income--statutory basis." Other examples are as follows:

Balance Sheet Title Alternatives Basis of Presentation Financial Statement Title Cash Basis Statement of Cash and Owners’ Equity Modified Cash Basis( with or without owners’ equity)

Statement of Assets and Liabilities- Income Tax Basis

Regulatory accounting basis Balance Sheet- Regulatory Basis

Income Statement Title Alternatives

Basis of Presentation Financial Statement Title Cash basis Statement of Cash Receipts and

Disbursements( or Expenditures) Modified cash basis Statement of Revenues and

Expenses- Modified Cash Basis Income tax basis Statement of Revenues and

Expenses- Income Tax Basis Regulatory accounting basis Statement of Income- Regulatory

Accounting Basis

Statement of Cash Flows Title Alternatives

Basis of Presentation Financial Statement Title Cash basis or modified cash basis

Statement of Cash Flows-Cash Basis

Income basis Statement of Cash Flows-Income Tax Basis

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Regulatory accounting basis Statement of Cash Flows-

Regulatory Accounting Basis

When a "definite set of criteria having substantial support" is the basis for preparing the entity's financial statements, the specific title would depend on the criteria used to prepare the statements. For example, if the basis of accounting is the price-level basis, the title "Balance Sheet-Inflation Adjusted Basis" could be used.

FINANCIAL STATEMENT CAPTIONS Captions are headings within a financial statement that designate major groups of accounts to be totaled or subtotaled, for example "Assets" and "Liabilities." The authoritative literature is silent regarding the captions to be used within OCBOA financial statements. Therefore, there is no requirement to modify standard GAAP financial statement captions OCBOA financial statements. Captions may be modified if desired, however. Technical Practice Aid (TIS 1500.04)(Terminology for OCBOA Financial Statements) provides the following examples of modified captions: • Cash-basis financial statements

- Excess of revenue collected over expenses paid - Excess of expenses paid over revenue collected - Accumulated excess of revenue over expenses paid

• Tax-basis financial statements - Retained earnings-income tax basis - Net income-tax basis

Classified versus Unclassified Presentation ARB-43, Chapter 3A, states that "in the statements of manufacturing, trading, and service enterprises assets and liabilities are generally classified and segregated." ARB-43 further states that the term "current assets" is used to designate cash and other assets or resources commonly identified as those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business. Thus the term "current assets" encompasses in general such resources as

• Cash available for current operations and items that are the equivalent of cash

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• Inventories of merchandise, raw materials, goods in process, finished goods, operating supplies, and ordinary maintenance material and parts • Trade accounts, notes, and acceptances receivable • Receivables from officers, employees, affiliates, and others, if collectible in the ordinary course of business within a year • Installment or deferred accounts and notes receivable if they conform generally to normal trade practices and terms within the business • Marketable securities representing the investment of cash available for current operations • Prepaid expenses such as insurance, interest, rents, taxes, unused royalties, current paid advertising service not yet received, and operating supplies

The term "current liabilities" is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. The classification is intended to include obligations for items that have entered into the operating cycle, such as payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale; collections received in advance of the delivery of goods or performance of services; and debts which arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes. Other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually twelve months, are also intended for inclusion, such as short-term debts arising from the acquisition of capital assets, serial maturities of long-term obligations, amounts required to be expended within one year under sinking-fund provisions, and agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons. The current liability classification is also intended to include obligations that, by their terms, are due on demand or will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even though liquidation may not be expected within that period. Although ARB-43 is applicable to GAAP financial statements, these classification requirements should generally be followed in OCBOA financial statements.

OTHER PRESENTATION ISSUES

Consolidation Accounting Tax basis financial statements are prepared on the basis of accounting used by the entity for income tax purposes. Therefore, if the entity files a consolidated tax return, it should report consolidated results in its tax basis financial statements. If

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it does not file a consolidated tax return, then it should not report consolidated results. There is no authoritative guidance on the circumstances under which cash or modified cash basis financial statements should present consolidated results. Professional judgment should be used to determine which presentation-consolidated, unconsolidated, or combined-provides the most meaningful and relevant information. If consolidated financial statements are presented, then all consolidated entities should use the same basis of accounting. If the entity chooses not to present consolidated statements in a situation where GAAP would require consolidation, then the entity should record the investments using the equity method and provide information about the other entities in the notes to the financial statements. Financial information about the other entities should be presented on the same basis of accounting used to prepare the financial statements.

Change from GAAP to OCBOA A change from GAAP to OCBOA (or vice versa) does not represent a change in accounting principles as described in APB-20 (Accounting Changes). Therefore no justification for the change is required and no cumulative adjustment is necessary. When only current-year financial statements are presented, it is common practice to present the effect of the change in the accounting basis by showing beginning retained earnings as previously reported with an adjustment to convert to the new basis. Although it is not as common in practice, precedent also exists for either showing opening retained earnings on the new basis or showing the effects of the change as a cumulative-effect adjustment in the income statement. However, if comparative financial statements are presented, the prior year(s) should be restated and presented under the basis that the company has changed to. Restatement is necessary to ensure comparability with all periods presented. In both cases, the change in accounting basis should be disclosed in the notes to the financial statements.

REFERENCES IN THE FINANCIAL STATEMENTS

References to the Notes There is no authoritative requirement to include a reference to the notes in the financial statements; however, it is common practice to do so. The following are

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examples of references to the notes (generally placed at the bottom of the page of each financial statement):

• See accompanying notes. • See notes to the financial statements. • The accompanying notes are an integral part of these financial statements.

References to Selected Information When an entity wishes to include disclosures about only a few matters in the form of notes to compiled financial statements, such disclosures should be labeled "SELECTED INFORMATION-Substantially All Disclosures Required by Generally Accepted Accounting Principles Are Not Included." In this case, the reference should read as follows: "See accompanying selected information." Note that "selected information" is appropriate only for compiled financial statements. That is, reviewed or audited financial statements must contain full disclosure.

References to the Accountant's Report SSARS-1 (AR 100) (Compilation and Review of Financial Statements) requires that each page of compiled or reviewed financial statements include a reference such as "See accountants' report." Audit standards do not require a reference to the auditor's report. Note that these requirements extend to the notes (because the notes are part of the financial statements). However, there is diversity in practice as to how to meet this requirement. Some practitioners place the reference on each page of the notes and some place the reference only on the first page of the notes. Still others place a statement on each page of the financial statements that "the notes are an integral part of the financial statements" and therefore do not place the reference on the note pages. Any of these approaches is acceptable.

Management-Use-Only Financial Statements If the financial statements are compiled for management's use only, AR 100.22 requires that each page of the financial statements contain a reference to the restricted nature of the financial statements, such as

• Restricted for Management's Use Only

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• Solely for the information of and use by the management of XYZ Company and not intended to be and should not be used by any other party.

Placing the Reference The aforementioned references may be placed on the financial statements by installing footers in the financial statement software, by using a rubber stamp, by manually writing the reference, or by any other method that is practical for the accountant.

FINANCIAL STATEMENT DISCLOSURES Determining the adequacy of disclosure is probably the most challenging aspect of preparing OCBOA financial statements. According to AU 623.09, OCBOA financial statements should include all informative disclosures that are appropriate for the basis of accounting used. Thus, the disclosures required for OCBOA financial statements are essentially the same as those required for GAAP financial statements. Specifically, informative disclosures can be classified in the following categories:

• Summary of significant accounting policies • Financial statement items • Presentation requirements • Other information

Format of Disclosures Generally, notes are accumulated and presented on separate pages following the primary financial statements. The notes should be arranged in the same order as the amounts in the financial statements they pertain to.

Title of Notes When the notes are presented on separate pages, the first page of the notes should contain an appropriate title, such as

ACME COMPANY NOTES TO THE FINANCIAL STATEMENTS

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The format and capitalization policy of the notes should follow that of the headings on the primary financial statements. When a single financial statement is presented and notes are presented on separate pages, the title should include the name of the statement, as follows:

ACME COMPANY NOTES TO THE STATEMENT OF REVENUE AND

EXPENSE~INCOME TAX BASIS

When compiled financial statements include only selected notes but omit substantially all other disclosures, the title should be modified, as follows:

ACME COMPANY

SELECTED INFORMATION-Substantially All Disclosures Are Omitted

Summary of Significant Accounting Policies AU 623.10 requires that notes accompanying OCBOA financial statements include a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from GAAP. However, the effects of the differences between GAAP and the OCBOA used need not be quantified. Interpretation No. 14 of SAS-62 (AU 9623.91) clarifies that the discussion of the basis of presentation may be brief. In describing the differences between GAAP and the basis used, only the primary differences need to be described. Differences that are not significant need not be described. Examples of descriptions of the basis of accounting used are as follows:

• Cash basis "the basis of cash receipts and disbursements" • Modified cash basis "the basis of cash receipts and disbursements, with some assets and liabilities recorded" or, alternatively, "the modified cash basis" • Income tax basis "the basis of accounting used for federal income tax reporting" or, alternatively, "the accrual method of accounting for federal income tax purposes"

GAAP requires that the significant accounting policies used to prepare the financial statements be disclosed, including policies that

• A selection from existing acceptable alternatives • Industry peculiarities

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• Unusual or innovative applications of accounting principles

Specific Disclosures The following specific disclosures are typically included in the summary of significant accounting policies in OCBOA financial statements.

Cash basis

The summary of significant accounting policies note for cash and modified cash basis financial statements should include a discussion of any accrual adjustments or modifications. All modifications or adjustments should have substantial support. The following is an example of this disclosure: The accompanying financial statements have been prepared on the modified cash basis of accounting. That basis differs from generally accepted accounting principles primarily because the Company has not recognized balances, and the related effects on earnings, or accounts receivable from customers and of accounts payable to vendors.

Tax basis

The summary of significant accounting policies note for tax basis financial statements should disclose

• Whether the basic method of accounting is cash or accrual • The tax filing status of the entity • That revenues and related assets and expenses and related obligations are recognized when they are reported or deducted for federal income tax purposes • That nontaxable income and nondeductible expenses are included in the determination of net income • The nature of any optional tax methods of accounting followed • The nature of any important judgments or policies necessary for an understanding of the methods of recognizing revenue and allocating costs to current and future periods

The following is an example of this disclosure: The accompanying financial statements have been prepared on the cash basis of accounting used by the Company for federal income tax purposes. That basis differs from generally accepted accounting principles primarily because receipts of rent in advance are recognized immediately instead of being deferred and

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because expenses generally are recognized when paid instead of when the underlying obligation is incurred.

Interim Financial Statements Disclosures made in interim financial statements should include information on how inventories and costs of sales were determined. These disclosures should also state that deferrals and accruals have been provided only when they would have been provided at yearend and, thus, the financial statements should not be viewed as an indicator of results for the year.

Financial Statement Items AU 623 states that when the financial statements contain items that are the same as, or similar to, those in GAAP financial statements, similar disclosure should be included. For example, income tax basis financial statements and modified cash basis financial statements usually reflect depreciation, long-term debt, and owners' equity. Thus, the disclosures for depreciation, long-term debt, and owners' equity in such financial statements should be comparable to those in GAAP financial statements. Interpretation No. 14 of SAS-62 (AU 9623.92) clarifies this guidance by stating that when OCBOA financial statements contain elements, accounting, or items for which GAAP would require disclosure, the OCBOA statements should either provide the relevant disclosure that would be required for those items in a GAAP presentation or provide information that communicates the substance of that disclosure. Applying the guidance in AU 623 requires the accountant to

• Identify financial statement items for which GAAP would require disclosure. GAAP provides a multiplicity of disclosures for items in financial statements, including disclosures about amounts, components of amounts, measurement, fair value, transactions, and other information. Financial statement items for which GAAP would require disclosure can be identified by reading the financial statements and looking for such items or by referring to a disclosure checklist. • Decide whether the GAAP disclosure requirement is relevant to the OCBOA presentation. Generally, if GAAP would require disclosure for items reported in an OCBOA presentation and the GAAP measurement has a counterpart in the basis or accounting used, the GAAP disclosure requirement will be relevant. • Decide whether to follow the GAAP requirement or provide information that communicates the substance of that requirement. Alternative ways of

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communicating GAAP disclosure requirements may create efficiencies. For example, alternative methods of • Management's plans, including disclosure of possible discontinuance of activities • Information about the recoverability or classification of recorded assets or the amounts and classifications of liabilities

Assets and Liabilities Information disclosed for assets and liabilities commonly includes the following items:

• Restricted cash, segregated from cash available for current operations, with a description of the nature of the restriction • The aggregate market value of marketable securities • Accounts and notes receivable from officers, employees, and affiliates, presented separately with disclosure of the effective interest rate on notes receivable • The major classes of property, plant, and equipment; depreciation expense for the period; the method(s) used in computing depreciation; and the aggregate accumulated depreciation • The method of determining inventory cost (e.g., LIFO or FIFO)

Stockholders' Equity The financial statements often disclose information on stockholders' equity, as follows:

• For each class of stock, the number of shares authorized, issued, and outstanding; the par or stated value; and, in summary form, the pertinent rights and privileges of each outstanding class (if more than one class is outstanding) • The existence of stock option and stock purchase plans • Restrictions on payment of dividends • Changes for the period in the separate components of stockholders' equity

Subsequent Events AU 623.10 notes that disclosure of subsequent events should be considered when assessing the adequacy of disclosures in OCBOA types for GAAP purposes:

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1. Events that occur after the date of the balance sheet that must be disclosed in order to prevent the financial statements from being misleading 2. Events that provide additional evidence about conditions that existed at the date of the balance sheet and that affect the estimates inherent in preparing the financial statements

Risks and Uncertainties SOP 94-6 (Disclosure of Certain Significant Risks and Uncertainties) requires a number of disclosures for GAAP financial statements, which are summarized as follows:

• Nature of operations An entity should disclose a description of major products or services it sells or provides and its principal markets. This information is useful because it helps financial statement users understand the nature of the entity's business and the risks common to that business. • General use of estimates GAAP financial statements should include an explanation that the preparation of financial statements in conformity with GAAP requires the use of management's estimates. • Certain significant estimates If certain criteria are met, the entity is required to disclose the nature of an uncertainty if it is at least reasonably possible that a change in an estimate will occur in the near term. The purpose of this disclosure is to communicate to financial statement users that there is a good possibility that certain estimated amounts in the current-year financial statements will change significantly and impact next year's financial statements. • Vulnerability due to certain concentrations If certain criteria are met, the entity is required to disclose information about its vulnerability due to concentrations, for example, a significant volume of business conducted with one customer.

The AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements provides examples for applying the GAAP requirements for disclosing risks and uncertainties in OCBOA financial statements.

Omission of Disclosures An entity may request the accountant to compile financial statements that omit substantially all the disclosures required by GAAP, including disclosures that might appear in the body of the financial statements. AR 100.16 notes that the accountant may compile such financial statements provided the omission of

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substantially all disclosures is clearly stated in the report and is not, to his or her knowledge, undertaken with the intention of misleading those who might reasonably be expected to use such financial statements. When the entity wishes to include disclosures about only a few matters in the form of notes to financial statements that omit substantially all disclosures, such disclosures should be labeled "Selected Information-Substantially All Disclosures Required by Generally Accepted Accounting Principles Are Not Included." When the accountant compiles and reports on OCBOA financial statements that omit substantially all disclosures, AR 100.17 requires disclosure of the basis of accounting. This disclosure may be in an attached footnote or in a note on the face of the financial statements. If disclosure is not made as part of the financial statements, modification of the compilation report would be required. For example, the following sentence would be added to the first paragraph of the standard compilation report: "The financial statements have been prepared on the accounting basis used by the Company for federal income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles."

NOTE: Just because an item is not required to be disclosed does not mean that it should not be disclosed. If the accountant believes the disclosure of an item is necessary in order to prevent the financial statements from being misleading, or if he or she believes the additional information is important for the users of the financial statements, the accountant should consider making the disclosure.

SUPPLEMENTARY INFORMATION OCBOA presentations may include a variety of information that supplements the basic financial statements, such as detailed schedules, summaries, comparisons, or statistical information. However, there is no authoritative guidance on what may or may not be presented as supplementary information. SAS-29 (AU 551) (Reporting on Information Accompanying the Basic Financial Statements in Auditor-Submitted Documents) defines this type of information as

• Additional details of items in, or related to, the basic financial statements, unless the information has been identified as being part of the basic financial statements • Consolidating information • Historical summaries of items extracted from basic financial statements, including graphs prepared on a computer • Statistical data

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• Other material, some of which may be from sources outside the accounting system or outside the entity

Financial statements often include detailed schedules, summaries, comparisons, or statistical information that are not part of the basic financial statements, such as

• Budgets for an expired period • Cost of goods sold schedule • Manufacturing expenses schedule • Selling expenses • General and administrative expenses • Details of marketable securities • Property and equipment schedule • Aging analysis of accounts receivable • Details of sales by product line, territory, or salesman

Normally, supplementary information is separated from the basic financial statements. Most practitioners present supplementary information on separate pages after the basic financial statements (and footnotes, if included). It is also a good idea to separate the supplementary information from the basic financial statements by including a title page marked "Supplementary Information." If a separate report is presented on the supplementary information it should follow that page.

Reporting on Supplementary Information When supplementary information accompanies compiled or reviewed financial statements, AR 100.45 requires the accountant to describe in his or her report on the statements, or in a separate report, the degree of responsibility, if any, he or she is taking with respect to the supplementary information. Reporting on supplementary information accompanying compiled or reviewed financial statements is discussed in Chapter 10, "Compiling and Reviewing OCBOA Financial Statements: Procedures and Reporting." When an auditor submits a document containing audited financial statements to his or her client or others, the auditor has a responsibility to report on all information contained in the document. Accordingly, the auditor must express an opinion on the supplementary information or disclaim an opinion on it. Reporting on supplementary information accompanying audited financial statements is discussed in Chapter 9, "Auditing OCBOA Financial Statements: Procedures and Reporting."

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FORM AND STYLE OF PRESENTATION Generally, authoritative literature does not require the accountant to follow a specific format or style when preparing financial statements. However, a firm may choose to adopt a consistent approach to the preparation of financial statements and presentations. The following sections highlight some of these form and style considerations.

Title Page Many accountants include a title page in all financial statement presentations. The title page should contain the name of the entity, the title of the financial statements, the OCBOA used to prepare the financial statements, and the date or period covered. The following is an example:

ACME COMPANY FINANCIAL STATEMENTS-INCOME TAXBASIS Years Ended December 31, 20X7and 20X6

The name of the entity should be the actual legal name. In addition, the legal form of the entity (e.g., trust, estate, or S corporation) should be disclosed if it is not apparent from the entity's legal name. Examples of other appropriate entity names are as follows:

• UPSTATE EVENT AND RACE PROMOTIONS, INC • MR. AND MRS. ROBERT W. EVANS • THE ESTATE OF VAN PRICE

Accountant's Report AU 623.05 requires reports on audited financial statements to use a title that includes the word "independent." Reports on compiled or reviewed financial statements are not required to include a title or heading, although some CPAs do include such a heading. Examples of report headings are as follows. For audited financial statements: • INDEPENDENT AUDITOR'S REPORT And for compiled or reviewed financial statements: • ACCOUNTANT'S REPORT • ACCOUNTANTS'S REPORT ON FINANCIAL STATEMENTS

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The report is generally addressed to the board of directors or stockholders. For closely held companies, the report is sometimes addressed to an individual or owner. However, the accountant's report is not a letter and should not include street addresses, ZIP Codes, or salutations such as "Dear Sirs." Examples of appropriate addresses are as follows: To the Board of Directors ACME Company Greenville, South Carolina To the Stockholders ABC Company Mr. and Mrs. Robert W. Evans Greenville, South Carolina To the Partners LMN Limited Partnership Greenville, South Carolina Mrs. Sarah Payne, Executor Estate of Van Price Greenville, South Carolina Both AR 100 and AU 508 require signatures on the accountant's report. AR 100.11 and AR 100.34 state that the accountant's compilation or review report should include the signature of the accounting firm or the accountant as appropriate. It further states that the signature could be manual, stamped, electronic, or typed. AU 508.08 states that the auditor's report should include the manual or printed signature of the auditor's firm. Although it is not an authoritative requirement, many CPAs present their report on firm letterhead.

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Chapter 5 - Cash and Modified Cash-Basis Financial Statements


Recognize what type of clients and organizations would benefit from using the cash basis of accounting.

Recognize what type of clients and organizations would benefit from using the modified cash basis of accounting.

Identify the requirements for changing the basis of accounting from GAAP to OCBOA.

Indicate what must be disclosed when preparing pure cash or modified cash basis financial statements.

OVERVIEW OF CASH-BASIS FINANCIAL STATEMENTS SAS-62 (AU 623.04) (Special Reports) states that other comprehensive bases of accounting includes "the cash receipts and disbursements basis of accounting, and modifications of the cash basis having substantial support." Cash-basis financial statements are beneficial to clients for many reasons. One of the major benefits is that some clients can understand cash-basis financial statements better than they can GAAP financial statements. Another major advantage: Because accountants do not need to consider the measurement requirements of GAAP, the financial statements can often be prepared on a more timely and cost-efficient basis. For cash-basis financial statements, many of the measurement principles associated with GAAP simply do not exist.

Pure Cash Basis of Accounting It is important to understand the difference between the "pure" cash basis and the modified cash basis of accounting. Under the pure cash basis, revenues are recognized when cash is received rather than when earned and expenses are recognized when cash is disbursed rather than when incurred. Under the pure cash basis, long-term assets are not capitalized, and, hence, no depreciation or amortization is recorded. Also, no accruals are made for payroll taxes, income taxes, or pension costs and no prepaid expenses are recorded.

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Entities using the pure cash basis of accounting normally present a single statement titled "Statement of Cash Receipts and Disbursements." In this form of presentation, cash receipts from sales, the incurrence of debt, contributions, and so forth, and the disbursements for debt repayment, expenses, and the purchase of fixed assets are summarized to show the change in cash during the period. According to the AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements, pure cash basis financial statements may be appropriate whenever the entity

• Is interested primarily in understanding cash flow • Has a limited number of financial statement users • Has relatively simple operations engaged in one primary activity • Does not have significant amounts of debt, fixed assets, or other items that would be recognized under the accrual basis of accounting

Entities that might use the pure cash basis of accounting include estates, trusts, civic ventures, student activity funds, and political campaigns and committees.

Modified Cash Basis of Accounting The modified cash basis is a hybrid method that combines features of both the cash basis and the accrual basis of accounting. Modifications to the cash basis include such items as the capitalization of assets and the accrual of income taxes. Modified cash-basis financial statements are intended to provide more information to users than cash financial statements, while still avoiding the complexities of full-accrual GAAP financial statements. AU 623.04 permits modifications to the cash basis that have substantial support in the accounting literature. Because the modified cash basis is not formalized in authoritative pronouncements, modifications have evolved through common usage. Entities that use the modified cash basis of accounting generally possess the following characteristics:

• They are profit oriented • They distribute profits as collected (e.g., through bonuses and retirement plan contributions) • They have significant inventory and credit arrangements with Vendors • They make material capital expenditures or incur material amounts of debt • Their operations are somewhat sophisticated, and accounting for them may become complex

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An example of an entity that may use the modified cash basis of accounting is a professional association of doctors, lawyers, or CPAs.

ISSUES TO CONSIDER IN CASH-BASIS FINANCIAL STATEMENTS

Choosing the Appropriate Basis of Accounting In determining the appropriate basis of accounting, CPAs should consider the following issues:

• Does the entity have inventory? If so, the pure cash basis may not be helpful. • What basis of accounting does the entity use in preparing its income tax return? If the accrual basis is used, preparing financial statements on the same basis makes sense. • Does the entity's cash flow parallel its income and expenses? The pure cash basis may be appropriate. • Was the entity formed for tax purposes? If yes, the owners are probably interested in the tax effects of transactions and the income tax basis would be more appropriate.

Although AU 623 does not address the determination of the appropriate basis of accounting, CPAs should be careful not to be associated with financial statements that may be considered misleading. AU 623.09 contains the following guidance:

The auditor should apply essentially the same criteria to financial statements prepared on an other comprehensive basis of accounting as he or she does to financial statements prepared in conformity with generally accepted accounting principles. Therefore, the auditor's opinion should be based on his or her judgment regarding whether the financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretation.

The foregoing statement means that the auditor has a responsibility to determine whether the financial statements are misleading. The AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements states that the accountant should consider whether OCBOA financial statements could be misleading whenever the following conditions are present:

• The entity has substantial unfunded obligations, commitments, and contingent liabilities that would not be recorded on the cash or tax basis.

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• The entity has delayed paying accounts payable and other current liabilities not shown on a cash-basis statement. • The financial statements have been compiled with substantially all disclosures omitted.

Change in Basis of Accounting Authoritative literature does not address accounting for a change in accounting basis. APB-20 (Accounting Changes) provides guidance for reporting accounting changes within the same basis. However, a change in accounting basis is not the same as an accounting change. When only current-year financial statements are presented, it is common practice to present the effect of the change in the accounting basis by showing beginning retained earnings as previously reported with an adjustment to convert to the new basis. Although it is not as common in practice, precedent also exists for either showing opening retained earnings on the new basis or showing the effects of the change as a cumulative-effect adjustment in the income statement. However, according to TIS 9030.10 (Change from Generally Accepted Accounting Principles [GAAP] to an Other Comprehensive Basis of Accounting [OCBOA] or from OCBOA to GAAP), if comparative financial statements are presented, the prior year(s) should be restated and presented under the basis that the company has changed to. Restatement is necessary to ensure comparability with all periods presented. In both cases, the change in accounting basis should be disclosed in the notes to the financial statements. Guidance on reporting on a change in the basis of accounting in compilation, review, and audit engagements is discussed in Chapter 9, "Auditing OCBOA Financial Statements: Procedures and Reporting" and Chapter 10, "Compiling and Reviewing OCBOA Financial Statements: Procedures and Reporting."

Change in Accounting Principle APB-20 (Accounting Changes) provides standards for accounting for and disclosing accounting changes in financial statements. A change in accounting principle generally is defined as a change from one acceptable principle to another or a change in the method of applying an acceptable accounting principle. APB-20 requires that the cumulative effect of the change be reported in net income in the period of the change or that the prior-period financial statements be restated depending on the nature of the accounting change. Further, APB-20 permits a change in accounting principle only if the entity justifies the use of an alternative acceptable accounting principle on the basis that it is preferable.

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Under .the modified cash basis of accounting, changes in accounting principles could occur when entities elect modifications to the pure cash basis that are different from those of prior periods. APB-20 requires that the nature of and justification for a change in accounting principle and its effect on income be disclosed in the financial statements of the period in which the change is made. The justification for the change should explain clearly why the newly adopted accounting principle is preferable. Because the pure cash basis reflects only cash receipts and cash disbursements, the only change in accounting principle that could affect that basis of accounting is a change in which type of arrangements are classified as cash or cash equivalents.

Changes in Equity Accounts When both financial position and results of operations are presented, APB-12 (Omnibus Opinion-1967) requires disclosure of changes in the separate accounts comprising stockholders' equity (in addition to retained earnings) and changes in the number of shares of equity securities during at least the most recent annual fiscal period and any subsequent interim period presented. Interpretation No. 14 of SAS- 62 (AU 9623.92) requires cash, modified cash, and income tax basis financial statements with items requiring disclosure under GAAP to either follow the GAAP disclosure requirements for those items or provide information that communicates the substance of those GAAP requirements. Therefore, modified cash basis financial statements at present both financial position and results of operations should disclose changes in the components of stockholders' equity. Companies generally report the current year's changes in stockholders' equity accounts other than retained earnings in separate statements or notes to the financial statements when presenting both financial position and results of operations for one or more years. APB-9 (Reporting the Results of Operations) states that the statement of income and the statement of retained earnings (separately or combined) are designed to reflect, in a broad sense, the "results of operations." Therefore, to present results of operations under GAAP, changes in retained earnings must be disclosed. Based on Interpretation No. 14 of SAS-62 (AU 9623.90), modified cash basis financial statements should also disclose the changes in retained earnings when results of operations are presented. This disclosure can be made in a separate financial statement, in the notes to the financial statements, or as part of another basic statement (such as the income statement or balance sheet). The statement of cash receipts and disbursements prepared under the pure cash basis of accounting does not reflect stockholders' equity or retained earnings. Accordingly, the aforementioned disclosures are not required under the pure cash basis of accounting.

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Statement of Cash Flows FAS-95 (Statement of Cash Flows) states that "a business enterprise that provides a set of financial statements that reports both financial position and results of operations shall provide a statement of cash flows for each period for which results of operations are provided." However, Interpretation No. 14 of SAS-62 (AU 9623.94) states that "a statement of cash flows is not required in presentations using the cash, modified cash, or income tax basis of accounting." Although a statement of cash flows is not required in pure cash or modified cash basis presentations, if a presentation of cash receipts and disbursements is presented in a format similar to a statement of cash flows, or if the entity chooses to present a statement of cash flows, the statement should either conform to the requirements for a GAAP presentation or communicate their substance.

PURE CASH BASIS As noted earlier, under the pure cash basis of accounting, transactions are recognized based on the timing of cash receipts and disbursements. As a result, cash and cash equivalents are the only assets recognized, and there are no liabilities. All receipts of cash are treated as cash increases and all disbursements of cash are treated as cash decreases. Under the pure cash basis, long-term assets are not capitalized, so there is no depreciation or amortization. Accruals are not made and prepaid assets are not recorded. Thus, the purchase of an item such as a vehicle is reflected as an expenditure under the pure cash basis and is not recorded as an asset, and the receipt of an item such as loan proceeds is reflected as a cash receipt and is not recorded as a liability. Entities using the pure cash basis of accounting normally present a single statement titled "Statement of Cash Receipts and Disbursements."

Measurement and Recognition Considerations

Cash and Cash Equivalents

The pure cash basis of accounting recognizes and measures all transactions by their effect on cash and cash equivalents. Cash equivalents include items such as savings accounts, certificates of deposit, and money market accounts. Increases in cash and cash equivalents include cash sales, collections on credit sales, borrowings, and proceeds from sales of assets. Cash and cash equivalents are decreased by payments of expenses, purchases of assets or investments, payments on debt service, payments of tax and agency withholdings, and payment of income taxes.

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Investments

Under the pure cash basis of accounting, investments are not capitalized when purchased. Instead, the purchase results in a cash disbursement. Income from investments is recognized only when cash is received.

Property, Plant, and Equipment

Under the pure cash basis of accounting, purchases of property, plant, and equipment are not capitalized and depreciation is not recognized. Instead, the purchase results in a cash disbursement. When property, plant, and equipment is financed with debt, only the actual cash disbursement (ie., debt service payment) is recognized. An increase in cash results when property, plant, and equipment is sold.

Debt

Proceeds from borrowing are included as cash receipts under the pure cash basis of accounting. Payments for principal and interest are included as cash disbursements. Direct financing of assets is usually not recorded, because the entity does not actually receive the cash proceeds of the financing.

