How to Review Financial Statements Efficiently and Effectively

Tips to quickly review financial statements and to ensure effectiveness

Most CPA firms create financial statements for their clients. This blog post tells you how to create and review financial statements efficiently and effectively.

Review Financial Statements

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How to Create Financial Statements

First, staff members create the original financial statements. Where possible, electronically link the trial balance to the financial statements. Doing so will expedite the financial statement process and enhance the integrity of the numbers. Ask the staff member to do the following:

  • Prepare the initial draft of the statements
  • Create clear disclosures
  • Complete a current financial statement disclosure checklist 
  • Research any nonstandard opinion or report language (place sample reports from PPC or other sources in the file) — later the partner will compare this supporting document to the opinion or report
  • Research any additional reports (e.g., Yellow Book, Single Audit); place copy of such reports in the file — the partner or manager will have such reports available for their review
  • The staff person should review the partner’s planning document to see if any new standards are to be incorporated into this to year’s financial statements

How to Proof the Financial Statements

Second, proof your financial statements. The proofer usually does the following before the partner or managers’ review:

  • Add (foot the numbers for) all statements, notes, schedules
  • Tick and tie numbers such as:
    • Total assets equal total liabilities and equity
    • Ending cash on the cash flow statement agrees with the balance sheet
    • Net income on the income statement agrees with the beginning number of an indirect method cash flow statement
    • Numbers in the notes agree with the financial statements
    • Numbers in the supplementary schedules agree with the financial statements
  • Review financial statements for compliance with firm formatting standard 
  • Read financial statements for appropriate grammar and punctuation (consider using Grammarly)
  • Compare the table of contents to all pages in the report
  • Review page numbers

Partner or Manager Review

Finally, the partner or manager reviews the financial statements. Having the proofer do their part will minimize the review time for this final-stage review.

Here are tips for the final review:

  • Scan the complete set of financials to get a general feel for the composition of the report (e.g., Yellow Book report, supplementary information, the industry, etc.) — this is a cursory review taking three or four seconds per page
  • Read the beginning part of the summary of significant accounting policies taking note of the reporting framework (e.g., GAAP), type of entity (e.g., nonprofit), and whether the statements are consolidated or combined — doing so early provides context for the remaining review of the financials
  • Read the opinion or report noting any nonstandard language (e.g., going concern paragraph)
    • Agree named financial statement titles in the opinion or report to the financial statements
    • Agree the dates (e.g., year-end) in the opinion or report and compare to the statements
    • Compare supporting sample report (as provided by your staff member and noted above) to the opinion or report
    • Compare representation letter date to the opinion or review report date
  • Review the balance sheet making mental notes of line items that should have related notes (retain those thoughts for review of the notes)
  • Review the income statement
  • Review the statement of changes in equity (if applicable)
  • Review the cash flow statement
  • Review the notes (making mental notes regarding sensitive or important disclosures so you can later see if the communication with those charged with governance appropriately contains references to these notes)
  • Return to the balance sheet to see if there are additional disclosures needed (since you just read the notes, you will be more aware of omissions — e.g., intangibles are not disclosed)
  • Review supplementary information (and related opinion for this information if applicable)
  • Review other reports such as Yellow Book and Single Audit (the staff member preparing the financial statements should have placed supporting examples in the file; refer to the examples as necessary)
  • If the review is performed with a printed copy of the statements, use yellow highlighter to mark reviewed sections and numbers
  • If the review is done on paper, pencil in corrections and provide corrected pages to the staff member for amendments to be made
  • If the review is performed on the computer, take screenshots of pages needing corrections and provide to the staff member
  • Alternatively, make corrections using Track Changes if the financial statements are in a Word document; these changes will appear in a different color so you can visually see what was changed; Word also provides a different color for each person who makes a change, so you can see who changed what

Last Step

Destroy all drafts–or at a minimum, don’t leave them in the file. Once the financial statements are complete, there is no reason to retain drafts.

Your Suggestions

What other review procedures do you use?

