Deciphering financial statements for non-financial professionals - Part 2

July 25, 2014

How reliable are these financial statements anyway?

This second post of my Deciphering Financial Statements for Non-financial Professionals series addresses how you, as a financial statement reader, can determine how much reliance you can take from a set of financial statements. In this series of posts, I will provide insight into financial reporting and related topics geared toward non-financial professionals who need to understand financial statements as part of their professional roles. I encourage you to also read the other installments in the series (past and future), particularly the introduction published on July 25, 2014 as that post sets the scene for the series and includes a number of resources you may find useful as you go along.

Why do I need to know what level of assurance has been provided?

When reading a set of financial statements it's important for the reader to understand what assurance, if any, has been provided by an independent auditor or accountant. This knowledge enables the reader to make judgments as to whether they should be looking beyond the financial statements for other information on which to base their understanding of the company's operations. Such information may include details of specific balances within the financial statements or other documents the company has made available to the public.

How can I tell what level of assurance has been provided?

The reader can identify the type of assurance provided by looking for an auditor's or accountant's report immediately preceding the financial statements. These are easy to identify by titles such as “Independent Auditor's Report” or “Review Engagement Report”. If either an audit or review report is present, this will indicate that some level of assurance has been provided by an independent auditor or accountant. The absence of such a report or the presence of a report entitled “Notice to Reader” indicates that neither an auditor nor an accountant has provided any assurance on those financial statements. The exception to this rule is with interim financial statements filed by public companies. If the company has filed a “notice of no auditor review” ahead of the financial statements, this indicates that the company's auditor has provided no assurance to the company's audit committee on those financial statements. The absence of such a notice indicates that the company's auditor has performed an auditor's review of those financial statements on behalf of the audit committee.

What's an audit?

An audit constitutes the highest level of assurance typically provided by an independent auditor on a company's financial statements. When providing an audit opinion, an auditor is providing positive assurance on the company's financial statements, meaning that the auditor has performed specific procedures on the underlying financial information and the financial statements themselves to determine whether those financial statements are reasonable and to verify that no material misstatements exist. An audit may involve such procedures as:

  • assessing what areas of the financial statement pose a risk of material misstatement and performing procedures to ensure those amounts are not materially misstated;
  • evaluating management's accounting policies to ensure that they are consistent with the accounting standards under which the financial statements are prepared;
  • scrutinizing management's significant judgments and estimates;
  • observing and verifying physical assets;
  • reperforming management's calculations;
  • evaluating management's internal controls related to financial reporting in order to identify and address related audit risks and testing key internal controls, where this approach is considered efficient;
  • evaluating disclosure contained in the notes to the financial statement to ensure it is complete, accurate and consistent with management's accounting policies and the relevant accounting standards; and
  • collecting and evaluating appropriate sources of documentation, including confirmation with third parties and source information such as contracts and invoices.

Does an audit mean I don't need to worry about fraud issues?

An audit also involves certain considerations with respect to identifying indications of fraud; however it is important to understand that a standard financial statement audit is not designed specifically to identify fraud. Should the auditor identify fraud or indicators of fraud during their audit, they are obligated to take appropriate action. However, a well orchestrated fraud, particularly one involving collusion, may or may not be identified by standard audit procedures.

What's a review?

A review opinion constitutes a lesser level of assurance than that provided by an audit opinion, involving the provision of negative assurance on the plausibility of the financial statements. What this means is that the auditor has performed certain limited procedures on the underlying financial information and found that the financial statements are plausible and nothing came to light through the course of these procedures to indicate a material misstatement may exist. The procedures performed to support a review opinion are much less invasive than those performed to support an audit opinion, consisting primarily of analytical review, discussion with appropriate members of the company's management and, where necessary and in only specific circumstances, limited audit-style procedures. Limitations on the auditor's responsibility to identify fraud in connection with a review engagement are similar to those limitations described above in connection with an audit.

What's a "Notice to Reader" or compilation?

You may also come across financial statements with a “Notice to Reader”, also referred to as a compilation. When an auditor or accountant performs a compilation, they are simply compiling the company's financial records into a financial statement with no amount of assurance provided. Unlike an auditor performing an audit or a review, there is no requirement that an auditor or accountant performing a compilation be independent of the company whose financial statements they're producing. Regardless of these limitations, a qualified accountant cannot be associated with financial information that they know to be misleading and, as such, you may take some comfort in this fact.

What if there's no report attached to the financials at all?

Should you come across a set of financial statements preceded by no report whatsoever, you essentially have no assurance that they are reasonable, plausible, not materially misstated or otherwise not potentially misleading. In the case that you are using such financial statements, you should apply a high level of scrutiny to them, limit your reliance on them and look to other sources of information to supplement those financial statements in your decision making process.

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