Agency Transactions

Payroll disbursements are recorded under the pure cash basis of accounting as the paychecks are written. Payroll withholdings are reflected in disbursements when the applicable payments are made. Sales taxes collected are included in cash receipts and payments to government agencies are included in cash disbursements.

Income Taxes

Income taxes are recognized as cash disbursements when the entity makes the payment.

MODIFIED CASH BASIS The modified cash basis is a hybrid method that combines features of both the cash basis and the accrual basis of accounting. Modifications to the cash basis include such items as the capitalization of assets and the accrual of income taxes. Modified cash basis financial statements are intended to provide more

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information to users than cash financial statements, while still avoiding the complexities of full accrual GAAP financial statements.

Acceptable Modifications The basic concept to guide cash basis modifications is to be logically consistent by treating interrelated accounts (such as sales and purchases) on the same basis in the financial statements. Modifications of the cash basis of accounting to record depreciation on plant and equipment and to accrue income taxes are recognized in AU 623.04c. TIS Section 1500.05 (Substantial Support for Modifications in Cash Basis) provides some clarification of the term "substantial support." According to TIS 1500.05, a modification of the pure cash basis has substantial support if both of the following conditions are met:

• It is equivalent to the accrual basis of accounting and • It is not illogical (an illogical method would be recording revenue on the accrual basis and recording purchases and other costs on the cash basis)

The AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements provides the possible modifications to the pure cash basis of accounting.

NOTE: According to the AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements, one would have difficulty justifying a modification as having "substantial support" if it is used "rarely" in practice.

If modifications to the cash basis of accounting do not have substantial support, the auditor should include an explanatory paragraph in his or her report (preceding the opinion paragraph) and should include in the opinion paragraph the appropriate modifying language and a reference to the explanatory paragraph.

NOTE: SSARS-1 (AR 100) (Compilation and Review of Financial Statements) does not require an explanatory paragraph in compilation or review reports, if the matter is properly disclosed in the financial statements. However AR 100 does not preclude the accountant from emphasizing a matter. See Chapter 9, "Auditing OCBOA Financial Statements: Procedures and Reporting," and Chapter 10, "Compiling and Reviewing OCBOA financial statements: Procedures and Reporting,” for further guidance.

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Modified Cash Basis versus GAAP If the modifications are so extensive that the modified "cash basis" statements are, in the accountant's judgment, equivalent to financial statements on the accrual basis, the statements should be considered GAAP basis. In that case, a standard audit, review, or compilation report should be used. The appropriate report should be modified as appropriate because of departures from GAAP. For example, financial statements that are presented in conformity with generally accepted accounting principles, except that material leases are not capitalized, are considered GAAP financial statements containing a GAAP departure. In practice, the accountant must use his or her judgment to determine whether modified cash-basis financial statements are tantamount to financial statements on the accrual basis. Many practitioners believe that the inclusion of the following modifications indicate that modified cash-basis financial statements are essentially GAAP financial statements containing departures:

• Trade accounts receivable and payable have been accrued. • Deferred income taxes and deferred tax expense have been recorded. • Assets under capital leases and related obligations have been recognized.

However, no single modification will determine whether the financial statements are GAAP financial statements. The accountant should collectively evaluate all of the modifications made to the financial statements.

NOTE: Be alert for situations in which pure cash or modified cash basis financial statements are actually income tax basis financial statements. This frequently occurs when the client uses the cash basis of accounting for income tax reporting. If the financial statements agree with the entity's income tax return (except that the financial statements may include nontaxable items or nondeductible expenses), the financial statements should be designated as being on the income tax basis of accounting. See Chapter 6, "Income Tax Basis Financial Statements," for a discussion of the income tax basis of accounting.

Measurement and Recognition Considerations In practice, the following issues are the most frequent complications that arise when making modifications to the pure cash basis of accounting. In considering these complications, the author recommends that once a modification is made, the entity should in general follow GAAP related to the recognition and measurement of that item. For example, if an entity capitalizes property, plant,

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and equipment, then any interest that would have been capitalized under GAAP also should be capitalized, and impairment losses should be recognized and measured. However, circumstances may arise in which an entity is justified in deviating from this recommendation. In those situations, the entity's accounting policy and how that policy differs from GAAP should be disclosed in the notes to the financial statements. Quantifying the difference between the entity's policy and GAAP is not required. Finally, the accountant should collectively evaluate all of the modifications made to the entity's financial statements to determine whether the financial statements may, in reality, be GAAP financial statements containing departures.

Inventory

Modification of the pure cash basis is sometimes made to record inventories. Under these circumstances, the entity should also record cost of goods sold using the same basis. Modifying the pure cash basis to record inventories raises several significant questions, such as the following:

• Should overhead and other indirect expenses be capitalized? Entities may include only direct costs in inventory or capitalize material amounts of overhead. This decision should be based on which approach provides the most accurate portrayal of operations. • Should a valuation allowance be recorded if cost is greater than net realizable value? Some accountants believe that impairment losses should be recognized if the pure cash basis of accounting is modified to record inventories. Others believe that recognizing impairment losses is inconsistent with the cash transaction nature of the financial statements. If impairment losses are not recognized, the description of the differences from GAAP should disclose that impairment losses are recognized when realized rather than when probable. • Should inventory cost reflect cash payments only or should it include financed amounts? If significant amounts of inventory are financed, capitalizing only the portion representing cash payments may result in artificially low inventory amounts. Accordingly, the modified cash basis may not be appropriate in situations where financed inventory amounts are significant.

Non- Trade Receivables

Although some practitioners believe that recording sales on the accrual basis and reflecting related trade receivables is inconsistent with the cash orientation of the

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modified cash basis of accounting, most believe that it is appropriate to record non-trade receivables. However, recording receivables raises several significant questions, such as

• Should premiums or discounts be recorded to account for note terms that are different from market? • Should a valuation allowance be recorded if the receivable has been impaired?

Although there is no authoritative guidance for either of the foregoing questions, the overriding consideration should be to record receivables in a manner that is meaningful and not misleading.

Investments

The pure cash basis of accounting is sometimes modified to reflect investments as assets. GAAP requires that investments in debt and equity securities be recorded at cost and subsequently adjusted to fair value at each reporting date. Accountants differ as to whether investments recorded under the modified cash basis of accounting should be adjusted to fair value.

Prepaid Expenses

Under GAAP, prepaid expenses are capitalized and expensed over the period of time they relate to. Most accountants do not record prepaid expenses under the modified cash basis of accounting.

Property, Plant, and Equipment

Capitalization of property, plant, and equipment is one of the most common modifications to the pure cash basis of accounting. Several significant questions arise when property, plant, and equipment are capitalized:

• Should interest be capitalized on property, plant, and equipment constructed by the entity for its own use? • Should impairment losses be recognized in accordance with GAAP?

Although there is no authoritative guidance for either of these questions, the overriding consideration should be to record property, plant, and equipment in a manner that is meaningful and not misleading.

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Depreciation

If property, plant, and equipment are capitalized, depreciation should be calculated and charged to operations over the assets' useful lives.

Current and Long-Term Liabilities

If the pure cash basis of accounting is modified to record liabilities, the accountant should consider whether other modifications are needed to ensure that the approach is logical.

Revenue

Under the pure cash basis of accounting, revenue is recognized when cash is collected and costs are recognized when cash is disbursed. TIS 1500.05 (Substantial Support for Modifications in Cash Basis) states that it would be illogical to record revenue on the accrual basis and record purchases and other costs on the cash basis.

Income Taxes

Under the pure cash basis of accounting, income taxes are recognized when cash disbursement is made. If modification is made to record accruals for income taxes, the amounts accrued should be based on the taxes reflected on the entity's income tax return. This approach is consistent with the guidance in TIS 1500.05 (Substantial Support for Modifications in Cash Basis), which states that "generally income tax accruals are derived from the tax payable or receivable on the entity's income tax return(s)."

DISCLOSURES IN CASH-BASIS FINANCIAL STATEMENTS Determining the adequacy of disclosure is probably the most challenging aspect of preparing pure cash or modified cash basis financial statements. According to AU 623.09, OCBOA financial statements should include all informative disclosures that are appropriate for the basis of accounting used. Thus, the disclosures required for OCBOA financial statements are essentially the same as those required for GAAP financial statements. Specifically, informative disclosures can be classified in the following categories:

• Summary of significant accounting policies • Disclosures related to financial statement items

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• Disclosures related to items not specifically identified on the face of the financial statements

Recommendations

The following are recommendations for applying the general guidance in AU 623. However, the accountant should always use his or her professional judgment in determining the necessary disclosures for a fair presentation in accordance with the pure cash or modified cash basis of accounting.

Basis of Accounting AU 623.10 requires that notes accompanying OCBOA financial statements should include a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from GAAP. Interpretation No. 14 of SAS-62 (AU 9623.91) clarifies this requirement, noting that the discussion of the basis of accounting, which is required by AU 623.10, may be brief and only needs to describe the primary differences from GAAP. The intent of the disclosure of the basis of accounting is to warn the financial statement user that the financial statements are not prepared using GAAP, not to reconcile the basis of accounting with GAAP. Normally, the disclosure of the basis of accounting is included at the beginning of the summary of significant accounting policies. As discussed in Chapter 10, "Compiling and Reviewing OCBOA Financial Statements: Procedures and Reporting," if the financial statements are compiled with substantially all disclosures omitted, the compilation report should be modified to disclose the basis of accounting.

Pure Cash Basis

The following is an example of a disclosure of the basis of accounting when the pure cash basis is used:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting The Company prepares its financial statements using the cash receipts and disbursements basis of accounting. Under that basis, all transactions are recognized as either cash receipts or disbursements. The only asset is

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cash; liabilities are not recognized. Noncash transactions are not recognized in the financial statements.

Modified Cash Basis

The following is an example of a disclosure of the basis of accounting when the modified cash basis is used:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting The accompanying financial statements have been prepared using the modified cash basis of accounting. Under this method, revenues are recognized when collected rather than when earned, and expenses generally are recognized when paid rather than when incurred. This basic approach is modified to include inventory, fixed assets and the related depreciation, liabilities for sales taxes, accrued payroll taxes, retirement contributions, and income taxes payable. Consequently, accounts receivable due from customers, trade accounts payable and accrued expenses other than those mentioned above are not included in the accompanying financial statements.

Summary of Significant Accounting Policies GAAP financial statements must disclose all significant accounting policies used by the reporting entity, according to APB-22 (Disclosure of Accounting Policies). APB-22 specifically requires disclosure of accounting policies to identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. Specifically, the summary of significant accounting policies should encompass those accounting principles and methods that involve any of the following:

• A selection from existing acceptable alternatives • Principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are predominantly followed in that industry • Unusual or innovative applications of generally accepted accounting principles

Examples of disclosures by a business entity commonly required in GAAP financial statements with respect to accounting policies would include, among

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others, those relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. The following sections provide examples of accounting policies normally found in modified cash basis financial statements.

Income Taxes

If the reporting entity is a pass-through entity such as an S corporation, partnership, or sole proprietorship, the entity's tax-exempt status should be disclosed. This disclosure, normally labeled "Income Taxes," is typically included in the summary of significant accounting policies. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POUCIES Income Taxes The Corporation, with the consent of its stockholders, has elected to have its income taxed under Section 1372 of the Internal Revenue Code, which provides that, in lieu of corporation income taxes, the stockholders are taxed on their proportionate share of the Corporation's taxable income. Therefore, no provisions or liability for federal income tax is reflected in the accompanying financial statements.

Consolidation

APB-22 requires disclosure of the basis of consolidation in GAAP financial statements if consolidated financial statements are presented. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The accompanying consolidated financial statements include Upstate Event and Race Promotions, Inc., and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

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Inventory

If the reporting entity modifies the cash basis of accounting to reflect inventory, the summary of significant accounting policies should disclose the basis of valuation and the method of determining cost. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Inventory The Company's inventory is valued at the lower of cost or market (last in, first out) using the retail method.

Property and Equipment

If the reporting entity modifies the cash basis of accounting to capitalize property and equipment, the summary of significant accounting policies should disclose this information. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Property and Equipment Property and equipment are stated at cost less accumulated depreciation computed on the declining balance and straight-line methods. The assets are depreciated over their estimated useful lives, which range from 5 to 35 years. Gains and losses from property and equipment dispositions are recognized when the assets are sold or abandoned.

Related Party Transactions FAS-57 (Related Party Disclosures) requires GAAP financial statements to include the following disclosures for related-party transactions:

• Nature of the relationship with the related party • Description of the related-party transactions • Dollar amounts of the transactions • Amounts due from or to related parties as of the date of each balance sheet presented

According to Interpretation No. 14 of SAS-62 (AU 9623.93), the substance of the disclosure requirements in FAS-57 (Related Party Disclosures) can be communicated in the financial statements in ways other than disclosing the dollar

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amounts of the transactions. For example, percentages may be used instead of dollar amounts. The following is an example of this disclosure:

NOTE B-RELATED PARTY TRANSACTIONS The Company leases its office building from a partnership that is owned by two stockholders of the Company on a month-to-month basis. The total amount of the lease payments for 20X7 was $56,000. At December 31, 20X6, the Company owed the partnership $4,300.

Commitments and Contingencies Commitments are contractual obligations for a future expenditure. Contingencies are existing conditions that may create a legal obligation in the future but that arise from past transactions or events. FA5-5 (Accounting for Contingencies) provides the accounting guidance for recording contingencies in GAAP financial statements, based on the likelihood that a gain or loss has occurred, as follows:

• Probable If information available prior to financial statement issuance indicates that it is probable that an asset has been impaired or a liability incurred at the date of the financial statements and the amount of loss is reasonably estimable. • Reasonably possible If an accrual is not made because one or both of the conditions are not met but there is a reasonable possibility that a loss may have been incurred, the notes to the financial statements must disclose the nature of the contingency and give an estimate of the loss or range of loss or state that such an estimate cannot be made. • Remote If the chance of the future event or events occurring is slight, no accrual or disclosure is required.

The existence and nature of material commitments and contingencies should be disclosed in pure cash and modified cash basis financial statements. The following are examples of these disclosures:

NOTE C—COMMITMENTS The Company leases four offices and warehouse facilities in North Carolina and Georgia. The leases have terms ranging from one to six years and expire at various dates through October 20Y9. Total rental expense for the years ended December 31, 20X7 and 20X6, was $367,964 and $328,400, respectively. NOTE D-CONTINGENCIES

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The Company is involved in litigation involving a claim for $75,000 that, in the opinion of the Company's legal counsel, is not expected to result in an award that would have a materially adverse effect on the Company's financial position.

Uncertainties SOP 94-6 (Disclosure of Certain Significant Risks and Uncertainties) requires a number of disclosures for GAAP financial statements, which are summarized as follows:

• Nature of operations An entity should disclose a description of major products or services it sells or provides and its principal markets. This information is useful because it helps financial statement users understand the nature of the entity's business and the risks common to that business. • General use of estimates GAAP financial statements should include an explanation that the preparation of financial statements in conformity with GAAP requires the use of management's estimates. • Certain significant estimates If certain criteria are met, the entity is required to disclose the nature of an uncertainty if it is at least reasonably possible that a change in an estimate will occur in the near term. The purpose of this disclosure is to communicate to financial statement users that there is a good possibility that certain estimated amounts in the current-year financial statements will change significantly and impact next year's financial statements. • Vulnerability due to certain concentrations If certain criteria are met, the entity is required to disclose information about its vulnerability due to concentrations (for example, a significant volume of business conducted with one customer).

The AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements provides examples for applying the GAAP requirements for disclosing risks and uncertainties in OCBOA financial statements. In addition, the disclosure considerations in SAS-59 (AU 341) (The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern) apply to cash-basis financial statements. If significant doubt exists about the entity's ability to continue as a going concern, the notes to the financial statements should disclose all relevant factors, such as

• A discussion of the conditions and events that raise substantial doubt about the entity's ability to continue as a going concern. • The possible effects of those conditions and events.

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• Management's evaluation of the significance of the conditions and events and any mitigating factors. • Management's plans, including disclosure of possible discontinuance of activities. • Information about the recoverability or classification of recorded assets or the amounts and classifications of liabilities.

Subsequent Events AU 623.10 notes that disclosure of subsequent events should be considered when assessing the adequacy of disclosures in OCBOA financial statements. Subsequent events consist of the following two types for GAAP purposes:

1. Events that occur after the date of the balance sheet that must be disclosed to prevent the financial statements from being misleading. 2. Events that provide additional evidence about conditions that existed at the date of the balance sheet and that affect the estimates inherent in preparing the financial statements.

Asset Impairment Even though an impairment loss may not be recognized in cash basis financial statements, disclosure of the impairment of a recorded asset may be necessary to prevent the financial statements from being misleading.

Changes in Accounting Principles or Estimates APB-20 (Accounting Changes) requires disclosure of certain information in GAAP financial statements when a material change in accounting principle or estimate is present. Accordingly, cash-basis financial statements should disclose the nature of any change and its effect on income for the period of the change. For changes in accounting principles, the justification for the change should also be disclosed.

Investments If marketable securities are presented in accordance with FAS- 115 (Accounting for Certain Investments in Debt and Equity Securities), disclosures required by that statement, or information that communicates the substance of those disclosures, should be made.

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Property and Equipment If the reporting entity modifies the cash basis of accounting to capitalize property and equipment, the balance of major classes of assets should be disclosed by nature or function. In addition, the disclosure of depreciation in modified cash-basis financial statements should be the same as that in GAAP financial statements. Accordingly, total accumulated depreciation, depreciation expense for each period presented, and a general description of the method or methods used in computing depreciation expense should be disclosed.

Terms of Debt Agreements Disclosures related to debt agreements should include a discussion of interest rates, maturity dates, pledged assets, and restrictive covenants.

Restrictions on Assets and Equity Disclosure of restrictions on any assets or stockholders' equity, partners' capital, or proprietor's capital (e.g., the ability to pay dividends or limitations imposed by debt agreements) may be necessary to keep cash-basis financial statements from being misleading.

Employee Benefit Plans If the reporting entity sponsors a pension plan for its employees or provides other postretirement benefits, the notes to the financial statements should include disclosures about the plan.

Income Taxes Cash-basis financial statements should include disclosures about the significant components of income taxes for each period for which a statement of revenues and expenses is presented, as well as the amounts and expiration dates of any operating loss and tax credit carryforwards.

Disclosures in Pure Cash-Basis Presentations No authoritative guidance specifically addresses which matters should be disclosed when only a single statement of cash receipts and disbursements is prepared under the pure cash basis of accounting. However, AU 623.09 states

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that the financial statements, including related notes, should be "informative of matters that may affect their use, understanding and interpretation." AU 623.10 notes that the following disclosures should be considered in OCBOA financial statements (most would also be appropriate for a single statement of cash receipts and disbursements):

• Uncertainties • Related-party transactions • Subsequent events • Restrictions on assets and owners' equity

AU 623.10 further states that "financial statement prepared on an other comprehensive basis of accounting should include, in the accompanying notes, a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from generally accepted accounting principles." APB-22 (Disclosure of Accounting Policies), requires disclosure of accounting policies applicable to a stand-alone basis financial statement. Because assets, liabilities, and noncash transactions are not recognized under the pure cash basis of accounting, common significant accounting policy disclosures are not relevant.

NOTE: Just because an item is not required to be disclosed, that does not mean that it should not be disclosed. If the accountant believes the disclosure of an item is necessary in order to prevent the financial statements from being misleading, or if he or she believes the additional information is important for the users of the financial statements, the accountant should consider making the disclosure.

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Chapter 6 - Income Tax Basis Financial Statements


Recognize what type of organizations would benefit from using the income tax basis of accounting.

Identify the acceptable ways to present nontaxable revenues and nondeductible expenses in income tax basis financial statements.

Recognize the proper method for recording inventory related to: Valuation, Identification and Capitalization of Indirect Costs for income tax basis financial statements.

OVERVIEW SAS-62 (AU 623.04) (Special Reports) recognizes "the basis of accounting the reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements" as an other comprehensive basis of accounting. That basis is referred to as the income tax basis of accounting. It is typically based on federal income tax laws found in the Internal Revenue Code (IRC), along with related regulations, revenue rulings, and procedures. These laws and regulations deal with the determination of taxable income and therefore focus on the measurement of revenues and expenses (and in some cases on the determination of the basis of assets and liabilities). However, income tax laws generally do not address financial statement presentation or disclosure considerations. The income tax basis of accounting is most useful for small nonpublic entities whose financial statement users are interested primarily in the tax aspects of their relationship with the entity. Typically, entities that use the income tax basis of accounting are

• Profit-oriented enterprises (such as small closely held companies for which conversion to GAAP would be costly) • Partnerships whose partnership agreements require the use of the tax basis of accounting

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• Not-for-profit organizations seeking relief from the requirements of FAS-116 (Accounting for Contributions Received and Contributions Made) and FAS-117 (Financial Statements of Not-For-Profit Organizations)

The income tax basis of accounting covers a range of alternative bases, from cash to full accrual, depending on the nature of the reporting entity and, in some cases, the entity's elections. In some situations, the entity is required to pay taxes under the alternative minimum tax (AMT) system rather than the regular tax system. In those situations, most practitioners prepare income tax basis financial statements using the regular tax rules. Disclosures reconciling the difference between the actual tax expense and the tax expected based on income reported in the financial statements are then used to communicate that the entity paid taxes under the AMT rules.

NOTE: The overall objective of income tax basis financial statements is to present the entity's financial position and results of operations using the recognition and measurement guidelines used for income tax purposes. Therefore, income tax basis financial statements are not a mere reformatting of the entity's tax return.

IRS ACCOUNTING METHODS In general, the IRC allows two overall methods of accounting: the cash method and the accrual method. Most individuals and many small businesses use the cash method of accounting. Under the cash method, income includes all items actually or constructively received during the year and expenses are deducted in the year they are actually paid or the property is transferred. Under the accrual method, income is reported in the year earned and expenses are deducted in the year incurred.

Inventories The IRC requires businesses that use inventories (i.e., they produce or purchase merchandise and sell it to produce income) to use the accrual method for inventory purchases and sales.

NOTE: There have been instances of the IRS attempting to define "merchandise" as any "materials" or "supplies" that are purchased by a business. However, the Tax Court has held that where the inherent nature of the business is that of a service provider and the taxpayer uses materials that are an indispensable and inseparable part of rendering its service, the materials are not merchandise.

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NOTE: The courts have generally based their conclusion on what constitutes a "significant income-producing factor" on the ratio of material or merchandise to gross receipts. The Tax Court established in Wilkinson-Beane, Inc., that when materials or merchandise do not exceed approximately 15% of gross receipts, they will not be considered a significant income-producing factor. However, the 15% rule is not a safe harbor. Even if an entity has a materials percentage of less than 15%, the IRS may still require the entity to use the accrual method by arguing that the cash method significantly distorts income.

Exceptions The following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental:

• Qualifying small business taxpayers under Revenue Procedure 2002-28 • Qualifying taxpayers under Revenue Procedure 2001-10

Qualifying Small Business Taxpayer Revenue Procedure 2002-28 allows qualifying small business taxpayers to use the cash method of accounting if they meet the following criteria:

• The business must have average annual gross receipts of $10 million or less. Gross receipts are tested by using the average of the three preceding years and including total sales from all businesses (net of returns and allowances), plus receipts of interest, dividends, and rents but excluding pass-through sales tax collections. • The business is not prohibited from using the cash method under IRC Section 448 (Section 448 deals primarily with tax shelters). • The principal business activity must be something other than mining, manufacturing, wholesale trade, retail trade, or information industries. The business also must not be conducting a farming activity. However, if the principal business activity is the provision of services, including the provision of property incident to those services, the taxpayer may use the cash method for all of its business activity, even if part of the business activity is described in one of the preceding ineligible business activities. • The business must not have changed (or have not been required to change) from the cash method because the business became ineligible to use the cash method under Revenue Procedure 2002-28.

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Qualifying Taxpayer An entity is a qualifying taxpayer under Revenue Procedure 2001-10 only if the entity is not a tax shelter as defined under IRC Section 448(d)(3) and the entity satisfies the gross receipts test for each prior tax year ending on or after December 17, 1998. The average annual gross receipts for each test year must be $1 million or less. Unlike Revenue Procedure 2002-28, which contains certain eligibility requirements, Revenue Procedure 2001-10 allows any business (other than a tax shelter) to use the cash method.

Methods Permitted Entities may select an accounting method based on the following rules.

C Corporations

Generally, C corporations are required to use the accrual method of accounting. However, IRC Section 448 allows the use of the cash method if the corporation's average gross receipts are $5 million or less for the prior three years. In addition, the IRC allows qualified personal service corporations to use the cash method.

S Corporations

S corporations generally are eligible to use either the cash method or accrual method of accounting. However, S corporations that allocate more than 35% of their losses to shareholders who do not actively participate in the management of the business cannot use the cash method.

Partnerships

Partnerships are generally eligible to use either the cash method or accrual method of accounting. However, limited partnerships generally cannot use the cash method if they allocate more than 35% of their tax losses to limited partners. In addition, if general or limited partnerships have C corporation partners, they cannot use the cash method if they have average gross receipts of more than $5 million for the three preceding tax years.

Sole Proprietorships

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Generally, sole proprietorships are eligible to use either the cash or accrual method of accounting. In addition, a sole proprietor may use the accrual method for the business and the cash method for nonbusiness income and deductions.

ISSUES TO CONSIDER IN INCOME TAX BASIS FINANCIAL STATEMENTS

Nontaxed Entities AU 623.04 defines the income tax basis of accounting as the basis an entity uses or expects to use to file its income tax return. However, AU 623 does not provide any additional guidance on what is meant by the phrase "income tax return." If taken literally, many entities would not be able to use the income tax basis under AU 623, because they do not file "income tax returns," but, rather, file information returns (such as Form 1065, U.S. Partnership Return of Income, or Form 990 (Return of Organization Exempt from Income Tax». Interpretation No. 14 of SAS-62 (AU 9623.93), however, provide examples of not for- profit organizations using the accounting principles followed in filing Form 990, effectively acknowledging that such entities may issue income tax basis financial statements.

Nontaxable Revenues and Nondeductible Expenses Under federal income tax law, some transactions are not recognized. For example, receipts such as interest on obligations of state and local governments and proceeds from life insurance policies are not included in revenue. Costs such as premiums paid on officers' life insurance policies are not deductible. When income tax basis financial statements are presented, nontaxable revenues and nondeductible expenses should be recognized. Nontaxable revenues should be recognized when they are received (cash method) or when they are earned (accrual method). Nondeductible expenses should be recognized in the period in which they are paid (cash method) or when they are incurred (accrual method). There are three equally acceptable ways to present nontaxable revenues and nondeductible expenses in income tax basis financial statements:

1. As a separate line item in the revenue and expense sections of the statement of revenues and expenses (this is the most common presentation) 2. As additions and deductions to net income 3. As a disclosure item in the notes to the financial statements

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Note that the recognition of nontaxable revenues and nondeductible expenses may result in reporting net income on income tax basis financial statements that differs from taxable income reported on the tax return. In most situations, it is not necessary to highlight this difference. However, this matter can be disclosed in the notes to the financial statements if desired.

Tax Changes

Change in Basis of Accounting

Authoritative literature does not address accounting for a change in accounting basis. APB-20 (Accounting Changes) provides guidance for reporting accounting changes within the same basis. However, a change in accounting basis is not the same as an accounting change. When only current-year financial statements are presented, it is common practice to present the effect of the change in the accounting basis by showing beginning retained earnings as previously reported with an adjustment to convert to the new basis. Although not as common in practice, precedent also exists for showing either opening retained earnings on the new basis or the effects of the change as a cumulative-effect adjustment in the income statement. However, according to TIS 9030.10 (Change from Generally Accepted Accounting Principles [GAAP] to an Other Comprehensive Basis of Accounting [OCBOA] or from OCBOA to GAAP), if comparative financial statements are presented, the prior year(s) should be restated and presented under the basis that the company has changed to. Restatement is necessary to ensure comparability with all periods presented. In both cases, the change in accounting basis should be disclosed in the notes to the financial statements. Guidance on reporting on a change in the basis of accounting in compilation, review, and audit engagements is discussed in Chapter 9, "Auditing OCBOA Financial Statements: Procedures and Reporting" and Chapter 10, "Compiling and Reviewing OCBOA Financial Statements: Procedures and Reporting."

Change in Tax Law or Accounting Principle

APB-20 (Accounting Changes) provides standards for accounting for and disclosing accounting changes in financial statements. A change in accounting principle is defined as a change from one acceptable principle to another or a change in the method of applying an acceptable accounting principle. APB-20 requires that the cumulative effect of the change be reported in net income in the

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period of the change or that the prior-period financial statements be restated, depending on the nature of the accounting change. Further, APB-20 permits a change in accounting principle only if the entity justifies the use of an alternative acceptable accounting principle on the basis that it is preferable. According to footnote 34 of AU 623.31, a change in tax law is not considered a change in accounting principle. If tax laws have not changed but the entity changes its method for accounting for items for tax purposes, it would be reflected as a change in accounting principle. Changes in accounting principles in income tax basis financial statements usually occur because of elections such as the following:

• Change from the cash method to the accrual method • Change in the method of valuing inventories, such as from FIFO to LIFO • Change in the method of reporting income from contracts, such as from the completed-contract method to the percentage-of completion method

APB-20 requires that the nature of, and justification for, a change in accounting principle and its effect on income be disclosed in the financial statements of the period in which the change is made. However, because making elections such as those described above does not require justification, the disclosure is not required to include a justification for the change. The following is an example of this disclosure: Effective July 1, 20X7, the Company changed its method of accounting from the cash method to the accrual method and, as of that date, recognizes trade accounts receivable when revenues are earned rather than when cash is received and recognizes trade accounts payable when expenses are incurred rather than when cash is disbursed. The excess of trade accounts receivable over trade accounts payable recognized on July 1, 20X7, in the amount of $34,000 has been recorded in the accompanying financial statements as a deferred credit and will be included in taxable income through 20X9 using the straight-line method .

Change in Fiscal Year

A taxpayer must request IRS approval to change its accounting period. In addition, the IRS requires taxpayers to change their fiscal year in certain circumstances (e.g., a corporation electing S corporation status is required to change to a December 31 year-end unless it can show that the fiscal year is its natural business year or it pays a deposit). Neither APB-20 nor any other authoritative literature addresses a change in an entity's fiscal year. A technical practice aid (TIS 1800.03) states, however, that disclosure of such a change is generally considered necessary to make the financial statements meaningful to users. The following is an example of this disclosure:

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NOTE CHANGE IN FISCAL YEAR Effective for the calendar year beginning January 1, 20X7, the Company will change from a fiscal-year end of June 30 to December 31. A six-month fiscal transition period from July l, 20X6 through December 31, 20X6, precedes the start of the new calendar-year cycle.

