In a webcast on August 31, 2011, Mr. Michael Glynn, CPA, of the AICPA staff, gave a wonderful word picture of the levels of assurance in a review and audit. Here’s his idea: Filling up a bucket with procedures produces different levels of assurance. I would like to expand Mr. Glynn’s description and provide an illustration.
- In an audit, the accountant
providesobtain reasonable assurance that there are no material errors in the financial statements. - In a review, the accountant
providesobtain limited assurance that there are no material errors in the financial statements. - In a compilation,the accountant does not
provideobtain any assurance that there are no material errors in the financial statements.
Notice the similarity and difference? The overlap between these definitions is how much assurance the accountant provides obtains that there are no material errors in the financial statements.
The differences?
- In a compilation? No assurance.
- In a review? Limited assurance.
- In an audit? Reasonable assurance– which is a high level
Mr. Glynn uses the illustration of filling up a bucket. The bucket is the amount of assurance. You pour water into the bucket and check to see how full it is. Pour in just a few procedures and inquiries, check the bucket, and realize it’s not very full. Add a few more procedures and inquiries and analytical procedures, check the bucket, and realize you’re up to the level of limited assurance. You’re ready to issue a review report.
Here’s a picture of the bucket that is filled to the limited assurance level:
Pour in a bunch more water and you get the bucket almost full. Pour in a lot of inquiries, a bunch of predictive tests, confirmations in some areas, go look at the inventory, talk to management and employees about fraud, and pour in a bunch of discussions of internal control, then check the bucket, see that it is pretty full, and realize you have reached the ‘reasonable’ level of assurance. You’re ready to issue an audit opinion.
Here’s a picture of the bucket that is filled to the reasonable assurance level:
What about a compilation?
As I have mentioned elsewhere, in spite of the wording of a compilation report, the level of assurance is not zero. There is a very low level of assurance that is built into the financial statements that go along with a compilation report. It is really low, but there is still some water in the bucket.
For example, a reader of compiled financial statements can trust that the accountant has obtained some minimal assurance that the numbers actually tie back to the client’s general ledger. Income accounts are in revenue part of the income statement and expense accounts are shown as an expense. If there’s property and equipment, depreciation will be recorded. If an organization extends credit to customers, there will be receivables recorded.
What is the conceptual support for this? If there are really obvious errors in compiled financial statements, the accountant has to address it.
Two illustrations are depreciation expense and an allowance for doubtful accounts. A company that has lots of property and equipment that is used in running the business should have depreciation. If the depreciation expense account is zero, the accountant cannot just ignore that in a compilation. If the company is extending credit to all customers and it usually takes customers a few weeks to pay, then there will be a bunch of receivables. If the receivable balance is zero, the number is obviously wrong. In this miserable economy, it would be really weird for the allowance for doubtful accounts at that client for all clients to be zero. Even in a compilation, an accountant should ask about an allowance that is zero.
The end result is that the numbers in a compilation report could be way off – so far off that the errors would change the decisions of anyone reading the financial statements. By the way that’s the definition of material. However, the really, really obvious stuff would be fixed. I contend that “no assurance” is not zero assurance.
Here is a bucket filled to the “no assurance” level in a compilation:
Not much water in that bucket, but there is some.
The level of water needed is a matter of professional judgment. You may reach a considered opinion that this much water is limited assurance. I might conclude I need more water to be at the limited assurance level. My buddy at another firm might conclude that the cutoff for limited assurance is lower than what you and I believe. That is what professional judgment is all about.
I don’t know how to quantify the levels of assurance. I drew a graph in a previous post to show the concept. Look here and here.
Here again is the visual of filling a bucket, going from compilation to review to audit:
Update: Changed on 10-20 to reflect the idea that a CPA obtains assurance, but does not provide assurance.