How to Report Debt Covenant Violations

Violations may require debt to be shown as current

How does a debt covenant violation affect the presentation of debt on a balance sheet?

If a debt covenant violation occurs, the debt should be classified as current unless the lender provides a waiver for at least one year from the balance sheet date or the debtor is able to cure the violation subsequent to the balance sheet date but before the issuance date (or date available for issuance) of the financial statements.

Some loans provide for a grace period. If the violation is cured during the grace period, the debt–other than current maturities–will be reported as as long-term. Also if the cure has not already occurred but the company demonstrates it is probable that it (the cure) will occur within the grace period, then, again, the debt will be reported as long-term.

report debt covenant violations

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The Main Consideration

The main consideration in classifying long-term debt is whether the amount is due or callable within one year of the balance sheet date. (By definition, a liability is current when due within one year of the balance sheet date.) If due or callable within the year subsequent to the period-end, the amount generally should be reported as current. (One exception: when it is probable the cure will occur within the grace period.) If a debt covenant violation is timely cured, then the debt is no longer callable and will, therefore, remain long-term. The same is true if the creditor provides a waiver that extends one year beyond the balance sheet date.

Note–Even minor violations of debt agreements may allow the creditor to call a loan.

FASB Codification Guidance

470-10-45 of the FASB Codification provides the following guidance:

Some long-term loans require compliance with quarterly or semiannual covenants that must be met on a quarterly or semiannual basis. If a covenant violation occurs that would otherwise give the lender the right to call the debt, a lender may waive its call right arising from the current violation for a period greater than one year while retaining future covenant requirements. Unless facts and circumstances indicate otherwise, the borrower shall classify the obligation as noncurrent, unless both of the following conditions exist:

a. A covenant violation that gives the lender the right to call the debt has occurred at the balance sheet date or would have occurred absent a loan modification.
b. It is probable that the borrower will not be able to cure the default (comply with the covenant) at measurement dates that are within the next 12 months.

Is Disclosure Required if a Waiver is Obtained?

If the company obtains a waiver for one year from the balance sheet date, must the financials disclose this fact (that a waiver was obtained)?

The AICPA answers this question–in Q&A section 3200 (paragraph 17)–with the following:

The authoritative literature applicable to nonpublic entities does not address disclosure of debt covenant violations existing at the balance-sheet date that have been waived by the creditor for a stated period of time. Nevertheless, disclosure of the existing violation(s) and the waiver period should be considered* for reasons of adequate disclosure. If the covenant violation resulted from nonpayment of principal or interest on the debt, inability to maintain required financial ratios, or other such financial covenants, that information may be vital to users of the financial statements even though the debt is not callable.

*Emphasis added by CPA-Scribo

Translation: It is wise to disclose the debt covenant violation and the existence of the waiver.

FASB’s Current Work on a New Standard

On January 10, 2017, the FASB issued the Exposure Draft, Debt (Topic 470): Simplifying the Classification of Debt in a Classified Balance Sheet (Current versus Noncurrent). Click here for more information.

Are You Up to Speed on the New Pro Forma Information Standard?

Providing "What if?" information to clients can be helpful

The Accounting and Review Services Committee (ARSC) issued SSARS 22 Compilation of Pro Forma Financial Information. You may remember that ARSC did not address pro forma information in SSARS 21. SSARS 22 clarifies AR 120 Compilation of Pro Forma Information and codifies it as AR-C 120.

Pro Forma Information

So what is pro forma information? It is a presentation that shows what the significant effects on historical financial information might have been had a consummated or proposed transaction (or event) occurred at an earlier date.

Pro Forma Information

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To understand SSARS 22, let’s answer a few questions.

Examples of Pro Forma Information

Examples of pro forma information include presenting financial statements for the following:

  • Business combinations
  • The selling of a significant part of a business
  • A change in the capitalization of an entity

Again we are providing financial information as though the transaction or event has–already–occurred.

Required Disclosures

In pro forma financial information, what should be disclosed?