Changes in Equity and Capital Accounts

When both financial position and results of operations are presented, APB-12 (Omnibus Opinion-1967) requires disclosure of changes in to retained earnings) and of the changes in the number of shares of equity securities during at least the most recent annual fiscal period and any subsequent interim period presented. Interpretation No. 14 of SAS-62 (AU 9623.92) requires OCBOA financial statements with items requiring disclosure under GAAP to either follow the GAAP disclosure requirements for those items or provide information that communicates the substance of those GAAP requirements. Therefore, income tax basis financial statements that present both financial position and results of operations should disclose changes in the components of stockholders' equity. Companies generally report the current year's changes in stockholders' equity accounts other than retained earnings in separate statements or notes to the financial statements when presenting both financial position and results of operations for one or more years. APB-9 (Reporting the Results of Operations) states that the statement of income and the statement of retained earnings (separately or combined) are designed to reflect, in a broad sense, the "results of operations." Therefore, to present results of operations under GAAP, changes in retained earnings must be disclosed. Based on Interpretation No. 14 of SAS-62 (AU 9623.94), income tax basis financial statements also should disclose the changes in retained earnings when results of operations are presented. This disclosure can be made in a separate financial statement, in the notes to the financial statements, or as part of another basic statement (such as the income statement or balance sheet).

ACCRUAL METHOD Under the accrual method, income is reported in the year earned and expenses are deducted in the year incurred. Entities using the accrual method include an amount as gross income for the tax year in which all events that fix the entity's right to receive the amount have occurred and the entity can determine the amount with reasonable accuracy. Under this rule, an amount is included in gross income on the earliest of the following dates:

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• When payment is received • When the income amount is due to the entity • When the income is earned

Expenses are generally deducted or capitalized when all of the following conditions are met:

• All events necessary to establish the fact of liability or deduction have occurred. • The amount of the liability or deduction is determinable with reasonable accuracy. • Economic performance has occurred. Economic performance occurs when property or services are provided to (or by) another party or when the property is used.

Safe Harbor Rule Under a special safe harbor rule, economic performance is deemed to occur when payment is made if property or services can reasonably be expected to be provided to the business within three and a half months of payment. Otherwise, economic performance does not occur until the property or services are provided to the business.

Recurring Item Exception An exception to the economic performance rule allows certain recurring items to be treated as incurred during the tax year even though economic performance has not occurred. The exception applies if all of the following conditions are met:

• All events have occurred that fix the amount of the liability • The liability can be determined with reasonable accuracy • Economic performance occurs on or before the earlier of

- eight and a half months following the close of the tax year or - The date the entity files a timely tax return

• The item is recurring in nature and the entity consistently treats similar items in this way

• Either - The item is not material or - Accruing the item currently results in a better match against income than accruing the item in the year of economic performance

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The exception does not apply to interest; workers' compensation claims, tort, breach of contract, and violation of law claims; liabilities incurred by a tax shelter; and other liabilities not specifically addressed by the economic performance statute and regulations.

Revenue and Expense Measurement and Presentation Issues

Revenues

Generally, revenue recognition does not differ between GAAP and the accrual method for income tax reporting purposes. However, special rules may apply to the following:

• Installment sales Under GAAP, revenue is ordinarily recognized at the time a sale is made, even if the sales price will be collected in installments. For tax purposes, the income from an installment sale is recognized when it is fixed and determinable and all events have occurred. Deductions are permitted later if the sale becomes uncollectible. In addition, profits from installment sales may be recognized entirely in the year of sale or recognized under the installment method as sales proceeds are collected. •Sales returns Under tax law, no allowance for returns is permitted. Returns cannot be recorded until they occur. GAAP requires recognition of probable returns in the period the sale is recognized. • Advance payments For tax purposes, advance payments for services to be performed in a later tax year are generally recognized as income in the year the payment is received. However, if the services are to be performed by the end of the next tax year, the entity can elect to postpone recognizing the advance payment until the next tax year. Under GAAP, advance payments are generally recorded as deferred revenue and recognized when earned. • Long-term contracts Generally, entities must report earnings from long-term contracts for tax purposes using the percentage-of-completion method. However, entities with average gross receipts of $10 million or less for the three taxable years preceding the contract year and that perform only real property contracts that will be completed within two years or manufacturing contracts that will be completed within one year may use the completed-contract method. Under GAAP, most long-term construction contracts are recognized under the percentage-of-completion method.

Rental Income and Expense

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Under GAAP, lessees and lessors are required to recognize rent under noncancelable operating leases on a straight-line method over the period the lessee controls the use of the leased property. For income tax reporting purposes, accrual method lessors usually recognize rental income under operating leases when earned, and accrual method lessees generally recognize rent expense under operating leases when payments are due.

Nontaxable Revenues and Nondeductible Expenses

Under federal income tax law, some transactions are not recognized. For example, receipts such as interest on obligations of state and local governments and proceeds from life insurance policies are not included in revenue. Costs such as premiums paid on officers' life insurance policies are not deductible. When presenting income tax basis financial statements, nontaxable revenues and nondeductible expenses should be recognized. Nontaxable revenues should be recognized when they are received (cash method) or when they are earned (accrual method). Nondeductible expenses should be recognized in the period in which they are paid (cash method) or when they are incurred (accrual method).

Balance Sheet Measurement and Presentation Issues

Receivables

Under the IRC, entities must use the specific charge-off method to deduct bad debt losses related to trade notes and accounts receivable. Under that method, receivables are not charged to expense until all collection efforts have been exhausted and they are deemed worthless. GAAP requires entities to provide an allowance for receivables for which collection is doubtful.

Inventories

Recording inventory requires consideration of the following:

• Valuation The tax law allows entities to value inventory using the cost method, lower of cost or market method, or retail method. • Identification Acceptable methods for identifying items in inventory include the specific identification method, the FIFO method, and the LIFO method. • Capitalization of Indirect Costs IRC Section 263A requires that certain indirect costs be allocated to inventory and included in its cost. These

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indirect costs include indirect labor, officers' compensation, pension and other related costs, employee benefit expenses, depreciation, rent, taxes, utilities, insurance, and repairs and maintenance.

Investments

In general, investments in debt and equity securities are carried at cost for income tax reporting purposes. Accordingly, gains and losses under the income tax basis generally are recognized only when realized. Under GAAP, entities account for investments in accordance with FAS-1l5 (Accounting for Certain Investments in Debt and Equity Securities), which results in unrealized gains and losses being recognized in some cases. Under GAAP, the equity method is used to account for investments when the investor can exercise significant influence over the investee. Generally, significant influence exists when the ownership interest is 20% or more. For tax purposes, the equity method of accounting does not exist. Instead, dividend income is included in income. A pro rata share of the investee income or loss is not recorded by the investor.

Prepaid Expenses

Expenses paid in advance are deductible only in the year that the expense applies to, unless the expense qualifies for the "12-month rule." Under the 12-month rule, the entity is not required to capitalize amounts paid to create certain rights or benefits that do not extend beyond the earlier of the following:

• 12 months after the right or benefit begins • The end of the tax year after the tax year in which payment is made The 12-month rule is illustrated in the following examples.


The following are common differences in GAAP and income tax reporting for property and equipment:

• For tax purposes, most property and equipment is depreciated under the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, major categories of assets are automatically assigned specific lives and depreciation methods. MACRS often results in more rapid depreciation over shorter lives than would be required by GAAP.

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• Section 179 of the IRC permits taxpayers to deduct the cost incurred to acquire certain property and equipment during the year, up to specified limits. GAAP does not permit recording of a similar expense. • Assets contributed by an owner may be valued at the owner's tax basis rather than at the fair value required for GAAP by APB-29 (Accounting for Nonmonetary Transactions). • Tax laws pertaining to capital leases are less explicit than GAAP. Generally, an equipment lease is not considered to be a capital lease unless it contains a bargain-purchase option.

Intangible Assets

For tax purposes, intangible assets (including goodwill) acquired after August 10, 1993 (or July 25, 1991 if elected) are referred to as IRC Section 197 intangibles and may be amortized over a 15-year life beginning with the month the assets were acquired. GAAP requirements depend on whether the intangible asset is goodwill or, if not, whether the intangible asset has a finite or indefinite life.

Liabilities

No expenses may be accrued and deducted for tax purposes until (1) all events necessary to establish the fact of liability or deduction have occurred, (2) the amount of the liability or deduction is determinable with reasonable accuracy, and (3) economic performance has occurred. In most cases, this results in liabilities being accrued in the same period they would be for GAAP.

CASH METHOD Most individuals and many small businesses use the cash method of accounting. Under the cash method, income includes all items actually or constructively received during the year. The fair value of any property or services received is also included in income.

Constructive Receipt For tax purposes, income is constructively received when an amount is credited to the entity or made available without restriction. Possession is not required. If income is received by an authorized agent, the entity is considered to have received it when the agent receives it. Income is not constructively received if control of its receipt is subject to substantial restrictions or limitations.

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Expenses Under the cash method, expenses are deducted in the year they are actually paid or the property is transferred. In some cases, however, expenses are deducted in a different period to more clearly reflect taxable income (e.g., depreciation expense).

NOTE: The cash method of accounting for income tax purposes is not the same as the cash basis of accounting discussed in Chapter 5. Under the cash basis discussed in that chapter, transactions are recorded as receipts and disbursements (Le., no assets are capitalized) unless the cash basis is modified for certain transactions.

Measurement and Presentation Issues The following are common exceptions to the general rule that transactions are not recognized until cash is received or paid.

Inventories

Generally, tax law requires the use of inventories whenever necessary to clearly reflect income, which is usually the case whenever the production, purchase, or sale of merchandise is an income-producing factor. Therefore, even if an entity uses the cash method, tax law usually requires the use of the accrual method to account for purchases and sales of inventory. Exceptions for qualifying small businesses are discussed earlier in this chapter.

Prepaid Expenses

Expenses paid in advance are deductible only in the year that the expense applies to, unless the expense qualifies for the "12-month rule." Under the 12-month rule, an entity is not required to capitalize amounts paid to create certain rights or benefits that do not extend beyond the earlier of the following:

• 12 months after the right or benefit begins • The end of the tax year after the tax year in which payment is made

The 12-month rule is illustrated in Examples 6-3 and 6-4 below.

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DISCLOSURES IN INCOME TAX BASIS FINANCIAL STATEMENTS Determining the adequacy of disclosure is probably the most challenging aspect of preparing income tax basis financial statements. According to AU 623.09, OCBOA financial statements should include all informative disclosures that are appropriate for the basis of accounting used. Thus, the disclosures required for OCBOA financial statements are essentially the same as those required for GAAP financial statements. Specifically, informative disclosures can be classified in the following categories:

• Summary of significant accounting policies • Disclosures related to financial statement items • Disclosures related to items not specifically identified on the face of the financial statements

Recommendations The following are recommendations for applying the general guidance in AU 623. However, the accountant should always use his or her professional judgment in determining the necessary disclosures for a fair presentation in accordance with the income tax basis of accounting.

Basis of Accounting AU 623.09 requires that notes accompanying OCBOA financial statements include a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from GAAP. Interpretation No. 14 of SAS-62 (AU 9623.91) clarifies this requirement, noting that the discussion of the basis of accounting, required by AU 623.09, may be brief and only needs to describe the primary differences from GAAP. The intent of the disclosure of the basis of accounting is to warn financial statement users that the financial statements are not prepared using GAAP' not to reconcile the basis of accounting with GAAP. Normally, the disclosure of the basis of accounting is included at the beginning of the summary of significant accounting policies. As discussed in Chapter 10, "Compiling and Reviewing OCBOA Financial Statements: Procedures and Reporting," if the financial statements are compiled with substantially all disclosures omitted, the compilation report should be modified to disclose the basis of accounting.

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Accrual Method

The following is an example of a disclosure of the basis of accounting when the pure accrual method is used for income tax purposes:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTINGPOUCIES Basis of Accounting The Company prepares its financial statements using the accrual method of accounting used for income tax reporting. This basis differs from generally accepted accounting principles primarily because

• Depreciation is calculated using the statutory accelerated cost recovery periods instead of useful lives • Accounts receivable are written off when deemed uncollectible, with no allowance for uncollectible accounts reflected in the financial statements • Losses on disposition of long-lived assets are recognized when the asset is sold rather than at the point at which management decides to dispose of the asset

Cash Method

The following is an example of a disclosure of the basis of accounting when the cash method is used for income tax purposes:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting The accompanying financial statements have been prepared using the cash method of accounting used for federal income tax reporting. Consequently, certain revenues and expenses are recognized in the determination of income in different periods than they would be if the financial statements were prepared in conformity with generally accepted accounting principles. Although income tax rules are used to determine the timing of the reporting of revenues and expenses, nontaxable revenues and nondeductible expenses are included in the determination of net income.

Summary of Significant Accounting Policies

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GAAP financial statements must disclose all significant accounting policies used by the reporting entity, according to APB-22 (Disclosure of Accounting Policies). APB-22 specifically requires disclosure of accounting policies to identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. Specifically, the summary of significant accounting policies should encompass those accounting principles and methods that involve any of the following:

• A selection from existing acceptable alternatives • Principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are predominantly followed in that industry • Unusual or innovative applications of generally accepted accounting principles

Examples of disclosures by a business entity commonly required in GAAP financial statements with respect to accounting policies include disclosures relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. The following sections provide examples of accounting policies normally found in income tax basis financial statements.

Income Taxes If the reporting entity is a pass-through entity such as an S-corporation, partnership, or sole proprietorship, the entity's tax-exempt status should be disclosed. This disclosure, normally labeled "Income Taxes," is normally included in the summary of significant accounting policies. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES Income Taxes The Corporation, with the consent of its stockholders, has elected to have its income taxed under Section 1372 of the Internal Revenue Code, which provides that, in lieu of corporation income taxes, the stockholders are taxed on their proportionate share of the Corporation's taxable income. Therefore, no provisions or liability for federal income tax is reflected in the accompanying financial statements.

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Consolidation

APB-22 requires disclosure of the basis of consolidation in GAAP financial statements if consolidated financial statements are presented. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The accompanying consolidated financial statements include Upstate Event and Race Promotions, Inc., and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Inventory

The accounting policy for pricing inventory should be disclosed either in the notes to the financial statements or in the caption on the statement of assets, liabilities, and equity. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Inventory The Company's inventory is valued at the lower of cost or market (last in, first out) using the retail method.

Receivables

If the reporting entity has significant amounts of receivables, the summary of significant accounting policies should disclose the information required by SOP 01-6 (Accounting by Certain Entities [Including Entities with Trade Receivables] That Lend to or Finance the Activities of Others).

Depreciation

Disclosure of depreciation methods should address the use of prescribed periods and methods, but may be more extensive. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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Depreciation Rental equipment and property and equipment are stated at cost. Depreciation is computed using accelerated cost recovery and modified cost recovery methods allowable under the Internal Revenue Code. The recovery periods being used are 5 and 7 years for furniture, fixtures, and equipment and 31.5 years for leasehold improvements.

Start-Up Costs

It is common to disclose the accounting policy related to start-up cost .and organization costs in the summary of significant accounting policies. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization Costs Prior to the start of business, the Company incurred certain organization costs related to the development of the retail store, training employees, and a preopening marketing campaign. Those costs amounted to $12,500 as of June 1, 20X7 (the date the Company started business). Under generally accepted accounting principles, those costs would be expensed as incurred. For income tax purposes, however, these expenses have been capitalized and are being amortized, using the straight-line method, over 60 months.

Related- Party Transactions FAS-57 (Related Party Disclosures) requires GAAP financial statements to include the following disclosures for related-party transactions:

• Nature of the relationship with the related party • Description of the related-party transactions • Dollar amounts of the transactions • Amounts due from or to related parties as of the date of each balance sheet presented

According to Interpretation No. 14 of SAS-62 (AU 9623.92), the substance of the disclosure requirements in FAS-57 (Related Party Disclosures) can be communicated in the financial statements in ways other than disclosing the dollar amounts of the transactions. For example, percentages may be used instead of dollar amounts. The following is an example of this disclosure:

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NOTE B-RELATED PARTY TRANSACTIONS The Company leases its office building from a partnership that is owned by two stockholders of the Company on a month-to-month basis. The total amount of the lease payments for 20X7 was $56,000. At December 31, 20X6, the Company owed the partnership $4,300.

Commitments and Contingencies Commitments are contractual obligations for a future expenditure. Contingencies are existing conditions that may create a legal obligation in the future but that arise from past transactions or events. FAS-5 (Accounting for Contingencies) provides the accounting guidance for recording contingencies in GAAP financial statements, based on the likelihood that a gain ,or loss has occurred, as follows:

• Probable If information available prior to financial statement issuance indicates that it is probable that an asset has been impaired or a liability incurred at the date of the financial statements and the amount of loss is reasonably estimable. • Reasonably possible If an accrual is not made because one or both of the conditions are not met but there is a reasonable possibility that a loss may have been incurred, the notes to the financial statements must disclose the nature of the contingency and give an estimate of the loss or range of loss or state that such an estimate cannot be made. • Remote If the chance of the future event or events occurring is slight, no accrual or disclosure is required.

The existence and nature of material commitments and contingencies should be disclosed in income tax basis financial statements. The following are examples of these disclosures: NOTE C-COMMITMENTS

The Company leases four offices and warehouse facilities in North Carolina and Georgia. The leases have terms ranging from one to six years and expire at various dates through October 20Y9. Total rental expense for the years ended December 31, 20X7 and 20X6, was $367,964 and $328,400, respectively.

NOTE D-CONTINGENCIES The Company is involved in litigation involving a claim for $75,000 that, in the opinion of the Company's legal counsel, is not expected to result in an award that would have a materially adverse effect on the Company's financial position.

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Uncertainties SOP 94-6 (Disclosure of Certain Significant Risks and Uncertainties) requires a number of disclosures for GAAP financial statements, which are summarized as follows:

• Nature of operations Entities should disclose a description of major products or services the entity sells or provides and its principal markets. This information is useful because it helps financial statement users understand the nature of the entity's business and the risks common to that business. • General use of estimates GAAP financial statements should include an explanation that the preparation of financial statements in conformity with GAAP requires the use of management's estimates. • Certain significant estimates If certain criteria are met, the entity is required to disclose the nature of an uncertainty if it is at least reasonably possible that a change in an estimate will occur in the near term. The purpose of this disclosure is to communicate to financial statement users that there is a good possibility that certain estimated amounts in the current-year financial statements will change significantly and impact next year's financial statements. • Vulnerability due to certain concentrations If certain criteria are met, the entity is required to disclose information about its vulnerability due to concentrations, for example, a significant volume of business conducted with one customer.

The AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements provides examples of recommendations for applying the GAAP requirements for disclosing risks and uncertainties in OCBOA financial statements. In addition, the disclosure considerations in SAS-59 (AU 341) (The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern) apply to income tax basis financial statements. If significant doubt exists about the entity's ability to continue as a going concern, the notes to the financial statements should disclose all relevant factors, such as

• A discussion of the conditions and events that raise substantial doubt about the entity's ability to continue as a going concern • The possible effects of those conditions and events • Management's evaluation of the significance of the conditions and events and any mitigating factors • Management's plans, including disclosure of possible discontinuance of activities

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• Information about the recoverability or classification of recorded assets or the amounts and classifications of liabilities

Subsequent Events AU 623.10 notes that disclosure of subsequent events should be considered when assessing the adequacy of disclosures in OCBOA financial statements. For GAAP purposes, subsequent events consist of the following two types:

1. Events that occur after the date of the balance sheet that must be disclosed to prevent the financial statements from being misleading 2. Events that provide additional evidence about conditions that existed at the date of the balance sheet and that affect the estimates inherent in preparing the financial statements

Asset Impairment Even though an impairment loss might not be recognized in income tax basis financial statements, disclosure of the impairment of a recorded asset may be necessary to prevent the financial statements from being misleading.

Changes in Accounting Principles or Estimates APB-20 (Accounting Changes) requires disclosure of certain information in GAAP financial statements when a material change in accounting principle or estimate is present. Accordingly, income tax basis financial statements should disclose the nature of any change and its effect on income for the period of the change. For changes in accounting principles, the justification for the change should also be disclosed.

Investments If marketable securities are presented in accordance with FAS-US (Accounting for Certain Investments in Debt and Equity Securities), disclosures required by that statement or information that communicates the substance of those disclosures should be made.

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Property and Equipment The balance of major classes of assets should be disclosed by nature or function. In addition, the disclosure of depreciation in income tax basis financial statements should be the same as that in GAAP financial statements. Accordingly, total accumulated depreciation, depreciation expense for each period presented, and a general description of the method or methods used in computing depreciation expense should be disclosed.

Terms of Debt Agreements Disclosures related to debt agreements should include a discussion of interest rates, maturity dates, pledged assets, restrictive covenants.

Restrictions on Assets and Equity Disclosure of restrictions on any assets or stockholders' equity, partners' capital, or proprietor's capital (e.g., the ability to pay dividends or limitations imposed by debt agreements) may be necessary to prevent income tax basis financial statements from being misleading.

Employee Benefit Plans If the reporting entity sponsors a pension plan for its employees or provides other postretirement benefits, the notes to the financial statements should include disclosures about the plan.

Income Taxes FAS-109 (Accounting for Income Taxes) requires disclosure of information about the entity's income tax provision and obligation. Information typically disclosed in income tax basis financial statements includes:

• An explanation, where applicable, if income tax is not provided or if there is an unusual relationship between income tax expense and income before taxes • The amounts of tax credits • The amounts and expiration dates of any operating loss and tax credit carryforwards

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In nontaxable entities (such as S corporations, partnerships, and sole proprietorships), losses, tax credits, and certain other items pass from the entity to the owners. Therefore, the financial statements should not include federal income tax expense or a related liability. Carryforwards exist only at the owner level-the reporting entity has none. Because the financial statements do not reflect income taxes, the entity's tax exempt status should be disclosed in the notes to the financial statements. The following are examples of this disclosure. S Corporation

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Income Taxes The Corporation, with the consent of its stockholders, has elected to have its income taxed under Section 1372 of the Internal Revenue Code, which provides that, in lieu of corporation income taxes, the stockholders are taxed on their proportionate share of the Corporation's taxable income. Therefore, no provisions or liability for federal income tax is reflected in the accompanying financial statements.

NOTE: Just because an item is not required to be disclosed does not mean that it should not be disclosed. If the accountant believes the disclosure of an item is necessary in order to prevent the financial statements from being misleading, or if he or she believes the additional information is important for the users of the financial statements, the accountant should consider making the disclosure.

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Chapter 7 – Other Basis of Accounting


Indicate what type of entities use regulatory basis financial statements. Recognize why insurance entities are required to maintain records in

accordance with statutory accounting practices. Recognize why some governmental agencies require contractors to file

prequalification reports to qualify for bidding on or performing work for the agency.

Identify the valuation techniques that should be used for different types of assets.

INTRODUCTION In addition to the cash, modified cash, and income tax basis of accounting, SAS-62 (AU 623.04) (Special Reports) recognizes the "basis of accounting that the reporting entity uses to comply with the requirements or financial reporting provisions of a governmental regulatory agency to whose jurisdiction the entity is subject." Further, AU 623.04 states that OCBOA would include "a definite set of criteria having substantial support that is applied to all material items appearing in the financial statements."

REGULATORY BASIS OF ACCOUNTING Regulatory basis financial statements are prepared by many types of entities, including insurance companies, credit unions, construction contractors, and some not-for-profit organizations. Regulated entities must report financial information to the federal, state, or local governmental agency that regulates them.

NOTE: AU 623.05 allows auditors to report on regulatory basis financial statements as OCBOA financial statements only if the statements and auditor's report are intended solely for the information and use of those within the entity and the regulatory agency whose jurisdiction the entity is under.

Insurance Companies

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Regulatory Basis versus Contractual Basis An auditor is sometimes asked to report on special-purpose financial statements prepared to comply with a contractual agreement or regulatory provisions. In most circumstances, these types of presentations are intended solely for the use of the parties to the agreement, regulatory bodies, or other specified parties. Financial statements prepared in conformity with a contractual basis that does not meet the AU 623.04 definition of the regulatory basis should not be treated as regulatory basis financial statements. See the discussion in this chapter under the heading "Agreed-Upon Basis" for guidance on these presentations.

Insurance Companies One of the most common examples of regulatory basis accounting is the "statutory" basis used by insurance companies for filing financial reports with state regulatory authorities. These regulatory authorities in each state generally require insurance companies licensed to do business in the state to file an "Annual Statement" and audited financial statements with the state insurance commissioner. The financial statements are prepared using statutory accounting practices (SAP), which vary from state to state. Insurance entities prepare their statutory financial statements in accordance with accounting principles and practices prescribed or permitted by the insurance department of their state of domicile, that is, SAP. SAP are considered an OCBOA as described in AU 623.04. To create greater uniformity both in the laws and their administration and to recommend desirable legislation in state legislatures, the state commissioners of insurance organized an association that is known today as the National Association of Insurance Commissioners (NAIC). The work of the NAIC over the years has helped to eliminate many conflicts of state law and to promote more uniform and efficient regulation of insurance companies. The decisions of the NAIC are not binding on any of the commissioners, but state legislatures and insurance departments generally adopt, with some exceptions, NAIC "model statutes" or regulations. State insurance departments require insurance entities to maintain records in accordance with statutory accounting practices. Statutory accounting employs those accounting principles and practices prescribed or permitted by an insurer's domiciliary insurance department and in some instances, by the insurance departments of other states in which the insurer is licensed to do business. Effective January 1, 2001, most states adopted a comprehensive updated manual entitled Accounting Practices and Procedures Manual, as revised by the National Association of Insurance Commissioners' (NAIC's) Codification project.

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The updated Accounting Practices and Procedures Manual, along with any subsequent revisions, is referred to as "the revised Manual." The revised Manual contains extensive disclosure requirements. As a result, after a state adopts the revised Manual, its statutory basis of accounting will include informative disclosures appropriate for that basis of accounting. The NAIC Annual Statement Instructions prescribe that the financial statements be included in the annual audited financial report. Some states might not adopt the revised Manual, or they might adopt it with significant departures. Interpretation No. 12 of SAS-62 (AU 9623,60) provides guidance on disclosures in financial statements prepared on a statutory basis. Each state insurance department requires all insurance entities licensed to write business in that state to file an "Annual Statement," also referred to as "the convention blank," "statutory blank," or simply "the blank," with the state insurance commissioner for each individual insurance entity. Most states require the blank to be filed by March 1 of the following year. All states require that the Annual Statement for the calendar year be comparative, presenting the amounts as of December 31 of the current year and the amounts as of the immediately preceding December 31. The Annual Statement includes numerous supplementary financial data, such as Analysis of Operations by Lines of Business and detailed schedules of investments. The primary emphasis of SAP is on demonstrating the solvency (i.e., the ability to pay claims in the future) of insurance companies to state regulators. Consequently, SAP financial statements present many balance sheet accounts on a liquidation basis rather than a going-concern basis. AU Section 623.09 states that "When reporting on financial statements prepared on a comprehensive basis of accounting other than generally accepted accounting principles, the auditor should consider whether the financial statements (including the accompanying notes) include all informative disclosures that are appropriate for the basis of accounting used." The auditor should apply essentially the same criteria to financial statements prepared on an OCBOA as he or she does to financial statements prepared in conformity with GAAP. Therefore, the auditor's opinion should be based on his or her judgment regarding whether the financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretation. AU Section 623.02 states that generally accepted auditing standards apply when an auditor conducts an audit of and reports on financial statements prepared on an OCBOA. Thus, in accordance with the third standard of reporting, "informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report."

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AU 623.09 and AU 623.10 state that financial statements prepared on a comprehensive basis of accounting other than GAAP should include all informative disclosures that are appropriate for the basis of accounting used. That includes a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from GAAP. The provisions of the preamble of the revised Manual that states, "GAAP pronouncements do not become part of SAP until and unless adopted by the NAIC," do not negate the requirements of AU 623.10, which also states that when "the financial statements [prepared on an other comprehensive basis of accounting] contain items that are the same as, or similar to, those in financial statements prepared in conformity with generally accepted accounting principles, similar informative disclosures are appropriate." Disclosures in statutory basis financial statements for items and transactions that are accounted for in essentially the same or in a similar manner under the statutory basis as under GAAP should be the same as, or similar to, the disclosures required by GAAP unless the revised Manual specifically states the NAIC Codification rejected the GAAP disclosures. Disclosures should also include those required by the revised Manual. The disclosures used in statutory basis financial statements for items or transactions that are accounted for differently under the statutory basis than under GAAP but in accordance with the revised Manual, should be the disclosures required by the revised Manual. If the accounting required by the state of domicile for an item or transaction differs from the accounting set forth in the revised Manual for that item or transaction but it is in accordance with GAAP or superseded GAAP, the disclosures in statutory basis financial statements for that item or transaction should be the applicable GAAP disclosures for the GAAP or superseded GAAP. If the accounting required by the state of domicile for an item or transaction differs from the accounting set forth in the revised Manual, GAAP or superseded GAAP, sufficient relevant disclosures should be made. According to Interpretation No. 12 of SAS-62 (AU 9623.60), when evaluating the adequacy of disclosures, the auditor should also consider disclosures related to matters that are not specifically identified on the face of the financial statements, such as

• Related-party transactions • Restrictions on assets and owners' equity • Subsequent events • Uncertainties

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Other matters should be disclosed if such disclosures are necessary to prevent the financial statements from being misleading. The following is an example note disclosure, based on an illustration in SOP 94-5, as amended by SOP 01-5:

NOTE X-STATUTORY ACCOUNTING PRACTICES The Company's statutory financial statements are presented on the basis of accounting practices prescribed or permitted by the [State of domicile] Insurance Department. [State of domicile] has adopted the National Association of Insurance Commissioners' statutory accounting practices (NAIC SAP) as the basis of its statutory accounting practices, except that it has retained the prescribed practice of writing off goodwill immediately to statutory surplus in the year of acquisition. In addition, the commissioner of the [State of domicile] Insurance Department has the right to permit other specific practices that may deviate from prescribed practices. The commissioner has permitted the Company to record its home office property at estimated fair value instead of at depreciated cost as required by NAIC SAP. This accounting practice increased statutory capital and surplus by $1.9 million and $1.7 million at December 31, 20X7 and 20X6, respectively, over what it would have been had the permitted practice not been allowed. The Company's statutory capital and surplus, including effects of the permitted practice, was $25.5 million and $23.9 million at December 31, 20X7 and 20X6, respectively. Had the Company amortized its goodwill over ten years and recorded its home office property at depreciated cost, in accordance with NAIC SAP, the Company's capital and surplus would have been $25.4 million and $23.7 million at December 31, 20X7and 20X6, respectively.

The appropriate form of report on regulatory basis financial statements depends on the use of the report. If the regulatory basis financial statements will be used solely for filing with regulatory authorities, a separate paragraph is added to the end of the audit report stating that the report is intended solely for the information and use of those within the entity and the regulatory agencies whose jurisdiction the entity is under and is not intended to be and should not be used by anyone other than these specified parties. Such a paragraph is appropriate even though by law or regulation the auditor's report may be made a matter of public record. The auditor may use this form of report only if the financial statements and report are intended solely for use by those within the entity and one or more regulatory agencies whose jurisdiction the entity is under.

