Review Engagements (#272)
/In this podcast episode, we discuss the nature of review engagements. Key points made are noted below.
Types of Audit Activities
There’s a range of audit activities. Most people are familiar with the full audit, since lenders usually require that a borrower have one each year. A full audit is quite detailed, and involves an examination of the client’s books and control systems. A review is a notch down from an audit, which also means that it’s less expensive. Anyone who’s a CPA already knows what a review is, so I’m going to focus instead on what you can expect from a review as a client.
Activities in a Review Engagement
There is no examination of company controls, no confirmations go out for receivables or loans, there’s no physical inventory count or fixed asset count, and the auditors don’t go digging around through your accounting records, looking for backup evidence – which is also known as substantive testing.
Analytical Procedures
It doesn’t sound like they do much of anything, which is not entirely true. What they do perform is analytical procedures, which involves comparing different sets of financial and operational information, to see if historical relationships are continuing forward into the current period. In most cases, they do – for example, if your days of receivables figure has been around 45 days for the past few years, then chances are it will still be somewhere fairly close to 45 days in the current period. If so, great – the auditors will assume that your reported numbers are probably about right. But if those relationships change, then there’s a possibility that the financial records are incorrect, which might be due to errors or some kind of fraudulent reporting activity.
There are different types of analytical procedures. As I just pointed out, the auditor might choose to compare the current period’s ending account balances or ratios to prior periods. So, they might look at the current ratio, or days of inventory, or the debt/equity ratio over the past few years, or maybe the gross profit percentage or the net profit percentage. Or, they could do some comparisons of financial to nonfinancial data, such as revenue per employee, or sales per retail store. And, they might compare your actual results to your budget – though that relationship can be weak if you don’t have much of a history of accurately projecting future results. And as another example, they could do an historical analysis of sales by individual product, or sales region, or distribution channel, basically just looking for significant changes.
What does the auditor do with all this analysis? They’ll set some thresholds for what to investigate and what to ignore. It’ll depend on the size of the company, but maybe they decide to investigate any variance of more than 20%, and which is greater than $50,000. The type of investigation of these variances is pretty simple – they just ask management. If the responses don’t seem reasonable, then the auditor could take additional steps to investigate further, maybe by making additional inquiries with other people.
Other Review Inquiries
In addition to that, the auditor will make other inquiries. It’s a standard checklist. I won’t go through it all, but they’ll ask about things like whether there have been any asset impairments, or issues with loan covenants, or maybe hedging activities, or any new revenue recognition methods, or restructuring charges, or any off-balance sheet transactions. Basically, they’re looking for anything out of the ordinary. They’re also going to make inquiries about fraud – things like whether you have any knowledge of fraud that involves management, or any allegations of fraud by anyone. And, they’ll ask about any hanging issues from the last review, such as what you did with any misstatements found the last time around.
In short, it’s a pretty thorough discussion of anything that might impact the financial statements. And they might walk the same questions around through several people on the management team, just to see if they uncover any inconsistencies in the responses.
After all that, they’re going to compare the information they’ve found to what’s stated in the financial statements, to see if it all makes sense. They could also compare the financials to the ending balances in the general ledger, just to make sure that the financials accurately reflect the accounting records. And finally, they’ll see if there are any misstatements that should be corrected, and whether any disclosures should be added or expanded upon. If so, these issues have to be brought to the attention of management, along with a request to correct the situation.
Another possibility is that the auditor may find that the client can’t continue as a going concern, which is to say that it may go bankrupt. If so, another discussion is whether to disclose this possibility in the financial statements, since they’ll otherwise be misleading.
Grounds for Withdrawal
If the auditor keeps making pointed suggestions about revising the financial statements and you don’t want to, then the auditor is perfectly justified in withdrawing from the engagement. If the revisions are made, then the auditor will issue a review report, which clarifies the exact nature of the work that was done, and which specifies that it wasn’t a full audit.
When to Use an Audit
Why would you want a review instead of an audit? Because it’s much less expensive. It’s impossible to say exactly how much, because there’s still a minimum of overhead involved in working with any client, and because some organizations are just more complex than others. Still, at a very rough guess, a review is maybe a quarter to a third as expensive as an audit. If you’re in startup mode and need to preserve cash, a review could be a reasonable way to go.
Another benefit of a review over an audit is that the auditors will be on-site for far less time, which means that they won’t be taking up your staff’s time anywhere near as much as they would in a full audit. And that may not be a minor consideration when you’re under staffed.
However – the users of a company’s financial statements might not want a review, because it doesn’t give them any real assurance that the financial statements are correct. So, you need to check with your investors and lenders first, before signing up for a review, to make sure that it’s OK with them.
Also, there’s one case where you have to have a review – and on a quarterly basis. This is when the company is publicly-held. In that case, the SEC requires that there’s a review following the end of the first, second, and third quarters, followed by a full audit at the end of the year.
Summary
In summary, to look at a review from a high level, it’s essentially a consulting engagement for the auditor, who conducts a reasonable inspection of the books and makes inquiries to see if there’re any anomalies. The auditor can then make suggestions to management for improving the financial statements; if management decides not to do so, then the auditor has grounds to pull out.
Related Courses
How to Conduct a Compilation Engagement