  • A description of the transaction (or event) that is reflected in the presentation
  • The date on which the transaction (or event) is assumed to occur
  • The financial reporting framework
  • The source of the financial information
  • The significant assumptions used
  • Any significant uncertainties about those assumptions
  • A statement that the pro forma information should be read in conjunction with the related historical information and that the pro forma information is not necessarily indicative of the results that would have been attained had the transaction (or event) actually taken place

Independence

Must the accountant consider his or her independence? Yes, since this is a compilation engagement. (Note: The preparation of the pro forma information is considered a nonattest service.)

Acceptance and Continuance

Should the accountant perform acceptance and continuance procedures? Yes.

Engagement Letter

Is an engagement letter required? Yes, and it must be signed by the accountant’s firm and management or those charged with governance.

Compilation Procedures

What compilation procedures should be performed?

  • Read the pro forma financial information to determine if it is appropriate in form and free from obvious material misstatement
  • Obtain an understanding of the underlying transaction or event (that the pro forma information is based upon)
  • Determine that management includes:
    • Complete financial statements for the most recent year (or from the preceding year if financial statements for the most recent year are not yet available) or make such financial statements readily available (e.g., post on a public website)
    • If pro forma financial information is presented for an interim period, either historical interim financial information for that period (which may be in condensed form) or make such interim information readily available
    • For business combinations, the relevant financial information for the significant parts of the combined entity
  • Determine that the information in the preceding bullet has been subjected to a compilation, review or an audit
  • Determine that the compilation, review or audit report on the historical information is included in any document containing the  pro forma financial information (or made readily available such as on a public website)
  • Determine whether the significant assumptions and uncertainties are disclosed
  • Determine whether the source of the historical financial information on which the pro forma information is based is appropriately identified

Pro Forma in Conjunction with Other Services

Can the pro forma engagement be performed in conjunction with a compilation, review or an audit? Yes. Alternatively, the pro forma engagement can be performed separately.

Required Documentation

What documentation is to be retained in the file?

  • Engagement letter
  • The results of procedures performed
  • Copy of the pro forma financial information
  • Copy of the accountant’s compilation report

Compilation Report Required

Is a compilation report to be issued? Yes. (See sample report below.)

Is the accountant offering any assurance regarding the pro forma information? No.

Can the pro forma compilation report be added to the accountant’s report on historical financial statements? Yes. Alternatively, the pro forma compilation report can be presented separately.

Effective Date of SSARS 22

What’s the effective date of SSARS 22? The standard is effective for compilation reports on pro forma financial information dated on or after May 1, 2017.

Potential New Service for Your Clients

If you are not already providing pro forma information to clients, consider suggesting this service when appropriate. Clients may find pro forma information helpful in evaluating the potential sale of stock, the borrowing of funds for a project, or the sale of a part of the business.

Sample SSARS 22 Compilation Report

Exhibit B of SSARS 22 provides the following sample compilation report on pro forma financial information:

Management is responsible for the accompanying pro forma condensed balance sheet of XYZ Company as of December 31, 20X1, and the related pro forma condensed statement of income for the year then ended (pro forma financial information), based on the criteria in Note 1. The historical condensed financial statements are derived from the financial statements of XYZ Company, on which I (we) performed a compilation engagement, and of ABC Company, on which other accountants performed a compilation engagement. The pro forma adjustments are based on management’s assumptions described in Note 1. (We) have performed a compilation engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. I (we) did not examine or review the pro forma financial information nor was (were) I (we) required to perform any procedures to verify the accuracy or completeness of the information provided by management. Accordingly, I (we) do not express an opinion, a conclusion, nor provide any form of assurance on the pro forma financial information.

The objective of this pro forma financial information is to show what the significant effects on the historical financial information might have been had the underlying transaction (or event) occurred at an earlier date. However, the pro forma condensed financial statements are not necessarily indicative of the results of operations or related effects on financial position that would have been attained had the above mentioned transaction (or event) actually occurred at such earlier date.

[Additional paragraph(s) may be added to emphasize certain matters relating to the compilation engagement or the subject matter.]