NOTE: "Public record," for purposes of auditor's reports on financial statements of a regulated entity that are prepared in accordance with the financial reporting provisions of a government regulatory agency, includes circumstances in which specific requests must be made by the public to

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obtain access to or copies of the report. In contrast, the auditor is precluded from using this form of report in circumstances in which the entity distributes the financial statements to parties other than the regulatory agency either voluntarily or upon specific request.

If the financial statements and report are intended for use by parties other than those within the entity and one or more regulatory agencies whose jurisdiction the entity is under, the auditor should follow the guidance in SAS-1 (AU 544) (Lack of Conformity with Generally Accepted Accounting Principles). After expressing a qualified or adverse opinion as to conformity with GAAP, the auditor may express an opinion on whether the statements are presented in conformity with statutory accounting practices.

Financial Institutions Banks and savings institutions are required by federal regulations to file quarterly Federal Financial Institutions Examination Council of Thrift Supervision (OTS) thrift Financial Reports (collectively referred to as "call reports"). Call reports contain certain financial information, including amounts used to calculate regulatory capital. Prior to March 1997, banks and savings institutions prepared call reports using regulatory accounting practices (RAP). However, the FFIEC adopted GAAP effective with the March 1997 call reports. Credit unions with assets of $10 million or more must present their financial statements using GAAP. Credit unions with less than $10 million in assets may present their financial statements using RAP. According to the AICPA Audit and Accounting Guide Depository and Lending Institutions: Banks and Savings Institutions, Credit Unions, Finance Companies and Mortgage Companies, RAP constitutes an OCBOA, and auditors can report on RAP financial statements in accordance with AU 623. As required by AU 623.05 for regulatory basis financial statements, reported on as an OCBOA, the auditor's report should contain a restricted-use paragraph and be used only if the regulatory basis financial statements are intended solely for filing with the applicable regulatory agency.

Not-for-Profit Organizations Some states allow charitable organizations to use IRS Form 990 (Return of Organizations Exempt from Income Tax) as a uniform annual report for reporting to both state and federal governments. Some of those states require the Form 990 to be accompanied by an auditor's report on the financial statements included in the form. If the financial statements presented on the Form 990 are intended solely for filing with the regulatory agency, the auditor may report on the financial statements in accordance with AU 623. As required by AU 623.05for regulatory basis financial statements reported on as an OCBOA, the auditor's

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report should contain a restricted-use paragraph and be used only if the regulatory basis financial statements are intended solely for filing with the applicable regulatory agency. If the Form 990 will be used for purposes other than regulatory filings (e.g., copies of the Form 990 are distributed to contributors and others), the auditor should express a qualified or adverse opinion on the statements if they are not in conformity with GAAP. In addition, according to Interpretation No. 14 of SAS-62 (AU 9623.93), separate financial statements prepared using the financial information in Form 990 can be reported on as income tax basis, rather than regulatory basis or GAAP basis financial statements. See Chapter 6, "Income Tax Basis Financial Statements," for further discussion of the income tax basis of accounting.

Construction Contractors

Some governmental agencies require contractors to file prequalification reports to qualify for bidding on or performing work for the agency. These reports are often preprinted forms that include both an accountant's report and financial information. Typically, the financial information consists of a balance sheet and accompanying schedules. If the accountant compiles the financial information and issues a compilation report, he or she may report on the financial information as a "prescribed form." If the financial statements presented on the prequalification report are intended solely for filing with the regulatory agency, the auditor may report on the financial statements in accordance with AU 623. As required by AU 623.05 for regulatory basis financial statements reported on as an OCBOA, the auditor's report should contain a restricted use paragraph and be used only if the regulatory basis financial statements are intended solely for filing with the applicable regulatory agency.

Prescribed Forms Accountants may be engaged to report on financial information presented in prescribed forms or schedules. SSARS-3 (Compilation Reports on Financial Statements Included in Certain Prescribed Forms) (AR 300.02) defines a prescribed form as

... any standard preprinted form designed or adopted by the body to which it is to be submitted, for example, forms used by industry trade associations, credit agencies, banks, and governmental and regulatory bodies other than those concerned with the sale or trading of securities.

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To satisfy AR 300.02, the prescribed form must be either designed or adopted by the body that the financial statements are to be submitted to. For example, a bank may require a business or an individual to submit financial information in a certain prescribed form as part of a credit evaluation process. On the other hand, a form designed by the client or by another party to which the financial statements do not have to be submitted does not meet the AR 300.02 definition of a "prescribed form." AR 300.03, however, provides an alternative format for a compilation report on financial statements included in certain prescribed forms. This alternative format applies only when the prescribed form and its accompanying instructions call for departures from GAAP or fail to request required disclosures. The special reporting format established by AR 300.03 does not apply to prescribed forms that must be submitted to governmental and regulatory bodies charged with regulating the sale or trading of securities.

OTHER BASES OF ACCOUNTING The fourth category of OCBOA is a broad conceptual category described as "a definite set of criteria having substantial support that is applied to all material items in the financial statements." One example of this category is provided in AU 623.04-the general price level basis of accounting. However, there is no further guidance for evaluating whether a particular basis of accounting has "substantial support," is "applied to all material items," or is sufficiently established to qualify as having a "definite set of criteria."

Substantial Support SAS-69(AU 411)(The Meaning of "Present Fairly in Accordance with Generally Accepted Accounting Principles") includes the following category as the second ranked source of established accounting principles: Pronouncements of bodies, composed of expert accountants, that deliberate accounting issues in public forums for the purpose of establishing accounting principles or describing existing accounting practices that are generally accepted. The AICPA's Accounting Standards Executive Committee (AcSEC) is generally recognized as being in this category. Thus, an AcSEC pronouncement could provide substantial support for an OCBOA. However, industry or trade group publications on accounting are not generally recognized as being in this category, and such a publication would generally not provide substantial support.

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Definite Criteria A "definite set of criteria" is analogous to the concept of "suitable criteria" found in the Statements on Standards for Attestation Engagements (SSAE). The third general standard for attest engagements Status that a CPA should perform an engagement only if he or she has return' to believe that "the subject matter is capable of evaluation against criteria that are suitable and available to users." In order to be considered suitable, the criteria must have all of the following four attributes:

1. Objectivity Criteria should be free from bias. 2. Measurability Criteria should permit reasonably consistent measurements, qualitative or quantitative, of subject matter. 3. Completeness Criteria should be sufficiently complete so that those relevant factors that would alter a conclusion about subject matter are not omitted. 4. Relevance Criteria should be relevant to the subject matter.

The attestation standards require that all four attributes of suitability-objectivity, measurability, completeness, and relevance-be present in order to be considered suitable criteria.

All Material Items Application to all material items is the third requirement.

Price-Level Basis AU 623.04 provides, as an example of the fourth category of OCBOA, the price-level basis of accounting. APB Statement No.3, issued by the Accounting Principles Board (predecessor of the FASB),provided guidance for a comprehensive application of price-level adjusted financial statements. Price-level adjusted financial statements can be presented in a variety of ways; for example:

• General purchasing power approach Under the general purchasing power approach, historical cost financial statements of an entity are restated for changes in general price levels . For example, the historical cost of certain balance-sheet items, such as inventory and property and equipment, are adjusted (e.g., the consumer price index in the United States). Moreover, the income statement reflects adjustments to items, such as cost of goods sold, depreciation and appreciation, or devaluation of net monetary items held by an entity due to general price-level

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changes. This methodology is sometimes referred to as the historical cost/ constant purchasing power approach or constant dollar accounting. • Current cost approach The objective of the current cost approach is to present balance-sheet and income statement amounts at their current costs. For example, nonmonetary assets, such as inventories, may be reflected at the lower of replacement cost, based on current vendor prices for similar items or recoverable amounts. • Current cost/general purchasing power approach The current cost approach described above can also reflect the effect of general price-level changes. When it does, it is referred to as current cost/ general purchasing power or current cost/ constant purchasing power accounting. Under this approach, the current cost financial statements of an entity are restated for changes in general price levels by multiplying certain balance-sheet and income statement captions by an appropriate price index. Thus, current value information and price-level information are not mutually exclusive; both types of information can be presented in a single set of adjusted information.

Current Value Basis GAAP requires the use of current-value accounting for financial statements of certain types of entities (for example, investment companies, employee benefit plans, personal financial statements, and mutual and common trust funds). However, current value may be considered an OCBOA for other entities. Interpretation No. 11 of SAS-62 (AU 9623.55) states that an auditor may accept an engagement to report on current-value financial statements that supplement historical-cost financial statements of a real estate entity if the auditor believes the following two conditions exist:

1. The measurement and disclosure criteria used to prepare the current-value financial statements are reasonable and 2. Competent persons using the measurement and disclosure criteria would ordinarily obtain materially similar measurements or disclosures.

SOP 82-1 (Accounting and Financial Reporting for Personal Financial Statements) requires that personal financial statements "present assets at their estimated current values and liabilities at their estimated current amounts" and provides the following definitions:

• Estimated current value of an asset The amount at which the item could be exchanged between a buyer and seller, each of whom is well informed and willing, and neither of whom is compelled to buy or sell (costs of disposal, such as commissions, if material, should be considered in determining estimated current value)

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• Estimated current amount of a liability The discounted amount of cash to be paid (the discount rate should be the rate implicit in the transaction in which the debt was incurred)

The specific techniques that could be used to prepare current value basis financial statements are summarized as follows:

Account

Valuation Technique

Receivables Discounted amounts of cash expected to be received using appropriate interest rates as of the date of the financial statements

Marketable securities Quoted market prices

Options Published market prices

Investments in closely held businesses

Various techniques, such as multiple of earnings, liquidation value, reproduction value, appraisals, discounted future cash flows, or adjustments of book value or cost of the client's share of the equity

Real estate (including leaseholds)

Various techniques, such as reference to recent sales of similar properties, estimated realizable value of property, discounted net cash flows expected from the property, appraisals, and assessed value in relation to market values in the area

Intangible assets Discounted projected net cash flows (or cost if no other information is available)

Future interest and similar assets

Discounted future cash flows if rights are fixed, amounts are determinable, no future service is involved, and amount is not contingent on an event

Payables and other liabilities The lesser of discounted cash flows using the rate implicit in the transaction and the amount at which the debt can be currently discharged

Noncancelable commitments Discounted cash flows if commitment is fixed, amounts are determinable, no future service involved, and commitment is not contingent on an event

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Income taxes payable Estimated net tax liability as of the date of the financial statements

Liquidation Basis Interpretation No.8 of SAS-58 (AU 9508.33) states that a liquidation basis of accounting may be considered GAAP for entities in liquidation or for which liquidation appears imminent. Therefore, the liquidation basis is an OCBOA only when it is used for a company that is not in liquidation or for which liquidation does not appear imminent. The differences between liquidation basis and estimated current value basis may be subtle. The liquidation basis presents assets at amounts expected to be realized in liquidation and liabilities at amounts expected to be paid to creditors. The estimated current value basis presents assets at the amounts at which they could be exchanged between well-informed and willing buyers and sellers at the date of the financial statements, and presents liabilities at the discounted amount of cash to be paid. However, liquidation values are sometimes used as estimates of current value.

Agreed-Upon Basis An accountant is sometimes asked to report on special-purpose financial statements prepared to comply with a contractual agreement or regulatory provisions. In most circumstances, these types of presentations are intended solely for the use of the parties to the agreement, regulatory bodies, or other specified parties. These types of presentations include the following:

• A special-purpose financial presentation prepared in compliance with a contractual agreement or regulatory provision that does not constitute a complete presentation of the entity's assets, liabilities, revenues, and expenses but is otherwise prepared in conformity with GAAP or an OCBOA • A special-purpose financial presentation (may be a complete set of financial statements or a single financial statement) prepared on a basis of accounting prescribed in an agreement that does not result in a presentation in conformity with GAAP or an OCBOA

According to Interpretation No. 18 of SSARS-1 (AR 9100.63), an accountant who is asked to report on special-purpose financial statements prepared to comply with a contractual agreement or regulatory provision that specifies a special basis of presentation may issue a compilation or review report on those financial statements in accordance with AR 100.

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NOTE: A "contractual agreement" as discussed is an agreement between the client and one or more third parties other than the auditor. NOTE: When a contractual agreement or regulatory provision specifies the use of a prescribed form for which the accountant has been engaged to compile the financial statements, he or she should follow the guidance in AR 300.

Incomplete Presentations

An entity may engage an accountant to report on a special-purpose financial presentation prepared in compliance with a contractual agreement or regulatory provision that does not constitute a complete presentation of the entity's assets, liabilities, revenues, or expenses but is otherwise prepared in conformity with GAAP or an OCBOA. For example, a purchase agreement may require an entity to provide a schedule of net assets sold, measured in conformity with GAAP, but limited to the asset to be sold and liabilities to be transferred. Also, a governmental agency may require a schedule of revenues and certain expenses for an entity in which revenues and expenses are measured in conformity with GAAP, but the expenses are defined to exclude certain items such as interest, depreciation, and income taxes. According to AU 623.24, the foregoing financial presentations and similar presentations should generally be regarded as financial statements, even though certain items may be excluded. Further, the presentations should differ from complete financial statements only to the extent necessary to meet the special purposes for which they were prepared. In addition, AU 623.24 states that when these financial presentations contain items that are the same as, or similar to, those contained in a full set of financial statements prepared in conformity with GAAP, similar informative disclosures are appropriate. Special purpose financial statements should be suitably titled to avoid any implication that they present financial position, results of operations, or cash flows. When an auditor reports on financial statements prepared on a basis of accounting prescribed in a contractual agreement or regulatory provision that results in an incomplete presentation that is otherwise in conformity with GAAP or an OCBOA, the auditor's report should include: • A title that includes the word "independent" • A paragraph that

- States that the financial statements identified in the report were audited

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- States that the financial statements are the responsibility of the company's management and that the auditor is responsible for expressing an opinion on the financial statements based on the audit

• A paragraph that

- States that the audit was conducted in accordance with generally accepted auditing standards and includes an identification of the United States of America as the country of origin of those standards (for example, "auditing standards generally accepted in the United States of America" or "United States generally accepted auditing standards"). - States that those standards require that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. - States that an audit includes:

• Examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements • Assessing the accounting principles used and significant estimates made by management and • Evaluating the overall financial statement presentation

- States that the auditor believes that the audit provides a reasonable basis for his or her opinion

• A paragraph that:

- Explains what the presentation is intended to present and refers to the note to the special-purpose financial statements that describes the basis of presentation - If the basis of presentation is in conformity with generally accepted accounting principles, states that the presentation is not intended to be a complete presentation of the entity's assets, liabilities, revenues, and expenses

• A paragraph that expresses the auditor's opinion (or disclaims an opinion) related to the fair presentation, in all material respects, of the information the presentation is intended to present in conformity with GAAP or an OCBOA. If the presentation is prepared in conformity with GAAP, the paragraph should include an identification of the United States of America as the country of origin of those accounting principles (for example, "accounting principles generally accepted in the United States of America" or "United States generally accepted accounting principles"). If the auditor concludes that the information the presentation is intended to present is not presented fairly on the basis of accounting described or if there has been a limitation on the scope of the audit, he or she should disclose all the substantive reasons for that conclusion in an explanatory

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paragraph(s) (preceding the opinion paragraph) of the report and should include in the opinion paragraph appropriate modifying language and a reference to such explanatory paragraph(s). • A separate paragraph at the end of the report stating that the report is intended solely for the information and the use of those within the entity, the parties to the contract or agreement, the regulatory agency the report is being filed with, or those with whom the entity is negotiating directly and is not intended to be and should not be used by anyone other than these specified parties. However, such a paragraph is not appropriate if the report and related financial presentation are to be filed with a regulatory agency, such as the SEC, and are to be included in a document (such as a prospectus) that is distributed to the general public. • The manual or printed signature of the auditor's firm • The date

NOTE: Sometimes the auditor's client may not be the person responsible for the financial statements that the auditor is reporting on. For example, when the auditor is engaged by the buyer to report on the seller's financial statements prepared in conformity with a buy-sell agreement, the person responsible for the financial statements may be the seller's management. In this case, the wording of the report should be changed to clearly identify the party that is responsible for the financial statements reported on. NOTE: If the basis of presentation is an OCBOA, the report should state that the basis of presentation is a comprehensive basis of accounting other than GAAP and that it is not intended to be a complete presentation of the entity's assets, liabilities, revenues, and expenses on the basis described.

Compiled or reviewed special-purpose financial statements prepared in accordance with a contractual agreement or regulatory provision, which do not constitute a complete presentation of the entity's assets, liabilities, revenues, or expenses but are otherwise prepared in conformity with GAAP or OCBOA, should:

• Include the disclosure of the basis of presentation in the notes to the financial statements • Differ from financial statements prepared in accordance with GAAP or OCBOA only to the extent necessary to meet the special purpose for which the presentation is prepared • Contain similar informative disclosures when the presentation contains items that are the same as or similar to those contained in a full set of financial statements

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• Include titles that avoid any implication that the special purpose financial statements are intended to present financial position, results of operations, or cash flows

When reporting on compiled or reviewed special-purpose financial statements prepared in accordance with a contractual agreement or regulatory provision, which does not constitute a complete presentation of the entity's assets, liabilities, revenues, or expenses but is otherwise prepared in conformity with GAAP or an OCBOA, the accountant's report should be expanded to include two explanatory paragraphs with the following information: First Additional Paragraph

• An explanation of what the presentation is intended to present and reference to a note to the financial statements that describes the basis of accounting. In a compilation engagement in which the entity chooses to omit substantially all of the disclosures and does not disclose in the financial statements the basis of presentation, the accountant should disclose the basis in the compilation report. • A statement indicating that the presentation is not intended to be a complete presentation of the entity's assets, liabilities, revenues, and expenses

Second Additional Paragraph

• A statement indicating that the report is intended solely for the information and use of the specified parties • An identification of the specified parties to whom the use is restricted • A statement that the report is not intended to be, and should not be used by, anyone other than the specified parties

NOTE: In some cases, restricted-use reports filed with regulatory agencies are required by law or regulation to be made available to the public as a matter of public record. Also, a regulatory agency as part of its oversight responsibility for an entity may require access to restricted-use reports in which they are not named as a specified party. NOTE: If the basis of presentation is an OCBOA, the first paragraph should state that the basis of presentation is a comprehensive basis of accounting other than GAAP and that the presentation is not intended to be a complete presentation of the entity's assets, liabilities, revenues, and expenses on the basis described.

Presentation That Is not in Conformity with GAAP or OCBOA

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The accountant may be asked to report on special-purpose financial statements prepared in conformity with a basis of accounting that departs from GAAP or an OCBOA. A loan agreement, for example, may require the borrower to prepare consolidated financial statements in which assets, such as inventory, are presented on a basis that is not in conformity with GAAP or an OCBOA. An acquisition agreement may require the financial statements of the entity being acquired (or a segment of it) to be prepared in conformity with GAAP except for certain assets, such as receivables, inventories, and properties for which a valuation basis is specified in the agreement. Financial statements prepared according to a basis of accounting as discussed above are not considered to be prepared in conformity with a "comprehensive basis of accounting" as described in AU 623.04, because the criteria used to prepare such financial statements do not meet the requirement of being" criteria having substantial support," even though the criteria are definite. When an auditor reports on these types of financial presentations, the report should include • A title that includes the word "independent" • A paragraph that

- States that the special-purpose financial statements identified in the report were audited - States that the financial statements are the responsibility of the company's management and that the auditor is responsible for expressing an opinion on the financial statements based on the audit


- States that the audit was conducted in accordance with generally accepted auditing standards and includes an identification of the United States of America as the country of origin of those standards (for example, "auditing standards generally accepted in the United States of America" or "U.S. generally accepted auditing standards") - States that those standards require that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. - States that an audit includes

• Examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements • Assessing the accounting principles used and significant estimates made by management and • Evaluating the overall financial statement presentation

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- States that the auditor believes that the audit provides a reasonable

basis for the auditor's opinion

• A paragraph that - Explains what the presentation is intended to present and refers to the note to the special-purpose financial statements that describes the basis of presentation - States that the presentation is not intended to be a presentation in conformity with GAAP • A paragraph that includes a description and the source of significant interpretations, if any, made by the company's management relating to the provisions of a relevant agreement • A paragraph that expresses the auditor's opinion (or disclaims an opinion) related to the fair presentation, in all material respects, of the information the presentation is intended to present on the basis of accounting specified. If the auditor concludes that the information the presentation is intended to present is not presented fairly on the basis of accounting described or if there has been a limitation on the scope of the audit, the auditor should disclose all the substantive reasons for his or her conclusion in an explanatory paragraph(s) (preceding the opinion paragraph) of the report and should include in the opinion paragraph appropriate modifying language and a reference to such explanatory paragraph(s) • A separate paragraph at the end of the report stating that the report is intended solely for the information and use of those within the entity, the parties to the contract or agreement, the regulatory agency the report is being filed with, or those with whom the entity is negotiating directly and is not intended to be and should not be used by anyone other than these specified parties. For example, if the financial statements have been prepared for the specified purpose of obtaining bank financing, the report's use should be restricted to the various banks with whom the entity is negotiating the proposed financing • The manual or printed signature of the auditor's firm • The date Compiled or reviewed special-purpose financial statements prepared in conformity with a contractual agreement that is not in conformity with GAAP or OCBOA should:

• Include the disclosure of the basis of presentation in the notes to the financial statements

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• Contain similar informative disclosures when the presentation contains items that are the same as, or similar to, those contained in GAAP or OCBOA financial statements • Include titles that avoid any implication that the special purpose financial statements are intended to present financial position, results of operations, or cash flows

When reporting on compiled or reviewed special-purpose financial statements prepared in accordance with a contractual agreement that does not conform to GAAP or OCBOA, the accountant's report should be expanded to include two explanatory paragraphs with the following information. First Additional Paragraph

• An explanation of what the presentation is intended to present, a reference to a note to the financial statements that describes the basis of presentation, and an explanation that the presentation is not intended to be a presentation in conformity with GAAP. In a compilation engagement in which the entity chooses to omit substantially all of the disclosures and does not disclose in the financial statements the basis of presentation, the accountant should disclose the basis in the compilation report. • A description of any significant interpretations made by management of the contractual agreement.

Second Additional Paragraph

• A statement that the report is intended solely for the information and use of the specified parties and is not intended to be and should not be used by anyone other than these specified parties.

A standard review report includes a statement that the accountant is not aware of any material modifications that should be made to the financial statements in order for them to be "in conformity with GAAP." However, when the accountant is engaged to report on a special-purpose financial presentation pursuant to a contractual agreement that results in a presentation that does not conform with GAAP or an OCBOA, he or she should modify the report to reference the basis of accounting prescribed by the contractual agreement referred to in the notes because the presentation is not intended to conform with GAAP. If the accountant becomes aware that the information the presentation is intended to present contains a departure from the basis of presentation described that is material to the financial statements, he or she should consider whether modification of his or her report is adequate to disclose the departure.

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Chapter 8 – Unique Entities


Recognize the proper measurement and presentation of personal financial statements to comply with OCBOA.

Indicate how personal financial statements will differ when using pure cash or modified cash accounting basis.

Identify the issues to consider in not-for-profit financial statements to comply with FAS-117.

INTRODUCTION This chapter covers some of the specialized accounting and reporting issues related to various types of entities, including individuals and not-for-profit organizations.

PERSONAL FINANCIAL STATEMENTS Personal financial statements include the financial statements of an individual or a group of related individuals, such as a husband and wife or a family. In this chapter, the personal financial statements illustrated are those of a husband and wife. SOP 82-1 (Accounting and Financial Reporting for Personal Financial Statements) provides guidance on measurement and presentation of personal financial statements. The AICPA Audit Guide Personal Financial Statements Guide provides guidance on performance and reporting for audit, review, and compilation of personal financial statements in accordance with SOP 82-1. SOP 82-1 establishes the current value basis of accounting as GAAP for personal financial statements. However, the Personal Financial Statements Guide recognizes that personal financial statements might be prepared using an OCBOA, stating

The accountant may compile, review, or audit personal financial statements that are prepared in conformity with a comprehensive basis of accounting that presents assets and liabilities at values and amounts other than estimated current values and amounts. For purposes of personal financial statements, other comprehensive bases of accounting include, for example, historical cost, tax, and cash.

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Issues to Consider in Personal Financial Statements

Ownership of Assets

Personal financial statements generally present the combined assets and liabilities of a husband and wife. In these cases, it may be useful to disclose each individual's interest in the net assets in an additional statement or in a note to the financial statements. When personal financial statements are prepared for only one of a group of joint owners, only the individual's share should be included as part of his or her assets. If an individual is a joint owner of property, state law should be used to determine the individual's interest in the property. The individual's interest in the property will determine what proportion of the value of the property should be included in the individual's personal financial statements. If ownership is based on joint tenancy, however, it may be necessary to consult legal counsel to determine the individual's interest in the property. In addition, if the client has an interest in a separate business (for example, is the owner of a closely held corporation), the property should be shown as a separate asset and not presented with other investments.

Choosing the Basis of Accounting

SOP 82-1 states that personal financial statements should present assets at their estimated current values and liabilities at their estimated current amounts and describes in detail the principles for such presentation. SOP 82-1 also states that assets, liabilities, and changes in them should be accounted for on the accrual basis. The AICPA's Personal Financial Statements Guide states that the accountant may compile, review, or audit personal financial statements that are prepared in conformity with a comprehensive basis of accounting that presents assets and liabilities at values and amounts other than estimated current values and amounts. Personal Financial Statements Guide states that other comprehensive bases of accounting include, for example, historical cost, tax, and cash:

• Historical cost basis The historical cost basis generally measures the individual's assets and liabilities in accordance with GAAP used for business entities. • Income tax basis The income tax basis measures the individual's assets and liabilities in accordance with the principles the individual uses for federal or other income tax reporting.

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• Cash basis Under the pure cash basis, the only asset reported is cash and there are no liabilities; only cash receipts and disbursements are reported as increases and decreases in net assets. • Modified cash basis Under the modified cash basis, the pure cash basis is modified to report certain assets and liabilities, generally as they would be reported under either the historical cost or income tax basis.

Basic Financial Statements

Under GAAP, a complete set of financial statements consists of a statement of financial condition, a statement of changes in net worth, and the related notes. Each financial statement should include references to the notes and should state that the notes are an integral part of the financial statements. Although there is no comprehensive list of the notes that should be included in personal financial statements, see the section of this chapter titled "Disclosures in Personal Financial Statements" for some of the notes that typically appear. The GAAP statement of financial condition, or balance sheet, is divided into four main sections:

1. Assets 2. Liabilities 3. Income tax effects 4. Net worth

In the asset section, the economic resources of the client (individual or group of individuals) are presented. Generally, assets should be presented in order of liquidity. The liability section of the statement of financial condition displays the client's debt. Liabilities should be presented in order of maturity. Significant assets and liabilities may represent limited business activities. That is, the activity does not constitute a separate trade or business. An investment in commercial real estate financed with a mortgage is an example of a limited business activity. Assets and liabilities related to a limited business activity should be reported as separate amounts and not netted against one another. The third section of a statement of financial condition prepared in conformity with GAAP presents the estimated income tax effect on the difference between the reported assets and liabilities and their tax bases. The fourth and final section of the statement of condition measures the net worth of the individual. In the net worth section, a single amount is presented, and no attempt is made to differentiate among the types of net worth (such as donated capital, earned capital, and appreciated capital).

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When an OCBOA is used, the design of the statement of financial condition should be similar except for the following:

• The statement does not present an "income tax effect" section • It should not use terms normally associated with current value- basis presentations such as "financial condition" and "net worth"

NOTE: "Assets and liabilities" and "net assets" could be used in place of terms such as "financial condition" and "net worth."

A statement of changes in net worth is the activity statement in a set of personal financial statements. The statement summarizes the transactions and events that have increased and decreased the client's net worth for the year.

NOTE: SOP 82-1 states that the presentation of a statement of changes in net worth is optional. In practice, the statement is rarely presented because creditors do not normally consider it necessary. If the statement is presented as part of an OCBOA presentation, the title should not use terms normally associated with current value basis presentations. Instead, the title could refer to changes in net assets or equity.

Cash Basis Financial Statements

Pure Cash

Under the pure cash basis, revenues are recognized when cash is received rather than when earned, and expenses are recognized when cash is disbursed rather than when incurred. Under the pure cash basis, long-term assets are not capitalized, and, hence, no depreciation or amortization is recorded. Also, no accruals are made for taxes and no prepaid expenses are recorded. Individuals using the pure cash basis of accounting normally present a single statement titled "Statement of Cash Receipts and Disbursements." In this form of presentation, cash receipts from salary, the incurrence of debt, contributions, and so forth, and the disbursements for debt repayment, expenses, and the purchase of fixed assets are summarized to show the change in cash during the period.

Modified Cash

The modified cash basis is a hybrid method that combines features of both the cash basis and the accrual basis of accounting. Modifications to the cash basis

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include such items as the capitalization of assets and the accrual of taxes. Modified cash basis financial statements are intended to provide more information to users than cash financial statements while still avoiding the complexities of current value GAAP financial statements. AU 623.04 permits modifications to the cash basis that have substantial support in the accounting literature. Because the modified cash basis is not formalized in authoritative pronouncements, modifications have evolved through common usage. Modifications to personal financial statements can be measured using either the historical cost basis or current value basis.

Historical Cost Basis Financial Statements Prior to the issuance of SOP 82-1, the historical cost basis was considered GAAP for personal financial statements. At that time, GAAP for commercial entities (historical cost) was generally applicable to those personal financial statements. Accordingly, historical cost principles applied to business entities is generally applicable to personal financial statements prepared on the historical cost basis.

Establishing Historical Cost of Assets

Assets acquired through a normal purchase transaction should be recorded at the original cost. For example, investments and personal assets, such as jewelry, art, and household furnishings should be recorded at their original cost. When personal assets are acquired through other means, the assets should be accounted for as follows:

• Inheritance The value generally used in the determination of federal estate tax or state inheritance tax is fair value at the date of inheritance. Accordingly, assets acquired by inheritance should be recorded at the fair value at the date of inheritance. • Gift The asset should be recorded at the fair value at the time of the gift.

Cash and Cash Equivalents

Cash should include cash in all bank accounts. Cash equivalents include items such as savings accounts, certificates of deposit, and money market accounts.

Life Insurance Policies

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Life insurance policies should be reported at their cash surrender value less any loans outstanding.

Receivables

Receivables of individuals are generally due from related parties or buyers of real estate and other investments. They are usually supported by promissory notes. Disclosures for loans required by SOP 01-6 (Accounting by Certain Entities [Including Entities with Trade Receivables] That Lend or Finance the Activities of Others) should be included. Alternatively, information that communicates the substance of those requirements could be provided.

Business Interests

If the client has an interest in a separate business (for example, is the owner of a closely held corporation), the property should be shown as a separate asset and not presented with other investments. If the individual either controls the business or has the ability to exercise significant influence over its operating and financial policies, the investment should be presented in the financial statements at cost adjusted for any accumulated undistributed earnings or losses since acquisition.

