Guide To Compilation & Review

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SELFSTUDY CONTINUING PROFESSIONAL EDUCATION
Companion to PPC's Guide to
Compilation
and Review
Engagements
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Interactive Selfstudy CPE

Companion to PPC's Guide to
Compilation and Review Engagements
TABLE OF CONTENTS
Page
COURSE 1: ENGAGEMENT ADMINISTRATION
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Lesson 1:
Engagement Letters and Workpaper Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Lesson 2:
Compilation Procedures and Checklists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
42
Lesson 3:
Review Procedures and Checklists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
67
Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
105
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
115
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
119
COURSE 2: PREPARING FINANCIAL STATEMENTS FOR COMPILATIONS AND REVIEWS

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
121
Lesson 1:
Form and Presentation of Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
123
Lesson 2:
Reporting on Compiled or Reviewed Financial Statements . . . . . . . . . . . . . . . . . . . . . . .
174
Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
237
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
248
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
251
COURSE 3: PROPRIETORSHIPS, PARTNERSHIPS, AND S CORPORATIONS:

SPECIAL REPORTING ISSUES
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
255
Lesson 1:
Proprietorships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
257
Lesson 2:
Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
273
Lesson 3:
S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
317
Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
351
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
361
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
365
ANSWER SHEETS AND EVALUATIONS

Course 1: Examination for CPE Credit Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Course 1: Selfstudy Course Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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INTRODUCTION
Compilation and Review Engagements consists of three interactive selfstudy CPE courses. These are companion
courses to PPC's Compilation and Review Engagements designed by Thomson Tax & Accounting editors to
enhance your understanding of the latest issues in the field. There is a charge for grading and processing your
answer sheet for each course. To obtain credit, your Examination for CPE Credit Answer Sheet must be
submitted for grading by September 30, 2008. Copies of the Examination for CPE Credit Answer Sheet may be
made if more than one person wants to complete this selfstudy course.
Taking the Courses
Each course is divided into lessons. Each lesson addresses an aspect of compilation and/or reviews. You are
asked to read the material and, during the course, to test your comprehension of each of the learning objectives by
answering selfstudy quiz questions. After completing each quiz, you can evaluate your progress by comparing
your answers to both the correct and incorrect answers and the reason for each. References are also cited so you
can go back to the text where the topic is discussed in detail.
Qualifying Credit Hours QAS or Registry
PPC is registered with the National Association of State Boards of Accountancy as a sponsor of continuing
professional education on the National Registry of CPE Sponsors (Registry) and as a Quality Assurance Service
(QAS) sponsor. Part of the requirements for both Registry and QAS membership include conforming to the
Statement on Standards of Continuing Professional Education (CPE) Programs (the standards). The standards were
developed jointly by NASBA and the AICPA. As of this date, not all boards of public accountancy have adopted the
standards. Each course is designed to comply with the standards. For states adopting the standards, recognizing
QAS hours or Registry hours, credit hours are measured in 50minute contact hours. Some states, however, require
100minute contact hours for self study. Your state licensing board has final authority on accepting Registry hours,
QAS hours, or hours under the standards. Check with the state board of accountancy in the state in which you are
licensed to determine if it participates in the QAS program and allows QAS CPE credit hours. This course is based
on one CPE credit for each 50 minutes of study time in accordance with standards issued by NASBA. Note that
some states require 100minute contact hours for self study. You may also visit the NASBA website at
www.nasba.org for a listing of states that accept QAS hours.
CPE requirements are established by each state. You should check with your state board of accountancy to
determine the acceptability of this course. We have been informed by the North Carolina State Board of Certified
Public Accountant Examiners and the Mississippi State Board of Public Accountancy that they will not allow credit
for courses included in books or periodicals.
Obtaining CPE Credit
After completing a course, you can receive CPE credit by logging on to our Online Grading System at
OnlineGrading.Thomson.com. Click the purchase link and a list of exams will appear. You may search for the
exam using wildcards. Payment for the exam is accepted over a secure site using your credit card. For further
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the examination. If you prefer, you may continue to mail your completed Examination for CPE Credit Answer
Sheet to Thomson Tax & Accounting for grading. For the print product, answer sheets are bound into the course
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acronym. Please ensure you use the correct answer sheet for each course. Payment of $69 (by check or credit
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Examination for CPE Credit Answer Sheet. Payment of $69 must accompany each answer sheet submitted. We
would also appreciate a separate Course Evaluation from each person who completes an examination.
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Express Grading: An express grading service is available for an additional $24.95 per examination. Course
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Guide to Compilation and Review Engagements
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COMPANION TO PPC'S GUIDE TO COMPILATION AND REVIEW ENGAGEMENTS
COURSE 1
ENGAGEMENT ADMINISTRATION FOR COMPILATIONS AND REVIEWS
OVERVIEW
COURSE DESCRIPTION:
This interactive selfstudy course addresses several aspects of compilation and

review engagements. This course is designed to enhance your understanding of
engagement administration related to the performance of compilations and
reviews, including independence issues related to these engagements. Finally,
procedures and checklists for compilations and reviews are presented to ensure
compliance with Statements on Standards for Accounting and Review Services
(SSARS").
PUBLICATION/REVISION
DATE:
August 2007
RECOMMENDED FOR:
Users of PPC's Guide to Compilation and Review Engagements
PREREQUISITE/ADVANCE
PREPARATION:
Basic knowledge of Attest Engagements and Related Reporting Requirements
CPE CREDIT:
8 QAS Hours, 8 Registry Hours

Check with the state board of accountancy in the state in which you are licensed to
determine if it participates in the QAS program and allows QAS CPE credit hours.
This course is based on one CPE credit for each 50 minutes of study time in
accordance with standards issued by NASBA. Note that some states require
100minute contact hours for self study. You may also visit the NASBA website at
FIELD OF STUDY:
Accounting
EXPIRATION DATE:
Postmark by September 30, 2008
KNOWLEDGE LEVEL:
Basic
LEARNING OBJECTIVES:
Lesson 1 Engagement Letters and Workpaper Documentation
Completion of this lesson will enable you to:
Identify SSARS requirements relating to engagement letters.
Design appropriate engagement letters to use in compilation or review engagements.
Produce appropriate workpapers in compilation or review engagements.
Recognize independence issues affecting compilation or review engagements.
Lesson 2 Compilation Procedures and Checklists
Assess the suitability of issuing managementuseonly or thirdparty use financial statements in compilation
engagements.
Summarize the compilation procedures required by SSARS.
Lesson 3 Review Procedures and Checklists
Describe the knowledge required of an accountant to perform a review engagement.
Choose appropriate analytical procedures to perform in a review engagement.
Analyze the necessary elements of a representation letter required in a review engagement.
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TO COMPLETE THIS LEARNING PROCESS:

Send your completed Examination for CPE Credit Answer Sheet, Course Evaluation, and payment to:
Thomson Tax & Accounting
CARTG071 Selfstudy CPE
P.O. Box 966
Fort Worth, TX 76101
See the test instructions included with the course materials for more information.
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Lesson 1:Engagement Letters and Workpaper

Documentation
This lesson discusses the use of engagement letters and other workpapers in compilation and review
engagements, including the requirements of SSARS No. 1, to aid the practitioner in practice administration.
Independence issues with respect to compilation and review engagements are also addressed, including
references to applicable authoritative literature.
Learning Objectives:
Identify SSARS requirements relating to engagement letters.
Design appropriate engagement letters to use in compilation or review engagements.
Produce appropriate workpapers in compilation or review engagements.
Recognize independence issues affecting compilation or review engagements.
ENGAGEMENT LETTERS
Introduction
SSARS No. 1 requires an engagement letter when compiled financial statements are intended for management's
use only and a compilation report will not be issued. SSARS No. 1 does not require an engagement letter for other
engagements involving unaudited financial statements of a nonpublic entity. However, it is generally recommended
that accountants issue engagement letters for all engagements.
Why Engagement Letters?
Engagement letters are advantageous to both the client and the CPA for several reasons, including:
a. Helping to Avoid Client Misunderstanding. In today's environment, an engagement letter is needed for both
old and new clients. To avoid misunderstanding, the engagement letter describes in detail the services to
be rendered, the fee, and the other terms and conditions of the engagement. Oral agreements may result
in differences of recollection or understanding between the CPA and the client.
b. Helping to Avoid Staff Misunderstanding. A copy of the engagement letter in the workpapers provides the
staff of the accounting firm with an authoritative reference to supplement their oral instructions. This will
eliminate confusion and misunderstanding as to the type of engagement to be performed, the date and
period covered by the financial statements, and the nature of the report expected to be rendered.
c. Reducing Potential Legal Liability. Many adverse consequences may result from failing to obtain a written
engagement letter. In the case of services that are new to the client, it is particularly important to obtain
engagement letters as protection against misunderstandings and the lawsuits that may result.
d. Improving Practice Management. Ordinarily, the engagement partner should review the engagement letter
before it is presented to the client. A timely review may be the vehicle that permits the partner to amend
the terms of the engagement, approve the proposed fee and payment schedule, and set up guidelines to
minimize possible collection problems.
e. Clarifying Contractual Obligation. Engagement letters are evidence that a contract is created when an
accountant agrees to render services and a client agrees to pay for them. The engagement letter should
contain a clearcut delineation of the duties and responsibilities of the client and of the CPA firm.
Studies have shown that, although engagement letters are used in most audit engagements (and will be required
under SAS No. 108), they are used in as few as half of compilation engagements. However, the need for engage
ment letters in compilation and review engagements can be even greater in order to prove that the accountant was
not engaged to perform an audit. Failure to obtain such a letter can, in retrospect, be a costly mistake.
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Will We Offend Our Longstanding Clients?

Experience has shown that the majority of clients will not find the engagement letter offensive if presented and
explained in person. The following paragraph explains steps to overcome client resistance. However, if the CPA
determines that it is not advisable to request that the client sign an engagement letter, he may wish to develop the
understanding orally and mail a letter of confirmation. If a confirmation letter is not mailed, the accountant may wish
to document the oral communication in a note or memo to the engagement workpapers. Obviously, neither of these
alternatives has the legal value of a letter signed by the client, but either will document the CPA's efforts to comply
with SSARS No.1 (AR 100).
Overcoming Client Resistance
Most practitioners recognize the merits of using engagement letters, but some find that their clients resist them. The
following steps can be employed to overcome client resistance and avoid damage to client relations:
a. Explain that engagement letters are obtained for all compilation and review engagements; the client should
not think this engagement is unique.
b. Explain the reasons for an engagement letter and that it also benefits management.
c. Review the letter with the client personally. Explain that the engagement letter is intended to help the client
fully understand exactly what the practitioner is doing. It lists any limitations of the practitioner's services
so that the client will not allow important functions to fall between the cracks.
What SSARS No. 1 Requires
Understanding with the Entity When the Financial Statements Are for Thirdparty Use. SSARS No. 1 (AR
100.05) suggests that accountants establish an understanding, preferably in writing, with the client when unaudited
financial statements of a nonpublic entity intended for thirdparty use are involved. (A written communication is
required for SSARS engagements when the compiled financial statements are for managementuseonly, as
discussed in the following paragraph.) According to the SSARS, the understanding should include
a. A description of the nature and limitations of the services.
b. A description of the report the accountant expects to render.
c. A statement that the engagement cannot be relied on to detect errors, fraud, or illegal acts.
d. A statement that the accountant will inform the appropriate level of management of any fraud or material
errors that come to his or her attention and any illegal acts that come to his or her attention, unless they
are clearly inconsequential.
Understanding with the Entity When the Financial Statements Are for Managementuseonly. When the
financial statements are intended for managementuseonly, SSARS No. 1, AR 100.20, requires accountants to
obtain an engagement letter, preferably signed by management, documenting an understanding with the entity
regarding the services to be performed and the use and limitations on the use of those financial statements. The
understanding with the entity should include the following matters:
a. A description of the nature and limitations of the services to be performed.
b. A statement that a compilation is limited to presenting in the form of financial statements information that
is the representation of management.
c. A statement that no opinion or any other form of assurance on the financial statements is (or will be)
provided.
d. A statement that the financial statements will not be audited or reviewed.
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e. An acknowledgment of management's representation and agreement that the financial statements are not
to be used by third parties.
f. A statement that management has knowledge about the nature of the procedures applied and the basis
of accounting and assumptions used in the preparation of the financial statements.
g. A statement that the engagement cannot be relied on to disclose errors, fraud, or illegal acts.
When the financial statements are intended for managementuseonly, SSARS No. 1 also requires the following
communications to be made in the engagement letter, if applicable:
a. A statement that substantially all disclosures (and the statement of comprehensive income and cash flows,
if applicable) required by GAAP or an OCBOA may be omitted.
b. A statement that material departures from GAAP or OCBOA may exist and the effects of those departures,
if any, on the financial statements may not be disclosed.
c. A statement that there is a lack of independence.
d. A reference to the supplementary information submitted with the financial statements.
Additional Matters to Include in the Letter. The following list provides additional matters accountants may wish to
consider including in an engagement letter when financial statements are intended for managementuseonly.
a. Use by Others within the Organization. As previously noted, the definition of management in SSARS No.
1 limits management's ability to share the financial statements with others within the organization who are
not management. Furthermore, as discussed later in this course, use of the financial statements must be
limited to members of management who have knowledge about the nature of the procedures applied and
the basis of accounting or assumptions used in the preparation of the financial statements." That
knowledge must be sufficient to enable users to understand the limitations of the statements and put them
into the proper context.
One way the accountant may approach this issue is by addressing the engagement letter to each member
of management deemed to have sufficient knowledge. Since that would require each member to sign the
letter, however, this option may entail more work than the issue merits.
If members of management who possess such knowledge want to share the financial statements with other
members, it is their responsibility and not the accountant's to determine if those other members are
appropriate recipients of the financial statements. If they lack the requisite knowledge, it is their
responsibility to educate the other members to enable them to understand the potential limitations of the
information before they receive it.
b. Notification of Need for Thirdpartyuse Financial Statements. Some accountants may wish to include in the
letter a statement that management should notify the CPA if there is a need to provide the financial
statements to a third party. Such a statement serves two functions. First, it reinforces the fact that the
managementuseonly financial statements are not appropriate for thirdparty use. Second, it informs the
client that the accountant can provide a SSARS No. 1 report on the financial statements, which would allow
them to be used by third parties.
c. Appropriateness of Financial Statements for Intended Use. Accountants have no responsibility to determine
whether the managementuseonly financial statements are appropriate for management's intended use.
d. Communication of Known Departures. It is generally not recommended that accountants identify known
departures from GAAP or OCBOA in their engagement letters. It is, however, recommended that
accountants include language in the engagement letter to clarify that the accountant is not responsible for
communicating known departures from GAAP or OCBOA.
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e. Restriction on Distribution. If accountants discover that managementuseonly financial statements have

been distributed to (and, thus, are being used by) third parties, SSARS No. 1 requires that accountants
discuss the issue with the client and ask that they have the statements returned. For that reason,
accountants should add additional language in the engagement letter to clarify that management also
agrees to not distribute the financial statements to thirdparty users.
Risk of Oneway Communication. Although SSARS No. 1 expresses a preference for a signed engagement letter in
a compilation of managementuseonly financial statements, it does not require management's signature. There
are risks with issuing a oneway communication in that situation. Certain of the matters required to be communi
cated are management representations. For example, the understanding with the client is required to include a
statement that (a) management is responsible for the entity's financial statements and (b) management has
acknowledged its representations and agrees that the financial statements are not to be used by third parties. Thus,
a communication that does not require a management signature may be inadequate. For that reason, it is generally
recommended that accountants always obtain a signed engagement letter when compiling managementuseonly
financial statements.
Engagement Letters When Reporting on Specified Elements or Pro Forma Financial Information SSARS
Nos. 13 and 14
SSARS No. 13 (AR 110.06) suggests that accountants should establish an understanding, preferably in writing,
with the client when the accountant is engaged to compile, or otherwise issues a compilation report on, one or
more specified elements, accounts, or items of a financial statement. SSARS No. 14 (AR 120.09) suggests that
accountants should establish an understanding, preferably in writing, with the client when the accountant is
engaged to compile, or otherwise issues a compilation report on, pro forma financial information. According to both
SSARS No. 13 and SSARS No. 14, the understanding should include
a. A description of the nature and limitations of the services.
c. A statement that the engagement cannot be relied on to detect errors, fraud, or illegal acts.
d. A statement that the accountant will inform the appropriate level of management of any fraud or material
errors that come to his or her attention and any illegal acts that come to his or her attention, unless they
are clearly inconsequential.
Period Covered by the Engagement Letter
If accountants plan to document their communication with the client via an engagement letter, do they need to
obtain a new letter every year? Although the standard does not address that issue specifically, many accountants
meet with their clients and update their engagement understandings at least annually. Doing so and documenting
the understanding in an engagement letter ensures that it (a) reflects the scope of services the accountants are
currently providing and (b) contains all legal protection clauses available to the accountants. Since virtually all
accountants today utilize computers as a part of their daily routine, the generation of annual engagement letters
requires little time.
Other accountants have adopted the practice of issuing one engagement letter to cover the current engagement as
well as any subsequently performed for a client. Those accountants obtain an engagement letter in the year in
which they are first engaged to provide services for the client; however, they do not require a new letter in each
subsequent year unless circumstances change.
SSARS No. 1 also does not address whether one engagement letter can be used to describe all of the services the
accountants will provide to a client. However, in general one engagement letter can cover multiple services. For
instance, obtaining an engagement letter for each monthly financial statement that a firm compiles or reviews is
unnecessary.
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Using Engagement Letters to Minimize Liability

If an accountant does not comply with SSARS in a compilation or review engagement, a client may be successful
in recovering damages suffered based on the accountant's actions under contract or tort law. According to tort law
concepts, the client ordinarily will be successful in suing the accountant if he can establish fraud, constructive
fraud, or negligence.
One way to minimize liability is to obtain an engagement letter. The engagement letter is an invaluable loss
prevention/loss mitigation measure. When a dispute arises between the accountant and the client regarding
services for which the client has contracted, the burden of proof is on the accountant to prove that the agreement
was for a lower service (compilation and review), not an audit.
Despite the language included in the engagement letters, however, practitioners should always remember that
there are three assertions implied in a compilation report (notwithstanding the disclaimer in that report):
a. The accountant does not know of any circumstances or evidence that indicates that the financial
statements may be materially misleading or false.
b. If the financial statements omit substantially all disclosures, such omission was not undertaken with the
intent to mislead users.
c. The accountant has no reason to believe that the financial statements do not follow GAAP or OCBOA.
An accountant should not issue a compilation report without considering these three assertions. It should be
recognized that compilation engagements are not risk free. In fact, based on malpractice insurance claims, a
compilation is the most likely engagement in which a CPA firm's quality of work will be called into question.
Additional Engagement Letter Provisions for Limiting a Firm's Liability
There are a number of additional provisions that CPAs may want to add to their engagement letters. The use of
some of these provisions is becoming common. They can be very effective at limiting a firm's legal liability and
assisting a firm to resolve client disputes in a costeffective manner. Those additional provisions are discussed in
the following paragraphs.
Release from Claims Because of Management Representations. Some accounting firms include provisions in
their engagement letters requiring the client to indemnify them in the event that they are sued by a third party for
unidentified risks resulting from false representations made to the accounting firm by members of client's manage
ment. Although AICPA Ethics Ruling No. 94 concludes that such clauses do not impair a firm's independence, the
SEC has taken the position that this type of arrangement does impair the accounting firm's independence.
Accordingly, indemnification provisions (and other provisions limiting a firm's liability exposure) should only be
used for nonSEC engagements. Many large firms are now including them in nonpublic client engagement letters,
and at least one court has expressly upheld and enforced the provision. The following is an example of this type of
provision (which should only be used for nonpublic companies):
During the course of our engagement, we will request information and explanations from man
agement regarding the company's operations, future plans, specific transactions, and account
ing systems and procedures. At the conclusion of our engagement, we will require, as a
precondition to the issuance of our report, that management will provide certain representations
in a written representation letter. The procedures we will perform in our engagement and the
conclusions we reach as a basis for our report will be heavily influenced by the written and oral
representations that we receive from management. In view of the foregoing, the company agrees
to release our firm and its personnel from any liability and costs relating to our services under this
letter resulting from false or misleading representations made to us by any member of the
company's management.
Alternatively, the firm may elect to add the following sentences in place of the last sentence of the clause.
Accordingly, false representations could cause us to expend unnecessary efforts or could cause
a material error or a fraud to go undetected by our procedures. In view of the foregoing, you agree
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that we shall not be responsible for any misstatements in the company's financial statements that
we may fail to detect as a result of false or misleading representations that are made to us by
management.
AICPA Ethics Ruling No. 94 currently concludes that such additional engagement letter provisions do not impair a
firm's independence. However, the AICPA's Professional Ethics Executive Committee has issued an exposure draft
of a proposed ethics interpretation, Indemnification, Limitation of Liability, and ADR Clauses in Engagement
Letters," under Rule 101, Independence, that provides guidance to members on the impact that certain indemnifi
cation and limitation of liability provisions may have on a member's independence when included in engagement
letters or other client agreements. The proposed interpretation would delete Ethics Ruling No. 94. In general, the
proposed interpretation would place restrictions on certain indemnification or limitation of liability clauses that
would be considered to impair the auditor's independence. Finally, there is an additional question whether these
clauses would be enforced by a court and, if enforced, how they would be interpreted. As a result, caution should
be exercised when an accountant considers using indemnification or limitation of liability provisions. It is generally
recommended that accountants consult with their legal counsel and insurance carrier when considering the use of
such language in the engagement letter.
Alternative Dispute Resolution. Alternative dispute resolution (ADR) is a popular way of attempting to resolve
client disputes without exposing the firm to the cost and uncertainty of litigation. ADR generally takes less time than
litigation and provides a better chance of preserving the client/auditor relationship. ADR techniques apply primarily
to client disputes (for example, fee disputes) rather than thirdparty claims because the engagement letter is a
twoparty contract and does not bind thirdparty users.
Arbitration is perhaps the oldest form of ADR. It closely resembles litigation and is usually presided over by an
attorney. In an arbitration, the parties present their respective cases to an arbitrator (or panel of arbitrators) who
renders a verdict at the conclusion of the case. The arbitrator acts as both judge and jury by making evidentiary
rulings, ordering discovery, and imposing sanctions in addition to deciding the issues in the case.
While arbitration may sometimes represent an attractive alternative to litigation, it has some significant drawbacks.
First, arbitrators sometimes tend to simply split the difference between the two parties' claims. Second, there is no
guarantee that a client who does not like the arbitrator's decision cannot have it overturned in court. Third, and most
importantly, a firm's agreement, without the consent of its insurance carrier, to submit to binding arbitration may
limit the insurer's ability to defend the case and void the firm's insurance coverage for that claim. Before adding
language regarding arbitration or other alternative dispute resolution methods to engagement letters, accountants
should consult with their attorney and should obtain a written consent from their insurance carrier.
Another wellknown ADR technique is mediation. While mediation is often discussed along with arbitration, it is a
vastly different process. In mediation, no resolution is imposed on the disputing parties by a neutral party. Instead,
mediation is little more than voluntary settlement negotiations facilitated by a neutral party. Mediation is a highly
successful and satisfactory means of resolving disputes and is generally embraced by all professional liability
insurers because it usually results in a speedier and less costly resolution of liability claims.
Mediation frequently succeeds when negotiations fail for a number of reasons, including the following:
The parties are brought into the settlement discussions so they can hear firsthand (not through their
attorneys) the strengths and weaknesses of their opponent's case.
The discussion takes place in a controlled atmosphere that prevents the parties from storming out of the
discussions at the first sign of disagreement.
Mediations are not about winning or losing, but rather about finding a resolution that is better than the result
likely to be achieved through litigation.
By communicating through the mediator, the parties are able to reach compromises that are not possible
where neither party is willing to blink first for fear of showing weakness.
Because mediation is about reaching agreement and because the parties spend little time together in facetoface
meetings, there is an opportunity for the parties to resolve their differences without destroying their business
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relationship. One of the main advantages of mediation is that it allows a CPA firm to resolve client claims without
destroying the accountantclient relationship.
The principal weakness of mediation is that it does not always resolve the claim. The following language can be
inserted into an engagement letter to provide for use of an alternative dispute resolution method in cases where
there is a dispute with a client.
If any dispute, controversy, or claim arises, either party may, upon written notice to the other party,
request that the matter be mediated. Such mediation will be conducted by a mediator appointed
by and pursuant to the Rules of the American Arbitration Association or such other neutral
facilitator acceptable to both parties. Both parties will exert their best efforts to discuss with each
other in good faith their respective positions in an attempt to finally resolve such dispute or
controversy.
Each party may disclose any facts to the other party or to the mediator which it, in good faith,
considers necessary to resolve the matter. All such discussions, however, will be for the purpose
of assisting in settlement efforts and will not be admissible in any subsequent litigation against the
disclosing party. Except as agreed by both parties, the mediator will keep confidential all informa
tion disclosed during negotiations. The mediator may not act as a witness for either party in any
subsequent arbitration between the parties.
The mediation proceedings will conclude within sixty days from receipt of the written notice
unless extended or terminated sooner by mutual consent. Each party will be responsible for its
own expenses. The fees and expenses of the mediator, if any, will be borne equally by the parties.
If any dispute, controversy, or claim cannot be resolved by mediation, then the dispute, contro
versy, or claim will be settled by arbitration in accordance with the Rules of the American Arbitra
tion Association (AAA) for the Resolution of Accounting Firm Disputes. No prehearing discovery
will be permitted unless specifically authorized by the arbitration panel. The arbitration hearings
will take place in the city closest to the place where this agreement was performed in which the
AAA maintains an office, unless the parties agree to a different locale.
The award issued by the arbitration panel may be confirmed in a judgment by any federal or state
court of competent jurisdiction. All reasonable costs of both parties, as determined by the
arbitrators, including (1) the fees and expenses of the AAA and the arbitrators and (2) the costs,
including reasonable attorneys' fees, necessary to confirm the award in court, will be borne
entirely by the nonprevailing party (to be designated by the arbitration panel in the award) and
may not be allocated between the parties by the arbitration panel.
Such arbitration shall be binding and final. In agreeing to arbitration, we both acknowledge that
in the event of a dispute over fees charged by the accountant, each of us is giving up the right to
have the dispute decided in a court of law before a judge or jury and instead we are accepting the
use of arbitration for resolution.
Specifying a Time Limitation. A CPA firm can also limit its liability exposure by including a provision requiring that
all claims with respect to services be asserted within a specified period of time, such as one year from the date the
subject services were performed. This limitation provision will protect the firm from a substantial portion of claims
arising out of fraud as well as frivolous counterclaims in the event that the firm is required to sue a client for unpaid
professional fees. A sample of this provision follows:
Because there are inherent difficulties in recalling or preserving information as the period after an
engagement increases, you agree that, notwithstanding the statute of limitations of the State of
[Fill in client's state of domicile.], any claims based on this engagement must be filed within
[12] months after performance of our service, unless you have previously provided us with a
written notice of a specific defect in our services that forms the basis of the claim.
PEEC has issued an exposure draft of a proposed ethics interpretation (discussed previously in this course), which
would cause a member's independence to be impaired if a member tries to impose such a time limitation.
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If a CPA firm wishes to utilize any of the preceding clauses to limit its liability, the firm should consult its legal counsel
and its insurance carrier. In addition, it is important that the client take note of the clauses before signing and
returning the engagement letter. Otherwise, there is a danger that the courts may be unwilling to enforce the
provisions. This means the CPA firm either points out such clauses to the client when the engagement letter is
delivered or types such clauses in bold print and/or capital letters so that they will stand out from the remainder of
the engagement letter.
Informing Clients of Outsourcing Arrangements
In general, it will be rare for accounting firms to outsource portions of compilation or review engagements.
However, firms often will outsource other services which might be covered by their compilation or review engage
ment letter, such as tax services. Ethics Ruling 112 (ET 191.224.225) under Rule 102, Integrity and Objectivity,
requires that clients be informed, preferably in writing, if the practitioner's firm will outsource professional services
to thirdparty service providers. If the practitioner intends to use thirdparty service providers (that is, entities not
controlled or employed by the accounting firm), the client must be informed before confidential client information
is shared with the service provider. Also, revised Ethics Ruling No. 1 (ET 391.001.002) under Rule 301, Confidential
Client Information, states that if the accounting firm does not enter into a contractual agreement with the thirdparty
service provider requiring the party (1) to maintain the confidentiality of the client's information and (2) to have
procedures in place to prevent unauthorized release of confidential information, the accounting firm must obtain
the client's consent to disclose the client's confidential information to the thirdparty service provider.
In cases where the practitioner chooses to provide written disclosure that a thirdparty service provider will be used,
the following paragraph may be included in the engagement letter.
We may from time to time, and depending on the circumstances, use certain thirdparty service
providers to assist us in serving your account. We may share confidential information about you
with the service providers, but remain committed to maintaining the confidentiality and security of
your information. Accordingly, we maintain internal policies, procedures, and safeguards to
protect the confidentiality of your personal information. In addition, we will secure confidentiality
agreements with all service providers to maintain the confidentiality of your information and we
will take reasonable precautions to determine that they have appropriate procedures in place to
prevent the unauthorized release of your confidential information to others. In the event that we
are unable to secure an appropriate confidentiality agreement, you will be asked to provide your
consent prior to the sharing of your confidential information with the thirdparty service provider.
Furthermore, we will remain responsible for the work provided by any such thirdparty service
providers.
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SELFSTUDY QUIZ
Determine the best answer for each question below. Then check your answers against the correct answers in the
following section.
1. For which of the following engagements does SSARS No. 1 require an engagement letter?
a. When compiled financial statements are intended for management's use only and a compilation report will
be issued.
b. When reviewed financial statements are intended for management's use only.
c. When compiled financial statements are intended for management's use only and a compilation report will
not be issued.
d. When reviewed financial statements are intended for thirdparty and management's use.
2. What is the most important way engagement letters help to avoid misunderstandings on the part of the staff
of the accounting firm?
a. By specifying the fee structure to avoid misunderstandings between the firm and the client.
b. By describing in detail the services to be rendered to eliminate confusion as to the type of engagement
to be performed.
c. By protecting the firm against misunderstandings from which lawsuits could result.
d. By delineating clearcut duties and responsibilities on the part of the client and the firm indicating a contract
has been created.
3. Why might the need for engagement letters in compilation and reviews be greater than for audit engagements?
a. In order to establish a description of the nature and limitations of the services.
b. In order to prove that the accountant was not engaged to perform an audit.
c. In order to allow the engagement partner to amend the terms of the engagement at a later date, if
necessary.
d. In order to inform management as to the nature of the procedures applied and basis of accounting and
assumptions used in the preparation of the financial statements.
4. According to SSARS No. 1, which of the following elements should be present in an engagement letter for
BOTH when the financial statements are for thirdparty use AND when the financial statements are for
managementuseonly?
a. A statement that the engagement cannot be relied on to detect errors, fraud, or illegal acts.
c. A statement that the financial statements will not be audited and reviewed.
d. A statement that no opinion or any other form of assurance on the financial statements is (or will be)
provided.
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5. In an engagement letter for a compilation or review engagement for managementuseonly, what is the most
important aspect of including an acknowledgement of management's representation and agreement that the
financial statements are not to be used by third parties?"
a. The statement improves practice management by ensuring the financial statements are not distributed to
unrelated third parties.
b. The statement helps avoid staff misunderstanding by communicating to the staff for whom the financial
statements will be prepared.
c. The statement avoids misunderstanding with the client regarding the nature and limitations of the services
to be provided.
d. The statement reduces the potential legal liability of the firm should the client distribute the financial
statements to others within the organization.
6. When financial statements are intended for managementuseonly, SSARS No.1 requires what additional
communications, if applicable, in the engagement letter?
a. A description of the report the accountant expects to render.
b. A statement that there is a lack of independence.
c. A statement that accountants will discuss the distribution of financial statements to thirdparty users at
management's discretion.
d. A statement that a compilation is limited to presenting in the form of financial statements information that
7. Which of the following assertions is implied in a compilation report?
a. The engagement cannot be relied on to disclose errors, fraud, or illegal acts.
b. Management has knowledge about the nature of the procedures applied and the basis of accounting and
assumptions used in the preparation of the financial statements.
c. The financial statements will not be audited or reviewed.
d. The accountant has no reason to believe that the financial statements do not follow GAAP or OCBOA.
8. Based on malpractice insurance claims, during which engagement is a CPA firm's quality of work most likely
to be called into question?
a. Audit and other attestation engagements.
b. Reviews.
c. Compilations.
9. Which of the following additional provisions can be used to limit a firm's liability in an engagement letter for
nonSEC engagements only?
a. Release from Claims Because of Management Representations.
b. Alternate Dispute Resolution.
c. Specifying a Time Limitation.
d. Informing a Client of Outsourcing Arrangements.
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10. Which of the following is a disadvantage of using arbitration as a means of alternative dispute resolution?
a. Arbitration is little more than negotiation of a voluntary settlement facilitated by a neutral party.
b. The arbitration process preserves the client relationship because the parties spend little time together in
facetoface meetings.
c. There is no guarantee that a client who does not like the arbitrator's decision cannot have it overturned in
court.
d. Past experience indicates that success rates in resolving client disputes are lower using the arbitration
process as opposed to litigation.
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SELFSTUDY ANSWERS
This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the
appropriate material. (References are in parentheses.)
1. For which of the following engagements does SSARS No. 1 require an engagement letter? (Page 3)
a. When compiled financial statements are intended for management's use only and a compilation report will
be issued. (This answer is incorrect. SSARS No. 1 does not require an engagement letter when compiled
financial statements are intended for management's use only and a compilation report will be issued.)
b. When reviewed financial statements are intended for management's use only. (This answer is incorrect.
SSARS No. 1 does not require an engagement letter when reviewed financial statements are intended for
management's use only.)
c. When compiled financial statements are intended for management's use only and a compilation
report will not be issued. (This answer is correct. SSARS No. 1 requires an engagement letter when
compiled financial statements are intended for management's use only and a compilation report will
not be issued.)
d. When reviewed financial statements are intended for thirdparty and management's use. (This answer is
incorrect. SSARS No. 1 does not require an engagement letter when reviewed financial statements are
intended for thirdparty and management's use.)
2. What is the most important way engagement letters help to avoid misunderstandings on the part of the staff
of the accounting firm? (Page 3)
a. By specifying the fee structure to avoid misunderstandings between the firm and the client. (This answer
is incorrect. Details of the fee structure assist the partner of the firm in minimizing potential collection
issues.)
b. By describing in detail the services to be rendered to eliminate confusion as to the type of
engagement to be performed. (This answer is correct. A copy of the engagement letter in the
workpapers provides the staff of the accounting firm with an authoritative reference to supplement
their oral instructions.)
c. By protecting the firm against misunderstandings from which lawsuits could result. (This answer is
incorrect. Engagement letters assist in protecting the firm from potential lawsuits.)
d. By delineating clearcut duties and responsibilities on the part of the client and the firm, indicating a
contract has been created. (This answer is incorrect. Engagement letters establish the contractual nature
of the engagement, which assist the firm and the client in identifying their respective responsibilities.)
3. Why might the need for engagement letters in compilation and reviews be greater than for audit engagements?
(Page 3)
a. In order to establish a description of the nature and limitations of the services. (This answer is incorrect.
Establishing the nature and limitations of the services to be rendered is an element of engagement letters
for compilation, review, and audit engagements.)
b. In order to prove that the accountant was not engaged to perform an audit. (This answer is correct.
An engagement letter for compilations and reviews can be used to prove the accountant was not
engaged to perform an audit, thereby avoiding costly potential legal action.)
c. In order to allow the engagement partner to amend the terms of the engagement at a later date, if
necessary. (This answer is incorrect. Allowing the engagement partner to amend the terms of the
engagement is an advantage of engagement letters for compilation, review, and audit engagements.)
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d. In order to inform management as to the nature of the procedures applied and basis of accounting and
assumptions used in the preparation of the financial statements. (This answer is incorrect. Informing
management as to the nature of the procedures applied and basis of accounting and assumptions used
in the preparation of financial statements is an element of engagement letters for compilation, review, and
audit engagements.)
4. According to SSARS No. 1, which of the following elements should be present in an engagement letter for
BOTH when the financial statements are for thirdparty use AND when the financial statements are for
managementuseonly? (Page 4)
a. A statement that the engagement cannot be relied on to detect errors, fraud, or illegal acts. (This
answer is correct. According to SSARS No.1, this element of an engagement letter should be
included in engagements when the financial statements are for thirdparty use and when the
financial statements are for managementuseonly.)
b. A description of the report the accountant expects to render. (This answer is incorrect. According to SSARS
No. 1, this element should be included in an understanding when the financial statements are for thirdparty
use.)
c. A statement that the financial statements will not be audited and reviewed. (This answer is incorrect.
According to SSARS No. 1, this element should be included in an understanding when the financial
statements are for managementuseonly.)
d. A statement that no opinion or any other form of assurance on the financial statements is (or will be)
provided. (This answer is incorrect. According to SSARS No. 1, this element should be included in an
understanding when the financial statements are for managementuseonly.)
5. In an engagement letter for a compilation or review engagement for managementuseonly, what is the most
important aspect of including an acknowledgement of management's representation and agreement that the
financial statements are not to be used by third parties?" (Page 4)
a. The statement improves practice management by ensuring the financial statements are not distributed to
unrelated third parties. (This answer is incorrect. The statement does not ensure the financial statements
are not distributed to unrelated third parties, only that management is aware the financial statements are
not to be used by third parties.)
b. The statement helps avoid staff misunderstanding by communicating to the staff for whom the financial
statements will be prepared. (This answer is incorrect. While the statement does indicate to staff for whom
the financial statements are prepared, this is not the most important aspect when considering inclusion
of this element.)
c. The statement avoids misunderstanding with the client regarding the nature and limitations of the services
to be provided. (This answer is incorrect. The statement indicates for whom the financial statements will
be prepared, not the nature and limitations of the services to be provided.)
d. The statement reduces the potential legal liability of the firm should the client distribute the financial
statements to others within the organization. (This answer is correct. Failure to obtain an
acknowledgement by management that the financial statements are not to be used by third parties,
including others within the organization, could result in misunderstandings and resulting lawsuits.)
6. When financial statements are intended for managementuseonly, SSARS No.1 requires what additional
communications, if applicable, in the engagement letter? (Page 5)
a. A description of the report the accountant expects to render. (This answer is incorrect. SSARS No. 1
recommends this statement be included in an engagement letter when the financial statements are for
thirdparty use.)
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b. A statement that there is a lack of independence. (This answer is correct. SSARS No. 1 requires this
statement in the engagement letter, if applicable.)
c. A statement that accountants will discuss the distribution of financial statements to thirdparty users at
management's discretion. (This answer is incorrect. SSARS No. 1 requires that if accountants discover that
managementuseonly financial statements have been distributed to third parties, accountants discuss the
issue with the client and ask that they have the statements returned.)
d. A statement that a compilation is limited to presenting in the form of financial statements information that
is the representation of management. (This answer is incorrect. SSARS No. 1 recommends this statement
be included in a standard engagement letter when the financial statements are for managementuseonly.)
7. Which of the following assertions is implied in a compilation report? (Page 7)
a. The engagement cannot be relied on to disclose errors, fraud, or illegal acts. (This answer is incorrect. This
statement is expressly indicated in the engagement letter with the client.)
b. Management has knowledge about the nature of the procedures applied and the basis of accounting and
assumptions used in the preparation of the financial statements. (This answer is incorrect. This statement
is expressly indicated in the engagement letter with the client.)
c. The financial statements will not be audited or reviewed. (This answer is incorrect. This statement is
expressly indicated in the engagement letter with the client.)
d. The accountant has no reason to believe that the financial statements do not follow GAAP or
OCBOA. (This answer is correct. This assertion is implied in all compilations reports and should be
considered by the accountant when compilation reports are being prepared.)
8. Based on malpractice insurance claims, during which engagement is a CPA firm's quality of work most likely
to be called into question? (Page 7)
a. Audit and other attestation engagements. (This answer is incorrect. Based on malpractice claims, audits
and attest engagements are not the most likely work of an accountant to be called into question.)
b. Reviews. (This answer is incorrect. Based on malpractice claims, review engagements are not the most
likely work of an accountant to be called into question.)
c. Compilations. (This answer is correct. Due to misunderstandings on the part of the CPA firm and
client management as to the nature of compilations, these engagements result in higher numbers
of malpractice claims.)
9. Which of the following additional provisions can be used to limit a firm's liability in an engagement letter for
nonSEC engagements only? (Page 7)
a. Release from Claims Because of Management Representations. (This answer is correct. Although
an AICPA ethics ruling concludes that such clauses do not impair a firm's independence, the SEC
has taken the position that this type of arrangement does impair the accounting firm's
independence. Therefore, this provision should only be used in nonSEC engagements.)
b. Alternate Dispute Resolution. (This answer is incorrect. Alternate dispute resolution may be used in
engagement letters for SEC and nonSEC engagements to limit a firm's legal liability.)
c. Specifying a Time Limitation. (This answer is incorrect. Specifying a time limitation may be used in
engagement letters for SEC and nonSEC engagements to limit a firm's legal liability. However,
accountants should consult with their legal counsel and insurance carrier when considering the use of
such language.)
d. Informing a Client of Outsourcing Arrangements. (This answer is incorrect. Informing a client of
outsourcing arrangements may be used in engagement letters for SEC and nonSEC engagements to limit
a firm's legal liability.)
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10. Which of the following is a disadvantage of using arbitration as a means of alternative dispute resolution?
(Page 8)
a. Arbitration is little more than negotiation of a voluntary settlement facilitated by a neutral party. (This answer
is incorrect. Mediation is little more than negotiation of a voluntary settlement facilitated by a neutral party.)
b. The arbitration process preserves the client relationship because the parties spend little time together in
facetoface meetings. (This answer is incorrect. The mediation process preserves the client relationship
because the parties spend little time together in facetoface meetings.)
c. There is no guarantee that a client who does not like the arbitrator's decision cannot have it
overturned in court. (This answer is correct. Since a client can attempt to overturn the arbitrator's
decision in court, the process sometimes results in the inefficient use of additional resources to
resolve a claim.)
d. Past experience indicates that success rates in resolving client disputes are lower using the arbitration
process as opposed to litigation. (This answer is incorrect. In fact, arbitrators tend to simply split the
difference between the two parties' claims.)
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WORKPAPER DOCUMENTATION
Required and Suggested Workpapers for a Review Engagement
Workpaper documentation for review engagements is discussed briefly in SSARS No. 1 (AR 100.35.38). It does
not specify the form and content of the documentation but states that the following should be documented:
a. Any findings or issues that in the accountant's judgment are significant.
b. The matters covered in the accountant's inquiry procedures.
c. The analytical procedures performed.
d. The expectations, where significant expectations are not otherwise readily determinable from the
documentation of the work performed, and factors considered in the development of those expectations.
e. Results of the comparison of the expectations to the recorded amounts or ratios developed from recorded
amounts.
f. Any additional procedures performed in response to the significant unexpected differences arising from
the analytical procedure and the results of such additional procedures.
g. Unusual matters that the accountant considered during the performance of the review procedures,
including their disposition.
h. Communications, whether oral or written, to the appropriate level of management regarding fraud or illegal
acts that come to the accountant's attention.
i. The representation letter.
In general, the following items, at a minimum, should be included in the CPA's workpapers for a review engagement
in order to support compliance with the major requirements of SSARS No.1 (AR100):
a. Engagement letter.
b. Checklist or memorandum describing the CPA's knowledge of the client's business and industry.
c. Checklist, work program, and matters covered in inquiry procedures, including names of persons
responding to inquiries.
d. Documentation of the analytical procedures performed, expectations, factors considered in the
development of the expectations, results of comparison between expected and actual amounts, and any
additional procedures performed in response to significant unexpected differences arising from the
analytical procedures.
e. Support for data in notes to the financial statements.
f. Discussion of unusual matters encountered.
g. Documentation of any findings or issues that in the CPA's judgment are significant.
h. Documentation of communications, whether oral or written, to the appropriate level of management
regarding fraud or illegal acts that come to the accountant's attention.
i. Representation letter.
j. Compilation workpapers, if the CPA compiles statements preparatory to review.
k. Copies of reports from other accountants who have audited or reviewed a subsidiary, etc.
l. Reasons for a stepdown in level of service from an audit, if any.
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Required and Suggested Workpapers for a Compilation of Thirdpartyuse Financial Statements

SSARS No. 1 (AR 100) does not include any required workpaper documentation for a thirdpartyuse compilation
engagement. However, at a minimum, the CPA's workpapers for such a compilation engagement should generally
include the following:
a. Engagement letter.
b. Checklist or memorandum describing knowledge of the client's business and industry.
c. Documentation that the CPA read the compiled financial statements.
d. Working trial balance, adjustments, and other workpapers necessary to bridge the gap from the client's
accounting records to the compiled financial statements.
e. Support for data in notes to the financial statements.
f. Discussion of unusual matters encountered.
g. Documentation of communications, whether oral or written, to the appropriate level of management
regarding fraud or illegal acts that come to the accountant's attention.
h. Reasons for a stepdown in level of service from an audit or a review, if any.
Required and Suggested Workpapers for a Managementuseonly Compilation Engagement
SSARS No. 1 (AR 100) does not discuss workpaper documentation for a managementuseonly compilation
engagement. When considering the nature and extent of workpapers to prepare for such an engagement, however,
accountants might want to consider the workpapers for a thirdpartyuse compilation engagement listed in the
preceding paragraph. Accountants are not, however, bound by that listing. Accountants performing a manage
mentuseonly compilation engagement should consider retaining, at a minimum, the engagement letter, proce
dures checklist, and copies of financial statements submitted to the client.
Documentation Requirements for Nonattest Services
ET Interpretation 1013, Performance of Nonattest Services," requires accountants who perform nonattest ser
vices for their compilation or review clients to document in writing their understanding with their client. The
Interpretation does not specify how the written understanding is to be documented, so the accountant has
flexibility. For example, the understanding might be documented in a separate engagement letter, in the workpa
pers, in an internal memo, or in the engagement letter obtained in conjunction with the compilation or review.
Workpaper Retention Requirements
SSARS does not address or establish requirements for the retention of compilation or review workpapers. In the
wake of the SarbanesOxley Act of 2002, which requires that the workpapers for public company audit clients be
maintained for seven years, some states have adopted sevenyear retention periods applicable to both public and
nonpublic company attest engagements (defined in the Uniform Accountancy Act as including SAS audits, SSARS
reviews, and examinations of prospective financial statements). In addition, the National Association of State
Boards of Accountancy (NASBA) amended the Uniform Accountancy Act (UAA) to include a sevenyear record
retention requirement. NASBA has issued an exposure draft of modifications to the UAA Model Rules that would
require a fiveyear retention period unless otherwise specified by professional standards.
In addition, the AICPA issued SAS No. 103, Audit Documentation, which supersedes SAS No. 96. This statement
expands the auditor's documentation requirements and provides guidance on revisions to audit documentation
made after the date of the auditor's report. The statement provides a 60day period following delivery of the
auditor's report to the client during which the audit engagement file should be completed, and a fiveyear docu
ment retention period. In determining workpaper retention policies, firms should be aware of the requirements of
the new SAS. If firms perform audits, they will likely want to have similar workpaper retention requirements for
compilations and reviews; if they do not perform audits, they may still choose to consider the audit requirements.
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Retention Location. Accountants who perform compilation or review services for a client often perform other
nonattest services, such as tax return preparation or bookkeeping services, or other attest services for the same
client. In these instances, the question often arises regarding where the accountant who performs these multiple
services for a client should file the workpapers. In other words, should all of the workpapers related to a client be
filed together, should separate complete files be maintained for each type of service, or can the files for each type
of service share some documents? Additionally, if a portion of the workpapers are electronic with the remaining
portion being manual, how should the workpapers be filed?
In general, neither the format or the location are relevant. It is only important that the accountant retain all of the
required documentation and be able to locate this documentation when it is necessary (i.e, peer review, court order,
use in subsequent years, etc.). Best practices would suggest that although accountants may maintain separate
files for engagements performed for an individual client, the accountant should store all of the engagement work
related to an individual client together. In addition, best practices would also suggest that each manual workpaper
related to a predominately electronic engagement should be listed in the electronic workpaper index as an external
workpaper.
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SELFSTUDY QUIZ
following section.
11. Which of the following elements are suggested for inclusion in the workpapers for review, compilation for
thirdpartyuse, AND compilation for managementuseonly engagements?
a. The analytical procedures performed.
c. Results of the comparison of the expectations to the recorded amounts or ratios developed from recorded
amounts.
d. Documentation that the CPA read the compiled financial statements.
12. Three of the following answer choices illustrate documentation required to be included in review
workpapers pursuant to SSARS No. 1. Which of the following is recommended for inclusion in review
workpaper documentation?
a. Communications, whether oral or written, to the appropriate level of management regarding fraud or illegal
acts that come to the accountant's attention.
b. Representation letter.
c. The matters covered in the accountant's inquiry procedures.
d. Engagement letter.
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SELFSTUDY ANSWERS
11. Which of the following elements are suggested for inclusion in the workpapers for review, compilation for
thirdpartyuse, AND compilation for managementuseonly engagements? (Page 18)
a. The analytical procedures performed. (This answer is incorrect. Analytical procedures are performed in
review and audit engagements only. Therefore, they would not be included in the workpapers of a
compilation engagement.)
(This answer is correct. This element is suggested for inclusion in the workpapers of all three types
of engagements.)
c. Results of the comparison of the expectations to the recorded amounts or ratios developed from recorded
amounts. (This answer is incorrect. The results of comparisons are related to analytical procedures, which
are performed in review and audit engagements only. Therefore, they would not be included in the
workpapers of a compilation engagement.)
d. Documentation that the CPA read the compiled financial statements. (This answer is incorrect. Such
documentation is only suggested in the case of compilation engagements, not reviews.)
12. Three of the following answer choices illustrate documentation required to be included in review
workpapers pursuant to SSARS No. 1. Which of the following is recommended for inclusion in review
workpaper documentation? (Page 18)
a. Communications, whether oral or written, to the appropriate level of management regarding fraud or illegal
acts that come to the accountant's attention. (This answer is incorrect. According to SSARS No. 1,
communications should be included in workpaper documentation for review engagements.)
b. Representation letter. (This answer is incorrect. According to SSARS No. 1, a representation letter is
required documentation included in workpaper documentation for review engagements.)
c. The matters covered in the accountant's inquiry procedures. (This answer is incorrect. According to
SSARS No. 1, documentation of the accountant's inquiry procedures should be included in workpaper
documentation for review engagements.)
d. Engagement letter. (This answer is correct. While an engagement letter is not required by SSARS
No.1 in a review engagement, its use and inclusion in the workpapers for a review engagement is
recommended.)
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INDEPENDENCE ISSUES RELATING TO COMPILATION AND REVIEW

ENGAGEMENTS
Independence is an important issue for many small practitioners because the only type of report a CPA can issue
on financial statements when he or she is not independent is a compilation report. However, independence is much
easier to define than to apply. An infinite variety of situations can occur that raise questions regarding indepen
dence issues but are not necessarily independence problems. Therefore, it is important for CPAs to understand the
various rules and regulations that govern independence. The following paragraphs discuss the authoritative
literature relating to independence and provide some examples of client services or situations that might impair an
accountant's independence.
Authoritative Literature Relating to Independence
The primary rules governing independence are found in the AICPA Code of Professional Conduct (Conduct Code).
It is generally recommended that the CPA read Rule 101 of the Conduct Code, the interpretations of Rule101, and
the independence rulings for guidance concerning independence. This guidance can be found in the AICPA
Professional Standards, ET Sections101 and 191. [PPC's Guide to Quality Control provides an Independence,
Integrity and Objectivity Questionnaire" that covers each of the independence interpretations and rulings. That
Guide may be ordered by calling (800)3238724 or via PPC's website at ppc.thomson.com.]
Independence requirements also can be found in the SSARS, statements on auditing standards, and statements
on standards for attestation engagements. While the authoritative literature governing these various types of
engagements contains a great deal of discussion about the concepts of independence, identifying independence
problems, and about resolving nonindependence situations, the basic concept of independence is the same
regardless of the level of service or the type of engagement. Basically, accountants are independent if they are free
from obligation to or interest in their clients.
Conceptual Framework for Independence. In January 2006, the Professional Ethics Executive Committee
(PEEC) published a Conceptual Framework for AICPA Independence Standards (ET 100.01) which describes the
riskbased approach used by PEEC to determine whether a member's relationship with a client poses an unaccept
able risk to the member's independence. Revisions were made to Interpretation 1011 at the same time.
Exhibit 11
Independence Rules
Independence Consideration
Another CPA Firm's Participation
Cooperative Arrangement with a Client
Employment with a Client
Family Relationships
Fee Issues
Financial Institution Clients
AICPA Ref.
ET 191.142.143
ET 101.14
ET 101.04
ET 101.02
ET 101.04, ET 191.103.104
ET 191.075.076, ET 191.081.082,
ET191.150.151, ET 191.170.171
ET 191.226.229
ET 101.12
ET 191.204.205
ET 101.02, ET 101.10, ET 101.17,
ET191.138.139, ET 191.162.163,
ET191.184.185
ET 101.02, ET 191.182.183
ET 101.08, ET 102.03, ET 191.192.193
ET 101.02, ET 101.07, ET 191.134.135,
ET 191.196.197, ET 191.220.221
Gifts or Entertainment
Governmental Clients
Indemnification of a Client
Investments
Lease Property
Litigation
Loans
23
Nonprofit Organization Clients

Referral
Retirement, Savings, Health and Welfare, or Similar Plan
Services to Clients
Significant Influence
CART07
ET 101.06, ET 191.027.028,
ET191.031.034, ET 191.061.062,
ET191.128.129, ET 191.186.187
ET 102.03
ET 101.17, ET 191.041.042,
ET191.119.120, ET 191.214.215,
ET191.222.223
ET 101.02, ET 101.05, ET 102.03,
ET191.003.004, ET 191.017.018,
ET191.021.024, ET 191.031.032,
ET191.037.038, ET 191.144.145,
ET191.164.165, ET 191.198.199,
ET191.206.297, ET 191.222.225
ET 191.212.213
No Independence Interpretations or Rulings. In situations where there are no independence interpretations or

rulings that address an accountant's particular independence circumstance, the Interpretation 1011 revisions
require the accountant to evaluate whether his or her particular independence situation would lead a reasonable
person who is aware of all of the facts to conclude that the accountant is not independent. When making that
determination, accountants must refer to the riskbased approach described in the Conceptual Framework for
AICPA Independence Standards.
Required Documentation. If the threats to independence are not at an acceptable level, safeguards should be
applied to eliminate the threats or reduce them to an acceptable level. In instances where threats to independence
are not at an acceptable level, thereby requiring safeguards, the following should be documented:
The threats identified.
The safeguards applied to eliminate the threats or reduce them to an acceptable level.
Unacceptable Risk. The Introduction to the Conceptual Framework for AICPA Independence Standards indicates
that under a riskbased approach to analyzing independence, a member's relationship with a client is evaluated to
determine whether it poses an unacceptable risk to the member's independence. Risk is unacceptable if the
relationship would compromise (or would be perceived as compromising by an informed third party having
knowledge of all relevant information) the member's professional judgment when rendering an attest service to the
client.
Threats. Threats to independence are circumstances that could impair independence. Many different circum
stances (or combinations of circumstances) can create threats to independence. Some examples include the
following:
Selfreview threat. Reviewing your own nonattest work, or that of your team, as part of the attest
engagement.
Advocacy threat. Actions that promote an attest client's interests or position, such as representing a client
in tax court.
Adverse interest threat. Actions or interests between the accountant and the client that are in opposition,
such as a threat of litigation by either party.
Familiarity threat. Accountants who have close or longstanding relationships with attest clients.
Undue influence threat. Attempts by an attest client's management to exercise influence over the
accountant, such as pressure to reduce audit procedures for the purpose of reducing audit fees.
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Financial selfinterest threat. Potential benefit to an accountant from a financial relationship with an attest
client, such as excessive reliance on revenue from a single attest client.
Management participation threat. Performing management functions on behalf of an attest client, such as
making hiring decisions.
Safeguards. Safeguards are controls that mitigate or eliminate threats to independence. To be effective, safe
guards must eliminate the threat or reduce to an acceptable level the threat's potential to impair independence.
There are three broad categories of safeguards:
Safeguards created by the profession, legislation, or regulation. Examples include continuing education
requirements on independence and ethics, and external review of a firm's quality control system.
Safeguards implemented by the attest client. Examples include a tone at the top that emphasizes the attest
client's commitment to fair financial reporting, and policies and procedures that are designed to achieve
fair financial reporting.
Safeguards implemented by the firm. Examples include rotation of senior personnel who are part of the
attest engagement team, and the involvement of another firm to perform part of an audit.
This new overarching principle in determining independence may cause new legal liability concerns for accoun
tants who will no longer be able to strictly use a rules approach to determining their independence. The provisions
of the Conceptual Framework for AICPA Independence Standards became effective April 30, 2007. A copy of the
Conceptual Framework and the revisions to Interpretation 1011 can be found on the AICPA's website at
www.aicpa.org/members/div/ethics/index.htm.
Impairment of Independence by Unpaid Fees
An accountant's independence can be impaired by unpaid fees. Specifically, Ethics Ruling No.52
(ET191.103.104) states that an accountant's independence is considered impaired if fees (billed or unbilled) for
professional services rendered more than one year prior to the date of the accountant's report remain unpaid when
the current year's report is released. (While Ruling No.52 does not indicate that the unpaid fee must be of a certain
amount before it impairs independence, clearly inconsequential amounts would not impair independence.) Gener
ally, the engagement partner assigned to each client is aware of not only the status of uncollected fees, but also
unbilled fees applicable to that client. Accordingly, the engagement partner (or the incharge accountant under the
engagement partner's supervision) should have the primary responsibility for determining if there are unpaid fees
that would impair the firm's independence. That partner should determine that all prior year's fees are collected
before the current year's report is issued.
Does Providing Accounting/Writeup Services Impair a CPA's Independence?
For a small business engagement, a frequent concern about meeting independence requirements is the effect of
providing accounting assistance to the client. An accountant may be asked to provide accounting services to
clients who are too small to employ an adequate accounting staff and concerns may arise that the accountant's
independence has been impaired in these circumstances. In addition, for many small businesses, the accountant
serves as a primary business consultant and may unknowingly be providing services as part of a compilation or
review engagement that impair his or her independence. The following paragraphs discuss the effects of account
ing/writeup services on independence and specifically address Ethics Interpretation1013 (ET101.05), Perfor
mance of Nonattest Services."
Performance of Nonattest Services. ET 92.01 defines an attest engagement as an engagement that requires
independence. Audits, examinations, agreedupon procedures engagements, reviews, and compilations are,
therefore, attest engagements. With the exception of compilations, attest engagements cannot be performed if the
accountant's independence is impaired; compilations can be performed provided the accountant's report dis
closes the lack of independence. Interpretation 1013 describes the requirements that must be met in order for the
performance of nonattest services for an attest client to not impair independence:
The Member Should Not Perform Management Functions. Under the Interpretation, independence is
considered to be impaired if an accountant (or his or her firm) performs management functions or makes
25
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management decisions for a client. However, the accountant may assist management in those functions
or decisions.
The Client Must Agree to Perform Certain Functions. The accountant should be sure that the client is in a
position to make an informed judgment on the results of the nonattest services and that the client
understands its responsibilities to
a. Designate an individual who possesses suitable skill, knowledge, or experience, preferably within
senior management, to be responsible for overseeing the services to be performed.
b. Evaluate the adequacy and results of the services performed.
c. Make all management decisions and perform management functions.
d. Accept responsibility for the results of the services.
In cases where the client is unable or unwilling to assume all of these responsibilities, the accountant's
performance of the nonattest services would impair independence.
The Understanding Between the Member and the Client Must be Documented in Writing. To help prevent
any type of misunderstanding with the client, the Interpretation states that before performing the nonattest
services, the accountant must document in writing his or her understanding with the client regarding the
following
a. Objectives of the engagement (i.e., the nonattest services).
b. Services to be performed.
c. Client's acceptance of its responsibilities.
d. Accountant's responsibilities.
e. Any limitations of the engagement.
The Interpretation does not specify how the written understanding is to be documented, so the accountant
has flexibility. For example, the understanding might be documented in a separate engagement letter, in
the workpapers, in an internal memo, or in the engagement letter obtained in conjunction with an attest
engagement. It is common in many small business engagements for the accountant to also provide
nonattest services, such as tax return preparation or bookkeeping services.
Certain activities performed as part of a nonattest service are considered to be management functions and,
therefore, impair independence regardless of whether the auditor complies with the other requirements of Inter
pretation 1013. The Interpretation lists common nonattest service activities and notes whether they are or are not
considered to impair independence. The interpretation specifically states that performance of the following general
activities would impair an auditor's independence (that is, they would preclude the auditor from being indepen
dent):
Exercising authority on behalf of a client, such as authorizing, executing, or consummating a transaction,
or having the authority to do so.
Preparing source documents, in electronic or other form, that evidence the occurrence of a transaction.
Having custody of client assets.
Supervising client employees performing their normal recurring activities.
Determining which of the auditor's recommendations should be implemented.
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Reporting to the board of directors on behalf of management.