[Signature of accounting firm or accountant, as appropriate] [Accountant’s city and state]
[Date of the accountant’s report]

How to Write Clear Financial Statement Disclosures

Tips on clarifying your narrative communications

Creating clear financial statement disclosures is not always easy. Creating (unintentional) confusion? Well, that’s another matter.

Financial Statement Disclosures

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Clear Financial Statement Disclosures

Let’s pretend that Olympic (CPA) judges rate your most recent note disclosures, flashing scores to a worldwide audience. What do you see? Tens everywhere—or something much less?

Balance sheets tend to be clear. Why? The accounting equation. Assets always equal liabilities plus equity. But there is no disclosure equation (darn it) and without such, we flounder. 

Since we tend to be linear thinkers, we enjoy Pascal more than Hemingway, numbers more than words, debits and credits more than paragraphs. Accountants’ brains are wired that way—at least that’s my excuse.

I recall—in 1983—English teachers coming to my University of Georgia accounting classes. At the time, I thought, “What a waste!” Now decades later, I see the wisdom. Accounting is more than just numbers. It is a communication made up of financial statements and narratives. So, in the name of clearer disclosures, I offer these suggestions.

Consider Your Readers

Who will read the financial statements? Owners, lenders, and possibly vendors. Owners—especially those of smaller businesses—may need simpler language. Some CPAs write notes as if CPAs (alone) will read the financial statements. While accounting is technical, we need—as much as possible—to simplify.  

Use Short Paragraphs

Some lengthy paragraphs choke the reader and cause confusion. Breaking long paragraphs into shorter ones makes the print more accessible. And the shortening of paragraphs transforms overwhelming mouthfuls into bite-sized morsels. 

Then say what needs to be said, and get out of there. Less is more in many instances. When we try to say too much, we sometimes say…too much. Additionally, short sentences are helpful.   

Use Short Sentences

I’m not sure, but CPAs may have invented the run-on sentence. As I read one of those beauties, I feel as though I can’t breathe. And by the end, I’m gasping. Breaking long sentences into shorter ones makes your reader more comfortable. And she will thank you. And while we are addressing more succinct language, how about using more concise words?

Use Shorter Words

CPAs don’t receive merit badges for long, complicated words. Our goal is to communicate, not to impress. For example, split is better than bifurcate.  

And attorneys are not our model. I sometimes see notes that are simply regurgitations of legal agreements, copied word for word—and you can feel the stiltedness. Do your reader a favor and translate the legalese into digestible—and might I say, more enjoyable—language. 

Use Tables

Long sentences with several numbers can be confusing. Readers comprehend tables more quickly than jumbled narratives.

Write Your Own Note

Too many CPAs copy note examples from the Internet without understanding whether the language fits the financial statements they are creating. Make sure the language is appropriate for your company.

Put Disclosures in the Right Buckets (or Reference)

Think of each disclosure header as a bucket. For example, if the notes include a related party disclosure, then that’s where the related party information goes. If the debt note includes a related party disclosure (and this may be necessary), then make reference–in the related party disclosure–to the debt note. You don’t want your reader to think all of the related party disclosures are in one place (the related party note) when one is somewhere else (the debt note). The same issue arises in subsequent event notes.

Have a Second Person Review the Notes

When writing, we sometimes think we are clear when we are not. Have a second person review the note for proper punctuation, spelling, structure and clarity. If you don’t have a second person available to review the notes, perform a cold review the next day—you will almost always see necessary revisions. I find that reading out loud helps me assess my writing’s clarity.

I also use Grammarly to edit documents. The software provides grammar feedback as you write. If you don’t have a second person to review your financials, I highly recommend this product.

Use a Current Disclosure Checklist

Vetting your notes with a disclosure checklist may be the most tedious and necessary step. FASB and GASB continue to issue new statements at a rapid rate, so using a checklist is needed to ensure completeness.   

Winning Gold

I hope these suggestions help you win gold–10s everywhere. May you hear your national anthem and glow in the success of clear communication.

By the way, FASB recently issued exposure drafts related to the materiality of disclosures. We need guidance that helps us assess when disclosures are necessary—and when they are not. So hopefully, in the not-to-distant future, we’ll have standards that assist in determining when disclosures are needed.