Real Estate

Individuals may own personal residences, rental property, vacation homes, or speculative real estate. Generally, income-producing property, such as rental property, should be depreciated. For non-income-producing property, such as a personal residence, the carrying amount should be the original cost plus the cost of any improvements.

Future Interests

Future interests are nonforfeitable rights to receive future sums. SOP 82-1 states that future interests that have all the following characteristics should be included in GAAP financial statements:

• The rights are for fixed or determinable amounts. • The rights are not contingent on the holder's life expectancy or the occurrence of a particular event, such as disability or death. • The rights do not require future performance of service by the holder.

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The foregoing criteria are generally the same as those for recognition of future interests by entities other than individuals and are applicable to historical cost basis personal financial statements. Future interests that may have those characteristics include:

• Guaranteed minimum portions of pensions • Vested interests in pension or profit sharing plans • Deferred compensation contracts • Beneficial interests in trusts • Remainder interests in property subject to life estates • Annuities • Fixed amounts of alimony for a definite future period

Income Taxes

The liability for income taxes payable should include unpaid income taxes for completed tax years and an estimated amount for income taxes accrued for the elapsed portion of the current tax year to the date of the financial statements. That estimate should be based on the relationship of taxable income earned to date to the total estimated taxable income for the year, net of taxes withheld or paid with estimated income tax returns. Current income taxes payable should include state and local, as well as federal, income taxes. In addition, deferred income taxes on the difference between the tax and historical cost basis of properties should be calculated and recorded in historical cost basis personal financial statements. SOP 82-1 requires GAAP personal financial statements to include a provision for estimated income taxes on the differences between the estimated current values of assets and estimated current amounts of liabilities over their tax bases. Historical cost basis financial statements do not report assets and liabilities as their estimated values and amounts and would not report such a tax provision.

Commitments

Noncancellable commitments to pay future sums that have all the following characteristics should be presented as liabilities:

• The commitments are for fixed or determinable amounts. • The commitments are not contingent on others' life expectancies or the occurrence of a particular event, such as disability or death. • The commitments do not require future performance of service by others.

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Noncancellable commitments that may have those characteristics include fixed amounts of alimony for a definite future period and charitable pledges.

Other Liabilities

Other liabilities reported in historical cost basis financial statements include property taxes, insurance, utilities, balances on major credit cards, and others. Notes payable may include loans for automobiles and other personal assets, student loans, and mortgage payables on real estate. Income Tax Basis Financial Statements AU 623.04 recognizes "the basis of accounting the reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements" as an other comprehensive basis of accounting.

Accounting Methods

In general, the Internal Revenue Code (IRC) allows two overall methods of accounting: the cash method and the accrual method. Most individuals and many small businesses use the cash method of accounting. Under the cash method, income includes all items actually or constructively received during the year and expenses are generally deducted in the year they are actually paid or the property is transferred. Under the accrual method, income is generally reported in the year earned, and expenses are generally deducted in the year incurred. However, an individual may use one accounting method to account for a business and another method to account for personal items. In addition, if the individual operates two or more separate and distinct businesses, he or she may choose a different accounting method for each, as long as it is consistently applied and clearly reflects income. Although most individuals use the cash method, the IRC requires that taxpayers that use inventories (i.e., they produce or purchase merchandise and sell it to produce income) use the accrual method for inventory purchases and sales.

NOTE: Revenue Procedure 2002-28 allows qualifying small-business taxpayers who are otherwise required to use the accrual method to use the cash method if they have average annual gross receipts of $10 million or less. See Chapter 6, "Income Tax Basis Financial Statements," for further discussion of this exception.

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Receivables

Under the IRC, taxpayers must use the specific charge-off method to deduct bad debt losses related to trade notes and accounts receivable. Under that method, receivables are not charged to expense until all collection efforts have been exhausted and they are deemed worthless. A business bad debt can be either partially or totally worthless. If the individual can collect some but not all of the receivable, he or she can deduct the portion that is deemed worthless. A nonbusiness bad debt is deductible only in the year it becomes totally worthless. GAAP requires entities to provide an allowance for receivables for which collection is doubtful.

Business Interests

Under GAAP, the equity method is used to account for investments when the investor can exercise significant influence over the investee. Generally, significant influence exists when the ownership interest is 20% or more. For tax purposes, the equity method of accounting does not exist. Instead, dividend income is included in income. A pro rata share of the investee income or loss is not recorded by the investor.

Income Taxes

The liability for income taxes payable should include unpaid income taxes for completed tax years and an estimated amount for income taxes accrued for the elapsed portion of the current tax year to the date of the financial statements. That estimate should be based on the relationship between taxable income earned and date to total estimated taxable income for the year net of taxes withheld or paid with estimated income tax returns. Current income taxes payable should include state and local, as well as federal, income taxes. Because the income tax basis of accounting measures revenues and expenses in conformity with income tax rules, there are no temporary differences in recognizing taxable income.

Disclosures in Personal Financial Statements According to AU 623.09, OCBOA financial statements should include all informative disclosures that are appropriate for the basis of accounting used. Thus, the disclosures required for OCBOA personal financial statements are essentially the same as those required for GAAP personal financial statements. Informative disclosures can be classified as follows:

• Summary of significant accounting policies

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• Disclosures related to financial statement items • Disclosures related to items not specifically identified on the face of the financial statements

Recommendations The following is a discussion of the author's recommendations for applying the general guidance in AU 623; however, the accountant should always use his or her professional judgment in determining the necessary disclosures for a fair presentation in accordance with the income tax basis of accounting.

Basis of Accounting

AU 623.09 requires that notes accompanying OCBOA financial statements include a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from GAAP. Interpretation No. 14 of SAS-62 (AU 9623.91) clarifies this requirement, noting that the discussion of the basis of accounting required by AU 623.09 may be brief: it only needs to describe the primary differences from GAAP. The intent of the disclosure of the basis of accounting is to warn the financial statement user that the financial statements are not prepared using GAAP, not to reconcile the basis of accounting with GAAP. Normally, the disclosure of the basis of accounting is included at the beginning of the summary of significant accounting policies. As discussed in Chapter 10, "Compiling and Reviewing OCBOA Financial Statements: Procedures and Reporting," if the financial statements are compiled with substantially all disclosures omitted, the compilation report should be modified to disclose the basis of accounting. The following is an example of a disclosure of the basis of accounting when the historical cost basis of accounting is used:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting Robert and Libby Evans prepare their financial statements on the historical cost basis of accounting. The results under that basis differ from those under generally accepted accounting principles primarily because the investments in rental real estate are reported at their depreciated cost rather than at their estimated current values.

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The following is an example of a disclosure of the basis of accounting when the income tax basis of accounting is used:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting Robert and Libby Evans prepare their financial statements on the basis of accounting used for federal income tax purposes. The results under that basis differ from those under generally accepted accounting principles primarily because assets are not reported at their estimated current values.

Summary of Significant Accounting Policies The first note (or disclosure) presented after the financial statements should be a summary of significant accounting policies. As noted in APB-22 (Disclosure of Accounting Policies), the following topics should be considered in determining what accounting principles and methods to describe in the summary:

• A selection from existing acceptable alternatives • Principles and methods peculiar to the industry that the reporting enterprise operates in, even if such principles and methods are predominantly followed in that industry • Unusual or innovative applications of generally accepted accounting principles (GAAP) (and, as applicable, of principles and methods peculiar to the industry that the reporting enterprise operates in)

For most personal financial statements, only descriptions related to the first category (existing acceptable alternatives) are presented in the summary of significant accounting policies. For example, SOP 82- 1identifies several methods that can be used to determine the current value of investments in real estate.

Other Disclosures Although there is no comprehensive list of what notes should be included in personal financial statements, according to SOP 82-1 the CPA should include disclosures sufficient to make the financial statements adequately informative. Some of the disclosures required by SOP 82-1 that are generally considered necessary in OCBOA financial statements include the following:

• The individuals who make up the reporting entity

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• The nature of joint ownership for assets presented in the financial statements (if applicable) • Names of the companies or industries if investment portfolios are concentrated in one or a few companies or industries • For investments in a closely held business (i.e., ownership not available to the general public):

- The name of the closely held business - The client's ownership percentage in the business - The nature of the business - The accounting basis used to prepare the financial statements - Summarized financial information about the assets, liabilities, and results of operations - Significant loss contingencies

•Intangible assets and their estimated useful lives • The face amount of life insurance • Nonforfeitable rights not presented as an asset • The following tax information:

- Unused operating loss and capital loss carryforwards - Other unused deductions and credits (and their expiration periods, if applicable) - The differences between the reported values of assets and liabilities by individual items or categories, and their tax bases

• Maturities, interest rates, and other relevant information for receivables and debt • Noncancelable commitments not reported as liabilities In addition, the CPA should consider whether other disclosures are necessary for the personal financial statements to satisfy the standard for adequate disclosure. For example, contingencies or related-party transactions may require disclosure.

Personal Financial Statement Engagement Issues

Accepting the Client

The AICPA's Personal Financial Statements Guide states that the CPA may consider the following points when determining whether to accept an engagement to audit, review, or compile personal financial statements: • Facts that relate to the individual's integrity

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• The level of business risk associated with the financial statements • The CPA's ability to perform the engagement • Factors related to independence • The adequacy of accounting records and other data Potential clients should be evaluated carefully to ensure that the CPA associates only with clients who have integrity. In assessing the integrity of a potential client, the CPA may make inquiries of bankers, lawyers, and other professionals who know the client. Before proceeding, however, the CPA should inform the prospective client that he or she intends to make these inquiries.

NOTE: Although evaluation of the individual's integrity is an important element in determining whether to accept an engagement to compile or review personal financial statements, the actual acceptance of the engagement does not imply that the CPA vouches for the integrity of the individual. That is, the acceptance of an engagement recognizes that the CPA is naturally concerned with the individual's integrity, but acceptance should not be viewed by third parties as a validation of the individual's integrity.

Business risk can be described as the probability that an individual's assets will not be realized at an amount at least equal to their stated value or that the individual will not be able to pay liabilities as they mature. Although all engagements entail a certain amount of risk, the CPA should be alert to situations in which the business risk is unusually high. The business risk may relate directly to the individual for whom the personal financial statements are being audited, reviewed, or compiled. For example, if the individual's financial condition suggests that he or she is unable to pay obligations as they mature, the level of business risk related to the client would tend to be assessed as high. Business risk can also relate to the types of assets and liabilities held by an individual. For example, the level of business risk would be considered higher if a significant portion of an individual's assets is based on the estimated value of a professional practice than if an individual's assets are concentrated almost entirely in investments in governmental bonds and marketable securities. Although the CPA does not express an assurance on the financial statements in a compilation engagement, and in a review engagement the assurance is limited, SSARS-1(AR 100) (Compilation and Review of Financial Statements) requires that the CPA "possess a general understanding of the nature of the entity's business transactions, the form of its accounting records, the stated qualifications of its accounting personnel, the accounting basis on which the financial statements are to be presented, and the form and content of the financial statements." In personal financial statement engagements, the form of accounting records might not be integrated and may be incomplete. In addition, there may be no one

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responsible for or trained to assume the accounting responsibilities normally found in a business enterprise. The CPA should consider whether these and other obstacles would prevent him or her from satisfying professional requirements for an audit, review, or compilation engagement. The client acceptance process should address whether the CPA or members of his or her firm have relationships, either direct or indirect, with the individual that would impair independence. Although a compilation report can be issued when independence is impaired, the report must disclose the lack of independence. The CPA may not issue a review or audit report when he or she is not independent. Although the CPA cannot expect an individual to have an accounting system as sophisticated as that of a business enterprise, the information contained in the records must be adequate for the preparation of personal financial statements in accordance with GAAP.As part of the initial discussion with the client, the CPA should examine the nature and extent of the prospective client's accounting system, records, financial statements, and other financial data. Sometimes the CPA needs to perform other accounting services before the auditing, reviewing, or compiling the personal financial statements. For example, the CPA might need to prepare the individual's tax return or provide guidance on what basic accounting records are needed and what procedures should be implemented for the preparation of personal financial statements. The CPA should discuss such services with the individual before accepting the engagement.

Understanding the Client's Accounting Records An individual's accounting system that is the basis for the preparation of personal financial statements seldom consists of a general ledger integrated with various other records and schedules; in many engagements, the individual's accounting system is more informal than formal. Nevertheless the CPA must develop a general understanding of the form of the client's accounting records. The CPA should make inquiries covering a variety of formal and informal records, documents, and transactions in order to provide a comprehensive approach to capturing all material accounts and events. Appendix B to the AICPA's Personal Financial Statements Guide lists possible sources of information that the client should consider (and that the CPA should make inquiries about) in preparing personal financial statements. The sources are summarized as follows (this is not to be considered a complete list or to apply to every engagement):

Sources of Information Potential Accounts and Transactions

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That Might Be Discovered

Checkbooks Determination of year-end cash balances

Identification of categories of cash receipts for the period, including types of income, investment dispositions, and borrowings

Identification of categories of cash disbursements for the period, including types of expenses, investment acquisitions, and reductions of debt

Broker's statements Identification of investments held Discovery of loans outstanding

Property insurance Identification of ownership interest

policies and schedules in assets

Wills Identification of assets owned

Leases Identification of assets and related liabilities

Listings of value of safe deposit box contents

Identification of assets owned

Real estate and personal property tax returns

Identification of assets owned

Income tax returns Identification of income-producing assets

Identification of expense-generating liabilities

Identification of tax liability or refund

Financial records of other entities

Identification of ownership interest in assets Identification of sources of income

Outside parties Identification of pending litigation Valuation of various assets and

liabilities Restrictions on assets owned

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The CPA can obtain a general understanding of the client's accounting records from previous experience or by making inquiries of the individual.

Consider Obtaining a Representation Letter SSARS standards do not require that a representation letter be obtained in an engagement for the compilation of personal financial statements, but the AICPA's Personal Financial Statements Guide recommends that one be obtained. Furthermore, because of the informal nature of most personal financial records, some practitioners obtain written representation from the client to confirm the oral representations made in personal financial statement compilation engagements.

Audit of Personal Financial Statements Generally accepted auditing standards apply to audits of personal financial statements in the same manner as to audits of other financial statements. The scope of the audit should enable the independent auditor to conclude that he or she has a reasonable basis for expressing an opinion on whether the statements are presented fairly in conformity with the basis of accounting used. Generally accepted auditing standards include obtaining an understanding of internal control sufficient to plan the audit and to determine the nature, timing, and extent of tests to be performed, tests of accounting records and of responses to inquiries, and other procedures considered necessary in the circumstances. Most of the independent auditor's work in forming his or her opinion on personal financial statements consists of obtaining evidential matter concerning the assertions of existence or occurrence, completeness, rights and obligations, valuation or allocation, and presentation and disclosure in the financial statements. Because of the nature of personal financial records, obtaining that evidential matter may be difficult. As a result, it may be impracticable to conduct an audit of personal financial statements in accordance with generally accepted auditing standards and express an unqualified opinion.

Reporting Standards The reporting standards for personal financial statements are essentially the same as those that apply to commercial enterprise financial statements. In general, the only report modification necessary when reporting on personal financial statements is the identification of the reporting entity. When the compiled financial statements omit substantially all disclosures, the personal financial statements must nonetheless include a note describing the basis of accounting. That note may be an attached note or a note that appears

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on the face of each financial statement. If a note describing the basis of accounting is not included, a sentence modeled on the following example should be added to the first paragraph of the compilation report: The financial statement(s) is (are) intended to present the assets and liabilities of Robert and Libby Evans at historical cost. Reporting on Personal Financial Statements Included in Written Personal Financial Plans SSARS-6 (AR 600) (Reporting on Personal Financial Statements Included in Written Personal Financial Plans) provides an exemption from SSARS-1 (AR 100) for personal financial statements that are included in written personal financial plans prepared by an accountant, and specifies the form of written report required under the exemption. Because the purpose of such financial statements is solely to assist in developing the client's personal financial plan, they frequently omit disclosures required by GAAP and contain departures from GAAP or from OCBOA. When all of the following conditions exist, an accountant may submit a written personal financial plan containing unaudited personal financial statements to a client without complying with the requirements of AR 100:

• The accountant establishes an understanding with the client, preferably in writing, that the financial statements

- Will be used solely to assist the client and the client's advisers to develop the client's personal financial goals and objectives; and - Will not be used to obtain credit or for any purposes other than developing these goals and objectives.

• Nothing comes to the accountant's attention during the engagement that would cause the accountant to believe that the financial statements will be used to obtain credit or for any purposes other than developing the client's financial goals and objectives.

Interpretation No. 1 of SSARS-6 (AR 9600.01) states that development of a client's personal financial goals and objectives includes implementing the personal financial plan by the client or the client's advisers because implementing the plan may be considered the culmination of the process of developing personal financial goals and objectives. Therefore, an accountant may submit a written personal financial plan containing unaudited personal financial statements to a client to be used by the client or the client's advisers to implement the personal financial plan without complying with the requirements of AR 100, provided the conditions described in AR 600.03 exist. Examples of

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implementation of a personal financial plan by the client's advisers include use of the plan by

• An insurance broker who will identify specific insurance products • An investment adviser who will provide specific recommendations about the investment portfolio • An attorney who will draft a will or trust documents

The following is an example of an appropriate report by an accountant using the exemption provided by AR 600: The accompanying statement of financial condition of Robert and Libby Evans as of December 31, 20X7, was prepared solely to help you develop your personal financial plan. Accordingly, it may be incomplete or contain other departures from generally accepted accounting principles and should not be used to obtain credit or for any purposes other than developing your financial plan. We have not audited, reviewed, or compiled the statement. Each page of the personal financial statements should include a reference to the accountant's report.

NOT-FOR-PROFIT ORGANIZATIONS The AICPA Audit and Accounting Guide Not-for-Profit Organizations recognizes that not-for-profit organizations may present their financial statements on a basis of accounting other than GAAP. This section discusses the general considerations for OCBOA financial statements for not-for-profit organizations and provides specific guidance on the cash, income tax, and regulatory bases of accounting.

Issues to Consider in Not-for-Profit Financial Statements

Fund Accounting

Before the issuance of FAS-117 (Financial Statements of Not-for-Profit Organizations), not-for-profit accounting was characterized by the use of fund accounting. Fund accounting establishes units of accountability generally based on contractual arrangements, donor restrictions, and management preferences. Typical funds used by most not-for-profit organizations are Current Operating Funds (Unrestricted and Restricted), Plant Funds, Loan Funds, Endowment Funds, Annuity and Life-Income Funds, and Agency Funds. Before the issuance of FAS-117, the financial statements of not-for-profit organizations were formatted with multiple columns (one column for each fund type) and, generally,

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a total column. However, the fund accounting basis does not meet the criteria in SAS-62 (AU 623.04) (Special Reports) for an OCBOA. Financial statements prepared using the income tax basis may look very similar to fund accounting basis financial statements, however, if certain elections are made. For example, Form 990 allows not-for-profit organizations to follow FAS-1l6 (Accounting for Contributions Received and Contributions Made) and FAS-1l7 for income tax reporting purposes, but Form 990 also provides a space for reporting either fund balance information or net asset information.

Statement of Functional Expenses

FAS-117 (Financial Statements of Not-for-Profit Organizations) requires that voluntary health and welfare organizations "provide a statement that reports expenses by their functional and natural classification in a matrix format." Other types of not-for-profit organizations are encouraged, but are not required, to present information by their natural classifications. They are required, however, to present information on the statement of activities or in the notes to the financial statements about expenses by their functional classifications. According to Interpretation No. 14 of SAS-62 (AU 9623.93), instead of showing expenses by their functional classifications, the income tax basis statement of activities of a not-for-profit organization could present expenses according to their natural classifications, and a note to the statement could use estimated percentages to communicate information about expenses incurred by the major program and supporting services. AU 9623.93 further states that a voluntary health and welfare organization could take such an approach instead of presenting the matrix of natural and functional expense classifications that would be required for a GAAP presentation, or, if information has been gathered for the Form 990 matrix required for such organizations, it could be presented either in the form of a separate statement or in a note to the financial statements.

Cash-Basis Financial Statements

Pure Cash

Many not-for-profit organizations with relatively simple operations prepare financial statements based on cash receipts and disbursements. According to the AICPA's nonauthoritative practice aid Preparing and Reporting on Cash- and Tax-Basis Financial Statements, pure cash-basis financial statements may be appropriate whenever the entity

• Is interested primarily in understanding cash flow • Has a limited number of financial statement users • Has relatively simple operations engaged in one primary activity

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• Does not have significant amounts of debt, fixed assets, or other items that would be recognized under the accrual basis of accounting

Not-for-profit organizations that use the pure cash basis of accounting include civic ventures, student activity funds, and political campaigns and committees.

Modified Cash

The modified cash basis is a hybrid method that combines features of both the cash basis and the accrual basis of accounting. Modifications to the cash basis include such items as the capitalization of assets and the accrual of certain expenses. Modified cash basis financial statements are intended to provide more information to users than cash financial statements while still avoiding the complexities of full accrual GAAP financial statements. AU 623.04 permits modifications to the cash basis that have substantial support in the accounting literature. Because the modified cash basis is not formalized in authoritative pronouncements, modifications have evolved through common usage.

Pledges

Some practitioners believe that recording unconditional promises on the accrual basis and reflecting related pledge receivables is inconsistent with the cash orientation of the modified cash basis of accounting. If pledge receivables are recorded, some practitioners question whether a valuation allowance should be recorded if the receivable has been impaired. Although there is no authoritative guidance on this question, the overriding consideration should be to record receivables in a manner that is meaningful and not misleading.

Investments

The cash basis of accounting may be modified to capitalize payments to acquire marketable securities. In addition, if significant amounts of securities are donated, these donated securities should be recorded in the financial statements or the amount of securities donated during the period should be disclosed in the notes to the financial statements. Accountants differ on whether investments recorded under the modified cash basis of accounting should be adjusted to fair value in accordance with FAS-124 (Accounting for Certain Investments Held by Not-for-Profit Organizations).

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Capitalization of property, plant, and equipment is one of the most common modifications to the pure cash basis of accounting. Several significant questions arise when property, plant, and equipment are capitalized:

• Should interest be capitalized on property, plant, and equipment constructed by the entity for its own use? • Should impairment losses be recognized in accordance with GAAP?

Although there is no authoritative guidance on either of the foregoing questions, the overriding consideration should be to record property, plant, and equipment in a manner that is meaningful and not misleading. In addition, if significant amounts of property and equipment are donated, these donated assets should also be recorded in the financial statements or the amount of assets donated during the period should be disclosed in the notes to the financial statements.

Net Assets

Financial statements prepared on the modified cash basis of accounting should present net assets rather than fund balances. However, the statement of assets, liabilities, and net assets is permitted to reflect total net assets only, rather than amounts for each of the three classes of net assets as required by FAS-117 (Financial Statements of Not-for- Profit Organizations). Disclosures related to restrictions on net assets should be provided in the notes to the financial statements, however.

FAS-117 FAS-117 (Financial Statements of Not-for-Profit Organizations) requires that the equity section (net asset section) of the statement of financial position include three classes of net assets, which are defined as follows:

1. Permanently restricted net assets Net assets resulting (1) from contributions and other inflows of assets whose use by the organization is limited by donor-imposed stipulations that can neither expire with the passage of time nor be fulfilled or otherwise removed by actions of the organization, (2) from other asset enhancements and diminishments subject to the same kinds of stipulations, and (3) from reclassifications from (or to) other classes of net assets as a consequence of donor-imposed stipulations.

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2. Temporarily restricted net assets Net assets resulting (1) from contributions and other inflows of assets whose use by the organization is limited by donor-imposed stipulations that can either expire with the passage of time or be fulfilled and removed by actions of the organization pursuant to those stipulations, (2) from other asset enhancements and diminishments subject to the same kinds of stipulations, and (3) from reclassifications to (or from) other classes of net assets as a consequence of donor-imposed stipulations, their expiration with the passage of time, or their fulfillment and removal by actions of the organization pursuant to those stipulations. 3. Unrestricted net assets Net assets that are neither permanently restricted nor temporarily restricted by donor-imposed stipulations.

FAS-117 also requires the statement of activities to disclose the changes in those classes of net assets. Interpretation No. 14 of SAS-62 (AU 9623.90) states that either GAAP presentation requirements should be followed in OCBOA financial statements or the substance of the GAAP requirements should be communicated in some other manner. The substance of the FAS-117presentation requirements could be communicated in the notes to the financial statements rather than on the face of the financial statements. For example, the statement of assets, liabilities, and net assets could present total net assets and the statement of revenues, expenses, and changes in net assets could present the total change in net assets rather than the change in each class of net assets. The additional information about significant restrictions and changes in net assets could then be provided in the notes to the financial statements. In addition, the notes could use actual amounts, estimates, or percentages to communicate information about significant restrictions and changes in those amounts.

Income Tax Basis Financial Statements SAS-62 (AU 623.04) (Special Reports) recognizes "the basis of accounting the reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements" as an other comprehensive basis of accounting. However, AU 623 does not provide any additional guidance on what is meant by the phrase "income tax return." If taken literally, not-for-profit organizations would not be able to use the income tax basis under AU 623, because they do not file "income tax returns" but, rather, file information returns (Form 990, Return of Organization Exempt from Income Tax). Interpretation No. 14 of SAS-62 (AU 9623.93), however, provides examples of not-for-profit organizations using the accounting principles followed in filing Form 990, effectively acknowledging that such entities may issue income tax basis financial statements.

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Accounting Methods

In general, a not-for-profit organization may prepare Form 990 using the cash, accrual, or hybrid method. The method depends on the accounting method normally used to keep the organization's books and records. Regardless of the accounting method used, it should be applied consistently from year to year.

Pledges

Pledges receivable for income tax reporting may be different from amounts measured under GAAP, for the following reasons:

• Not-for-profit organizations are permitted, but not required, to adopt FAS-116 (Accounting for Contributions Received and Contributions Made) for tax purposes. • For income tax reporting, the free use of materials, equipment, or facilities is not reflected as revenue. GAAP requires organizations to recognize unconditional promises to give the free use of materials, equipment, or facilities in the financial statements. • If organizations use the cash method for income tax reporting, they would not reflect pledges receivable in the financial statements.

Grants Receivable

The reporting of grants receivable is similar to the reporting of pledges receivable. Organizations electing to follow FAS-116 (Accounting for Contributions Received and Contributions Made) for purposes of filing Form 990 must determine whether grants are unconditional promises to give (follow guidance in FAS-116), conditional promises to give (not recognized), or exchange transactions (review terms of grant to determine when to recognize).

Investments

Not-for-profit organizations are permitted, but not required, to follow FAS-124 (Accounting for Certain Investments Held by Not-for-Profit Organizations) for tax purposes. Accordingly, organizations may carry investments at cost or fair value.

Grants Payable

FAS-116 (Accounting for Contributions Received and Contributions Made) requires that grants made to others be recognized as expenses in the period they are made. Further, such grants are recorded at the fair value of assets given or

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to be given, and grants payable in the future are recorded at their present value. For income tax reporting, organizations are not required to follow FAS-116. Therefore, in accrual method income tax basis statements, grants payable may be reported at the amounts promised, without discounting those amounts to present value. Organizations using the cash method of accounting should not recognize grants payable in the financial statements.

Deferred Revenue

Accounting for deferred revenue from exchange transactions is the same for GAAP and the income tax basis of accounting. Accordingly, revenue from the sale of goods or services should be deferred for tax purposes if it is received in advance. Accounting for deferred revenue related to contributions depends on whether the organization follows FAS-116 (Accounting for Contributions Received and Contributions Made) for income tax reporting. If the organization follows FAS-116, contributions whose use is donor restricted to future periods should be recognized in income tax basis financial statements in the period they are received; no amounts are deferred. If the organization does not follow FAS-116, it should report contributions whose use is donor-restricted to future years as deferred revenue.

Net Assets

Not-for-profit organizations are not required to follow FAS-117 (Financial Statements of Not-for-Profit Organizations) for tax purposes. FAS-117 requires that the equity section (net asset section) of the statement of financial position include three classes of net assets, which are defined as follows:

1. Permanently restricted net assets Net assets resulting (1) from contributions and other inflows of assets whose use by the organization is limited by donor-imposed stipulations that can neither expire with the passage of time nor be fulfilled or otherwise removed by actions of the organization, (2) from other asset enhancements and diminishments subject to the same kinds of stipulations, and (3) from reclassifications from (or to) other classes of net assets as a consequence of donor-imposed stipulations. 2. Temporarily restricted net assets Net assets resulting (1) from contributions and other inflows of assets whose use by the organization is limited by donor-imposed stipulations that can either expire with the passage of time or be fulfilled and removed by actions of the organization pursuant to those stipulations, (2) from other asset enhancements and diminishments subject to the same kinds of stipulations, and (3) from

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reclassifications to (or from) other classes of net assets as a consequence of donor-imposed stipulations, their expiration with the passage of time, or their fulfillment and removal by actions of the organization pursuant to those stipulations. 3. Unrestricted net assets Net assets that are neither permanently restricted nor temporarily restricted by donor-imposed stipulations.

If the organization follows FAS-117 for tax purposes, the equity section (net asset section) of the statement of assets, liabilities, and net assets should include information about the three classes of net assets. Organizations that do not follow FAS-117 (Financial Statements of Not-for-Profit Organizations) for tax purposes may use fund accounting and report fund balances rather than net assets when preparing Form 990. Fund accounting establishes units of accountability generally based on contractual arrangements, donor restrictions, and management preferences. Typical funds, used by most not-for profit organizations, are Current Operating Funds (Unrestricted and Restricted), Plant Funds, Loan Funds, Endowment Funds, Annuity and Life-Income Funds, and Agency Funds. Consistent with Form 990 requirements, organizations that do not follow FAS-117 should reflect amounts for the following fund balances either in the statement of assets, liabilities, and fund balances or in the notes to the financial statements:

• Current funds • Land, building, and equipment fund • Endowment fund or other funds

Contributions

Not-for-profit organizations are not required to follow FAS-116 and FAS-117 in recording and reporting contributions for tax purposes. Accordingly, the following differences from GAAP may occur:

• Organizations that do not follow FAS-117 may use fund accounting and report fund balances rather than net assets when preparing Form 990. Accordingly, contributions are reported as increases in the appropriate fund balances. • Organizations that do not follow FAS-116 are not required to discount contributions resulting from pledges receivable that will be collected in future years to their present value. • Organizations that do not follow FAS-116 should report all contributions whose use is donor-restricted to future years as deferred revenue.

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Depreciation

Not-for-profit organizations are not required to use the tax depreciation methods and rules that apply to for-profit entities. Accordingly, they may use GAAP or tax depreciation methods.

Taxes

A not-for-profit organization should report taxes on its accrual method income tax basis financial statements based on the amounts due on the organization's tax return as of the date of the statement of assets, liabilities, and net assets. If the organization uses the cash method for tax reporting purposes, the financial statements should reflect the amount of taxes paid during the year. Examples of taxes on a not-for-profit organization are income tax on unrelated business income and excise taxes on the net investment income of private foundations.