Serving as a client's stock transfer or escrow agent, registrar, or general counsel.
Establishing or maintaining internal controls, including performing ongoing monitoring activities for a
client.
Exhibit 12 provides a table adapted from Interpretation 1013 that lists various types of nonattest services an
auditor may perform and addresses the impact of those services on the auditor's independence.
Exhibit 12
Impact on Independence of Performance of Nonattest Servicesa
Type of
Nonattest Service
Bookkeeping
Nontax
disbursement
Independence Would Not Be Impaired

Record transactions for which manage
ment has determined or approved the
appropriate account classification, or
post coded transactions to a client's
general ledger.
Prepare financial statements based on
information in the trial balance.
Post clientapproved entries to a client's
trial balance.
Propose standard, adjusting, or correct
ing journal entries or other changes
affecting the financial statements to the
client provided the client reviews the
entries and the member is satisfied that
management understands the nature of
the proposed entries and the impact the
entries have on the financial statements.
Using payroll time records provided
and approved by the client, generate
unsigned checks, or process client's
payroll.
Transmit clientapproved payroll or
other disbursement information to a
financial institution provided the client
has authorized the member to make the
transmission and has made arrange
ments for the financial institution to limit
the corresponding individual payments
as to amount and payee. In addition,
once transmitted, the client must autho
rize the financial institution to process
the information.
27
Independence Would Be Impaired

Determine or change journal entries,
account codings or classification for
transactions, or other accounting
records without obtaining client
approval.
Authorize or approve transactions.
Prepare source documents.
Make changes to source documents
without client approval.
Accept responsibility to authorize pay

ment of client funds, electronically or
otherwise, except as specifically pro
vided for with respect to electronic
payroll tax payments.
Accept responsibility to sign or cosign
client checks, even if only in emergency
situations.
Maintain a client's bank account or
otherwise have custody of a client's
funds or make credit or banking deci
sions for the client.
Approve vendor invoices for payment.
Type of
Nonattest Service
Benefit plan
administrationb
Investment
advisory or
management

Communicate summary plan data to
plan trustee.
Advise client management regarding
the application or impact of provisions
of the plan document.
Process transactions (e.g., investment/
benefit elections or increase/decrease
contributions to the plan; data entry;
participant confirmations; and process
ing of distributions and loans) initiated
by plan participants through the mem
ber's electronic medium, such as an
interactive voice response system or
Internet connection or other media.
Prepare account valuations for plan
participants using data collected
through the member's electronic or
other media.
Prepare and transmit participant state
ments to plan participants based on
data collected through the member's
electronic or other medium.
Recommend the allocation of funds that
a client should invest in various asset
classes, depending upon the client's
desired rate of return, risk tolerance, etc.
Perform recordkeeping and reporting of
client's portfolio balances including
providing a comparative analysis of the
client's investments to thirdparty
benchmarks.
Review the manner in which a client's
portfolio is being managed by invest
ment account managers, including
determining whether the managers are
(a)following the guidelines of the cli
ent's investment policy statement;
(b)meeting
the
client's
invest
mentobjectives;and(c) conforming to
the client's stated investment styles.
Transmit a client's investment selection
to a brokerdealer or equivalent pro
vided the client has authorized the
brokerdealer or equivalent to execute
the transaction.
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Make policy decisions on behalf of
client management.
When dealing with plan participants,
interpret the plan document on behalf of
management without first obtaining
management's concurrence.
Make disbursements on behalf of the
plan.
Have custody of assets of a plan.
Serve a plan as a fiduciary as defined by
ERISA.
Make investment decisions on behalf of

client management or otherwise have
discretionary authority over a client's
investments.
Execute a transaction to buy or sell a
client's investment.
Have custody of client assets, such as
taking temporary possession of securi
ties purchased by a client.
CART07
Type of
Nonattest Service
Corporate finance
consulting or
advisory
Executive or
employee search
Business risk
consulting
Information sys
tems design,
installation, or
integration

Assist in developing corporate strate
gies.
Assist in identifying or introducing the
client to possible sources of capital that
meet the client's specifications or crite
ria.
Assist in analyzing the effects of pro
posed transactions including providing
advice to a client during negotiations
with potential buyers, sellers, or capital
sources.
Assist in drafting an offering document
or memorandum.
Participate in transaction negotiations in
an advisory capacity.
Be named as a financial advisor in a
client's private placement memoranda
or offering documents.
Recommend a position description or
candidate specifications.
Solicit and perform screening of candi
dates and recommend qualified candi
dates to a client based on the client
approved criteria (e.g., required skills
and experience).
Participate in employee hiring or com
pensation discussions in an advisory
capacity.
Provide assistance in assessing the
client's business risks and control pro
cesses.
Recommend a plan for making
improvements to a client's control pro
cesses and assist in implementing
these improvements.
Install or integrate a client's financial
information system that was not
designed or developed by the member
(e.g., an offtheshelf accounting pack
age).
Assist in setting up the client's chart of
accounts and financial statement for
mat with respect to the client's financial
information system.
Design, develop, install, or integrate a
client's information system that is unre
lated to the client's financial statements
or accounting records.
Provide training and instruction to client
employees on an information and con
trol system.
29

Commit the client to the terms of a
transaction or consummate a transac
tion on behalf of the client.
Act as a promoter underwriter, broker
dealer, or guarantor of client securities,
or distributor of private placement mem
oranda or offering documents.
Maintain custody of client securities.
Commit the client to employee compen

sation or benefit arrangements.
Hire or terminate client employees.
Make or approve business risk deci

sions.
Present business risk considerations to
the board or others on behalf of man
agement.
Design or develop a client's financial

information system.
Make other than insignificant modifica
tions to source code underlying a cli
ent's existing financial information sys
tem.
Supervise client personnel in the daily
operation of a client's information sys
tem.
Operate a client's local area network
(LAN) system.
CART07
Notes:
a
This exhibit is adapted from AICPA Ethics Interpretation 1013, Performance of Nonattest Services" as revised
January 27, 2005.
When auditing plans subject to the Employee Retirement Income Security Act (ERISA), Department of Labor
(DOL) regulations, which may be more restrictive, must be followed.
Interpretation 1013 (ET 101.05) also addresses tax compliance services. Preparing a tax return and transmitting
the tax return and related payment, either electronically or in paper form, to a taxing authority does not impair
independence as long as the accountant does not have custody or control of the client's funds and the individual
overseeing the tax services (a) reviews and approves the return and payment and (b) signs the return prior to
transmittal, if required for the filing. Signing and filing a tax return impairs independence unless the accountant has
legal authority to do so and
the taxing authority has prescribed procedures, allowing the taxpayer to permit the accountant to sign and
file a return on their behalf, that meet the standards for electronic return originators and officers outlined
in IRS Form 8879, or
an individual in client management who is authorized to sign and file the tax return provides the accountant
with a signed statement that indicates
The return being filed.
That the individual is authorized to sign and file the return.
That the individual has reviewed the return, including accompanying schedules, and it is true,
correct, and complete to the best of their knowledge and belief.
That the individual authorizes the accountant to sign and file the return on behalf of the client.
The Interpretation also indicates that the accountant's representation of the client in an administrative proceeding
before a taxing authority does not impair independence providing that the accountant obtains the client's agree
ment prior to committing the client to a specific resolution with the taxing authority. Independence is impaired if the
accountant represents the client in court or in a public hearing to resolve a tax dispute.
In addition, under Interpretation 1013, certain appraisal, valuation, or actuarial services are considered to impair
independence. Performing appraisal, valuation, or actuarial services impairs independence if the results are
material to the financial statements and the service involves significant subjectivity. For example, a material asset
appraisal or business valuation generally involves significant subjectivity, and therefore would impair indepen
dence if performed for financial statement purposes. However, an actuarial valuation of a client's pension liabilities
ordinarily does not require significant subjectivity and, therefore, would not impair independence even if the
amount was material.
Under Interpretation 1013 certain types of forensic accounting services may impair independence. Independence
is impaired if an accountant conditionally or unconditionally agrees to provide expert witness testimony for a client.
However, under certain defined conditions, independence is not impaired if the accountant provides expert witness
testimony for a large group of plaintiffs or defendants that includes the accountant's client. If the accountant
provides litigation services where he or she is a trier of fact, special master, courtappointed expert, or arbitrator in
a matter involving a client, independence is impaired.
In some cases, the accountant may assist with the client's internal audit function. Interpretation 1013 also
addresses the impact of those services on the accountant's independence. According to the Interpretation,
performance of internal audit assistance services does not impair the accountant's independence as long as the
accountant is not an employee of the client or does not act in the capacity of management (for example, determin
30
CART07
ing the scope, risk, and frequency of internal audit activities). The accountant should be satisfied that the client (a)
understands its responsibility for internal controls (including ongoing monitoring) and (b) understands its responsi
bility for directing the internal audit function. The general requirements of the Interpretation discussed previously
(such as documenting the understanding with the client) also must be met. With respect to providing assistance
with the internal audit function, the accountant should be satisfied that the board of directors and/or audit commit
tee (if one exists) is fully informed of the engagement.
Should Proposing Journal Entries and Preparing Financial Statements in Connection with an Audit be Viewed as
Bookkeeping and, Therefore, Nonattest Services? Interpretation 1013 includes bookkeeping as an example of a
nonattest service. Rather than define bookkeeping, the Interpretation provides several examples of services that
would be considered bookkeeping. Two of those examples, which are listed in Exhibit 12, are (a) proposing
standard, adjusting, or correcting journal entries or other changes affecting the financial statements to the client
and (b) preparing financial statements based on information in the trial balance. Practice questions have arisen as
to whether those examples mean that proposing journal entries and preparing financial statements in connection
with a compilation or review should be viewed as bookkeeping and, therefore, nonattest services subject to the
Interpretation. As a practical matter, small and midsize nonpublic entities typically view proposing journal entries
and preparing financial statements as part of the attest engagement, and, based on implementation guidance
provided in questions and answers published by the AICPA Professional Ethics Executive Committee (PEEC)
during 2004 and 2005, it is clear that PEEC did not intend for Interpretation 1013 to require viewing those services
as separate from the attest engagement.
In general, bookkeeping services are services that involve processing an entity's transactions or preparing an
entity's accounting records. For example, preparing an entity's accounting journals and ledgers by entering
information provided by management into Peachtree or other accounting software is a bookkeeping service
because it involves preparing an entity's accounting records. Bookkeeping services that
a. Constitute management functions, such as authorizing or approving purchase orders or preparing sales
invoices, would impair independence.
b. Do not constitute management functions, such as recording disbursements approved by management,
would not impair independence provided the accountant obtained the understanding with the entity
required by the Interpretation. Failure to obtain the required understanding would impair independence.
However, failure to comply with the Interpretation's requirement to document that understanding would not
impair independence but would be a violation of Rule 202, Compliance With Standards, of the AICPA's Code
of Professional Conduct.
In general, preparing financial statements as part of a compilation or review would not be considered a bookkeep
ing service. Preparing financial statements as part of the attest service does not involve processing the entity's
transactions or preparing its accounting records.
Proposing adjustments of an entity's accounting records in connection with a compilation or review also would not
be considered a bookkeeping service. To illustrate, assume that as part of the review of the financial statements of
a small or midsize nonpublic entity the accountant proposes journal entries to capitalize improvements recorded as
repairs expense and to charge to expense repairs capitalized as improvements; to record depreciation calculated
using the accountant's depreciation software; to convert the carrying amounts of inventory and cost of sales from
amounts determined using the firstin, firstout method to the lastin, firstout method based on the accountant's
calculation of indexes and changes in layers; to recognize liabilities for subsequent disbursements; to record the
valuation allowance for customer account balances; and to record the current and deferred income tax provisions.
Those are adjustments of the accounting records prepared by the entity.
In general, the number of journal entries proposed in connection with a compilation or review is not relevant to
whether that is a bookkeeping service and, therefore, subject to the Interpretation. As a practical matter, however,
the entity's accounting records may be in such poor condition that the accountant cannot perform sufficient
procedures to determine the journal entries needed. To overcome the scope limitation, bookkeeping services may
be performed to bring those inadequate accounting records into substantial completion so that the accountant can
perform the required procedures.
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To illustrate, assume that an entity changed accounting software during the year and did not have sufficient controls
in place to ensure the proper transfer of accounting information and that since the conversion, totals of subsidiary
ledgers have differed materially from the related general ledger account balances. In that situation, the accountant
would be unable to perform sufficient procedures to determine the journal entries needed to issue either a
compilation or review report. That scope limitation could be overcome by having the entity, members of the
accountant's firm, or a bookkeeping service prepare adequate accounting records for the period from just prior to
the conversion through yearend.
Accountants who are unable to make a judgment as to whether they are providing bookkeeping services are not
prohibited from concluding that they are providing services subject to the Interpretation and following the Inter
pretation's requirements.
Additional Questions in Applying Interpretation 1013. The following are questions that are likely to arise as
accountants apply the requirements of the Interpretation. The responses are general views on such matters based
on the requirements of Interpretation 1013.
a. Impact on Compilation and Review Services.
Question How does Interpretation 1013 impact compilation and review services?
Response If the accountant performs nonattest services for a compilation or review client,
independence will be impaired if any of the following occurs:
(1) The accountant performs management functions or makes management decisions.
(2) The client is unwilling or unable to assume all of the responsibilities for: management decisions
and functions; designating an individual who possesses suitable skill, knowledge, or experience,
preferably within senior management, to oversee any nonattest services performed for the client,
such as bookkeeping services, payroll services, tax services, or profitsharing plan services;
evaluating the adequacy and results of, and accepting responsibility for, the services provided;
and establishing and maintaining internal controls, including monitoring related ongoing
activities.
(3) The accountant does not establish the understanding with the client regarding: the objectives
of the engagement, the services to be performed, the client's acceptance of its responsibilities,
the accountant's responsibilities, and any limitations of the nonattest engagement.
If independence is impaired, the accountant may still issue a compilation report as long as the report
is modified to indicate the lack of independence. In a compilation engagement in which the financial
statements are intended for managementuseonly, the engagement letter would need to be modified,
in lieu of the report, to indicate the lack of independence. The following sentence should be added
to either the report or the engagement letter, as applicable, to indicate the lack of independence.
We are not independent with respect to the entity.
b. Providing Routine Advice to Clients.
Question If a client calls the accountant and asks a technical question, would this be considered a
nonattest service for which ET Interpretation 1013 would apply?
Response No, routine activities performed by the accountant, such as providing advice and
responding to clients' technical questions as part of the normal clientaccountant relationship, are not
considered nonattest services for which ET Interpretation 1013 would apply.
c. Inadvertent Noncompliance.
Question What if the accountant inadvertently fails to comply with the Interpretation's requirement
to document in writing the accountant's understanding with the client?
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Response A failure to document the understanding with the client is not considered to impair a
member's independence provided such understanding has been established. Rather, such a failure,
regardless of whether it was isolated or inadvertent, would be considered a failure to comply with an
ethics standard under Rule 202, Compliance with Standards.
d. Independence Rules of Other Regulatory Bodies.
Question If the accountant performs attest services for his or her client and the work is subject to
oversight by other regulatory bodies (e.g., Government Accountability Office, Department of Labor,
and Securities and Exchange Commission), how does the Interpretation apply?
Response The requirements of the Interpretation must be met, along with any independence rules
of the applicable regulatory body that are more restrictive than the requirements of the Interpretation.
Failure to comply with independence rules of the regulatory body relating to nonattest services would
constitute a violation of the Interpretation.
e. Assessing Whether an Individual Possesses Suitable Skill, Knowledge, or Experience.
Question How does an accountant assess a client's designated employee possesses suitable skill,
knowledge, or experience as required by the Interpretation?
Response It is not intended that the client's employee possess a level of technical expertise equal
to the accountant's. The client employee need only understand the nonattest services enough to be
able to provide general direction for the services; understand the key issues the accountant identifies;
make any required management decisions; and evaluate the adequacy of, and accept responsibility
for, the results of the accountant's work. This may mean the accountant will need to educate his or her
client in order to allow them to assume these responsibilities. For example, if the accountant performs
routine bookkeeping services for an attest client, he or she could ensure compliance with the
requirements of the Interpretation by reviewing the proposed journal entries with the client and
explaining in general terms how each entry affects the financial statements. The client should then be
in a position to approve the journal entries and accept responsibility for the financial statements.
f. Nonattest Services Performed before the Client Becomes an Attest Client
Question The accountant accepts a compilation or review engagement for a client for whom he or
she has previously provided only bookkeeping services. Prior to accepting the attest engagement,
the practitioner does not have a written understanding with the client under Interpretation 1013. Has
the practitioner violated the requirements of the Interpretation?
Response No, the ET 1013 documentation requirement does not apply to nonattest services
performed before the client becomes an attest client. The accountant would be permitted to prepare
the required documentation upon acceptance of the compilation or review engagement, provided the
accountant is able to demonstrate his or her compliance with the other general requirements during
the period covered by the financial statements, including the requirement to establish an
understanding with the client. As a practical matter, practitioners who are initially engaged to only
provide nonattest services but expect to subsequently be engaged to also provide attest services
should consider structuring the engagement so that performance of the nonattest services will not
impair independence for the attest services.
Illustrative Examples. Independence is much easier to define than to apply. An infinite variety of situations can
occur that raise questions about independence but are not necessarily impairment problems. The following
paragraphs provide several scenarios relating to accounting services in which accountants' independence might
be impaired. Also included with each scenario is (considering the guidance in Interpretation 1013 and related
nonauthoritative guidance) whether or not the services are permitted under Interpretation 1013 (that is, whether or
not the services impair the accountant's independence).
a. Scenario: A CPA accepts the responsibility of signing or cosigning a client's checks in emergency
situations.
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Is Independence Impaired? Yes, independence of the CPA would be considered to be impaired since
such activities are considered management functions. Having the authorization to sign or cosign checks
on a client's bank account, even if such activity is never performed, impairs independence.
b. Scenario: A CPA performs payroll services for a client including preparing payroll tax forms and returns
(for example, Form 941, Form W2, etc.) and preparing semimonthly payroll checks. The CPA also cosigns
each payroll check on behalf of an officer of the client.
Is Independence Impaired? Yes, independence of the CPA would be considered to be impaired because
having the authorization to sign or cosign checks on a client's bank account is a management function.
However, preparation of payroll tax returns does not impair independence as long as the auditor does not
have the authority to sign them. In addition, making electronic payroll tax payments does not impair
independence provided the payments are made in accordance with U.S. Treasury Department or
comparable guidelines and the client has made arrangements for its financial institution to limit such
payments to the named payee.
c. Scenario: When performing monthly accounting services for a client, the CPA codes the check stubs (that
is, determines the general ledger accounts to which the disbursements should be recorded and writes the
appropriate account numbers on each check stub) based on the description included by the client on the
check stubs.
Is Independence Impaired? No, independence is not impaired. Normally, coding check stubs will not
impair the accountant's independence as long as the client provides sufficient detail to clearly identify the
nature of each transaction. Note that, in some cases, the accountant can determine the nature of a
transaction based on who the check has been issued to (for example, the electric company, office supply
company, etc.). However, the accountant should be careful not to assume the role of management, thereby
losing independence with respect to the client.
d. Scenario: A CPA records journal entries in the client's accounting system.
Is Independence Impaired? No, the accountant's independence would not be impaired provided that the
client understands the nature and impact of the journal entries. For example, the accountant could provide
the client with a printout of proposed journal entries accompanied by clear explanations, ask the client to
review the printout, and then ask whether the client has any questions about the entries. Although not
required, some accountants obtain the client's written approval of the proposed journal entries by, for
example, signing or initialing the journal entries or on a separate journal entry approval form. If a
representation letter is obtained (as in a review) such language might also be included in the representation
letter.
e. Scenario: A CPA installs prepackaged accounting software, such as QuickBooks, for his or her client and
sets up the chart of accounts and financial statement format defaults.
Is Independence Impaired? No, the CPA's independence is not impaired. In its Background and Basis
for Conclusions, the Professional Ethics Executive Committee states that independence is not considered
impaired, as this type of service does not constitute designing" a system, provided the CPA does not
create or change the source code(s) underlying the prepackaged software.
The AICPA has an Ethics Hotline where members of the AICPA's Professional Ethics Team answer questions about
independence and other behavioral issues. The tollfree number for the Ethics Hotline is (888)7777077.
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SELFSTUDY QUIZ
following section.
13. If a firm's independence is impaired, a report may still be issued for what type of engagement?
a. Audit.
b. Agreedupon procedures.
c. Review.
d. Compilation.
14. Which of the following is the primary source for the rules governing independence for CPAs?
a. Statements of Standards for Attestation Engagements.
b. Statements on Auditing Standards.
c. AICPA Code of Professional Conduct.
d. Statement on Standards for Accounting and Review Services.
15. What type of approach does the Professional Ethics Executive Committee use to determine whether or not a
member's independence with a client has been impaired?
a. Threatlevel approach.
b. Unrelatedthird party approach.
c. Riskbased approach.
d. Reasonableperson approach.
16. John Smith, CPA, performs an annual review for ABC, Inc. Smith has played golf once a month with ABC's chief
financial officer for 10 years. This is an example of what type of threat to Smith's independence?
a. Familiarity threat.
b. Undue influence threat.
c. Advocacy threat.
d. Management participation threat.
17. John Smith, CPA, performs an annual review for ABC, Inc. ABC's controller meets with Smith prior to the
engagement and indicates that, due to budget constraints, he wants Smith to lower the cost of the review by
reducing the extent of analytical procedures associated with the review. This is an example of what type of threat
to Smith's independence?
a. Selfreview threat.
c. Adverse interest threat.
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18. John Smith, CPA, performs an annual compilation for ABC, Inc. ABC's accounting manager is on temporary
leave, and the controller requests that Smith handle the approval of all vendor invoices for payment in her
absence. This is an example of what type of threat to Smith's independence?
a. Advocacy threat.
c. Familiarity threat.
19. Walker & Walker LLP performs an annual review on the financial statements of XYZ, Inc. XYZ's policies and
procedures manual contains a statement regarding its commitment to fair and accurate reporting in its financial
statements which each employee in the department must sign. This is an example of what type of safeguard
to mitigate or eliminate threats to independence?
a. Safeguard created by the profession, legislation, or regulation.
b. Safeguard implemented by the attest client.
c. Safeguard promulgated by boards of directors.
d. Safeguard implemented by the firm.
20. Walker & Walker LLP performs an annual compilation on the financial statements of XYZ, Inc. Walker will release
the compilation report for XYZ on June 30, 2007. The engagement partner realizes that some fees related to
an internal control review performed in May 2007 are unbilled. Based on the above scenario, is Walker's
independence impaired?
a. No, independence would only be impaired if the fees had already been billed to the client.
b. Yes, independence is considered impaired when fees, billed or unbilled, are unpaid by the date the
compilation report is issued.
c. Perhaps, depending on the amount of the unbilled fees as a percentage of Walker's annual revenue.
d. No, the unbilled fees were for professional services rendered less than one year prior to the current year's
report release date.
21. Walker & Walker LLP performs an annual review on the financial statements of XYZ, Inc. In addition to this year's
review, Walker advises XYZ regarding the application of provisions in the plan document of XYZ's new
employee retirement plan. Based on the above scenario, is Walker's independence impaired?
a. No, as long as before the services are performed, the client and accountant document their understanding
of the engagement in writing.
b. Yes, independence is impaired because such consultation is considered the performance of the
management function of the client.
c. No, independence is not impaired as long as the employment retirement plan is nondiscriminatory in
nature.
d. Yes, independence is impaired because accountants are not permitted to engage in the design of a
company's employee retirement benefit system.
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22. Lincoln and Lincoln LLP performs an annual review on the financial statements of LCI, Inc. Due to senior level
engagement personnel's computer network expertise, Lincoln also contracts with LCI to provide training to
Lincoln employees on the LAN system and to operate its LAN system. Based on the above scenario, is Lincoln's
independence impaired?
a. No, independence is not impaired as long as Lincoln is not engaged in the design of the LAN.
b. Yes, independence is impaired because the operation of the network is considered the performance of the
c. No, independence is not impaired because Lincoln is not issuing an audit opinion on the annual financial
statements of the client.
d. Yes, independence is impaired because Lincoln would be providing training to client employees on an
information and control system.
23. Lincoln and Lincoln LLP performs an annual compilation on the financial statements of LCI, Inc. LCI also
engages Lincoln to prepare a valuation of LCI's pension liabilities to predict future cash needs. Based on the
above scenario, is Lincoln's independence impaired?
a. No, independence is not impaired as long as Lincoln also serves as the pension plan fiduciary as defined
by ERISA.
b. Yes, independence is impaired whenever a nonattest service is performed on pension liabilities.
c. No, independence is not impaired because the calculation of the pension liabilities does not require
significant subjectivity.
d. Perhaps, depending on whether or not the pension plan obligations are material to the financial statements
of the client.
24. Lincoln and Lincoln LLP performs an annual compilation on the financial statements of LCI, Inc. In 2007, Lincoln
proposes nineteen (19) correcting journal entries to management as a part of the compilation process. Based
on the above scenario, do Lincoln's proposed journal entries constitute attest or nonattest services?
a. Attest services, because proposing journal entries is typically viewed as part of the attest engagement.
b. Nonattest services, because, based on the number of journal entries proposed, the engagement is a
considered bookkeeping service.
c. Attest services, because proposing journal entries is typically considered a function of the internal auditing
department of the client.
d. Nonattest services, assuming that the accountant makes the proposed adjustments without obtaining
client approval.
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SELFSTUDY ANSWERS
13. If a firm's independence is impaired, a report may still be issued for what type of engagement? (Page 23)
a. Audit. (This answer is incorrect. Audit engagements cannot be performed if the accountant's
independence is impaired.)
b. Agreedupon procedures. (This answer is incorrect. Agreedupon procedures engagements cannot be
performed if the accountant's independence is impaired.)
c. Review. (This answer is incorrect. Review engagements cannot be performed if the accountant's
independence is impaired.)
d. Compilation. (This answer is correct. If independence is impaired, compilation reports may be
issued if the report discloses the lack of independence.)
14. Which of the following is the primary source for the rules governing independence for CPAs? (Page 23)
a. Statements of Standards for Attestation Engagements. (This answer is incorrect. While these statements
address independence requirements, this is not the primary source of rules governing independence.)
b. Statements on Auditing Standards. (This answer is incorrect. While these statements address
independence requirements, these statements are not the primary source of rules governing
independence.)
c. AICPA Code of Professional Conduct. (This answer is correct. Rule 101 of the Conduct Code is the
primary source for issues related to independence.)
d. Statement on Standards for Accounting and Review Services. (This answer is incorrect. While SARS
address independence requirements, they are not the primary source of rules governing independence.
15. What type of approach does the Professional Ethics Executive Committee use to determine whether or not a
member's independence with a client has been impaired? (Page 23)
a. Threatlevel approach. (This answer is incorrect. Threats are circumstances that could impair
independence and are used to determine the acceptable level of risk in determining the independence of
a member and the client.)
b. Unrelatedthird party approach. (This answer is incorrect. This is not an approach used to determine
whether or not a member's independence with a client has been impaired.)
c. Riskbased approach. (This answer is correct. A member's relationship is examined to determine
whether it poses an unacceptable risk to the member's independence.)
d. Reasonableperson approach. (This answer is incorrect. This approach is required when there are no
independence interpretations or rulings that address a member's particular independence circumstance.)
16. John Smith, CPA, performs an annual review for ABC, Inc. Smith has played golf once a month with ABC's chief
financial officer for 10 years. This is an example of what type of threat to Smith's independence? (Page 24)
a. Familiarity threat. (This answer is correct. A familiarity threat is one in which the accountant has a
close or longstanding relationship with attest clients.)
b. Undue influence threat. (This answer is incorrect. The question scenario does not correctly describe an
undue influence threat.)
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c. Advocacy threat. (This answer is incorrect. The question scenario does not correctly describe an advocacy
threat.)
d. Management participation threat. (This answer is incorrect. The question scenario does not correctly
describe a management participation threat.)
17. John Smith, CPA, performs an annual review for ABC, Inc. ABC's controller meets with Smith prior to the
engagement and indicates that, due to budget constraints, he wants Smith to lower the cost of the review by
reducing the extent of analytical procedures associated with the review. This is an example of what type of threat
to Smith's independence? (Page 24)
a. Selfreview threat. (This answer is incorrect. The question scenario does not correct depict a selfreview
threat.)
b. Undue influence threat. (This answer is correct. An undue influence threat is one in which client's
management attempts to exercise influence over the accountant.)
c. Adverse interest threat. (This answer is incorrect. The question scenario does not correctly describe an
adverse interest threat.)
d. Management participation threat. (This answer is incorrect. The question scenario does not correctly
depict a management participation threat.)
18. John Smith, CPA, performs an annual compilation for ABC, Inc. ABC's accounting manager is on temporary
leave, and the controller requests that Smith handle the approval of all vendor invoices for payment in her
absence. This is an example of what type of threat to Smith's independence? (Page 24)
a. Advocacy threat. (This answer is incorrect. The question scenario does not correctly depict an advocacy
threat.)
b. Undue influence threat. (This answer is incorrect. The question scenario does not correctly depict an
undue influence threat.)
c. Familiarity threat. (This answer is incorrect. The question scenario does not correctly depict a familiarity
threat.)
d. Management participation threat. (This answer is correct. A management participation threat is one
in which the CPA is performing management functions on behalf of an attest client.)
19. Walker & Walker LLP performs an annual review on the financial statements of XYZ, Inc. XYZ's policies and
procedures manual contains a statement regarding its commitment to fair and accurate reporting in its financial
statements which each employee in the department must sign. This is an example of what type of safeguard
to mitigate or eliminate threats to independence? (Page 25)
a. Safeguard created by the profession, legislation, or regulation. (This answer is incorrect. An example of
a safeguard created by the profession is a requirement for continuing education on independence or ethics
by state accounting boards.)
b. Safeguard implemented by the attest client. (This answer is correct. A management policy that sets
a tone emphasizing its commitment to integrity of the financial reporting system is an example of
a safeguard implemented by the attest client.)
c. Safeguard promulgated by boards of directors. (This answer is incorrect. While a safeguard promulgated
by a board of directors would be acceptable, there is a more appropriate response to the question.)
d. Safeguard implemented by the firm. (This answer is incorrect. The question scenario indicates the policy
is that of the entity under review and therefore the accounting firm would not be implementing the policy.)
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20. Walker & Walker LLP performs an annual compilation on the financial statements of XYZ, Inc. Walker will release
the compilation report for XYZ on June 30, 2007. The engagement partner realizes that some fees related to
an internal control review performed in May 2007 are unbilled. Based on the above scenario, is Walker's
independence impaired? (Page 25)
a. No, independence would only be impaired if the fees had already been billed to the client. (This answer
is incorrect. The impairment of independence is not solely tied to the billing status of fees.)
b. Yes, independence is considered impaired when fees, billed or unbilled, are unpaid by the date the
compilation report is issued. (This answer is incorrect. There is a time limit concerning how long fees
remain unpaid before independence is impaired. This answer choice does not reflect the correct time
period.)
c. Perhaps, depending on the amount of the unbilled fees as a percentage of Walker's annual revenue. (This
answer is incorrect. Independence can be impaired regardless of the percentage of annual revenues the
unbilled amount represents.)
d. No, the unbilled fees were for professional services rendered less than one year prior to the current
year's report release date. (This answer is correct. According to Ethics Ruling No. 52, an
accountant's independence is considered impaired if fees, billed or unbilled, for professional
services rendered more than one year prior to the date of the accountant's report remain unpaid
when the current year's report is released.)
21. Walker & Walker LLP performs an annual review on the financial statements of XYZ, Inc. In addition to this year's
review, Walker advises XYZ regarding the application of provisions in the plan document of XYZ's new
employee retirement plan. Based on the above scenario, is Walker's independence impaired? (Page 25)
a. No, as long as before the services are performed, the client and accountant document their
understanding of the engagement in writing. (This answer is correct. According to Interpretation
1013, an accountant may assist management in certain nonattest functions or decisions under
certain guidelines, but the understanding between the accountant and the client must be
documented in writing.)
b. Yes, independence is impaired because such consultation is considered the performance of the
management function of the client. (This answer is incorrect. Mere consultation regarding provisions in a
plan document is not considered performance of the management function of the client.)
c. No, independence is not impaired as long as the employment retirement plan is nondiscriminatory in
nature. (This answer is incorrect. The nature of the employment retirement plan is unrelated to any
impairment of independence.)
d. Yes, independence is impaired because accountants are not permitted to engage in the design of a
company's employee retirement benefit system. (This answer is incorrect. An accountant's independence
is impaired if designing a client's financial information system, not merely consulting the client regarding
provisions in an employee benefit program.)
22. Lincoln and Lincoln LLP performs an annual review on the financial statements of LCI, Inc. Due to senior level
engagement personnel's computer network expertise, Lincoln also contracts with LCI to provide training to
Lincoln employees on the LAN system and to operate its LAN system. Based on the above scenario, is Lincoln's
independence impaired? (Page 27)
a. No, independence is not impaired as long as Lincoln is not engaged in the design of the LAN. (This answer
is incorrect. Accountants may design a client's information system that is unrelated to the client's financial
statements or accounting records without impairing independence.)
b. Yes, independence is impaired because the operation of the network is considered the performance
of the management function of the client. (This answer is correct. According to Interpretation 1013,
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the operation of the LAN network is considered the performance of the management function of the
client and would impair independence.)
c. No, independence is not impaired because Lincoln is not issuing an audit opinion on the annual financial
statements of the client. (This answer is incorrect. The lack of performance of attest services does not
correctly reflect the effect on auditor independence as described in the question scenario.)
d. Yes, independence is impaired because Lincoln would be providing training to client employees on an
information and control system. (This answer is incorrect. The accountant's independence is NOT
impaired for simply training employees on the system.)
23. Lincoln and Lincoln LLP performs an annual compilation on the financial statements of LCI, Inc. LCI also
engages Lincoln to prepare a valuation of LCI's pension liabilities to predict future cash needs. Based on the
above scenario, is Lincoln's independence impaired? (Page 30)
a. No, independence is not impaired as long as Lincoln also serves as the pension plan fiduciary as defined
by ERISA. (This answer is incorrect. Serving as plan fiduciary would impair the accountant's
independence.)
b. Yes, independence is impaired whenever a nonattest service is performed on pension liabilities. (This
answer is incorrect. This answer choice does not correctly reflect the situation in which the calculation of
the plan's pension liabilities would impair independence.)
c. No, independence is not impaired because the calculation of the pension liabilities does not require
significant subjectivity. (This answer is correct. The calculation of the plan's liabilities does not
require significant subjectivity; therefore, independence is not impaired under Interpretation 1013.)
d. Perhaps, depending on whether or not the pension plan obligations are material to the financial statements
of the client. (This answer is incorrect. The degree of materiality is NOT the determining factor as it relates
to the impairment of independence described by the scenario in this question.)
24. Lincoln and Lincoln LLP performs an annual compilation on the financial statements of LCI, Inc. In 2007, Lincoln
proposes nineteen (19) correcting journal entries to management as a part of the compilation process. Based
on the above scenario, do Lincoln's proposed journal entries constitute attest or nonattest services? (Page 31)
a. Attest services, because proposing journal entries is typically viewed as part of the attest
engagement. (This answer is correct. Based on guidance published by the AICPA Professional
Ethics Executive Committee, the proposal of journal entries should typically be viewed as part of
the attest engagement, even though Interpretation 1013 includes proposing journal entries as one
aspect of a bookkeeping service.)
b. Nonattest services, because, based on the number of journal entries proposed, the engagement is a
considered bookkeeping service. (This answer is incorrect. In general, the number of journal entries is not
relevant to whether the activity will be classified as an attest or nonattest service.)
c. Attest services, because proposing journal entries is typically considered a function of the internal auditing
department of the client. (This answer is incorrect. The proposal of journal entries is typically the purview
of the accountant engaged in the attestation service.)
d. Nonattest services, assuming that the accountant makes the proposed adjustments without obtaining
client approval. (This answer is incorrect. Making adjustments to client records without obtaining client
approval would impair the independence of the firm and is unrelated to whether or not the service is
classified as an attest or nonattest function.)
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Lesson 2:Compilation Procedures and Checklists

This lesson discusses the factors a practitioner should consider when performing compilation engagements,
including whether to issue managementuseonly financial statements or a thirdparty compilation report. The
lesson also includes the procedures a practitioner must follow to perform compilation engagements, including
checklists to assist in the administration of the engagement.
Assess the suitability of issuing managementuseonly or thirdparty use financial statements in compilation
engagements.
Summarize the compilation procedures required by SSARS.
INTRODUCTION
A compilation engagement involves presenting information, consisting of management's representations in the
form of financial statements, without expressing assurance on them. Accountants are not required to make
inquiries or perform other procedures to corroborate or review the information supplied by management. However,
accountants have certain other responsibilities as specified in SSARS No. 1 (AR 100) because of this direct
association with the financial statements.
What SSARS No. 1 Requires
SSARS No. 1 requires accountants who submit financial statements to clients or others, at a minimum, to compile
those statements. However, whether accountants are required to issue a compilation report depends on the
intended use of the financial statements:
When the financial statements are intended for thirdparty use, accountants must issue a SSARS No. 1
compilation report.
When the financial statements are not reasonably expected to be used by third parties (that is, they are
intended for managementuseonly), accountants may choose to issue an engagement letter, preferably
signed by management, in lieu of a compilation report.
What SSARS No. 1 Does Not Require
Since the definition of a compilation engagement indicates that the CPA is merely putting information supplied by
the client into proper financial statement form without expressing any assurance, it is logical to assume that
required procedures relating to verifying the accuracy of those statements are minimal. SSARS No. 1, (AR 100.09),
clearly states that accountants are . . . not required to make inquiries or perform other procedures to verify,
corroborate, or review information supplied by the entity." Likewise, accountants have no obligation to obtain an
understanding of, or communicate deficiencies in, internal control, or to assess control risk. This does not reduce
the accountants' obligation to obtain additional or revised information if they become aware that information
supplied by the client is inaccurate, incomplete, or misleading; nor does it reduce the accountants' responsibilities
when compiling thirdpartyuse financial statements that contain departures from generally accepted accounting
principles (GAAP). It does, however, allow accountants to provide assistance with financial statements at minimal
expense to their clients by limiting (with the exception of procedures discussed later in this course) their efforts to
the mechanics of putting the information in the form of financial statements.
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COMPILATIONS OF MANAGEMENTUSEONLY FINANCIAL STATEMENTS

Introduction
Statement on Standards for Accounting and Review Services (SSARS) No. 8, Amendment to Statement on Stan
dards for Accounting and Review Services No. 1, Compilation and Review of Financial Statements, allows CPAs to
provide managementuseonly financial statements without issuing a compilation report in certain situations.
SSARS No. 8 was not published as a standalone statement. Instead, the provisions of SSARS No. 8 were
incorporated into SSARS No. 1. Whenever a reference to SSARS No. 1 appears, it is to the amended version of that
statement.
Why Issued
SSARS No. 8 was designed to provide relief from the reporting requirements of SSARS No. 1 in certain situations.
It was developed primarily to address concerns of some accountants, who believed the reporting requirements of
SSARS No. 1 prior to the amendment were unnecessary in some situations and placed them at a competitive
disadvantage with other financial statement service providers.
Many accountants wanted an easier, more costeffective way of providing financial statements to clients who did
not intend to distribute such statements to third parties. In those situations, many accountants were concerned that
SSARS No. 1 caused them to spend undue time listing departures in their compilation report that (a) the client was
already aware of and (b) were related to adjustments the client had already determined to be unnecessary for its
purposes. ARSC issued SSARS No. 8 to specifically address those situations.
Summary of SSARS No. 8
SSARS No. 8
a. Allows accountants to provide clients with managementuseonly financial statements without issuing a
compilation report if the statements are not reasonably expected to be used by third parties. SSARS No.
1 (AR 100.04) defines third parties differently than other authoritative literature. For purposes of SSARS No.
1, third parties include everyone except those members of management who are knowledgeable about the
nature of procedures to be applied and the basis of accounting and assumptions used in the preparation
of the financial statements.
b. Requires accountants to follow the compilation performance standards in SSARS No. 1.
c. Allows accountants to issue an engagement letter, preferably signed by management, containing specific
communications to management in lieu of a compilation report. Accountants may still issue a SSARS No.
1 compilation report when they submit managementuseonly financial statements.
Pros and Cons of Issuing Managementuseonly Financial Statements
Reasons to Apply the Provisions of SSARS No. 8. Some accountants cite the following as reasons to apply the
provisions of SSARS No. 8 whenever possible:
a. The Standard Does Not Create a New Level of Service. The amendments made to SSARS No. 1 as a result
of SSARS No. 8 continue to require accountants to compile financial statements that they submit to clients;
thus, it is a still a quality, professional service CPAs can provide their clients. The performance standards
are the same whether the accountant compiles managementuseonly financial statements or issues a
compilation report.
b. The Standard Does Not Require Accountants to Issue a Compilation Report. The amendments made to
SSARS No. 1 as a result of SSARS No. 8 require accountants to communicate to clients certain matters
(similar to those required for compilations prepared for thirdpartyuse) about the nature and limitations of
their services. They do not, however, require a compilation report. Some accountants believe the
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requirement to issue a report results in a more costly service to clients since their firms require additional
levels of review whenever reports are issued in accordance with professional standards. Thus, they believe
SSARS No. 8 enables them to provide clients with a more effective service at reduced costs.
c. Accountants Are Not Required to Detail Known Departures from the Basis of Accounting Used to Prepare
the Financial Statements. The amendments made to SSARS No. 1 as a result of SSARS No. 8 do not require
accountants to identify in the engagement letter known departures from the basis of accounting used to
present the financial statements. As discussed previously, many accountants found the SSARS No. 1
requirement to be timeconsuming and to provide little benefit if management is already aware of the
departures. Since the accountant does not have to spend time detailing known departures, SSARS No. 8
allows them to provide clients with useful financial information in a more efficient manner.
d. The Standard Amends the SSARS No. 1 Definition of Submission," Leaving It to the Accountants'
Professional Judgment to Determine When They Must Comply with the Compilation Standards. In recent
years, there has been diversity in practice about how to apply the SSARS No. 1 definition of submission.
Reasons against Applying the Provisions of SSARS No. 8. Other accountants, however, see certain risks with
providing services under SSARS No. 8. Those accountants cite the following as reasons to avoid SSARS No. 8:
a. Unsophisticated Clients Could Be Misled by the Financial Statements Submitted, Particularly When Such
Financial Statements Are Not Prepared in Conformity with an Established Basis of Accounting (GAAP or
OCBOA). Because SSARS No. 8 does not require accountants to detail in the engagement letter known
departures from the basis of accounting used to present the financial statements (that is, GAAP or OCBOA),
some accountants are concerned that unsophisticated clients might not fully understand the extent to
which the statements might not present the company's financial position, cash flows, or results of
operations. Consequently, they are concerned that such clients might make inappropriate business
decisions when they rely on such statements, and could potentially attempt to place blame on the CPA for
not communicating the statements' deficiencies. To address this risk, the CPA might choose to
communicate to the client any known departures in the engagement letter; however, doing this significantly
reduces the potential efficiencies of applying SSARS No. 8.
b. Many Accountants Believe There Is No Such Thing As Managementuseonly" Financial Statements.
History has shown that such statements frequently end up in the hands of thirdparty users such as banks
and other lenders. As a result, some accountants believe SSARS No. 8 could rarely be applied.
c. The Statement Enables Management to Provide Potentially Misleading Financial Statements to Third Parties.
Since managementuseonly financial statements might contain a variety of departures from established
bases of accounting, and the accountant is not required to report on the statements, some accountants
are concerned that third parties that inadvertently receive such statements will not be informed about their
limitations or warned against their use. While placing a warning (or legend) on the financial statements
might reduce this risk, it also raises other concerns, as discussed later in this course.
d. Applying the Performance Requirements for a Compilation Can Be Difficult If the Financial Statements
Contain Numerous Departures from GAAP or OCBOA. SSARS No. 8 does not require a report, but it does
require the accountant to follow the performance standards in SSARS No. 1 for a compilation (have a
knowledge of the industry and the client, read the financial statements for obvious errors, etc.). Applying
those procedures when the financial statements contain numerous departures from prescribed basis of
accounting can be problematic. Though this course provides guidance on how the procedures might be
applied, certain areas are still difficult.
Ultimately, accountants will have to decide whether to submit managementuseonly financial statements without
issuing a compilation report. Accountants who choose to submit compiled managementuseonly financial state
ments without a compilation report generally will do so for clients for whom they currently prepare monthly financial
statements that omit substantially all disclosures. In addition, accountants who prepare tax returns and then submit
the related financial statements to clients for their use only may also find these communication requirements useful.
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CONSIDERING THE INTENDED USE OF THE FINANCIAL STATEMENTS

Introduction
Accountants who elect to submit managementuseonly financial statements without issuing a compilation report
will also have to determine the clients for which they may provide such services. Factors such as the definition of
management and third parties, the adequacy of management's knowledge, and the intended use of the financial
statements will affect the accountants' ability to submit managementuseonly financial statements without a report
in specific client situations.
Thirdpartyuse versus Managementuseonly Financial Statements
If the financial statements are, or can reasonably be expected to be, used by a third party, managementuseonly
financial statements are not appropriate for the client. In considering this provision, it is important to understand
how the term third party is defined in SSARS No. 1:
All parties except for members of management who are knowledgeable about the nature of the
procedures applied and the basis of accounting or assumptions used in the preparation of the
Thus, managementuseonly financial statements may only be issued if all intended users (a) are members of
management and (b) possess the requisite knowledge to understand the limitations of the financial statements.
Clearly, this limits management's ability to share the financial statements with others within the organization that
cannot be considered management. Thus, SSARS No. 1 limits the use of the financial statements to those
individuals who meet the definition of management within an organization. Consequently, the financial statements
are not appropriate for internal use only (that is, for use by all individuals within an organization).
Who Is Management? Though not required by SSARS No. 1, accountants might find the definition of management
in SFAS No. 57, Related Party Disclosures, helpful when considering which employees might be considered
members of management:
Persons who are responsible for achieving the objectives of the enterprise and who have the
authority to establish policies and make decisions by which those objectives are to be pursued.
Management normally includes members of the board of directors who are also members of
management, the chief executive officer, chief operating officer, vice presidents in charge of
principal business functions (such as sales, administration, or finance), and other persons who
perform similar policymaking functions. Persons without formal titles also may be members of
management.
This definition clarifies that others beside the traditional management team may also be appropriate users of
managementuseonly financial statements, and provides accountants with some flexibility when considering who
is expected to use the statements. In addition, because client organizations vary extensively, the determination of
who might be considered management may vary from one client to the next. In the end, the accountant should use
his or her professional judgment to determine who are the appropriate users within an organization.
Adequacy of Management's Knowledge
Managementuseonly financial statements compiled without a compilation report may contain numerous mea
surement departures from established bases of accounting (e.g., GAAP or OCBOA), as long as they meet the
client's needs. Because of that possibility, SSARS No. 1 requires that users have sufficient knowledge of account
ing matters to understand the possible limitations of such statements and to be able to put the information into its
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proper context. But how does the accountant determine whether management is knowledgeable enough to
understand the financial statements? When making that determination, accountants may consider the following:
Management's Actions. Like the adage says, actions speak louder than words. Thus, accountants might
consider management's actions when determining the extent of their financial knowledge. Actions that
might indicate knowledgeable management include
Asking questions about the financial statements and related matters.
Initiating discussions with the accountant prior to making important decisions that might have financial
consequences to the entity.
In contrast, a member of management who is surprised when net income reflected in yearend reviewed
GAAP financial statements is significantly different from net income portrayed in interim, compiled financial
statements containing numerous departures might be considered as lacking the required knowledge.
Accordingly, accountants might decide to issue a SSARS No. 1 compilation report when submitting
financial statements to such clients.
Nature of the Business. Management of a client that operates in a new or rapidly changing industry might
find it more difficult to attain (and maintain) the level of knowledge about accounting matters described in
the statement. Such clients might frequently engage in new, complex, or emerging types of business
transactions for which the accounting consequences are not always clearcut. Thus, it might be more
difficult for management to understand (a) the financial effects of its actions on the company's financial
position, cash flows, and results of operations and (b) the limitations of financial statements that contain
numerous departures. Consequently, accountants might choose to issue a SSARS No. 1 compilation
report when submitting financial statements to such clients.
Ultimately, it is up to the accountants to determine if they are comfortable with the level of management's knowl
edge and understanding of the possible limitations of managementuseonly financial statements. From a practical
standpoint, however, management should represent to the accountants in the engagement letter that all intended
users are members of management who possess the requisite knowledge. As long as the intended users appear
reasonable and nothing comes to the accountants' attention to contradict management's representations, the
accountants can rely on management's representation and perform a compilation of managementuseonly finan
cial statements.
Intended Use of the Financial Statements
Accountants should consider the reasons for which the client intends to use the financial statements. This might be
done based on the accountants' knowledge of and past experience with the client, as well as based on discussions
with the client as to how they intend to use the financial statements. SSARS No. 1 requires a client representation
that managementuseonly financial statements are not intended for thirdparty use. Accountants who become
aware that the financial statements have been distributed to third parties have certain responsibilities. Those
responsibilities are discussed later in this lesson. SSARS No. 1 provides that, absent any contradictory information
that comes to their attention, accountants may rely on those representations without performing any further
procedures.
Accountants should not, however, ignore information that would suggest that the financial statements might be
used by third parties. For example, if accountants have compiled financial statements for the client in years past to
meet certain provisions in a loan agreement, they might question whether such requirements are still in effect
before agreeing to submit managementuseonly financial statements. Accountants might also question the need
for thirdpartyuse financial statements if the client has entered into a new lending relationship during the current
year. If obvious facts suggest that the financial statements might be used by third parties (despite management's
representation to the contrary), accountants should compile and report on the statements in accordance with
SSARS No. 1.
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Accountants' Responsibilities When Managementuseonly Financial Statements Are Distributed to Third