Open Tax Years Disclosure May Not Be Required

Peer reviewers continue to wrongly critique open tax year disclosures

Are open tax year disclosures required?

ASC 740-10-50 Unrecognized Tax Benefit Related Disclosures does not require a disclosure when there is no “unrecognized tax benefit.” Many CPAs (including myself) believed that a disclosure of the open tax years was required, even when the entity had no unrecognized tax benefit (or uncertain tax position). An AICPA non-authoritative Technical Question and Answer (TPA 5250.15) had said that nonpublic entities should disclose open tax years regardless of whether the entity had uncertain tax positions; that guidance has been removed.

open tax years disclosure

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The AICPA clarified that the open tax years disclosure is not required for companies without unrecognized tax positions, but peer reviewers are still (incorrectly) writing MFCs and even FFCs related to financial statements without the open tax years disclosure, even for entities without unrecognized tax positions.

When is a Disclosure Material?

FASB proposes to clarify materiality as it relates to disclosures

Back in the fall of 2015, FASB issued two proposed standards to address materiality as it relates to disclosures:

  1. Amendment to conceptual framework
  2. Update to Topic 235-10 (Notes to Financial Statements)

The intent of FASB is to clarify that it does not establish materiality and that the preparers have (some) discretion in determining disclosures to be included in financial statements.

Financial Statements

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Proposed Changes

FASB’s proposals would:

  • Clarify that FASB does not define materiality.
  • State that materiality is a legal concept.
  • Delete the existing discussion of materiality in FASB’s conceptual statements and replace it with a broad observance of the Supreme Court’s definition of materiality.
  • State that materiality is applied to quantitative and qualitative disclosures individually and in the aggregate in the context of the financial statements taken as a whole.
  • Clarify that an omission of immaterial information is not an accounting error.

The proposed FASB language (in the amendment to FASB’s conceptual framework) includes the following:

Materiality is a legal concept.* In the United States, a legal concept may be established or changed through legislative, executive, or judicial action. The Board observes but does not promulgate definitions of materiality. Currently, the Board observes that the U.S. Supreme Court’s definition of materiality *, in the context of the antifraud provisions of the U.S. securities laws, generally states that information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information.* Consequently, the Board cannot specify or advise specifying a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.

* Emphasis added by CPA-Scribo

Investors are Fuming

As usual, investor groups are raising a ruckus. The New York Times even did a piece about investor perspectives. Historically investors have wanted everything and the kitchen sink. After all, gathering and presenting the information costs them nothing. While I respect the need for clear and useful investor information (and this should be provided), financial statement users should receive only information that is relevant and pertinent to decision making.

Excessive disclosures are a waste of time and money. Worse yet, they may even distract from valuable information in the financial statements.

Regardless of how one defines materiality, there will always be judgment (see my recent post: Materiality is Not (Just) a Number). The subjectivity involved in applying materiality will not disappear simply because a legal definition is used.

Overkill by Financial Statement Reviewers

The exposure draft titled Assessing Whether Disclosures are Material points out that some audit committees see the omission of immaterial disclosures as “errors.” Some regulators and government agencies have this same perspective. New FASB requirements are added to disclosure checklists, and if the financial statements don’t include every (possible) note, it’s considered a mistake. This process is fallacious and–in some cases–detrimental to providing information to financial statement users. Preparers, after being stung by a regulator or some other outside party, become paranoid and then spend an inordinate amount of time adding minutiae. The result: Notes that contain an overabundance of information.

For example, who cares if a company with $300 million in assets spends $2,542 for advertising? The preparer–fearing the audit committee, regulator, or government agency–includes the advertising disclosure and adds to the clutter that dilutes the overall financial statement communication. It’s counterproductive (for crying out loud). Does the advertising note help? I don’t think so.

Your Thoughts

We’ll see where this all goes. Once FASB provides additional information, I’ll pass it along to you.

What are your thoughts concerning the proposed FASB amendments?