FAS-117 FAS-1l7 (Financial Statements of Not-for-Profit Organizations) requires that the equity section (net asset section) of the statement of financial position include three classes of net assets: permanently restricted, temporarily restricted, and unrestricted. FAS-117 also requires the statement of activities to disclose the changes in those classes of net assets. Interpretation No. 14 of SAS-62 (AU 9623.90) states that either GAAP presentation requirements should be followed in OCBOA financial statements or the substance of the GAAP requirements should be communicated in some other manner. The substance of the FAS-117 (Financial Statements of Not-for-Profit Organizations) presentation requirements could be communicated in the notes to the financial statements rather than on the face of the financial statements. For example, the statement of assets, liabilities, and net assets could present total net assets and the statement of revenues, expenses, and changes in net assets could present the total change in net assets rather than the change in each class of net assets. The additional information about significant restrictions and changes in net assets could then be provided in the notes to the financial statements. In addition, the notes could use actual amounts, estimates, or percentages to communicate information about significant restrictions and changes in those amounts.

Disclosures in Not-for-Profit Financial Statements

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Basis of Accounting

AU 623.09 requires that notes accompanying OCBOA financial statements include a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from GAAP. Interpretation No. 14 of SAS-62 (AU 9623.91) clarifies this requirement, noting that the discussion of the basis of accounting, required by AU 623.09, may be brief and only needs to describe the primary differences from GAAP. The intent of the disclosure of the basis of accounting is to warn the financial statement user that the financial statements are not prepared using GAAP, not to reconcile the basis of accounting with GAAP. Normally, the disclosure of the basis of accounting is included at the beginning of the summary of significant accounting policies. As discussed in Chapter 10, "Compiling and Reviewing OCBOA Financial Statements: Procedures and Reporting," if the financial statements are compiled with substantially all disclosures omitted, the compilation report should be modified to disclose the basis of accounting. The following is an example of this disclosure:

NOTE A-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting The accompanying financial statements have been prepared using the modified cash basis of accounting. Under this method, revenues are recognized when collected rather than when earned, and expenses generally are recognized when paid rather than when incurred. Consequently, the Organization has not recognized pledges receivable from donors, accounts payable to vendors, and their related effects on the change in net assets in the accompanying financial statements.

Summary of Significant Accounting Policies According to APB-22 (Disclosure of Accounting Policies), GAAP financial statements must disclose all significant accounting policies used by the reporting entity. APB-22 specifically requires disclosure of accounting policies to identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. Specifically, the summary of significant accounting policies should encompass those accounting principles and methods that involve any of the following:

• A selection from existing acceptable alternatives

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• Principles and methods peculiar to the industry that the reporting entity operates in, even if the principles and methods are predominantly followed in that industry • Unusual or innovative applications of generally accepted accounting principles

For example, a not-for-profit organization might disclose information about the following alternatives that exist for income tax basis financial statements:

• The organization may choose not to record contributions and pledges receivable in accordance with FAS-1l6. • The organization may choose not to follow the financial statement presentation requirements in FAS-117. • The organization may carry investments at cost rather than fair value. • The organization may calculate depreciation using tax of GAAP methods.

Tax Exempt Status

The Audit Guide requires not-for-profit organizations to disclose their tax-exempt status in GAAP financial statements. Similar disclosure should be made in OCBOA financial statements. The following is an example of this disclosure:

NOTE A-SUMARY OF SIGNIFICANT ACCOUNTING POLICIES Income Tax Status The Organization is a not-for-profit organization pursuant to Section 501(c)7 of the Internal Revenue Code (the Code), and therefore, the Organization is tax-exempt under Section 501(a) of the Code. The Organization had no material unrelated business income during the years ended June 30, 20X7 and 20X6. Accordingly, there is no provision for federal income tax.

Pledges

If OCBOA financial statements include pledges receivable, the notes should communicate the substance of the GAAP disclosure requirements. The disclosure should include information about payment terms, any allowance for uncollectible amounts, and the discount (if amounts have been discounted).

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Investments

If marketable securities are presented in accordance with FAS-124 (Accounting for Certain Investments Held by Not-for-Profit Organizations), disclosures required by that statement or information that communicates the substance of those disclosures should be made.

Deferred Revenue

Because GAAP requires revenue related to restricted contributions to be recognized in the statement of activities in the period the revenue is received, no amounts are deferred in GAAP financial statements. However, income tax basis financial statements may have deferred revenue related to contributions restricted to use in future periods. Because GAAP financial statements disclose changes in restricted amounts through the presentation on the statement of activities, similar information should be provided in OCBOA financial statements. Therefore, information about significant changes in deferred revenue related to contributions restricted to use in future periods should be provided in the notes to the financial statements using either actual amounts, estimated amounts, or percentages. In addition, cash-basis financial statements may be modified to record deferred revenue. This typically consists solely of revenue from exchange transactions that has been received but not yet earned. If it is material, deferred revenue resulting from exchange transactions should be segregated from other liabilities in OCBOA financial statements.

Net Assets

FAS-1l7 (Financial Statements of Not-for-Profit Organizations) requires that the equity section (net asset section) of the statement of financial position include three classes of net assets: permanently restricted, temporarily restricted, and unrestricted. FAS-1l7 also requires the dollar amount and types of permanent restrictions and temporary restrictions on net assets to be disclosed either on the face of the statement of financial position as secondary captions of those classes of net assets or in the notes to the financial statements. Interpretation No. 14 of SAS-62 (AU 9623.90) states that either GAAP presentation requirements should be followed in OCBOA financial statements or the substance of the GAAP requirements should be communicated in some other manner. The substance of the FAS-117 presentation requirements should be communicated in the notes to the financial statements. For example, the statement of assets, liabilities, and net assets presents total net assets and the statement of revenues, expenses, and changes in net assets presents the total

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change in net assets rather than the change in each class of net assets. The additional information about significant restrictions and changes in net assets is provided in the notes to the financial statements. In addition, the notes may use actual amounts, estimates, or percentages to communicate information about significant restrictions and changes in those amounts. The following is an example of this disclosure:

NOTE D-NET ASSETS Net assets include $870,444 and $680,230 at December 31, 20X7 and 20X6, respectively, related to an endowment fund which, according to the donors' instructions, is to remain intact in perpetuity. Net assets also include $103,758 and $96,732 at December 31, 20X7 and 20X6, respectively, related to earnings from the endowment fund and contributions which the Organization has not yet expended in the manner specified by the donors. During the years ended December 31, 20X7 and 20X6, the Organization expended $29,110 and $44,280, respectively, in restricted funds in accordance with donor restrictions.

NOTE: Because Form 990 requires amounts for the three classes of net assets or the different fund balances to be included on the form, disclosures in income tax basis financial statements could use actual amounts, because that information is readily available.

Donated Services

Unlike GAAP, which requires disclosing the activities and programs that donated services were used for, the nature and extent of those services, and the amount recognized as revenue during the period, donated services are not reported as revenue in income tax basis financial statements and are rarely included in modified cash basis financial statements. Therefore, information should be included in the notes to OCBOA financial statements about the nature and extent of any donated services and the activities or programs that donated services were used for. The fair value of those services (which is required in GAAP financial statements) may also be included, but is not required.

Donated Materials, Equipment, or Facilities

Because the donated use of materials, equipment, or facilities is not reported in income tax basis financial statements and is rarely included in modified cash basis financial statements, information about the free use of such items should be included in the notes to the financial statements.

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Functional Expenses

FAS-117 (Financial Statements of Not-for-Profit Organizations) requires that voluntary health and welfare organizations "provide a statement that reports expenses by their functional and natural classification in a matrix format." Other types of not-for-profit organizations are encouraged, but are not required, to present information by their natural classifications. They are required, however, to present information on the statement of activities or in the notes to the financial statements about expenses by their functional classifications. According to Interpretation No. 14 of SAS-62 (AU 9623.93), instead of showing expenses by their functional classifications, the income tax basis statement of activities of a not-for-profit organization could present expenses according to their natural classifications, and a note to the statement could use estimated percentages to communicate information about expenses incurred by the major program and supporting services. AU 9623.93 further states that a voluntary health and welfare organization could take such an approach instead of presenting the matrix of natural and functional expense classifications that would be required for a GAAP presentation, or, if information has been gathered for the Form 990 matrix required for such organizations, it could be presented either in the form of a separate statement or in a note to the financial statements.

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Chapter 9 - Auditing OCBOA Financial Statements


Distinguish among the primary differences between audits of OCBOA financial statements and GAAP financial statements.

Recognize what the auditor report should include when reporting on financial statements that are prepared in conformity with an OCBOA.

Recognize the different types of opinions that can be issued for audit reports and indicate when each would be issued.

Indicate how information outside the basic financial statements should be presented.

INTRODUCTION If a CPA is requested to audit OCBOA financial statements for a client that is a nonpublic entity, the Statements on Auditing Standards (SAS) must be observed during the engagement. Fundamentally, the approach for auditing OCBOA financial statements is the same as the approach for auditing GAAP financial statements. For example, concepts and procedures related to accepting, planning, and performing GAAP financial statement engagements should also be followed for OCBOA financial statement engagements. This chapter concentrates on the unique aspects of an audit of OCBOA financial statements and on identifying and describing the preparation of reports for other comprehensive bases of accounting. For a complete discussion of audit engagements, including specific procedures, reports, and checklists, refer to Miller Audit Procedures.

AUDIT PROCEDURES The process of gathering evidence to test assertions in an audit is generally the same whether GAAP or an OCBOA is used, and the assertions themselves are generally the same. The primary differences between audits of OCBOA financial statements and GAAP financial statements are as follows:

• Certain assertions may be tested differently

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• The auditor needs to have knowledge of both GAAP and the OCBOA; often the collaboration of tax specialists and accounting/ audit specialists is required for income tax basis financial statements • Engagement letters and management representation letters require some modification when auditing OCBOA financial statements, as follows:

- The titles of financial statements should conform to the appropriate OCBOA titles - References to the basis of accounting should identify the OCBOA

Most of an independent auditor’s work in forming an opinion on the financial statements consists of obtaining and evaluating evidential matter concerning assertions in the financial statements. Assertions are generally classified according to the following five broad categories:

1. Existence or occurrence Reported assets and liabilities exist at the financial statement date and the recorded amounts represent transactions that occurred during the accounting period. 2. Completeness All transactions and accounts that should be presented are included. 3. Rights and obligations Assets properly represent rights owned by the client and liabilities represent obligations of the client. 4. Valuation and allocation All accounts are valued in accordance with the basis of accounting used. 5. Presentation and disclosure Accounts and related information are properly classified, described, and disclosed.

Assertions in financial statements that are prepared using an OCBOA are conceptually the same as assertions in GAAP financial statements. However, the assertions may differ somewhat in their details. For example:

• In GAAP financial statements, an assertion that revenue is complete means that all sales have been recorded for which the earning process is complete. • In income tax basis financial statements, as assertion that revenue is complete means that revenue includes all sales that are fixed and determinable and for which all events have occurred. • In cash-basis financial statements, an assertion that revenue is complete means that revenue includes all cash collected related to sales.

Similar distinctions may be made for each assertion and for each account in OCBOA financial statements.

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In audits of GAAP and OCBOA financial statements, the auditor assesses control risk and inherent risk. The auditor then attempts to limit detection risk by performing analytical procedures and tests of details. Other possible differences in audits of GAAP and OCBOA financial statements include the following:

• Audits of OCBOA financial statements are likely to take less time than audits of GAAP financial statements because OCBOA financial statements typically do not include deferred taxes, capital leases, and other transactions that complex accounting rules apply to. • Although audits of OCBOA financial statements tend to take less time than audits of GAAP financial statements, some additional time is spent evaluating the adequacy of disclosures in OCBOA financial statements. • Cash-basis financial statements often contain fewer assets and liabilities than GAAP financial statements, which normally decreases the time required to perform the audit. • In audits of income tax basis financial statements, the inherent risk that revenue is understated and expenses is overstated is often high because management tends to apply aggressive interpretations of tax laws in order to minimize taxable income. This often results in additional time spent evaluating whether accounting policies and methods meet the realistic possibility standard and are properly disclosed.

AUDIT REPORTS The audit report is the final step in the entire audit process. From the users' viewpoint, the auditor's report is the primary product of an audit. When reporting on financial statements is prepared in conformity with an OCBOA, the auditor should include in the report:

• A title that includes the word "independent" • A paragraph that

- States that the financial statements identified in the report were audited

- States that the financial statements are the responsibility of the company's management and that the auditor is responsible for expressing an opinion on the financial statements based on the audit


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- States that the audit was conducted in accordance with generally accepted auditing standards and includes an identification of the United States of America as the country of origin of those standards (for example, "auditing standards generally accepted in the United States of America" or "U.S. generally accepted auditing standards"). - States that those standards require that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement - States that an audit includes

- Examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements - Assessing the accounting principles used and significant estimates made by management and - Evaluating the overall financial statement presentation

- States that the auditor believes that his or her audit provides a reasonable basis for the opinion


- States the basis of presentation and refers to the note to the financial statements that describes the basis - States that the basis of presentation is a comprehensive basis of accounting other than generally accepted accounting principles

• A paragraph that expresses the auditor's opinion (or disclaims an opinion) on whether the financial statements are presented fairly, in all material respects, in conformity with the basis of accounting described. If the auditor concludes that the financial statements are not presented fairly on the basis of accounting described or if there has been a limitation on the scope of the audit, he or she should disclose all the substantive reasons for the conclusion in an explanatory paragraph(s) (preceding the opinion paragraph) of the report and should include in the opinion paragraph the appropriate modifying language and a reference to the explanatory paragraph(s). • If the financial statements are prepared in conformity with the requirements or financial reporting provisions of a governmental regulatory agency, a separate paragraph at the end of the report stating that the report is intended solely for the information and use of those within the entity and the regulatory agencies whose jurisdiction the entity is under and is not intended to be and should not be used by anyone other than these specified parties. Such a paragraph is appropriate even though by law or regulation the auditor's report may be made a matter of public record. The auditor may use this form of report only if the financial

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statements and report are intended solely for use by those within the entity and one or more regulatory agencies whose jurisdiction the entity is under.

NOTE: "Public record," for the purposes of an auditor's reports on financial statements of a regulated entity that are prepared in accordance with the financial reporting provisions of a government regulatory agency includes circumstances in which specific requests must be made by the public to obtain access to or copies of the report. In contrast, the auditor is precluded from using this form of report in circumstances in which the entity distributes the financial statements to parties other than the regulatory agency either voluntarily or upon specific request. NOTE: If the financial statements and report are intended for use by parties other than those within the entity and one or more regulatory agencies whose jurisdiction the entity is under, the auditor should follow the guidance in SAS-1 (AU 544) (Lack of Conformity with Generally Accepted Accounting Principles).

• The manual or printed signature of the auditor's firm. • The date.

Auditor's Standard Report The standard report includes an introductory paragraph, a scope paragraph, and an opinion paragraph. The introductory paragraph describes the basic responsibilities of management and the auditor with respect to the financial statements. The scope paragraph provides a summarized description of the audit process. The auditor's opinion on the entity's financial statements is expressed in the opinion paragraph. The auditor's report is usually addressed to the groups or individuals who appointed the auditor. For corporate clients, this may be the board of directors, the stockholders, or the audit committee. For an unincorporated client, this may be the partners or the proprietor. When an audit is performed at the request of a party other than the management or the owners of the audited entity, the auditor's report should be addressed to the party who requested the audit.

TYPES OF AUDIT OPINIONS

Unqualified Opinion

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An auditor may issue an unqualified opinion on an entity's financial statements only when both of the following two conditions are met:

1. The audit has been conducted in accordance with GAAS. 2. The financial statements are presented in conformity with the OCBOA in all material respects.

If either of the foregoing conditions is not met, one of the following opinions must be issued: (1) a qualified opinion, (2) an adverse opinion, or (3) a disclaimer of opinion.

Qualified Opinion A qualified opinion is issued when any of the following circumstances has a material impact on the financial statements:

• Scope limitations Sufficient evidential matter cannot be collected because of engagement circumstances or restrictions imposed by the client, and the auditor has concluded not to disclaim an opinion. • Departures from OCBOA The basis of accounting, which include adequate disclosures, has not been observed by the client in the presentation of the financial statements, and the auditor has concluded not to express an adverse opinion.

A qualified opinion excludes a specific item from the auditor's opinion. Therefore, the auditor expresses an opinion that the financial statements as a whole are presented fairly in conformity with the OCBOA, excluding the item or items specified in the auditor's report. A qualified opinion should include the word" except" or "exception" in a phrase such as "except for" or "with the exception of."

Adverse Opinion Departures from the OCBOA may be so material and pervasive that the financial statements taken as a whole are misstated or misleading and, therefore, cannot be relied on. Under these circumstances, the auditor should issue an adverse opinion.

Disclaimer of Opinion The necessity for disclaiming an opinion may arise because of either of the following conditions:

• A severe limitation on the scope of the audit Client-imposed circumstances or engagement circumstances may arise during the audit

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that prevent the auditor from applying one or more audit procedures the auditor considers necessary. Such conditions could be so highly material and severe that it would be inappropriate to issue a qualified opinion; therefore, the auditor should disclaim an opinion on the financial statements. • Lack of independence If the auditor is not independent, he or she must disclaim an opinion on the financial statements.

Conditions Precluding an Unqualified Opinion There are three conditions that preclude the auditor from issuing an unqualified opinion: (1) scope limitation, (2) OCHOA departure, and (3) lack of independence. Materiality is an essential consideration in determining the appropriate type of opinion for a given set of circumstances. For example, if a misstatement is immaterial relative to the financial statements of the entity for the current period and is not expected to have a material effect in future periods, it would be appropriate for the auditor to issue an unqualified report. There are no simple, well defined guidelines that enable auditors to decide when something is material; therefore, in application, deciding on actual materiality in a given situation is a difficult judgment. However, generally speaking, a misstatement in the financial statements would be considered material if knowledge of the misstatement would affect a decision of a reasonable user of the financial statements.

Scope Limitations The two major categories of scope limitations are:

1. Restrictions caused by a client (e.g., refusal to permit inquiry of outside legal counsel, refusal to permit confirmation of accounts receivable, refusal to furnish the auditor with a letter of representations) 2. Limitations beyond the control of either the client or the auditor (e.g., inadequate accounting records; timing of the auditor's work, such as when the auditor is engaged too late to observe physical inventory)

Scope limitations require the auditor to express either a qualified opinion or to disclaim an opinion. Note that an adverse opinion is not appropriate when limitations on the scope of the audit exist, because an adverse opinion relates to a deficiency in the financial statements rather than a deficiency in the scope of the audit.

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Although the effect on the auditor's report is the same for either restriction, the interpretation of materiality is likely to be different. For scope restrictions that are imposed by the client, the auditor should be concerned that management may be attempting to prevent discovery of misstated information; in these cases, the auditor usually disclaims an opinion if the condition is material. On the other hand, when restrictions are caused by conditions beyond the client's control, a qualified opinion is more likely. The description of the scope limitation should not be incorporated in the auditor's report by reference to a note to the financial statements because the auditor, not the client, is responsible for the description of the scope limitation. It should be noted that a scope limitation does not exist when the auditor is able to obtain satisfactory evidence by applying alternative procedures.

Qualified Opinion Due to a Scope Limitation

When the auditor concludes that a qualified opinion should be issued for a limitation on the scope of the engagement, the auditor's report should contain:

• An introductory paragraph The wording is the same as in the auditor's standard report. • A scope paragraph The wording of the scope paragraph should be modified by adding the phrase "Except as discussed in the following paragraph" to the beginning of the first sentence in the paragraph. • An explanatory paragraph A separate paragraph should be added, following the scope paragraph, to explain the nature of the scope limitation. • An opinion paragraph The opinion paragraph must be qualified by using the phrase "except for" or a similar phrase. In addition, the opinion paragraph must refer to the explanatory paragraph.

Disclaimer of Opinion Due to a Scope Limitation

When the auditor concludes that a disclaimer of opinion should be issued for a limitation on the scope of the engagement, the auditor's report should

• Contain an introductory paragraph The wording of the introductory paragraph should be modified to state "We were engaged to audit" instead of "We have audited" and the statement of the auditor's responsibility to express an opinion on the financial statements should be deleted. • Omit the scope paragraph The scope paragraph of the auditor's standard report is omitted to avoid overshadowing the disclaimer of opinion (i.e., to

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avoid stating anything that might lead readers to believe that other parts of the financial statements were audited and therefore might be fairly stated). • Contain an explanatory paragraph A separate paragraph should be added, following the introductory paragraph, to explain the nature of the scope limitation. • Contain a disclaimer of opinion paragraph In this paragraph the auditor specifically states that an opinion cannot be expressed on the financial statements because the significance of the scope limitation precluded the auditor from forming an opinion.

Departures from the OCBOA Departures from the OCBOA include (1) using inappropriate accounting principles (e.g., valuing property and equipment at current values instead of historical cost); (2) improperly applying accounting methods (e.g., incorrect application of the LIFO costing method to inventory); and (3) inadequate disclosures in the financial statements or the related footnotes. When a client does not observe accounting principles, the auditor must decide whether an unqualified, a qualified, or an adverse opinion should be issued on the financial statements. The selection of the appropriate opinion depends on the materiality amount of the departure, the number of financial statement items affected by the departure, and the effects of the departure on the financial statements taken as a whole. An unqualified opinion can be issued if the departure is not significant to the fair presentation of the financial statements. If the departure affects the fairness of the financial statements but overall the statements can be relied on, a qualified opinion can be issued. On the other hand, when the departure is so significant that the financial statements should not be relied on, an adverse opinion must be issued. Note that a disclaimer of opinion is not appropriate when the auditor observes a departure from the OCBOA. This is because the auditor has gathered sufficient evidence to place him or her in a position to express an opinion and therefore cannot avoid disclosing a known departure from the OCBOA by denying an opinion on the financial statements.

Qualified Opinion Due to a Departure from the OCBOA

When the auditor concludes that a qualified opinion should be issued due to an OCBOA departure, the auditor's report should contain the following:

• An introductory paragraph The wording is the same as in the auditor's standard report.

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• A scope paragraph The wording is the same as in the auditor's standard report because no limitations have been placed on the scope of the audit. • An explanatory paragraph A separate paragraph should be added, following the scope paragraph, to explain all of the significant reasons for the qualified opinion and to describe the on the financial statements. If the effects are not reasonably determinable, the report should state so. • An opinion paragraph The opinion paragraph must be qualified by using the phrase "except for" or a similar phrase. In addition, the opinion paragraph must refer to the explanatory paragraph.

Adverse Opinion Due to a Departure from the OCBOA

When the auditor concludes that an adverse opinion should be issued due to an OCBOA departure, the auditor's report should contain the following:

• An introductory paragraph The wording is the same as in the auditor's standard report. • A scope paragraph The wording is the same as in the auditor's standard report because no limitations have been placed on the scope of the audit. • An explanatory paragraph A separate paragraph should be added, following the scope paragraph, to explain all of the significant reasons for the adverse opinion and to describe the departure from the OCBOA and its effects, or potential effects, on the financial statements. • An opinion paragraph The opinion paragraph should state that because of the effects of the departures from the OCBOA, the financial statements are not presented fairly in conformity with the OCBOA. In addition, the opinion paragraph must refer to the explanatory paragraph.

Accounting Changes

The auditor should express a qualified opinion with respect to accounting changes if any of the following conditions exist:

• A newly adopted accounting principle is not in conformity with the OCBOA. • The method of accounting for the effect of the change is not in conformity with the OCBOA. • Management has not provided reasonable justification for the change in accounting principle.

If the effect of the change is highly material, the auditor should express an adverse opinion on the financial statements.

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In addition, in subsequent years, the auditor should continue to express his or her exception with respect to the financial statements for the year of change as long as they are presented and reported on. Whenever an accounting change causes an auditor to express a qualified or an adverse opinion on the conformity of financial statements with the OCBOA for the year of change, he or she should consider the possible effects of that change when reporting on subsequent year's financial statements as follows:

• The auditor's report should disclose his or her reservations with respect to the financial statements for the year of change, if such statements are presented and reported on with a subsequent year's financial statements. • If an entity has adopted an accounting principle that is not in accordance with the OCBOA, its continued use might have a material effect on the statements of a subsequent year on which the auditor is reporting. In this situation, the auditor should express either a qualified opinion or an adverse opinion, depending on the materiality of the departure in relation to the statements of the subsequent year. • If an entity accounts for the effect of a change prospectively when the OCBOA requires restatement or the inclusion of the cumulative effect of the change in the year of change, the auditor should express a qualified or an adverse opinion on the subsequent year's financial statements.

Lack of Independence The second general standard requires that the auditor be independent. If the auditor has not met the independence requirements specified by the AICPA Code of Professional Conduct, any procedures performed would not be in accordance with GAAS. Therefore, AU 504 (Association with Financial Statements) requires the auditor to issue a disclaimer of opinion regardless of the extent of audit procedures applied. Under these circumstances, no introductory, scope, or explanatory paragraphs are included in the auditor's report. The disclaimer of opinion should simply state that the auditor is not independent and that no opinion is expressed on the financial statements. The reason for the lack of independence and any procedures performed should not be described in the auditor's report. An example of such a report, which is only one paragraph, is as follows: Board of Directors and Stockholders Doug Schacht Company, Inc. We are not independent with respect to Doug Schacht Company, Inc., and the accompanying statement of assets, liabilities, and equity-income tax basis as of December 31, 20X7, and the related statement of revenues and expenses

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income tax basis for the year then ended were not audited by us and, accordingly, we do not express an opinion on them . [Signature] [date]

Unqualified Audit Reports with Explanatory Language Added Certain circumstances may require modification of the wording (e.g., explanatory paragraph) of the auditor's standard report but not modification of the auditor's unqualified opinion on the financial statements. These circumstances include:

• Substantial doubt about the entity's ability to continue as a going concern • Lack of consistency in accounting principles or in the method of their application • Emphasis of a matter • Departure from an accounting principle • The auditor's opinion being based in part on the report of another auditor, when part of the audit is performed by another auditor • Certain matters relating to reports on comparative financial statements • Certain matters relating to supplementary information • Other information in a document containing audited financial statements being materially inconsistent with information appearing in the financial statements

It is important to distinguish between unqualified audit reports with modified wording only, and the qualified, adverse, and disclaimer reports already discussed. The unqualified audit report with modified wording meets the criteria of a complete audit with satisfactory results and financial statements that are fairly presented, but the auditor believes it is important, or is required, to provide additional information. In a qualified, adverse, or disclaimer of opinion report, the auditor either has not performed a satisfactory audit or is not satisfied that the financial statements are fairly presented.

Substantial Doubt about the Entity's Ability to Continue as a Going Concern SAS-59 (AU 341) (The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern) identifies an uncertainty condition referred to as a substantial doubt about an entity's ability to continue as a going concern. If an auditor concludes that there is substantial doubt about an entity's continued existence as a going concern, an unqualified opinion should be expressed and an explanatory paragraph should be added immediately following the opinion

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paragraph. The explanatory paragraph is required even though adequate disclosures are made in the financial statements. AU 341.12 requires that the explanatory paragraph include the phrase "substantial doubt about its [the entity's] ability to continue as a going concern," or similar wording. If similar wording is used, the terms "substantial doubt" and "going concern" must be used. The standard introductory, scope and opinion paragraphs are not changed and should not refer to the explanatory paragraph. The audit report should unequivocally convey the auditor's conclusion about the going-concern status of the entity. A conclusion that contains conditional terminology such as "If the company is unable to obtain financing, there may be substantial doubt about the entity's ability to continue as a going concern" is not definitive enough. AU 341 precludes the auditor from using such conditional language. AU 341 does not specifically discuss the conditions related to substantial doubt about an entity's ability to continue as a going concern that may lead the auditor to issue a disclaimer of opinion. However, it does note that nothing in SAS-59 (AU 341) is intended to preclude an auditor from declining to express an opinion on the financial statements.

Reissued Reports and Going-Concern Matters

A client may ask an auditor to reissue the audit report on the entity's financial statements and remove a going-concern explanatory fourth paragraph after a situation giving rise to substantial doubt about the entity's ability to continue as a going concern has been resolved. Guidance in this situation is provided in Interpretation No. 1 of SAS-59 (AU 9341.01-.02) (Eliminating a Going-Concern Explanatory Paragraph from a Reissued Report). AU 9341.02 states that auditors may, but are under no obligation to, reissue the audit report on the entity's financial statements. However, if the auditor elects to reissue his or her report and is considering whether to eliminate the going-concern paragraph in a reissued report, AU 9341.02 states that the auditor should perform the following procedures:

• Audit the event or transaction that caused the entity to request that the auditor reissue the audit report and eliminate the going-concern paragraph from it. • Perform the procedures specified in paragraph 12 of SAS- I, Section 560 (AU 560) (Subsequent Events) pertaining to subsequent events. • Reassess the going-concern status of the entity at the date of reissuance by (1)performing any procedures the auditor deems necessary and (2) reconsidering existing conditions and events and management's plans as of the date of reissuance.

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Reliance on Third-Party Funding

Many entities may be relying on significant financial support from third parties to support their deficit operations and mitigate any going-concern issues. Such third parties may include major stockholders, family members of the stockholders, or other affiliated entities. The auditor's decision not to modify the auditor's report for a going concern uncertainty in such situations depends on receiving adequate evidence regarding the third party's future financial participation and support.

Lack of Consistency in Accounting Principles or in the Method of Their Application The second standard of reporting states that the auditor's report shall "identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period." The auditor should distinguish between (1) changes that affect consistency and (2) changes that may affect comparability but do not affect consistency. This is important because only changes that affect consistency require a report with wording modification of the auditor's report. The following are examples of changes that affect consistency and, therefore, require an explanatory paragraph, if they are material:

• Change from one accounting principle to another accounting principle (e.g., change from FIFO to LIFO inventory valuation or change from the declining balance method to the straightline method of depreciation) • Change in the reporting entity (e.g., presenting consolidated or combined statements in place of statements of individual entities, changing specific subsidiaries comprising the group of companies for which consolidated statements are presented) • Corrections of errors involving accounting principles • Change in accounting principles that is inseparable from a change in accounting estimates

Other accounting changes affect the comparability of the financial statements and may require disclosure in the financial statements, if material. Changes that do not result in a lack of consistency and therefore do not require the auditor to add an additional paragraph to the standard report include the following:

• Changes in accounting estimates (e.g., decreases in the estimated useful lives of depreciable assets) • Error corrections not involving accounting principles (e.g., mathematical errors in the previous year's financial statements)

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• Variations in format and presentation of financial information (e.g., change in classification of an expenditure from general and administrative to selling expense) • Modifying or adopting an accounting principle for substantially different transactions or events • Change that may have a material effect in the future (A change in accounting principle may have no material effect in the current year, but is expected to have a material effect in future years. This expectation should be disclosed in a note to the financial statements; however, there is no need to refer to the change in accounting principle in the auditor's report in the current or future years.)