Parties
SSARS No. 1 states that accountants who become aware that managementuseonly financial statements have
been distributed to third parties should
Discuss the situation with the client and request that the financial statements be returned.
If the client does not comply with that request within a reasonable period of time, the accountant should
notify known third parties that the financial statements are not intended for thirdparty use, preferably in
consultation with his or her attorney. Alternatives that might be discussed with an attorney include, but are
not limited to, an evaluation, if possible, of any damages that might have been, or may be, incurred because
of the use by a third party, and whether to continue to provide services to the client.
As discussed in the preceding paragraph, SSARS No. 1 places a responsibility on accountants who discover that
managementuseonly financial statements have been distributed to (and, presumably, are being used by) third
parties. In general, distributing managementuseonly financial statements to third parties is a violation of the terms
of the engagement. For that reason, accountants should generally add additional language in the engagement
letter to clarify that management also agrees not to distribute the financial statements to thirdparty users.
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CART07
SELFSTUDY QUIZ
following section.
25. What was the primary reason SSARS No. 8 was published as an amendment to SSARS No. 1?
a. It provided additional guidance to service providers by clarifying some ambiguities in SSARS No. 1.
b. It strengthened reporting requirements for compilations intended for use by third parties.
c. It provided relief from some reporting requirements for compilations intended for use by management only.
d. It replaced SSARS No. 1 as the primary statement regarding compilations intended for both
managementuseonly and thirdparties.
26. What is one advantage accountants cite when applying the provisions of SSARS No. 8 in the issuance of
managementuseonly financial statements?
a. SSARS No. 8 allows accountants to utilize streamlined compilation performance standards, resulting in
a more efficient and costeffective way to provide management with financial statements tailored to its
needs.
b. SSARS No. 8 does not require identifying known departures from the basis of accounting used to prepare
the financial statements, avoiding redundancies in communications with management.
c. SSARS No. 8 requires accountants to conform to more stringent reporting standards, shielding service
providers from potentially costly litigation.
d. SSARS No. 8 creates a new, higher level of service, providing accountants with a competitive advantage
over other financial statement issuers.
27. What is one risk accountants cite when applying the provisions of SSARS No. 8 in the issuance of
managementuseonly financial statements?
a. SSARS No. 8 is intended for managementuseonly financial statements, but accountants assume third
parties will have access to them, resulting in lost fee realization on the part of the firm.
b. SSARS No. 8 does not require identifying known departures from the basis of accounting used to prepare
the financial statements, perhaps causing unsophisticated clients to make inappropriate business
decisions in reliance on those statements.
c. SSARS No. 8 does not require accountants to issue a compilation report, thereby omitting important
disclosures to management which might lead to inappropriate business decisions in reliance on those
statements.
d. SSARS No. 8 requires that management make certain representations to third parties before releasing the
financial statements, while accountants are not assured management will provide the appropriate
disclosures to potential third party users.
28. According to the definition in SSARS No. 1, which of the following persons is most likely to be considered a
third party" as it relates to managementuseonly financial statements?
a. Accounting manager.
b. Vice president of sales.
c. Accounts receivables clerk.
d. Vice president of finance.
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29. When deciding whether to issue a SSARS No. 1 compilation report or apply SSARS No. 8 and issue
managementuseonly financial statements, which of the following factors should an accountant consider?
a. Total revenues of the company.
b. Adequacy of the internal control system.
c. Compliance with debt covenants.
d. Actions of management.
managementuseonly financial statements, what is the first question an accountant might pose to a client?
a. What is the intended use of the financial statements?
b. What is the nature of your business?
c. How many members are in your management team?
d. What is the financial background of your management team?
31. What is the first action accountants should take if they discover that managementuseonly financial statements
have been distributed to third parties?
a. Discontinue the relationship with the client based on management's violation of the terms of the
engagement.
b. Consult with an attorney to decide on a course of action to limit potential liability resulting from a third
party's inappropriate reliance on the financial statements.
c. Discuss the situation with the client and request that the financial statements be returned.
d. Review the engagement letter to determine the agreedupon means of resolution pursuant to a violation
of the terms of the engagement.
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SELFSTUDY ANSWERS
25. What was the primary reason SSARS No. 8 was published as an amendment to SSARS No. 1? (Page 43)
a. It provided additional guidance to service providers by clarifying some ambiguities in SSARS No. 1. (This
answer is incorrect. SSARS No. 8 did not clear up ambiguities from SSARS No. 1.)
b. It strengthened reporting requirements for compilations intended for use by third parties. (This answer is
incorrect. SSARS No. 8 did not strengthen reporting requirements.)
c. It provided relief from some reporting requirements for compilations intended for use by
management only. (This answer is correct. SSARS No. 8 was intended to address accountants'
concerns that the requirements of SSARS No. 1 placed them at a competitive disadvantage to other
financial statement service providers.)
d. It replaced SSARS No. 1 as the primary statement regarding compilations intended for both
managementuseonly and thirdparties. (This answer is incorrect. SSARS No. 8 was not published as a
standalone statement but to be incorporated into SSARS No. 1.)
26. What is one advantage accountants cite when applying the provisions of SSARS No. 8 in the issuance of
managementuseonly financial statements? (Page 43)
a. SSARS No. 8 allows accountants to utilize streamlined compilation performance standards, resulting in
a more efficient and costeffective way to provide management with financial statements tailored to its
needs. (This answer is incorrect. SSARS No. 8 requires accountants to follow the compilation performance
standards in SSARS No. 1.)
b. SSARS No. 8 does not require identifying known departures from the basis of accounting used to
prepare the financial statements, avoiding redundancies in communications with management.
(This answer is correct. SSARS No. 8 eliminates this requirement which some accountants feel is
too timeconsuming and of little to no benefit to management.)
c. SSARS No. 8 requires accountants to conform to more stringent reporting standards, shielding service
providers from potentially costly litigation. (This answer is incorrect. SSARS No. 8 provides relief from some
reporting standards, perhaps exposing accountants to additional liability.)
d. SSARS No. 8 creates a new, higher level of service, providing accountants with a competitive advantage
over other financial statement issuers. (This answer is incorrect. SSARS No. 8 does not create a new, higher
level of service but perhaps a more efficient one, allowing accountants to compete with other financial
statement issuers.)
27. What is one risk accountants cite when applying the provisions of SSARS No. 8 in the issuance of
managementuseonly financial statements? (Page 44)
a. SSARS No. 8 is intended for managementuseonly financial statements, but accountants assume third
parties will have access to them, resulting in lost fee realization on the part of the firm. (This answer is
incorrect. Some accountants do believe that third parties will obtain access to managementuseonly
statements, yet the primary risk to the firm will be increased legal liability, not lost revenue.)
b. SSARS No. 8 does not require identifying known departures from the basis of accounting used to
prepare the financial statements, perhaps causing unsophisticated clients to make inappropriate
business decisions in reliance on those statements. (This answer is correct. SSARS No. 8 eliminates
this requirement, yet some accountants believe that unsophisticated clients might not fully
understand the extent to which the statements might not present the company's financial position.)
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c. SSARS No. 8 does not require accountants to issue a compilation report, thereby omitting important
disclosures to management which might lead to inappropriate business decisions in reliance on those
statements. (This answer is incorrect. While SSARS No. 8 does not require accountants to issue a
compilation report, important disclosures are made to management in an engagement letter.)
d. SSARS No. 8 requires that management make certain representations to third parties before releasing the
financial statements, while accountants are not assured management will provide the appropriate
disclosures to potential third party users. (This answer is incorrect. Management is not permitted to release
financial statements compiled under SSARS No. 8 to third parties.)
28. According to the definition in SSARS No. 1, which of the following persons is most likely to be considered a
third party" as it relates to managementuseonly financial statements? (Page 45)
a. Accounting manager. (This answer is incorrect. While management" normally includes persons at
executive levels, an accounting manager could be considered management under the definition in SSARS
No.1.)
b. Vice president of sales. (This answer is incorrect. Vice presidents in charge of principal business functions
are normally considered management and meet the definition in SSARS No. 1.)
c. Accounts receivables clerk. (This answer is correct. According to SSARS No. 1, third party" is
defined as all parties except for members of management who are knowledgeable about the nature
of the procedures applied and the basis of accounting or assumptions used in the preparation of
the financial statements. The A/R clerk is not likely to meet the definition of management.)
d. Vice president of finance. (This answer is incorrect. Vice presidents in charge of principal business
functions are normally considered management and meet the definition in SSARS No. 1.)
managementuseonly financial statements, which of the following factors should an accountant consider?
(Page 45)
a. Total revenues of the company. (This answer is incorrect. Total revenues are irrelevant when deciding
between application of SSARS No. 1 and SSARS No. 8.)
b. Adequacy of the internal control system. (This answer is incorrect. While the adequacy of the internal
control system might provide evidence of management's financial knowledge, the accountant should first
consider management's questions and discussion regarding the financial statements when deciding
between application of SSARS No. 1 and SSARS No. 8.)
c. Compliance with debt covenants. (This answer is incorrect. The existence of debt covenants is irrelevant
when deciding between application of SSARS No. 1 and SSARS No. 8. and also might indicate that the
financial statements will be used by third parties.)
d. Actions of management. (This answer is correct. Based on discussions with management and
observation of company's procedures prior to the engagement, accountants should be able to
ascertain the extent of management's financial knowledge and decide which type report is
appropriate.)
managementuseonly financial statements, what is the first question an accountant might pose to a client?
(Page 46)
a. What is the intended use of the financial statements? (This answer is correct. The intended use of
the financial statements is the most appropriate guiding factor when deciding between the two
options.)
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b. What is the nature of your business? (This answer is incorrect. While the nature of a client's business might
lend evidence as to how the financial statements will be used, it does not provide assurance that they will
not be used by third parties.)
c. How many members are in your management team? (This answer is incorrect. The size of the client's
management team is irrelevant when deciding between application of SSARS No. 1 and SSARS No. 8.)
d. What is the financial background of your management team? (This answer is incorrect. While the financial
background of a client's management team might lend evidence as to the ability of management to
understand managementuseonly financial statements, it does not provide assurance that they will not
be used by third parties.)
31. What is the first action accountants should take if they discover that managementuseonly financial statements
have been distributed to third parties? (Page 47)
a. Discontinue the relationship with the client based on management's violation of the terms of the
engagement. (This answer is incorrect. While the decision to terminate the relationship might be ultimately
justified, this is not the first action the accountant should take.)
b. Consult with an attorney to decide on a course of action to limit potential liability resulting from a third
party's inappropriate reliance on the financial statements. (This answer is incorrect. Consultation with an
attorney would be the second step.)
c. Discuss the situation with the client and request that the financial statements be returned. (This
answer is correct. SSARS No. 1 indicates that this step should be taken first when managementuse
only financial statements have been distributed to third parties.)
d. Review the engagement letter to determine the agreedupon means of resolution pursuant to a violation
of the terms of the engagement. (This answer is incorrect. Alternative dispute resolution might be
necessary, but this is the not first action the accountant should take.)
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COMPILATION PROCEDURES
Introduction
SSARS No. 1 establishes several performance requirements for all compilation engagements, including engage
ments to compile financial statements for management use only, engagements to compile specified elements,
accounts, or items of a financial statement, and engagements to compile pro forma financial information. Therefore,
accountants who are engaged to compile financial statements or information or those who submit financial
statements to clients or others should
a. Establish an understanding with the entity regarding the services to be performed (AR 100.05).
b. Have, or obtain, knowledge of the accounting principles and practices of the entity's industry and a general
understanding of certain matters related to the entity itself (AR 100.07.08).
c. Consider whether it will be necessary to perform other accounting services such as assistance in adjusting
the books of account or consultation on accounting matters (AR 100.08).
d. Take certain actions when the accountant becomes aware that information supplied by the entity is
incorrect, incomplete, or otherwise unsatisfactory (AR 100.09).
e. Read the compiled financial statements and consider whether they appear to be appropriate in form and
free from obvious material error (AR 100.10).
Those requirements are discussed in more detail in the following paragraphs. Note that SSARS No. 1 does not
specify who must complete the compilation performance procedures. In general, the SSARS performance proce
dures may be delegated to any individual within the CPA firm (including a paraprofessional) who (a) possesses the
necessary experience, knowledge, and skills to perform the procedures effectively and (b) is adequately super
vised. The flowchart in Exhibit 21 presents an overview of the professional standards accountants should follow
when compiling financial statements.
Understanding with the Entity
SSARS No. 1 requires accountants to document an understanding with the client through the use of an engage
ment letter for compiled managementuseonly financial statements. Engagement letters are not required for
compilations for which a report will be issued; however, it is good practice to use engagement letters in all
engagements.
Knowledge of the Industry
The level of knowledge of the accounting principles and practices of the industry must be sufficient to enable the
accountants to compile the financial statements in the appropriate form. For example, before compiling financial
statements of a securities broker, the accountants should have a sufficient understanding of the securities industry
to know that classification of current assets and liabilities is not appropriate.
The required knowledge of the accounting principles and practices of the industry does not have to be present to
accept the engagement. However, the accountant must acquire the knowledge before completing the engage
ment.
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Exhibit 21
Compilation of Financial Statements
Did you
submit
financial
statements?
SSARS No. 1 is not

applicable
No
Yes
Are any
exemptions
from
SSARS No. 1
applicable?
Follow applicable guidance:

Reporting on Personal Financial Statements Included in
Written Personal Financial Plans (SSARS No. 6)
Compilation Reports on Financial Statements Included in
Certain Prescribed Forms (SSARS No. 3)
Litigation support services (SSARS No. 1, Interpretation 20)
Yes
No
Were you
engaged to com
pile and report
on financial
statements?
Yes
Follow the performance and reporting requirements of SSARS No. 1
No
Do you rea
sonably
expect a third
party to use
the compiled
financial state
ments?
Yes
Follow the performance requirements of SSARS No. 1, AND

Follow the communication requirements of SSARS No. 1,
which include either:
Issuing a SSARS No. 1 compilation report OR
Obtaining an engagement letter preferably signed by
management
No
Knowledge of the Client

The second prerequisite concerns knowledge about the specific client, rather than the industry in general. Again,
accountants do not have to possess an understanding of the client's business to accept the engagement. They
must, however, possess the requisite knowledge of the client before they complete the engagement. Accountants
can normally acquire this understanding through observation and inquiry of client personnel.
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SSARS No. 1, (AR 100.08), lists the following specific areas of the client's business about which accountants
should have a general understanding:
a. Nature of the Entity's Business Transactions. This refers to sources of revenues, its major expenditures, etc.
b. Form of its Accounting Records. This means knowledge of books of original entry, subsidiary journals and
ledgers, data processing applications, etc.
c. Stated Qualifications of its Accounting Personnel. This suggests knowledge of the education, training, and
experience of personnel involved in the recordkeeping function. (The word stated" permits the accountant
to rely on representations made by client personnel.)
d. Accounting Basis on Which the Financial Statements Are to Be Presented. This refers to GAAP or some other
comprehensive basis of accounting such as the tax basis or cash basis.
e. Form and Content of the Financial Statements. This suggests application of knowledge of both the client
and its industry so that the statements can be presented in proper form.
Compilation of Managementuseonly Financial Statements. In a compilation of managementuseonly financial
statements, observation and inquiry of client personnel and the review of the accounting records generally will
provide accountants with the required knowledge of items a. through c. Applying items d. through e., however, may
be more complex. In the majority of cases, accountants and management will discuss the expected form and
content of financial statements by first discussing the basis of accounting (GAAP or OCBOA) on which such
statements are to be prepared. From that starting point, depending on its needs, management may request the
accountants to omit (a) certain accruals or other adjustments necessary to conform the statements to the basis of
accounting and/or (b) disclosures required by that basis of accounting. In other situations, management might
request so many modifications/omissions to the statements that they will not conform to either GAAP or OCBOA. In
any event, accountants can only apply the requirements in items d. and e. in the above paragraph by considering
the nature and extent of omissions/modifications to the financial statements that management has requested the
accountants to make. Thus, when considering the form and content of the financial statements, accountants should
consider only whether the statements reflect the omissions or modifications management has asked the accoun
tants to either make or omit (e.g., accruals of accounts receivables, inventory, etc.). Furthermore, it is manage
ment's responsibility, and not the accountants', to determine if the form and content of financial statements
requested will result in a financial presentation that is appropriate for management's intended use. In general, it is
not the accountants' responsibility to determine if the financial statements will be, in fact, appropriate for the use for
which management intends.
As discussed in the preceding paragraph, the performance requirements of SSARS No. 1 that relate to manage
mentuseonly financial statements can be met only by considering the omissions/modifications that management
has requested the accountants to make. Some accountants may decide to document in their workpapers the basis
of accounting that will be used to prepare the financial statements, as well as the specific modifications and
omissions that management has requested. Others may believe such factors are better documented in the
engagement letter. Those who choose to document those matters, however, will have to address the question Is
it necessary to update such documentation when the client's requests change?"
This question creates somewhat of a dilemma for the accountants. If such documentation does not list all known
departures and is not updated as the client's requests change, its value is questionable. On the other hand, if such
documentation lists all known departures and is updated as the client's requests change, the potential efficiencies
of compiling managementuseonly financial statements without issuing a compilation report may be lost; conse
quently, accountants might find that it is easier to compile and report on those statements.
Reading the Compiled Financial Statements
The reading of the financial statements that is required by SSARS No. 1, (AR 100.10), stipulates an inspection of the
statements after their preparation. The inspection is a review of the final product before release. In some firms, this
procedure is performed by requiring a review by the partner signing the statements or a second partner review. The
reading should be directed toward identifying material departures from GAAP (including inadequate disclosure)
and mathematical or clerical errors.
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Compilation of Managementuseonly Financial Statements. In some cases, it might be difficult for an accoun
tant to have a basis for reading managementuseonly financial statements. As discussed previously, the nature
and extent of modifications/omissions to the financial statements that management requests sometimes makes it
difficult to determine the basis of accounting to which the final financial statements conform. If that is unclear, it is
likewise difficult to identify material departures from that basis or to determine how the financial statements should
be titled. For accountants who decide to detail known departures in the engagement letter, the financial statement
titles can be listed as one of the departures from either GAAP or OCBOA. In the end, accountants should merely
read the statements to determine whether they are (a) appropriate given the modifications or omissions manage
ment has requested and (b) free of mathematical or clerical errors.
Other Accounting Services
SSARS No. 1 (AR 100) requires accountants to consider, on the basis of his knowledge of the client, whether they
should provide other accounting services such as assistance in journalizing, posting, or adjusting the books.
Accountants should not compile financial statements from records that they suspect, because of their knowledge
of the client, to be an inadequate basis for such statements. They should instead provide the accounting services
necessary to complete the accounting records. When considering whether it is necessary to provide other account
ing services, the accountants should consider the modifications/omissions to the financial statements that manage
ment has requested the accountant to make, as discussed in previous paragraphs. Accounting services that involve
processing an entity's transactions or preparing an entity's accounting records would be considered nonattest
services. Accounting services, such as proposing journal entries and preparing financial statements, performed as
part of the compilation or review would not be considered nonattest services. If an accountant performs nonattest
services for a compilation or review client, he or she must comply with the requirements of ET Interpretation 1013,
Performance of Nonattest Services."
Incorrect, Incomplete, or Unsatisfactory Information
Under SSARS No. 1, accountants should consider whether information received from the client is incorrect,
incomplete, or otherwise unsatisfactory based on (a) other procedures they have performed (e.g., accounting
services), (b) knowledge of the client, or (c) the form and content of the financial statements themselves. When
compiling managementuseonly financial statements however, accountants must consider this issue in light of the
modifications/omissions to the financial statements management has asked them to make, as discussed in previous
paragraphs.
Legend for Managementuseonly Financial Statements
SSARS No. 1 requires each page of managementuseonly financial statements to include a reference (or legend)
that restricts the use of such statements to management. The requirements of the legend, and how it should be
placed on the financial statements is beyond the scope of this course.
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COMPILATION ENGAGEMENT CHECKLISTS

Compilation Checklists Should Include Procedures Necessary to Comply with the QC Standards
All CPA firms that perform compilation engagements should have a QC system that conforms to the requirements
of the QC standards. In spirit, most firms that use standardized compilation checklists already do this. However, the
checklists they use may not contain the steps necessary to sufficiently document compliance with the QC stan
dards.
Select a System of Compilation Checklists That Complements Your Firm Size
QC checklists for compilation engagements can be designed in many ways. While no two firms approach a
compilation engagement in exactly the same manner, firms of common size tend to follow similar engagement
procedures. For example, sole practitioners who are involved in all facets of a compilation engagement (from
bookkeeping to issuing the report or engagement letter) may need only a limited number of checklists. On the other
hand, large firms that delegate engagement responsibilities to several accountants may need a more elaborate
system of checklists to track the flow of the work through the firm.
Exhibit 22 presents guidelines for designing a firm's own system of QC checklists. This exhibit can be used to
a. Tailor the firm's QC system to indicate which checklists are necessary (if the firm has not adopted PPC's
QC system outlined in PPC's Guide to Quality Control).
b. Tailor PPC's QC system to fit the specific needs of each firm.
Exhibit 22
Compilation Checklists and Workpapers
Note:The terms required, recommended, optional, and not applicable do not necessarily indicate the SSARS
requirements. However, the checklists and practice aids identified as required are generally the minimum
necessary to document compliance with the SSARS and peer review requirements.a Some of the procedures
required to be performed to comply with peer review requirements may not have to be accomplished by
completing one of the checklists or practice aids listed below. For example, for thirdpartyuse financial statement
engagements, an understanding with the client regarding the services to be performed is required. However, an
engagement letter is not required. If the engagement letter (recommended, but not required per this exhibit) is not
issued, compliance with this procedure is ensured by completing the compilation procedures checklist (required
per this exhibit).
Thirdpartyuse
Financial Statement
Engagements
Managementuseonly Financial
Statement Engagementsb
Written
Firm
Policies
Recommended
Recommended
Compilation
Procedures
Checklists
REQUIRED
REQUIRED
Engagement
Acceptance
Form
Recommended
Recommended
Engagement
Letters
Recommended
REQUIRED
Description
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Thirdpartyuse
Financial Statement
Engagements
Managementuseonly Financial
Statement Engagementsb
Client
Information
Form
Recommended
Recommended
Compilation
Reporting
Checklist
Recommended
Not Applicable
Recommended
Optional
Recommended
Not Applicablec
REQUIRED
REQUIREDd
Description
Financial State
ment Disclosure
Checklist
Summarized
Longform
Technical
Reviewer
Checklist
Adjusted
Trial
Balance
Client's
Financial
Statements
Accountant's
Compilation
Report
Other
Workpapers
Notes:
a
Firms that compile managementuseonly financial statements without issuing a report as the highest level of
service provided by the firm are not required to join a peer review program. However, if the firm is already
subject to peer review, the managementuseonly compilations will be subject to selection by the peer
reviewers.
This exhibit assumes the firm will issue an engagement letter in lieu of a report when managementuseonly
financial statements are compiled.
For managementuseonly financial statements, an independent internal review would be performed in lieu of
a technical review.
All of the items noted are required except the report, which is not applicable as indicated in note b.
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At some stage in a firm's growth, the size of the client base and staff makes it impractical to orally communicate the
many nuances of the firm's engagement process. Accordingly, a firm should consider preparing a written docu
ment that explains the engagement process and the use of checklists on each engagement. Care should be taken
to ensure that the engagement approach agrees with the policies and procedures in the firm's QC document.
A firm's QC document should not be confused with written procedures that explain how to conduct a compilation
or review engagement. A QC document is an overall policy and procedure statement that explains a firm's system
for complying with the quality control elements found in the QC standards. For example, regarding engagement
performance, the firm's QC document may say, among other things, that standardized checklists and forms are
used to supervise compilation and review engagements. The QC document normally does not specify how those
checklists are used, but instead references a separate explanation in the firm's accounting manuals.
Firms also should determine whether they want their quality control policies and procedures to cover compilations
of managementuseonly financial statements. In connection with such engagements, firms will have to consider
issues such as whether to require a review by a technical partner and, if so, how frequently such a review should
take place (first engagement only, monthly, annually, etc.). More importantly, if a firm's existing QC procedures
require such a review for compilation engagements, firms may need to clarify whether those same QC procedures
should apply to compilations of managementuseonly financial statements.
Compilation Procedures Checklists
The Compilation Procedures Checklists provide documentation of compliance with professional standards and
peer review requirements. The professional staff person in charge of the compilation engagement generally should
complete the checklist. Three compilation procedures checklists are as follows:
Compilation Procedures Checklist (Comprehensive). This checklist may be used for all compilation
engagements in which a report will be issued. Various steps on the checklist include expanded discussions
or memory joggers highlighting items accountants should consider when completing compilation
engagements.
Compilation Procedures Checklist (Summarized). This checklist is designed for accountants who (a)
frequently perform compilation engagements, (b) are familiar with the requirements of SSARS, and (c)
intend to issue a compilation report. The checklist does not include the memory joggers found in the
comprehensive compilation checklist noted above. Accountants who perform a significant number of
compilations and are familiar with SSARS often find such memory joggers to be cumbersome and
unnecessary.
Procedures Checklist for Compilations of Managementuseonly Financial Statements. This checklist may
be used when compiling managementuseonly financial statements (that is, financial statements not
intended to be used by third parties) without issuing a report.
Firm policies can simply require that a Compilation Procedures Checklist" be completed for each engagement.
When a compilation report will be issued, the decision of whether to use the comprehensive or summarized
checklist can be made on an engagementbyengagement basis, depending on the personnel involved in the
engagement. If firms prefer, however, they can be more specific in their firm policies by designating the circum
stances under which the summarized checklist may be used.
Engagement Acceptance Form
SQCS No. 2 requires CPA firms to establish policies and procedures to minimize the likelihood of accepting or
continuing association with a client whose management lacks integrity. Consequently, before a firm accepts an
engagement to prepare compiled or reviewed financial statements, it should carefully consider whether it should be
associated with the client and/or the engagement. This decision is normally based on factors such as the following:
a. The client's integrity.
b. The firm's ability to service the client properly.
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c. The client's financial strength.

d. The fee arrangements.
e. Independence.
f. The client's potential for growth.
g. Information obtained from predecessor accountants.
The Engagement Acceptance Form" is designed to assist a firm in making this decision. This form can also be
used to evaluate the desirability of continuing to perform an engagement for an existing client, particularly when a
situation arises that would have caused the firm to reject the client or engagement initially.
Engagement Letters
As discussed in the first lesson, SSARS No. 1 requires accountants to document an understanding with the client
through the use of an engagement letter when managementuseonly financial statements are compiled without
issuing a report. For all other SSARS engagements, the SSARS require an understanding with the client regarding
the terms of the engagement. However, an engagement letter is not required.
Client Information Form
The Client Information Form" is designed to document compliance with SSARS No. 1, AR 100.07.08, regarding
the knowledge required for a compilation, and AR 100.26.28 regarding the level of knowledge necessary for a
review engagement. The knowledge required for a review engagement is somewhat more comprehensive than for
a compilation engagement. However, rather than use two separate forms, one form that meets both requirements
is generally acceptable since the time necessary to complete the additional review engagement information is
minimal. The form is generally reviewed annually by the personnel assigned to the client and updated annually for
any changes in the client's operations.
Compilation Reporting Checklist
This checklist is designed to document the SSARS reporting requirements when accountants compile financial
statements and issue a report. It presents common reporting requirements for compiled financial statements. It
should be emphasized, however, that this checklist cannot be a substitute for accountants' exercise of professional
judgement and knowledge of SSARS.
Technical Reviewer Checklist
Some firms designate someone not involved with the engagement to review financial statements and selected
workpapers. (Because of limited resources, smaller firms may find this impossible.) These independent reviews
concentrate on the accountants' report and financial statement presentation and disclosure and are performed by
someone with a strong technical background. Firms sometimes use this person to monitor compliance with certain
firm policies. In order for this position to be effective, the person must have sufficient authority to ensure that all
points are resolved.
In some firms, the independent technical review is required before the workpapers and report go to the engage
ment partner. In other firms, the technical review comes after the engagement partner's review.
For managementuseonly financial statements, an independent internal review would be performed in lieu of a
technical review. If required by the partner or the Firm's quality control policies and procedures, such a review
should include a review of the engagement letter and financial statements and supplementary information.
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OTHER REQUIREMENTS OF THE PROFESSION

Rule 201
Accountants must keep in mind that in any engagement they must comply with the general standards of Rule 201
(ET 201) of the AICPA Code of Professional Conduct. While pronouncements of the ARSC (SSARS and interpreta
tions of SSARS) are designed to provide guidance to accountants attempting to comply with Rule 201, accountants
must use judgment and guidance from other accounting literature for areas not addressed in SSARS No. 1 (AR
100).
Quality Control Standards
QC standards require all CPA firms that perform compilation or review engagements to have a QC system. This
requirement applies to interim as well as yearend financial statement engagements. A QC system is a series of
policies, procedures, and related checklists designed to provide a firm with reasonable assurance of conforming to
professional standards. Specifically, SQCS No. 2 (QC 20) requires that a firm's QC system encompass the
following QC elements:
Independence, integrity, and objectivity.
Personnel management.
Acceptance and continuance of clients and engagements.
Engagement performance.
Monitoring.
As previously discussed, when designing checklists to perform compilation engagements, the accountants should
also consider including QC steps to comply with the QC standards.
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SELFSTUDY QUIZ
following section.
32. What is the most important reason SSARS No. 1 requires accountants to have knowledge of the industry to
compile financial statements for a client?
a. In order to properly detail known departures from the basis of accounting used to prepare the financial
statements.
b. In order to perform an accurate analytical review comparing the client to other companies within the same
industry.
c. In order to appropriately classify accounting items specific to a particular industry.
d. In order to determine whether or not to accept the engagement by determining if the firm possesses the
appropriate technical expertise as defined by SSARS No. 1.
33. According to SSARS No. 1, what is required of the accountant in determining the qualifications of accounting
personnel of the client in a compilation engagement?
a. The accountant must compare the stated qualifications of all accounting personnel to appropriate
documentation maintained at relevant state licensing boards.
b. The accountant may rely on the representations made by client personnel.
c. The accountant must verify the accounting qualifications of management personnel who sign the
engagement letter.
34. What is one dilemma encountered by accountants in meeting the performance requirements established by
SSARS No. 1 with respect to managementuseonly financial statements?
a. Reading the compiled financial statements and considering whether they appear to be appropriate in form
is more difficult when management requests significant omissions and modifications from GAAP or
OCBOA.
b. Gaining knowledge of the accounting practices and principles of the client's industry is more difficult when
management requests financial statements to be presented in a form other than GAAP or OCBOA.
c. Establishing an understanding with the entity regarding the services to be performed is more difficult when
management requests significant omissions and modifications from GAAP or OCBOA.
d. Obtaining knowledge of the client is more difficult when management requests financial statements to be
presented in a form other than GAAP or OCBOA.
35. What is a major difference between the presentation of compiled financial statements for managementuse
only and for third parties?
a. SSARS No. 1 requires the cover page of managementuseonly financial statements to include a reference
that restricts the use of such statements to management.
b. SSARS No. 1 requires the cover page of managementuseonly financial statements to detail the known
departures from the basis of accounting used to prepare the financial statements.
c. SSARS No. 1 requires the cover page of managementuseonly financial statements to detail the members
of client's management who are permitted to rely on the financial statements.
d. SSARS No. 1 requires each page of managementuseonly financial statements to include a reference that
restricts the use of such statements to management.
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36. Which of the following quality control elements is required in a firm's quality control system to conform to SQSC
No. 2, which requires all CPA firms that perform compilation engagements to have a QC system?
a. Risk control assessment.
b. Monitoring.
c. Review of fee realization.
d. Threat to independence evaluation.
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SELFSTUDY ANSWERS
32. What is the most important reason SSARS No. 1 requires accountants to have knowledge of the industry to
compile financial statements for a client? (Page 54)
a. In order to properly detail known departures from the basis of accounting used to prepare the financial
statements. (This answer is incorrect. Although the issuance of a compilation report under SSARS No. 1
requires this disclosure, the nature of the industry would not affect this standard requirement of SSARS
No.1.)
b. In order to perform an accurate analytical review comparing the client to other companies within the same
industry. (This answer is incorrect. Analytical review procedures are performed in a review or audit
engagement, not a compilation engagement.)
c. In order to appropriately classify accounting items specific to a particular industry. (This answer is
correct. To enable accountants to compile the financial statements in the appropriate form, they
must have sufficient knowledge of the accounting principles and practices of the client's industry.)
d. In order to determine whether or not to accept the engagement by determining if the firm possesses the
appropriate technical expertise as defined by SSARS No. 1. (This answer is incorrect. The accountant does
not have to possess the required knowledge before accepting the engagement but must acquire the
knowledge before completing the engagement.)
33. According to SSARS No. 1, what is required of the accountant in determining the qualifications of accounting
personnel of the client in a compilation engagement? (Page 56)
a. The accountant must compare the stated qualifications of all accounting personnel to appropriate
documentation maintained at relevant state licensing boards. (This answer is incorrect. The accountant
is not required to obtain corroboration of qualifications of the client's personnel.)
b. The accountant may rely on the representations made by client personnel. (This answer is correct.
SSARS No. 1 states that an accountant should have a general understanding of only the stated"
qualifications of a client's accounting personnel and, therefore, can rely on client representations.)
c. The accountant must verify the accounting qualifications of management personnel who sign the
engagement letter. (This answer is incorrect. SSARS No. 1 states that an accountant should have a general
understanding of only the stated" qualifications of a client's accounting personnel.)
34. What is one dilemma encountered by accountants in meeting the performance requirements established by
SSARS No. 1 with respect to managementuseonly financial statements? (Page 57)
a. Reading the compiled financial statements and considering whether they appear to be appropriate
in form is more difficult when management requests significant omissions and modifications from
GAAP or OCBOA. (This answer is correct. The nature and extent of modifications and omissions to
the financial statements that management requests sometimes makes it difficult to determine the
basis of accounting to which the financial statements conform.)
b. Gaining knowledge of the accounting practices and principles of the client's industry is more difficult when
management requests financial statements to be presented in a form other than GAAP or OCBOA. (This
answer is incorrect. Management's request that financial statements be presented in a form other than
GAAP or OCBOA would have no effect on the ability to gain knowledge of the client's industry.)
c. Establishing an understanding with the entity regarding the services to be performed is more difficult when
management requests significant omissions and modifications from GAAP or OCBOA. (This answer is
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incorrect. Management's request of significant omissions and modifications from GAAP or OCBOA would
have no effect on the ability to establish an understanding with the entity regarding the services to be
performed.)
d. Obtaining knowledge of the client is more difficult when management requests financial statements to be
presented in a form other than GAAP or OCBOA. (This answer is incorrect. Management's request that
financial statements be presented in a form other than GAAP or OCBOA would have no effect on the ability
to obtain knowledge of the client.)
35. What is a major difference between the presentation of compiled financial statements for managementuse
only and for third parties? (Page 57)
a. SSARS No. 1 requires the cover page of managementuseonly financial statements to include a reference
that restricts the use of such statements to management. (This answer is incorrect. SSARS No. 1 requires
this disclosure; however, this answer choice does not correctly state the required disclosure.)
b. SSARS No. 1 requires the cover page of managementuseonly financial statements to detail the known
departures from the basis of accounting used to prepare the financial statements. (This answer is incorrect.
SSARS No. 1 does not require this disclosure in an engagement to compile managementuseonly
financial statements.)
c. SSARS No. 1 requires the cover page of managementuseonly financial statements to detail the members
of client's management who are permitted to rely on the financial statements. (This answer is incorrect.
SSARS No. 1 does not require this disclosure.)
d. SSARS No. 1 requires each page of managementuseonly financial statements to include a
reference that restricts the use of such statements to management. (This answer is correct. SSARS
No. 1 requires this disclosure on each page of managementuseonly financial statements.)
36. Which of the following quality control elements is required in a firm's quality control system to conform to SQSC
No. 2, which requires all CPA firms that perform compilation engagements to have a QC system? (Page 62)
a. Risk control assessment. (This answer is incorrect. A risk control assessment is not an element required
by SQCS No. 2 to be included in a firm's QC system.)
b. Monitoring. (This answer is correct. SQCS No. 2 requires this element as part of a firm's QC system.)
c. Review of fee realization. (This answer is incorrect. A review of fee realization is not an element required
by SQCS No. 2 to be included in a firm's QC system.)
d. Threat to independence evaluation. (This answer is incorrect. While a firm must be vigilant in identifying
threats to independence, this type of evaluation is not an element required by SQCS No. 2 to be included
in a firm's QC system.)
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Lesson 3:Review Procedures and Checklists

This lesson discusses the factors a practitioner should consider when performing review engagements, including
a detailed discussion of the different types of analytical procedures used in a review. The lesson also includes the
procedures a practitioner must follow to perform review engagements, including the proper elements of a
representation letter.
Describe the knowledge required of an accountant to perform a review engagement.
Choose appropriate analytical procedures to perform in a review engagement.
Analyze the necessary elements of a representation letter required in a review engagement.
INTRODUCTION
SSARS No. 1, (AR100.04), as amended, defines a review of financial statements as follows:
Performing inquiry and analytical procedures that provide the accountant with a reasonable basis
for expressing limited assurance that there are no material modifications that should be made to
the financial statements for them to be in conformity with GAAP or, if applicable, OCBOA.
The definition clearly states that the accountant is expected to perform inquiry and analytical procedures before
expressing limited assurance. Thus, merely compiling financial statements and reading them is an insufficient basis
for expressing limited assurance. On the other hand, as stated in SSARSNo.1, (AR100.25), a review does not
contemplate obtaining an understanding of internal control and assessing control risk, tests of accounting records
and of responses to inquiries by obtaining corroborating evidential matter, and certain other procedures ordinarily
performed during an audit. Thus, the procedures required for a review of financial statements fall somewhere
between the two extremes of compilation standards and GAAS.
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KNOWLEDGE OF THE BUSINESS

SSARS No. 1, (AR100.26), requires an accountant who issues a review report to possess a level of knowledge of
the accounting principles and practices of the industry in which the entity operates. Also, the accountant should
obtain an understanding of the entity's business that will provide him, through the performance of inquiry and
analytical procedures, with a reasonable basis for expressing limited assurance that there are no material modifica
tions that should be made to the financial statements.
What Level of Knowledge Is Necessary?
The accountant need not be an expert in the industry nor even have experience in the industry. He must, however,
be familiar with its unique principles and practices. Unless the accountant is at least aware of the accounting
principles and practices of the industry, he will not have an adequate basis for the selection of his inquiries and
analytical procedures, nor will he have a sound basis for making professional judgments concerning the results of
the review procedures.
Each business within an industry is unique to some degree. Thus, the accountant must go beyond his knowledge
of the industry and acquire an understanding of the entity's business. An understanding of the industry, but not the
entity, is not an adequate basis for performing a review.
The particular aspects of the entity's business that the accountant should understand are stated in SSARSNo.1,
(AR100.28):
The accountant's understanding of the entity's business should include a general understanding
of the entity's organization, its operating characteristics, and the nature of its assets, liabilities,
revenues, and expenses. This would ordinarily involve a general knowledge of the entity's
production, distribution, and compensation methods, types of products and services, operating
locations, and material transactions with related parties.
The level of understanding concerns the scope of the accountant's knowledge rather than its depth. Familiarity with
each of the areas discussed previously is sufficient, whereas an indepth knowledge of the industry but a lack of
familiarity with the entity's business (or vice versa) is not an adequate basis for performing a review service.
How to Acquire It
Generally, an accountant acquires an understanding of the industry through experience with the entity being
reviewed or other entities in the same industry. However, experience is not a prerequisite for performing a review. In
the absence of experience, the accountant must acquire his knowledge of the industry through study or consulta
tion. AICPA guides, industry publications, financial statements of other entities in the industry, textbooks, periodi
cals, and individuals knowledgeable about the industry are all potential references.
Likewise, previous experience is an excellent way to obtain an understanding of the entity's business. Inquiries of
personnel, observation of operations, and review of previous financial statements are also methods of becoming
familiar with the entity's business.
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INQUIRIES
What Is Required?
SSARS No. 1, (AR100.31), states that the accountant should consider making the following inquiries:
a. Inquiries of members of management having responsibility for financial and accounting matters
concerning
(1) Whether the financial statements have been prepared in conformity with GAAP consistently applied.
(2) The entity's accounting principles and practices and the methods followed in applying them and
procedures for recording, classifying, and summarizing transactions, and accumulating information
for disclosure in the financial statements.
(3) Unusual or complex situations that may have an effect on the financial statements.
(4) Significant transactions occurring or recognized near the end of the reporting period.
(5) The status of uncorrected misstatements identified during the previous engagement.
(6) Matters about which questions have arisen in the course of applying the review procedures.
(7) Events subsequent to the date of the financial statements that would have a material effect on the
(8) Their knowledge of any fraud or suspected fraud affecting the entity involving management or others
where the fraud could have a material effect on the financial statements, for example, communications
received from employees, former employees, or others.
(9) Significant journal entries and other adjustments.
(10) Communications from regulatory agencies.
b. Inquiries concerning actions taken at meetings of stockholders, board of directors, committees of the
board of directors, or comparable meetings that may affect the financial statements.
The first two areas of inquiry relate to the requirement that the accountant possess a level of knowledge of the
accounting principles and practices of the industry in which the entity operates and an understanding of the entity's
business.
SSARS No. 1 (AR 100) requires that the accountant inquire about actions taken at meetings of stockholders, board
of directors, etc. However, obtaining formal copies of the minutes may prove futile in many cases since many
closely held companies are lackadaisical about formal records of such meetings.
The requirement for inquiries of members of management having responsibility for financial and accounting
matters relates to the last sentence in the first paragraph of the standard review report: All information included in
these financial statements is the representation of the management (owners). . . ." As discussed more fully later in
this course, AR100.32 requires the accountant to obtain a representation letter from management or the owners.
The use of the words should consider" in SSARSNo.1, (AR100.31), leaves little room for the accountant to avoid
inquiries into the areas listed above. However, the accountant has great latitude as to the extent of his inquiries. In
determining which specific inquiries to make, an accountant may consider (a)the nature and materiality of the
items, (b) the likelihood of misstatement, (c) knowledge obtained during current and previous engagements, (d)
the stated qualifications of the entity's accounting personnel, (e) the extent to which a particular item is affected by
management's judgment, and (f) inadequacies in the entity's underlying financial data.
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SELFSTUDY QUIZ
following section.
37. Which of the following procedures is expected to be performed in a review engagement based on the limited
assurance provision in SSARS No. 1?
a. Obtaining an understanding of and assessing internal control risk.
b. Tests of accounting records by obtaining corroborating evidential matter.
c. Tests of responses to inquiries of client personnel by obtaining corroborating testimony from other
personnel.
d. Inquiry of client personnel and analytical procedures.
38. According to SSARS No. 1, an accountant should possess an understanding of which of the following aspects
of a client's business to perform a review?
a. Operating locations.
b. Payment terms for all suppliers.
c. Production schedules for each major product line.
d. Investment options of the client's retirement plan.
39. Why should an accountant make inquiries of members of management concerning the entity's accounting
principles and practices?
a. To provide the accountant guidance before tests are performed to evaluate the effectiveness of internal
controls.
b. To illustrate that the accountant possesses the requisite knowledge of the entity and the industry in which
the entity operates.
c. To determine whether or not management possesses the financial expertise to produce financial
statements in accordance with GAAP or OCBOA.
d. To predict whether events subsequent to the date of the financial statements will have a material effect on
the financial statements.
40. In determining the specific inquiries to make in a review engagement, which one of the following factors might
an accountant most likely consider?
a. The relevance of the item based on engagements with clients in the same industry.
b. The extent to which a particular item is affected by management's judgment.
c. The emphasis that management has placed on the item in terms of overall operational strategy.
d. The likelihood that the item will expose the accountant to potential liability if not addressed in the review
engagement.
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SELFSTUDY ANSWERS
37. Which of the following procedures is expected to be performed in a review engagement based on the limited
assurance provision in SSARS No. 1? (Page 67)
a. Obtaining an understanding of and assessing internal control risk. (This answer is incorrect. This
procedure would ordinarily be performed during an audit, not a review engagement.)
b. Tests of accounting records by obtaining corroborating evidential matter. (This answer is incorrect. This
procedure would ordinarily be performed during an audit, not a review engagement.)
c. Tests of responses to inquiries of client personnel by obtaining corroborating testimony from other
personnel. (This answer is incorrect. Tests of inquiries of client personnel would normally involve obtaining
corroborating evidential matter and is ordinarily performed during an audit, not a review engagement.)
d. Inquiry of client personnel and analytical procedures. (This answer is correct. SSARS No. 1 clearly
states that the accountant is expected to perform inquiry and analytical procedures before
expressing limited assurance.)
38. According to SSARS No. 1, an accountant should possess an understanding of which of the following aspects
of a client's business to perform a review? (Page 68)
a. Operating locations. (This answer is correct. SSARS No. 1 requires the accountant to have general
knowledge of the client's business.)
b. Payment terms for all suppliers. (This answer is incorrect. SSARS No. 1 requires the accountant to have
general knowledge of the client's business. Knowledge of the payment terms for all suppliers is more depth
than required.)
c. Production schedules for each major product line. (This answer is incorrect. SSARS No. 1 requires the
accountant to have general knowledge of the client's business. Knowledge of the production schedules
for each major product line is more depth than required.)
d. Investment options of the client's retirement plan. (This answer is incorrect. SSARS No. 1 requires the
accountant to have general knowledge of the client's business. Knowledge of the investment options of
the client's retirement plan is more depth than required.)
39. Why should an accountant make inquiries of members of management concerning the entity's accounting
principles and practices? (Page 69)
a. To provide the accountant guidance before tests are performed to evaluate the effectiveness of internal
controls. (This answer is incorrect. The effectiveness of internal controls is not tested in a review
engagement.)
b. To illustrate that the accountant possesses the requisite knowledge of the entity and the industry
in which the entity operates. (This answer is correct. This line of inquiry relates to the requirement
that the accountant possess a level of knowledge of the accounting principle and practices of the
industry in which the entity operates and an understanding of the entity's business.)
c. To determine whether or not management possesses the financial expertise to produce financial
statements in accordance with GAAP or OCBOA. (This answer is incorrect. This inquiry is not directly
related to the financial expertise of management, but to the entity's principles and practices as a whole.)
d. To predict whether events subsequent to the date of the financial statements will have a material effect on
the financial statements. (This answer is incorrect. This inquiry is not relevant when predicting subsequent
events, although inquiries regarding subsequent events should be made during a review engagement.)
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40. In determining the specific inquiries to make in a review engagement, which one of the following factors might
an accountant most likely consider? (Page 69)
a. The relevance of the item based on engagements with clients in the same industry. (This answer is
incorrect. While experience with clients in the same industry provide knowledge of the industry, an item
in question could be more or less significant to the particular client in question.)
b. The extent to which a particular item is affected by management's judgment. (This answer is correct.
Items that entail significant judgment on the part of management could pose a greater risk of
misstatement on the financial statements.)
c. The emphasis that management has placed on the item in terms of overall operational strategy. (This
answer is incorrect. Inquiries should be made of management having responsibility for financial and
accounting matters. While operational strategy might ultimately affect the financial statements, this is not
the most likely factor an accountant would consider.)
d. The likelihood that the item will expose the accountant to potential liability if not addressed in the review
engagement. (This answer is incorrect. While accountants should always be aware of items giving rise to
potential litigation, this is not the most likely factor an accountant would consider.)
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ANALYTICAL PROCEDURES
Purpose of Analytical Procedures
Analytical procedures should assist the accountant in identifying relationships and individual items that appear
unusual. Often the analytical procedures can identify problem areas in the financial statements that are not always
evident when the financial statements are merely read by the accountant. The results of analytical procedures
should be used as a basis for making additional inquiries when appropriate. Together with the accountant's
knowledge of the industry, understanding of the entity's business, and inquiries, the analytical procedures provide
the basis for the limited assurance given in the accountant's review report.
What Are Analytical Procedures?
SSARS No. 1, (AR100.29), states that analytical procedures should include
a. Developing expectations by identifying and using relationships that are expected to exist based on the
understanding of the entity and the industry in which the entity operates.
b. Comparing recorded amounts, or ratios developed from recorded amounts, to expectations.
There are three basic types of analytical procedures:
a. Trend analysis involves the study of the change in accounts over time. For example, when comparative
financial statements are presented, accountants often compare current year amounts with those of the prior
year. That is the simplest form of trend analysis. Comparisons of amounts for several successive years,
however, are generally more reliable and useful.
b. Reasonableness tests are those that estimate a financial statement amount or the change in an amount
from the prior year. Generally, reasonableness tests use operating or other nonfinancial data, e.g.,
estimating investment income by considering the amount invested and the average interest rate, or
estimating payroll expense by considering the number of employees and average wage rates. However,
reasonableness tests sometimes use only financial information, e.g., estimating depreciation expense by
considering the average investment in property and equipment and the depreciation methods used.
c. Ratio analysis involves the study of the relationship between two financial statement amounts. Ratios
generally assess an aspect of (1) operations, e.g., a ratio of net income to sales, (2) financial position, e.g.,
a ratio of current assets to current liabilities, or (3) operations as related to financial position, e.g., a ratio
of net income to total assets.
Selecting Appropriate Analytical Procedures
The accountant should apply analytical procedures to the financial statements to identify and provide a basis for
inquiry about the relationships and individual items that appear to be unusual and that may indicate a material
misstatement. The key to effective use of analytical procedures is identifying the existence or absence of an
expected relationship or the presence of an unexpected relationship, e.g., there should be a predictable relation
ship among sales, accounts receivable, and bad debt expense based on the historical patterns of the business.
Also, the accountant would expect a relationship to change in predictable ways in response to known changes in
volume of production or sales, product mix, customer composition, and the local economy. A precise quantification
of these relationships is not required. Instead, the accountant should focus on a few key relationships, or drivers,
that provide an improved understanding of the financial statements and significant operating or financial changes.
Management of a small business generally will already have identified the drivers they consider important in
running the business. The accountant can learn about those key relationships or drivers during discussions held
with management to obtain an understanding of the client, or based on prior experience with the client or the
client's industry. In a small business engagement, the accountant normally has a sufficient understanding of the
client and its operations to judgmentally identify the expected relationships.
Analytical procedures include comparing actual results with industry statistics or anticipated results. However,
accountants who review the financial statements of nonpublic companies may not often make such comparisons
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either because relevant information needed for a particular analytical procedure is not available or not relevant to
the client. (A discussion of the limitations of analytical procedures occurs later in this lesson.) Instead, practitioners
generally use their experience with the client and their knowledge of the relationships that are significant in the
client's industry to determine which relationships should be studied.
The following guidelines may be helpful in selecting appropriate analytical procedures:
a. To avoid applying unnecessary analytical procedures, determine the objective of the procedure being
considered; i.e., is the procedure designed to provide information about existence or occurrence,
completeness, rights or obligations, valuation or allocation, accuracy or classification, or cutoff? Then
consider whether additional assurance about that assertion is needed to express limited assurance on the
financial statements or whether sufficient assurance already has been obtained through inquiry and other
b. If accounts required adjustments in prior years, inquiries (rather than analytical procedures) may be a more
costeffective way of determining whether adjustments also need to be made in the current year.
c. Income statement accounts are best analyzed by using ratios and reasonableness tests; trend analysis is
less useful. Ratio analysis is the most effective analytical procedure for studying balance sheet accounts.
d. Misstatements in an account can be distributed throughout the period or occur solely in one or a few
months. Analytical procedures should be designed to detect at least part of any material error that has
occurred. For example, comparing monthly sales over several years is generally more useful than
comparing annual sales for the same period. Similarly, analytical procedures also tend to be more effective
when applied on a divisional or product line basis.
e. It is generally more effective to estimate changes that should have occurred in the accounts being
analyzed, based on the company and the circumstances, rather than to compare a current year amount
with the prior year's to determine if it appears unreasonable.
Examples of Analytical Procedures
The types of analytical procedures applied will vary with the accountant's previous experience with the client, the
client's industry, the nature and materiality of the accounts involved, and the nature of financial, operating, and
other nonfinancial data available. Although checklists of procedures can be very helpful, they cannot substitute for
professional judgment. As conditions change from one client to another or one period to another, the accountant
must challenge any standard checklist or list of priorperiod procedures. However, the following paragraphs give
some examples of analytical procedures that may be appropriate in certain circumstances.
Trend Analysis. Trend analysis compares either the absolute dollar amount or percentage change in accounts
over time. When the accountant reads comparative financial statements and questions the fluctuations in accounts
between years, he or she is applying the most basic analytical procedure. Other examples are comparison of
monthly sales for the current period with those of prior periods, or analysis of a fiveyear sales trend. Regression
analysis is a statistical method of trend analysis. Many computer software programs are available for use in
regression analysis.
Reasonableness Tests. A reasonableness, or predictive, test is a comparison of a recorded amount with an
expectation developed based on financial or nonfinancial data. Some reasonableness tests involve ratios using
financial information. For example, certain expense accounts are estimated by computing the following ratios:
a. Depreciation expense average depreciable property and equipment.
b. Repairs and maintenance property and equipment.
c. Interest expense interestbearing debt.
d. Average depreciable property and equipment average depreciation period.
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Other reasonableness tests involve estimating account balances by using operating or other nonfinancial data. For
example:
a. Estimating revenue based on capacity, such as in a health care facility.
b. Estimating commissions based on sales volume.
c. Estimating investment income based on the amount invested and the average interest rate.
d. Estimating payroll expense based on the number of employees and average wage rates.
Ratio Analysis. Ratio analysis is the comparison of relationships between financial statement accounts, the
comparison of an account with nonfinancial data (such as the comparison of sales per square foot of retail space),
or the comparison of relationships between entities in an industry (such as comparison of gross profit with the
industry average). Ratio analysis is most appropriate when the relationship between accounts is stable and fairly
predictable. Some of the most common ratios evaluated are elements of net income as a percentage of sales, e.g.,
gross profit or operating expenses. (In fact, such percentages are often presented on the face of the income
statement, especially when computerprepared financial statements are presented.) Some of the common ratios
used for ratio analysis are as follows:
a. Accounts Receivable Ratios. These ratios help determine the collectibility and adequacy of accounts
receivable, the allowance for doubtful accounts, and the provision for bad debts. Some of the more
common accounts receivable ratios include:
(1) Allowance for Doubtful Accounts as a Percentage of Accounts Receivable used to review the
reasonableness of the allowance account as compared to the ending accounts receivable balance.
(2) Bad Debt Expense as a Percentage of Net Credit Sales used to determine the sufficiency of writeoffs
based on current year sales.
(3) Accounts Receivable Turnover indicates the quality of the accounts receivable, and also provides
an indication of how successfully the client is collecting its outstanding accounts receivable.
(4) Days Sales in Accounts Receivable estimates the average collection period for credit sales.
(5) Accounts Receivable by Aging Category to Total Accounts Receivable used in conjunction with the
days sales in accounts receivable ratio [see item (4)] to determine how the collection period changed.
(The percentage breakdown among categories shows which aging category is responsible for the
collection period change.)
b. Inventory Ratios. These ratios help assess the valuation of inventory. Some of the more common inventory
ratios include:
(1) Inventory Turnover indicates how efficiently inventory was used. Represents the number of times
inventory was sold in one year.
(2) Days of Inventory on Hand estimates the average duration of inventory during the year.
(3) Gross Profit Margin indicates how much of every net sales dollar resulted in gross profit. More
importantly, however, this ratio can serve as an indicator of unusual variances in cost of sales and
inventory.
c. Profitability, Leverage, and Liquidity Ratios. These ratios generally do not provide information about specific
assertions or accounts; rather, they help assess overall operating effectiveness, liquidity, and longterm
solvency.
(1) Current Ratio indicates the amount of liquid assets available to liquidate current debt or the
company's ability to meet its current obligations.
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(2) Quick Ratio similar to the current ratio except that it omits items that cannot be quickly converted to
cash. It indicates a more conservative estimate of liquidity.
(3) Liabilities to Equity determines the extent of liabilities used to finance assets.
(4) Debt to Equity determines the extent of nonequity capital used to finance assets.
(5) Times Interest Earned used with the debt to equity ratio to focus on cash flow necessary to service
longterm debt payments.
(6) Return on Total Assets indicates how productively the company used its assets to produce profits.
The ratio can be used to examine trends in efficiency.
(7) Asset Turnover indicates how efficiently the company utilized its assets.
(8) Return on Equity indicates the efficiency with which common shareholders' equity is employed by
the firm.
(9) Return on Net Sales indicates how much of every net sales dollar resulted in profit after taxes.
(10) Operating Expenses as a Percentage of Net Sales indicates how much of every net sales dollar was
used for operating expenses.
Ratios should not be computed just for the sake of computing them. Generally, practitioners should select only
those ratios that provide information about assertions or accounts that are considered significant.
Developing an Analytical Ratio History. Many practitioners compute ratios and analyze trends using their own
internal accounting software package (for example, using a spreadsheet software such as Excel or Lotus). In such
cases, the CPA selects the appropriate ratios for each engagement based on his or her knowledge of the client's
business and industry, inquiries performed, and other analytical procedures performed and creates a computer
ized worksheet that will automatically compute the selected ratios. Practitioners should select only the ratios that
provide information about assertions or accounts that are considered significant for a particular engagement (i.e.,
the key drivers discussed previously). The CPA can then use this worksheet for the current and past periods to
create an analytical ratio history for that client. This history provides the CPA with a trend analysis that studies the
change in various ratios over a period of time. The spreadsheet can then be carried forward and used for analysis
in future periods. Comparisons of amounts for several successive years generally provides the CPA with more
reliable and useful information.
Developing Expectations
SSARS No. 1, as amended by SSARS No. 10, requires the accountant to develop and document expectations.
Forming an expectation is a critical phase of the analytical procedures process since the expectation represents the
accountant's prediction of recorded amounts or ratios developed from recorded amounts. Once expectations are
developed, the accountant will often find when performing analytical procedures that differences exist between the
expectation and the recorded amount or ratio. If such differences are significant, they may be indicative of possible
material misstatements, and the accountant should obtain explanations for such differences. The following para
graphs discuss developing expectations. The accountant's response when the results of analytical procedures are
unfavorable is discussed later in this lesson.
Expectations are developed by identifying plausible relationships that are reasonably expected to exist based on
the accountant's understanding of the client and the industry in which the client operates. The accountant selects
from a variety of data sources to form expectations:
Prior period information.
Management's budgets or forecasts.
Industry data.
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Nonfinancial data.
Information obtained when compiling interim financial statements.
When developing expectations, the accountant should consider the following:
a. Economic and Competitive Conditions. The accountant should have an understanding of the industry in
which the client operates, including significant trends.
b. Changes in the Business. Discussing changes in the business with the client prior to developing the
expectations helps the accountant obtain a better understanding of the client's business so appropriate
expectations can be developed. This discussion might take place as part of the accountant's obtaining or
updating his or her understanding of the client's business, or as part of other inquiries performed, as
previously discussed.
c. The Type of Account Involved. The way an expectation is developed depends on the account. Expectations
sometimes may be developed similarly for similar types of accounts. For example:
Expectations of fixed expenses might be based on prioryear balances.
Expectations of variable expenses might be based on relationships with other accounts.
Expectations for accounts affected by a variety of factors might be based on relationships between
financial and nonfinancial information.
Accountants can expect relationships between related financial statement amounts to cause the changes
in those amounts to move in the same or opposite directions (i.e., a direct or inverse relationship,
respectively). Unexpected increases or decreases may indicate that the information supplied by the entity
is incorrect, incomplete, or otherwise unsatisfactory. The following accounts often exhibit a direct
relationship (that is, if the primary account increases, the related accounts can also be expected to
increase):
Sales and
Accounts Receivable
Cost of Sales
Selling Expenses
Outbound Freight
Commissions
Inventory and
Accounts Payable
Warehousing Costs
Wages and Salaries Expense and
Payroll Taxes
Health Insurance
Interest Expense and
Longterm Debt
Legal Expense (for collection of bad debts)
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Cash and Investments and

