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Bureau of Residential Finance

Newsletter: Spring 1999

FINANCIAL STATEMENTS CLARIFIED

Most organizations, whether they are privately held businesses, publicly owned corporations or nonprofit entities, must prepare reports on their financial performance. These reports help owners and managers make operating decisions, enable creditors to evaluate loan applications and provide individuals with information to make investment decisions. Financial statements are also used extensively by government agencies as one of their tools for oversight of regulated industries.

Each Residential Mortgage Licensee is required to have its financial statements audited annually by an independent certified public accountant. For licensees who solely broker residential mortgage loans, instead of the audit, compilation financial statements may be acceptable.

Types of Reports:

There are three (3) types of reports on financial statements, a compilation, a review and an audit. Each is designed to meet a different need and provide a different level of assurance as to the fair presentation of the financial statements.

A compilation is useful to small, privately held entities that need help in preparing their financial statements. It entails preparing financial statements of private entities based on information provided by the entity's management.

A review may be adequate for entities that must report their financial positions to third parties, such as creditors or regulatory agencies. Reviewed financial statements may also be useful to business owners who are not actively involved in managing their companies. The submission of a review report is not contemplated by the Illinois Residential Mortgage License Act of 1987.

Audits are appropriate for entities that must offer a higher level of assurance to outside parties. An unqualified opinion from a Certified Public Accountant ("CPA") after an audit provides reasonable assurance to outside parities that the entity's financial statements fairly present its financial position and results of operation in accordance with certain accounting principles. An audit includes such procedures as confirmation with outside parties, observation of inventories and testing selected transactions by examining supporting documents.

Compilation:

A compilation offers no assurance as to whether material or significant, changes are necessary for the financial statements to be in conformity with generally accepted accounting principles, the cash basis or the income tax basis of accounting. During a compilation, the information is simply arranged into a conventional financial statement format. No investigation is undertaken unless the CPA becomes aware that the information provided is in error or is incomplete.

What does a compilation entail?

The CPA becomes familiar with the accounting principles and practices common to the client's industry and acquires a general understanding of the entity's transactions and how they are recorded.

After compiling the financial statements, the CPA is obliged to read them and consider whether they are appropriate in form and free from obvious material errors. The CPA then issues a standard report that says, in effect, that the financial statements were compiled, but because they were not audited or reviewed, no opinion is expressed.

Compilation standards permit an accountant to compile financial statements that omit footnote disclosures required by generally accepted accounting principles or another comprehensive basis of accounting (cash or income tax). This is allowable as long as the omission is clearly indicated in the report and there is no intent to mislead users. When footnote disclosures have been left out, the CPA adds a paragraph to the compilation report stating that management has elected to omit disclosures. This paragraph lets the user know that if the financial statements contained this information, it might affect the users' conclusions.

Audit:

Companies may engage a CPA to audit its financial statements and to issue a report that provides the highest level of assurance that the financial statements are presented fairly in conformity with generally accepted accounting principles.

In an audit, the CPA must be independent of the client and the financial statements must contain all required footnotes. In Illinois, only a CPA, licensed by the State, may perform an audit.

What does an audit entail?

To gather evidence on the reliability of the financial statements, the CPA performs search and verification procedures. In an audit, the CPA generally confirms balances with banks or creditors, observes inventory counting and tests selected transactions by examining supporting documents. Sources outside the client organization are contacted to gather information that may be more objective than that obtained from internal sources. For example, CPA usually obtains written confirmation from a client's customers about client receivables. By accumulating this type of evidence, the CPA tries to reduce the risk that the financial statements will be materially misstated.

The auditor then issues a report stating that the financial statements are presented fairly, in all material respect, in conformity with generally accepted accounting principles. An audit is planned and performed to provide reasonable assurance that material errors or fraud are detected. Fraud concealed through forgery or collusion may not be found because the auditor is not trained to catch forgeries, nor with customary audit procedures detect all conspiracies. An audit provides a reasonable level of assurance that the financial statements are free of material errors and fraud. An audit does not; however, provide a guarantee of absolute assurance.

   Sources: AICPA - Statements of Auditing Standards (AICPA, Professional Standards, vol. 1, 1997)