Financial Statements: How to Weigh Compilation vs. Review vs. Audit
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Any business needs credibility in its financial statements and will need to weigh a compilation vs. a review vs. an audit, the most formal option.
Say you’re finally about to close a deal that could change everything for your company. But before you take such a momentous step, you have to take a good, hard look at your records – maybe just in the financial assurance mirror, but possibly under a microscope.
To choose the right level of scrutiny for your financial reports, you’ll need to engage a CPA and pick one of three views: a basic compilation report, a more involved review or the most thorough, an audit.
This is the most basic accounting service, a cover page written by a CPA that accompanies a set of your financial statements. It shows lenders you have an association with a CPA, but doesn’t offer a deep level of assurance on the accuracy of the financial statements.
Since the CPA does a cursory check on basic features of your financial statements to write a compilation letter, no special preparation is required on your part.
A compilation may be sufficient for a small business owner seeking a personal loan. But most of the time, a more credible review or audit will be required for a business loan.
Overall, the review process involves:
- Review and inquiries on financials;
- Making inquiries related to the accounting practices and principles used by the business; and
- Performing analytical procedures to understand current-year and prior-year balances, or current-year balances outside the CPA’s expectations.
To know where to look for potential accounting errors, the CPA needs to have enough information about your company and understand your industry and its accounting principles. You need to gather all documents requested in advance by the CPA, including your:
- Trial balance;
- Bank reconciliations; and
- Accrual schedule, deferred revenue and more.
A review will usually satisfy prospective lenders, buyers and investors who don’t have a lot at stake. In particular, reviews are used for seeking a smaller line of credit or a small business loan.
When the loan requires a company to comply with certain loan covenants, a review vs. audit discussion is probably needed. Businesses often use a review as a stepping stone to reduce the challenges of a first-year audit.
The audit is the most thorough assurance service, requiring considerably more effort on the CPA’s part — and yours, as you’ll field more information requests.
In an audit, a CPA is required to obtain evidence through inquiry with appropriate personnel, physical inspection, verification and substantive testing procedures. A CPA also will examine supporting or source documents, send third-party confirmations to confirm the balances and legal matters, and perform analytical and other procedures.
Auditors want to be sure your financial statements are free from material error or fraud. Audits are generally required if you are:
- Planning a major financing;
- Looking for extended credit from major suppliers;
- Raising equity;
- Planning to sell a business;
- Expecting your company to have a public offering in the future; or
- Expecting your company will be funded by the federal or state governments.
All publicly traded companies are required to have their financial statements audited and reported to the SEC on a quarterly and annual basis.
When considering compilation vs. review vs. audit, don’t buy an electron microscope when a magnifying glass will do. Consult with your CPA to identify the service level suitable to your needs.