Investment Income (such as interest and dividends)
d. The Number of Expectations Needed for an Account. Ordinarily, there is no need to develop more than one
expectation for an account. For example, if a sufficiently precise expectation can be developed based on
the prioryear balance, there is no need to also compare the account balance with a forecasted amount.
Also, if two or more expectations are equally effective, the accountant should select the one that is the most
efficient to develop or use. For example, if the prioryear balance adjusted for known changes, the
relationship with another account, and a forecast are equally effective expectations, but the forecasted
balance is the easiest to use, that should be the expectation.
Documenting Expectations. SSARS No. 1, as amended by SSARS No. 10, states that expectations developed by
the accountant in performing analytical procedures in connection with a review of financial statements ordinarily are
less encompassing than those developed in an audit. The SSARS also states that the accountant should document
the analytical procedures performed, the expectations (where significant expectations are not otherwise readily
determinable from the documentation of the work performed), and factors considered in the development of those
expectations. Peer review comments continue to note that accountants are having difficulty complying with the
SSARS No. 1 analytical procedures documentation requirements, including documenting expectations.
Other than stating that the accountant ordinarily is not required to corroborate management's responses with other
evidence, SSARS No. 1, as amended by SSARS No. 10, does not provide further guidance with respect to what it
means for expectations developed in connection with performing review analytical procedures to be less encom
passing than those developed in an audit or how such expectations should be documented. The AICPA issues
paper titled Analytical Procedures in a Review Engagement assists accountants in understanding the requirements
related to the use of analytical procedures in review engagements and how the use of analytical procedures should
be documented. A copy of the issues paper can be obtained from the AICPA's website at www.aicpa.org. In
addition, the AICPA has developed a practice aid titled Review Engagements New and Expanded Guidance on
Analytical Procedures, Inquiries, and Other Procedures which can be ordered at www.cpa2biz.com.
Although not specifically stated in the SSARS, it is good practice to develop an expectation for each analytic.
However, there does not necessarily need to be a one to one correspondence between the expectations formed
and the analytics performed, as one expectation may apply to multiple analytics. In addition, because the objective
of a review is to provide the accountant with a reasonable basis for expressing limited assurance that there are no
material modifications that should be made to the financial statements, expectations need only be developed in
terms of a range (for example, sales are expected to increase between 10% and 15%) and that analytics do not
necessarily need to be developed for each financial statement item. The selection of which accounts to apply
analytical procedures to is a matter of professional judgement based on materiality and the accountants' knowl
edge of the client and the industry in which the client operates. The accountant should apply analytical procedures
to the financial statements to identify and provide a reasonable basis for inquiry about the relationships and
individual items that appear to be unusual and that may indicate a material misstatement. The selection of
appropriate analytical procedures is discussed in more detail earlier in this lesson. The examples presented in the
AICPA Issues Paper are consistent with this approach. In each example, there is one expectation developed for
each analytic, expectations are expressed in terms of a range, and the reason for each expectation is noted.
EXHIBITS 31 and 32 present examples of how to document expectations in a review engagement.
Exhibit 31
Documenting Expectations in a Review Engagement An Example
Background
An accountant is engaged to review the financial statements of Vista Building Suppliers, Inc., a company that
provides building supplies to home builders.
Sample documentation
Vista Building Suppliers, Inc.
Analytical Procedures
For the year ended December 31, 20XX
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Expectations:
The following are factors that should affect the relationship between current and prior year amounts:
Because of lower interest rates, new home sales and new home building are up. Consequently, a 5% to 10%
increase in sales is expected. A similar increase is expected in cost of goods sold and days sales in accounts
receivable.
Because of an increase in the production of prefabricated and custom items, the Company had to borrow
additional funds. Therefore, an increase of between 10% and 15% is expected in loans payable and interest
expense.
No significant change in either days of inventory on hand or inventory turnover is expected. Any change greater
than 5% will be subjected to additional inquiries.
Analytics:
Current Year
Sales
Cost of goods sold
Interest Expense
Loans Payable
2,375,000
1,780,000
48,000
498,000
Prior Year
$
2,175,000
1,625,000
42,000
437,000
Change
$
200,000
155,000
6,000
61,000
% Change
9.20 %
9.54 %
14.29 %
13.96 %
Days sales in accounts receivable = Accounts receivable (net)/ (Net sales/360)

Current year days sales in receivables = $1,600,000/ ($2,375,000/360)
= 243 days
Prior year days sales in receivables = $1,250,000/ ($2,175,000/360)
= 207 days
The increase of 36 days sales in accounts receivable (243 days 207 days) represents a 17% increase. This
increase is greater than the expected 5% to 10% increase. Discussions with Vista's management indicate that
because new home starts are up, home builders have more need for cash flow up front and, consequently, have
been slower to pay for their supplies. A comparison of last year's aged accounts receivables with this year's aged
accounts receivables also indicates that home builders have been slower to pay.
Days of inventory on hand = Inventory at the end of the period/ (Total cost of goods sold/360)
Current year days of inventory on hand = $1,100,000/ ($1,780,000/360)
= 222 days
Prior year days of inventory on hand = $990,000/ ($1,625,000/360)
= 219 days
Inventory turnover = cost of sales/average inventory
Current year inventory turnover = $1,780,000/ (($1,100,000 + $990,000)/2)
= 1.7 times
Prior year inventory turnover = $1,625,000/ (($990,000 + $900,000)/2)
= 1.7 times
Exhibit 32 uses the information presented in Exhibit 31 to complete the Analytical Procedures Documentation
Form."
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Exhibit 32
Documenting Expectations Using the Analytical Procedures Documentation Form
Company:Vista Building Suppliers, Inc.
Balance Sheet Date:12/31/XX
Completed by:JRD
DateCompleted:3/11/XX
Instructions:This optional documentation form is designed to assist accountants in meeting the analytical
procedures documentation requirements of SSARS No. 1. Accountants should refer to the previous discussion
prior to completing this form.
Financial Statement Drivers
Sales, Debt, Inventory
General Expectations
Because of lower interest rates, new home sales and new home building are up. Consequently, a 5% to 10% increase
in sales is expected. A similar increase is expected in cost of goods sold and days sales in accounts receivable.
Because of an increase in the production of prefabricated and custom items, the Company had to borrow additional
funds. Therefore, an increase of between 10% and 15% is expected in loans payable and interest expense.
No significant change in either days of inventory on hand or inventory turnover is expected. Any change greater than
5% will be subjected to additional inquiries.
Name of Account or Ratio:Sales
Account or Ratio Expectation
5% to 10% increase.
Calculation and Comparison

Current Year
Prior Year
Change
% Change
$ 2,375,000
$ 2,175,000
$ 200,000
9.20 %
Additional Procedures or Conclusion

Change is within expected range.
Name of Account or Ratio:Cost of Goods Sold
5% to 10% increase.
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Current Year
Prior Year
Change
% Change
$ 1,780,000
$ 1,625,000
$ 155,000
9.54 %

Name of Account or Ratio:Interest Expense
10% to 15% increase.
Current Year
Prior Year
Change
% Change
$ 48,000
$ 42,000
$ 6,000
14.29 %

Name of Account or Ratio:Loans Payable
10% to 15% increase
Current Year
Prior Year
Change
% Change
$ 498,000
$ 437,000
$ 61,000
13.96%

Name of Account or Ratio:Days Sales in Accounts Receivable
5% to 10% increase
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Current year days sales in receivables =$1,600,000/($2,375,000/360)
=243 days
Prior year days sales in receivables =$1,250,000/($2,175,000/360)
=207 days
The increase of 36 days sales in accounts receivable (243 days 207 days) represents a 17% increase. This increase
is greater than the expected 5% to 10% increase. Discussions with Vista's management indicate that because new
home starts are up, home builders have more need for cash flow up front and, consequently, have been slower to pay
for their supplies. A comparison of last year's aged accounts receivables with this year's aged accounts receivables
also indicates that home builders have been slower to pay.
Name of Account or Ratio:Days of Inventory on Hand
< 5% change.
Current year days of inventory on hand =$1,100,000/($1,780,000/360)
=222 days
Prior year days of inventory on hand =$990,000/($1,625,000/360)
=219 days
Name of Account or Ratio:Inventory Turnover
< 5% change.
Current year inventory turnover =$1,780,000/(($1,100,000 + $990,000)/2)
=1.7 times
Prior year inventory turnover =$1,625,000/(($990,000 + $900,000)/2)
=1.7 times
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In a situation where no significant changes are expected, the accountant might document expectations as follows:
Based on discussions with owner/manager, no significant changes from prior year amounts are expected.
All increases/decreases greater than 5% will be subjected to additional procedures.
When the Results of Procedures Are Unfavorable
When results of analytical procedures are unfavorable (i.e., the accountant believes that fluctuations from expected
amounts are significant) SSARSNo.1, (AR100.25), requires the accountant to apply additional procedures suffi
cient to achieve limited assurance that no material modifications are necessary to conform the financial statements
with GAAP. Additional procedures should be applied to determine whether or not any differences between
expected and actual results are material adjustments that should be booked by the client and, if so, the amount that
should be booked. These additional procedures may take the form of inquiries and additional analytical proce
dures. However, in many cases, accountants will combine additional inquiry or analytical procedures with prepar
ing other accounting schedules or analyses to explain fluctuations. Differences between expected and actual
results may be caused by imprecise expectations, and can be explained when additional procedures are per
formed.
If management has a valid business reason that explains the difference, management's responses to followup
inquiries do not need to be tested in a review engagement, provided the practitioner believes they are reasonable.
Corroboration is not required in a review. SSARS No. 1 (AR 100.25) states that a review does not contemplate . .
. tests . . . of responses to inquiries by obtaining corroborating evidential matter . .." However, the practitioner
should be careful that management properly considers the inquiries and does not provide perfunctory explana
tions.
Because of the nature of analytical procedures, it is usually not possible to explain the entire amount of the
difference. An explanation of the exact amount of the difference is not necessary. It is only necessary to obtain a
sufficient explanation to reduce the difference to an acceptable level. If, however, a satisfactory explanation of the
difference cannot be obtained, other procedures will have to be performed to obtain limited assurance about the
recorded amount.
SSARS No. 1, (AR100.38), requires the accountant to document the matters covered in the analytical procedures.
Although not required, some accountants document analytical procedures, particularly the results of ratio and
trend analysis, in carryforward workpapers or in a permanent file to facilitate historical comparisons.
Limitations of Analytical Procedures
Applying analytical procedures can be an effective method of identifying misstatements in financial statements.
However, they do have certain limitations, including the following:
a. Inquiries may be more effective for certain assertions or accounts. For example, analytical procedures are
ineffective when accounts are subject to significant management discretion, such as those involving
estimates, because relationships are unpredictable. Similarly, it is difficult to obtain assurance about the
assertions of existence or ownership through analytical procedures.
b. Analytical procedures are ineffective when factors affecting accounts are not constant over time.
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c. Analytical procedures are less precise and accurate as account relationships become more remote.
d. Reasonableness tests usually depend to some extent on operating data, which may not be available.
e. Ratios may not be comparable with industry statistics, with ratios computed for other clients, or within the
same client over time because of changes in accounting principles or because of differences in the way
they are computed.
Analytical Procedures on Initial Engagements
Practitioners often question how to apply analytical procedures on initial engagements. For example, how can an
accountant evaluate the results of procedures applied for the current year if he is unsure whether amounts are
comparable with prior years or if the company is newly formed? SSARS No. 1 (AR 100.35) states
Knowledge acquired in the performance of audits of the entity's financial statements, compilation
of the financial statements, or other accounting services may result in modification of the review
procedures described in AR100.29.31. However, such modification would not reduce the
degree of responsibility the accountant assumes with respect to the financial statements he has
reviewed.
Although AR100.35 does not cite initial engagements as a situation in which the accountant may choose to modify
the inquiry and analytical procedures described in AR100.29.31, it is reasonable to conclude that such proce
dures be modified in initial engagements (or engagements in which the company has insufficient history for such
procedures to be meaningful). In initial review engagements, accountants often must rely on making additional
inquiries, compiling the financial statements, or providing other accounting services to supplement the limited
analytical procedures that can be performed in an initial engagement because of insufficient history.
Analytical procedures on initial engagements can consist of comparisons with results for similar clients or to
industry statistics, and of analysis of the interrelationships between accounts such as an analysis of selling
expenses to sales. However, in those cases, accountants should pay particular attention to the limitations
described above.
Documenting Planning Materiality
From a practical standpoint, most practitioners use professional judgment when considering materiality in the
planning stages of a review engagement. Because SSARS do not require a practitioner to document materiality,
few practitioners prepare a planning materiality worksheet or similar document.
Accumulating Passed Adjustments
In most small business review engagements, the client records the majority (if not all) of the adjusting entries
proposed by the accountants. Significant differences in expectations and recorded amounts when applying
analytical procedures are generally followed up with additional procedures and/or inquiries to explain the differ
ence, or additional procedures are performed to isolate the potential misstatement. For that reason, it is usually
unnecessary in a review engagement for accountants to accumulate passed adjustments to determine their impact
on the financial statements. Consequently, practitioners seldom prepare a summary of differences worksheet or
similar document.
Although it is both conservative and prudent to encourage the client to book all misstatements or adjustments in a
review engagement, in the event passed adjustments do exist, SSARS does not require such adjustments to be
included in the management representation letter. That is, the practitioner may, but is not required to, follow the
guidance in SAS 85, Management Representations, and include the passed adjustments in the representation
letter, including attaching a summary of the adjustments to the letter.
In evaluating the materiality of adjustments, the practitioner should not use the estimate of planning materiality,
which is used to determine the nature, timing, and extent of review procedures to be applied, to determine whether
an adjustment (individually or combined with other adjustments) is material. Evaluation materiality is different from
planning materiality.
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In evaluating adjustments, the practitioner should consider the adjustments in relation to individual accounts (e.g.,
accounts receivable) and subtotals (e.g., current income), not to their relationship to planning materiality. The
practitioner should also evaluate the passed adjustments from a qualitative perspective. For example, a small
adjustment may be particularly sensitive to the users of the financial statements and, therefore, material. Of course,
evaluation materiality, which consists of quantitative and qualitative assessments, has to be viewed from the
perspectives of the financial statement users and whether the amount or disclosure would be important to the
decisions that users would be making.
In summary, best practices include
a. All adjustments should be booked by the client. If significant differences in expectations and recorded
amounts are noted when applying analytical procedures, such differences should be followed up with
additional procedures and/or inquiries to explain the difference, or additional procedures should be
performed to isolate the potential misstatement.
b. If all adjustments are not booked, the practitioner should evaluate the adjustments that are not booked by
assessing their materiality (individually and in combination) in relation to individual accounts, subtotals,
and totals in the financial statements.
c. Do not use planning materiality for the evaluation in item b. above.
d. Finally, also evaluate the adjustments from a qualitative materiality perspective.
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READING THE REVIEWED FINANCIAL STATEMENTS

SSARS No. 1, (AR 100.31(c)), requires the accountant to read the financial statements (also required for compiled
statements by AR 100.10). See the discussion in the previous lesson regarding the meaning of reading the financial
statements.
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OBTAINING REPORTS FROM OTHER ACCOUNTANTS

If significant components (divisions, branches, subsidiaries, partnerships, or joint ventures in which the entity has
a significant investment) are reviewed or audited by other accountants, AR 100.31(d) requires that the accountant
obtain reports from the other accountants as a basis, in part, for his report on his review of the financial statements
of the entity. Although not required by SSARS, the accountant may want to obtain a written confirmation of the other
accountants' independence.
The omission in SSARS No. 1 (AR 100) of any reference to relying on compilation reports of other accountants
suggests that it would be inappropriate for the accountant to base his review report on another accountant's
compilation report of a significant component of the entity. The reason for this is that no assurances can be derived
from another accountant's compilation report.
Referring to reports of other accountants in the review report is beyond the scope of this course.
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COMMUNICATION OF INTERNAL CONTROL RELATED MATTERS

SAS No. 112, Communicating Internal Control Related Matters Identified in an Audit (AU325), establishes the
auditor's responsibility to communicate significant deficiencies and material weaknesses in an entity's internal
control. It requires the auditor to inform management and those charged with governance of any significant
deficiencies and material weaknesses in the design or operation of internal control. SAS No. 112, however, does
not apply to either a compilation or review engagement. SSARSNo.1, AR100.25, explicitly states that a review
does not contemplate obtaining an understanding of internal control," nor does it contemplate communicating
significant deficiencies or material weaknesses. It is important for the client to understand that those are not the
same as significant deficiencies and material weaknesses; rather, significant deficiencies and material weaknesses
in an entity's internal control may permit errors, fraud, and illegal acts to occur. Thus, some accountants prefer to
clarify in the engagement letter that they have no responsibility, in a compilation or review engagement, to
communicate deficiencies in the entity's internal control. Because of that situation, the following language is
included in the sample engagement letter.
We have no responsibility to identify and communicate deficiencies in your internal control as part
of this engagement.
In the case of Robert Wooler Co. v. Fidelity Bank (Pennsylvania Superior Court, June 29, 1984), a company
sustained a loss when an employee misappropriated cash receipts, and the company's accounting firm was held
liable for failing to inquire about the system of internal control, which apparently facilitated the theft. Unfortunately,
the case has been widely quoted as placing a duty on accountants to report detected control deficiencies to clients
in unaudited engagements. In this particular case, however, the accounting firm, as a matter of practice, instructed
employees to be alert for possible improvements in client's accounting policies and procedures, systems of
control, and duties assigned to accounting personnel. The firm also had a policy to inquire into the allocation of the
client's bookkeeping duties. Some knowledgeable attorneys believe that the court decision cannot be generalized
and that failure to comply with the accounting firm's own policies regarding internal control was a principal reason
behind the court's finding. The ARSC has not moved to amend SSARSNo.1 (AR 100) to require accountants to
inquire into internal control matters or to communicate deficiencies in internal control. Based on the foregoing, an
accountant generally has no obligation in compilation and review engagements beyond client service consider
ations (unless expressly agreed to) to inquire about internal control matters or to communicate deficiencies in
internal control.
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CART07
SELFSTUDY QUIZ
following section.
41. Estimating rent income of an office building by considering the average rent per square foot and the total square
footage of the building is what type of analytical procedure?
a. Trend analysis.
b. Statistical projection.
c. Reasonableness test.
d. Ratio analysis.
42. Which of the following is the best approach an accountant may use to select appropriate analytical procedures?
a. Discussions with management to understand the exposure items management considers will have a
material affect on the financial statements.
b. Review of trade journals in a client's industry to ascertain the most important financial statement issues
facing the client's industry.
c. Discussions with management to learn about key relationships within the client's business affecting
d. Review of prior years' workpapers to ensure that current year's procedures consistently reflect the
analytical procedures used in the past.
43. In which of the following instances might inquiry be more costeffective than analytical procedures in
determining whether adjustments need to be made?
a. When accounts require additional assurance about an assertion made by management in order to express
limited assurance.
b. When accounts can be analyzed on a product line basis.
c. When the accounts being analyzed are balance sheet accounts.
d. When accounts required adjustments in prior years.
44. Calculating inventory turnover is an example of what type of analytical review procedure?
a. Trend analysis.
b. Regression analysis.
d. Ratio analysis.
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45. When developing expectations for analytical review procedures in compliance with SSARS No. 10, which of
the following would an accountant most likely consider?
a. The type of account involved.
b. The effectiveness of the client's internal controls.
c. Gross sales for the current year.
d. The status of uncorrected misstatements identified during the previous engagement.
46. If results of analytical procedures are unfavorable compared to expectations, what might be appropriate
additional procedures the accountant might perform to explain fluctuations and achieve limited assurance as
required by SSARS No. 1?
a. Corroborating all management responses to followup inquiries by obtaining corroborating evidential
matter.
b. Combining additional inquiry and analytical procedures with preparing other accounting schedules.
c. Performing additional analytical procedures until the entire amount of the difference is accounted for in a
satisfactory manner.
d. Corroborating perfunctory management responses to followup inquiries by obtaining corroborating
evidential matter.
47. Which of the following is considered a weakness of analytical review procedures?
a. They are less likely to identify misstatements between two accounts that have a direct relationship.
b. They will not uncover differences if factors affecting accounts are constant over time.
c. They are less precise as account relationships become more remote.
d. They are less effective when the accounting practices and principles of the client are consistent from year
to year.
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SELFSTUDY ANSWERS
41. Estimating rent income of an office building by considering the average rent per square foot and the total square
footage of the building is what type of analytical procedure? (Page 74)
a. Trend analysis. (This answer is incorrect. Trend analysis involves the study of the change in accounts over
time.)
b. Statistical projection. (This answer is incorrect. Statistical projection is not a type of analytical procedure.)
c. Reasonableness test. (This answer is correct. Reasonableness tests are those that estimate a
financial statement amount or the change in an amount from the prior year using operating or other
nonfinancial data.)
d. Ratio analysis. (This answer is incorrect. Ratio analysis involves the study of the relationship between two
financial statement amounts.)
42. Which of the following is the best approach an accountant may use to select appropriate analytical procedures?
(Page 74)
a. Discussions with management to understand the exposure items management considers will have a
material affect on the financial statements. (This answer is incorrect. Analytical procedures should be
designed to identify items that the accountant considers will have a material effect on the financial
statements.)
b. Review of trade journals in a client's industry to ascertain the most important financial statement issues
facing the client's industry. (This answer is incorrect. While such a review might reveal relationships helpful
in selecting analytical review procedures for the client, the accountant should always hold discussions with
management to understand the client's business as well.)
c. Discussions with management to learn about key relationships within the client's business affecting
financial statements. (This answer is correct. The key to effective use of analytical procedures is
identifying the existence or absence of an expected relationship or the presence of an unexpected
relationship. Periodic discussions with management are important to identify such relationships.)
d. Review of prior years' workpapers to ensure that current year's procedures consistently reflect the
analytical procedures used in the past. (This answer is incorrect. While such a review might indicate
analytical review procedures which were useful in the past, the accountant should always hold discussions
with management to understand any changes in significant relationships that might affect those
procedures in the current year.)
43. In which of the following instances might inquiry be more costeffective than analytical procedures in
determining whether adjustments need to be made? (Page 75)
a. When accounts require additional assurance about an assertion made by management in order to express
limited assurance. (This answer is incorrect. If accounts require additional assurance, analytical
procedures should be performed in addition to inquiry in order to express limited assurance.)
b. When accounts can be analyzed on a product line basis. (This answer is incorrect. Analytical review
procedures are effective when applied on a product line basis.)
c. When the accounts being analyzed are balance sheet accounts. (This answer is incorrect. Analytical review
procedures, particularly ratio analysis, are effective when applied to balance sheet accounts because it
involves the relationship between two financial statement accounts.)
d. When accounts required adjustments in prior years. (This answer is correct. If an account
repeatedly requires adjustment, key relationships might not be present to make analytical review
effective, making inquiry of management more costeffective.)
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44. Calculating inventory turnover is an example of what type of analytical review procedure? (Page 76)
a. Trend analysis. (This answer is incorrect. Trend analysis involves the study of the change in accounts over
time.)
b. Regression analysis. (This answer is incorrect. Regression analysis is a statistical method of trend
analysis.)
c. Reasonableness test. (This answer is incorrect. Reasonableness tests are those that estimate a financial
statement amount or the change in an amount from the prior year using operating or other nonfinancial
data.)
d. Ratio analysis. (This answer is correct. Ratio analysis involves the study of the relationship between
two financial statement amounts, in this case cost of sales and average inventory.)
45. When developing expectations for analytical review procedures in compliance with SSARS No. 10, which of
the following would an accountant most likely consider? (Page 78)
a. The type of account involved. (This answer is correct. Accounts may be affected by a variety of
factors depending on their nature, e.g. balance sheet v. income statement accounts. This, in turn,
will drive the expectations of accountants when performing analytical review procedures.)
b. The effectiveness of the client's internal controls. (This answer is incorrect. The effectiveness of internal
controls is not tested in a review engagement; therefore, it would not be used in developing expectations.)
c. Gross sales for the current year. (This answer is incorrect. While this figure might be used in analytical
review procedures, gross sales would not be used independently to develop expectations.)
d. The status of uncorrected misstatements identified during the previous engagement. (This answer is
incorrect. This information should be gathered during the inquiry of management; however, it will not be
useful when developing expectations for analytical review procedures.)
46. If results of analytical procedures are unfavorable compared to expectations, what might be appropriate
additional procedures the accountant might perform to explain fluctuations and achieve limited assurance as
required by SSARS No. 1? (Page 84)
a. Corroborating all management responses to followup inquiries by obtaining corroborating evidential
matter. (This answer is incorrect. Corroborating responses by obtaining evidential matter is not required
by SSARS No. 1.)
b. Combining additional inquiry and analytical procedures with preparing other accounting sched
ules. (This answer is correct. These additional procedures would satisfy the requirements of SSARS
No. 1.)
c. Performing additional analytical procedures until the entire amount of the difference is accounted for in a
satisfactory manner. (This answer is incorrect. It is usually not possible to explain the entire amount of the
difference, nor is it necessary to comply with SSARS No. 1.)
d. Corroborating perfunctory management responses to followup inquiries by obtaining corroborating
evidential matter. (This answer is incorrect. Corroborating responses by obtaining evidential matter is not
required by SSARS No. 1.)
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47. Which of the following is considered a weakness of analytical review procedures? (Page 84)
a. They are less likely to identify misstatements between two accounts that have a direct relationship. (This
answer is incorrect. Analytical procedures are more likely to detect misstatements when accounts have
direct relationships to each other, e.g. sales and accounts receivable.)
b. They will not uncover differences if factors affecting accounts are constant over time. (This answer is
incorrect. Analytical procedures are more likely to uncover differences if factors affecting accounts are
constant, e.g. cost of raw materials does not experience dramatic changes from year to year.)
c. They are less precise as account relationships become more remote. (This answer is correct.
Accounts with no key relationships, e.g. goodwill, are more appropriate for inquiry, not analytical
procedures.)
d. They are less effective when the accounting practices and principles of the client are consistent from year
to year. (This answer is incorrect. Analytical procedures are more effective when the accounting practices
and principles of the client are consistent from year to year, e.g. the method used to book allowances for
doubtful accounts is unchanged.)
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REPRESENTATION LETTERS
Obtaining a representation letter in a review engagement is a required procedure. AR100.32 states:
Written representations are required from management for all financial statements and periods
covered by the accountant's review report.
The specific written representations obtained by the accountant will depend on the individual engagement circum
stances and the nature and basis of the presentation of the financial statements. SSARS No. 1, as amended,
requires that specific representations should relate to the following:
a. Management's acknowledgment of its responsibility for the fair presentation in the financial statements of
financial position, results of operations, and cash flows in conformity with generally accepted accounting
principles.
b. Management's belief that the financial statements are fairly presented in conformity with generally
accepted accounting principles.
c. Management's acknowledgment of its responsibility to prevent and detect fraud.
d. Knowledge of any fraud or suspected fraud affecting the entity involving management or others where the
fraud could have a material effect on the financial statements, including any communications received from
employees, former employees, or others.
e. Management's acknowledgment of full and truthful responses to all inquiries.
f. The completeness of information.
g. Information about subsequent events.
Also, certain additional representations should be obtained, such as matters that relate specifically to the entity's
business or industry.
In some cases, accountants who request representation letters on review engagements may encounter resistance
from their nonaudit clients, primarily because they do not understand the purpose of the representation letter or the
matters discussed in the letter. The following paragraphs discuss ways to sell representation letters to review
clients.
Reasons for Obtaining a Representation Letter
The primary reasons for obtaining a representation letter in a review engagement should be explained to the small
business owner/manager, as follows:
a. Management is being asked to acknowledge its primary responsibility for the financial statements. Even
if the accountant compiled the statements prior to reviewing them, they are the primary responsibility of
management. (The letter does not change or add to management's fundamental responsibilities, nor does
it relieve the accountants of their responsibilities. It simply clarifies the traditional roles that each perform.)
b. The representation letter avoids misunderstandings, serves as a memory jogger, and provides a list of
important matters that may affect the financial statements.
Modifications to the Standard Letter
A client representation letter is usually prepared by the accountant, but it is a communication from the client to the
accountant and is signed by client management. However, it may be advisable to modify some of the standard
wording to make the owner/manager more comfortable with the reasonableness of the representations being
requested. Also, certain additional representations may be desirable.
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Alternative Wording. Exhibit 33 presents alternative wording that can be used in a client representation letter. The
alternative wording modifies the standard wording to make it more suitable for a review of a small business.
Exhibit 33
Improved Wording of Representation Letters
Alternative Wordinga
Illustrative Letter
We have no plans or intentions that may materially We have not adopted any plans nor do we have
affect the carrying value or classification of assets present intentions that could materially affect the
and liabilities.
carrying value or classification of assets or liabilities
in the financial statements.
There are no material transactions that have not There are no material transactions that have not
been properly reflected in the financial statements. been properly reflected in the financial statements,
and there are no undisclosed assets or liabilities.
There are no violations or possible violations of laws
or regulations whose effects should be considered
for disclosure in the financial statements or as a
basis for recording a loss contingency, and there
are no other material liabilities or gain or loss
contingencies that are required to be accrued or
disclosed.
There are no violations or possible violations of laws

or regulations whose effects are regarded as
significant enough to be considered for disclosure
in the financial statements or as a basis for
recording a loss contingency, and there are no other
material liabilities or gain or loss contingencies that
are required to be accrued or disclosed.
Note:
a
Modifications are italicized for emphasis.
Additional Representations. Certain additional representations may be advisable in the representation letter. For
example:
a. Adjusting Entries. Some accountants believe that it is desirable to obtain management's acknowledgment
of responsibility for adjustments proposed in a review engagement. The owner/manager of the business
might state I am in agreement with the adjusting journal entries you have recommended, and they have
been posted to the Company's accounts."
b. Segregation of Business and Personal Transactions. Small businesses often have informal recordkeeping
systems, and it is easy to commingle personal and business transactions. Thus, it is beneficial to have the
owner/manager acknowledge that the accounts do not contain personal transactions.
c. Pledged Assets. Many small businesses have pledged fixed assets as collateral on debt obligations. If that
is the case, the representation that states nor has any asset been pledged" should be followed by the
phrase except as made known to you [and disclosed in the financial statements]." The bracketed phrase
is optional.
d. Questions about Significant Matters Have Arisen. When questions about significant matters have arisen in
the course of applying the review procedures, the accountant may wish to have the owner/manager include
representations about his responses to the accountant's concerns.
e. Specialized Industry. If the client operates in a specialized industry, the accountant should modify the letter
by including additional representations contained in the AICPA Industry Audit and Accounting Guides
relating to that industry. Examples are provided in PPC's Guide to Construction Contractors, PPC's Guide
to Homeowner's Associations and Other Common Interest Realty Associations, and PPC's Guide to Audits
of Nonprofit Organizations.
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Refusal to Furnish a Representation Letter

If the accountant requests a representation letter and the client refuses to provide one, SSARS No. 1, (AR 100.66),
states that the accountant would not normally be in a position to render either a review or compilation report. Thus,
a stepdown to a compilation generally is not appropriate. Even though a compilation report offers no assurance,
the accountant should not be associated with statements that may be misleading and thus should resign from the
engagement.
Periods Covered by the Representation Letter
According to SSARS No. 1, representation letters should include all periods covered by the accountant's report. In
other words, if comparative financial statements are being reported on, the representations obtained at the
completion of the most recent review should address all periods being reported on. If the owner/manager changed
during or after the period or periods being reported on, the current owner/manager may be hesitant to provide this
assurance. The accountant may point out that the first paragraph of the letter limits the confirmant's response to his
or her best knowledge and belief. SSARS No. 1, as amended, requires the accountant to obtain representations for
all periods covered by the review report from the current owner/manager.
Date of the Representation Letter
As a result, SSARS No. 1, as amended by SSARS No. 15, states that the representation letter should be dated as
of the date that the letter is presented and signed by the client. In no event should the letter be presented and
signed prior to completion of the review. Proposed SSARS Omnibus 2007 makes it clear that completion of the
review includes obtaining written representations from management and that management's written representa
tions should be made as of the date of the accountant's review report.
Updating Representation Letters
There are circumstances in which accountants should consider obtaining updating representation letters from
management. For instance, significant time may lapse between when the accountant obtains a management
representation letter after completion of the review procedures and when the accountant issues his or her report; or
a material subsequent event may occur after the representation letter is obtained but prior to issuance of the report.
In addition, if a predecessor accountant is asked by a former client to reissue his or her report on the financial
statements of a prior period, and those financial statements are to be presented on a comparative basis with
reviewed financial statements of a subsequent period, the predecessor accountant should obtain an updating
representation letter before reissuing a report on financial statements of a prior period. The updating management
representation letter should address (a) whether management is aware of any new information that would cause
them to believe that any of the previous representations should be modified, and (b) whether any events occurring
subsequent to the latest balance sheet date of the financial statements reported on by the predecessor require
disclosure in or adjustment to such financial statements.
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LEGAL REPRESENTATION LETTERS IN A REVIEW ENGAGEMENT

Unlike an audit engagement, SSARS does not require the accountant to obtain a legal representation letter [see
SAS No. 12, Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments (AU 337)]. In general,
requesting a letter would be rare and would occur only in situations where the accountant had questions or
unresolved issues regarding a material disclosure or amount in the reviewed financial statements pertaining to
litigation, claims, or assessments, which could be resolved by obtaining a legal representation letter. In such
situations, when the accountant determines that a legal representation letter is needed, but is prevented from
obtaining the letter by the client, consideration should be given to withdrawing from the engagement and not
issuing a review report.
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REVIEW ENGAGEMENT CHECKLISTS

Select a System of Review Checklists That Complements Your Firm Size
Although no two firms approach engagements in the same way, firms of similar sizes tend to follow similar
engagement procedures. Exhibit 34 presents guidelines for presenting a firm's own system of QC checklists.
Exhibit 34
Review Checklists and Workpapers
Note:The terms required, recommended, and optional do not necessarily indicate SSARS requirements.
However, the checklists and practice aids identified as required are the minimum necessary to document
compliance with SSARS and peer review requirements. Some of the procedures required to be performed to
comply with peer review requirements may not have to be accomplished by completing one of the checklists or
practice aids listed below. For example, an understanding with the client regarding the services to be performed is
required. However, an engagement letter is not required. If the engagement letter (recommended, but not required
per this exhibit) is not issued, compliance with this procedure is ensured by completing the review procedures
checklist (required per this exhibit).
Description
Sole Practitioners
Other Firms
Written
Firm
Policies
Optional
Recommended
Engagement
Acceptance
Form
Recommended
Recommended
Engagement
Letter
Recommended
Recommended
Client
Information
Form
Recommended
Recommended
Review
Procedures
Checklists
Inquiry and
Analytical
Procedures
Program
REQUIRED
Recommended
100
REQUIRED
Recommended
CART07
Description
Sole Practitioners
Other Firms
Review
Reporting
Checklist
Recommended
Recommended
Recommended
Recommended
Optional
Recommended
Financial Statement Disclo

sure
Checklist
Summarized
Longform
Technical
Reviewer
Checklist
Letter of
Representation
REQUIRED
REQUIRED
REQUIRED
REQUIRED
Adjusted
Trial
Balance
Client's
Financial
Statements
Accountant's
Review
Report
Other
Workpapers
The Review Procedures Checklist" and the Inquiry and Analytical Procedures Program" suggested in Exhibit 34
are discussed in the following paragraphs.
Review Procedures Checklist
The Review Procedures Checklist" primarily addresses the following areas:
a. Acceptance and continuance.
b. Independence.
c. Stepdown considerations.
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d. Establishing an understanding with the client.

e. Obtaining necessary background knowledge.
f. Performing inquiry and analytical procedures.
This checklist does not duplicate provisions of the other checklists suggested for review engagements. Instead, the
Review Procedures Checklist" addresses the specific requirements of SSARSNo.1 (AR 100). The Incharge
Accountant should complete the checklist. It is recommended that this checklist be completed on all review
engagements (interim as well as year end) regardless of the size of the accounting firm.
A firm's engagement checklists should interface with its QC document so that the necessary documentation
needed for peer reviews is properly included in the engagement workpapers.
Inquiry and Analytical Procedures Program
The Inquiry and Analytical Procedures Program" is a stepbystep checklist of the inquiries and analyses that
should normally be performed on a typical review engagement. Although completion of this checklist is not
required to meet SSARS or peer review requirements, it is strongly recommended that it be completed for all review
engagements, regardless of the size of the accounting firm, since it provides detailed guidance not found in other
checklists. Consequently, this is a required form in the QC system outlined in PPC's Guide to Quality Control. The
Inquiry and Analytical Procedures Program" is designed for the typical commercial entity and can be tailored to fit
individual clients or industries.
Review Reporting Checklist
This checklist is designed to document the reporting considerations required by SSARS. It presents common
reporting requirements for reviewed financial statements. It should be emphasized, however, that the checklist
cannot be a substitute for an accountant's exercise of professional judgment and knowledge of SSARS.
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SELFSTUDY QUIZ
following section.
48. According to SSARS No. 1, when is obtaining a representation letter required in a review engagement?
a. In review engagements where inquiry of management will not be performed.
b. In review engagements where the internal controls have not been tested.
c. Only in initial review engagements.
d. In all review engagements.
49. According to SSARS No. 1, which of the following is a specific representation required by management in the
representation letter?
a. Management's reliance on the accountant to prevent and detect fraud.
b. Management's acknowledgement that the company is in compliance with all debt covenants related to
longterm liabilities.
c. Management's acknowledgement that it has complied with all applicable SEC rules and regulations.
d. Management's acknowledgement of full and truthful responses to all inquiries.
50. What is the most appropriate course of action with respect to the representation letter when the review
engagement covers two fiscal years and ownership or management changes during the second fiscal year
covered by the report?
a. The accountant is still required to obtain representation from current ownership or management for all
periods covered by the review report.
b. Current ownership or management may provide the appropriate representations on the date of transfer
of ownership or management control going forward, and the accountant can rely on the previous
ownership's representations in the previous year's representation letter.
c. The accountant must obtain one representation letter covering all fiscal years of the engagement signed
by both the current and previous owners and/or management.
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SELFSTUDY ANSWERS
48. According to SSARS No. 1, when is obtaining a representation letter required in a review engagement?
(Page 96)
a. In review engagements where inquiry of management will not be performed. (This answer is incorrect.
Inquiry of management should always be performed in review engagements.)
b. In review engagements where the internal controls have not been tested. (This answer is incorrect. Internal
controls are not tested in review engagements.)
c. Only in initial review engagements. (This answer is incorrect. This answer choice does not correctly reflect
when representation letters are required.)
d. In all review engagements. (This answer is correct. Obtaining a representation letter in a review
engagement is required by SSARS No. 1.)
49. According to SSARS No. 1, which of the following is a specific representation required by management in the
representation letter? (Page 96)
a. Management's reliance on the accountant to prevent and detect fraud. (This answer is incorrect. In the
representation letter, management must acknowledge its responsibility to prevent and detect fraud.)
b. Management's acknowledgement that the company is in compliance with all debt covenants related to
longterm liabilities. (This answer is incorrect. In the representation letter, there is no requirement for a
specific reference to debt covenants.)
c. Management's acknowledgement that it has complied with all applicable SEC rules and regulations. (This
answer is incorrect. Review engagements are performed on nonpublic clients; therefore, references to
SEC regulations are not required in a representation letter for a review engagement.)
d. Management's acknowledgement of full and truthful responses to all inquiries. (This answer is
correct. This acknowledgment is required by SSARS No. 1.)
50. What is the most appropriate course of action with respect to the representation letter when the review
engagement covers two fiscal years and ownership or management changes during the second fiscal year
covered by the report? (Page 98)
a. The accountant is still required to obtain representation from current ownership or management for
all periods covered by the review report. (This answer is correct. SSARS No. 1 requires the
accountant to obtain representation for all periods covered by the review report from the current
owner or manager.)
b. Current ownership or management may provide the appropriate representations on the date of transfer
of ownership or management control going forward, and the accountant can rely on the previous
ownership's representations in the previous year's representation letter. (This answer is incorrect. This
answer choice does not correctly reflect the requirements of SSARS No. 1.)
c. The accountant must obtain one representation letter covering all fiscal years of the engagement signed
by both the current and previous owners and/or management. (This answer is incorrect. SSARS No. 1 has
no requirement that the accountant to obtain representation for all periods covered by the review report
from the previous owner or manager.)
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EXAMINATION FOR CPE CREDIT

CARTG071 Engagement Administration for Compilations and Reviews
Test Instructions
1. Following these instructions is an examination consisting of multiple choice questions. You may complete the
exam by logging on to our online grading system at OnlineGrading.Thomson.com. Click the purchase link
and list of exams will appear. You may search for the exam using wildcards. Payment for the exam is accepted
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history. If you lose your certificate, you may return to the site and reprint your certificate.
If you prefer, you may continue to mail your completed answer sheet to the address below. In the print product,
the answer sheets are bound with the course materials. For the CDROM product, answer sheets may be
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1. What is one of the primary advantages of issuing an engagement letter for all compilation or review
engagements?
a. Improves the assessment of internal controls.
b. Reduces potential legal liability.
c. Ensures compliance with SSARS No 1.
d. Clarifies planning materiality for the client and staff.
2. MVV, Inc. refuses to pay for the compilation report issued by G&W, CPA, because MVV's bank required audited
financial statements before extending a line of credit. What element of an engagement letter would have been
most effective in preventing this disagreement?
a. A statement the engagement cannot be relied on to detect errors, fraud, or illegal acts.
b. A statement that a compilation is limited to presenting in the form of financial statements information that
c. A description of the report the accountant expects to render.
d. A statement that there is a lack of independence.
3. To comply with SSARS No. 1, when must an accountant obtain an engagement letter signed by management?
a. Before the compilation or review procedures begin.
b. During the compilation or review.
c. By the date on the compilation or review report.
d. An engagement letter signed by management is not required.
4. LRA Bank has filed suit against W&J, CPA, claiming that the financial statements W&J compiled for HRC, Inc.
overstated the inventory on HRC's balance sheet. What element of an engagement letter would have been most
effective in preventing this litigation?
a. A statement that the engagement cannot be relied upon to detect errors, fraud, or illegal acts.
c. A statement that the financial statements will not be audited and reviewed.
d. A statement that there is a lack of independence.
5. What is one method an accountant might employ to reduce the risk that financial statements compiled for
managementuseonly are issued to third parties?
a. Print Internal Use Only" on each page of the compilation report.
b. Add a statement in the engagement letter that management should notify the CPA if there is a need to
provide financial statements to a third party.
c. Sign an agreement with the client agreeing to arbitration should any issues arise regarding the distribution
of the financial statements.
d. Add statement in the engagement letter stating that there is a lack of independence.
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6. T&J, CPA has compiled the financial statements of MVA Dining for the last five years, during which time
ownership of MVA has changed three times. What is the most effective way for T&J to avoid potential
misunderstandings with the new owners about the nature of the services it provides MVA?
a. Provide a copy of the original engagement letter signed by MVA to the new owners.
b. Require the signature of the new owners on the original engagement letter signed by MVA.
c. Update its engagement letter with MVA on an annual basis.
d. Document in a permanent file that the financial statements are based on representations made by
management.
7. When a dispute arises between the accountant and the client regarding services for which the client has
contracted, on whom does the burden of proof fall to prove that the agreement was for a compilation or review
and not an audit?
a. The client.
b. The accountant.
c. The burden of proof falls equally on both parties.
d. It depends on the facts and circumstances of the dispute.
8. US Bank has filed suit against T&J, CPA, alleging that T&J understated the longterm liabilities of Mom and
Pop's Caf on its compiled financial statements. T&J relied upon Mom and Pop's representation in compiling
the financial statements. What is the most effective tool for T&J to employ to mitigate losses arising from this
type of situation?
a. Obtain errors and omissions insurance to protect its assets in the case of suits by third parties based on
misrepresentations made by Mom and Pop.
b. Instruct its attorneys to produce the engagement letter for US Bank, substantiating the fact that the financial
statements are based on representations made by management.
c. Include an indemnity clause in the engagement letter requiring Mom and Pop to indemnify T&J if T&J is
sued by a third party for misrepresentations made by Mom and Pop.
d. Issue a statement to US Bank regarding the nature and limitations of compilation engagements for
nonpublic entities.
9. Which of the following forms of alternative dispute resolution most closely resembles the litigation process?
a. Arbitration.
b. Mediation.
c. Remediation.
d. Thirdparty negotiation.
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10. In 2007, W& J, CPA is reviewing the protective provisions of their engagement letter. The managing partner is
pleased to see provisions for legal action a client could take other than a jury trial. Later in 2007, HRC, Inc. files
suit against W&J, CPA, in a dispute regarding financial statements compiled by W&J in 2003. What element
of an engagement letter would have been most effective in preventing this litigation?
a. Including a reference to the statute of limitations of the state in which W&J is licensed.
b. Agreeing to resolve disputes over services provided through the arbitration process.
c. Agreeing to resolve disputes over services provided through nonbinding arbitration.
d. Including a provision that all claims be asserted within a specified period of time.
11. What is one reason why an accountant would include an engagement letter in the workpaper documentation
for a review engagement?
a. Inclusion is required by SSARS No. 1.
b. Inclusion is required by SSARS No. 8.
c. Inclusion provides specified reasons for a stepdown in level of service from an audit.
d. Inclusion clarifies the contractual obligation between the accountant and client.
12. HST, CPA is engaged to perform a compilation of the financial statements of IMO Co. Heretofore, HST has only
performed audit engagements of public companies, so HST refers to SSARS No.1 for guidance on workpaper
documentation for a compilation engagement. Which element is required by SSARS No. 1 to be included in
workpapers in a compilation engagement?
a. SSARS No. 1 does not discuss workpaper documentation for compilation engagements.
b. Engagement letter.
c. Representation letter.
d. Documentation of communications to the appropriate level of management regarding fraud or illegal acts.
13. While a variety of authoritative literature discusses the concept of independence, what is the best definition of
this concept as it relates to accountants and their clients?
a. Accountants are independent if no related party transactions exist between the accountants and their
clients.
b. Accountants are independent if they have no direct, material financial interest in their clients.
c. Accountants are independent if they are free from obligation to or interest in their clients.
d. Accountants are independent if they have no direct or indirect, material financial interest in their clients.
14. JFK, CPA, performs an annual review for CCM, Inc. CCM has been a client of JFK for 15 years, represents 40%
of JFK's service fee revenue, and has changed ownership within the last year. Based on these facts, what is
the most likely threat to JFK's independence in the performance of this review engagement?
a. Advocacy threat.
b. Financial selfinterest threat.
c. Undue influence threat.
d. Familiarity threat.
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15. When no rulings or interpretations address an accountant's specific independence issue with a client, what
source(s) must an accountant use as guidance?
a. The case examples promulgated by the Professional Ethics Executive Committee.
b. The riskbased approach described in the Conceptual Framework for AICPA Independence Standards.
c. The decisions handed down in court cases with fact patterns similar to the one the accountant faces.
d. The guidance provided by the AICPA Code of Professional Conduct (Conduct Code).
16. GHWB LLP performs an annual review for KBP, Inc. Due to their longstanding relationship, KBP asks the firm
to represent KBP in tax court involving a potential tax liability that is material to KBP's financial statements. If
GHWB accepts, what type of threat does this engagement pose to its independence?
a. Adverse interest threat.
c. Advocacy threat.
17. In general, what is considered unacceptable risk to an accountant's independence in a relationship with a
client?
a. If the client does not provide for safeguards that mitigate or eliminate threats to independence.
b. If the firm does not provide for safeguards that mitigate or eliminate threats to independence.
c. If the relationship involves material financial risks to the accountant if the accountant cannot perform the
attest engagement according to the expectations of the client.
d. If the relationship would compromise the member's professional judgment when rendering an attest
service to the client.
18. JQA LLP performs an annual review on the financial statements of UVA Co. What is the most likely example of
a safeguard that could be implemented by JQA that might mitigate or eliminate threats to independence?
a. JQA could rotate senior personnel assigned to the review engagement.
b. JQA senior personnel could publish articles in trade journals regarding the importance of independence
on attest engagements.
c. JQA could design UVA's accounting systems to ensure independence from UVA while engaged on the
review.
d. JQA could institute a policy banning firm personnel from contact with all clients unrelated to the
engagement.
19. What is the primary purpose of Ethics Interpretation 1013?
a. To document the riskbased approach to analyzing independence.
b. To clarify issues related to independence impaired by unpaid fees.
c. To address independence issues related to the performance of nonattest services.
d. To provide guidelines to the accountant regarding acceptable threat levels to independence in attest
engagements.
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20. DDE LLP performs an annual review on the financial statements of WPA, Inc., in addition to tax compliance
services. Since the controller of WPA is on vacation, DDE's tax partnerincharge signs WPA payroll tax returns
on behalf of WPA to avoid late filing fees and penalties. Based on the above scenario, is DDE's independence
impaired?
a. No, independence is not impaired as long as before the services are performed, the client and accountant
document their understanding of the engagement in writing.
b. Yes, independence is impaired because signing payroll tax returns is considered the performance of the
c. No, independence is not impaired as long the tax partnerincharge is also a signatory on the operating
account of WPA.
d. Yes, independence is impaired because accountants are not permitted to assist management in the
performance of management functions.
21. If independence is impaired on a compilation report for thirdparty use, what action is required on the part of
the accountant?
a. The accountant must not issue a report if the financial statements are being compiled for thirdparty use.
b. The accountant must resign from the engagement since a compilation is an attest engagement and
independence is required by the standards.
c. The accountant must implement safeguards to mitigate threats to independence before issuing the
compilation report.
d. The accountant must document the lack of independence on the compilation report.
22. GWB LLP performs an annual review on the financial statements of MTX, Inc. While entertaining the client at
a baseball game, the partnerincharge responds to MTX's CFO's question about a technical issue related to
how the client books depreciation on a monthly basis. Based on the above scenario, which of the following
correctly matches the auditor's response with the determination as to whether or not an attest service has been
performed?
i. because the partner in charge has violated the
provisions of ET Interpretation 1013
ii. because the partner in charge has not violated
provisions of ET Interpretation 1013
iii because SSARS No. 1 has been violated.
1 Yes, an attest function has been performed

2 No, an attest function has not been performed
a. 1 and i
b. 1 and iii
c. 2 and i
d. 2 and ii
23. What is one requirement of SSARS No. 1 when issuing compiled financial statements?
a. When financial statements are intended for thirdparty use, accountants must issue a SSARS No. 1
compilation report.
b. When financial statements are intended for managementuseonly, accountants must issue a SSARS No.
1 compilation report.
c. When financial statements are intended for thirdparty use, accountants must issue a report on the
effectiveness of internal controls.
d. When financial statements are intended for thirdparty use, accountants must make inquiries or perform
other procedures to verify, corroborate, or review information supplied by the entity.
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24. Tyler CPA performs an annual compilation on the financial statements of PSW, Ltd. While talking to PSW's owner
at a Rotary Club meeting, Tyler learns that PSW is building new plants in two new locations. Due to past
experience with the client, Tyler believes that this expansion cannot be funded using cash reserves or cash flows
from ongoing operations. Based on the above scenario, what type of compilation report should Tyler most likely
prepare?
a. Compiled financial statements intended for thirdparty use, because it appears that PSW will need updated
financials to obtain bank financing for its expansion.
b. Compiled financial statements intended for managementuseonly, because PSW's management will
require specialized reporting to enable it to make strategic decisions regarding the planned expansion.
c. Compiled financial statements intended for thirdparty use, because the representation letter signed by
PSW's owner only covers the issuance of statements for thirdparty use.
d. Compiled financial statements intended for managementuseonly, because Tyler will be able to reduce
the length of time needed to complete the compilation and provide management with timely information
in order to make a decision on the expansion.
25. What is one reason that certain accountants will not advocate the issuance of managementuseonly financial
statements in application of SSARS No. 8?
a. Because their practices will see a reduction in fee revenue when clients request the new, lower level of
service that these financial statements require.
b. Because they feel the lack of internal control testing performed in the compilation of these financial
statements exposes them to additional liability.
c. Because they feel they will offend existing clients by requesting a signed engagement letter on an annual
basis.
d. Because they feel that all financial statements eventually end up in the hands of third parties, regardless
of original intention.
26. FDR CPA performs an annual compilation on the financial statements of NYS Co. NYS believes in open
communication with its employees and wants to provide each employee with financial information regarding
the company. Based on NYS' objective, what type of financial statements should FDR issue?
a. Compiled financial statements because FDR will also be corroborating statements by management with
additional inquiry and procedures.
b. Compiled financial statements intended for managementuseonly, because the financial statements will
be for internal use only.
c. Compiled financial statements intended for thirdparty use, because all employees in the organization will
not be knowledgeable about the procedures applied in the engagement.
d. Compiled financial statements intended for managementuseonly, because FDR can issue the financial
statements to management, who may distribute the statements to rankandfile employees at its option.
27. What is one way to reduce exposure to liability when an accountant issues managementuseonly financial
statements?
a. Insert additional language in the engagement letter indicating the educational and work experience
requirements of client personnel who should have access to the financial statements.
b. Insert additional language in the engagement letter clarifying management's agreement not to distribute
the financial statements to third party users.
c. Insert additional language in the engagement letter detailing the analytical review procedures to be
performed in the compilation of the financial statements.
d. Insert additional language in the engagement letter specifying a description of the nature and limitations
of the services to be performed.
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28. WJC LLP wants to perform a compilation for a potential client, HRC, Inc., that specializes in commercial real
estate. HRC wants to hire WJC due to its reputation as the premiere accounting service provider for the real
estate industry. What is an additional step WJC must take to comply with SSARS No. 1 performance standards
for compilation engagements?
a. WJC must obtain a general understanding of matters related to HRC before completing the engagement.
b. WJC must obtain a list of all parties who will have access to the compiled financial statements.
c. WJC must procure a signed engagement letter from HRC if the financial statements will be for
managementuseonly.
d. Since WJC is an expert in the industry, no additional steps are necessary to perform the compilation.
29. What is one required element for engagements for both managementuseonly and thirdparty use financial
statements?
a. Engagement letters.
b. Representation letters.
c. Compilations procedures checklists.
d. Written firm policies.
30. WJC LLP has been approached to perform a compilation for a potential client, HRC, Inc. Which of the following
is the most important factor WJC should consider before accepting the engagement?
a. WJC's ability to service the client properly.
b. WJC's ability to test the internal controls of HRC's accounting system.
c. WJC's ability to rely on the results of analytical procedures performed during the compilation.
d. WJC's ability to confirm the stated educational background of HRC's financial management.
31. When an accountant performs a review of financial statements, what level of assurance does an accountant
express on the financial statements?
a. No assurance.
b. Limited assurance.
c. Unqualified assurance.
d. Absolute assurance.
32. JQA LLP has performed an annual compilation on the financial statements of UVA Co. for the past five years.
This year, UVA has requested a review of the financial statements in conjunction with obtaining a lineofcredit.
Which of the answer choices below correctly identifies one of two additional procedures JQA must perform
during this year's engagement that it hasn't in past years?
a. Reading the financial statements.
b. Testing of accounting records.
c. Assessing control risk.
d. Inquiry of client personnel.
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33. What is one similarity between the performance standards for a compilation and a review?
a. Both require obtaining an understanding of and assessing internal control risk.
b. Both require tests of accounting records by obtaining corroborating evidential matter.
c. Both require tests of responses to inquiries of client personnel by obtaining corroborating testimony from
other personnel.
d. Both require knowledge of the industry and the client's business.
34. JFK, CPA, is performing a review for a new client, CCM, Inc. What is one course of action JFK might take to meet
the performance standards for a review engagement?
a. Review the requirements of Section 404 of SarbanesOxley and their applicability to CCM.
b. Send confirmation letters to customers of CCM to corroborate its accounts receivable balance.
c. Review financial statements of other companies in the same industry as CCM.
d. Create a plan to perform a risk assessment on the accounting records of CCM.
35. Why are analytical procedures important in a review engagement?
a. They assist the accountant in identifying relationships and individual items that appear unusual.
b. They relieve the accountant of the necessity of performing inquiry of client personnel during the review
engagement.
c. They provide the accountant with basis necessary to express unqualified opinion as to the fairness of the
d. They provide the accountant with substantive evidential matter to management's responses to inquiry.
36. GHWB LLP is planning the annual review for KBP, Inc. The incharge wants to determine if KBP has experienced
a material increase in freight compared to the prior year. What type of analytical review procedure will be most
effective in accomplishing this objective?
a. Ratio analysis.
b. Reasonableness tests.
c. Trend analysis.
d. Statistical projections.
37. When is the use of ratio analysis most effective as an analytical procedure?
a. When the accountant compares financial data in several successive years.
b. When the relationship between accounts is stable and fairly predictable.
c. When accounts required adjustments in prior years.
d. When the accountant needs a predictive test based on financial data only.
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38. Tyler CPA will perform a review on the financial statements of PSW, Ltd. Tyler wants to confirm his expectation
of PSW's annual interest expense using analytical procedures. What type of analytical review procedure will
be most effective in accomplishing this objective?
a. Trend analysis.
b. Statistical projection.
d. Ratio analysis.
39. What is a primary reason a representation letter is required in all review engagements?
a. It provides management with details regarding the analytical review procedures to be performed on the
engagement.
b. It clarifies the traditional roles of the accountant and management.
c. It relieves the accountant of responsibility should management be engaged in fraud or misrepresentation.
d. It highlights the responsibility on the part of the accountant to detect fraud through client inquiry and
40. WJC LLP has been engaged to perform a review of the financial statements of HRC Co. After performing the
requisite procedures on the financial statements, WJC requests a signed representation letter, but HRC refuses
to provide one. Based on the above circumstances, which of the following would be the most prudent course
of action on the part of WJC?
a. WJC should resign from the engagement.
b. WJC should stepdown the engagement from a review to a compilation as it cannot provide limited
assurance without a representation letter.
c. WJC should consult an attorney and attempt to collect any unpaid fees billed to date.
d. WJC should issue the review report with a disclaimer stating that management did not provide a
representation letter.
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GLOSSARY
Accounting change: As defined by SFAS No. 154, an accounting change is one of the following: 1) Change in
accounting estimate, 2) Change in reporting entity, or 3) Change in accounting principle. The accountant's reporting
responsibility varies depending on which type of change affects the financial statements on which the accountant
is reporting.
Analytical procedures: Substantive tests made by study and comparison of plausible relationships among both
financial and nonfinancial data. These tests focus on the reasonableness of expected relationships and the
identification of significant unexpected differences.
Alternative dispute resolution (ADR): A method of resolving client disputes without exposing the accountant to the
cost and uncertainty of litigation, such as arbitration or mediation.
Arbitration: A type of ADR whereby the parties to a dispute present their respective cases to an arbitrator who
renders a verdict at the conclusion of the case.
Attest engagement: An engagement that requires independence on the part of the accountant, such as audits,
examinations, agreedupon procedures, reviews, and compilations.
Basis of accounting: Refers to when transactions or events are recognized for reporting.
Comparative financial statements: Financial statements of two or more periods presented in columnar form.
Compilation of financial statements: Presenting in the form of financial statements information that is the
representation of management (owners) without undertaking to express any assurance on the statements.
Engagement letter: A written communication with the client that documents the accountant's understanding with
the client about the performance of the professional engagement. Matters addressed in an engagement letter
include the objectives of the engagement, the accountant's responsibility, the client's responsibility, and limitations
of the engagement.
Financial Accounting Standards Board (FASB): The Financial Accounting Standards Board (FASB) is an
independent authoritative body created in 1973 to replace the American Institute of Certified Public Accountants
(AICPA) Accounting Principles Board and authorized by the AICPA Code of Professional Conduct as a promulgator
of generally accepted accounting principles (GAAP), primarily for nongovernment entities.
Financial statement: A presentation of financial data, including accompanying notes, derived from accounting
records and intended to communicate an entity's economic resources or obligations at a point in time, or the changes
therein for a period of time, in accordance with generally accepted accounting principles (GAAP) or another
comprehensive basis of accounting other than GAAP (OCBOA). The basic financial statements in a typical GAAP
financial statement presentation are as follows: 1) Statement of Financial Position or Balance Sheet, 2) Statement
of Income, 3) Statement of Comprehensive Income, 4) Statement of Retained Earnings or Changes in Stockholders'
Equity, and 5) Statement of Cash Flows.
Fiscal year: A fiscal year is an accounting year ending on the last day of any month except December.
Independence: Regardless of the level of service or type of engagement, a situation in which accountants are free
from obligation to or interest in their clients. The CPA must be independent not only in fact but in appearance.
Inquiry: Inquiry is the seeking of appropriate information from knowledgeable persons inside (both management
and staff) or outside the entity (e.g., bankers, attorneys, vendors, customers, predecessor accountant) with the
approval of management. Inquiry is required under the performance standards of a review engagement.
Materiality: The magnitude of an omission or misstatement of accounting information that, in light of surrounding
circumstances, makes it probable that the judgment of a reasonable person relying on the information would have
been changed or influenced by the omission or misstatement.
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Mediation: A type of ADR in which voluntary settlement negotiations are facilitated by a neutral third party.
Misstatement: An item that causes the financial statements not to conform to GAAP (or an OCBOA).
Nonattest services: Services that do not require the accountant to be independent, such as bookkeeping, tax return
preparation, and providing routine advice to clients.
Nonpublic entity: Any entity other than (a) one whose securities trade in a public market either on a stock exchange
(domestic or foreign) or in the overthecounter market, including securities quoted only locally or regionally, (b) one
that makes a filing with a regulatory agency in preparation for the sale of any class of its securities in a public market,
or (c) a subsidiary, corporate joint venture, or other entity controlled by an entity covered by (a) or (b).
Notes to Financial Statements: An integral part of financial statements used to present material disclosures
required by GAAP that are not otherwise presented in the financial statements, i.e. on the face of the statements or
in the Summary of Significant Accounting Policies."
OCBOA: A comprehensive basis of accounting other than generally accepted accounting principles such as the
following: 1) a basis of accounting that the reporting entity uses to comply with the requirements or financial reporting
provisions of a governmental regulatory agency to whose jurisdiction the entity is subject; 2) a basis of accounting
that the reporting entity uses or expects to use to file its income tax return for the period covered by the financial
statements; 3) the cash receipts and disbursements basis of accounting, and modifications of the cash basis having
substantial support, such as recording depreciation on fixed assets or accruing income taxes; or 4) a definite set of
criteria having substantial support that is applied to all material items appearing in financial statements, such as the
pricelevel basis of accounting.
Quality control system: A series of policies, procedures, and related checklists designed to provide a firm with
reasonable assurance of conforming to professional standards.
Ratio analysis: A type of analytical procedure that involves the study of the relationship between two financial
statement amounts.
Reasonableness test: A type of analytical procedure that involves estimating a financial statement or the change
in an amount from the prior year by using operating or other nonfinancial data.
Representation letter: Letter signed by client management detailing representations made by management related
to all financial statements and periods covered by an accountant's review report.
Review of financial statements: Performing inquiry and analytical procedures that provide the accountant with a
reasonable basis for expressing limited assurance that there are no material modifications that should be made to
the statements for them to be in conformity with GAAP (or an OCBOA).
Scope limitation: In a review engagement, a scope limitation occurs when the accountant is prevented from
performing adequate inquiry and analytical review procedures necessary to provide limited assurance on the
Statements on Standards for Accounting and Review Services (SSARS): The official pronouncements of the
AICPA that govern the professional conduct of a CPA when engaged to compile or review financial statements of a
nonpublic entity.
Statements on Auditing Standards (SAS): The 10 generally accepted auditing standards (GAAS) are interpreted
and expanded upon in Statements on Auditing Standards (SAS), issued periodically by the Auditing Standards
Board of the American Institute of Certified Public Accountants (AICPA). They provide the detail and guidance
needed to meet the 10 GAAS standards.
Substantive tests: Tests of details of transactions or balances, or analytical procedures performed to detect material
misstatements.
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Summary of Significant Accounting Policies: A disclosure required by GAAP when basic financial statements are
issued by an accountant, which identify and describe the accounting principles followed by the reporting entity and
the methods of applying those principles that materially affect the determination of financial position, results of
operations, or cash flows.
Supplementary or Other Information: Detailed schedules, summaries, comparisons, or statistical information that
are not part of the basic financial statements and are not required for a fair presentation in accordance with GAAP,
often included in the unaudited financial statements of a nonpublic entity. Examples of supplementary information
include, but are not limited to, budgets for an expired period, selling expenses, and details of sales by product line.
Third party: As defined by SSARS No. 1, all parties except for members of management who are knowledgeable
about the nature of the procedures applied and the basis of accounting or assumptions used in the preparation of
Trend analysis: A type of analytical procedure that involves the study of the change in accounts over time.
Workpapers: An accountant's primary record of procedures applied, evidence obtained, and conclusions reached
in an attest engagement. Workpapers for compilations or reviews might include, but are not limited to, the
engagement letter, checklists and memoranda, analyses, memoranda, representation letter, and documentation of
inquiry and analytical procedures performed. Workpapers may be in paper or electronic form or in the form of other
media.
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INDEX
A
ACCOUNTANT'S REPORTS
Components audited or reviewed
by other accountants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
Other accountants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
DATA PROCESSING SERVICES

