Financial statements are perhaps the best way to evaluate a business’s performance and determine its debt paying ability. In general, there are two types of financial statements – audited and un-audited.
Audited financial statements are those statements that have been reviewed by an independent Certified Public Accountant (CPA), who has expressed his/her professional opinion of a business. The CPA is bound by generally accepted auditing standards. Un-audited financial statements contain no such opinions or statements. This greatly limits their usefulness in evaluating a business’s financial health.
CPAs in the United States follow guidelines that are called “General Accepted Accounting Principles” (GAAP). GAAP derives much of its authority from the American Institute of Certified Public Accountants. Beginning in 2006, the GAAP now allows CPAs to provide a wider range of financial reporting with regard to financial statements. Companies may now choose from three different levels of service.
Financial Statement Audits
Audits provide the highest degree of assurance for evaluators. An independent CPA uses various techniques to verify the accuracy of the information in the statement, and then expresses an opinion on the fairness of the financial statements and provides assurance that the underlying data has been tested. The CPA firm then provides written assurance that financial reports are ‘fairly presented in conformity with generally accepted accounting principles (GAAP).’ The measure for ‘fairly presented’ is that there is less than 5% chance (5% audit risk) that the financial statements are ‘materially misstated’.
Financial Statement Reviews
Reviewed financial statements are unaudited and provide a much lower degree of assurance than audits. During a review, the CPA firm makes inquiries and performs analytical procedures, which allows the CPA to express limited assurance that it is not aware of any material changes. For example, in a review, a CPA would likely ask management how inventory quantities are determined. In an audit, the CPA would observe the taking of physical inventory, and personally review the obsolete or damaged items. While a review doesn’t provide the same degree of assurance an audit, some financial statement users may find it an acceptable alternative.
Financial Statement Compilations
Compilations provide no assurance, and are also unaudited financial statements. The CPA firm only assists in preparing the financial statements, but it is not required to verify the information. Since the information is not verified, the CPA gives no assurance as to whether the financial statements meet any of the professional standards. In a compilation, the CPA only agrees to demonstrate that he/she has a high level of knowledge of accounting principles and practices. The CPA also makes certain that the data are in the correct format and clerically accurate.
In the end, it is up to the reader and/or user of the financial statements to determine the financial health of the business and to assess their own level of comfort with the statements. Lenders, investors and customers need to be assured with the accuracy of the financial statements and request the level of scrutiny they require.