Modification to the Standard Auditor's Report as a Result of a Lack of Consistency When a change in accounting principles or in the method of their application materially affects the comparability of the entity's financial statements, the auditor should include an explanatory paragraph in the auditor's standard report. The auditor should not modify his or her opinion, provided the change in accounting principles is properly accounted for and disclosed in the financial statements. The explanatory paragraph, following the opinion paragraph, should (1) identify the nature of the change and (2) refer the reader to the note in the financial statements that discusses the change in detail. The standard introductory, scope, and opinion paragraphs are not changed and should not refer to the explanatory paragraph. The addition of the explanatory paragraph in the auditor's report is required in the auditor's reports on financial statements of subsequent years as long as the year of the change is presented and reported on. An exception to this requirement occurs when a change in accounting principle that does not require a cumulative effect adjustment is made at the beginning of the earliest year presented and reported on, such as a change from FIFO to LIFO. However, if the accounting change is accounted for by retroactive restatement of the financial statements affected, the explanatory paragraph is required only in the year of the change. It should be noted that items that materially affect the comparability of the financial statements generally require disclosure in the notes to the financial statements. A qualified audit report for inadequate disclosure may be required if the client refuses to properly disclose the items.

Emphasis of a Matter Although reporting standards and rules are very detailed, it would be difficult to promulgate rules to provide guidance in every reporting situation. To provide

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some reporting flexibility, the auditor's report may emphasize a matter regarding the financial statements without qualifying the opinion. AU 508.19 presents the following as possible matters that the auditor may want to emphasize:

• The entity reported on is a component of a larger entity. • The entity has had significant transactions with related parties. • A significant subsequent event has taken place. • Accounting matters, other than those involving changes in accounting principles, exist that affect the comparability of the financial statements with those of the preceding period.

When the auditor decides to emphasize a matter, an explanatory paragraph may be added, either following or preceding the opinion paragraph, and an unqualified opinion should be expressed. The standard introductory, scope, and opinion paragraphs should not refer to the explanatory paragraph.

Change from GAAP to OCBOA A change from GAAP to OCBOA (or vice versa) does not represent a change in accounting principles as described in APB-20 (Accounting Changes), therefore no justification for the change is required and no cumulative adjustment is necessary. However, the change in accounting basis should be disclosed in the notes to the financial statements. A change from GAAP to OCBOA does not require modification of the audit report. However, the auditor may consider adding an explanatory paragraph that highlights

• A difference in the basis of presentation from that used in prior years or • That another report has been issued on the entity's financial statements prepared in conformity with another basis of presentation; for example, when cash-basis financial statements are issued in addition to GAAP financial statements

Part of the Audit is Performed by Other Auditors More than one audit firm may participate in an audit of a client. An auditor may report on the financial statements of a consolidated or combined entity, even if he or she has not audited every single entity, branch, or component that is included in the consolidated or combined financial statements.

REPORTING ON COMPARATIVE FINANCIAL STATEMENTS

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Most financial statements are presented on a comparative basis. AU 508.65requires that prior-year financial statements presented with the current year be reported on by the continuing auditor or, when appropriate, by the predecessor auditor. When all financial statements presented have been audited by the same auditor, the introductory, scope, and opinion paragraphs refer to and report on all the financial statements presented. This simply means that plural terms are substituted for singular terms (ie., reference made to statements of assets, liabilities, and equity) and all the periods presented are identified. Also, the auditor's report on comparative financial statements should ordinarily be dated as of the date of completion of fieldwork for the most recent audit. If one or more of the financial statements presented on a comparative basis require that the auditor's report be modified, the report modification guidelines discussed earlier in this chapter should be followed. For example, the current year's financial statements might be presented in accordance with the OCBOA and the prior year's financial statements might not be presented in accordance with the OCBOA. In this case, (1) the introductory paragraph refers to both the current year's and the prior year's financial statements; (2) immediately preceding the opinion paragraph, an explanatory paragraph that contains an explanation of the deviation from the OCBOA in the prior year's financial statements is added; and (3) the opinion paragraph contains an unqualified opinion on the current year's financial statements and a qualified opinion ("except for "), including reference to the explanatory paragraph, on the prior year's financial statements.

REPORTING ON INFORMATION ACCOMPANYING THE BASIC FINANCIAL STATEMENTS

Reporting on Voluntary Additional Information Auditor-submitted documents may contain information outside the basic financial statements, such as schedules of cost of goods sold and general and administrative expenses, statistical data concerning operating ratios and trends, and historical financial summaries. SAS-29 (AU 551) (Reporting on Information Accompanying the Basic Financial Statements in Auditor-Submitted Documents) requires the auditor to report on such additional information and state the degree of responsibility he or she is taking for the additional information. It is important that the auditor clearly distinguish between responsibility for the primary financial statements and responsibility for the additional information. Usually, the auditor has not performed a sufficiently detailed audit to justify an opinion on the additional information; however, in some instances the auditor may be satisfied that the information is fairly stated in all material respects in relation to the basic financial statements taken as a whole.

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The auditor's report on additional information may be presented separately in the auditor-submitted document or included as a separate paragraph in the auditor's report on the basic financial statements. Regardless of the method selected by the auditor to report on this information, AU 551.06 states that the auditor's report on the accompanying information should • State that the audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole.

• Clearly identify the accompanying information presented and state that it is presented for purposes of additional analysis and is not a required part of the basic financial statements. • Either express an opinion on whether the accompanying information is fairly stated in all material respects in relation to the basic financial statements as a whole or disclaim an opinion. The auditor has no obligation to apply any auditing procedures to the accompanying information; however, expression of an opinion is appropriate only when the accompanying information has been subjected to the audit procedures applied in the audit of the basic financial statements.

The following illustrates a paragraph added to the auditor's standard report applicable to information accompanying the basic financial statements in an auditor-submitted document:

Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The [identify accompanying information] is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has not been subjected to the auditing procedures applied in the audit of the basic financial statements, and, accordingly, we express no opinion on it.

DATING OF THE AUDITOR'S REPORT SAS-1 (AU 530) (Dating of the Independent Auditor's Report) states that, generally, the date of the auditor's report should be the date that substantially all fieldwork has been completed. The auditor's responsibility for reviewing for subsequent events is normally limited to the period beginning with the financial statement date and ending with the date of the auditor's report, which is the last day of fieldwork (commonly referred to as the "subsequent period").

Events Occurring after Completion of Fieldwork but before Issuance of Report

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There are two types of subsequent events that require consideration and evaluation by the auditor:

1. Events that provide additional evidence with respect to conditions that existed at the balance-sheet date and affect the estimates inherent in the process of preparing financial statements. These events have a direct effect on the financial statements and require adjustment. 2. Events that provide evidence with respect to conditions that did not exist at the date of the balance sheet but arose subsequent to that date. These events have no direct effect on the financial statements and should not result in an adjustment; however, disclosure may be required in notes to the financial statements.

Effect of Subsequent Events Requiring Adjustment of the Financial Statements

If the auditor becomes aware of a subsequent event requiring adjustment of the financial statements, the auditor should observe the following requirements:

• The adjustment is made in the financial statements and disclosure of the event is made. In such circumstances, the auditor should either dual-date the report or date it as of the later date (ie., the date of the event). See "Methods Available for Dating the Auditor's Report for a Subsequent Event" (below). • The adjustment is made in the financial statements but disclosure of the event is not made because it is not considered necessary. In such circumstances, the auditor's report should be dated as of the date of completion of fieldwork. • No adjustment is made to the financial statements. In such circumstances, the auditor should qualify his or her opinion; in some cases, a disclaimer of opinion or an adverse opinion may be appropriate.

Effect of Subsequent Events Requiring Disclosure

If the auditor becomes aware of a subsequent event requiring disclosure, he or she should observe the following requirements:

• Disclosure of the event is made If disclosure of the event is made (either in a note or in the auditor's report), the auditor should either dual-date the report or date it as of the later date (ie., the date of the event). See "Methods Available for Dating the Auditor's Report for a Subsequent Event" (below).

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• Disclosure of the event is not made In such circumstances, the auditor should qualify his or her opinion; in some cases, a disclaimer of opinion or an adverse opinion is appropriate.

Methods Available for Dating the Auditor's Report for a Subsequent Event

The following two equally acceptable options are available to the auditor for dating his or her report for a subsequent event occurring after completion of fieldwork but before issuance of the related financial statements:

1. Dual-date the audit report An example of dual-dating would be "March 19, 20X8, except for Note X, as to which the date is March 30, 20X8." In such instances, the auditor's responsibility for events occurring subsequent to the completion of fieldwork is limited to the specific event referred to in the note, or otherwise disclosed. 2. Date the audit report as of the date of the subsequent event In such instances, the auditor's responsibility for subsequent events extends to the date of the report; accordingly, the auditor should extend to that date the subsequent events procedures that are performed.

RESTRICTING THE USE OF AN AUDITOR'S REPORT A" general use" report is one that is not restricted to specified parties. A "restricted use" report is one that is intended only for specified parties. The need for restriction on the use of a report may result from

• The purpose of the report • The nature of the procedures applied • The basis of or assumptions used • The extent to which the procedures performed are generally known or understood • The potential for the report to be misunderstood

An auditor is not precluded from restricting the use of any report. Also, if an auditor issues a single combined report covering both (1) subject matter that requires restriction to specified parties and (2) subject matter that ordinarily does not require such a restriction, then the auditor should restrict to the specified parties the use of such a single combined report. An auditor should consider informing his or her client that restricted-use reports are not intended for distribution to nonspecified parties.

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SAS-87 (AU 532) (Restricting the Use of an Auditor's Report) provides guidance to auditors to help them determine whether an engagement requires a restricted-use report and, if so, what elements to include in that report.

Circumstances Requiring Reports to Be Restricted The auditor should restrict the use of a report in the following circumstances:

• The subject matter of the accountant's report or the presentation being reported on is based on measurement or disclosure criteria contained in contractual agreements or regulatory provisions that are not m conformity with GAAP or OCBOA. • The accountant's report is issued as a by-product (here referred to as a "by-product report") of a financial statement audit. Such a report is based on the results of procedures designed to enable the auditor to express an opinion on the financial statements taken as a whole, not to provide assurance on the specific subject matter of the report. Examples of such by-product reports include those issued pursuant to SAS-60 (AU 325) (Communication of Internal Control Related Matters Noted in an Audit); SAS-61 (AU 380) (Communication with Audit Committees); and SAS-62 (AU 623) (Special Reports).

Specified Parties in Restricted-Use Reports The auditor should restrict the use of by-product reports to an entity's audit committee, board of directors, management, others within the organization, and specified regulatory agencies; and, in the case of reports on compliance with aspects of contractual agreements, to the parties to the contract or agreement. An auditor may be asked to consider adding other parties as specified parties in a restricted-use report. The auditor should not agree to add other parties as specified parties of a by-product report. However, if an auditor is reporting on subject matter or a presentation based on criteria contained in contractual agreements or regulatory provisions, the auditor may agree to add other parties as specified parties; in such circumstances, the auditor should consider factors such as the identity of the other parties and the intended use of the report. If the auditor agrees to add other parties as specified parties, The auditor should obtain affirmative acknowledgment, ordinarily In writing, from the other parties of their understanding of

1. The nature of the engagement 2. The measurement or disclosure criteria used in the engagement, and 3. The related report

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If the auditor agrees to add such other parties after he or she has issued the report, the auditor may either reissue the report or provide other written acknowledgment that the other parties have been added as specified parties. If the report is reissued, the report date should not be changed. If the auditor provides written acknowledgment, it ordinarily should state that no -procedures have been -performed subsequent to the date of the report.

Restricted-Use Report Language In a report that is restricted as to use, the auditor should add a separate paragraph at the end of the report that includes the following:

• A statement that the report is intended solely for the information and use of the specified parties • An identification of the specified parties • A statement that the report is not intended to be and should not be used by anyone other than the specified parties

The following is an example of such a paragraph:

This report is intended solely for the information and use of [the specified parties] and is not intended to be and should not be used by anyone other than these specified parties.

The report may list the specified parties or refer the reader to the specified parties listed elsewhere in the report.

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Chapter 10 - Compiling and Reviewing OCBOA Financial Statements


Indicate how to compile or review OCBOA financial statements for a client that is a nonpublic entity so that they are compliant with the Statements on Standards for Accounting and Review Services (SSARS).

Identify what knowledge must be gained about a client in order to compile their financial statements.

Indicate what inquiries must be performed in order to verify, corroborate, or review information that is supplied by the audited entity.

Recognize the fundamental steps that must be performed in a review engagement.

Identify all of the elements that must be present in the audit report.

INTRODUCTION If a CPA is requested to compile or review OCBOA financial statements for a client that is a nonpublic entity, the Statements on Standards for Accounting and Review Services (SSARS) must be observed during the engagement. Fundamentally, the approach for compiling or reviewing OCBOA financial statements is the same as the approach for compiling or reviewing GAAP financial statements. For example, concepts and procedures related to accepting, planning, and performing GAAP financial statement engagements should also be followed for OCBOA financial statement engagements. This chapter concentrates on the unique aspects of compilations and reviews of OCBOA financial statements and on identifying and describing report preparation for other comprehensive bases of accounting. For a complete discussion of compilation and review engagements, including specific procedures, reports, and checklists, refer to Miller Compilations & Reviews.

COMPILATION ENGAGEMENT PROCEDURES SSARS-1 (AR 100.04) (Compilation and Review of Financial Statements) defines a compilation as follows:

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Presenting in the form of financial statements information that is the representation of management (owners) without undertaking to express any assurance on the statements. AR 100.09 clearly states that the accountant "is not required to make inquiries or perform other procedures to verify, corroborate, or review information supplied by the entity." Likewise, the accountant has no responsibility to obtain an understanding of, or communicate deficiencies in, internal control or assess control risk. AR 100 provides for two types of compilations:

1. A compilation with a report is required when the accountant has been engaged to compile and report on the financial statements or when he or she reasonably expects that the financial statements might be used by a third party. This may be referred to as a "traditional compilation." 2. A compilation without a report is available when the accountant does not reasonably expect the financial statements to be used by a third party. This may be referred to as a "management-use-only compilation."

Note that in either case the performance requirements in AR 100 must be followed. The difference is the form of communication used. Traditional compilations must have a compilation report; management- use- only compilations must have a written engagement letter.

Traditional Compilations AR 100 states that in all compilation engagements, the performance standards in AR 100.05 and AR 100.07-100.10 should be followed. These performance standards consist of:

• Having or obtaining a general understanding of the industry • Having or obtaining a general understanding of the client's business • Being aware of the information provided • Reading the compiled financial statements

Knowledge of the Industry

Knowledge of the industry means that the CPA has a sufficient understanding of the industry to know what the financial statements for an entity in that industry should look like and to be aware of any accounting principles or practices that are unique to that industry. The CPA does not have to be an industry expert, and he or she can obtain this general understanding if it is not already possessed (for example, through AICPA Guides, nonauthoritative industry guides, trade publications). For many compilation engagements, the client reports in an accounting environment where specialized accounting principles are not relevant

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and where, therefore, the CPA's understanding of OCBOA accounting principles, procedures, and methods is sufficient to satisfy the criterion of an adequate understanding of the accounting principles used in the client's industry.

Knowledge of the Client

AR 100.08 states that the accountant must possess or obtain a certain knowledge about the entity whose financial statements he or she is compiling. This knowledge includes:

• Nature of the entity's business transactions: sources of revenue, major expenditures, etc. • Form of its accounting records: knowledge of books, subsidiary journals and ledgers, data processing applications, etc. • Stated qualifications of its accounting personnel: knowledge of the education, training, and experience of personnel (the accountant can rely on representations made by client personnel) • Accounting basis on which the financial statements are to be presented-refers to GAAP or OCBOA • Form and content of the financial statements-requires the accountant to apply principles of industry so financial statements can be presented in proper form

Necessity to Perform Other Accounting Services

AR 100.08 states that" on the basis of that understanding, the accountant should consider whether it will be necessary to perform other accounting services, such as assistance in adjusting the books of account or consultation on accounting matters, when he or she compiles financial statements." In many cases, the financial statements may need to be adjusted (accruals, deferrals, depreciation, etc.) before they are compiled. In some cases, financial statements do not even exist, so they must be assembled before they are compiled.

Awareness Concerning Information Supplied

AR 100.09 states that "the accountant is not required to make inquiries or perform other procedures to verify, corroborate, or review information supplied by the entity." However, the CPA may have made inquiries or performed other procedures. The results of such inquiries or procedures, knowledge gained from prior engagements, or the financial statements on their face may cause the CPA to become aware that information supplied by the entity is incorrect, incomplete,

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or otherwise unsatisfactory. If any evidence or information comes to the CPA's attention regarding fraud or an illegal act that may have occurred, the CPA should request that management consider the effect of the matter on the financial statements. Additionally, the CPA should consider the effect of the matter on his or her compilation report. In circumstances where the CPA believes that the financial statements are materially misstated, he or she should obtain additional or revised information. If the entity refuses to provide additional or revised information, the CPA should withdraw from the engagement.

NOTE: Whether an act is, in fact, fraudulent or illegal is a determination that is normally beyond the CPA's professional competence. A CPA, in reporting on financial statements, presents him- or herself as one who is proficient in accounting and compilation or review services. The CPA's training, experience, and understanding of the client and its industry may provide a basis for recognition that some client acts coming to his or her attention might be fraudulent or illegal. However, the determination of whether a particular act is fraudulent or illegal would generally be based on the advice of an informed expert qualified to practice law, or it may have to await final determination by a court of law.

Reading the Financial Statements

"Reading" the financial statements involves a final inspection of the financial statements before release. This review should focus on identifying material departures from the basis of accounting used (including inadequate disclosure) and mathematical or clerical errors. Traditional Compilation Program

Management-Use-Only Compilations In all compilation engagements, the performance standards in AR 100.07-100.10 should be followed. These performance standards consist of

• Having or obtaining a general understanding of the industry • Having or obtaining a general understanding of the client's business • Being aware of the information provided • Reading the compiled financial statements

The performance standards in a management-use-only compilation are the same as those described earlier for a traditional compilation.

Understanding with the Client

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AR 100.05 requires the CPA to establish an understanding with the client regarding the services to be performed. The understanding should also provide (1) that the engagement cannot be relied upon to disclose errors, fraud, or illegal acts and (2) that the accountant will inform the appropriate level of management of any material errors that come to his or her attention and any fraud or illegal acts that come to his or her attention, unless they are clearly inconsequential. If the engagement is to compile financial statements for management's use only, a written communication is required. This engagement letter must contain the following elements:

• A description of the nature and limitations of the services to be provided • A statement that a compilation is limited to presenting in the form of financial statements information that is the representation of management • A statement that the financial statements will not be audited or reviewed • A statement that no opinion or any other form of assurance on the financial statements will be provided • An acknowledgment that management has knowledge about the nature of the procedures applied and the basis of accounting and assumptions used in the preparation of the financial statements • An acknowledgment of management's representation and agreement that the financial statements will not be used by third parties • A statement that the engagement cannot be relied upon to disclose errors, fraud, or illegal acts

The engagement letter should also include the following additional matters, if applicable:

• A statement that material departures from GAAP or OCBOA may exist and the effects of those departures on the financial statements is not required to be disclosed • A statement that substantially all disclosures (and the statement of comprehensive income and statement of cash flows, if applicable) required by GAAP or OCBOA may be omitted • A statement that the accountant is not independent • A reference to any supplementary information that may be Included

Third Parties

AR 100.01 states that financial statements may be submitted to a client (management-use only financial statements) if the financial statements "are not reasonably expected to be used by a third party." In deciding whether the financial statements are, or reasonably might be, expected to be used by a third party, the accountant may rely on management's representation without further inquiry, unless information comes to the

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accountant's attention that contradicts management's representation. AR 100.04 defines "third parties" as

All parties except for members of management who are generally knowledgeable and understand the nature of the procedures applied and the basis of accounting and assumptions used in the preparation of the financial statements.

Note that this is a definition by exception. In other words, the starting point for determining who is a third party is that all parties are third parties, with the exception of certain members of management. Those certain members of management would be those members who are knowledgeable enough about the business to be able to put the information in the proper context.

Management-Use-Only Compilation Program

REVIEW ENGAGEMENT PROCEDURES The fundamental steps in a review engagement are as follows:

• Develop an understanding of the accounting principles and practices used in the client's industry • Develop a general understanding of the client's organization, its operating characteristics, and the nature of its assets, liabilities, revenues, and expenses • Make appropriate inquiries of the client • Perform appropriate analytical procedures • Read the client's financial statements

Accounting Principles and Practices Procedures for conducting a review of financial statements are generally limited to inquiries and analytical procedures. The specific inquiries made and analytical procedures performed should be tailored to the engagement based on the accountant's knowledge of the client's business and industry. The performance of a review engagement assumes that the accountant has an adequate understanding of the accounting principles and practices of the client's industry. Review procedures can be performed effectively only if the accountant is familiar with the industry-specific accounting principles used by the client. For many review engagements, the client reports in an accounting environment where specialized accounting principles are not relevant and where, therefore, the CPA's understanding of OCBOA accounting principles, procedures, and

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methods is sufficient to satisfy the criterion of an adequate understanding of the accounting principles used in the client's industry.

Analytical Procedures Analytical procedures involve the study, comparison, and evaluation of relationships among financial and nonfinancial data at a point in time and the trend in those relationships over a period of time. A basic premise underlying analytical procedures is that plausible relationships among data may reasonably be expected to exist in the absence of known conditions to the contrary. Particular conditions that can cause variations in these relationships include, for example, specific unusual transactions or events, accounting changes, business changes, random fluctuations, or misstatements. In a review, the objectives of analytical procedures are

• To provide a basis for the limited assurance provided in the review report • To identify financial statement items that appear to be materially misstated

Analytical procedures often provide a basis for additional inquiries, because the procedures can bring to the accountant's attention other significant matters affecting the financial statements that might otherwise not have been apparent. There are two general steps in performing analytical procedures:

1. Develop expectations by identifying and using plausible relationships that are reasonably expected to exist based on the accountant's understanding of the entity and the industry the entity operates in 2. Compare the recorded amounts or ratios developed from recorded amounts to the expectations developed

Inquiries Inquiries are a fundamental technique used in a review engagement to collect information relevant to the financial statements.

Types of Inquiries

Because of the nature of the inquiry technique, there is no complete list of inquiries that should be made in a review engagement. However, AR 100.31 states that the accountant should consider making the following inquiries:

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• Inquiries concerning conformity with the OCBOA The accountant should make inquiries to determine whether the financial statements have been prepared in conformity with the OCBOA and whether there have been changes in the application of accounting principles. If such changes have occurred, inquiries should be made to determine whether the changes are appropriate and, if so, whether the changes have been accounted for and disclosed in a manner consistent with APB-20 (Accounting Changes). • Inquiries concerning the entity's accounting principles The accountant should be aware of which accounting procedures the client uses. Accounting procedures should be adequate to record, classify, and summarize transactions and accumulate information for disclosure in the financial statements in a manner that conforms to the OCBOA. The understanding of the nature of the client's accounts provides the accountant with background to determine whether the accounting procedures used are appropriate for the client's industry. • Inquiries concerning unusual or complex situations The following are examples of situations that might have an effect on the financial statements that the accountant would ordinarily inquire about:

- Business combinations - New or complex revenue recognition methods - Impairment of assets - Disposal of a business segment - Use of derivative instruments and hedging activities - Sales and transfers that may call into question the classification of investments - Adoption of new stock compensation plans or changes to existing plans - Significant, unusual, or infrequently occurring transactions - Changes in litigation or contingencies - Changes in major contracts with customers or suppliers - Application of new accounting principles - Changes in accounting principles or the methods of applying them - Trends and developments affecting accounting estimates - Compliance with debt covenants - Changes in related parties or significant new related parties - Material off-balance-sheet transactions, special-purpose entities, and other equity investments - Unique terms for debt or capital stock that could affect classification

• Inquiries concerning significant transactions The accountant should make inquiries about significant transactions that occurred or were recognized near the end of the reporting period. • Inquiries concerning the status of uncorrected misstatements The accountant should make inquiries about whether adjustments have been

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recorded subsequent to a previous engagement and, if so, the amounts recorded and period in which such adjustments were recorded. • Inquiries concerning matters about which questions have arisen The accountant should make inquiries where questions have arisen in the course of applying the review procedures. • Inquiries concerning subsequent events The accountant should make inquiries concerning events that occur subsequent to the date of the financial statements that could have a material effect on the financial statements. Such events should be judged to determine whether they require an adjustment to, or a disclosure in, the reviewed financial statements. • Inquiries concerning fraud The accountant should make inquiries regarding management's knowledge of fraud or suspected fraud affecting the entity involving management or others where the fraud could have a material effect on the financial statements, for example, communications received from employees, former employees, or others. • Inquiries concerning significant journal entries The accountant should make inquiries concerning significant journal entries and other adjustments. • Inquiries concerning communications from regulatory agencies The accountant should make inquiries about communications the client has received from regulatory agencies. • Inquiries concerning actions taken by the board The accountant should make inquiries concerning actions taken at meetings of shareholders, board of directors, committees of the board of directors, or comparable meetings that may affect the financial statements.

Other Review Procedures Once the inquiries and analytical procedures are performed, the accountant needs to be familiar with the client and its operations to truly understand the financial statements. AR 100.31 states that the accountant should read the financial statements to "consider, on the basis of information coming to the accountant's attention, whether the financial statements appear to conform with generally accepted accounting principles" or an OCBOA. The accountant must use experience and professional judgment to assimilate the information obtained and read the financial statements in the context of that information. A review does not contemplate obtaining an understanding of internal control or assessing control risk, assessing fraud risks, tests of accounting records and of responses to inquiries by obtaining corroborating evidential matter, performance of procedures designed to detect material misstatements due to fraud or illegal acts, and certain other procedures ordinarily performed during an audit. Thus, a review does not provide assurance that the accountant will become aware of all significant matters that would be disclosed in an audit. However, the accountant

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may become aware that information coming to his or her attention is incorrect, incomplete, or otherwise unsatisfactory. If any evidence or information comes to the accountant's attention regarding fraud or an illegal act that may have occurred, he or she should request that management consider the effect of the matter on the financial statements. Additionally, the accountant should consider the effect of the matter on his or her review report. In circumstances where the he or she believes the financial statements are materially misstated, the accountant should perform the additional procedures deemed necessary to achieve limited assurance that there are no material modifications that should be made to the financial statements in order for the statements to be in conformity with the basis of accounting.

Management Representations Written representations are required from management for all financial statements and periods covered by the accountant's review report. For example, if comparative financial statements are reported on, the representations obtained at the completion of the most recent review should address all periods being reported on. The specific written representations obtained by the accountant will depend on the circumstances of the engagement and the nature and basis of presentation of the financial statements. AR 100.32 requires the following specific representations from management:

• Management's acknowledgment of its responsibility for the fair presentation in the financial statements of assets, liabilities, equity, revenue, and expenses in conformity with the OCBOA • Management's belief that the financial statements are fairly presented in conformity with the OCBOA • Management's full and truthful response to all inquiries • Completeness of information • Information concerning subsequent events • Management's acknowledgement of its responsibility to prevent and detect fraud • Management's knowledge of any fraud or suspected fraud affecting the entity involving management or others where the fraud could have a material effect on the financial statements, including any communications received from employees, former employees, or others

The written representations should be addressed to the accountant and should be dated no earlier than the date of the review report. The letter should be signed by those members of management whom the accountant believes are responsible for, and knowledgeable about, the matters covered in the representation letter. Normally, the chief executive officer and chief financial officer or others with equivalent positions in the entity should sign the representation letter.

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Documentation Documentation is the principal record of the review procedures performed and the conclusions reached in performing the review. Because of the different circumstances in individual engagements, it is not possible to specify the form or content of the documentation the accountant should prepare. However, AR 100.36 states that The documentation should include any findings or issues that in the accountant's judgment are significant, for example, the results of review procedures that indicate that the financial statements could be materially misstated, including actions taken to address such findings, and the basis for the final conclusions reached. According to AR 100.37, the documentation of the review engagement should include the following:

• The matters covered in the inquiries • The analytical procedures performed • The expectations discussed above, where significant expectations are not otherwise readily determinable from the documentation of the work performed, and factors considered in their development • Results of the comparison of the expectation with the recorded amounts or ratios developed from recorded amounts • Any additional procedures performed in response to significant unexpected differences arising from the analytical procedures and the results of such procedures • Unusual matters considered during the performance of the review procedures, including their disposition • Communications, whether oral or written, to the appropriate level of management regarding fraud or illegal acts that come to the accountant's attention • The management representation letter

REPORTING STANDARDS The reporting standards for OCBOA financial statements are essentially the same as those that apply to GAAP financial statements. In general, the only report modification necessary when preparing financial statements using OCBOA other than GAAP is the identification of the financial statements.

Compilation Reports

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The following elements should be included in a compilation report on OCBOA financial statements:

• A statement that a compilation has been performed in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants • A statement that a compilation is limited to presenting in the form of financial statements information that is the representation of management • A statement that the financial statements have not been audited or reviewed and, accordingly, the accountant does not express an opinion or any other form of assurance on them • A signature (manual, stamped, electronic, or typed) of the accounting firm or the accountant, whichever is appropriate • The date of the compilation report (as discussed in a subsequent section titled "Report Date")

NOTE: It should be noted that the above standards are different from those described in SAS-62 (AU623) (Special Reports). AU623 requires a separate paragraph in the auditor's report that (1) states the basis of presentation and refers to the note to the financial statements that describes the basis and (2) states the basis of presentation as a comprehensive basis of accounting other than GAAP. It would be inappropriate to include a separate paragraph of this nature in a compilation report, because the paragraph would constitute an assurance that the financial statements are prepared in accordance with a particular basis of accounting. In a compilation report, the CPA offers no assurance that the financial statements are prepared in accordance with OCBOA. See Chapter 9 for a discussion of audit reports on OCBOA Financial statements.

Review Reports The following elements should be included in a review report on OCBOA financial statements:

• A statement that a review has been performed in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants • A statement that all information included in the financial statements is the representation of management of the client • A statement that a review consists principally of inquiries of the client's personnel and analytical procedures applied to financial data • A statement that a review is substantially less in scope than an audit, the objective of which is the expression of an opinion regarding the financial statements taken as a whole; accordingly, no such opinion is expressed

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• A statement that the accountant is not aware of any material modifications that should be made to the financial statements in order for them to be in conformity with the basis of accounting described in the appropriate note to the financial statements • A signature (manual, stamped, electronic, or typed) of the accounting firm or the accountant, whichever is appropriate • The date of the review report (as discussed in a subsequent section titled "Report Date")

Association with Financial Statements A CPA's name should not be used in a document that includes a client's financial statements that have not been audited, unless the CPA performs a compilation or review of the financial statements and his or her report accompanies them. The financial statements can include the name of the CPA if the client observes the following:

• There is an indication accompanying the financial statements that the CPA did not compile or review the financial statements and • There is an indication accompanying the financial statements that the CPA assumes no responsibility for the financial statements

This notation may appear on each financial statement or on a separate page as a preamble to the financial statements. If the client uses the name of the CPA in a document containing financial statements that have not been audited and that were not compiled or reviewed by the CPA and the document does not contain an adequate indication that the CPA takes no responsibility for the financial statements, the CPA should advise the client that the use of the CPA's name is inappropriate. If the client does not remove the CPA's name from the document, the CPA should consider consulting with legal counsel.