Independence, effect on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
ACCOUNTING SERVICES
Automated bookkeeping services . . . . . . . . . . . . . . . . . . . . . . . 25
Effect of SSARS No. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
ENGAGEMENT LETTERS
Client resistance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Compilations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3, 54, 61
Limiting liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Managementuseonly financial statements . . . . . . . . . . . . 54, 61
Oral understanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Period covered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Pro forma financial information . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Reviews . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3, 61
Specified elements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Written understanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Accumulating passed adjustments . . . . . . . . . . . . . . . . . . . . . . . 85
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Documenting planning materiality . . . . . . . . . . . . . . . . . . . . . . . 85
Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74, 75
Initial engagements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Limitations of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Ratio analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Ratio history, developing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Reasonableness tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Selection of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Trend analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Workpapers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18, 102
I
INDEPENDENCE
Accounting services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Authoritative literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conceptual framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other accountants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Performance of nonattest services . . . . . . . . . . . . . . . . . . . . . . .
Unpaid fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B
BUSINESS
Accountant's knowledge of . . . . . . . . . . . . . . . . . . . . . . . . . . 55, 68
25
23
23
33
23
88
25
25
INDUSTRY ACCOUNTING PRACTICES

Accountant's knowledge of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
INQUIRIES
Review procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
CHECKLISTS AND FORMS

Background for system of checklists . . . . . . . . . . . . . . . . . . . . 100
Compilations (under SSARS)
Client information form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Compilation reporting checklist . . . . . . . . . . . . . . . . . . . . . . 61
Engagement acceptance form . . . . . . . . . . . . . . . . . . . . . . . 60
Engagement letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Procedures checklists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Technical reviewer checklist . . . . . . . . . . . . . . . . . . . . . . . . . 61
Firm policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Reviews
Engagement letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Inquiry and analytical procedures program . . . . . . . . . . . 102
Procedures checklist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Representation letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Review reporting checklist . . . . . . . . . . . . . . . . . . . . . . . . . . 102
INTERNAL CONTROLS
Communication of weaknesses to clients . . . . . . . . . . . . . . . . . 89
Study and evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
INVESTEES
Reports on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
K
KNOWLEDGE
Client's business
Compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Industry
Compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Industry accounting practices
Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
CODE OF PROFESSIONAL CONDUCT (AICPA)

Rule 201 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
55
68
54
68
COMPILATION ENGAGEMENTS
Engagement letter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Internal controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
Legal exposure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Performance procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Reading the financial statements . . . . . . . . . . . . . . . . . . . . . . . . 56
Workpapers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
LEGAL EXPOSURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
LIMITED ASSURANCE
Review of financial statements . . . . . . . . . . . . . . . . . . . 67, 68, 74
M
MANAGEMENTUSEONLY FINANCIAL STATEMENTS
Accountants' responsibilities when managementuseonly
financial statements are distributed to third parties . . . . . . . . . 47
Considering the intended use of the financial statements
Adequacy of management's knowledge . . . . . . . . . . . . . . . 45
Intended use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
COMPONENTS OF A BUSINESS
Reports of other accountants . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
CORPORATE JOINT VENTURES
Obtaining reports on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
119

Legend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Thirdparty versus management . . . . . . . . . . . . . . . . . . . . . .
Pros and cons of issuing managementuseonly financial
statements
Reasons against applying the provisions
of SSARS No. 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reasons to apply the provisions of SSARS No. 8 . . . . . . .
57
45

44
43
P
PEER REVIEW
Checklists for performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Engagement letter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Internal control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67, 89
Knowledge of the business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Limited assurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Obtaining reports from other accountants . . . . . . . . . . . . . . . . . 88
Ratio history, developing a . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Reading the financial statements . . . . . . . . . . . . . . . . . . . . . . . . 87
Review reporting checklist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Standards and procedures . . . . . . . . . . . . . . . . . . . 68, 69, 74, 87
Workpapers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18, 100
STATEMENTS ON AUDITING STANDARDS

No. 60, AU 325 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
QUALITY CONTROL
Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
STATEMENTS ON STANDARDS FOR ACCOUNTING AND

REVIEW SERVICES (SSARS)
No. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3, 4, 18, 42, 67, 68, 68,
69, 69, 74, 84, 85, 87, 96
No. 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
No. 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
R
READING THE FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . 87
Inquiries, relationship of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Modifications to the standard letter . . . . . . . . . . . . . . . . . . . . . .
Additional representations . . . . . . . . . . . . . . . . . . . . . . . . . . .
Alternative wording . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Periods covered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reasons for obtaining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Refusal to furnish . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
SSARS No. 1 guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Updating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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69
96
97
97
98
96
98
96
98
SUBSIDIARIES
Reports on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
W
WORKPAPERS
Compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Nonattest services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Retention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18, 100
REVIEW ENGAGEMENTS
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
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COURSE 2
Preparing Financial Statements for Compilations and Reviews
OVERVIEW
COURSE DESCRIPTION:
This interactive selfstudy course addresses the form and presentation of financial
statements and also provides comprehensive guidance on the reporting require
ments related to compilation and review engagements.
DATE:
August 2007
RECOMMENDED FOR:
PREPARATION:
Basic knowledge of attest engagements and related reporting requirements.
CPE CREDIT:

FIELD OF STUDY:
Accounting
EXPIRATION DATE:
KNOWLEDGE LEVEL:
Basic
Lesson 1 Form and Presentation of Financial Statements
Identify the necessary elements of the basic financial statements in a compilation or review report.
Recommend the appropriate disclosures related to the basic financial statements, including accompanying
notes and other supplementary information.
Construct a statement of cash flows in accordance with SFAS No. 95.
Lesson 2 Reporting on Compiled or Reviewed Financial Statements
Identify the basic reporting requirements relating to compiled or reviewed financial statements.
Evaluate situations requiring special reporting issues relating to compiled or reviewed financial statements.
Employ the appropriate reporting procedures when comparative financial statements are compiled or
reviewed.
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P.O. Box 966
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Lesson 1:Form and Presentation of Financial

Statements
This lesson discusses the form and presentation of basic financial statements and the accountant's report
produced by the practitioner in a compilation or review engagement. Included are detailed discussions covering
the statement of cash flows, the accompanying notes, and supplementary information related to the financial
statements.
Identify the necessary elements of the basic financial statements in a compilation or review report.
Recommend the appropriate disclosures related to the basic financial statements, including accompanying
notes and other supplementary information.
Construct a statement of cash flows in accordance with SFAS No. 95.
INTRODUCTION
The form and presentation issues discussed in this lesson are divided into sections that represent the following
main components of a bound set of financial statements.
a. Title Page
b. Table of Contents
c. Accountant's Report
d. Basic Financial Statements
e. Summary of Accounting Policies (unless included as part of the notes to the financial statements)
f. Notes to Financial Statements
g. Supplementary or Other Information
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TITLE PAGE
General
A title page is recommended for all financial statement presentations. The title page should contain the name of the
entity, the title of the financial statements, and the date or period covered, as illustrated below.
XYZ CORPORATION
FINANCIAL STATEMENTS
Years Ended December 31, 20X6 and 20X5
Name of Entity
The name of the entity should be presented exactly as listed in the charter, partnership agreement, or other
appropriate legal document. When the entity is not a regular corporation, the type of entity should generally be
disclosed parenthetically in the accountant's report. Examples of appropriate presentations of the name of the
entity are as follows:
a. ABC CORPORATION
b. XYZ LTD.
c. JONES NURSERY
d. THE ESTATE OF JOHN DOE
e. MR. AND MRS. JOHN Q. PUBLIC
f. JANE DOE TESTAMENTARY TRUST
Title of Financial Statements
If the presentation includes more than one type of financial statement (e.g., Balance Sheet, Statement of Income
and Retained Earnings, and Statement of Cash Flows), the term Financial Statements is the most practical method
of communicating to the reader what is included in the presentation. When only one type of statement is presented,
it is more appropriate to use the exact title of the statement as follows:
BALANCE SHEET or STATEMENT OF INCOME
When consolidated or combined financial statements are presented, the title page should include the words
consolidated or combined, as in the following examples:
a. CONSOLIDATED FINANCIAL STATEMENTS
b. COMBINED BALANCE SHEET
c. CONSOLIDATED STATEMENT OF INCOME AND RETAINED EARNINGS
If comparative periods are presented in a package that contains only one type of statement, the title should appear
as follows:
BALANCE SHEETS or STATEMENTS OF INCOME
When financial statements include supplementary or other information, the title should be modified as follows:
FINANCIAL STATEMENTS AND SUPPLEMENTARY
(OR OTHER) INFORMATION
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Some practitioners add a description of the service performed to the title of the financial statements on the title page
as follows:
XYZ CORPORATION
COMPILED FINANCIAL STATEMENTS
However, the policy adopted for all PPC companion guides is to omit a description of the service from the title
except when different levels of service are performed, as discussed later in this lesson.
Date or Period Covered
When both a balance sheet and statement of income are presented, the period covered by the statement (or
statements) of income should be shown on the title page as follows:
a. Years Ended December 31, 20X6 and 20X5
b. Three Months Ended March 31, 20X6 and 20X5
c. Six Months Ended June 30, 20X6
d. One Month and Six Months Ended June 30, 20X6
The last day of the month should be used even if that date falls on a Sunday or holiday, except in circumstances
such as the following:
a. Entities on a 52/53 week accounting period:
(1) Years Ended December 27, 20X6 (52 weeks) and January 3, 20X6 (53weeks)
(2) Year (52 weeks) Ended January 2, 20X6
b. Entities using 13week quarters:
Quarters (13 weeks) Ended March 29, 20X6 and March 27, 20X5
c. Initial financial statements for new entities:
From January 23, 20X5 (Date of Inception) to March 31, 20X5
d. Financial statements for liquidating entities:
From January 1, 20X5 to September 17, 20X5 (Date of Liquidation)
When only balance sheets are presented, the date of the statements would appear as follows:
December 31, 20X6 and 20X5
Different Levels of Service Comparative Financial Statements
Comparative financial statements may include one period that is audited and another period that is unaudited. The
title page may indicate the level of service when this occurs as follows:
XYZ CORPORATION
Years Ended December 31, 20X6 (Audited) and 20X5 (Unaudited)
or
Years Ended December 31, 20X6 (Unaudited) and 20X5 (Audited)
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TABLE OF CONTENTS
A table of contents may not be useful to the reader of financial statement presentations unless supplementary
information is included. If a table of contents is presented, the title of each statement or schedule should be listed
in the table of contents exactly as it appears on the statement or schedule.
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PRESENTATION OF THE ACCOUNTANT'S REPORT

General
The wording of the accountant's compilation or review report and other considerations that affect the degree of
responsibility assumed by the accountant are discussed later in this course. This section discusses presentation
and format considerations for the accountant's report.
Letterhead
There is no requirement that the accountant's report be printed on the firm's letterhead (nor is there any SSARS
requirement that the accountant's report be manually signed, or that the financial statements be bound). Conse
quently, the report can be presented on plain stationery without letterhead. However, it is generally preferable for
the accountant's report to be presented on the firm's letterhead. The use of letterhead adds the formality that
reflects the professional approach to association with financial statements. Many practitioners use inhouse com
puter systems that produce the appropriate accountant's report on computer paper. In these situations, the
accountant can enhance the professional appearance of the product by binding the computerprepared state
ments and report in report covers containing the firm name and logo.
Heading of Accountant's Report
No heading is needed when the accountant's compilation or review report appears on letterhead, although some
accountants prefer to use one. This avoids any misunderstanding about the type of report (for example, when a
separate report is issued on supplementary information). When the report does not appear on the letterhead, using
a heading such as one of the following is generally recommended:
a. ACCOUNTANT'S REPORT
b. ACCOUNTANT'S REPORT ON FINANCIAL STATEMENTS
c. ACCOUNTANT'S REPORT ON SUPPLEMENTARY INFORMATION
A minor point, but of interest to some, is the placement of the apostrophe in Accountant's. Many accountants have
questioned whether to use singular or plural terminology when referring to themselves as they report on reviewed
or compiled financial statements. While there is no authoritative guidance on this issue, the AICPA has issued an
AICPA Technical Practice Aid (TIS 9160.25) that addresses how to determine which term to use. According the TPA,
In practice, sole practitioners often use singular terms; firms that have one partner with professional staff use both
singular and plural; and firms that have more than one partner most often use plural. However, the use of singular
or plural references to the accountant or auditor is purely discretionary. For ease of report preparation, firms should
be consistent in their use of singular or plural in all reports."
Address
Generally, the accountant's report should be addressed to the Board of Directors, Stockholders, or both. Reports
are not intended as letters. Accordingly, addresses that include street names and zip codes are not appropriate.
Many firms also omit the city and state in the address, especially when the report is addressed to stockholders who
are widely dispersed. Examples of appropriate addresses follow:
a. To the Board of Directors
XYZ Corporation
Philadelphia, Pennsylvania
b. To the Stockholders
XYZ Corporation
c. To the Shareholders and Board of Directors
XYZ Corporation
Littlefield, New Jersey
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For closely held companies, it may be appropriate to address the report to a specific individual as follows:
Mr. John Small
Small Manufacturing, Inc.
Monroe, Louisiana
Examples of addresses that may be appropriate for entities other than corporations are as follows:
a. Personal financial statements:
Mr. and Mrs. John P. Doe
Los Angeles, California
b. Partnerships:
(1) To the Managing Partner
ABC Company
New York, New York
or
(2) Ms. Barbara J. Greene
General Partner
XYZ Ltd. Partnership
Austin, Texas
c. Proprietorship financial statements:
Mr. John J. Jones
Jones Funeral Parlor
Tampa, Florida
d. Trust financial statements:
Mr. John T. Smith
Trustee
Mary B. Doe Testamentary Trust
Detroit, Michigan
e. Estate financial statements:
Mr. George S. Clark
Executor
Estate of John P. Doe
Columbus, Ohio
Salutations
Common practice in the profession is to exclude salutations such as Dear Sirs" or Gentlemen" from the accoun
tant's report.
Signature
SSARS No. 1 (AR 100.11) requires a signature of the accounting firm or the accountant when the accountant is
engaged to report on compiled financial statements or submits financial statements for use by a third party. SSARS
No. 1 (AR 100.39) requires that review reports contain a signature of the accounting firm or the accountant, as
appropriate. The signature placed on a compilation or a review report can be manual, stamped, electronic, or
typed.
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It is common practice to omit complimentary closings such as Sincerely" or Very truly yours" and to sign the
report with the firm's signature rather than an individual's signature unless the accountant is a sole practitioner.
These practices add formality to the accountant's report. However, certain state boards of accountancy require the
individual signature of a shareholder if the firm is a professional corporation. Likewise, certain regulatory agencies
require signature by the individual engagement partner. Signatures are seldom followed by the title Certified
Public Accountant" since, in most cases, the letterhead will include the title.
Date of Report
The date of the report affects the responsibility assumed by the accountant. Selection of the appropriate date is
discussed later in this course along with other reporting considerations. Examples of date formats are as follows:
a. March 3, 20X6
b. March 3, 20X6 (except for Note D, which is as of April 20, 20X6)
Firms with multiple offices generally precede the date with the office's location that issued the report, for example:
Midland, Texas
March 31, 20X6
Periods Covered
Generally, the periods covered in the accountant's report should agree with the periods covered in the financial
statements' headings. However, when reporting on comparative interim financial statements for different periods,
some accountants refer to the periods covered in the accountant's report as the periods then ended" rather than
to the specific periods covered. For example, a report on financial statements covering the one month and nine
months ended September 30, 20XX, might refer to the balance sheet of XYZ Company as of September 30, 20XX,
and the related statement of income and retained earnings for the periods then ended." While this is not technically
correct, it may be a practical necessity, particularly if the accountant is using a software package that is set up this
way and cannot be easily modified.
Use of I" versus We" in Accountant's Report
Many accountants have questioned whether to use the singular (I) or plural (We) when referring to themselves in the
accountant's compilation or review report. The previous discussion regarding the placement of the apostrophe in
Accountant's also provides guidance in determining a suitable pronoun to use.
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SELFSTUDY QUIZ
following section.
1. If a title page is included in the financial statement presentation, which of the following elements should be
included?
a. Name of the entity, letterhead of accountant, and the period covered.
b. Name of the entity, title of the financial statements, and date of the report.
c. Name of the entity, title of the financial statements, and the period covered.
d. Name of the entity, letterhead of the accountant, and date of the report.
2. Why might an accountant want to include the firm's letterhead on the accountant's report?
a. Use of the letterhead adds further assurance that the financial statements are prepared in accordance with
GAAP or OCBOA.
b. Use of the letterhead adds professionalism to the association with the financial statements.
c. Use of the letterhead is required to comply with SSARS.
d. Use of the letterhead helps thirdparty users to form an opinion on the fairness of the financial statements
based on the firm preparing them.
3. The accountant's report for compilations and reviews is required by SSARS to contain which of the following
elements?
a. Signature of the accounting firm of the accountant.
b. Professional salutation such as Dear Sirs" or Gentlemen."
c. Complimentary closing such as Sincerely" or Very truly yours."
d. Address of the client, including street name and zip code.
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SELFSTUDY ANSWERS
1. If a title page is included in the financial statement presentation, which of the following elements should be
included? (Page 124)
a. Name of the entity, letterhead of accountant, and the period covered. (This answer is incorrect. There is
no requirement that the letterhead of the accountant appear in the financial statement presentation.)
b. Name of the entity, title of the financial statements, and date of the report. (This answer is incorrect. The
date of the report would appear in the accountant's report, but not on the title page.)
c. Name of the entity, title of the financial statements, and the period covered. (This answer is correct.
Each of these elements is recommended for inclusion in the title page.)
d. Name of the entity, letterhead of the accountant, and date of the report. (This answer is incorrect. There
is no requirement that the letterhead of the accountant appear in the financial statement presentation. The
date of the report would appear in the accountant's report, but not on the title page.)
2. Why might an accountant want to include the firm's letterhead on the accountant's report? (Page 127)
a. Use of the letterhead adds further assurance that the financial statements are prepared in accordance with
GAAP or OCBOA. (This answer is incorrect. Use of the letterhead on the accountant's report provides no
additional assurance related to the financial statement's conformity with GAAP or OCBOA.)
b. Use of the letterhead adds professionalism to the association with the financial statements. (This
answer is correct. While not required by SSARS, firm letterhead adds to the professional
appearance of the accountant's report.)
c. Use of the letterhead is required to comply with SSARS. (This answer is incorrect. Use of the letterhead
is not an element of the accountant's report required by SSARS.)
d. Use of the letterhead helps thirdparty users to form an opinion on the fairness of the financial statements
based on the firm preparing them. (This answer is incorrect. Use of the letterhead on the accountant's
report does not assist thirdparty users in determining the fairness or accuracy of the financial statements.)
3. The accountant's report for compilations and reviews is required by SSARS to contain which of the following
elements? (Page 128)
a. Signature of the accounting firm of the accountant. (This answer is correct. SSARS No. 1 requires
this element when the accountant is engaged to report on either compiled or reviewed financial
statements.)
b. Professional salutation such as Dear Sirs" or Gentlemen." (This answer is incorrect. Reports are not
intended as letters and, as such, salutations are not required by SSARS.)
c. Complimentary closing such as Sincerely" or Very truly yours." (This answer is incorrect. Reports are not
intended as letters and, as such, complimentary closings are not required by SSARS.)
d. Address of the client, including street name and zip code. (This answer is incorrect. Reports are not
intended as letters and, as such, the client's address is not required by SSARS.)
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BASIC FINANCIAL STATEMENTS

What Are They?
The basic financial statements included in the typical GAAP financial statement presentation are:
a. Balance Sheet
b. Statement of Income
c. Statement of Comprehensive Income
d. Statement of Retained Earnings or Changes in Stockholders' Equity
e. Statement of Cash Flows
The typical presentation also includes descriptions of accounting policies and notes to financial statements. Form
and presentation considerations for each of these items is discussed in more detail in the lessons that follow. PPC's
Guide to Preparing Financial Statements expands on the form and presentation of financial statements and
provides comprehensive guidance regarding the application of GAAP to each component of the financial state
ments.
Comparative Financial Statements
Although they are not required, ARB No. 43 clearly states that comparative financial statements enhance the
usefulness of statements and are therefore preferable. When comparative financial statements are presented, the
notes should include data for prior years to the extent that they continue to be of significance, and the accountant's
report should cover all years. When the manner or basis of presenting items has changed because of reclassifica
tion or other reasons, an explanation of the change should be made in the statements. If the change is caused by
correction of an error or by an accounting change, the practitioner should refer to SFAS No. 154, Accounting
Changes and Error Corrections. (Reporting when there is a change in prior period financial statements is discussed
later in this lesson.)
Heading Financial Statements
The heading of each financial statement should include the legal name of the entity, the title of the specific
statement, and the date or period covered.
Reference to Accountant's Report
SSARS No. 1 requires that each page of the financial statements include a reference such as See accountant's
compilation report" or See accountant's review report." In general, the following standard reference can be placed
at the bottom of each page of the financial statements and supplementary schedules for both compilation and
review engagements:
See accountant's report.
Although SSARS does require that each page of the financial statements include a reference to the accountant's
report, SSARS does not require that the reference specify whether the financial statements are compiled or
reviewed.
An alternative presentation is to place the reference to the accountant's report in the heading of the statements as
follows:
XYZ COMPANY
BALANCE SHEET
SEE ACCOUNTANT'S REPORT
December 31, 20XX
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If the statements include notes, the reference can be expanded to read:

See accompanying notes and accountant's report.
Although the expanded reference to accompanying notes is not required by SSARS, it is a common practice and
generally recommended that accountants include such a reference if the financial statements include notes.
Referencing to the accountant's report on each page of the notes is unnecessary when each page of the basic
financial statements includes a reference to both the accountant's report and the notes. This position is supported
by the following:
a. SSARS No. 1 (AR 100.04) states that the financial statements include accompanying notes, but does not
include notes to financial statements as an example of a financial statement.
b. Both SAS No. 29 (AU 551) and TIS 9150.08 from the AICPA's Technical Practice Aids define the basic
financial statements as the balance sheet, statement of income, statement of retained earnings or changes
in stockholders' equity, and statement of cash flows.
c. TIS 9150.16 from the AICPA's Technical Practice Aids addresses this very question and recognizes that the
application of this requirement varies in practice.
Legend for Managementuseonly Financial Statements
SSARS No. 1 requires each page of managementuseonly financial statements to include a reference (or legend)
that restricts the use of such statements to management. It provides the following as examples of legends that
would be appropriate to meet the standard:
a. Restricted for management's use only.
b. Solely for the information and use by the management of ABC Company and not intended to be and should
not be used by any other party.
Because the legends illustrated in SSARS No. 1 are examples only, practitioners may also use other language that
restricts the use of the financial statements to management. Some accountants, for example, believe that one of the
most compelling reasons for including a legend on such financial statements is to inform third party users who
inadvertently receive the financial statements that they should not rely on such statements. Such risk arises
because, as discussed previously in this workbook, managementuseonly financial statements often contain
material departures from GAAP or OCBOA and generally also omit all disclosures required by those bases of
accounting. Those accountants may want to add additional language, such as the following, to the legend to inform
potential third party users of the risks inherent with the use of such statements.
These financial statements may contain material departures from established bases of account
ing, and the effect of those departures, if any, on the financial statements may not be disclosed.
Accordingly, the financial statements are intended solely for the information and use of certain
management of ABC Company and should not be used by third parties or others who are not
knowledgeable about such matters.
Placing the Legend. In many cases, managementuseonly financial statements will omit substantially all disclo
sures. Thus, accountants can comply with SSARS No. 1 by placing the legend on each page of the financial
statements. Generally, most accountants will place the legend on the financial statements using the same com
puter software used to prepare the statements. Sometimes, however, limitations of those programs will not permit
that. In those cases, accountants can place the legend on the financial statements by using a stamp that bears the
appropriate language or by writing the restrictive language on each page of the statements with a pen.
When accountants compile financial statements accompanied by note disclosures, however, questions sometimes
arise about the need to also place a legend on each page of such disclosures. Generally, it is not necessary to place
the legend on each page of the note disclosures; by simply placing the legend on each page of the basic financial
statements, accountants would be complying with the substance of the standard.
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Use of Unaudited"
The financial statement title is sometimes followed parenthetically with Unaudited." This is not required by SSARS
No. 1 (AR 100), but some accountants prefer such disclosure to emphasize that compiled or reviewed statements
are unaudited. [In addition, TIS 9150.04 of the AICPA Technical Practice Aids provides guidance on this subject by
emphasizing that SSARS does not require that each page of compiled or reviewed financial statements of a
nonpublic entity be marked as unaudited."]
Different Levels of Service
When issuing comparative financial statements, the level of service provided for each period may differ. If both
periods are unaudited, but one is compiled and the other reviewed, the level of service for each period should be
indicated parenthetically after the date in the heading of the statement.
XYZ CORPORATION
BALANCE SHEETS
December 31, 20X6 (Reviewed) and 20X5 (Compiled)
Disclosure if one of the periods is audited and the other unaudited must be made either in the statement headings
or column headings. Disclosure in the statement heading would be as follows:
XYZ CORPORATION
BALANCE SHEETS
December 31, 20X6 (Audited) and 20X5 (Unaudited)
or
December 31, 20X6 (Unaudited) and 20X5 (Audited)
Disclosure in the column headings would be as follows:
XYZ CORPORATION
BALANCE SHEETS
December 31, 20X6 and 20X5
20X6
(Audited)
20X5
(Unaudited)
ASSETS
CURRENT ASSETS
Cash
Accounts receivable, etc.
$
$
XXX
XXX
$
$
XXX
XXX
Referencing Notes
While there is no requirement that individual notes be referenced to specific items in the financial statements (a
practice followed by many firms in the interest of clarity), each of the financial statements should contain a general
reference to the notes (usually shown at the bottom of the page). A general reference is preferred because it
reduces both professional and clerical time. Also, as previously discussed, SSARS No. 1 (AR 100) requires that
each page of the financial statements include a reference such as See accountant's compilation report." Thus, the
two requirements can be combined as follows:
If notes are not referenced, each note page should include a reference to the accountant's report.
When selected information instead of all notes is presented in compilation reports under SSARS No. 1 (AR 100.16),
the financial statements should contain a reference to the selected information and the accountant's report, such as
the following:
See accompanying selected information and accountant's report.
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BALANCE SHEET
Balance Sheet Title
In practice, the most widely used title is balance sheet, and that is the term used throughout this course. Approxi
mately 90% of the nonpublic companies surveyed in PPC's Guide to Preparing Financial Statements use that title.
However, statement of financial position also is acceptable.
In certain situations, however, neither term is appropriate. Those terms are reserved for statements that purport to
present financial position in accordance with GAAP and should not be used with statements that are presented on
an OCBOA, such as the tax or cash basis.
SOP 821, Accounting and Financial Reporting for Personal Financial Statements, recommends that for personal
financial statements the balance sheet be titled Statement of Financial Condition."
Balance Sheet Format
The balance sheet may appear in sidebyside form (assets on the lefthand side of the statement and liabilities and
stockholders' equity on the righthand side), or it may appear in running form (assets at the top of the page and
liabilities and stockholders' equity at the bottom).
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INCOME STATEMENT
Title of Statement of Income
Alternative titles for presentation of an income statement include:
a. Statement of Income.
b. Income Statement.
c. Statement of Earnings.
d. Statement of Operations.
The title Statement of Operations" or Statement of Income (Loss)" may be used when the company has incurred
a loss during the reporting period. However, many practitioners continue to use the title Statement of Income"
when a loss occurs.
Frequently, a statement of income and a statement of retained earnings are presented as a single continuous
statement. In such instances, appropriate titles include:
a. Statement of Income and Retained Earnings.
b. Statement of Earnings and Retained Earnings.
c. Statement of Operations and Retained Earnings.
Income Statement Format
The income statement may be presented in either the multiplestep form, the singlestep form, or the modified
singlestep form. The multiplestep form shows several intermediate stages of income that may or may not have
particular significance. The singlestep statement lists and subtotals all income and credit items first, followed by a
listing of all costs, expenses, and debit items (including income taxes) with a subtotal. The difference between the
two subtotals represents the net results of operations for the period. The modified singlestep form sets forth
income before taxes, from which income taxes are deducted to arrive at net income.
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STATEMENTS OF RETAINED EARNINGS OR CHANGES IN

STOCKHOLDERS' EQUITY
General
In most situations, unless the client has debt or equity securities accounted for under SFAS No. 115, the only
stockholders' equity account to change during the period covered by the statements of a nonpublic entity will be
the retained earnings account. Generally, a combined statement of income and retained earnings is the best way
to disclose changes in retained earnings. Alternatively, the change in retained earnings may be disclosed ade
quately on the face of the balance sheet. Many computerprepared financial statements, for example, present
retained earnings on the balance sheet in two segments Prior or Beginning Retained Earnings and Current
Yeartodate Earnings. This adequately discloses the change in retained earnings especially when earnings repre
sent the only change. In other circumstances, the type of changes or number of changes will sometimes necessi
tate a separate statement of retained earnings. Changes, if any, in other stockholder equity accounts must also be
disclosed. Disclosure of these changes may be made in a note to the financial statements or may be presented in
a separate Statement of Changes in Stockholders' Equity. Illustrations presenting changes in stockholder equity
accounts are presented later in this lesson.
Compiled financial statements that omit substantially all disclosures may not include a statement of changes in
retained earnings and may not disclose the changes in retained earnings on the face of the financial statements.
Some accountants have questioned whether this lack of information should be considered a departure from GAAP.
According to paragraph 10 of APB No. 12, the changes in equity accounts is considered a required disclosure, but
not a required statement. Therefore, such information is not required to be disclosed in compiled financial state
ments that omit substantially all disclosures. However, when disclosures are omitted from compiled financial
statements, it is preferable to show the change in retained earnings either on the income statement or face of the
balance sheet, as discussed previously.
Combined Statement of Income and Retained Earnings
A combined statement of income and retained earnings could be presented as follows:
CONTINENTAL CORPORATION
STATEMENTS OF INCOME AND RETAINED EARNINGS
NET SALES
COST AND EXPENSES
Cost of products sold
Selling and administration
Interest on longterm debt
Miscellaneous
INCOME TAXES
Current
Deferred
20X6
$
35,337,000
20X5
$
32,785,000
21,780,000
7,032,000
891,000
244,000
29,947,000
20,530,000
6,525,000
910,000
215,000
28,180,000
INCOME BEFORE INCOME TAXES
5,390,000
4,605,000
NET INCOME
2,000,000
600,000
2,600,000
2,790,000
2,000,000
290,000
2,290,000
2,315,000
12,172,000
10,783,000
RETAINED EARNINGS AT BEGINNING OF YEAR

Cash dividends on common stock
(20X6 $.75 per share; 20X5 $.50 per share)
RETAINED EARNINGS AT END OF YEAR
138
(1,395,000 )
$
13,567,000
(926,000 )
$
12,172,000
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Restatement of Retained Earnings

An illustration of the restatement of retained earnings as it might appear in a statement of income and retained
earnings follows. (When there are numerous transactions in the retained earnings account, a separate statement of
retained earnings may be easier to understand.)
NET INCOME

As previously reported
Adjustments Note B
As restated
Cash dividends on common stock ($.75 per share)
2,790,000
12,172,000
(742,000 )
11,430,000
(1,395,000 )
12,825,000

Separate Statement of Retained Earnings
A separate statement of retained earnings might appear as follows:
THE FEDERAL COMPANY
STATEMENTS OF RETAINED EARNINGS
20X6
Net income
Dividends
In cash
On preferred stock ($3.50 a share)
On common stock (20X6 $1.25 a share; 20X5 $1.00
a share)
In stock
Fair value of 10,000 shares of common stock issued as
stock dividend 5%
139
1,586,000
875,000
20X5
$
(105,000 )
(105,000 )
(250,000 )
(200,000 )
(374,000 )
$
1,380,000
511,000
1,732,000

$
1,586,000
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Statement of Changes in Stockholders' Equity Comparative Statements Presented

Following is a comparative statement of changes in stockholders' equity:
THE EASTERN COMPANY
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
20X6
COMMON STOCK
Balance at beginning of year
Par value of shares issued
Sold under stock option plan (20X6 10,000 shares;
20X5 3,750 shares)
Stock dividend 3% (20X6 78,300 shares;
20X5 78,000 shares)
BALANCE AT END OF YEAR
ADDITIONAL PAIDIN CAPITAL
Proceeds or market value in excess of par value of shares
of common stock issued:
Sold under stock option plan
Stock dividend
RETAINED EARNINGS
Net income for the year
Dividends
Cash (20X6 $.50 a share; 20X5 $.40 a share)
Market value of shares of common stock issued as a
stock dividend 3%
13,000,000
20X5
$
12,591,250
50,000
18,750
391,500
390,000
13,441,500
13,000,000
580,000
289,650
30,000
783,000
10,350
280,000
1,393,000
580,000
6,560,000
3,065,000
6,152,000
2,118,000
(1,040,000 )
(1,174,500 )
(670,000 )
$
6,560,000
$
(450,000 )

(450,000 ) $
0
TOTAL STOCKHOLDERS' EQUITY
COMMON STOCK IN TREASURY

Purchase of 30,000 shares for treasury
140
(1,335,000 )
7,115,500
21,500,000
20,140,000
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Statement of Changes in Stockholders' Equity Single Year Statement

Following is a separate statement of changes in stockholders' equity for a single year:
THE COLUMBIA COMPANY
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Year Ended December 31, 20X6
Common
Stock
BALANCE AT BEGINNING OF
YEAR
Stock issued
Sale of 400,000 shares of
common stock
Sale of 10,000 shares of
common stock under
stock option plan
Net income
Dividends
Cash $.50 a share
In common stock 3%
(90,000 shares)
Treasury stock
Cost of 30,000 shares of
common stock
BALANCE AT END OF YEAR $
(Dollars in Thousands)
Additional
Common
Paidin
Stock in
Retained
Capital
Treasury
Earnings
13,000 $
580 $
6,560 $
$
Total
20,140
2,000
4,000
6,000
50

60

3,065

110
3,065
(1,535 )
(1,535 )
450
900
(1,350 )
(450 )
(450 )
15,500 $
5,540 $
6,740 $
(450 ) $
27,330

Negative Equity
If liabilities exceed assets, a negative equity balance will be reported. In those situations the term equity should not
be used and instead the following captions are generally recommended:
Negative equity shown in all periods Deficiency in assets" or Stockholders' deficit."
Negative equity shown in one period and positive equity shown in another period Stockholders' equity
(deficiency in assets)" or Stockholders' equity (deficit)."
141
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SELFSTUDY QUIZ
following section.
4. What reference does SSARS No. 1 require on each page of the basic financial statements for a compilation and
a review engagement?
a. Limited assurance provided."
b. See accountant's report."
c. Restricted for management's use only."
d. Unaudited."
5. What additional reference might each page of almost all financial statements compiled or reviewed contain?
a. A reference that the accountants provide no assurance on the fairness of the financial statements because
they are unaudited.
b. A reference to the report on the client's effectiveness of internal controls as required by Section 404 of SOX.
c. A reference to the accompanying notes to the financial statements.
d. A reference that the accountants are only responsible for the periods covered in the accountants' report.
6. Besides the title Balance Sheet," what other term is acceptable for this basic financial statement?
a. Statement of Assets and Liabilities.
b. Statement of Operations.
c. Statement of Financial Position.
7. In general, what is the best way to disclose changes in retained earnings?
a. A combined statement of cash flows and retained earnings.
b. A consolidated balance sheet and retained earnings.
c. A consolidated statement of financial position and retained earnings.
d. A combined statement of income and retained earnings.
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SELFSTUDY ANSWERS
4. What reference does SSARS No. 1 require on each page of the basic financial statements for a compilation and
a review engagement? (Page 133)
a. Limited assurance provided." (This answer is incorrect. This reference is not required, and also
compilation reports are not designed to provide limited assurance on the statements, unlike reviews.)
b. See accountant's report." (This answer is correct. SSARS No. 1 requires this reference on each
page of the financial statements. Depending on the engagement, the reference may state,"See
accountant's compilation report" or See accountant's review report.")
c. Restricted for management's use only." (This answer is incorrect. This reference is only required for
managementuseonly financial statements.)
d. Unaudited." (This answer is incorrect. This reference is not required by SSARS No.1, but some
accountants prefer such disclosure to emphasize that compiled or reviewed statements are unaudited.)
5. What additional reference might each page of almost all financial statements compiled or reviewed contain?
(Page 134)
a. A reference that the accountants provide no assurance on the fairness of the financial statements because
they are unaudited. (This answer is incorrect. This is not a common reference on each page of compiled
or reviewed financial statements.)
b. A reference to the report on the client's effectiveness of internal controls as required by Section 404 of SOX.
(This answer is incorrect. A report on internal controls is not required in compilation or review
engagements.)
c. A reference to the accompanying notes to the financial statements. (This answer is correct.
Although not required by SSARS, the inclusion of a reference to the notes is common practice. For
example, the reference commonly states,"See accompanying notes and accountant's report.")
d. A reference that the accountants are only responsible for the periods covered in the accountants' report.
(This answer is incorrect. This is not a common reference on each page of compiled or reviewed financial
statements.)
6. Besides the title Balance Sheet," what other term is acceptable for this basic financial statement? (Page 136)
a. Statement of Assets and Liabilities. (This answer is incorrect. This is not an acceptable title for a basic
financial statement.)
b. Statement of Operations. (This answer is incorrect. This is an acceptable title for an income statement, not
a balance sheet.)
c. Statement of Financial Position. (This answer is correct. Although the most widely used title for this
statement is Balance Sheet," Statement of Financial Position" is also acceptable.)
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7. In general, what is the best way to disclose changes in retained earnings? (Page 138)
a. A combined statement of cash flows and retained earnings. (This answer is incorrect. This is not an
acceptable way to disclose changes in retained earnings. Statements of cash flows are generally not
combined with other basic financial statements.)
b. A consolidated balance sheet and retained earnings. (This answer is incorrect. A consolidated balance
sheet itself might show the changes in retained earnings, but usually only when earnings represent the only
change to retained earnings.)
c. A consolidated statement of financial position and retained earnings. (This answer is incorrect. A
consolidated statement of financial position itself might show the changes in retained earnings, but usually
only when earnings represent the only change to retained earnings.)
d. A combined statement of income and retained earnings. (This answer is correct. This is the most
appropriate way to disclose changes in retained earnings, assuming retained earnings is only
affected by net income or loss and dividend payments.)
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STATEMENT OF CASH FLOWS

This lesson discusses the requirements of SFAS No. 95, Statement of Cash Flows. It discusses presenting specific
types of transactions in cash flow statements and preparing a separate schedule of noncash transactions. It also
illustrates alternative formats for presenting cash flow statements.
SFAS No. 95 requires presentation of a company's cash receipts and payments as part of a full set of financial
statements. If comparative statements are presented, a statement summarizing cash receipts and payments
should be presented for each period for which a statement of income is presented. These requirements apply to all
profitoriented entities and nonprofit organizations and apply whether or not the assets and liabilities are classified
as current or noncurrent.
How Cash Is Defined
A statement of cash flows shows the change in cash and cash equivalents during the period. Cash and cash
equivalents are defined in SFAS No. 95 as shown in Exhibit 11.
Exhibit 11
SFAS No. 95 Definitions
CASH
CASH EQUIVALENTS
Definition (SFAS No. 95, footnote 1)
Definition (SFAS No. 95, paragraph 8)
... cash includes not only currency on hand but

demand deposits with banks or other financial
institutions. Cash also includes other kinds of
accounts that have the general characteristics of
demand deposits in that the customer may deposit
additional funds at any time and also effectively
may withdraw funds at any time without prior notice
or penalty....
...shortterm, highly liquid investments that (a) are

readily convertible to known amounts of cash and (b)
are so near to their maturity that they present
insignificant risk of changes in value because of
changes in interest rates.
Examples Treasury bills, commercial paper, money

market accounts that are not classified as cash, and
other shortterm investments with original maturities
Examples Certificates of deposit,a money market of three months or less.
accounts, and repurchase agreements that have
the characteristics described above.
Note:
a
If penalties associated with certificates of deposit or money market accounts are material or if stated
terms effectively restrict withdrawal of funds, the funds should be classified as cash equivalents or
investments, depending on their maturity.
Basic Elements
A statement of cash flows has five basic elements:
a. Cash flows from operations.
b. Cash flows from investing activities.
c. Cash flows from financing activities.
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d. Net change in cash during the period.

e. Supplemental schedule of noncash investing and financing activities.
Accordingly, all cash receipts and payments should be classified as operating, investing, or financing activities, and
noncash transactions involving investing and financing activities, such as acquiring assets by assuming liabilities,
should be shown in a separate schedule rather than within the body of the statement. In addition, cash flow
statements should use descriptive terms such as cash and cash and cash equivalents rather than terms such as
funds.
Types of Cash Flows. Exhibit 12 shows how a typical company's transactions would be classified into operating,
investing, and financing activities according to the criteria in SFAS No. 95.
Gross and Net Cash Flows
SFAS No. 95 generally requires cash flows from investing and financing activities to be reported gross rather than
net. For example, cash flow statements would show the following amounts:
a. Investing Activities
(1) Proceeds from sales of assets and cash payments for capital expenditures rather than the net change
in property and equipment.
(2) Proceeds from sales of investment securities and purchases of investment securities rather than the
net change in investments.
(3) Loans made and collections on loans rather than the net change in notes and loans receivable (except
financial institutions that are permitted by SFAS No. 104 to net these).
b. Financing Activities
(1) Proceeds from longterm borrowings and repayments of longterm obligations (including capital
lease obligations) rather than the net change in longterm debt.
(2) Proceeds from shortterm debt and payments to settle shortterm debt rather than the net change in
shortterm debt when the debt term exceeds three months.
While the general rule calls for reporting gross cash flows, SFAS No. 95 permits reporting net cash flows from cash
receipts and payments relating to the following items, provided the original maturity of the asset or liability is three
months or less:
a. Cash equivalents and other investments.
b. Loans receivable.
c. Debt.
Format Considerations
SFAS No. 95 requires that cash flow statements report the net change in cash during the period presented and
reconcile the net change in cash to cash at the beginning of the period to obtain cash at the end of the period. The
ending balance of cash and cash equivalents on the statement of cash flows must agree with the balance sheet.
Therefore, it may be necessary to reclassify or subtotal cash captions on the balance sheet to agree with the
statement of cash flows.
Title. SFAS No. 95 does not specify a title for statements of cash flows.
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Order of Presentation. Although SFAS No. 95 does not address the order for presenting operating, investing, and
financing activities in statements of cash flows, virtually all companies will report cash flows from operations first.
Generally, the format used in the illustrations included in SFAS No. 95 is followed and show investing activities
following operations and financing activities last. It is acceptable, however, to present financing activities before
investing activities.
Captions. Because cash flow statements are classified according to cash flows from operating, investing, and
financing activities, captions are used to identify each section. Some typical examples are as follows:
a. Cash Flows from Operating Activities, Cash Flows from Investing Activities, Cash Flows from Financing
Activities
b. Cash Provided by (Used by) Operations, Cash Provided by (Used by) Investments, Cash Provided by
(Used by) Financing
c. Operations, Investments (or Investment Activities), Financing (or Financing Activities)
Cash Flows from Operating Activities
What Is Included? SFAS No. 95 defines cash flows from operating activities by exception; operating activities
include all transactions and events that are not investing or financing activities. Generally, however, operating
activities meet the following three criteria:
a. The amounts represent the cash effect of transactions or events.
b. The amounts result from a company's normal operations for delivering or producing goods for sale and
providing services.
c. The amounts are derived from activities that enter into the determination of net income.
Thus, cash flows from operating activities would include cash received from sales of goods or services, and cash
used in generating the goods or services such as for inventory, personnel, and administrative and other operating
costs. Collections of short or longterm notes receivable from customers arising from sales and payments of
shortterm or longterm notes payable to suppliers for materials for manufacture or goods for resale would be
considered operating activities. In addition, interest and dividend income and interest expense are considered to
be operating activities even though they are not precisely consistent with the preceding criteria. (Exhibit 12 lists
some typical examples of cash flows from operating activities.)
What Is Excluded? Cash flows from operating activities exclude (a) amounts that are not derived from cash
receipts and payments, e.g., accruals, deferrals, and allocations such as depreciation, and (b) amounts that are
considered to be derived from investing or financing activities rather than from operations, e.g., cash receipts and
payments related to property and equipment, or investments and dividends paid.
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Exhibit 12
Types of Cash Flows
OPERATING
INVESTING
FINANCING
CASH RECEIPTS FROM:
Shortterm borrowings
Longterm borrowings
Issuance of stock
CASH PAYMENTS FOR:

Inventory
Shortterm and longterm
notes payable to suppliers for
materials or goods
Wages
Other operating expenses
General and administrative
expenses
Interest (excluding amounts
capitalized)
Taxes
Purchase of trading securities
Other cash payments not
related to investing or
financing activities, such as
cash contributions and cash
refunds to customers
CASH PAYMENTS FOR:

Dividends
Repaymentof amounts
borrowed, e.g., shortterm
debt, longterm debt, and
capital lease obligations
Treasury stock
CASH PAYMENTS FOR:

Property and equipment
(including capitalized interest)
Availableforsale or
heldtomaturity securities
Loans to others
Acquiring nonoperating
assets, e.g., property and
equipment or a subsidiary, by
assuming liabilities
Issuing stock in exchange for
subscriptions receivable or
other noncash consideration
Converting debt to equity or
one class of stock to another,
e.g., common to preferred
Stock dividends or
distributions of property as
dividends
Converting notes receivable to
investments
149
CASH RECEIPTS FROM:

CASH RECEIPTS FROM:
Sale of goods and services
Sale of property and
Shortterm and longterm
equipment
notes receivable from
Sale of availableforsale or
customers arising from sales
heldtomaturity securities
of goods or services
Collections on loans
Sale or maturity of trading
Insurance proceeds relating to
securities
transactions classified as
Interest and dividends
investing
Other cash receipts not arising
from investing or financing
activities, such as amounts
received to settle lawsuits or
refunds from suppliers
NONCASH
INVESTING AND FINANCING
TRANSACTIONS
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Basic Format. SFAS No. 95 permits cash flows from operations to be presented in either of two basic formats: the
direct method or the indirect method. The following paragraphs describe each method and explain their advan
tages and disadvantages.
Direct Method. The direct method begins with cash receipts and deducts cash payments for operating costs and
expenses, individually listing the cash effects of each major type of revenue and expense. The following categories
of operating cash receipts and payments are required to be presented:
a. Cash collected from customers, including lessees and licensees.
b. Interest and dividends received.
c. Other operating cash receipts, if any.
d. Cash paid to employees and other suppliers of goods and services, including suppliers of insurance and
advertising.
e. Interest paid.
f. Income taxes paid.
g. Other operating cash payments, if any.
Because the direct method explicitly shows only cash receipts and payments, no adjustments are necessary for
noncash expenses such as depreciation or deferred income taxes. However, if the direct method is used, a
supplemental schedule reconciling net income to cash flows from operations is required. This is the same reconcili
ation that is shown in a statement prepared using the indirect method (see discussion later in this lesson). This
reconciliation should separately show all major classes of operating items, including, at a minimum, changes in
receivables and payables related to operating activity and changes in inventory. An example of the direct method
is as follows:
CASH FLOWS FROM OPERATING ACTIVITIES
Cash collected from customers
$ 348,000
Interest and dividends received
1,950
Cash paid to employees and suppliers
(284,700 )
Interest paid
(5,600 )
Income taxes paid
(11,000 )
NET CASH PROVIDED BY OPERATING ACTIVITIES
48,650
Proponents of the direct method believe that this approach is preferable because it shows the actual gross cash
payments and receipts from operating activities. In addition, some accountants believe the use of the direct method
makes the statement of cash flows easier to understand because there is no need to adjust for noncash items such
as depreciation. On the other hand, the direct method is not used by many companies, and it may take more time
to prepare a statement using the direct method than using the indirect method. Nevertheless, some companies
may find cash flow statements that use the direct method easier to understand.
Indirect Method. The indirect method starts with net income and adjusts for (a) noncash items such as depreci
ation and deferred income taxes and (b) accruals. An example of the indirect method is as follows:
Net income
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation
Gain on sale of equipment
Decrease in receivables
Increase in inventory
Increase in payables
150
223,000
29,400
(6,700 )
27,500
(7,700 )
32,600
298,100
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SFAS No. 95 allows the items reconciling net income to net cash flows from operating activities to be presented in
the statement of cash flows itself, as illustrated previously, or in a separate schedule. If the reconciling items were
presented in a separate schedule, the cash flow statement would show a single line item for cash flows from
operations such as the following:
Net Cash Flows from Operating Activities
298,100
In that case, a separate schedule would present a reconciliation of net income with net operating cash flows such
as:
RECONCILIATION OF NET INCOME TO NET CASH
FLOWS FROM OPERATING ACTIVITIES
Net income
Depreciation
Gain on sale of equipment
Decrease in receivables
Increase in inventory
Increase in payables
223,000
29,400
(6,700 )
27,500
(7,700 )
32,600
298,100
Whether a reconciliation of net income to net cash flows from operations is shown within the cash flow statement
itself or separately disclosed in the notes to the financial statements, all noncash items should be clearly distin
guished. Additionally, if the statement of cash flows is presented using the indirect method, the amounts of interest
(net of capitalized interest) and taxes paid should be disclosed.
Which Method Is Better? Many users of financial statements will find the direct method easier to understand and
more informative because it shows gross cash receipts and payments from operating activities. (This method is
also encouraged in SFAS No. 95.) Others may find the indirect method more informative because it allows
presentation of the reconciliation of net income to net cash flow in the body of the cash flow statement rather than
in a separate schedule as under the direct method. Most companies will find the indirect method easier and less
expensive to implement. However, the information presented under the indirect method must be in sufficient detail
to allow the reader to roughly approximate operating cash receipts and payments.
Changes in Operating Current Assets and Liabilities. When cash flows from operating activities are presented
using the indirect method, net income should be adjusted for changes during the period in operating current assets
and liabilities such as trade accounts receivable, accrued interest or dividends receivable, inventory, prepaid
expenses, trade accounts payable, and accrued interest payable and other accrued liabilities. The changes in each
account may be shown separately, though netting of certain accounts is permitted.
Noncash entries to current operating assets and liabilities generally should be presented as separate adjustments
to net income in arriving at cash flows from operations. Common examples of noncash transactions affecting
current operating assets and liabilities include recording a provision for bad debts and providing a reserve for
inventory obsolescence. To illustrate, assume that a company's activities relating to trade accounts receivable are
summarized as follows:
Accounts
Receivable
Allowance
for Doubtful
Accounts
Balance 1/1/X5
Sales
Cash collected
Bad debt provision
Writeoffs
50,000
300,000
(250,000 )

