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After talking to and consulting with business owners and entrepreneurs, I’ve noticed a basic gap in their knowledge of what each type of year-end financial engagement represents and delivers.
It’s important to distinguish between the three types of engagements and what message is conveyed by each engagement to the reader of the financial statements.
A third-party reader will often dictate the type of engagement you should choose, especially if there is borrowing involved.
Let’s examine each of the three types of engagements. They are:
Review and audit engagements are also referred to as “assurance engagements” and, as such, are subject to a formally developed set of accounting principles known as Generally Accepted Accounting Principles (GAAP) that dictate specific disclosures and presentation.
Compilation engagements are not subject to any presentation or disclosure requirements and are typically used when the readers of the financial statements are restricted to the owner/entrepreneur and the taxing authority (Canada Revenue Agency.
The starting point is the financial statement itself. The client and/or its management are technically responsible for the initial production of the financial statements.
I’ve heard too many clients say “My accountant has looked over the financial statements, so they must be correct”. This is a misconception that’s far too common.
There are no financial statement disclosure or presentation requirements associated with this engagement. So, the accountant has no obligation other than not to be associated if he/she is aware of any false or misleading results.
The simplicity of this engagement comes from the definition itself. Other than “compiling” the client’s trial balance into a financial statement format, there is generally no other work carried out. That is unless the results clearly indicate that there could be a false or misleading position.
Generally, there are no “notes to the financial statements” within a compilation engagement.
As an assurance engagement, the concept of materiality is applied to the financial statement results.
This concept ensures that only errors that would lead to a “material misstatement” are contemplated and that although there may be smaller errors present, in essence, they would not affect an average person’s perspective on the overall results and financial position.
As stated earlier, a review is considered an assurance engagement and therefore GAAP must be followed. This requires, among other things, specific note disclosures and presentations.
The work carried out by the accountant primarily consists of enquiry, comparison and discussion and uses the benchmark of plausibility as its standard.
Procedures such as verification, examination and scrutiny are associated with auditing and are not performed in a review engagement. The review engagement report attached to the financial statements includes wording that informs the reader that an audit has not been performed.
Although not as stringent as an audit, a review is often performed in the following circumstances:
• Where the amount of borrowing is below a certain threshold
• Where there are multiple owners and each wants some assurance that the financial statements have been independently assessed
• Where it is mandated by a Provincial or Federal regulation based on total revenue.
As mentioned above, an audit is also an assurance engagement and the concept of materiality explained earlier also applies to an audit.
It’s considered the most stringent of the three engagements. The documentation provided is both scrutinized and verified in order to satisfy the auditor that the underlying values are free of material misstatement.
In addition, the controls implemented by management to mitigate the risk of fraud and error are assessed by the auditor and any perceived weaknesses are communicated to the Board of Directors.
This assessment also informs the auditor as to which financial reporting areas may be subject to a greater risk of material misstatement and therefore these areas are targeted for additional audit procedures and examination.
An audit engagement lends itself to a more rigorous testing of the client’s financial reporting routines and practices. Therefore, more reliance can be placed by the reader on the overall results and disclosures.
Typically an audit is performed on private corporations and businesses in the following circumstances:
• Where a lender requires an audit to be undertaken as part of the lending agreement
• Where an absentee shareholder(s) considers that the investment is better protected by the conduct of an annual audit
• Where it is mandated by a Provincial or Federal regulation based on total revenue
• Where the client themselves feel that an audit provides stronger evidence of accuracy.