Financial Statement Legends A notation referring the reader to the "Accountant's Report" should appear on each page of the financial statements. There is no requirement to specifically describe the type of report (compilation, review, etc.) issued, but some CPAs do make a more specific reference.

NOTE: If the compilation engagement is for management use only, the legend should read similar to the following:"Restricted for Management's Use Only." NOTE: The compilation or review report should make no reference to specific procedures performed during the engagement.

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Report Address The report should be addressed to the person or group that hired the CPA to conduct the engagement. For a corporation, the report is typically addressed to the shareholders and board of directors. For a sole proprietorship or a partnership, the report is typically directed to the owner(s).

NOTE: There is no requirement in SSARS to use letterhead paper in the preparation of a compilation or review report.

Report Date For a compilation engagement, the report date should be the date the engagement is completed. For a review engagement, the report date should be the date the CPA completes the inquiry and analytical procedures. Generally, the report date is simply the day the procedures listed on the CPA's work program or procedures checklist are completed. The CPA has no responsibility to perform engagement procedures after the report date in a compilation or review; however, events may occur after the completion of fieldwork but before the issuance of a compilation or review report that require that the financial statements be modified. SSARS does not address this issue, but standards established by SAS-29 (AU 551) (Reporting on Information Accompanying the Basic Financial Statements in Auditor-Submitted Documents) may be followed in a compilation or review engagement. Subsequent events might come to the CPA's attention that require that the financial statements be adjusted or that additional disclosures be made. If the client does not make the appropriate adjustment or disclosure, the CPA must refer to the lack of conformance to generally accepted accounting principles in his or her compilation or review report. When the financial statements are appropriately modified, the CPA may date the engagement report in one of two ways. First the CPA may dual-date the report by using language such as "March 1, 20X8, except for Note X, to which the date March 22, 20X8 applies." Alternatively, the CPA may use the latter date only (March 22, 20X8) to date the compilation or review report. When the CPA uses the first approach (dual dating), his or her responsibility is limited only to the subsequent event specifically identified. On the other hand, when the second approach is used (single report date), the CPA may be responsible for subsequent events that may come to his or her attention up to the date of the report.

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NOTE: In compilation engagements and review engagements, the CPA is not required to perform engagement procedures specifically designed to identify subsequent events that may require financial statement modification. However, if the CPA becomes aware of events subsequent to the fieldwork date of the compilation or review engagement, the CPA has a professional responsibility to consider how such events affect the client's financial statements.

Report Signature The CPA firm's name, handwritten or printed, should be affixed to the report. It is common practice to sign the report with the firm's signature rather than an individual's signature, unless the accountant is a sole practitioner. However, some state boards of accountancy require that when a firm is a professional corporation, there should be an individual shareholder's name on the report. Also, some governmental agencies require that the report be signed using the engagement's partner signature.

Reporting on a Single Financial Statement A CPA may be engaged to compile or review a single financial statement. For example, the engagement may cover the statement of assets, liabilities, and equity but not the other financial statements. A CPA can report on a single financial statement if the engagement is a limited engagement and not a scope limitation imposed by the client. Hiring a CPA to report on a single financial statement does not relieve the client of presenting appropriate descriptions of significant accounting policies and notes to support the single financial statement. If the supporting disclosures are not made, the CPA's compilation report must follow the format applicable when substantially all disclosures are omitted (see the section entitled "Omission of Substantially All Disclosures"). If the engagement is for a review of financial statements and the supporting disclosures are not made, the CPA is prohibited from issuing a review report. Only those disclosures and notes relevant to the single financial statement to be reported on should be included. For example, when only the statement of assets, liabilities, and equity is compiled, descriptions of accounting policies and notes that apply to the statement of revenues and expenses should be omitted. When the CPA compiles or reviews only one financial statement but a complete set of financial statements is presented, there must be a clear indication on the uncompiled financial statements that the CPA did not compile, review, or audit them. The notation on each financial statement should resemble the following:

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This financial statement has not been audited, reviewed, or compiled by [name of CPA]. For this reason, the CPA accepts no responsibility for the preparation of the financial statement and provides no assurance that the financial statement is prepared in accordance with the basis of accounting described in Note X.

MODIFICATIONS TO THE STANDARD REPORT The standard compilation or review report may be modified for the following reasons:

• Lack of independence (review report not permitted) • Departures from the OCBOA • Restricted use of financial statements • Omission of selected disclosures or substantially all disclosures (review report not permitted) • Scope limitations • Uncertainties • Uncertainties related to going concern • Change in accounting principles • Use of the work of another CPA • Supplementary information • Emphasis of a matter

Lack of Independence A compilation report is permitted to be issued when the CPA is not independent. The CPA's lack of independence should be disclosed in the compilation report; however, the reason for the lack of independence should not be explained in the report. A review report on financial statements cannot be issued when the CPA is not independent.

NOTE: AR 100 notes that the determination of independence is a matter of professional judgment. The CPA should use the guidelines on independence provided by the AICPA Code of Professional Conduct Rule 101 (Independence), Interpretations of Rule 101, and Ethics Rulings on Independence.

Departures from the OCBOA If the CPA determines that the financial statements are not in conformity with the OCBOA and the client decides not to correct them, the CPA must then decide

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whether a modification to the report would be adequate to indicate the deficiencies in the financial statements taken as a whole.

Report Modification Is Adequate

If the CPA decides that the departures from the OCBOA can be adequately described in the report, a modified report can be issued. The modification consists of adding a separate paragraph to the report in which the departure is described. The effect of the departure on the financial statements, if it is known to the CPA, should be disclosed in the separate paragraph. If the effect of the departure is not known, however, the CPA is not required to determine it. When the effect is not known, the CPA must state this fact in the separate paragraph. The following courses of action are possible if a CPA believes that there are material accounting and reporting deficiencies in a client's financial statements:

• Persuade the client to revise the financial statements • Refer to the material departure in the compilation or review report (as described above) • If the CPA believes the client's intent is to mislead financial statement users, withdraw from the engagement

Report Modification Is Inadequate

In some circumstances, the CPA may conclude that it would be inadequate to simply add a separate paragraph (or paragraphs) to the report to explain the departure (or departures) from the OCBOA. If the CPA concludes that the modification to the standard report is not adequate to describe the effects of the departure, AR 100.47 states that the CPA should withdraw from the engagement and provide no further services on the financial statements. In addition, the CPA should consider consulting legal counsel. Generally, CPAs reach such a conclusion when it appears that the client's intention is to deceive users of the financial statements. Although it is difficult to provide specific guidance for determining when it is not appropriate to issue a report, Interpretation No.6 of SSARS-1 (AR 9100.18-.22) provides two examples of how the CPA should go about reaching a conclusion:

1. A client that has entered into a number of leasing arrangements that might be required to be capitalized under FAS-13. The client may not wish to capitalize such leases and may not have determined the effect of this departure from GAAP. However, the client may be willing to disclose in the financial statements information such as the nature of the leased property, the payments required under the leases, and other important terms of the

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leases. In those circumstances, the accountant is not likely to conclude that the departure was undertaken with the intention of misleading users even though the effect of the departure is not quantified in the financial statements or the accountant's report. 2. A client that has failed to provide for doubtful accounts and probable sales returns in the face of significant adverse business and economic conditions may be unwilling to acknowledge that an adjustment should be considered. This might cause the accountant to question whether other information the client provided is incorrect, incomplete, or otherwise unsatisfactory. Also, the accountant's general knowledge of the entity's business and related matters might lead him or her to conclude that the client's position indicates an intent to mislead users, particularly if the effects of the departure are not determined.

Restricted Use Financial Statements Sometimes a client requests that the CPA compile or review financial statements that are to be used only by the client. A CPA can accept such an engagement depending on the impact on the engagement fee, if any. If the CPA does agree to compile or review restricted-use financial statements, the following sentence must be added to the report: This report is intended solely for the information and use of the owners, management, and others within the company and is not intended to be, and should not be, used by anyone other than these specified parties.

Omission of Substantially All Disclosures A client may prepare its financial statements and omit substantially all disclosures. Interpretation NO.1 of SSARS-1 (AR 9100.01) states that a CPA generally should not accept an engagement that involves the review of financial statements with the omission of substantially all disclosures. If the CPA accepts an engagement but subsequently discovers that substantially all disclosures will be omitted, the CPA should include in the review report the disclosures that were omitted. If the client has not developed the information necessary for adequate disclosure, the CPA is not required to develop the data that normally would be included in the disclosures; the report should nonetheless specifically identify the nature of the omitted disclosures. In a compilation engagement, the client may request to omit substantially all disclosures. In this circumstance, AR 100.16 provides an alternative reporting format; however, it can be used only if the following conditions are satisfied:

• The omission of the disclosures is clearly stated in the compilation report.

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• The CPA does not believe that the omission of the disclosures was intended to mislead those who might reasonably be expected to rely on the financial statements. NOTE: If the CPA concludes that the purpose of omitting the disclosures is to deceive parties who might be relying on the financial statements, he or she should withdraw from the engagement.

The CPA should not attempt to determine that some disclosures are more important than others unless it appears that the client is omitting a specific disclosure in order to deceive users. Interpretation NO.9 of SSARS-1 (AR 9100.29) takes the position that the user of the financial statements is adequately warned of the limitation of the financial statements by the report language. Thus, there is no need to refer to a specific omission when substantially all disclosures have been omitted. The alternative reporting format requires that the CPA add a third paragraph to the standard compilation report stating that management has elected to omit substantially all the disclosures ordinarily included in financial statements prepared on the OCBOA. Interpretation NO.9 (AR 9100.29) notes that the wording of the third paragraph must convey that the client, not the CPA, has made the decision to exclude substantially all the disclosures. For example, the notation "These financial statements do not include substantially all disclosures" is inadequate, because it does not make clear that the CPA was not responsible for omitting the disclosures. When an accountant compiles and reports on financial statements that are presented in accordance with an OCBOA and that omit substantially all disclosures, AR 100.17 requires disclosure of the basis of accounting. This disclosure may be in an attached footnote or in a note on the face of the financial statements. If disclosure is not made as part of the financial statements, modification of the compilation report is required. For example, the following sentence is added to the first paragraph of the standard compilation report: lithe financial statements have been prepared on the accounting basis used by the Company for federal income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles." AICPA Technical Practice Aid 24 (TPA-24) (TIS 9150.24) (Issuing a Compilation Report with Substantially All Disclosures Omitted after Issuing a Report on Financial Statements Containing Full Disclosure) addresses the issue of whether an accountant can issue a compilation on financial statements that omit substantially all disclosures when those financial statements (with all disclosures) were previously compiled, reviewed, or audited. The issue is discussed in the context of a client wanting to issue financial statements that were previously compiled, reviewed, or audited to a vendor but omitting substantially all disclosures. TIS 9150.24 points out that a compilation report can be issued on the financial statements that omit substantially all disclosures if the guidance discussed in TIS 9150.24 is observed by the accountant. Furthermore, TIS

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9150.24 addresses an apparent contradiction in the compilation report because: The report states that the accountant has not reviewed or audited and disclaimed any assurance on the financial statements, which of course is not true. TIS 9150.24 states that the disclaimer in the compilation report, however, is intended to be engagement-specific and, therefore, refers only to the financial statements that accompany the accountant's report" and, thus, there is no contradiction.

Inclusion of More than a Few Disclosures Interpretation No. 22 of SSARS-1 (AR 9100.85) addresses the reporting issue that arises when a client includes more than a few required disclosures. Under this circumstance, Interpretation No. 22 requires that the CPA consider the omission of the other disclosures to be a departure from the OCBOA and observe the compilation reporting guidelines (discussed earlier; see the section titled "Departures from GAAP") in preparing the report. In addition, the notes to the financial statements cannot be labeled "Selected Information-Substantially All Disclosures Required by Generally Accepted Accounting Principles Are Not Included."

NOTE: Professional judgment must be exercised to determine whether financial statements omit substantially all disclosures or present more than a few required disclosures. In making this determination, the CPA should not view disclosures as components that are less valuable than components that appear directly on the face of the financial statements.

Scope Limitations Rule 201 of the AICPA Code of Professional Conduct requires the CPA to obtain sufficient relevant data to afford a reasonable basis for conclusions or recommendations in relation to any professional services performed. The inability to obtain sufficient relevant data is referred to as a "scope limitation" in audit, review, and compilation engagements. SSARS discuss the circumstances under which a scope limitation in an audit or a review may lead to the CPA issuing a compilation report. In an audit engagement, a scope limitation arises when the CPA is not able to collect sufficient competent evidential matter to satisfy GAAS. In a review engagement, a scope limitation arises when the CPA is not able to perform appropriate inquiries and analytical procedures, obtain a representation letter from the client, and complete other procedures the CPA deems necessary in order to satisfy the requirements established in SSARS. If the CPA encounters a significant scope limitation in an audit engagement, under certain circumstances the CPA may issue a qualified opinion or disclaim an opinion on the financial statements. When the CPA encounters a scope limitation in a review engagement, however/ the review is incomplete and the

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CPA is precluded from issuing a review report. A CPA who encounters a scope limitation in an audit (review) engagement may be requested before the audit (review) engagement is completed, to change the engagement to a review or compilation of financial statements. If the CPA decides to issue a compilation report, AR 100.55 requires that the report make no reference to:

• The higher-level engagement • The audit or review procedures performed as part of the higher-level engagement • The nature of the scope limitations that led to the change from the higher-level engagement to the compilation engagement . NOTE: SSARS do not discuss the circumstances under which a compilation report could be issued if there were a significant scope limitation in the compilation engagement. Presumably, the rationale is that a compilation is the lowest level of reporting on financial statements and a significant scope restriction would make compiling financial statements unacceptable.

Uncertainties Uncertainties relate to the possibility that amounts (including zero balances) appearing in the financial statements will not be realized in the future. For example, an inventory item may be presented at cost, but in six months it may have to be sold at a nominal amount because of changes in consumer taste. Alternatively, there may be no accrual for a pending lawsuit (a zero balance), but a court subsequently assess a multimillion-dollar judgment against the client. The preparation of financial statements requires that the client make a number of routine accounting adjustments based on estimates. In most instances, sufficient information is available for the client to make reasonable adjustments so that the financial statements conform to the OCBOA. When it is difficult to evaluate and quantify an adjustment (such as the evaluation of pending litigation or the cost recoverability of investments), the client should refer to FAS-5 (Accounting for Contingencies) for guidance. When a contingency is disclosed properly in the financial statements and no accrual is required, a footnote to AR 100.46 states that it is not necessary to add a paragraph describing the uncertainty. Nonetheless, both AR 100.46 and Interpretation No. 11 of SSARS-1 (AR 9100.38) state that the CPA may add a separate paragraph in his or her report emphasizing an uncertainty related to the financial statements. If the CPA decides to add a separate paragraph, it should describe the nature of the uncertainty, but the standard paragraphs should not be modified and it should not refer to the explanatory paragraph.

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Uncertainties Related to Going Concern During a compilation or review engagement, a CPA may become aware of conditions or events that raise substantial doubt about a client's ability to continue as a going concern. SAS-59 (AU 341) (The Auditor's Consideration of the Entity' s Ability to Continue as a Going Concern) lists the following:

• Negative trends For example, recurring operating losses, working capital deficiencies, negative cash flows from operating activities, adverse key financial ratios • Other indications of possible financial difficulties For example, default on loan agreements or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, restructuring of debt, noncompliance with statutory capital requirements, the need to seek new sources or methods of financing, the need to dispose of substantial assets • Internal matters For example, work stoppages or other labor difficulties, substantial dependence on the success of a particular project, uneconomic long-term commitments, the need to significantly revise operations • External matters that have occurred For example, legal proceedings, legislation, or similar matters that might jeopardize an entity's ability to operate; loss of a key franchise, license, or patent; loss of a principal customer or supplier; uninsured or underinsured catastrophe such as a drought, earthquake, or flood

The going-concern concept is based on the presumption that the client will continue to exist as a business entity in the foreseeable future (usually one year) in the absence of information to the contrary. However, business failure is not uncommon, and conditions may require the CPA to exercise professional judgment in evaluating the adequacy of going-concern disclosure in the financial statements. Some guidance for making that determination may be found in AU 341. When a business can no longer be considered a going concern, financial statements should not be based on accrual accounting but rather should reflect liquidation values. If the CPA becomes aware that the going-concern concept is inappropriate but the client refuses to use the liquidation basis to prepare the financial statements, the CPA should withdraw from the engagement. When uncertainties related to the client's ability to continue as a going concern exist but are adequately disclosed in the financial statements, a footnote to AR 100.46 states that it is not necessary to add a paragraph to the standard compilation or review report describing the uncertainties. On the other hand, Interpretation No. 11 of SSARS- 1 (AR 9100.38) states that although not required to do so, the CPA may consider drawing attention to this uncertainty in an

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explanatory paragraph. If the CPA decides to add such a separate paragraph, it should not be referred to in the standard paragraphs of the report. A footnote to AR 100.46 states that paragraphs 10 and 11 of AU 341 should be used to determine 'whether the adequate disclosure standard has been achieved when the ability of the client to continue as a going concern is in question. AU 341 states that disclosures with respect to the going-concern question could include:

• Factors that are the basis for raising the question of going concern • Possible effects on the financial statements of the factors that raised the question of going concern • Management's assessment of the significance of the factors and any mitigating circumstances • Possible discontinuance of operations • Management's plans to deal with the current circumstances (including relevant prospective information) • Information related to asset recoverability and classification and the amount and classification of liabilities

Disclosure requirements established by AU 341 apply to compilation and review engagements as well as to audit engagements. Thus, if the appropriate going-concern disclosures are not part of the compiled or reviewed financial statements, the CPA's report on the financial statements should include a paragraph describing the departure from generally accepted accounting principles (in this case, a disclosure violation). When the appropriate going-concern disclosures are made in the financial statements, there is no need to modify the compilation or review report; however, the CPA may add an emphasis paragraph to the compilation or review report that contains wording similar to the following (for a discussion of the emphasis paragraph, see the section in this chapter entitled "Emphasis of a Matter"):

As discussed in Note X, certain conditions indicate that the Company may be unable to continue as a going concern. The accompanying financial statements do not include any adjustments to the financial statements that might be necessary should the Company be unable to continue as a going concern.

NOTE: A client may request the CPA to eliminate a going-concern emphasis-of-a-matter paragraph from a previously issued report when the uncertainty has been removed in a subsequent accounting period. The CPA should evaluate such a request for a reissued report with caution and that the CPA should (1) obtain information about the mitigating event or transaction that prompted the client request for a reissued report and (2) reassess the going-concern status of the entity at the date of reissuance in light of conditions and circumstances existing at that date.

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A CPA may accept a compilation engagement whereby substantially all disclosures are omitted from the financial statements. When certain conditions suggest that the client may be unable to continue as a going concern and the financial statements omit all or substantially all disclosures, because the user is alerted that substantially all disclosures have been omitted from the financial statements (by the paragraph in the compilation report explaining the omission), going-concern disclosures are not required. Under this reporting circumstance (substantially all disclosures are omitted), the CPA cannot emphasize the going-concern matter in the compilation report because a report cannot introduce new information that is not actually included in the financial statements. However, if only disclosures in the financial statements are those related to the going-concern matter, the CPA may emphasize the going-concern matter in the compilation report but is not required to do so. Under this reporting circumstance (only the going-concern matter is disclosed) the disclosures should not be labeled as "Notes to the Financial Statements" but, rather, should be described as "Selected Information-Substantially All Disclosures Required by Generally Accepted Accounting Principles Are Not Included."

NOTE: A review report cannot be issued on financial statements that omit substantially all disclosures.

NOTE: The phrase "substantial doubt about the entity's ability to continue as a going concern" should be used only in audit reports when a matter is emphasized.

Change in Accounting Principles The manner of accounting for and disclosing a change in accounting principles depends on the nature of the change as described in APB- 20. Accounting changes might require (1) a cumulative adjustment (for example, a change from FIFO to LIFO), (2) a restatement of prior financial statements (for example, a change from LIFO to FIFO), or (3) neither a cumulative effects adjustment nor a restatement of the prior year's financial statements (for example, a consistent policy of changing from an accelerated method to the straight-line method at a specified point in the life of an asset to maximize depreciation). However, all accounting changes that result in a cumulative adjustment or a restatement must be adequately disclosed in the current year's financial statements. The SSARS do not require modification of the CPA's standard compilation or review report if the accounting change is properly accounted for and disclosed in the financial statements. Nonetheless, the CPA may emphasize in a separate paragraph that an accounting change has occurred.

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NOTE: The requirement in SSARS differs from the guidance in SAS-58 (AU 508) (Reports on Audited Financial Statements), which states that the auditor's report should highlight an accounting change. The explanatory paragraph in the audit report is not a qualified opinion; it is a modification to the standard auditor's report. The professional responsibilities of a compilation or review engagement are different from those of an audit; in a compilation or a review, however, a CPA should be aware that a client has changed accounting principles. If the accounting change is not properly disclosed, is not properly accounted for, or is not justified, the CPA should modify the compilation or review report because of a departure from the OCBOA.

Change in an Accounting Principle (Correction of an Error)

Accounting standards require that a change from an unacceptable accounting principle to an acceptable accounting principle be accounted for as a correction of an error. Under this approach, an adjustment is made to the beginning balance of retained earnings in the year in which the error is corrected and the financial statement presented on a comparative basis with the current year's financial statements is restated. Technical Practice Aid 15 (TIS 9150.15) (Consistency) raises the issue of how this change in accounting principle should be reported in a compilation or review report. TIS 9150.15 points out that if accounting standards (including disclosure requirements) are observed, there is no need to refer to the error correction in the accountant's report; however, the accountant may emphasize in a separate paragraph that an accounting change from an unacceptable method to an acceptable method has occurred. If a separate paragraph is included in the accountant's report, the general reporting guidance illustrated earlier should be followed.

Supplementary Information Basic GAAP financial statements include the balance sheet; statement of income (including comprehensive income); statement of retained earnings or changes in stockholders' equity; statement of cash flows; and notes to the financial statements (including the Summary of Significant Accounting Policies). The report that includes the basic financial statements may also include schedules that support information in the basic financial statements. AICPA Technical Practice Aid 8 (TPA-8) (TIS 9150.08) (Supplementary Information) points out that "if supporting schedules of balance sheet or income statement accounts are not identified as being part of the basic financial statements, they are considered supplementary information." All information that is part of the client's basic financial statements must, at a minimum, be compiled or reviewed according to SSARS. Information that is not

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part of the client's basic financial statements may be compiled or reviewed, depending on the requirements of the engagement as specified in the engagement letter or on the understanding with the client. Two common questions arise when supplementary information is included with the basic financial statements:

1. What is considered supplementary information, and where is it placed in the presentation? 2. Does the standard compilation or review report have to be modified if supplementary information is included?

Supplementary Information

The term "supplementary information" is not defined in SSARS. SAS-29 (AU 551) (Reporting on Information Accompanying the Basic Financial Statements in Auditor-Submitted Documents) defines this type of information as:

1. Additional details or explanations of items in or related to the basic financial statements 2. Consolidating information 3. Historical summaries of items extracted from basic financial statements 4. Statistical data 5. Other material, some of which may be from sources outside the accounting system or outside the entity

Presentation of Supplementary Information

Financial statements often include detailed schedules, summaries, comparisons, or statistical information that are not part of the basic financial statements, such as

• Budgets for an expired period • Schedule of cost of goods sold • Schedule of manufacturing expenses • Selling expenses • General and administrative expenses • Details of marketable securities • Property and equipment schedule • Aging analysis of accounts receivable • Details of sales by product line, territory, or salesperson

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Normally, supplementary information is separated from the basic financial statements. Most practitioners present supplementary information on separate pages after the basic financial statements (and notes to the financial statements, if included). It is also a good idea to separate the supplementary information from the basic financial statements by including a title page marked "Supplementary Information." If the accountant presents a separate report on the supplementary information, it should follow the title page. AR 100.49 requires that the accountant state the degree of responsibility, if any, he or she is taking with respect to the supplementary information that accompanies the basic financial statements. If the basic financial statements are compiled, then the compilation report should be modified or a separate report can be issued on the supplementary information. If the basic financial statements are reviewed, the degree of responsibility taken is stated either in the review report on the basic financial statements or in a separate report on the other data. Specifically, the explanation should state that the review was made primarily for the purpose of expressing limited assurance that there are no material modifications that should be made to the financial statements in order for them to be in conformity with the basis of accounting described in the notes to the financial statements, and, according to AR 100.49 either

• The other data accompanying the financial statements are presented only for supplementary analysis purposes and have been subjected to the inquiry and analytical procedures applied in the review of the financial statements and the accountant did not become aware of any material modifications that should be made to such data or • The other data accompanying the financial statements are presented only for supplementary analysis purposes and have not been subjected to the inquiry and analytical procedures applied in the review of the financial statements but were compiled from information that is the representation of management, without audit or review, and the accountant does not express an opinion or any other form of assurance on such data (in other words, the accountant is stating that he or she reviewed the financial statements but only compiled the supplementary information).

In any case, the important thing to remember is to clearly state the degree of responsibility the accountant is taking for any information accompanying the basic financial statements.

Supplementary Information Prepared by the Client

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When an engagement does not include compiling or reviewing supplementary information, the CPA does not have a responsibility to compile or review the information as described in SSARS. However, there should be no chance that readers of the financial statements will misunderstand the responsibility of the CPA for the supplementary information. Misunderstandings may be avoided (1) if the client clearly states (as a preamble to the supplementary information) that the supplementary information has not been compiled or reviewed by the accountant or (2) if the CPA adds a separate paragraph stating that the supplementary information has not been compiled or reviewed. In a review, there is another option: (3) The CPA may issue a separate report on the supplementary information, stating that the supplementary information has not been reviewed. When the CPA refers to unreviewed supplementary information in the review report or in a separate report, the following assertions should be made:

• The review is primarily for the purpose of expressing limited assurance that there are no material modifications that should be made to the financial statements in order for them to be in conformity with the basis of accounting described in the notes to the financial statements. • The other data accompanying the financial statements are presented only for supplementary analysis purposes and have not been subjected to the inquiry and analytical procedures applied in the review of the basic financial statements but were compiled from information that is the representation of management, without audit or review, and the accountant does not express an opinion or any other form of assurance on these data.

Emphasis of a Matter Reporting standards established by SSARS allow the CPA to add a separate paragraph emphasizing a matter. A footnote to AR 100.46 explicitly states that "nothing in this statement, however, is intended to preclude an accountant from emphasizing in a separate paragraph of his report a matter regarding the financial statements."

NOTE: The matter to be emphasized should relate to the compiled or reviewed financial statements. For example, it is inappropriate to emphasize matters such as the death of a key executive, the loss of a substantial customer, or labor unrest. On the other hand, the CPA may emphasize matters such as changes in estimates and related-party transactions.

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The following guidance is appropriate when a CPA decides to emphasize a matter:

• Emphasis paragraphs should not introduce new information about the financial statements; they should only highlight or emphasize a matter disclosed in the financial statements. • If the financial statements are deficient or do not contain a needed disclosure and the client does not correct the statements, the accountant is required to state, in a separate paragraph of the report, that the financial statements contain a departure from GAAP or OCBOA. This required paragraph differs from a voluntary emphasis paragraph. • Emphasis paragraphs should not contain information about the procedures the accountant has or has not performed. • Emphasis paragraphs should not contain the accountant's conclusions or opinions. • If the accountant decides to add an emphasis paragraph to highlight a going-concern disclosure in the client's financial statements, the term "substantial doubt" should not be used in that paragraph. ("Substantial doubt" is an audit-evidence based concept that should only be used in audit reports.)

NOTE: AR 100 permits, but never requires, an emphasis paragraph (as long as the matter is appropriately disclosed in the financial statements).

When the CPA decides to emphasize a matter, the matter should be described in a separate paragraph added to the standard report.

REPORTING ON COMPARATIVE FINANCIAL STATEMENTS In the previous discussion, compilation and review reports were described in the context of reporting on a single year's financial statements. When financial statements are presented in columnar form for two or more periods, the CPA has a responsibility to report on each period presented. The concepts and reporting formats discussed earlier in this section apply to reporting on comparative financial statements. For a complete discussion and detailed guidance on reporting on comparative financial statements, refer to Miller Compilations & Reviews.

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GLOSSARY

Basis of accounting - A framework for determining what information is presented in the financial statements and related notes and how it is presented. Code of Professional Conduct - provides guidance for the CPA in conducting his or her professional practice. Financial statement - A presentation of financial data, including accompanying notes, derived from the accounting records and intended to communicate an entity's economic resources or obligations at a point in time or the changes therein for a period of time in conformity with a comprehensive basis of accounting. FAS-115 (Accounting for Certain Investments in Debt and Equity Securities) – defines disclosure of fair-value information for debt and equity securities reported in GAAP presentations. FAS-87 (Employers' Accounting for Pensions) – defines disclosure of information about contributions to defined benefit plans based on actuarial calculations in GAAP presentations. GAAP – Generally accepted accounting principles. Generally accepted accounting principles encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. The standard of "generally accepted accounting principles" includes not only broad guidelines of general application, but also detailed practices and procedures. Interpretation No. 12 of SSARS-1 (AR 9100.41) (Reporting on a Comprehensive Basis of Accounting Other than Generally Accepted Accounting Principles) - The most extensive guidance on OCBOA financial statements in the SSARS. Measurement - how an item on a financial statement is quantified. Other Comprehensive Bases of Accounting (OCBOA) - refers to bases of accounting other than generally accepted accounting principles (GAAP). OCBOA – see other comprehensive bases of accounting. Recognition - Deals with when an item should be reported in the financial statements.

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Sarbanes-Oxley Act – The Sarbanes-Oxley Act of 2002, was signed into law by U.S. President George W. Bush and became effective on July 30, 2002.The Act contains sweeping reforms for issuers of publicly traded securities, auditors, corporate board members, and lawyers. It adopts tough new provisions intended to deter and punish corporate and accounting fraud and corruption, threatening severe penalties for wrongdoers, and protecting the interests of workers and shareholders. SAS-62 (AU 623) (Special Reports) - The primary guidance for OCBOA financial statements. Statements on Quality Control Standards (SQCSs) - A framework for quality control in a CPA firm that applies to both the functional and technical aspects of all types of accounting and auditing engagements.

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Index Basis of accounting, 244 Code of Professional Conduct,

244 FAS-115, 244 FAS-87, 244 Financial statement, 244 GAAP, 244 Interpretation No. 12, 244 Measurement, 244

OCBOA, 244 Other Comprehensive Bases of

Accounting, 244 Recognition, 245 Sarbanes-Oxley Act, 245 SAS-62, 245 Statements on Quality Control

Standards, 245

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