(20,000 )
10,000

25,000
(20,000 )
Balance 12/31/X5
80,000
15,000
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The operations section of the cash flow statement would be presented as follows:
Net income
Provision for losses on accounts receivable
Increase in accounts receivable
50,000
25,000
(50,000 )
25,000
If noncash entries are not material, however, it is generally appropriate to present only the net change in current
assets and liabilities.
Cash Flows from Investing Activities
Investing activities include the following:
a. Lending money and collecting on loans.
b. Acquiring and selling or disposing of availableforsale or heldtomaturity securities.
c. Acquiring and selling or disposing of productive assets that are expected to generate revenue over a long
period of time.
Exhibit 12 lists some typical examples of cash flows provided by and used in investing activities.
Format Considerations. SFAS No. 95 sets a general rule that cash receipts and payments should be reported on
a gross rather than a net basis. However, cash flows related to loans and shortterm investments with original
maturities of three months or less and credit card receivables may be reported net rather than gross. SFAS No. 95
specifically requires all other cash receipts and payments from investing activities to be reported on a gross basis.
(Note: SFAS No. 104 allows banks, savings institutions, and credit unions to net certain cash receipts and
payments. These are unique to financial institutions and is beyond the scope of this course.)
Certain investing activities, such as acquiring assets by assuming liabilities or exchanging assets, are noncash
transactions that do not involve cash receipts or payments. Nevertheless, SFAS No. 95 requires them to be
reported in a separate schedule so that information is provided on all investing activities.
Cash Flows from Financing Activities
SFAS No. 95 states that financing activities include the following:
a. Obtaining resources from owners and providing them with a return on, and a return of, their investment.
b. Obtaining resources from creditors and repaying the amounts borrowed or otherwise settling the
obligation.
Exhibit 12 lists some typical examples of cash flows provided by financing activities. The following paragraphs
discuss how to present cash flows from financing activities in statements of cash flows.
Format Considerations. While SFAS No. 95 generally requires cash receipts and payments to be reported on a
gross rather than a net basis, cash flows related to loans with original maturities of three months or less may be
reported net rather than gross. All other financing activities should be reported gross. (Note: SFAS No. 104 allows
banks, savings institutions, and credit unions to net certain cash receipts and payments. These are unique to
financial institutions and is beyond the scope of this course.)
Certain financing activities, such as issuing stock in exchange for property and equipment, do not involve cash
receipts or payments. (Exhibit 12 lists other typical examples of noncash financing activities.) Nevertheless, SFAS
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No. 95 requires financing activities that do not involve cash to be reported in a separate schedule so that
information is provided on all financing activities.
Noncash Investing and Financing Activities
SFAS No. 95 requires investing and financing activities that do not involve cash receipts and payments during the
period to be excluded from the cash flow statement and reported in a separate schedule. The appendix to SFAS
No. 95 includes the following illustrative schedule:
The Company purchased all of the capital stock of Company S for $950. In connection with the
acquisition, liabilities were assumed as follows:
Fair value of assets acquired
Cash paid for the capital stock
Liabilities assumed
1,580
(950 )
630
A capital lease obligation of $850 was incurred when the Company entered into a lease for new
equipment.
Additional common stock was issued upon the conversion of $500 of longterm debt.
Because the schedule of noncash investing and financing transactions is not selfbalancing, it is possible to
inadvertently omit a noncash transaction from the schedule. Thus, all investing and financing transactions should
be carefully reviewed to ensure that all noncash transactions are included.
Format Considerations. Noncash investing and financing activities should be disclosed either in narrative form or
in a schedule. The disclosure may be made on the same page as the statement of cash flows or elsewhere in the
financial statements, e.g., in the notes. An example presenting the schedule at the bottom of the cash flow
statement is as follows:
Net income
Depreciation
Increase in receivables
Decrease in inventory
Decrease in payables
CASH FLOWS USED BY INVESTING ACTIVITIES
Purchase of equipment
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds of longterm borrowings
Repayment of longterm borrowings
NET CASH PROVIDED BY FINANCING ACTIVITIES
NET INCREASE IN CASH
CASH AT BEGINNING OF YEAR
CASH AT END OF YEAR
66,200
7,200
(10,000 )
2,000
(4,400 )
61,000
(30,000 )
25,000
(5,000 )
20,000
51,000
75,000
126,000
15,600
SUPPLEMENTAL DISCLOSURES
Noncash Investing and Financing Transactions:
Capital lease obligation incurred for use of equipment
153
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SELFSTUDY QUIZ
following section.
8. According to SFAS No. 95, which of the following could be considered a cash equivalent" for purposes of the
statement of cash flows?
a. Demand deposits at banks.
b. Treasury bills.
c. CDs with no penalties for withdrawal.
d. Accounts receivable due in less than 30 days.
9. Which of the following are some of the basic elements of a statement of cash flows?
a. Cash flows from operations, cash flows from financing activities, and supplemental schedule of noncash
investing and financing activities.
b. Cash flows from investing activities, cash flows from financing activities, and cash flows from collection
activities.
c. Cash flows from operations, net change in cash during the period, and cash flows from public offerings
of securities during the period.
d. Cash flows from operations, cash flows from investing activities, and net change in retained earnings
during the period.
10. Which of the following is one of the criteria that will indicate cash flow from an operating activity?
a. The amounts are derived from activities that enter into the determination of net income.
b. The amounts are derived from repayments of amounts borrowed.
c. The amounts are derived from the periodic purchase of property or equipment.
d. The amounts are derived by the annual allocation of depreciation and amortization.
11. Cash dividends paid would be considered what type of cash flow for purposes of the statement of cash flows?
a. Cash flow from operating activities.
b. Cash flow from investing activities.
c. Cash flow from financing activities.
d. Noncash investing and financing activities.
12. What is one advantage of using the direct method in presenting cash flows from operations?
a. The direct method is usually easier to prepare and less expensive to implement.
b. The direct method is easier to understand because there is no need to adjust for noncash items such as
depreciation.
c. The direct method doesn't require the presentation of actual gross cash payments and receipts from
operating activities.
d. The direct method doesn't require any supplemental schedules to be prepared in order to comply with
SFAS. No. 95.
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13. When presenting cash flows from operations using the indirect method, changes in which of the following
accounts should be presented?
a. Changes in accounts receivable, inventory, and furniture and fixtures.
b. Changes in accounts receivable, accounts payable, and inventory.
c. Changes in land, automobiles, and accounts payable.
d. Changes in account payable, prepaid expenses, and notes payable.
14. In general, SFAS No. 95 requires cash receipts and payments from investing activities to be reported on what
basis?
a. Cash basis.
b. Net basis.
c. Accrual basis.
d. Gross basis.
15. Which of the following activities might be classified as a financing activity in the presentation of the statement
of cash flows?
a. Payments to suppliers.
b. Receipts of dividends from securities.
c. Payments to repurchase company stock.
d. Receipts from the sale of companyowned commercial real estate.
16. How does SFAS No. 95 address the presentation of noncash investing and financing activities in the financial
statements?
a. Accountants may display these items in narrative form in the footnotes to the financial statements.
b. Since these items are nonbalancing, disclosure would add ambiguity to the statement of cash flows and
therefore is not required.
c. Since these items are nonbalancing, these items should be included in management's discussion and
analysis of the annual report.
d. Accountants are required to disclose these items in the form of a schedule placed at the bottom of the cash
flow statement.
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SELFSTUDY ANSWERS
8. According to SFAS No. 95, which of the following could be considered a cash equivalent" for purposes of the
statement of cash flows? (Page 146, Page 149)
a. Demand deposits at banks. (This answer is incorrect. These deposits meet the definition of cash as defined
by SFAS No. 95.)
b. Treasury bills. (This answer is correct. According to SFAS No. 95, cash equivalents are readily
convertible to cash and are so near maturity that they present insignificant risk of changes in value
because of changes in interest rates.)
c. CDs with no penalties for withdrawal. (This answer is incorrect. These CDs meet the definition of cash as
defined by SFAS No. 95.)
d. Accounts receivable due in less than 30 days. (This answer is incorrect. Accounts receivable, regardless
of due date, would be considered neither cash nor cash equivalents.)
9. Which of the following are some of the basic elements of a statement of cash flows? (Page 146)
a. Cash flows from operations, cash flows from financing activities, and supplemental schedule of
noncash investing and financing activities. (This answer is correct. A statement of cash flows has
five basic elements. The other two elements are cash flows from investing activities and net change
in cash during the period.)
b. Cash flows from investing activities, cash flows from financing activities, and cash flows from collection
activities. (This answer is incorrect. Cash flows from collection activities is not one of the basic elements
of a statement of cash flows.)
c. Cash flows from operations, net change in cash during the period, and cash flows from public offerings
of securities during the period. (This answer is incorrect. Cash flows from public offerings of securities is
not one of the basic elements of a statement of cash flows.)
d. Cash flows from operations, cash flows from investing activities, and net change in retained earnings
during the period. (This answer is incorrect. Net change in retained earnings is not one of the basic
elements of a statement of cash flows.)
10. Which of the following is one of the criteria that will indicate cash flow from an operating activity? (Page 148)
a. The amounts are derived from activities that enter into the determination of net income. (This answer
is correct. Cash flows from operating activities generally result from a company's normal operations
and therefore enter into the determination of net income.)
b. The amounts are derived from repayments of amounts borrowed. (This answer is incorrect. This would be
an item indicating a change in cash flow resulting from a financing activity.)
c. The amounts are derived from the periodic purchase of property or equipment. (This answer is incorrect.
This would be an item indicating a change in cash flow resulting from an investing activity.)
d. The amounts are derived by the annual allocation of depreciation and amortization. (This answer is
incorrect. These items are not derived from cash receipts and payments, and therefore they are not part
of cash flows from operating activities.)
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11. Cash dividends paid would be considered what type of cash flow for purposes of the statement of cash flows?
(Page 149)
a. Cash flow from operating activities. (This answer is incorrect. Cash dividends paid do not enter into the
determination of net income and therefore are not considered cash payments for operating activities.)
b. Cash flow from investing activities. (This answer is incorrect. Cash dividends paid are not considered cash
payments for investing activities.)
c. Cash flow from financing activities. (This answer is correct. Cash dividends paid to shareholders
are considered cash payments for financing activities.)
d. Noncash investing and financing activities. (This answer is incorrect. Cash dividends paid, by definition,
would not be considered noncash" investing and financing activities on the statement of cash flows.)
12. What is one advantage of using the direct method in presenting cash flows from operations? (Page 150)
a. The direct method is usually easier to prepare and less expensive to implement. (This answer is incorrect.
The direct method is more difficult to prepare and more expensive to implement than the indirect method.)
b. The direct method is easier to understand because there is no need to adjust for noncash items such
as depreciation. (This answer is correct. The direct method shows the actual gross cash payments
and receipts from operating activities. Therefore, adjustments for noncash items are not necessary.)
c. The direct method doesn't require the presentation of actual gross cash payments and receipts from
operating activities. (This answer is incorrect. In fact, the direct method does show the actual gross cash
receipts and payments from operating activities.)
d. The direct method doesn't require any supplemental schedules to be prepared in order to comply with
SFAS. No. 95. (This answer is incorrect. The direct method requires a supplemental schedule reconciling
net income to cash flows from operations.)
13. When presenting cash flows from operations using the indirect method, changes in which of the following
accounts should be presented? (Page 151)
a. Changes in accounts receivable, inventory, and furniture and fixtures. (This answer is incorrect. Changes
in furniture and fixtures would be used in determining cash flows from investing activities.)
b. Changes in accounts receivable, accounts payable, and inventory. (This answer is correct. Using
the indirect method, changes during the period in operating current assets and liabilities should be
reflected to determine net cash flows from operating activities.)
c. Changes in land, automobiles, and accounts payable. (This answer is incorrect. Changes in land and
automobiles would be used in determining cash flows from investing activities.)
d. Changes in accounts payable, prepaid expenses, and notes payable. (This answer is incorrect. Changes
in notes payable would be used in determining cash flows from financing activities.)
14. In general, SFAS No. 95 requires cash receipts and payments from investing activities to be reported on what
basis? (Page 152)
a. Cash basis. (This answer is incorrect. Cash basis is a method of accounting, not a form of presentation
in the statement of cash flows.)
b. Net basis. (This answer is incorrect. Only certain shortterm investments and credit card receivables may
be reported on the net basis in the determination of cash flows from investing activities.)
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c. Accrual basis. (This answer is incorrect. The accrual basis is a method of accounting, not a form of
presentation in the statement of cash flows.)
d. Gross basis. (This answer is correct. With limited exceptions, cash receipts and payments from
investing activities should be reported on the gross basis.)
15. Which of the following activities might be classified as a financing activity in the presentation of the statement
of cash flows? (Page 149, Page 152)
a. Payments to suppliers. (This answer is incorrect. Payments of trade vendors would be considered an
operating activity in the statement of cash flows.)
b. Receipts of dividends from securities. (This answer is incorrect. Receipts of dividends from investments
would be considered an investing activity in the statement of cash flows.)
c. Payments to repurchase company stock. (This answer is correct. The purchase of treasury stock
by a company is considered a financing activity for purposes of the statement of cash flows.)
d. Receipts from the sale of companyowned commercial real estate. (This answer is incorrect. Receipts from
the sale of companyowned commercial real estate would be considered an investing activity in the
statement of cash flows.)
16. How does SFAS No. 95 address the presentation of noncash investing and financing activities in the financial
statements? (Page 153)
a. Accountants may display these items in narrative form in the footnotes to the financial statements.
(This answer is correct. These items may be presented in narrative or schedule form and may be
presented at the bottom of the cash flow statement or elsewhere in the financial statements, such
as the footnotes.)
b. Since these items are nonbalancing, disclosure would add ambiguity to the statement of cash flows and
therefore is not required. (This answer is incorrect. SFAS No. 95 requires disclosure of these items.
However, these items should be excluded from the cash flow statement.)
c. Since these items are nonbalancing, these items should be included in management's discussion and
analysis of the annual report. (This answer is incorrect. SFAS No. 95 requires disclosure of these items in
a separate schedule to the financial statements. Disclosure in MD&A is not sufficient to comply with SFAS
No. 95.)
d. Accountants are required to disclose these items in the form of a schedule placed at the bottom of the cash
flow statement. (This answer is incorrect. SFAS No. 95 requires disclosure of these items; however, the
accountant has discretion to determine the form and placement of the disclosure within the financial
statements.)
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COMPREHENSIVE INCOME
SFAS No. 130, Reporting Comprehensive Income, establishes standards for reporting and displaying comprehen
sive income and its components in a basic set of financial statements. The following paragraphs provide a definition
of comprehensive income and a brief discussion of certain related classification and presentation issues. Further
guidance regarding presentation and disclosure issues concerning comprehensive income may be found in PPC's
Guide to Preparing Financial Statements, which may be ordered by calling (800) 3238724 or via PPC's website at
ppc.thomson.com.
Definition of Comprehensive Income
Comprehensive income includes all changes in a company's equity during a period except those resulting from
investments by and distributions to owners. It includes net income and other changes in assets and liabilities that
are not reported in net income, but instead are reported as a separate component of stockholder's equity.
Examples of items that, in addition to net income, would be reported in comprehensive income include
Unrealized gains and losses on investments in marketable securities classified as availableforsale.
Foreign currency translation adjustments and gains and losses from certain foreign currency transactions.
Changes in the market value of certain futures contracts that qualify as a hedge.
Minimum pension liability adjustments.
If a company does not have any of these components of comprehensive income, then SFAS No. 130 does not
apply and the company is not required to report comprehensive income. In most situations, unless a client has debt
or equity securities accounted for under SFAS No. 115, accountants will find that their small business clients do not
have any of these comprehensive income components and that the reporting requirements of SFAS No. 130 are
therefore not applicable.
Presentation of Comprehensive Income
If a company has comprehensive income components, comprehensive income and its components are required to
be reported (or displayed) when a company presents a full set of financial statements. All items that are recognized
as comprehensive income are required to be reported in a financial statement that is displayed with the same
prominence" as the other basic financial statements. SFAS No. 130 does not specify a format for displaying
comprehensive income. According to that guidance, comprehensive income may be displayed in the income
statement (after net income), in a statement of changes in equity, or in a separate statement of comprehensive
income (as long as that statement begins with net income). The statement displaying comprehensive income
should include net income, the components of comprehensive income, and an amount designated as aggregate
comprehensive income.
Classifying Other Comprehensive Income. SFAS No. 130 divides comprehensive income into net income and
other comprehensive income. Other comprehensive income includes the revenues, expenses, gains, and losses
that under GAAP are included in comprehensive income, but excluded from net income. According to SFAS No.
130, other comprehensive income should be classified in the financial statement according to its nature. For
example, under current accounting standards, it should be classified in the following categories:
Unrealized gains and losses on certain investments in debt and equity securities.
Foreign currency items.
Minimum pension liability adjustments.
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Reclassification Adjustments. Adjustments to other comprehensive income may be necessary to avoid double
counting items that are displayed in net income in the current period that were previously reported as other
comprehensive income in prior periods. These items are referred to as reclassification adjustments. An example
would be realized gains or losses on availableforsale marketable securities reported in the current year's net
income that were reported as unrealized holding gains or losses in other comprehensive income in prior periods.
Reclassification adjustments should be calculated for each classification of other comprehensive income. For the
components of other comprehensive income (other than minimum pension liability adjustments), the entity may
either
a. display the components gross on the face of the financial statement; or
b. display the components net of reclassification adjustments and disclose the gross change in the notes to
Reporting Tax Effects Related to Other Comprehensive Income. Components of comprehensive income may
be presented net of related tax effects, or may be presented before related tax effects with one amount displayed
for the aggregate income tax expense or benefit related to the total other comprehensive income. However, the
amount of income tax expense or benefit allocated to each component of comprehensive income (and related
reclassification adjustments) should be disclosed on the face of the financial statements or in the notes to the
Financial Statement Presentation. An illustration of a statement of comprehensive income as it might appear in a
basic set of financial statements follows.
ABC COMPANY, INC.
STATEMENT OF COMPREHENSIVE INCOME
NET INCOME
OTHER COMPREHENSIVE INCOME, NET OF TAX

Foreign currency translation adjustments
Unrealized gains on securities:
Unrealized holding gains arising during the period
Less reclassification adjustment for gains included in net
income
Minimum pension liability adjustment
60,000
$
150,000
(30,000 )
120,000
(15,000 )
OTHER COMPREHENSIVE INCOME

621,000
165,000
$
786,000

Other Presentation Alternatives. SFAS No. 130 states that comprehensive income may be displayed in the
income statement (after net income) or as a separate column in a statement of changes in equity. The following
includes an illustration of a combined statement of income and comprehensive income for a company in its initial
year of applying SFAS No. 130.
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ABC COMPANY, INC.

STATEMENT OF INCOME AND COMPREHENSIVE INCOME
NET SALES
COST AND EXPENSES
Cost of sales
Selling, general and administrative
Interest on longterm debt
Miscellaneous
11,000,000
6,000,000
3,000,000
700,000
265,000
9,965,000
INCOME BEFORE INCOME TAXES
1,035,000
INCOME TAXES
Current
Deferred
314,000
100,000
414,000
NET INCOME

Unrealized gains on securities
Unrealized holding gains arising during the period
Less reclassification adjustment for gains included in net
income
Income tax expense related to other comprehensive
income
621,000
100,000
$
250,000
(50,000 )
200,000
(25,000 )
(110,000 )
165,000
786,000

Reporting Accumulated Comprehensive Income in the Balance Sheet
The accumulated balance of other comprehensive income must be displayed separately from retained earnings
and additional paidin capital in the equity section of the balance sheet and labeled with a descriptive title such as
accumulated other comprehensive income." The following is an example presentation of the equity section of the
balance sheet:
Common stock
Additional paidin capital
Retained earnings
Accumulated other comprehensive income
12,988,300
580,000
6,560,000
840,000
20,968,300
In addition, the accumulated balances for each component of other comprehensive income should be presented
on the face of the balance sheet in the statement of changes in stockholders' equity, or in the notes to the financial
statements.
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The following example illustrates presenting the accumulated balances for each component of other comprehen
sive income on the face of the balance sheet:
Common stock
Additional paidin capital
Retained earnings
Accumulated other comprehensive income:
Unrealized gains on securities
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12,988,300
580,000
6,560,000
305,000
611,000
(76,000 )
840,000
20,968,300
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SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

When Is It Required?
A summary of significant accounting policies is required by GAAP when financial statements that purport to present
financial position (Balance Sheet), results of operations (Statement of Income), or cash flows (Statement of Cash
Flows) are issued. When only one of these statements is issued, a summary of accounting policies pertinent to that
statement is required. The disclosure of significant accounting policies is required for financial statements of
notforprofit entities as well as for profitoriented entities. A summary of significant accounting policies is not
required in unaudited interim financial statements unless an accounting policy has been changed since the last
annual financial statement. As a practical matter some firms issuing interim full disclosure financial statements find
it easier to simply leave the summary of significant accounting policies in.
What Must Be Included?
General Requirements. APB Opinion No. 22 states that disclosure of accounting policies should identify and
describe the accounting principles followed by the reporting entity and the methods of applying those principles
that materially affect the determination of financial position, results of operations, or cash flows. In general, the
disclosure should encompass important judgments as to appropriateness of principles related to recognition of
revenue and allocation of asset costs to current and future periods. In particular, it should encompass those
accounting principles and methods that involve any of the following:
a. A selection from existing acceptable alternatives.
b. Principles and methods peculiar to the industry in which the reporting entity operates, even if such
principles and methods are predominantly followed in that industry.
c. Unusual or innovative applications of GAAP (and, as applicable, of principles and methods peculiar to the
industry in which the reporting entity operates).
Specifically Required Accounting Policy Disclosures. Several authoritative pronouncements specifically require
disclosure of an accounting policy. Some disclosures that are common for nonpublic companies are as follows:
Inventories the basis for stating inventories and the method of determining cost (ARB No. 43, Ch. 3A).
Depreciation a general description of the methods used in computing depreciation for major classes of
depreciable assets (APB Opinion No. 12).
Intangible Assets Subject to Amortization the weightedaverage amortization period, in total and by major
class (SFAS No. 142).
Cash Equivalents the policy used to determine which shortterm investments are treated as cash
equivalents in the statement of cash flows (SFAS No. 95).
Marketable Securities the basis on which the cost of a security sold or the amount reclassified out of
accumulated other comprehensive income into earnings was determined (SFAS No. 115 as amended by
SFAS No. 133) and the policy for requiring collateral or other security for repurchase agreements or
securities lending transactions (SFAS No. 140).
Notes Receivable or Loans the policy for recognizing interest income on impaired loans, including how
cash receipts are recorded (SFAS No. 118).
Advertising the policy used for reporting advertising (i.e., whether costs are expensed as incurred or when
the advertising first takes place) (SOP 937).
Trade Receivables or Loans the basis of accounting for trade receivables and loans, the method used to
determine the lower of cost or fair value of nonmortgage loans held for sale, the method used to recognized
interest income and estimate loan losses and doubtful accounts, and policies for nonaccrual loans and
receivables and charge offs (SOP 016).
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Sales and Similar Taxes the policy regarding the presentation of sales and similar taxes (e.g., use, value
added, and certain excise taxes), that is, whether such taxes are presented on a gross or net basis (EITF
Issue No. 063).
In addition to these examples, APB Opinion No. 22 identifies the following examples of required accounting policy
disclosures:
Recognition of profit on longterm, constructiontype contracts
Basis of consolidation
Recommended Accounting Policy Disclosures
As previously mentioned, APB Opinion No. 22 requires disclosure of all significant accounting policies. In addition
to disclosures required by specific pronouncements, it is generally recommended to disclose the accounting
methods prescribed by authoritative literature that are relatively complex such as the following:
Investments in Debt and Equity Securities describe the accounting treatment of unrealized gains and
losses for investments classified as trading securities, heldtomaturity securities, and availableforsale
securities.
Deferred Income Taxes briefly describe how current and deferred taxes are calculated.
Investments at Equity disclose the lag if the investee's year end differs from the investor's year end. APB
Opinion No. 18 recognizes that investees may not have the same year end as the investor and states that
a lag in reporting should be consistent from period to period." It is generally recommended that the lag
not exceed three months, which is consistent with the guidance given in ARB No. 51 for consolidations.
Derivatives describe the accounting treatment of gains and losses related to fair value, cash flow, or
foreign currency hedges.
Manner of Disclosure
Significant accounting policies can be presented on the face of the statements, as part of individual notes to the
financial statements, or in a separate note titled Summary of Significant Accounting Policies." APB Opinion No. 22
expresses a preference for a separate Summary of Significant Accounting Policies" as the initial note. When this
method is used, the summary should not duplicate details presented elsewhere in the notes. However, it is
appropriate to make specific reference to other notes that present related details.
Other Disclosures
Although there is no requirement that management acknowledge its responsibility with respect to the financial
statements, some companies follow the policy of including such an acknowledgment in the Summary of Signifi
cant Accounting Policies."
To make their financial statements more meaningful, some companies include a brief description of their activities.
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NOTES TO FINANCIAL STATEMENTS

General
Notes are an integral part of financial statements. They should be used to present material disclosures required by
GAAP that are not otherwise presented in the statements, i.e., on the face of the statements or in the Summary of
Significant Accounting Policies." (The Summary of Significant Accounting Policies," which is often considered to
be included in the general category of notes to financial statements, is discussed previously.) When comparative
financial statements are issued, ARB No. 43 requires disclosures for prior periods to be repeated if they continue to
be of significance. Many firms believe that disclosures related to the income statement and the statement of cash
flows generally should be presented for all periods; however, disclosures related to the balance sheet should be
evaluated to determine whether they are still meaningful.
The notes, as an integral part of the financial statements, are the responsibility of the client even though the
practitioner may assist with, or totally prepare, the statements and notes. The wording of the notes should follow
this principle, and such words as we," us," client," and our," should not be used so as to avoid any implication
of reference to the CPA. Use of the Company," the Corporation," or Management" is a more appropriate way of
referring to the client.
Format
Generally, notes are presented separately after the basic financial statements. The notes should be arranged in the
same order as they appear in the statements and each note should bear a heading that corresponds to a balance
sheet or income statement caption, if possible.
When the number of notes are few, it may be appropriate to present them at the bottom of the first financial
statement to which they refer. If the note also applies to other statements, a reference to it (such as See Note A on
the Balance Sheet") should be made on those statements.
Title
When the notes are presented on separate pages rather than on the face of the statements, the pages should be
appropriately titled as follows:
ABC CORPORATION
NOTES TO FINANCIAL STATEMENTS
December 31, 20X6
When a single statement is presented and notes are presented on separate pages, the title should include the
name of the statement rather than the general term financial statement."
ABC CORPORATION
NOTES TO BALANCE SHEET
December 31, 20X6
When the financial statements exclude substantially all disclosures but do include selected notes, the separate
pages of the notes should be labeled as follows:
ABC COMPANY
SELECTED INFORMATION Substantially All Disclosures Required by
Generally Accepted Accounting Principles Are Not Included
December 31, 20X6
Content
The notes should include disclosures required by GAAP that are not presented on the face of the statements or in
the summary of significant accounting policies. In addition, the practitioner should keep in mind that the financial
statements should include all information necessary to prevent them from being misleading regardless of whether
the disclosure is specifically required by accounting pronouncements.
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SUPPLEMENTARY OR OTHER INFORMATION

General
The unaudited financial statements of a nonpublic entity often include detailed schedules, summaries, compari
sons, or statistical information that are not part of the basic financial statements. This information, which is not
required for a fair presentation in accordance with GAAP, is often useful to the owners or management and, in some
cases, is prepared especially for creditors. As mentioned previously, information required by GAAP should be
presented on the face of the financial statements or in the notes. Supplemental schedules should not be used to
present information required by GAAP such as future minimum lease payments and fiveyear maturities of long
term debt. Forecasts or projections that accompany historical financial statements are normally not considered
supplementary or other information. However, budgets for an expired period of time are not prospective data, i.e.,
they are considered supplementary information and should be reported on in accordance with SSARS No. 1 (AR
100.60).
Content
The decision to present supplementary information is sometimes made at the suggestion of the CPA. The content
and extent of supplementary information can vary widely from details of amounts presented in the financial
statements to presentation of ratios and analyses. The content should be tailored to fit the needs of the particular
client and the statement users. The following items might appear as supplementary information:
a. Budgets for an expired period.
b. Cost of goods sold schedule.
c. Manufacturing expense schedule.
d. Selling expenses.
e. General and administrative expenses.
f. Details of marketable securities.
g. Property and equipment schedule.
h. Condensed historical financial statements.
i. Aging analysis of accounts receivable.
j. Department earnings statements.
k. Details of consolidation.
l. Organizational data (history, etc.).
m. Comparative statements expressed in percentages.
n. Details of sales by product line, territory, or salesman.
For reviewed financial statements, the company may want to present some of the analyses made during the
accountant's review such as:
a. Rates of inventory turnover.
b. Days of sales in accounts receivable.
c. Gross profit comparisons.
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Presentation
Normally, supplementary information is segregated from the basic financial statements, i.e., presented on separate
pages. In general, the supplementary schedules should be presented after the basic financial statements and
notes and, ordinarily, be preceded by a title page that is marked:
SUPPLEMENTARY INFORMATION
If a separate report on the supplementary information is to be presented, it should follow the title page.
The order of presentation can vary widely but should follow some logical pattern. One such method is to present
the schedules in the order in which the subject appears in the basic financial statements. If many schedules are
presented, the CPA may find it useful to include a table of contents in the financial statements.
Reporting
The accountant must describe in his report on the financial statements, or in a separate report, the degree of
responsibility, if any, he takes with regard to supplementary information.
Percentages
In general, percentages presented on the statement of income (as is commonly the case with computerprepared
statements) do not constitute supplementary information for purposes of the reporting requirements applicable to
supplementary information.
Charts and Graphs
The unaudited financial statements of a nonpublic entity sometimes include financial information presented in the
form of a chart or graph. Such information should ordinarily be considered supplementary information and
reported on as discussed in Lesson 2.
Details of Consolidation or Combination
When a company conducts its business through divisions, branches, or subsidiaries, the consolidated or com
bined financial statements generally are presented as the basic financial statements and frequently are accompa
nied by supplementary information that provides details about individual branches, divisions, or subsidiaries.
Supplementary schedules that provide details of consolidated financial statements are referred to as consolidating
financial statements and should be appropriately titled such as consolidating balance sheet or consolidating
statement of income.
Supplementary information showing details of other company groupings, for example, a group linked by common
ownership or control rather than parentsubsidiary relationships, are referred to as combining financial statements.
When combining financial statements are prepared, the individual statements should bear appropriate titles such
as combining balance sheet or combining statement of income.
Schedule Headings
Each schedule should be headed with a descriptive title that distinguishes it from the basic financial statements.
Normally, supplementary schedules are not referred to as statements" to avoid confusing them with basic financial
statements.
XYZ COMPANY
ANALYSIS OF COST OF SALES
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Reference to Report
In general, each supplementary schedule should include a reference to the accountant's report. Although not
specifically addressed in SSARS, including such a reference is a logical extension of the SSARS No. 1 (AR 100)
requirement to include the reference on each page of the financial statements. This reference is important because
the report describes the degree of responsibility, if any, that the CPA takes with regard to the schedules. It is
particularly important when reviewed financial statements are accompanied by compiled supplementary sched
ules. The appropriate reference when the accountant's report on the supplementary information is part of his report
on the basic financial statements would be
If a separate accountant's report on the supplementary information is presented, the reference would be
See accountant's report on supplementary information.
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SELFSTUDY QUIZ
following section.
17. Why might SFAS No. 130, Reporting Comprehensive Income, not apply to most compilation and review
engagements?
a. SFAS No. 130 relates to the effectiveness of internal controls and its impact on the accuracy of reporting
comprehensive income, and internal controls are not tested in a compilation or review.
b. SFAS No. 130 relates to the determination of comprehensive income by estimating the potential impact
of noncash investing and financing activities, activities which are not often experienced by small business
clients requesting a compilation or review.
c. SFAS No. 130 relates to certain debt or equity security investments by a company, and most small business
clients will not have any of these components when determining net income.
d. SFAS No. 130 relates to unrealized gains and losses in certain real estate transactions of a company and
resulting changes to a company's equity, transactions generally not associated with small business clients
requesting a compilation or review.
18. Which of the following accounting policy disclosures would commonly be required in a compilation or review
engagement?
a. Accounting policies related to accounts receivable, cash equivalents, and unrealized gains on securities.
b. Accounting policies related to cash equivalents, depreciation, and foreign currency translation
adjustments.
c. Accounting policies related to inventories, accounts receivable, and intangible assets subject to
amortization.
d. Accounting policies related to inventories, prepaid expenses, and postretirement liabilities related to
healthcare.
19. In the notes to the financial statements, what is the most likely reason an accountant would use the term the
Company" when discussing the material disclosures required by GAAP?
a. This term is required in the notes by ARB No. 43 in order to ensure consistency in disclosure from one client
to another.
b. This term is included in the legal name of the client and therefore appropriately used in the notes.
c. This term reinforces the professional nature of the relationship between the accountant and the client.
d. This term underscores the fact that the notes are the responsibility of the client.
20. What is the most likely reason an accountant would prepare supplemental schedules of information for a review
or compilation client?
a. This information is required for a fair presentation in accordance with GAAP.
b. This information might be required by the client's creditors.
c. This information can include items such as sales forecasts and projections that are particularly useful to
management.
d. This information can include schedules such as fiveyear maturities of longterm debt that can be used by
management to project future cash flow needs.
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SELFSTUDY ANSWERS
17. Why might SFAS No. 130, Reporting Comprehensive Income, not apply to most compilation and review
engagements? (Page 160)
a. SFAS No. 130 relates to the effectiveness of internal controls and its impact on the accuracy of reporting
comprehensive income, and internal controls are not tested in a compilation or review. (This answer is
incorrect. SFAS No. 130 does not relate to the effectiveness of a company's internal controls.)
b. SFAS No. 130 relates to the determination of comprehensive income by estimating the potential impact
of noncash investing and financing activities, activities which are not often experienced by small business
clients requesting a compilation or review. (This answer is incorrect. SFAS No. 130 does not relate to the
potential impact of noncash investing and financing activities.)
c. SFAS No. 130 relates to certain debt or equity security investments by a company, and most small
business clients will not have any of these components when determining net income. (This answer
is correct. Unless a client has debt or equity securities accounted for under SFAS No. 115, small
business clients will not have any comprehensive income components and SFAS No. 130 will not
apply.)
d. SFAS No. 130 relates to unrealized gains and losses in certain real estate transactions of a company and
resulting changes to a company's equity, transactions generally not associated with small business clients
requesting a compilation or review. (This answer is incorrect. SFAS No. 130 does not relate to unrealized
gains and losses in certain real estate transactions of a company.)
18. Which of the following accounting policy disclosures would commonly be required in a compilation or review
engagement? (Page 164)
a. Accounting policies related to accounts receivable, cash equivalents, and unrealized gains on securities.
(This answer is incorrect. The accounting policy for unrealized gains on securities is not commonly found
in a summary of significant accounting policies of a compilation or review report.)
b. Accounting policies related to cash equivalents, depreciation, and foreign currency translation
adjustments. (This answer is incorrect. The accounting policy for foreign currency translation adjustments
is not commonly found in a summary of significant accounting policies of a compilation or review report.)
c. Accounting policies related to inventories, accounts receivable, and intangible assets subject to
amortization. (This answer is correct. All of these items are commonly reported on basic financial
statements of small business clients and would be included in a summary of significant accounting
policies of a compilation or review report.)
d. Accounting policies related to inventories, prepaid expenses, and postretirement liabilities related to
healthcare. (This answer is incorrect. The accounting policy for postretirement liabilities related to
healthcare is not commonly found in a summary of significant accounting policies of a compilation or
review report.)
19. In the notes to the financial statements, what is the most likely reason an accountant would use the term the
Company" when discussing the material disclosures required by GAAP? (Page 166)
a. This term is required in the notes by ARB No. 43 in order to ensure consistency in disclosure from one client
to another. (This answer is incorrect. ARB No. 43 requires disclosures for prior periods to be repeated if
they continue to be of significance. ARB No. 43 does not require the use of the term the Company.")
b. This term is included in the legal name of the client and therefore appropriately used in the notes. (This
answer is incorrect. While this may be true for some clients, this is not the most likely reason an accountant
will use the term the Company.")
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c. This term reinforces the professional nature of the relationship between the accountant and the client. (This
answer is incorrect. While this term does connote professionalism, this is not the most likely reason an
accountant will use the term the Company.")
d. This term underscores the fact that the notes are the responsibility of the client. (This answer is
correct. While the accountant may assist with or totally prepare the notes, they are still the
responsibility of management. First person terms such as we," I," us," or our" should be avoided
to imply the accountant has responsibility for the notes. Thus, usage of this term or the
Corporation" or Management" reduces potential liability exposure and is the most likely reason an
accountant will use one of these terms.)
20. What is the most likely reason an accountant would prepare supplemental schedules of information for a review
or compilation client? (Page 167)
a. This information is required for a fair presentation in accordance with GAAP. (This answer is incorrect.
Supplementary information should not be used to present information required by GAAP. That information
should be presented in the basic financial statements or the notes.)
b. This information might be required by the client's creditors. (This answer is correct. Supplemental
information is often required by the creditors of small business clients in the ordinary course of
doing business. For example, a creditor might be interested in the aging of accounts receivable of
a client to determine the client's ability to meet its obligation in a timely manner.)
c. This information can include items such as sales forecasts and projections that are particularly useful to
management. (This answer is incorrect. Sales forecasts and projections that accompany historical
financial information are normally not considered supplementary or other information.)
d. This information can include schedules such as fiveyear maturities of longterm debt that can be used by
management to project future cash flow needs. (This answer is incorrect. This information is required by
GAAP and should be presented in the notes to the financial statements.)
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Lesson 2:Reporting on Compiled or Reviewed

Financial Statements
This lesson discusses the factors a practitioner should consider when performing compilation engagements,
including whether to issue managementuseonly financial statements or a thirdparty compilation report. The
lesson also includes the procedures a practitioner must follow to perform compilation engagements, including
checklists to assist in the administration of the engagement.
Identify the basic reporting requirements relating to compiled or reviewed financial statements.
Evaluate situations requiring special reporting issues relating to compiled or reviewed financial statements.
Employ the appropriate reporting procedures when comparative financial statements are compiled or
reviewed.
THE ACCOUNTANT'S REPORTING OBLIGATION

SSARS No. 1 (AR 100.01.03) discusses the accountant's performance and communication obligations for com
pilation and review engagements. In summary, these paragraphs state
a. A compilation is the minimum level of service that an accountant can provide before submitting unaudited
financial statements of a nonpublic entity to a client or others.
b. The accountant should not consent to the use of his name in a document or written communication
containing unaudited financial statements unless he has compiled or reviewed them or the financial
statements are accompanied by an indication that the accountant has not compiled or reviewed them and
that he assumes no responsibility for them.
c. If the accountant performs a compilation, a communication to management in the form of a report or an
engagement letter is required. The type of communication required will depend upon the intended use of
d. If the accountant performs more than one service (for example, a compilation and a review), the accountant
should issue the report appropriate for the highest level of service performed. SSARS No. 3 provides an
exception to this rule by allowing an accountant who has reviewed the financial statements of a nonpublic
entity to issue a compilation report on financial statements for the same period when those statements are
included in a prescribed form that calls for a departure from GAAP.
The term submission as referred to in item a. is defined in SSARS No. 1 (AR 100.04). Whenever accountants
prepare and present financial statements (manually or using a computer), they have submitted financial state
ments. When this occurs, the accountants must at least compile the financial statements in accordance with the
performance and communication requirements in SSARS No. 1.
Item b. encompasses situations when a client includes the accountants' names in a loan proposal, prospectus, or
other thirdparty written communication that includes clientprepared financial statements. If the client uses finan
cial statements that were previously compiled or reviewed by the accountants, the accountants should insist that
their report accompany the statements. If the financial statements are clientprepared, the accountants must insist
either that reference to their name be removed from the clientprepared document or that the statements be
accompanied by an indication that they have not compiled or reviewed them and take no responsibility for them. If
the accountants become aware that their name has been used improperly in any clientprepared document
containing unaudited financial statements, they should consider what actions might be appropriate, including
consultation with their attorney.
Item c. discusses compilation communication requirements. The guidance in this course, as it relates to compila
tions, only applies when accountants submit financial statements and are required to report (thirdpartyuse
financial statements) or choose the reporting communication option for managementuseonly financial state
ments.
Item d. (requiring the accountant to issue a report appropriate for the highest level of service) is discussed in more
detail later in this course.
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COMPILATION REPORTS
Required Elements
A report on compiled financial statements should state that
a. A compilation has been performed in accordance with Statements on Standards for Accounting and
Review Services issued by the American Institute of Certified Public Accountants.
b. A compilation is limited to presenting in the form of financial statements information that is the
representation of management (owners).
c. The financial statements have not been audited or reviewed and, accordingly, the accountant does not
express an opinion or any other form of assurance on them.
In addition, SSARS No. 1 requires
a. A signature of the accounting firm or the accountant. That signature can be manual, stamped, electronic,
or typed.
b. The date of the compilation report. The date of the accountant's report should be the date of completion
of the compilation procedures.
The report should not refer to any other procedures that the accountant may have performed. To do so might lead
the reader of the financial statements to conclude that the accountant is, in fact, offering some form of assurance.
Reference to Country of Origin
SAS No. 93, Omnibus Statement on Auditing Standards 2000, amends SAS No. 58, Reports on Audited Financial
Statements, to require auditors to identify in their reports the country of origin of the accounting principles used to
prepare the financial statements and the auditing standards they followed in performing the audit. In addition, SAS
No. 100, Interim Financial Information, requires the accountant's review report on the interim financial information of
a public company to identify the country of origin of the accounting principles used to prepare the financial
statements.
Although SAS No. 93 applies only to CPAs performing an audit in accordance with auditing standards and SAS No.
100 applies only to CPAs performing reviews of public companies, some accountants have questioned whether
they should include similar language in their compilation or review reports for nonpublic companies. ARSC issued
Interpretation No. 24 of SSARS No. 1, Reference to the Country of Origin in a Review or Compilation Report, to
address this question. The Interpretation states that SSARS do not require the reference to the country of origin of
the accounting principles used to prepare the financial statements, as compilation and review reports issued under
the SSARS refer to the American Institute of Certified Public Accountants. But it also concludes that nothing in
SSARS No. 1 precludes accountants from including such language in their compilation and review reports.
Consequently, accountants may choose to add such language to their reports.
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REVIEW REPORTS
Required Elements
Financial statements reviewed by an accountant should be accompanied by a report stating that
a. A review was performed in accordance with Statements on Standards for Accounting and Review Services
issued by the American Institute of Certified Public Accountants.
b. All information included in the financial statements is the representation of the management (owners) of
the entity.
c. A review consists principally of inquiries of company personnel and analytical procedures applied to
financial data.
d. A review is substantially less in scope than an audit, the objective of which is the expression of an opinion
regarding the financial statements taken as a whole and, accordingly, no such opinion is expressed.
e. The accountant is not aware of any material modifications that should be made to the financial statements
in order for them to be in conformity with generally accepted accounting principles, other than those
modifications, if any, indicated in his report.
In addition, SSARS No. 1 requires
a. A signature of the accounting firm or the accountant. That signature can be manual, stamped, electronic,
or typed.
b. The date of the review report. The date of the accountant's report should be the date of completion of the
review procedures.
Any other procedures that the accountant may have performed before or during the review engagement, including
those performed in connection with a compilation of the financial statements, should not be described in his report.
Reference to Country of Origin
As discussed previously, country of origin references are not required for SSARS review reports.
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HIGHEST LEVEL OF SERVICE

Different Levels of Service on the Same Financial Statements
If the accountant provides more than one level of service on the same financial statements, e.g., compilation and
review or compilation and audit, the financial statements should be accompanied by the accountant's report that is
appropriate for the highest level of service provided. This does not preclude the accountant from using procedures
that go beyond those required for the level of assurance expressed. Interpretation Nos. 3 (AR 9100.06.12) and 13
(AR 9100.46.49) of SSARS No. 1 provide guidance concerning the highestlevelofservice rule.
Interpretation No. 3 (AR 9100.06.12) provides guidance on the type of report to be issued when the accountant
performs procedures that go beyond those required. In other words, if a practitioner is engaged to compile financial
statements but decides to apply analytical procedures and make inquiries, is a review report required? In response,
the interpretation says no."
Interpretation No. 13 (AR 9100.46.49) addresses whether an accountant can perform audit procedures in a
compilation or review engagement and still issue a compilation or review report. For instance, if a client requests
that the accountant confirm accounts receivable in addition to compiling yearend financial statements, must the
engagement be changed to an audit? Interpretation No. 13 says no." Also, the accountant should not mention in
the report or accompanying notes to the financial statements that accounts receivable were confirmed.
Both interpretations stress that, in these situations, the accountant should place additional importance on the
understanding with the client regarding the nature of services to be rendered. The key factor in determining what
level of service must be reported on is knowing what the practitioner was engaged to perform. To avoid confusion,
it is generally recommended that written engagement letters be used for all compilation and review engagements.
An exception to the highestlevelofservice rule is indicated in SSARS No. 1 (AR 100.45). It prohibits the issuance
of a review report if the accountant is not independent, but it permits the issuance of a compilation report. The
accountant should issue a compilation report on financial statements of an entity with respect to which he is not
independent even though he has adhered to all other standards for a review engagement. Likewise, if an accoun
tant is not independent with respect to an audit engagement of a nonpublic client, he should issue a compilation
report.
Another exception to the highestlevelofservice rule is permitted by footnote 3 of SSARS No. 1 (AR 100). SSARS
No. 3 permits an accountant who has reviewed the financial statements to issue a compilation report on financial
statements for the same period included in a prescribed form, as discussed ealier in this course.
Different Levels of Service on Financial Statements of the Same Period
CPAs may be asked to perform a level of service that might be viewed as lower than the one they previously
performed on financial statements covering the same period. Examples of such situations are:
The client requests the CPA to compile financial statements that omit substantially all disclosures, even
though the CPA already has compiled, reviewed, or audited fulldisclosure financial statements for the
same period.
The client requests the CPA to compile a balance sheet that omits substantially all disclosures, even though
the accountant already has compiled, reviewed, or audited the complete financial statements for the same
period.
Clients generally make such requests because, particularly in financial statements of small businesses, the notes
include information about such things as profit sharing and related party transactions. If the financial statements are
being provided to certain parties, such as suppliers, clients may prefer not to make that type of information
available.
Many practitioners will consent to providing the compilation as long as they are satisfied that the client has a valid
business reason for the request and is not attempting to mislead the financial statement users. If the CPA believes,
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however, that there is no valid business reason for the client's request, the CPA should refuse to perform the
compilation.
If the CPA agrees to provide the compilation engagement, questions frequently arise about the form of the report.
The most common question is whether the accountant should refer in the compilation report to the prior level of
service performed on the statements. Because professional standards are silent on this issue, practice varies.
Presently, there appear to be two schools of thought on the issue:
Some accountants believe that a standard compilation report, modified by adding an explanatory
paragraph describing the lack of disclosures, should be issued. Thus, they believe no mention should be
made in the report of the prior compilation, review, or audit of the fulldisclosure financial statements. This
is particularly true, they believe, for situations in which the financial statements were previously audited
since users might infer a higher level of assurance because of the prior engagement.
Other accountants believe that the CPA's compilation report should disclose the existence of a complete
set of (fulldisclosure) compiled, reviewed, or audited financial statements in a paragraph such as the
following:
These financial statements were (This financial statement was) compiled by us from
(fulldisclosure) financial statements for the same period that we previously compiled
(or reviewed or audited) as indicated in our report dated January 30, 20XX.
Such disclosure, they argue, is necessary to protect CPAs from claims that they withheld information or
participated in a deceit (if, for example, the client, without the CPA's knowledge, told the financial statement
user that audited financial statements are not available).
The compilation discussed above should be considered a new and separate engagement. Thus, no mention of the
prior engagement need be made in the accountant's compilation report. However, before consenting to the client's
request, the CPA should ensure himself or herself that the client has a valid business reason for the request and is
not attempting to mislead financial statement users.
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DATE OF REPORTS
The date of completion of the accountant's review procedures, which include obtaining written representations
from management, should be used as the date of his report on reviewed financial statements. The date of
completion of the compilation should be used as the date of the accountant's report on compiled financial
statements. Completion of a compilation generally takes place on the date the financial statements are read, as the
term is used in SSARS No. 1 (AR 100.10). In practice, many accountants simply use the typing date as the date of
the accountant's report. Other accountants use the date the financial statements were drafted. As a practical matter,
the date probably has little bearing on the accountant's legal liability in a compilation engagement.
When a continuing accountant updates a previously issued report for purposes of reporting on comparative
financial statements, the report on the comparative statements should be dated when the work is completed on the
current period financial statements.
When an accountant reissues a previously issued report for purposes of reporting on comparative financial
statements, the report should bear the original date of the report unless financial statements have been revised, in
which case the reissued report should be dualdated.
A discussion of updated, reissued, and dualdated reports is found later in this course.
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REFERENCE TO ACCOUNTANT'S REPORT ON THE FINANCIAL

STATEMENTS
SSARS No. 1 requires that each page of compiled or reviewed financial statements include an appropriate
reference to the accountant's report such as See accountant's report." The guidance beginning at paragraphs
and discusses the mechanics of how these references are shown on the financial statements.
SSARS No. 1 requires a reference to the accountant's report, but it does not require marking each page unau
dited." TIS 9150.04 of the AICPA Technical Practice Aids provides guidance on this subject by emphasizing that
SSARS does not require that each page of compiled or reviewed financial statements of a nonpublic entity be
marked as unaudited." In general, such a label is unnecessary because most users of financial statements are
familiar with compilation and review services and such a label does not communicate to readers the financial
statement service performed.
If each page of the financial statements contains a statement indicating that the notes to financial statements are an
integral part of the statements, it is not necessary to present the reference to the accountant's report on note pages.
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REPORTING WHEN NOT INDEPENDENT

An accountant is precluded from issuing a review report on the financial statements of an entity with respect to
which he is not independent. He may, however, issue a compilation report, provided he complies with the compila
tion standards.
The accountant's compilation report should specifically disclose the lack of independence. However, the reason for
the lack of independence should not be described. When the accountant is not independent, he should include the
following as the last paragraph of his compilation report:
We are not independent with respect to XYZ Company.
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SELFSTUDY QUIZ
following section.
21. According to SSARS No. 1, can an accountant submit compiled financial statements of a sole proprietorship
to a thirdparty lender?
a. No, at a minimum, a review is required to submit unaudited financial statements to a thirdparty user.
b. Yes, at a minimum, a compilation is required to submit unaudited financial statements to a thirdparty user.
c. Yes, provided the accountant obtains a representation letter signed by management before submitting the
unaudited financial statements.
d. Yes, assuming the accountant provides limited assurance on the accuracy of the financial statements in
all material respects.
22. Which of the following are two of the required elements of a compilation report?
a. A signature of the accounting firm or the accountant and a statement that a compilation is limited to
presenting in the form of financial statements information that is the representation of management.
b. The date of the compilation report and a statement that the compilation is limited to tests such as inquiry
of client personnel and analytical procedures.
c. An accountant's report on stationery with the accounting firm's letterhead and a statement that a
compilation is limited to presenting in the form of financial statements information that is the representation
of management.
d. The date of the compilation report and a statement that the compilation has been performed in accordance
with Generally Accepted Accounting Principles.
23. Which of the following are two of the required elements of a review report?
a. A signature of the accounting firm or the accountant and a statement that the objective of a review is the
expression of an opinion regarding the financial statements taken as a whole, and accordingly, such
opinion is being expressed.
b. The date of the review report and a statement that a review consists principally of inquiries of company
personnel and analytical procedures applied to financial data.
c. A signature of the accounting firm or the accountant and a statement that the accountant is independent
in fact and appearance from management and its owners as required by SSARS No. 1.
d. The date of the review report and a statement that the accountant is not aware of any modifications that
should be made to the financial statements in order for them to be in conformity with GAAP.
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24. If, at the request of management, an accountant performs procedures that go beyond those required for a
particular engagement, e.g. inquiry of client personnel in a compilation engagement, what type of disclosure
should the accountant make?
a. The accountant should disclose the additional procedures performed in the accountant's report but not
in the notes to the financial statements.
b. The accountant should disclose the additional procedures performed in the notes to the financial
statements but not in the accountant's report.
c. The accountant should not mention the additional procedures performed in the accountant's report or the
notes to the financial statements.
d. The accountant should not mention the additional procedures performed in the accountant's report or the
notes to the financial statements, but should require a modified, signed engagement letter by
management.
25. What should be used as the date of an accountant's report on reviewed financial statements?
a. The date of the signed management representation letter.
b. The date of the signed management engagement letter.
c. The date the financial statements are read by the accountant, as the term in used in SSARS No. 1.
d. The date of completion of inquiry and analytical procedures.
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SELFSTUDY ANSWERS
21. According to SSARS No. 1, can an accountant submit compiled financial statements of a sole proprietorship
to a thirdparty lender? (Page 174)
a. No, at a minimum, a review is required to submit unaudited financial statements to a thirdparty user. (This
answer is incorrect. According to SSARS No. 1, a review is not the minimum level of service that an
accountant can provide before submitting unaudited financial statements of a nonpublic entity to a client
or others.)
b. Yes, at a minimum, a compilation is required to submit unaudited financial statements to a thirdparty
user. (This answer is correct. According to SSARS No. 1, a compilation is the minimum level of
service that an accountant can provide before submitting unaudited financial statements of a
nonpublic entity to a client or others.)
c. Yes, provided the accountant obtains a representation letter signed by management before submitting the
unaudited financial statements. (This answer is incorrect. A representation letter is not required by SSARS
No. 1 when preparing submitting compiled financial statements.)
d. Yes, assuming the accountant provides limited assurance on the accuracy of the financial statements in
all material respects. (This answer is incorrect. An accountant provides no assurance on the accuracy of
compiled financial statements.)
22. Which of the following are two of the required elements of a compilation report? (Page 175)
a. A signature of the accounting firm or the accountant and a statement that a compilation is limited
to presenting in the form of financial statements information that is the representation of
management. (This answer is correct. Both elements are required in a report on compiled financial
statements.)
b. The date of the compilation report and a statement that the compilation is limited to tests such as inquiry
of client personnel and analytical procedures. (This answer is incorrect. A compilation does not entail
inquiry of client personnel or analytical procedures. These are required in a review engagement.)
c. An accountant's report on stationery with the accounting firm's letterhead and a statement that a
compilation is limited to presenting in the form of financial statements information that is the representation
of management. (This answer is incorrect. The firm's letterhead is not required to be on a compilation
report, although it does add a degree of professionalism.)
d. The date of the compilation report and a statement that the compilation has been performed in accordance
with Generally Accepted Accounting Principles. (This answer is incorrect. A compilation report is
performed in accordance with Statements on Standards for Accounting and Review Services issued by
the AICPA.)
23. Which of the following are two of the required elements of a review report? (Page 176)
a. A signature of the accounting firm or the accountant and a statement that the objective of a review is the
expression of an opinion regarding the financial statements taken as a whole, and accordingly, such
opinion is being expressed. (This answer is incorrect. An audit has as its objective the expression of an
opinion regarding the financial statements taken as a whole, not a review. A review provides limited
assurance on the financial statements.)
b. The date of the review report and a statement that a review consists principally of inquiries of
company personnel and analytical procedures applied to financial data. (This answer is correct.
Both elements are required in a report on reviewed financial statements.)
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c. A signature of the accounting firm or the accountant and a statement that the accountant is independent
in fact and appearance from management and its owners as required by SSARS No. 1. (This answer is
incorrect. While an accountant must be independent to submit reviewed financial statements, this fact is
not required to be disclosed on the review report.)
d. The date of the review report and a statement that the accountant is not aware of any modifications that
should be made to the financial statements in order for them to be in conformity with GAAP. (This answer
is incorrect. The statement should state that the accountant is not aware of any material modifications that
should be made to the financial statements in order for them to be in conformity with GAAP.)
24. If, at the request of management, an accountant performs procedures that go beyond those required for a
particular engagement, e.g. inquiry of client personnel in a compilation engagement, what type of disclosure
should the accountant make? (Page 177)
a. The accountant should disclose the additional procedures performed in the accountant's report but not
in the notes to the financial statements. (This answer is incorrect. Disclosure in either the accountant's
report or the notes to the financial statements is not recommended.)
b. The accountant should disclose the additional procedures performed in the notes to the financial
statements but not in the accountant's report. (This answer is incorrect. Disclosure in the notes to the
financial statements is not recommended.)
c. The accountant should not mention the additional procedures performed in the accountant's report
or the notes to the financial statements. (This answer is correct. To avoid giving the impression of
greater assurance on the financial statements than is intended by the original engagement, the
accountant should avoid mentioning additional procedures which might mislead thirdparty users.)
d. The accountant should not mention the additional procedures performed in the accountant's report or the
notes to the financial statements, but should require a modified, signed engagement letter by
management. (This answer is incorrect. While an engagement letter is recommended, modification to the
letter referencing the additional procedures is not suggested. The accountant should, however, place
additional importance on the understanding with the client regarding the nature of the services to be
performed.)
25. What should be used as the date of an accountant's report on reviewed financial statements? (Page 179)
a. The date of the signed management representation letter. (This answer is incorrect. The date of the signed
management representation letter does not determine the date of the accountant's review report.)
b. The date of the signed management engagement letter. (This answer is incorrect. The date of the signed
management engagement letter does not determine the date of the accountant's review report. In fact,
engagement letters are not required to be signed by management, nor are they required in a review
engagement.)
c. The date the financial statements are read by the accountant, as the term is used in SSARS No. 1. (This
answer is incorrect. The date the financial statements are read by the accountant is generally the date of
an accountant's compilation report, not a review report.)
d. The date of completion of inquiry and analytical procedures. (This answer is correct. Since these
procedures are the basis for providing limited assurance on the financial statements, the date on
which those procedures are complete should be the date of the accountant's review report.)
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REPORTING ON FINANCIAL STATEMENTS THAT OMIT SUBSTANTIALLY

ALL DISCLOSURES
Financial statements that omit substantially all disclosures may be compiled by the accountant provided the
accountant's report discloses the omission, and the omission is not, to his knowledge, undertaken to mislead those
who might reasonably be expected to use the financial statements. Since the omission of material disclosures is a
departure from GAAP, the accountant's report must clearly indicate the departure. [However, see SSARS No. 3 (AR
300) for guidance when financial statements are included in a prescribed form.] SSARS No. 1 (AR 100.18) indicates
that a third paragraph should be added to the compilation report, stating
Management has elected to omit substantially all of the disclosures (and the statement of cash
flows) required by generally accepted accounting principles. If the omitted disclosures were
included in the financial statements, they might influence the user's conclusions about the
Company's financial position, results of operations, and cash flows. Accordingly, these financial
statements are not designed for those who are not informed about such matters.
Interpretation No. 9 of SSARS No. 1 (AR 9100.29.30) provides alternative wording for the omission of disclosures.
The interpretation points out, however, that the wording should not imply that the decision to omit disclosures was
the accountant's.
When the entity wishes to include disclosures about only a few matters in the form of notes to the compiled financial
statements, such disclosures should be labeled SELECTED INFORMATION Substantially All Disclosures
Required by Generally Accepted Accounting Principles Are Not Included." The third paragraph to the accountant's
compilation report is still necessary. The accountant should consider whether management's election to include
only selected disclosures causes the financial statements to be misleading (for example, by omitting only the
disclosures that contain negative information). If so, the accountant should request that the financial statements be
revised to include the omitted disclosures.
However, SSARS No. 1 (AR 100.17) requires accountants to disclose the basis of accounting used when compiling
OCBOA financial statements. If the financial statements are compiled in conformity with a comprehensive basis of
accounting other than GAAP and they do not disclose the basis of accounting used, the accountant's report should
be modified to disclose the basis.
Interpretation No. 1 of SSARS No. 1 (AR 9100.01.02) indicates that the above modification for compiled financial
statements is not appropriate for reviewed financial statements that omit substantially all disclosures. That is, a
general statement to the effect that substantially all disclosures have been omitted is not appropriate for reports on
reviewed financial statements. Since the omission of material disclosures is a departure from GAAP, the accoun
tant's review report should include the omitted disclosures. If the details to be disclosed have not been determined,
the accountant must identify in his report the specific nature of the omitted disclosures.
Because of these reporting requirements, an accountant ordinarily would not accept an engagement to review
financial statements that omit substantially all disclosures. When an accountant who undertakes to compile or
review financial statements subsequently finds that his client declines to include substantially all disclosures, he
should consider whether the omission is undertaken with the intention of misleading those who will use the
statements.
In a compilation that omits substantially all disclosures, what constitutes substantially? Interpretation No. 22 of
SSARS No. 1 (AR 9100.85.88) helps to address this question by noting that when the financial statements include
more than a few disclosures, substantially all disclosures required by generally accepted accounting principles
have not been omitted. Therefore, if the notes include more than a few disclosures, then the accountant would need
to treat each disclosure omitted as a departure from GAAP. However, the interpretation does not define how many
disclosures constitute more than a few, but rather leaves the determination of the exact number up to the accoun
tant's judgment based on the particular circumstances.
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However, the interpretation narrows this judgment area by stating that the omission of one or more notes, when
substantially all other disclosures are presented, should be treated in a compilation or review report like any other
departure from GAAP, with the nature of the departure and its effects, if known, disclosed. Consequently, when only
one or two notes are missing, the compilation does not omit substantially all disclosures. For example, when the
financial statements include all material notes except one, such as the lease disclosures required by SFAS No. 13,
the guidance discussed in this paragraph for reporting on financial statements that omit substantially all disclo
sures is not appropriate. SSARS No. 1 provides guidance for reporting on financial statements that include a
departure from GAAP in both compiled and reviewed statements.
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REPORTING WHEN THE STATEMENT OF CASH FLOWS OR

COMPREHENSIVE INCOME IS OMITTED
Omission of Statement of Cash Flows
According to SFAS No. 95, when a profitoriented entity or nonprofit organization presents both a balance sheet
and a statement of operations (income statement), a statement of cash flows should also be presented as a basic
financial statement. A statement of cash flows should be presented for each period for which an income statement
is presented. Thus, omitting the statement of cash flows constitutes a departure from GAAP. (Exceptions are
financial statements prepared on an other comprehensive basis of accounting, presentations that exclude either
the balance sheet or statement of income, prescribed forms, specialpurpose financial presentations in compliance
with contractual agreements, and personal financial statements.) Like other departures from GAAP, the accountant
must disclose the departure in a separate paragraph of his report. (However, see SSARS No. 3 for guidance when
financial statements are included in a prescribed form.) An example of the wording of the separate paragraph,
based on SSARS No. 1 (AR 100.47) is as follows:
A statement of cash flows for the year ended December 31, 20X5, has not been presented.
Generally accepted accounting principles require that such a statement be presented when
financial statements purport to present financial position and results of operations.
Omission of Comprehensive Income
SFAS No. 130, Reporting Comprehensive Income, requires comprehensive income and its components to be
reported when a company presents a full set of financial statements that report financial position, results of
operations, and cash flows. When less than a full set of financial statements is presented, presenting comprehen
sive income is generally optional if the omission of one or more statements required for a full set of financial
statements does not constitute a departure from GAAP. [For example, information about comprehensive income
would not be required for (a) standalone presentations of a balance sheet, income statement, or statement of cash
flows; (b) presentation of a balance sheet and statement of cash flows; or (c) presentation of an income statement
and statement of cash flows.] However, if the omission of one or more financial statements is a departure from
GAAP (such as presenting a balance sheet and income statement but omitting a statement of cash flows), omission
of comprehensive income and its components is also a departure from GAAP. Thus, comprehensive income and its
components must generally be reported whenever both a balance sheet and income statement are presented.
However, an entity that does not have any items of other comprehensive income in any period presented is not
required to report comprehensive income.
For entities with items of other comprehensive income, SFAS No. 130 requires comprehensive income and its
components to be presented in a financial statement displayed with the same prominence as other financial
statements. That does not mean that a separate statement of comprehensive income must be presented, however.
Comprehensive income may be reported in a single statement of income and comprehensive income, in a
separate statement of comprehensive income, or in a statement of changes in equity that includes comprehensive
income. Regardless of the method used, the statement displaying comprehensive income must include net
income, the components of other comprehensive income, and a total comprehensive income amount. Not report
ing comprehensive income, as required by SFAS No. 130, constitutes a departure from GAAP. Like other depar
tures from GAAP, the accountant must disclose the departure in a separate paragraph of his report. (However, see
SSARS No. 3 for guidance when financial statements are included in a prescribed form.) An example of the wording
of the separate paragraph is as follows:
Comprehensive income for the year ended December 31, 20X5, has not been presented. Gener
ally accepted accounting principles require that comprehensive income and its components be
presented when financial statements purport to present financial position, results of operations,
and cash flows.
Interpretation No. 25 to SSARS No. 1, Omission of the Display of Comprehensive Income in a Compilation,"
specifically addresses the situation of omitting the display of comprehensive income when issuing a compilation
report with substantially all disclosures omitted. In those instances, the display of comprehensive income may be
omitted by identifying the omission in the compilation report or engagement letter (for managementuseonly
compilations).
If the accountant compiles financial statements that include all disclosures but omit the display of comprehensive
income, the omission should be treated as a departure from GAAP.
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REPORTING ON FINANCIAL STATEMENTS WITH DEPARTURES FROM

GAAP (EXCLUDING PRESCRIBED FORMS AND SPECIALPURPOSE
PRESENTATIONS NOT IN CONFORMITY WITH GAAP)
The previous two sections discuss the accountant's reporting obligation when the financial statements omit
substantially all disclosures or the statement of cash flows. This section discusses reporting on financial statements
with measurement or disclosure departures from GAAP. (As mentioned previously, the omission of a single footnote
is also treated like a GAAP departure.)
What Is GAAP?
While accountants agree on the existence of a body of knowledge called GAAP, the determination that a particular
accounting principle is generally accepted may be difficult because no single reference source exists for all such
principles.
GAAP Hierarchy. Appendix J to SSARS No. 1, as amended by SSARS No. 15, outlines the hierarchy of sources of
GAAP for nongovernmental units as follows:
a. Accounting principles promulgated by a body designated by the AICPA Council to establish such
principles, pursuant to Rule 203 of the AICPA Code of Professional Conduct. This consists of FASB
Statements and Interpretations, APB Opinions, and AICPA Accounting Research Bulletins.
b. Pronouncements of bodies, composed of expert accountants, that deliberate accounting issues in public
forums for the purpose of establishing accounting principles or describing accounting principles that are
generally accepted, provided those pronouncements have been exposed for public comment and have
been cleared by a body referred to in category a. This consists of FASB Technical Bulletins and, if cleared
by the FASB, AICPA Industry Audit and Accounting Guides and AICPA Statements of Position.
c. Pronouncements of bodies, organized by a body referred to in category a. and composed of expert
accountants, that deliberate accounting issues in public forums for the purpose of interpreting or
establishing accounting principles or describing existing accounting principles that are generally
accepted, or pronouncements referred to in category b. that have been cleared by a body referred to in
category a. but have not been exposed for public comment. This consists of AICPA Accounting Standards
Executive Committee (AcSEC) Practice Bulletins that have been cleared by the FASB and consensus
positions of the FASB Emerging Issues Task Force.
d. Practices or pronouncements that are widely recognized as being generally accepted because they
represent prevalent practice in a particular industry, or the knowledgeable application to specific
circumstances of pronouncements that are generally acceptable. This includes AICPA accounting
interpretations and implementation guides, Qs and As" published by the FASB staff, and practices that
are widely recognized and prevalent either generally or in the industry.
e. In the absence of a pronouncement covered by Rule 203 or another source of established accounting
principles, other accounting literature may be considered, depending on its relevance in the circum
stances. Other accounting literature includes, for example, FASB Statements of Financial Accounting
Concepts; AICPA Issues Papers; International Accounting Standards of the International Accounting
Standards Committee; Government Accounting Standards Board (GASB) Statements, Interpretations,
and Technical Bulletins; Federal Accounting Standards Advisory Board (FASAB) Statements, Interpreta
tions, and Technical Bulletins; pronouncements of other professional associations or regulatory agencies;
Technical Information Service Inquiries and Replies included in the AICPA Technical Practice Aids; and
accounting textbooks, handbooks, and articles.
Generally, the accounting principles in category a. are undisputed as GAAP. If the accounting treatment of a
transaction or event is not covered by category a. but is covered by category b., c., or d., the accountant should be
prepared to justify a conclusion that another treatment is generally accepted. If there is a conflict between sources
within those categories, the accountant should follow the source specified in the higher category (for example,
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follow category b. treatment over category c.) or be prepared to justify a conclusion that a treatment specified by a
source in the lower category better presents the substance of the transaction. Generally, the accountant should
only consider other accounting literature, category e., in the absence of relevant accounting principles in category
a., b., c., or d.
Normally, a material GAAP departure is readily determinable. However, the proliferation of standards in recent years
makes it more difficult to remember all the subtle GAAP requirements. Many firms refer to a GAAP disclosure
checklist to ensure that they have considered all appropriate GAAP disclosures on compilation and review engage
ments. PPC's Guide to Preparing Financial Statements and PPC's Guide to GAAP are also excellent reference
sources for applying both GAAP measurement and GAAP disclosure standards. Those Guides can be ordered by
calling (800) 3238724 or via PPC's website at ppc.thomson.com.
What Is a Material GAAP Departure?
Determining whether GAAP departures are material to individual financial statements, to specific line items or
subtotals within financial statements, or to the financial statements taken as a whole is one of the most difficult
decisions in the profession. Materiality is defined in Financial Accounting Standards Board's Statement of Financial
Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information, as:
The magnitude of an omission or misstatement of accounting information that, in light of
surrounding circumstances, makes it probable that the judgment of a reasonable person relying
upon the information would have been changed or influenced by the omission or misstatement.
Some might argue that the FASB definition is nebulous, but a more definite statement is probably impossible since
materiality is a matter of judgment in the circumstances. While no quantitative guidelines exist, accountants often
use benchmarks to assist in assessing the materiality of GAAP departures. A benchmark used by some firms
follows:
Effect of Departure on Income before Tax
Materiality to Financial Statements
15%
69%
10% or greater
Not material
Danger area could be material
Probably is material
If income before tax approaches zero, the percentages may be applied to what would be considered normalized
income before tax for similar entities in similar industries.
Alternatives When Faced with a GAAP Departure
Although compiled financial statements may omit substantially all disclosures required by GAAP, the omission of
material disclosures from reviewed financial statements is a GAAP departure. As discussed previously, the accoun
tant should include in the review report all of the omitted disclosures or, if the details to be disclosed have not been
determined, the specific nature of the omitted disclosures. If, in the course of a compilation or review engagement,
the accountant becomes aware of material measurement departures from GAAP, he has three possible courses of
action:
a. persuade the client to revise the statements to conform with GAAP,
b. refer to the departure in his report, or
c. withdraw from the engagement.
Revision of the statements is, of course, the preferred course of action. If revision is not feasible, reporting the
departure in the accountant's report is appropriate unless the practitioner concludes that management's intention
is to mislead the reader. If modification of the report to disclose the departure is not adequate and the client refuses
to revise the statements, the accountant should withdraw from the engagement and consider consulting legal
counsel.
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If modification of the accountant's report is appropriate, the nature of the departure from GAAP should be disclosed
in a separate paragraph, and the effects (dollar amount) of the departure should be disclosed, if known. If the
effects are not known, the accountant is not required to determine them, but he must state in his report that no
determination of the effects of the departure has been made.
Rule 203 of the AICPA Code of Professional Conduct addresses a rare situation in which accountants are associ
ated with financial statements that contain a departure from GAAP because compliance with GAAP would result in
misleading financial statements. Rule 203 states that in audit and review engagements:
If, however, the statements or data contain such a departure and the member can demonstrate
that due to unusual circumstances the financial statements or data would otherwise have been
misleading, the member can comply with the rule by describing the departure, its approximate
effects, if practicable, and the reasons why compliance with the principle would result in a
misleading statement.
SAS No. 58 (AU 508), Reports on Audited Financial Statements, contains guidance for auditors in these circum
stances. However, similar guidance did not exist for accountants performing a review engagement. Therefore,
ARSC issued Interpretation No. 19 of SSARS No. 1 (AR 9100.73.75). The interpretation states that, when the
circumstances contemplated by Rule 203 (ET 203) are present in a review engagement, the practitioner should
include a separate paragraph in the review report that contains the information required by the rule. However, Rule
203 does not apply to a compilation engagement. Interpretation No. 19 states that when confronted with this
situation in a compilation engagement, the practitioner should treat the item as a departure from GAAP and report
accordingly.
Goodwill Accounting Departure. SFAS No. 142, Goodwill and Other Intangible Assets, provides guidance on
accounting for goodwill and intangible assets. The Statement requires that goodwill be assessed annually for
impairment. Many accountants have voiced concern that the cost of complying with SFAS No. 142 exceeds the
benefits for many small businesses that need compiled or reviewed financial statements. Consequently, many
small businesses choose not to incur the cost associated with performing an annual impairment test. If the client
chooses not to implement SFAS No. 142, the accountant should modify the compilation or review report to disclose
the GAAP departure as noted previously.
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REPORTING WHEN THERE ARE SIGNIFICANT DEPARTURES FROM GAAP

(EXCLUDING PRESCRIBEDFORMS AND SPECIALPURPOSE
PRESENTATIONS NOT IN CONFORMITY WITH GAAP)
According to Interpretation No. 7 of SSARS No. 1 (AR 9100.23.26), an accountant cannot modify a compilation or
review report to indicate that the financial statements are not fairly presented in conformity with GAAP (or OCBOA).
Thus, an adverse opinion is not appropriate in a compilation or review engagement. An adverse opinion can only
be expressed in an audit engagement.
The interpretation indicates that the accountant may wish to emphasize the limitations of financial statements
having significant GAAP departures (whether disclosure or measurement) in a separate explanatory paragraph in
the report. The explanatory paragraph is in addition to a separate paragraph that describes the departure. In
deciding whether to include an explanatory paragraph, the accountant should consider
a. The possible dollar magnitude of the effects of the departures.
b. The significance of the affected items to the entity.
c. The pervasiveness and overall impact of the misstatement.
d. Whether disclosure has been made of the effects of the departure.
The separate explanatory paragraph, which generally would be presented as the last paragraph of a compilation or
review report, might read as follows:
Because the significance and pervasiveness of the matters discussed above make it difficult to
assess their impact on the financial statements taken as a whole, users of these financial state
ments should recognize that they might reach different conclusions about the Company's finan
cial position, results of operations, and cash flows if they had access to revised financial
statements prepared in conformity with generally accepted accounting principles.
This paragraph is optional, and generally should only be used in rare situations when a departure, individually or
when viewed with other departures, becomes so pervasive that the financial statements lose their ability to
communicate to the user. The failure to determine the dollar impact of a departure may or may not cause such a
pervasive impact on the financial statements and, accordingly, would not automatically call for the use of the
optional paragraph.
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REPORTING ON COMPUTERPREPARED FINANCIAL STATEMENTS

Computerprepared financial statements for interim or annual periods that contain disclosure omissions or mea
surement departures must be reported on in accordance with SSARS No. 1 (AR 100). The accountant cannot place
a legend on computerprepared financial statements saying that the statements were not compiled, reviewed, or
audited by an accountant (or CPA) and thereby avoid the reporting requirements of SSARS No. 1.
In the past, the ARSC considered a proposed SSARS that would have granted an exemption from the requirements
of SSARS No. 1 (AR 100) when an accountant submits computerprepared interim financial statements to his client
or others. The proposed SSARS would have required the use of a legend on each page of the statements stating
that the statements did not purport to reflect all adjustments and disclosures required by GAAP (or an other basis
of accounting) and that they were not compiled, reviewed, or audited by the CPA. The proposed SSARS was widely
opposed and, consequently, the ARSC voted not to issue a SSARS on this subject. Thus, the ARSC reemphasized
that SSARS No. 1 makes no distinction between interim and annual financial statements or manual and computer
prepared financial statements.
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SELFSTUDY QUIZ
following section.
26. A client for whom an accountant is preparing a compilation wishes to omit the disclosures regarding prepaid
expenses and inventory valuation in the notes to the financial statements. Based on interpretations of SSARS
No. 1, must the accountant's compilation report state the financial statements omit substantially all disclosures?
a. Yes, assuming the notes include more than a few disclosures.
b. No, assuming the notes include more than a few disclosures.
c. Yes, assuming the prepaid expenses and inventory accounts are material to the financial statements.
d. No, assuming those are the only two notes required in the compilation of the financial statements.
27. Based on SFAS No. 95, is the omission of a statement of cash flows as a basic financial statement in a
compilation or review engagement a departure from GAAP?
a. Yes, when the compilation or review excludes the income statement.
b. Yes, when the report also presents a balance sheet and an income statement.
c. No, as long as disclosure is made in a separate paragraph of the compilation or review report.
d. No, because SFAS No. 95 only requires a statement of cash flows in audit engagements.
28. When preparing a compilation or review, where might an accountant find guidance to determine if a departure
from GAAP is material to the financial statements?
a. FASB Statement of Financial Accounting Concepts No. 2.
b. AICPA Statement on Auditing Standards No.69.
c. Statements on Standards for Accounting and Review Services No. 1.
d. Rule 203 of the AICPA Code of Professional Conduct.
29. In a review engagement, how should an accountant treat the omission of material disclosures from the financial
statements?
a. The accountant should include a paragraph stating that management has elected to omit material
disclosures required by GAAP.
b. The accountant should issue a compilation report in lieu of a review report as these omissions constitute
a material departure from GAAP.
c. The accountant should include in the review report all of the omitted disclosures since this is a departure
from GAAP.
d. The accountant should resign from the engagement due to management's refusal to disclose all material
items affecting the financial statements.
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30. In a review or compilation engagement, which of the following is a possible course of action when the
accountant becomes aware of material measurement departures from GAAP?
a. For a review, the accountant is required to revise the departures before issuing the review report. For a
compilation, no action is required on the part of the accountant.
b. For a compilation, the accountant may disclose the departure in the compilation report. For a review, the
accountant may not issue the review report unless the departure is revised to conform to GAAP.
c. For either type of engagement, the accountant may refer to the departure in the accountant's report.
d. For a compilation, the accountant may disclose the departure in the compilation report. For a review, the
accountant is required to resign from the engagement.
31. In a compilation or review, how might an accountant modify the accountant's report to indicate that financial
statements are not fairly presented in conformity with GAAP?
a. By issuing an adverse opinion on the financial statements.
b. By emphasizing the limitations of the financial statements.
c. By issuing a disclaimer of opinion on the financial statements.
d. By modifying the engagement letter with management to prohibit the issuance of the financial statements
to thirdparty users.
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SELFSTUDY ANSWERS
26. A client for whom an accountant is preparing a compilation wishes to omit the disclosures regarding prepaid
expenses and inventory valuation in the notes to the financial statements. Based on interpretations of SSARS
No. 1, must the accountant's compilation report state that the financial statements omit substantially all
disclosures? (Page 188)
a. Yes, assuming the notes include more than a few disclosures. (This answer is incorrect. Based on
Interpretation No. 22, omission of one or two notes, when substantially all other disclosures are presented,
should be treated like any other departure from GAAP in a compilation or review.)
b. No, assuming the notes include more than a few disclosures. (This answer is correct. Interpretation
No. 22 of SSARS No. 1 notes that when financial statements include more than a few disclosures,
substantially all disclosures required by GAAP have not been omitted.)
c. Yes, assuming the prepaid expenses and inventory accounts are material to the financial statements. (This
answer is incorrect. Based on Interpretation No. 22, omission of one or two notes, when substantially all
other disclosures are presented, should be treated like any other departure from GAAP in a compilation
or review. Materiality of the two accounts is not an issue.)
d. No, assuming those are the only two notes required in the compilation of the financial statements. (This
answer is incorrect. If those were the only two disclosures necessary in the compilation, then the financial
statements would omit substantially all disclosures and the accountant must clearly indicate the departure
in the compilation report.)
27. Based on SFAS No. 95, is the omission of a statement of cash flows as a basic financial statement in a
compilation or review engagement a departure from GAAP? (Page 189)
a. Yes, when the compilation or review excludes the income statement. (This answer is incorrect. If the
balance sheet or income statement were excluded, an exception would apply to SFAS No. 95 and the
exclusion of the statement of cash flows would not constitute a departure from GAAP.)
b. Yes, when the report also presents a balance sheet and an income statement. (This answer is
correct. SFAS No. 95 requires a statement of cash flows when a balance sheet and income statement
are also presented by a profitoriented entity.)
c. No, as long as disclosure is made in a separate paragraph of the compilation or review report. (This answer
is incorrect. Disclosure in a separate paragraph of the review or compilation report is required when a
departure from GAAP is present.)
d. No, because SFAS No. 95 only requires a statement of cash flows in audit engagements. (This answer is
incorrect. SFAS No. 95 requires a cash flow statement when a balance sheet and income statement are
also presented, regardless of the type of engagement.)
28. When preparing a compilation or review, where might an accountant find guidance to determine if a departure
from GAAP is material to the financial statements? (Page 191)
a. FASB Statement of Financial Accounting Concepts No. 2. (This answer is correct. This statement
defines materiality using a reasonable person" test to determine if a misstatement is material to the
b. AICPA Statement on Auditing Standards No.69. (This answer is incorrect. SAS No. 69 describes GAAP"
in general terms and outlines the hierarchy of GAAP for nongovernmental units.)
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c. Statements on Standards for Accounting and Review Services No. 1. (This answer is incorrect. SSARS No.
1 is the main source for requirements in a compilation or review, but does not attempt to define materiality.)
d. Rule 203 of the AICPA Code of Professional Conduct. (This answer is incorrect. Rule 203 deals with
accounting principles promulgated by a body designated by the AICPA Council to establish such
principles.)
29. In a review engagement, how should an accountant treat the omission of material disclosures from the financial
statements? (Page 187, Page 191)
a. The accountant should include a paragraph stating that management has elected to omit material
disclosures required by GAAP. (This answer is incorrect. While a general statement of omission of
substantial disclosures required by GAAP is appropriate in compilation reports, this is not appropriate in
a review engagement.)
b. The accountant should issue a compilation report in lieu of a review report as these omissions constitute
a material departure from GAAP. (This answer is incorrect. The accountant does not have to stepdown to
a compilation if management chooses to omit material disclosures from reviewed financial statements.)
c. The accountant should include in the review report all of the omitted disclosures since this is a
departure from GAAP. (This answer is correct. According to Interpretation No. 1 of SSARS No. 1, a
general statement of omission is not appropriate for a review report, and the accountant should
include each omitted disclosure in the review report.)
d. The accountant should resign from the engagement due to management's refusal to disclose all material
items affecting the financial statements. (This answer is incorrect. The accountant should resign from the
engagement when reaching the conclusion that management's intention is to mislead the reader of the
30. In a review or compilation engagement, which of the following is a possible course of action when the
accountant becomes aware of material measurement departures from GAAP? (Page 191)
a. For a review, the accountant is required to revise the departures before issuing the review report. For a
compilation, no action is required on the part of the accountant. (This answer is incorrect. For a review,
revision of the disclosures is not required. For a compilation, the accountant must, at a minimum, refer to
the departure in the report.)
b. For a compilation, the accountant may disclose the departure in the compilation report. For a review, the
accountant may not issue the review report unless the departure is revised to conform to GAAP. (This
answer is incorrect. For a review, the accountant may issue the report as long as the departure is disclosed
in the report.)
c. For either type of engagement, the accountant may refer to the departure in the accountant's report.
(This answer is correct. The accountant has three possible courses of action in this case: 1)
persuade the client to revise the statements to conform to GAAP, 2) refer to the departure in his
report, or 3) withdraw from the engagement.)
d. For a compilation, the accountant may disclose the departure in the compilation report. For a review, the
accountant is required to resign from the engagement. (This answer is incorrect. For a review, the
accountant is not required to resign from the engagement, but should do so if the client refuses to revise
the statements and disclosure of the departure is not adequate.)
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31. In a compilation or review, how might an accountant modify the report to indicate that financial statements are
not fairly presented in conformity with GAAP? (Page 193)
a. By issuing an adverse opinion on the financial statements. (This answer is incorrect. An adverse opinion
can only be expressed in an audit engagement.)
b. By emphasizing the limitations of the financial statements. (This answer is correct. Whether the
departures are related to disclosure or measurement, the accountant may discuss the limitations
of the statements in a separate explanatory paragraph in the report.)
c. By issuing a disclaimer of opinion on the financial statements. (This answer is incorrect. A disclaimer of
opinion can only be expressed in an audit engagement.)
d. By modifying the engagement letter with management to prohibit the issuance of the financial statements
to thirdparty users. (This answer is incorrect. This is a modification of the engagement letter, not the
accountant's report. Presumably, when a review or compilation report is requested by management, the
financial statements are intended to be distributed to third parties, and thus the accountant should not
issue the financial statements without the necessary disclosures in the report.)
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REPORTING WHEN THERE IS A SCOPE LIMITATION

Scope limitations occur in audit engagements when the auditor is prevented from applying GAAS because of
limitations imposed by the client or caused by circumstances. When an auditor encounters a scope limitation, he
issues either an except for opinion or a disclaimer of opinion. However, SSARS No. 1 (AR 100) does not permit such
reporting.
Scope limitations also can occur in SSARS engagements, especially in initial review engagements. In those cases,
it is not unusual for the accountant to raise questions about the reasonableness of amounts included in the financial
statements. Often, due to the timing of the engagement or inadequate accounting records, he also may be unable
to apply analytical procedures to obtain review assurance. SSARS No. 1 (AR 100.43) notes that when an accoun
tant is unable to perform the inquiry and analytical procedures necessary for a review or when the client does not
furnish a representation letter, the review will be incomplete and a review report cannot be issued. In this situation,
the accountant should consider whether the scope limitation also precludes him from issuing a compilation report.
In making that judgment, the accountant should consider the guidance in SSARS No. 1 (AR 100.63.68).
In considering the implications of the scope limitation, the accountant should evaluate the possibility that the
information affected by the scope restriction is incorrect, incomplete, or otherwise unsatisfactory. This evaluation is
a matter of professional judgment. In general, if the client is unable to provide additional or revised information due
to factors beyond his control, a stepdown from a review to a compilation is usually acceptable. The accountant
should consider the following:
a. Whether the reason for the scope limitation seems logical.
b. Whether the scope restriction significantly impairs the usefulness of the financial statements.
In deciding whether it would be appropriate to issue a compilation report when a scope restriction precludes a
review report, the accountant should determine if the scope restriction is clientimposed. SSARS No. 1 (AR 100.09),
requires that the accountant withdraw from the engagement if the client refuses to provide additional or revised
information. A scope restriction resulting from inadequate accounting records should normally be considered a
clientimposed scope restriction. Although the restriction may be unintentional, the maintenance of adequate
accounting records is within the client's control. Situations where the client is unable to provide additional or
revised information (for which a stepdown may be appropriate, as described in the preceding paragraph) should
be rare. One such situation would be when accounting records have been destroyed. Even in that case, the
accountant would be required to provide other accounting services to reconstruct significant transactions prior to
compiling the financial statements.
When there has been a restriction that precludes a review report and the accountant decides to issue a compilation
report, SSARS No. 1 (AR 100.68) indicates he should issue an appropriate compilation report without any reference
to the scope restriction. Previously, Interpretation No. 14 of SSARS No. 1, Reporting on Financial Statements
When the Scope of the Accountant's Procedures Has Been Restricted," provided reporting guidance in these
circumstances. In 1990, the ARSC withdrew this interpretation because the reporting guidance conflicted with
SSARS No. 1 (AR 100.68). The interpretation noted that an emphasis paragraph should be added to the compila
tion report describing the nature of the scope limitation, whereas AR 100.68 prohibits such a reference. The ARSC
concluded that describing the scope limitation that precluded the issuance of a review report might imply that
review procedures had been performed, causing the user to place undue reliance on the report.
If an accountant is unable to obtain the limited assurance required for a review and decides it would not be
appropriate to issue a compilation report, he should try to provide other accounting information to the client short
of submitting financial statements. For example, a working trial balance may satisfy the client's needs. Conversely,
the accountant may be able to perform an agreedupon procedures engagement and report accordingly.
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REPORTING ON FINANCIAL STATEMENTS INCLUDED IN MCS REPORTS

Unaudited historical financial statements are often included in reports on findings in Management Consulting
Services engagements (MCS reports). A question often arises as to what reporting responsibility the CPA/consul
tant has on those historical statements.
Some practitioners believe that the historical financial statements are incidental" to the purpose of the MCS
engagement, that reporting is governed solely by MCS standards, and that the inclusion of a compilation report
creates confusion on the part of the financial statement users. Consequently, they do not believe that accountants
are required to report on historical financial statements included in MCS reports.
Others distinguish between MCS reports that are intended for restricted use" and those that are intended for
general thirdparty use." Those practitioners believe that historical statements included in MCS reports should at
least be compiled if the MCS report is intended for general thirdparty use. However, they do not believe compila
tion is necessary if the distribution of the MCS report is to be restricted to the client and his or her advisers. This
approach is similar to the requirements of professional standards related to personal financial statements included
in written personal financial plans, which are exempted from SSARS No. 1 (AR 100) by SSARS No. 6 (AR 600), and
prospective financial statements intended for internal use only.
Currently, there is no provision in SSARS to exempt historical financial statements included in MCS reports.
Likewise, SSARS do not provide for different levels of service depending on the intended use of financial state
ments [other than the exemption provided for certain personal financial statements (SSARS No. 6 AR 600) and
the exemption related to certain litigation support services (Interpretation No. 20 of SSARS No. 1 AR
9100.76.79)]. Consequently, SSARS requires that any historical financial statements that the accountant submits
to clients or others, including statements included in MCS reports, at least be compiled.
During discussions between the MCS Executive Committee and ARSC to clarify for MCS practitioners what
constitutes submission of financial statements" under SSARS No. 1 (and, thus, triggers the reporting responsibil
ity), several examples came up that may be helpful. Accountants are not required, for example, to report on partial
presentations of economic activity, such as a schedule of costs or a summary of general and administrative
expenses, that might be included in an MCS report. Likewise, they are not required to report on other presentations
not considered financial statements, such as a trial balance. In addition, accountants are required to report only if
they have submitted the financial statements included in the MCS report. Accountants have submitted financial
statements when they have prepared" and presented" the statements.
Financial Statements Compiled or Reviewed by Another Accountant
If the MCS report includes financial statements that were compiled or reviewed by another accountant and the
other accountant's report is included, the CPA is not required to mention the statements in the report. If, however,
the other CPA's report is not included with the financial statements in the MCS report, the accountant should
include a reference to the other accountant's report that includes
a. A statement describing the service performed by the other accountant, without disclosing that accountant's
name.
b. The date of the other accountant's report.
c. A description of the standard disclaimer in a compilation report or, for a review, the standard limited
assurance language included therein.
d. A description of any modifications of the standard compilation or review report, including any paragraphs
that emphasize certain matters relating to the financial statements.
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An example of a paragraph that might be added to the consultant's report when the other accountants issued a
standard compilation report on the financial statements follows:
The 20X5 financial statements of XYZ Company were compiled by other accountants, whose
report dated February 1, 20X6, stated that they did not express an opinion or any other form of
assurance on those statements.
An example of a paragraph that might be added to the consultant's report when the other accountants issued a
standard review report on the financial statements follows:
The 20X5 financial statements of XYZ Company were reviewed by other accountants, whose
report dated February 1, 20X6, stated that they were not aware of any material modifications that
should be made to those statements in order for them to be in conformity with generally accepted
accounting principles.
Clientprepared Financial Statements
If the MCS report contains clientprepared financial statements, the accountant is not required to compile and
report on those statements. This is true even if the CPA reads the clientprepared statements before including them
in the MCS report, since merely reading them does not constitute submission" in accordance with SSARS No. 1
(AR 100). If, however, the accountant has made material modifications on the face of the statements, he has
submitted them and must compile and report on them in accordance with SSARS No. 1. In that case, professional
standards do not require the accountant to mention those statements in the MCS report at all. Accountants,
however, may choose to compile and report on such statements since they are included in a document (that is, the
MCS report) that bears their name and a compilation is the lowest level of service with which they would want to be
associated. If they decide not to compile the statements, SSARS No. 1 (AR 100.03) states that the accountant
should provide an indication that the clientprepared financial statements have not been compiled or reviewed.
Such a statement might be worded as follows:
The accompanying balance sheet of XYZ Company as of December 31, 20XX, the related
statements of income, and cash flows for the year then ended were not audited, reviewed, or
compiled by us (me), and accordingly we (I) do not express an opinion or any other form of
assurance on them.
Historical Financial Information Derived from a Tax Return and Included in a Business Valuation
Interpretation No. 23 of SSARS No. 1 (AR 9100.89.92), Applicability of Statements on Standards for Accounting
and Review Services When an Accountant Engaged to Perform a Business Valuation Derives Information from an
Entity's Tax Return," addresses the specific situation of including historical financial information derived from a tax
return in a business valuation. The Interpretation states that when an accountant derives financial information from
an entity's tax return to be presented as part of a business valuation, SSARS do not apply. Even if the accountant
has derived the financial information for the business valuation from a tax return he or she has prepared, SSARS do
not apply since financial forecasts, projections and similar presentations, and financial presentations included in
tax returns are not considered financial statements in accordance with AR 100.04. In addition, the Interpretation
goes on to state that when an accountant, who is performing a business valuation, derives financial information
from the client's tax return, or another accountant's audited, reviewed, or compiled financial statements, or client
prepared financial statements, the accountant should refer to the source of the financial information and include an
indication in the business valuation report that they have not audited, reviewed, or compiled such information and,
therefore, assume no responsibility for the information. Such a statement might be worded as follows:
In preparing our business valuation report, we have relied upon historical financial information
provided to us by management and derived from [Source of Information]. This financial infor
mation has not been audited, reviewed, or compiled by us and, accordingly, we do not express
an opinion or any form of assurance on the financial information.
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REPORTING WHEN ONLY ONE FINANCIAL STATEMENT IS PRESENTED

An accountant may issue a compilation report on a single financial statement such as a balance sheet. Likewise, he
may issue a review report on a single financial statement. Engagements to report on single financial statements are
limited reporting engagements, not scope restrictions.
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REPORTING WHEN SUPPLEMENTARY INFORMATION IS PRESENTED

What Is the Definition of Supplementary Information?
The term supplementary information (also commonly referred to as other," additional," or accompanying"
information) is not defined in SSARS literature. In general, the intent of SSARS No. 1 (AR 100.60) regarding the
accountant's responsibility for supplementary information in a compilation or review report parallels SAS No. 29,
Reporting on Information Accompanying the Basic Financial Statements in AuditorSubmitted Documents (AU
551.04). The information covered by SAS No. 29 includes the following:
a. Additional details or explanations of items in, or related to, the basic financial statements, unless the
information has been identified as being part of the basic financial statements.
b. Consolidating information.
c. Historical summaries of items extracted from basic financial statements, including graphs prepared on a
microcomputer.
d. Statistical data.
e. Other material, some of which may be from sources outside the accounting system or outside the entity.
Thus, nonaccounting as well as accounting information is supplementary information subject to the requirements of
SSARS No. 1 (AR 100.60). Also, selected financial data (as discussed in SAS No. 42 AU 552, Reporting on
Condensed Financial Statements and Selected Financial Data) presented with compiled or reviewed financial
statements is supplementary information subject to the reporting guidance of SSARS No. 1 (AR 100.60). Examples
of selected financial data include a schedule of selling, general, and administrative (SG&A) expenses and a
schedule of cost of goods sold. However, supplementary information does not include multiple income statements
(e.g., month and quarter to date, quarter and year to date, multiple quarters and year to date) included in a set of
computerprepared financial statements. Such income statements are historical financial statements and, accord
ingly, should be reported on by the accountant. (The accountant can identify the income statements being reported
on by either listing them in the body of the report or by listing them in an index and referring to the financial
statements included in the foregoing index.")
An AICPA Technical Practice Aid (TIS 9160.23) provides additional guidance on distinguishing between supple
mental information and basic financial statement information. (Although the practice aid is directed to audited
statements, it is also relevant to compiled or reviewed statements.) In part, the practice aid provides the following:
If the basic financial statements refer to specific information (i.e., See Exhibit A Schedule of
Operating Expenses"), such information is considered to be part of the basic financial statements
and is presumed to have been subjected to the auditing procedures applied to the basic financial
statements. This information is therefore not required to be reported on separately and should not
be referred to in the auditors' report. Any additional information presented with the basic financial
statements, but not referred to in such statements, should be considered supplementary
information unless described otherwise.
In general, the guidance in the nonauthoritative TPA is acceptable, with the following exceptions:
a. Professional standards do not prohibit referencing to supplementary information from the financial
statements. Although such a reference should be discouraged, it is not prohibited, and referencing to a
schedule from the face of a basic financial statement does not require that the schedule be considered part
of the basic financial statements.
b. The accountant's report should refer to all schedules and statements that are considered part of the basic
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In general, is is recommended that

a. Schedules providing detail of line items in the basic financial statements be considered supplementary
information.
b. All supplementary information be placed after the basic financial statements and notes and, ordinarily, be
preceded by a title page marked SUPPLEMENTARY INFORMATION."
c. If the client wishes to provide detail of line items in the basic financial statements and insists that the detail
be part of the basic financial statements, the detail should be presented on the face of the financial
statement.
d. If the client insists that a schedule providing detail of a line item in a basic financial statement be included
as part of the basic financial statements, the schedule should be either (1) treated as an additional page
of that basic financial statement and titled accordingly or (2) titled as a schedule and referred to as such
in the accountant's report (for example, We have compiled the accompanying balance sheet of XYZ
Company as of December 31, 20X5, and the related statement of income and retained earnings, statement
of cash flows, and schedule of operating expenses for the year then ended...").
Supplementary Information Accompanying Compiled Financial Statements
SSARS No. 1 (AR 100.60) requires that the accountant compile supplementary information that accompanies
historical financial statements that he has also compiled. The only exception to this guidance is clientprepared
supplementary information, which is discussed later in this course.
Supplementary Information Accompanying Reviewed Financial Statements
When reviewed financial statements are accompanied by supplementary information, SSARS No. 1 (AR 100.60)
allows the accountant to either review or compile the supplementary information. To review supplementary informa
tion, accountants must be able to subject the information to the inquiry and analytical procedures they will apply
during their review of the basic financial statements. Sometimes, however, it may be difficult (if not impossible) for
accountants to apply such procedures to certain types of supplementary information (e.g., schedules indicating the
number of employees, production statistics, such as pounds produced and pounds shipped, or square footage of
selling space). In that case, accountants would compile, rather than review, the nonfinancial information presented
with reviewed financial statements. If the accountant has applied inquiry and analytical procedures to the supple
mentary information, he should clearly indicate either in his review report on the basic financial statements or in a
separate report accompanying the supplementary information that:
a. The review of the basic financial statements was made for the purpose of expressing limited assurance that
there are no material modifications necessary for the financial statements to be in conformity with GAAP
(or OCBOA).
b. The supplementary information is presented only for supplementary analysis purposes.
c. The supplementary information has been subjected to the inquiry and analytical procedures applied in the
review of the basic financial statements.
d. The accountant did not become aware of any material modifications that should be made to the
If the accountant did not subject the supplementary information to the inquiry and analytical procedures, his report
should include items a. and b., but items c. and d. should be modified as follows:
c. The information was not subjected to the inquiry and analytical procedures applied in the review of the basic
financial statements, but was compiled from information that is the representation of management, without
audit or review.
d. The accountant does not express an opinion or any other form of assurance on the supplementary
information.
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In summary, unless the guidance in the next paragraph applies, the accountant's report always would describe his
responsibility for any supplementary information included with reviewed financial statements.
Clientprepared Supplementary Information
When the supplementary information is prepared or presented solely by the client, the reporting responsibility may
not be as obvious as when the accountant assembled or assisted in assembling the information. Clientprepared
supplementary information is normally included with compiled or reviewed financial statements in one of the
following ways: (a) the financial statements and the clientprepared information are bound by the accountant in his
firm's report cover (or typed on the accountant's watermark paper and stapled to the financial statements) or (b)
after the accountant submits the financial statements to the client, the client in turn attaches (in some manner)
supplementary information and distributes the package to third parties.
Clientprepared Supplementary Information Bound in the Accountant's Report Cover. When clientprepared
supplementary information is bound in the accountant's report cover, a third party would normally conclude
(absent a statement to the contrary) that the accountant has some responsibility for the information. Thus, in such
a situation, being silent about the accountant's responsibility for the clientprepared supplementary information is
not a valid alternative. This point is made clear in the first sentence of SSARS No. 1 (AR 100.60).
When the basic statements are accompanied by information presented for supplementary
analysis purposes, the accountant should clearly indicate the degree of responsibility, if any, he is
taking with respect to such information.
While there is general agreement that the accountant must explicitly state his responsibility, there are two views
about what he is required to say. One view is that SSARS No. 1 (AR 100.60) requires the accountant to compile or
review any supplementary information bound in his report cover. In other words, at a minimum, the accountant
must compile such information.
Another view is that the accountant can indicate that the information is client prepared and that it has not been
compiled or reviewed. Normally, this is accomplished with the following statement, presented as a separate
paragraph to the accountant's report or on a separate page before the clientprepared information:
The supplementary information on page X has been prepared by XYZ Company and is presented
only for supplementary analysis purposes. We (I) have not compiled, reviewed, or audited the
supplementary information and, accordingly, assume no responsibility for it.
The proponents of this view say that the phrase if any" in the first sentence of SSARS No. 1 (AR 100.60), allows the
accountant to indicate he assumes no responsibility" for the clientprepared information.
In general, it is preferable to at least compile the information because it normally is the minimum work that most
accountants would want to perform on any supplementary information (clientprepared or otherwise) included in
their report cover. In other words, they would at least read" the clientprepared information for obvious errors and
inconsistencies.
Supplementary Information Attached by the Client. The accountant's reporting responsibility for clientprepared
supplementary information attached to the financial statements after they are delivered by the accountant is not
directly addressed by SSARS. Realistically, the accountant has little control over the client's actions once he
delivers his report. However, situations do occur when the client clearly communicates to the accountant that the
financial statements will be combined with other clientprepared information and submitted by the client to third
parties, e.g., to a bank as part of a loan proposal package. In fact, the accountant may accompany the client when
he submits the package to the third party.
Guidance for these situations can be inferred from SSARS No. 1 (AR 100.03) and SSARS No. 2 (AR 200.03) that
discuss clientprepared financial statements included in a clientprepared document along with compiled or
reviewed financial statements. Basically, this guidance says the clientprepared financial statements should be
accompanied by a statement that they were not prepared by the accounting firm and the accounting firm assumes
no responsibility for them. Absent such a statement, the accountant is advised to consult with his attorney to
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consider what other actions are appropriate. To clarify the accountant's reponsibility, the accountant should ask the
client to include (preferably on a page immediately preceding the data) a statement such as the following:
The supplementary information on pages to has not been audited, reviewed, or
compiled by us (me), and, accordingly, we (I) do not express an opinion or any other form of
assurance on this information.
Alternatively, the accountant may desire to add the following paragraph to his compilation or review report before
the financial statements are delivered to the client:
All other information that may be included with (or attached to) the financial statements (and
supplementary information) identified in the preceding paragraphs has not been audited,
reviewed, or compiled by us (me) and, accordingly, we (I) do not express an opinion or any other
form of assistance on it.
Are Percentages Presented on Financial Statements Supplementary Information?
Percentages presented in the financial statements (as is commonly the case with computerprepared statements)
generally do not constitute supplementary information for purposes of the reporting requirements of SSARS No. 1
(AR 100). Accordingly, the accountant should not mention the percentages in his report. A related question is
whether the inclusion of percentages implies the accountant has performed analytical procedures, and thus must
report on the financial statements as if it were a SSARS review engagement. In general, presentation of percent
ages do not require the accountant to review the basic financial statements when he is engaged to compile such
statements.
Is a Forecast or Projection Presented with Historical Financial Statements Supplementary Information?
SSARS do not apply to any type of prospective information. The accountant is required to report separately on
prospective information included with historical financial statements. The prospective information must follow the
presentation and disclosure rules of SSAE No. 10, Attestation Standards: Revision and Recodification (AT 301,
Financial Forecasts and Projections). Generally, the accountant must either compile, examine, or apply agreed
upon procedures to the prospective information.
Another exception to this rule occurs for expired forecasts or projections, i.e., presentations that are no longer
prospective in nature because the prospective period has expired. An example would be 20X4 historical financial
statements presented alongside an expired 20X4 budget. Expired prospective information presented for compara
tive purposes meets the definition of supplementary information discussed previously; therefore, SSARS No. 1 (AR
100.60) applies. The level of service on the expired supplementary budget information generally should be limited
to a compilation, even when the historical financial statements are reviewed. This is based on the assumption that
the budget would not have been subjected to the inquiry and analytical procedures, if any, applied to the basic
Supplementary Information Presented without Financial Statements
Since standalone supplementary information will ordinarily not constitute a financial statement, the accountant has
no reporting responsibility under SSARS for such information.
Presentation Guidelines for Supplementary Information
Presentation guidelines for supplementary information are discussed previously in this course.
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SELFSTUDY QUIZ
following section.
32. What is one possible option for an accountant when a scope limitation affects the ability of the accountant to
issue a review report?
a. The accountant can issue a compilation report provided that the scope limitation results from inadequate
accounting records because the accounting records are within the client's control.
b. The accountant can issue a review report provided that the scope limitation is only limited to the
accountant's ability to perform inquiry of client personnel and does not affect the ability to perform
adequate analytical procedures.
c. The accountant can issue a compilation report provided that the scope limitation results from the inability
on the part of the client to provide additional information due to factors beyond the client's control.
d. The accountant can issue a review report if there is a scope limitation as long as the accountant receives
a signed representation letter from management.
33. What is one possible option for an accountant when management requests a compilation or review on a single
financial statement?
a. The accountant may issue a compilation or review report on a single financial statement since this scope
limitation does not prevent the accountant from adhering to the performance standards of a compilation
or review engagement.
b. The accountant may issue a compilation report on a single financial statement, but not on a review report,
since a review report involves a higher level of assurance on all of the basic financial statements.
c. The accountant may not issue a compilation or review report on a single financial statement since this is
considered a scope limitation.
d. The accountant may issue a compilation or review report on a single financial statement since this is
considered a limited reporting engagement, not a scope limitation.
34. Based on guidance from SSARS No.1 and other sources, which of the following items generally would be
considered supplementary information for purposes of a review or compilation engagement?
a. Schedule of SG&A expenses and quarterly income statements for the periods covered in the report.
b. Schedule of cost of goods sold and quarterly balance sheets.
c. Schedule of cost of goods sold and statements of cash flows on a cumulative basis showing the changes
in the cash balance throughout the year.
d. Schedule of SG&A expenses and a schedule of net sales by division.
35. According to SSARS No. 1, how does the accountant's responsibility differ in general when supplementary
information accompanies reviewed versus compiled financial statements?
a. The accountant may review or compile the supplementary information for reviewed financial statements.
b. The accountant is required to review the supplementary information for reviewed financial statements.
c. The accountant must describe his responsibility for the supplementary information in the accountant's
review report.
d. The accountant is required to perform analytical procedures on the supplementary information for the
reviewed financial statements.
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36. When percentages are included in computergenerated financial statements, what is the responsibility of the
accountant in a review or compilation?
a. In a compilation, the accountant should not mention the percentages in the compilation report, but in a
review the percentages are considered analytical procedures and should be mentioned in the review
report.
b. The accountant should not mention the percentages in either the compilation or a review report.
c. In a compilation, use of percentages implies the performance of analytical procedures, and the
compilation report should state that such procedures have not been performed in the compilation report.
The review report should not mention the percentages.
d. The accountant should not mention the percentages in either the compilation or the review report, as long
as substantive testing has been done on the percentages in both types of engagements.
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SELFSTUDY ANSWERS
32. What is one possible option for an accountant when a scope limitation affects the ability of the accountant to
issue a review report? (Page 200)
a. The accountant can issue a compilation report provided that the scope limitation results from inadequate
accounting records because the accounting records are within the client's control. (This answer is
incorrect. When a client imposes a restriction on additional information, SSARS No. 1 requires the
accountant to withdraw from the engagement. The maintenance of accounting records are generally
considered within management's control.)
b. The accountant can issue a review report provided that the scope limitation is only limited to the
accountant's ability to perform inquiry of client personnel and does not affect the ability to perform
adequate analytical procedures. (This answer is incorrect. If an accountant cannot perform inquiry of client
personnel, the review will be incomplete and a report cannot be issued.)
c. The accountant can issue a compilation report provided that the scope limitation results from the
inability on the part of the client to provide additional information due to factors beyond the client's
control. (This answer is correct. In rare circumstances, e.g. accounting records have been
destroyed by natural causes, the accountant may issue a compilation report, but is also required
to provide services to the client to help reconstruct significant transactions prior to compiling the
d. The accountant can issue a review report if there is a scope limitation as long as the accountant receives
a signed representation letter from management. (This answer is incorrect. If an accountant cannot
perform inquiry of client personnel and analytical procedures, the review will be incomplete and a report
cannot be issued, regardless of the presence of a client representation letter.)
33. What is one possible option for an accountant when management requests a compilation or review on a single
financial statement? (Page 203)
a. The accountant may issue a compilation or review report on a single financial statement since this scope
limitation does not prevent the accountant from adhering to the performance standards of a compilation
or review engagement. (This answer is incorrect. Management's request for a report on a single financial
statement, e.g. a balance sheet, is not considered a scope limitation.)
b. The accountant may issue a compilation report on a single financial statement, but not on a review report,
since a review report involves a higher level of assurance on all of the basic financial statements. (This
answer is incorrect. The higher level of assurance required in a review does not prevent a review report
from being issued on a single financial statement.)
c. The accountant may not issue a compilation or review report on a single financial statement since this is
considered a scope limitation. (This answer is incorrect. Management's request for a report on a single
financial statement, e.g. a balance sheet, is not considered a scope limitation.)
d. The accountant may issue a compilation or review report on a single financial statement since this
is considered a limited reporting engagement, not a scope limitation. (This answer is correct.
Management's request for a report on a single financial statement, e.g. a balance sheet, is not
considered a scope limitation.)
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34. Based on guidance from SSARS No.1 and other sources, which of the following items generally would be
considered supplementary information for purposes of a review or compilation engagement? (Page 204)
a. Schedule of SG&A expenses and quarterly income statements for the periods covered in the report. (This
answer is incorrect. Supplementary information does not include multiple income statements. Such items
should be reported on by the accountant.)
b. Schedule of cost of goods sold and quarterly balance sheets. (This answer is incorrect. Supplementary
information does not include balance sheets. Such items should be reported on by the accountant.)
c. Schedule of cost of goods sold and statements of cash flows on a cumulative basis showing the changes
in the cash balance throughout the year. (This answer is incorrect. Supplementary information does not
include multiple statements of cash flows. Such items should be reported on by the accountant.)
d. Schedule of SG&A expenses and a schedule of net sales by division. (This answer is correct. While
not defined in SSARS literature, supplementary information generally parallels the guidance
provided by SAS No. 29 and includes additional details of items in the financial statements, e.g.
SG&A expenses, and consolidating information, e.g. breakdowns of sales by division, as well as
other nonaccounting information.)
35. According to SSARS No. 1, how does the accountant's responsibility differ in general when supplementary
information accompanies reviewed versus compiled financial statements? (Page 205)
a. The accountant may review or compile the supplementary information for reviewed financial
statements. (This answer is correct. In the case of supplementary information accompanying
compiled financial statements, the accountant is only required to compile the information.)
b. The accountant is required to review the supplementary information for reviewed financial statements.
(This answer is incorrect. The accountant is not required to review the supplementary information,
although it is an option pursuant to SSARS No. 1.)
c. The accountant must describe his responsibility for the supplementary information in the accountant's
review report. (This answer is incorrect. The accountant is to disclose his responsibility for the
supplementary information in both a compilation and a review report.)
d. The accountant is required to perform analytical procedures on the supplementary information for the
reviewed financial statements. (This answer is incorrect. Analytical procedures on the supplementary
information are not required, unless the accountant is reviewing the information.)
36. When percentages are included in computergenerated financial statements, what is the responsibility of the
accountant in a review or compilation? (Page 207)
a. In a compilation, the accountant should not mention the percentages in the compilation report, but in a
review the percentages are considered analytical procedures and should be mentioned in the review
report. (This answer is incorrect. The percentages do not imply the performance of analytical procedures
and should not be mentioned in the review report.)
b. The accountant should not mention the percentages in either the compilation or a review report.
(This answer is correct. Inclusion of percentages is not considered supplementary information and
do not imply the performance of analytical procedures; therefore, they should not be mentioned in
either report.)
c. In a compilation, use of percentages implies the performance of analytical procedures, and the
compilation report should state that such procedures have not been performed in the compilation report.
The review report should not mention the percentages. (This answer is incorrect. The percentages do not
imply the performance of analytical procedures; therefore no further disclosure should be made on the
compilation report.)
d. The accountant should not mention the percentages in either the compilation or the review report, as long
as substantive testing has been done on the percentages in both types of engagements. (This answer is
incorrect. Substantive testing is not required on the percentages in either a compilation or review
engagement.)
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REQUIRED SUPPLEMENTARY INFORMATION

SFAS Nos. 19 and 69
SFAS No. 19 (as amended by SFAS No. 25) required oil and gas producing companies to disclose reserve
quantities as supplementary information. SFAS No. 69, Disclosures about Oil and Gas Producing Activities,
amended the above statements and grants relief from disclosure of reserve quantities for nonpublic companies.
Paragraphs 6 and 7 of SFAS No. 69 state
a. All enterprises engaged in oil and gas producing activities shall disclose in their financial statements the
method of accounting for costs incurred in those activities and the manner of disposing of capitalized costs
relating to those activities.
b. In addition, publicly traded enterprises that have significant oil and gas producing activities shall disclose
with complete sets of annual financial statements the information required by paragraphs 1034 of this
Statement. Those disclosures relate to the following and are considered to be supplementary information:
(1) Proved oil and gas reserve quantities.
(2) Capitalized costs relating to oil and gas producing activities.
(3) Cost incurred for property acquisition, exploration, and development activities.
(4) Results of operations for oil and gas producing activities.
(5) A standardized measure of discounted future net cash flows relating to proved oil and gas reserve
quantities.
If a nonpublic company desires to voluntarily disclose the supplementary information in a SSARS engagement, it
is generally recommended that the accountant counsel with his client to limit the level of service to a compilation.
However, if the client requests review assurance on such supplementary information, the accountant should make
inquiries of management and perform analytical procedures [SSARS No. 1 (AR 100.60)]. It is generally recom
mended that the accountant consult SAS No. 56 (AU 329), Analytical Procedures, for examples of inquiries that may
be appropriate.
Common Interest Realty Associations
A common interest realty association (CIRA) is an association of real estate owners that is responsible for providing
certain services and maintaining certain property that all the owners share or own in common. Two examples of
CIRAs are homeowners' associations and condominium associations. The AICPA audit and accounting guide titled
Common Interest Realty Associations (the CIRA Guide) requires that CIRA financial statements include certain
supplementary information related to estimated funding for future repairs and replacements of common property.
Statement of Position 935, Reporting on Required Supplementary Information Accompanying Compiled or
Reviewed Financial Statements of Common Interest Realty Associations amended the CIRA Guide to require that
the accountant at least compile the required supplementary information accompanying compiled or reviewed
financial statements. It also describes the accountant's compilation procedures and provides reporting guidance.
The following paragraphs discuss the SOP in more detail.
Required Supplementary Information. Paragraph 4.33 of the CIRA Guide describes the required supplementary
information that should accompany the basic financial statements as follows:
Estimates of current or future costs of future major repairs and replacements of all existing components,
such as roofs, including estimated amounts required, methods used to determine the costs, the basis for
calculations (including assumptions, if any, about interest and inflation rates), sources used, and the dates
of studies made for this purpose, if any.
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A presentation of components to be repaired and replaced, estimates of the remaining useful lives of those
components, estimates of current or future replacement costs, and amounts of funds accumulated for each
to the extent designated by the board.
Compilation Procedures. Whether the basic financial statements are compiled or reviewed, accountants gener
ally will compile the supplementary information required by the CIRA Guide since such information cannot be
subjected to the inquiry and analytical procedures performed in a review. To compile the required supplementary
information, accountants should
a. Establish an understanding with the client about the services the accountant will provide in connection with
the required supplementary information and how the report will be affected.
b. Consider what supplementary information is required by the CIRA Guide and how it will be presented.
c. Obtain an understanding of how the required supplementary information was developed. Ordinarily, this
understanding will include the following:
(1) The source of the information (e.g., engineering tables, estimates obtained from licensed contractors,
tables in technical manuals on useful lives, etc.)
(2) Whether the required supplementary information is based on current or future replacement costs. (If
based on future replacement costs, also consider the interest and inflation rates used to determine
funding requirements.)
d. Consider whether it will be necessary to perform other accounting services to compile the required
information.
e. Read the required supplementary information and consider whether it appears to be appropriate in form
and free from obvious material error.
If accountants become aware that the required supplementary information is incorrect, incomplete, or otherwise
unsatisfactory, they should obtain additional or revised information from the client. If the client does not provide
such information, accountants must consider whether modification of the report will adequately disclose the
deficiency. If so, they can include additional language in their report. If modification of the standard report is not
considered adequate, however, the accountant should withdraw from the engagement.
Reporting on the Required Supplementary Information. Accountants should indicate in their report the degree
of responsibility they are taking for the supplementary information. An example of an additional paragraph that can
be added to a compilation report follows:
The [Identify the required supplementary information.] on page XX is not a required part of the
basic financial statements but is supplementary information required by the American Institute of
Certified Public Accountants. We (I) have compiled [Identify the required supplementary infor
mation.] from information that is the representation of management of XYZ Association, without
audit or review. Accordingly, we (I) do not express an opinion or any other form of assurance on
the supplementary information.
When accountants become aware that the supplementary information has not been measured or presented in
conformity with the guidelines prescribed in the CIRA Guide, however, their report should describe the nature of any
material departures. The following is an example of a sentence that can be added to the example presented in the
preceding paragraph:
However, we (I) did become aware that the supplementary information about future repairs and
replacements of common property is not presented in conformity with the guidelines established
by the American Institute of Certified Public Accountants because [Describe the material depar
tures from the AICPA guidelines.].
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If the CIRA's compiled or reviewed financial statements omit the required supplementary information, accountants
should add a paragraph such as the following to their compilation or review reports:
The American Institute of Certified Public Accountants has determined that supplementary infor
mation about future major repairs and replacements of common property is required to supple
ment, but not required to be a part of, the basic financial statements. The Association has not
presented this supplementary information.
Accountants are not required to present the supplementary information in their reports.
SOP 935 does not prohibit accountants from reviewing the required supplementary information if engaged to do
so by their clients. It points out, however, that the required supplementary information is not subjected to the inquiry
and analytical procedures applied in a review of the basic financial statements. Therefore, SSARS would not apply.
Instead, the information can be reviewed in accordance with the guidance in Statement on Standards for Attesta
tion Engagements.
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REPORTING ON CHARTS AND GRAPHS

Equipped with computers capable of converting financial information to graphic presentations with the push of a
button, many accountants have traded traditional numerical presentations for bar graphs and pie charts that depict
a wide variety of supplementary information useful to their clients. Common examples include charts or graphs
depicting the following:
Number of days sales in accounts receivable
Sales by product line
Operating expenses by plant
Line of credit usage versus owned inventory
Charts and Graphs That Accompany Financial Statements
In general, when the basic financial statements are accompanied by information in the form of a chart or graph,
such information should be considered supplementary information. Accordingly, accountants should follow the
previous guidance to determine how to report on them. The following are some specific issues that should be
considered:
Accountants should check for consistency if the same information is presented numerically in the basic
financial statements and graphically in supplementary information.
Accountants should consider whether the information is presented in a way that is obviously misleading.
Due to the subjective nature of graphic presentations, accountants will ordinarily elect to report on them
as compiled even when they accompany reviewed financial statements.
Each chart or graph should include a reference to the accountant's report.
Standalone Charts and Graphs
When a chart or graph is presented alone, the accountant should first consider whether the graphic presentation
depicts all of the elements of a financial statement as described in SSARS No. 1 (AR 100). If it does, the accountant
would be required to at least compile the information. Generally, graphic presentations will not be considered
financial statements under SSARS No. 1 and, therefore, SSARS would not apply. Accordingly, accountants ordi
narily will have no reporting responsibility for standalone charts and graphs.
Even though there is no requirement to report on most standalone charts and graphs, some accountants may wish
to include reports indicating the degree of responsibility, if any, they are taking with respect to such presentations.
In that case, the reporting decision should be based on what type of information is presented. For example, a graph
that portrays the sources of working capital for the past three years might be considered a presentation of specified
elements of a financial statement. Another example is a graph depicting net sales, gross margins, and income for
the past five years, which might be considered a presentation of condensed financial information.
In summary, unless the standalone chart or graph constitutes a complete financial statement, the accountant has
no reporting responsibility. Rarely, if ever, would a chart or graph constitute a complete financial statement. The
type of financial information depicted in charts and graphs (that is, whether they are considered specified elements
or condensed financial information) determines how accountants should report if they elect to do so.
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REPORTING ON COMPARATIVE FINANCIAL STATEMENTS

When financial statements of two or more periods are presented in columnar form, the accountant should report on
each period presented. The accountant's report in such a situation is relatively simple to draft if certain changes
have not occurred. However, situations do change, e.g., clients change accountants, clients request different levels
of service, clients change their status as a public or nonpublic entity, additional information regarding previously
issued financial statements becomes available, and new financial reporting standards evolve. Each of these
changes can complicate the accountant's report on comparative financial statements. The following paragraphs
discuss the standard comparative reports and variations necessary because of the changes mentioned previously.
Standard Reports
Provided none of the previously discussed changes take place for any of the periods presented, the accountant's
report on comparative financial statements differs from his single period report solely in the scope paragraph. In the
scope paragraph, each period presented in the comparative financial statements must be identified. The accoun
tant is, as of the date of the current report, updating his reports on the financial statements of prior periods.
The term updated report is defined in SSARS No. 2 (AR 200.07) as
A report issued by a continuing accountant that takes into consideration information that he
becomes aware of during his current engagement and that reexpresses his previous
conclusions or, depending on the circumstances, expresses different conclusions on the financial
statements of a prior period as of the date of his current report.
If, because of additional information now available to him, the accountant cannot reexpress his previous conclu
sions, he should refer to the discussion that follows.
The following is an example of the scope paragraph of a standard compilation report on comparative financial
statements:
I (We) have compiled the accompanying balance sheets of XYZ Company as of December 31,
20X6 and 20X5, and related statements of income, retained earnings, and cash flows for the years
then ended, in accordance with Statements on Standards for Accounting and Review Services
issued by the American Institute of Certified Public Accountants.
The scope paragraph of a standard review report on comparative financial statements is as follows:
I (We) have reviewed the accompanying balance sheets of XYZ Company as of December 31,
20X6 and 20X5, and related statements of income, retained earnings, and cash flows for the years
then ended, in accordance with Statements on Standards for Accounting and Review Services
issued by the American Institute of Certified Public Accountants. All information included in these
financial statements is the representation of the management (owners) of XYZ Company.
Change in Level of Service Current Period Reviewed/Prior Period Compiled
The updating of the prior period report that is required when the level of service is the same for both periods is also
required when the level of service is higher for the current period, i.e., 20X6 reviewed/20X5 compiled. As noted
previously, the term updated report means that the accountant is issuing his report on the prior period as of a new
(updated) date. He must then reconsider his original conclusions based on any new information available.
Because the standard scope paragraph is different for review and compilation reports, the accountant cannot
update his report simply by presenting all periods reported on in the scope paragraph, as is the case when the level
of service is the same for each period. When the accountant provides a higher level of service in the current period,
he should update his report on the prior period by following the last paragraph of his review report on the current
period with his report on the prior period compiled statements.
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The following illustration of the accountant's report on comparative financial statements for two periods when the
financial statements of the current period have been reviewed and those of the prior period have been compiled is
based on SSARS No. 2 (AR 200.10):
I (We) have reviewed the accompanying balance sheet of XYZ Company as of December 31,
20X6, and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with Statements on Standards for Accounting and Review Services issued
by the American Institute of Certified Public Accountants. All information included in these finan
cial statements is the representation of the management (owners) of XYZ Company.
A review consists principally of inquiries of Company personnel and analytical procedures
applied to financial data. It is substantially less in scope than an audit in accordance with
generally accepted auditing standards, the objective of which is the expression of an opinion
regarding the financial statements taken as a whole. Accordingly, I (we) do not express such an
opinion.
Based on my (our) review, I am (we are) not aware of any material modifications that should be
made to the 20X6 financial statements in order for them to be in conformity with generally
The accompanying 20X5 financial statements of XYZ Company were compiled by me (us) in
accordance with Statements on Standards for Accounting and Review Services issued by the
American Institute of Certified Public Accountants. A compilation is limited to presenting in the
form of financial statements information that is the representation of management (owners). I
(We) have not audited or reviewed the 20X5 financial statements and, accordingly, do not express
an opinion or any other form of assurance on them.
Change in Level of Service Current Period Compiled/Prior Period Reviewed
When the level of service for the current year is lower than the prior period, i.e., 20X6 compiled/20X5 reviewed, the
accountant does not need to update his report on the prior period. However, he must (a) refer to his original review
report in his compilation report on the current period, including the original date of the report, and state that he has
not performed any procedures in connection with the review since that date or (b) reissue his review report on the
financial statements of the prior period.
The first alternative (referring in the current period compilation report to the original review report on the prior year)
can be accomplished by adding to the compilation report a paragraph as follows:
The accompanying 20X5 financial statements of XYZ Company were previously reviewed by me
(us) and my (our) report dated March 1, 20X6, stated that I was (we were) not aware of any
material modifications that should be made to those statements in order for them to be in
conformity with generally accepted accounting principles. I (We) have not performed any proce
dures in connection with that review engagement after the date of my (our) report on the 20X5
The second alternative introduces a new term, reissued report. A reissued report is defined in SSARS No. 2 (AR
200.07) as follows:
A report issued subsequent to the date of the original report that bears the same date as the
original report. A reissued report may need to be revised for the effects of specific events; in these
circumstances, the report should be dualdated with the original date and a separate date that
applies to the effects of such events.
The primary difference between a reissued report and an updated report is the date of the report. An updated report
bears a new date; a reissued report bears the original date. An updated report is appropriate when the accountant
has performed sufficient procedures subsequent to the original date to allow him to offer the same level of
assurance at the later date. Thus, an updated compilation report of a prior period can be presented with a review
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report of a current period. The compilation report offers no assurance and thus can be issued at the later date if the
accountant takes into consideration any information that he becomes aware of during his current engagement.
A reissued report is appropriate when a lower level of service is provided in the subsequent period. For example,
when a review report for the prior period is presented in comparative format with current period financial statements
that are compiled, a reissued report is appropriate.
Reissuing the prior period review report can be done by (a) creating one report in which the reissued prior period
report is simply tacked on to the end of the current period compilation report or (b) presenting the two reports
separately. If the two reports are presented separately, care should be taken that reference to both reports is
included in the comparative financial statements.
Change in Level of Service Current Period Audited/Prior Period Compiled or Reviewed
When the current period financial statements are audited and presented with prior period financial statements that
were not audited, SAS are the appropriate authority. SAS No. 26 (AU 504), Association With Financial Statements,
provides guidance for such situations.
Change in Level of Service Current Period Compiled or Reviewed/Prior Period Audited
If current period compiled or reviewed financial statements are presented in comparative form with prior period
audited statements, the accountant's reporting obligation is similar to that required when compiled financial
statements of the current period are presented with reviewed statements of the prior period. Both situations
represent a change to a lower level of service and thus require either (a) reissuance of the prior period report or (b)
reference to the prior period report in a separate paragraph of the current period report.
The second alternative, reference to the prior period report, is generally the most practical and is done by adding
a separate paragraph at the end of the compilation or review report on the current period financial statements.
SSARS No. 2 (AR 200.29) requires that the separate paragraph of the report indicate (a) that the financial state
ments were audited previously, (b) the date of the previous report, (c) the type of opinion expressed previously, (d)
if the opinion was other than unqualified, the substantive reasons therefore, and (e) that no auditing procedures
were performed after the date of the previous report. An example of such a separate paragraph is the following:
The financial statements for the year ended December 31, 20X5, were audited by me (us) (other
accountants) and I (we) (they) expressed an unqualified opinion on them in my (our) (their) report
dated March 1, 20X6, but I (we) (they) have not performed any auditing procedures since that
date.
Change in Level of Service Disclosures Omitted
SSARS No. 2 (AR 200.05) states that financial statements that omit substantially all disclosures, i.e., certain
compiled financial statements, are not comparable to financial statements that include such disclosures. The
standards set forth in SSARS No. 1 (AR 100) allow substantially all disclosures to be omitted only for compiled
financial statements. Thus, comparative financial statements that omit substantially all disclosures can be reported
on by a CPA only when all periods presented have been compiled.
SSARS No. 2 allows an accountant to compile financial statements that omit substantially all disclosures even if the
statements had previously been compiled, reviewed, or audited and did not omit substantially all disclosures. In
such situations, SSARS No. 2 (AR 200.30) and Interpretation No. 1 of SSARS No. 2, Reporting on Financial
Statements that Previously Did Not Omit Substantially All Disclosures," require that the accountant include an
additional paragraph in his compilation report indicating:
For Previously Audited Financial Statements:
a. The nature of the service.
b. The date of the report.
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c. Whether a qualified, adverse, or disclaimer of opinion was expressed.

d. The substantive reasons for the modified audit opinion.
In addition, the accountant should consider emphasizing in his compilation report any continuing uncertainty that
resulted in a previously modified audit report.
For Previously Compiled or Reviewed Financial Statements:
a. The nature of the service.
b. The date of the report.
c. The reasons for any modifications in the report.
d. Whether any paragraphs emphasized a matter regarding the financial statements.
An example of an appropriate report when prior period financial statements that omit substantially all disclosures
have been compiled from previously reviewed financial statements for the same period is as follows:
I (We) have compiled the accompanying balance sheets of XYZ Company as of December 31,
20X6 and 20X5, and the related statements of income, retained earnings, and cash flows for the
years then ended, in accordance with Statements on Standards for Accounting and Review
Services issued by the American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements information that is the
representation of management (owners). I (We) have not audited or reviewed the accompanying
financial statements and, accordingly, do not express an opinion or any other form of assurance
on them.
Management has elected to omit substantially all of the disclosures required by generally
accepted accounting principles. If the omitted disclosures were included in the financial state
ments, they might influence the user's conclusions about the Company's financial position,
results of operations, and cash flows. Accordingly, these financial statements are not designed
for those who are not informed about such matters.
The accompanying 20X5 financial statements were compiled by me (us) from financial state
ments that did not omit substantially all of the disclosures required by generally accepted
accounting principles and that I (we) previously reviewed as indicated in my (our) report dated
March 1, 20X6.
Change of Accountants General
When an accountant is reporting on comparative financial statements of a nonpublic entity that include statements
of a prior period previously reported on by another accountant, he has several options regarding the report on the
prior period financial statements:
a. He can attempt to have the predecessor accountant reissue his report.
b. He can make reference to the predecessor accountant's report in his own report.
c. He can perform a compilation, review, or audit of the prior period financial statements and issue his own
report.
Change of Accountants Predecessor Accountant Reissues His Report
A predecessor accountant is not required to reissue his report when the statements he reported on are included in
comparative financial statements. However, if he does so, he must consider whether his report is still appropriate.
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In making this determination, the predecessor should consider (a) the current form and manner of presentation of
the prior period financial statements, (b) subsequent events not previously known, and (c) changes in the financial
statements that require the addition or deletion of modifications to the standard report.
SSARS No. 2 (AR 200.21) requires a predecessor to perform the following procedures before reissuing his
compilation or review report on the financial statements of a prior period:
a. Read the financial statements of the current period and the successor's report.
b. Compare the prior period financial statements with those previously issued and with those of the current
period.
c. Obtain a letter from the successor that indicates whether he is aware of any matter that, in his opinion, might
have a material effect on the financial statements, including disclosures, reported on by the predecessor.
The predecessor should not refer in his reissued report to this letter or to the report of the successor.
The last procedure requires, in effect, a representation letter from the accountant reporting on the current period
If the predecessor accountant is going to reissue his report, he is obligated to consider any additional information
that he may have become aware of since the date of his previous report. This includes information that he obtains
as a result of the required procedures discussed in the previous paragraph. If the predecessor accountant believes
that the information may materially affect the prior period financial statements or his report on them, he must
a. make inquiries or perform analytical procedures similar to those he would have performed if he had been
aware of such information at the date of his report on the prior period financial statements, and
b. perform any other procedures he considers necessary in the circumstances.
The other procedures, if appropriate, might include discussing the information with the successor accountant and
reviewing his workpapers.
As discussed previously, a reissued report should bear the date of the original report. However, if the prior year
financial statements are changed because of additional information the predecessor obtains, he should ordinarily
dualdate his report. Dualdating is discussed later in this course. SSARS No. 2 (AR 200.23), also requires that the
predecessor accountant obtain a written statement from the former client setting forth the information currently
acquired and its effect on the prior period financial statements and, if applicable, expressing an understanding of
its effect on the predecessor's reissued report.
If the predecessor accountant is unable to complete the procedures required by SSARS No. 2, including proce
dures to follow up on any information that he becomes aware of, he should not reissue his report and may wish to
consult with his attorney.
Change of Accountants Reference Made to Predecessor Accountant's Report
If the current accountant chooses to refer in his report on comparative financial statements to the report of the
predecessor accountant, he should do so by adding one or more paragraphs to his report on the current period
financial statements. SSARS No. 2 (AR 200.17) states that the reference should include
a. A statement that the financial statements of the prior period were compiled or reviewed by another
accountant (other accountants).
b. The date of his (their) report.
c. A description of the standard form of disclaimer or limited assurance, as applicable, included in the report.
d. A description or a quotation of any modifications of the standard report and of any paragraphs emphasizing
a matter regarding the financial statements.
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The Reference to the Predecessor Accountant's Report Should Not Include the Name of the Predecessor
Accountant
SSARS No. 2 (AR 200.18.19) illustrates how reference to the predecessor accountant's report might read when
the predecessor issued a standard report.
a. When the predecessor reviewed the financial statements of the prior period, an example of the last
paragraph of the successor's report is as follows:
The 20X5 financial statements of XYZ Company were reviewed by other accountants
whose report dated March 1, 20X6, stated that they were not aware of any material
modifications that should be made to those statements in order for them to be in
conformity with generally accepted accounting principles.
b. When the predecessor compiled the financial statements of the prior period, an example of the last
paragraph of the successor's report is as follows:
The 20X5 financial statements of XYZ Company were compiled by other accountants
whose report dated February 1, 20X6, stated that they did not express an opinion or any
other form of assurance on those statements.
The following reference may be used when the predecessor issued a modified report:
The 20X5 financial statements of XYZ Company were reviewed by other accountants, whose
report dated March 1, 20X6, stated that they were not aware of any material modifications that
should be made to those statements with the exception of the matter described in the following
paragraph.
A statement of cash flows for the year ended 20X5 has not been presented. Generally accepted
accounting principles require that such a statement be presented when financial statements
purport to present financial position and results of operations.
Change of Accountants Successor Accountant Compiles, Reviews, or Audits Priorperiod Financial
Statements
If the successor accountant decides to compile or review the prior period financial statements, he must do so in
accordance with SSARS No. 1, and his reporting obligation becomes the same as that of a continuing accountant.
If he audits the prior period financial statements, he should refer to auditing literature. In either case, he should
make no reference in his report to the predecessor's previously issued report.
Change of Accountants Reporting Following a Merger or Purchase of an Accounting Firm
When there has been a merger or purchase of a firm, the new firm or purchaser should report as a successor
accountant and apply the guidance in SSARS No. 2 (AR 200.16). Basically, it permits the successor to (a) make
reference to the old or acquired firm's report or (b) assume compilation, review, or audit responsibility for the prior
period financial statements. The new firm or purchaser may also indicate in the report that a merger or purchase
took place if reference is made to the predecessor's report. Footnote 9 of AR 200.17 prohibits naming the
predecessor in the successor's report except in those instances when the predecessor accountant's practice was
acquired by, or merged with, that of the successor accountant.
Change of Accountants Predecessor Accountant Has Ceased Operations
A problem that is becoming more prevalent deals with the effect on a successor accountant's report on compara
tive financial statements when a predecessor accountant, who has compiled or reviewed the client's priorperiod
financial statements, has ceased operations. Section TIS 8900 of the AICPA Technical Practice Aids states that the
answer depends on whether the priorperiod financial statements have been restated.
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If the priorperiod financial statements were compiled or reviewed and have not been restated, the TIS states that
the successor accountant should add a paragraph to the report on the currentyear financial statements that
includes:
a. A statement that the priorperiod financial statements were compiled or reviewed by another accountant
who has ceased operations.
b. The date of the predecessor accountant's report.
c. A description of the standard form of disclaimer or limited assurance, as applicable, included in the report.
d. A description or quotation of any modifications of the standard report and any paragraphs emphasizing
a matter regarding the financial statements.
If the priorperiod financial statements were audited and have not been restated, the successor accountant should
add a paragraph to the report on the currentperiod financial statement that indicates (a) that the priorperiod
financial statements were audited by another accountant who has ceased operations, (b) the date of the predeces
sor auditor's report, (c) the type of opinion issued by the predecessor, (d) if the opinion was other than unqualified,
the substantive reasons therefore, and (e) that no auditing procedures were performed after the date of the
predecessor's report. Reference to the predecessor should not include the name of the predecessor.
If the priorperiod financial statements have been restated, the successor accountant should compile, review, or
audit those financial statements or the restatement adjustment(s) and report accordingly. In addition, the successor
is required to ensure that certain matters are communicated by management to the party responsible for winding
up the affairs of the predecessor accountant.
Change of Accountants What Is the Best Option?
Should the successor (a) attempt to have the previous accountant reissue his report, (b) make reference in his
report to the previous accountant's report, or (c) extend his services to include a compilation, review, or audit of the
prior period financial statements? The following are a few general observations:
a. Reference to the predecessor accountant's report is generally the simplest and least costly approach for
the client.
b. In many cases, the successor accountant may want to reformat the prior period statements. A reformatting
that does not affect caption totals in the previous financial statements, e.g., reordering of the presentation
of items under a major caption or a change to a more descriptive caption, would not prevent the successor
from referring to the predecessor's report. However, a restatement of the prior period financial statements
(such as the correction of a measurement, classification, or disclosure error) would require that:
(1) the predecessor accountant reissue his or her report,
(2) the successor accountant report on the financial statements for both years, or
(3) the successor accountant report on the restatement adjustment.
Reference to the previous report would not be acceptable in the first two options. Reference to the previous
report with modification would be appropriate if the third option is chosen. All three options would require
additional compilation or review procedures. Generally, the procedures required for the successor
accountant to report on the financial statements for both years would be the most costly option. And the
procedures required for the successor accountant to report on the restatement adjustment would generally
be the least costly of the three options.
c. There can, however, be some practical problems in working with a predecessor accountant. Who does the
predecessor accountant bill: the successor accountant or a client who perhaps fired him earlier? How are
differences in professional judgment resolved, e.g., what happens if the successor accountant thinks the
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prior period financial statements should be restated and the predecessor disagrees? Also note that review
of the successor accountant's workpapers by the predecessor is suggested by SSARS No. 2 in certain
situations and that a written representation from the successor accountant must be obtained by a
predecessor who reissues his report.
Change of Status Public to Nonpublic Entity
If the current status of the entity is nonpublic, the accountant should follow the guidance provided by SSARS, even
if the entity was a public entity for the prior periods presented. If the prior period statements were for a public entity,
they were either audited statements or unaudited in accordance with the provisions of SAS No. 26 (AU 504). If they
were audited, the accountant should refer to the previous discussion. If the prior period statements were unaudited
in accordance with SAS No. 26, the accountant should comply with the compilation or review standards in SSARS
No. 1 and report accordingly.
Although the term current status is not defined in SSARS literature, in general it means the status of the entity at the
balance sheet date. Thus, the status at the end of the current period is controlling regardless of the status during the
current period. For example, an entity that goes public on June 30, 20X5, is considered a public entity with regard
to financial statements for the year ended December 31, 20X5.
Change of Status Nonpublic to Public Entity
SSARS No. 2 (AR 200) is not the appropriate source of guidance for comparative financial statements when the
status of the entity is public as of the current balance sheet date. If the entity is public on the balance sheet date of
the current period, it is inappropriate to reissue or make reference to the accountant's prior period compilation or
review report in the report on the financial statements of the current period. Thus, the accountant must issue a new
report on the prior period financial statements in accordance with SASs.
Change in Priorperiod Financial Statements General
In the process of compiling or reviewing financial statements for the current period, an accountant may determine
that, in his judgment, the prior period financial statements should be restated. The accountant could arrive at this
determination because of mathematical or clerical errors, misapplication of GAAP (including inadequate disclo
sures), or because of facts existing at the date of the accountant's report on the prior period that he becomes aware
of during his current engagement.
Change in Priorperiod Financial Statements Continuing Accountant
If the accountant is a continuing accountant, he should restate the financial statements and/or alter his report. If the
accountant is reissuing his prior period report, i.e., level of service was higher for the prior period than for the current
period, the accountant generally should dual date his report as discussed later in this course. If the level of service
is the same or higher in the current period, the report on the prior period should be updated, i.e., use the same date
as for the report on the current period.
Regardless of a change in level of service, when a reference to a departure from GAAP in the continuing accoun
tant's original report on the prior period financial statements is changed, SSARS No. 2 (AR 200.14) requires that the
reissued or updated report include a separate explanatory paragraph indicating
a. The date of the accountant's previous report.
b. The circumstances or events that caused the reference to be changed.
c. When applicable, that the financial statements of the prior period have been changed.
The following is an example of an explanatory paragraph that is appropriate when an accountant's report contains
a changed reference to a departure from GAAP:
In my (our) previous (compilation) (review) report dated March 1, 20X6, on the 20X5 financial
statements, I (we) referred to a departure from generally accepted accounting principles because
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the Company carried its land at appraised values. However, as disclosed in Note X, the Company
has restated its 20X5 financial statements to reflect its land at cost in accordance with generally
Restated Priorperiod Financial Statements Successor Accountant
If the current period accountant is not a continuing accountant (i.e., the prior period was reported on by a
predecessor and the financial statements of the prior period have been restated), SSARS No. 2 (AR 200.25)
requires that
a. the predecessor accountant reissue his or her report,
b. the successor accountant report on the financial statements for both years, or
c. the successor accountant report on the restatement adjustment.
If the predecessor accepts the reporting obligation and reissues his report on the restated financial statements, he
should perform the procedures discussed in paragraph of this Guide. SSARS No. 2 (AR 200.23) also indicates that,
in those circumstances, the predecessor should dualdate his report. If the successor is to report on the restated
financial statements, he must perform a compilation or review in accordance with SSARS No. 1 or perform an audit
in accordance with the auditing standards that relate to restated financial statements. A successor's report on
restated prior period financial statements should not refer to the predecessor's previously issued report.
SSARS No. 2, as amended by SSARS No. 12, allows the additional option of having the successor accountant
report on the restatement adjustment only. In these reporting situations, the successor accountant should indicate
in the first paragraph of his or her compilation or review report that a predecessor accountant reported on the
financial statements of the prior period before restatement.
Obviously, the successor must weigh the advantages and disadvantages of each of the options before determining
whether to attempt to have the predecessor reissue his report or to expand his engagement to include services with
respect to the prior period financial statements.
Dual Dating
SSARS No. 2 (AR 200.07) states that a reissued report may need to be revised for the effect of specific events but
provides no guidance regarding which events require revision. Accounting and auditing literature, however, indi
cate that the following circumstances generally require revision of a previously issued report or a modification of the
financial statements of the prior period:
a. The correction of an error in previously issued financial statements. The correction of an error includes a
change from an accounting principle that is not generally accepted to one that is.
b. A material Type I" subsequent event that occurs between the original issuance of the accountant's report
and the reissuance of the financial statements. SAS No. 1 at AU 560 identifies Type I" and Type II"
subsequent events. Type I" events are those that provide additional evidence about conditions that existed
at the date of the balance sheet and, if material, require adjustment of the financial statements. For example,
the bankruptcy of a major customer after the balance sheet date and the resulting uncollectibility of an
account receivable would usually require adjustment of the financial statements before their issuance.
Such events do not require financial statement disclosure simply because of their occurrence. However,
other GAAP requirements may require the event to be disclosed. Type II" subsequent events relate to
conditions that did not exist at the balance sheet date being reported on and, accordingly, do not result
in adjustments to the financial statements, e.g., the sale of a bond or capital stock issue, the purchase of
a business, or the loss of plant or inventories as a result of fire or flood. Type II" subsequent events require
financial statement disclosures. Note, however, that SAS No. 1 at AU 560.08 states that financial statements
should not be adjusted for events occurring between the original issuance and the reissuance of the
financial statements unless the adjustment meets the criteria for the correction of an error or prior period
adjustments. However, the events may require disclosure in the reissued financial statements to keep them
from being misleading.
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c. The change to an accounting principle (including a change necessitated by the issuance of a new
authoritative accounting pronouncement) that requires retroactive application, e.g., a change from the
completedcontract method to the percentageofcompletion method of accounting for longterm
construction contracts.
d. Other prior period adjustments meeting the criteria in SFAS No. 16.
In most circumstances, if prior period financial statements are restated or the predecessor accountant revises his
report, he should dualdate his reissued report for the event, transaction, or circumstance that caused the change.
For example, if a material Type I" subsequent event occurs between the original issuance and the reissuance of the
financial statements, the event should be disclosed in the financial statements. In such circumstances, the prede
cessor accountant's report ordinarily is dated as follows: March 1, 20X6 [the original report date], except for Note
X, as to which the date is April 1, 20X6 [the date of the subsequent event]. The predecessor accountant also would
dualdate his report if the prior period financial statements are adjusted for the correction of an error or other prior
period adjustments. In those circumstances, the adjustment to the financial statements would be discussed in a
note to the financial statements, and the predecessor accountant's report would be dualdated with respect to the
note.
SAS No. 1 at AU 530.08 permits one exception to this dualdating rule. If the financial statements are changed
because of the occurrence of a subsequent event that requires disclosure only, the event may be disclosed in a
separate note to the financial statements captioned Event Subsequent to the Date of the Accountant's Report"
(Unaudited). In the case of a reissued report, such an event would be either (a) a Type I" subsequent event that
occurs between the original issuance and the reissuance of the financial statements and, therefore, is only
disclosed as explained previously or (b) a Type II" subsequent event. However, this approach is appropriate only
if financial statements and an accountant's report are reissued separately (that is, not as part of comparative
financial statements). If reissuance occurs as part of comparative financial statements, the event is covered in the
current period financial statements, and a subsequent event caption seems inappropriate. Under either approach,
the predecessor accountant's report would be dated the same as the original report.
Clientprepared Financial Statements
Guidance for reporting on comparative financial statements when one period contains a clientprepared financial
statement is found in SSARS No. 2 (AR 200.03), which is reproduced here.
Clientprepared financial statements of some periods that have not been audited, reviewed, or
compiled may be presented on separate pages of a document that also contains financial
statements of other periods on which the accountant has reported if they are accompanied by an
indication by the client that the accountant has not audited, reviewed, or compiled those financial
statements and that the accountant assumes no responsibility for them. Whenever the
accountant becomes aware that financial statements of other periods that have not been audited,
reviewed, or compiled have been presented in columnar form in a document with financial
statements on which he has reported and that his name has been used or his report included in
the document, he should advise his client that the use of his name or report is inappropriate and
should consider what other actions might be appropriate, including consultation with his attorney.
The following paragraphs discuss several reporting issues in relation to this guidance.
Clientprepared Financial Statements Bound in the Accountant's Report Cover. SSARS No. 2, AR 200.03, also
applies when an accountant binds clientprepared financial statements in a report that also contains compiled or
reviewed financial statements of a prior period. In that situation, an accountant is not generally required to compile
the clientprepared financial statements. Instead, the practitioner may indicate in the report that he or she has not
audited, reviewed, or compiled the financial statements and that he or she does not assume any responsibility for
them.
Clientprepared Financial Statements Attached by the Client. Once the accountant delivers his report on
compiled or reviewed financial statements, in reality, he has little control over or awareness of the client's subse
quent actions. However, situations will occur when the accountant becomes aware that the financial statements will
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be combined with clientprepared financial statements into a new document. As noted previously, a file folder that
contained loose copies of clientprepared financial statements and the separately bound compiled or reviewed
financial statement in the accountant's report jacket is generally not considered to be a new document. Rather, the
guidance in SSARS No. 2 (AR 200.03) refers to new documents that bind together" compiled/reviewed financial
statements with clientprepared financial statements, e.g., a bound loan proposal package. When the accountant
becomes aware that such a new document" will be created by the client, the logic in SSARS No. 2 (AR 200.03)
should be followed:
a. If the accountant's name is in no way mentioned in the new clientprepared document, the accountant has
no other responsibility. In other words, the compiled or reviewed financial statements have been retyped
by the client on plain paper, the accountant's report has been removed, and no reference is made about
the accountant in the document.
b. If the accountant's name is mentioned in the new client document, then a distinction must be made
regarding whether clientprepared financial statements are presented on a separate page from, or typed
alongside (parallel to), the compiled/reviewed financial statements.
(1) If the clientprepared financial statement is presented on a separate page, the accountant should
request that the client add a disclaimer.
(2) If the clientprepared financial statement is presented alongside the compiled/reviewed financial
statement, the accountant should advise the client to (a) remove all mention of the accountant's name
from the document, (b) move the clientprepared statement to a separate page and add a disclaimer,
or (c) have the accountant also compile or review the clientprepared statement. If the client refuses
any of these alternatives, the accountant should consult his attorney.
The Client's Disclaimer. As noted in the preceding paragraph, if a clientprepared document mentions the
accountant's name in any manner, SSARS No. 2 (AR 200.03) says any clientprepared financial statements in such
document must (a) be presented on a page separate from compiled or reviewed financial statements and (b)
contain a disclaimer. Note SSARS No. 2 (AR 200.03) says that the client makes the disclaimer. In general, the
client's disclaimer should be presented on a page immediately preceding the clientprepared financial statements
or on the face of such statements. Although not mandatory, an officer of the company could sign the disclaimer.
Such a disclaimer might read as follows:
The 20X5 financial statements have been prepared solely by the staff of XYZ Company and have
not been audited, reviewed, or compiled by the accounting firm of Jones and Morrison. Further
more, Jones and Morrison assume no responsibility for the 20X5 financial statements.
Larry Adams
Controller XYZ Company
When the accountant is clearly aware that the client intends to attach clientprepared financial statements to the
document submitted by the accountant, he may add the following disclaimer to his report before it is delivered to
the client.
All other information that may be included with (or attached to) the financial statements (and
supplementary information) identified in the preceding paragraphs has not been audited,
reviewed, or compiled by us (me) and, accordingly, we (I) assume no responsibility for it.
Flowchart of SSARS No. 2
The decision flowchart in Exhibit 21 summarizes the major features of SSARS No. 2 (AR 200). The footnote
references in the flowchart are to SSARS No. 2.
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Exhibit 21
Flowchart of SSARS No. 2 (AR 200)
COMPARATIVE
20X6, 20X5
SEE AUDITING
LITERATURE
SAS NO. 58
YES
ARE
20X6, 20X5
BOTH AUDITED?
NO
SEE AUDITING
LITERATURE
SAS NO. 26
IS
20X6 AUDITED
OR A PUBLIC
COMPANY?
YES
NO
CONTINUING
IS
20X6 LEVEL
OF SERVICE
20X5?
TYPE OF
ACCOUNTANT
PREDECESSOR
OR
SUCCESSOR
UPDATE
YES
ANY
ERRORS IN
20X5?
SSARS NO. 2
8 to 10
REFER
NO,
MOST COMMON
20X6<20X5
YOU HAVE
A CHOICE
IS
PREDECESSOR
TO CORRECT AND
REISSUE?
NO
NO
SSARS NO. 2
11, 12, 29
SSARS NO. 2
16 to 19, 29
YESa
NO
IS
PREDECESSOR
TO REISSUE?
REISSUE
SSARS NO. 2
8 & 29
SSARS NO. 2
20 to 24
YES
YES
SUCCESSOR
COMPILES OR
REVIEWS 20X5
OR THE
RESTATEMENT
ADJUSTMENT(S)
SSARS NO. 2
16 & 25 to 27
Note:
a
SSARS No. 4 (AR 400.10) requires the successor to request the client to notify the predecessor when the
successor believes that the priorperiod financial statements need to be restated.
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REPORTING ON ACCOUNTING CHANGES

SFAS No. 154, Accounting Changes and Error Corrections, defines an accounting change as one of the following:
Change in accounting estimate.
Change in reporting entity.
Change in accounting principle.
Change in Accounting Estimate
A change in accounting estimate results from additional information or new developments and does not require
prior period adjustment. Examples of accounting estimates that periodically change are allowances for bad debts,
useful lives of depreciable assets, and estimated annual tax rates. The effect of changes in estimates should be
reported in the period of the change and subsequent periods. Restatement of prior periods is not appropriate.
Disclosure of a change in an accounting estimate is necessary if the change affects several future periods, such as
a change in the useful lives of depreciable assets, or if the effect of the change is material.
SFAS No. 154 requires a change in the method of depreciation, amortization, or depletion for longlived nonfinan
cial assets to be accounted for as a change in accounting estimate effected by a change in accounting principle.
Those changes are considered changes in estimates for purposes of applying SFAS No. 154.
If the disclosure described previously is not included in the financial statements, accountants must modify their
compilation or review reports for a change in accounting estimate. Otherwise, modification of the report is unneces
sary.
Change in Reporting Entity
A change in reporting entity refers to a change that results in financial statements that are, in effect, the statements
of a different reporting entity. Typically, such changes are limited to changes in the companies or subsidiaries that
are included in combined or consolidated financial statements. A change in the legal form of business, e.g., sole
proprietorship to corporation, is not a change in reporting entity according to SFAS No. 154. When an accounting
change results in financial statements that are effectively the statements of a different reporting entity, the change
should be retrospectively applied to the financial statements of all prior periods presented. The financial statements
of the period of change shall describe the nature of the change and the reason for it. In addition, SFAS No. 154
requires disclosure of the effect of the change on income before extraordinary items, net income, and other
comprehensive income for all periods presented.
A change in reporting entity would not cause accountants to modify their compilation or review reports, unless the
necessary disclosures described in the preceding paragraph are not included in the financial statements.
Change in Accounting Principle
A change in accounting principle is generally defined as a change from one acceptable accounting principle to
another or a change in the method of applying an acceptable accounting principle. An example of changes in
accounting principle would be a change in the method of pricing inventories (e.g., FIFO to LIFO). A change from an
unacceptable method to an acceptable method is a correction of an error and not a change in accounting principle
as defined by SFAS No. 154.
Accounting for a Change in Accounting Principle. SFAS No. 154 establishes standards for accounting for and
reporting of a change in accounting principle. It applies to all voluntary changes in accounting principle as well as
to changes required by an accounting pronouncement when that pronouncement does not include explicit transi
tion provisions. If a pronouncement includes explicit transition provisions, those provisions should be applied.
According to SFAS No. 154, a change in accounting principle should be reported by retrospective application of
the new principle to the financial statements of all prior periods, unless it is impracticable to determine either the
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periodspecific effects or the cumulative effect of the change. Retrospective application is the application of a
different accounting principle to previous accounting periods as if it had always been used. The following steps are
required to retrospectively apply a new accounting principle:
a. Determine the cumulative effect of the change to the new accounting principle on periods before the
periods presented. Apply the cumulative effect of the change to the carrying amounts of assets and
liabilities as of the beginning of the first period presented.
b. If necessary, record an offsetting adjustment to the opening retained earnings balance for that period.
c. Adjust the financial statements for each individual prior period presented to reflect the periodspecific
effects of applying the new accounting principle.
If the cumulative effect of applying the change to all prior periods can be determined, but it is impracticable to
determine the periodspecific effects of the change on all prior periods presented, the cumulative effect of the
change should be applied to the balances of assets and liabilities as of the beginning of the earliest period to which
the new principle can be applied. In those situations, an offsetting adjustment to the opening retained earnings
balance for that period may be necessary. If it is impracticable to determine the cumulative effect of applying a
change in accounting principle to all prior periods, the new principle should be applied as if it were adopted
prospectively from the earliest date practicable.
When applying a new accounting principle retrospectively, an entity should include only the direct effects of the
change and the related income tax effects, if any. The retrospective application should not include any indirect
effects that would have been recognized if the new principle had been used in previous periods. Indirect effects of
the change that are actually incurred and recognized should be reported in the period the change is made. An
example of an indirect effect is a change in a nondiscretionary profitsharing contribution that is based on net
income.
Accounting Change Prescribed by New Pronouncements. Almost all recent FASB pronouncements require or
permit retroactive application when new accounting principles prescribed by them are adopted. AICPA audit and
accounting guides also might prescribe the manner of reporting a change in accounting principle.
Justification for a Change in Accounting Principle. A company should not change an accounting principle
unless the proposed principle also is in conformity with generally accepted accounting principles, and manage
ment believes that the new principle is preferable in the circumstances. SFAS No. 154 requires that the nature of a
change in accounting principle, management's justification for the change, and the effect of the change in account
ing principle be disclosed in the financial statements of the period in which the change is made.
Reporting on a Change in Accounting Principle. Accountants are not required to modify their compilation and
review reports provided the change is properly accounted for and adequately disclosed in the financial statements.
(That differs from the guidance for auditors discussed in SAS No. 58. That SAS requires auditors to add a
paragraph to their report when accounting principles have not been consistently applied from one period to the
next. Thus, auditors are required to add an explanatory paragraph to their report to highlight a change in account
ing principle.)
Although not required by SSARS, accountants may add an explanatory paragraph to their report if they wish. If
accountants choose to add a paragraph to their report highlighting the change in accounting principle, the
following language might be used:
As discussed in Note X, in 20XX the Company changed its method of pricing inventories from the
firstin, firstout method to the lastin, firstout method.
If the change in accounting principle is not properly accounted for, management does not have reasonable
justification for the change, or appropriate disclosures are not included in the financial statements, accountants
should modify their compilation or review reports because of a GAAP departure.
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SELFSTUDY QUIZ
following section.
37. Why might an accountant decide to compile, rather than review, the required supplementary information for
the financial statements of a homeowners' association?
a. Because such information cannot be subjected to the inquiry and analytical procedures performed in a
review of the basic financial statements.
b. Because compiling such information eliminates further disclosure requirements in the compilation report.
c. The accountant does not have a choice in a review engagement. If the financial statements are reviewed,
the required supplementary information must be reviewed.
d. Because compiling such information reduces potential liability exposure when reporting on required
38. When an accountant is reporting on comparative financial statements and the level of service is higher for the
current period, e.g. current period reviewed/prior period compiled, what is the accountant's responsibility with
respect to the prior period's report?
a. The prior period's report should refer to the original compilation report in the review report of the current
period.
b. The prior period's report should be reissued.
c. The prior period's financial statements should be reviewed and the prior period's report should be
updated.
d. The prior period's report should be updated.
39. What is one of an accountant's reporting options when financial statements in the current period are reviewed
and financial statements in the prior period have been audited?
a. Update the prior period's audit report to reflect the lower level of service in this year's review report.
b. Reissue the prior period's audit report by reflecting the current year's date on the reissued audit report.
c. Make reference to the prior period's audit report in a separate paragraph of this year's review report.
d. Update the prior period's audit report by reflecting the current year's date on the updated audit report.
40. If a current accountant chooses to make reference to a predecessor accountant's report in the current period
accountant's report, what are two of the elements should be included?
a. The date of the previous report and a description of any modifications of the standard report made by the
predecessor accountant.
b. A statement that the financial statements of the prior period were compiled or reviewed by another
accountant, whose name should be disclosed, and the date of the previous report.
c. A description of the standard form of disclaimer or limited assurance included in the report and the date
of the updated report of the predecessor.
d. A description of the standard form of disclaimer or limited assurance included in the report and reference
to the reissued report of the predecessor accountant.
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41. Which of the following would be considered general accounting changes as defined by SFAS No. 154?
a. Change in accounting principle, reporting entity and basis of accounting.
b. Change in accounting estimate, reporting entity and method of inventory valuation.
c. Change in accounting estimate, accounting principle and reporting entity.
d. Change in accounting principle, accounting estimate and presentation of basic financial statements.
42. What is one difference in the reporting requirements for a change in accounting principle for financial
statements that have been reviewed or compiled versus those that have been audited?
a. Auditors must disclose the nature of the change in accounting principle in the financial statements of the
period in which the change is made.
b. Auditors must apply any change in accounting principle retrospectively to the financial statements of all
prior periods.
c. Auditors must add a paragraph to their report when accounting principles have not been consistently
applied from one period to the next.
d. Auditors must include the indirect effects of the change in accounting principle in the financial statements
of all prior periods.
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SELFSTUDY ANSWERS
37. Why might an accountant decide to compile, rather than review, the required supplementary information after
reviewing the basic financial statements of a homeowners' association? (Page 214)
a. Because such information cannot be subjected to the inquiry and analytical procedures performed
in a review of the basic financial statements. (This answer is correct. The required supplementary
information in a review engagement of a homeowners' association is not subjected to inquiry and
analytical procedures performed in a review of the basic financial statements. Therefore,
accountants generally choose to compile such information.)
b. Because compiling such information eliminates further disclosure requirements in the compilation report.
(This answer is incorrect. Even if compiled, the accountant must make a reference in the compilation report
to the degree of responsibility taken for such information.)
c. The accountant does not have a choice in a review engagement. If the financial statements are reviewed,
the required supplementary information must be reviewed. (This answer is incorrect. If the basic financial
statements are reviewed, the accountant may choose to compile or review the required supplementary
information.)
d. Because compiling such information reduces potential liability exposure when reporting on required
supplementary information. (This answer is incorrect. In fact, based on experience, compiled financial
statements result in greater claims for negligence because third party users do not understand the
limitations of compilation engagements.)
38. When an accountant is reporting on comparative financial statements and the level of service is higher for the
current period, e.g. current period reviewed/prior period compiled, what is the accountant's responsibility with
respect to the prior period's report? (Page 217)
a. The prior period's report should refer to the original compilation report in the review report of the current
period. (This answer is incorrect. This is an option when the level of service is lower than the prior period,
e.g. current period compiled/prior period reviewed.)
b. The prior period's report should be reissued. (This answer is incorrect. This is an option when the level of
service is lower than the prior period, e.g. current period compiled/prior period reviewed.)
c. The prior period's financial statements should be reviewed and the prior period's report should be
updated. (This answer is incorrect. The prior period's financial statements do not have to be reviewed. The
prior period's report simply needs to be updated as defined by SSARS No. 2.)
d. The prior period's report should be updated. (This answer is correct. The responsibility is the same
as when the level of service has not changed from the previous year. SSARS No. 2 defines the term
updated report.")
39. What is one of an accountant's reporting options when financial statements in the current period are reviewed
and financial statements in the prior period have been audited? (Page 219)
a. Update the prior period's audit report to reflect the lower level of service in this year's review report. (This
answer is incorrect. Updating the prior period's report is necessary when the level of service increases from
the previous year.)
b. Reissue the prior period's audit report by reflecting the current year's date on the reissued audit report.
(This answer is incorrect. While reissuing the prior period's audit report is an option, the date of the report
would be the original date of the report, not the current date.)
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c. Make reference to the prior period's audit report in a separate paragraph of this year's review report.
(This answer is correct. The other option is to reissue the prior period's audit report. A reissued audit
report is defined in SSARS No. 2.)
d. Update the prior period's audit report by reflecting the current year's date on the updated audit report. (This
answer is incorrect. Updating the prior period's report is necessary when the level of service increases from
the previous year.)
40. If a current accountant chooses to make reference to a predecessor accountant's report in the current period
accountant's report, what are two of the elements that should be included? (Page 221)
a. The date of the previous report and a description of any modifications of the standard report made
by the predecessor accountant. (This answer is correct. SSARS No. 2 also requires a statement that
the financial statements of the prior period were compiled or reviewed by another accountant and
a description of the standard form of disclaimer or limited assurance included in the report.)
b. A statement that the financial statements of the prior period were compiled or reviewed by another
accountant, whose name should be disclosed, and the date of the previous report. (This answer is
incorrect. The name of the predecessor accountant should not be disclosed.)
c. A description of the standard form of disclaimer or limited assurance included in the report and the date
of the updated report of the predecessor. (This answer is incorrect. Updating the report of the predecessor
is not an option available to the current accountant.)
d. A description of the standard form of disclaimer or limited assurance included in the report and reference
to the reissued report of the predecessor accountant. (This answer is incorrect. If the current accountant
chooses to make reference to the predecessor accountant's report, a reissuance of such report is not
required.)
41. Which of the following would be considered general accounting changes as defined by SFAS No. 154?
(Page 229)
a. Change in accounting principle, reporting entity and basis of accounting. (This answer is incorrect. A
change in the basis of accounting, as long as both the previous basis and new basis are acceptable, is
a specific example of a change in accounting principle. A change from an unacceptable basis of
accounting to an acceptable basis is a correction of an error.)
b. Change in accounting estimate, reporting entity and method of inventory valuation. (This answer is
incorrect. A change in method of inventory valuation, as long as the previous method and new method are
acceptable, is a specific example of a change in accounting principle. A change from an unacceptable
method of valuation to an acceptable method is a correction of an error.)
c. Change in accounting estimate, accounting principle and reporting entity. (This answer is correct.
These are all accounting changes as defined by SFAS No. 154, Accounting Changes and Error
Corrections.)
d. Change in accounting principle, accounting estimate and presentation of basic financial statements. (This
answer is incorrect. A change in the presentation of basic financial statements is not an accounting change
as defined in SFAS No. 154.)
42. What is one difference in the reporting requirements for a change in accounting principle for financial
statements that have been reviewed or compiled versus those that have been audited? (Page 230)
a. Auditors must disclose the nature of the change in accounting principle in the financial statements of the
period in which the change is made. (This answer is incorrect. Disclosing the nature of the change in
accounting principle in the financial statements of the period in which the change is made is required for
accountants performing compilations and reviews as well.)
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b. Auditors must apply any change in accounting principle retrospectively to the financial statements of all
prior periods. (This answer is incorrect. Applying any change in accounting principle retrospectively to the
financial statements of all prior periods is required for accountants performing compilations and reviews
as well.)
c. Auditors must add a paragraph to their report when accounting principles have not been
consistently applied from one period to the next. (This answer is correct. Accountants are not
required to modify their compilation or review reports, as auditors are their reports, as long as the
change is properly accounted for and adequately disclosed in the financial statements.)
d. Auditors must include the indirect effects of the change in accounting principle in the financial statements
of all prior periods. (This answer is incorrect. In compilations, reviews, and audits, indirect effects of the
change in accounting principle should only be reflected in the period the change is made.)
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CART07

CARTG072 Preparing Financial Statements for Compilations and Reviews
Test Instructions
be misinterpreted.
courses). In order to receive the discounted fee, all courses must be submitted for grading at the same time.
7.
P.O. Box 966
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1. What is the most likely reason an accountant may want to include the level of service performed in the title page
of reviewed or compiled financial statements?
a. To ensure that the title page corresponds to the information presented in the accountant's report.
b. To conform to the accustomed method of presentation as recommended by SSARS No. 1.
c. To indicate when different levels of service are performed in comparative financial statements.
d. To indicate the level of service when only one financial statement is presented.
2. HST, a local CPA, has reviewed all of the basic financial statements for IMO Co. for the last two fiscal years. IMO
has a fiscal year end of September 30. What is the most appropriate presentation of the date or period covered
on the title page to the financial statements?
a. September 30, 2006 and 2005.
b. Years Ended September 30, 2006 and 2005.
c. September 30, 2006.
d. Year ended September 30, 2006.
3. For a compilation, which of the following is required by SSARS No. 1?
a. If financial statements are accompanied by notes, each page of the financial statements must include a
reference that states,"See accompanying notes and accountant's compilation report."
b. Each page of managementuseonly financial statements must include a reference that restricts the use
of such statements to management.
c. Each page of the notes to the financial statements must include a reference to the accountant's compilation
report.
d. The accountant must address the accountant's report to the client's board of directors or shareholders.
4. HST, a local CPA, has compiled the basic financial statements for IMO Co., and will include selected information
in the compilation report in lieu of all the notes to the financial statements. What is the required disclosure under
SSARS No. 1 in this situation?
a. The financial statements should include a reference to the selected information and the accountant's
report.
b. The accountant's report should include an additional paragraph referencing the selected information.
c. The title of the financial statements must reflect the inclusion of the selected information.
d. A separate title page should be included after the basic financial statements, but before the selected
information, which explains the omission of some of the notes to the financial statements.
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5. According to SFAS No. 95, when is a statement of cash flows for compiled or reviewed financial statements
required?
a. If comparative statements are presented, a statement of cash flows should be presented for at least the
current period.
b. If comparative statements are presented, a statement of cash flows should be presented for each period
for which a statement of financial position is presented.
c. If the financial statements are reviewed, a statement of cash flows should be presented for each period for
which a statement of income is presented. If the financial statements are compiled, a statement of cash
flows is optional since the accountant is expressing no assurance on the financial statements.
d. If comparative statements are presented, a statement of cash flows should be presented for each period
for which a statement of income is presented.
6. ABC Co. bought a 120month certificate of deposit in 2006 at a local bank earning 6% interest with an early
withdrawal penalty of 10%. How would this CD most likely be classified under SFAS No. 95?
a. Cash, because the CD is being held at a local bank and is only earning 6%.
b. Cash equivalent, because the 10% penalty is material to the face value of the CD.
c. Investment, because the maturity date of the CD is in 2016.
d. Cash equivalent, because the 10% penalty is not material to the face value of the CD and the maturity of
the CD is less than 30 years from purchase.
7. Which of the following is a requirement of SFAS No. 95 in the preparation of the statement of cash flows?
a. Cash flows from investing and financing activities should be reported on a net basis.
b. Cash flow statements should be organized in the following manner: cash flow from operating activities,
cash flow from investing activities, and cash flow from financing activities.
c. Cash flow statements should report the net change in cash during the period presented and reconcile the
net change in cash from the beginning balance to the ending balance.
d. Cash flow statements should be titled, "Statement of Cash Flows."
8. HRC Inc. borrows $5 million from First National Bank to invest in a new plant for its manufacturing operation.
How would this cash flow be classified in a statement of cash flows?
a. Noncash investing activities.
b. Cash flow from operating activities.
c. Cash flow from investing activities.
d. Cash flow from financing activities.
9. Why do most companies choose to use the indirect method, as opposed to the direct method, when presenting
cash flows from operations?
a. SFAS No. 95 encourages use of the indirect method.
b. The indirect method is easier to understand because it shows gross cash receipts and payments from
operating activities.
c. The indirect method allows cash flow from operations to be illustrated in a separate schedule.
d. The indirect method is easier and less expensive to implement.
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10. GWB Co. invests $50,000 in 1,000 shares of stock in TXW because the dividend will help supplement the
company's cash flow and pay for some financing costs associated with its longterm debt. How will the
dividends received from TXW be classified in a statement of cash flows?
a. Noncash investing activities.
b. Cash flow from operating activities.
c. Cash flow from investing activities.
d. Cash flow from financing activities.
11. How should a provision for bad debts be presented in the statement of cash flows?
a. As a separate adjustment to net income in arriving at cash flows from operating activities.
b. As a noncash investing activity and disclosed in a separate schedule at the bottom of the cash flow
statement.
c. If using the direct method, as an adjustment to reconcile net income to net cash provided by operating
activities.
d. As a separate adjustment to net income in arriving at cash flows from financing activities.
12. JFN Co. acquires LBP Co. for $2 million in cash and the assumption of $1 million in longterm liabilities. How
should this transaction be reflected in the statement of cash flows?
a. The $2 million should be reflected on a gross basis as cash flows from investing activities, and the
assumption of liabilities should be presented in a separate schedule.
b. The $2 million and the assumption of liabilities should be presented on the net basis in a separate schedule.
c. The $2 million should be reflected on a net basis as cash flows from investing activities, and the assumption
of liabilities should be presented in a separate schedule.
d. The $2 million should be reflected on a gross basis as cash flows from investing activities, and the
assumption of liabilities should be presented on a gross basis in the cash flows from financing activities.
13. With respect to a summary of significant accounting policies, which of the following statements is accurate
based on the general requirements of GAAP?
a. A summary of significant accounting policies is not required for notforprofit entities.
b. A summary of significant accounting policies pertinent to a particular statement is required when only one
financial statement has been issued.
c. A summary of significant accounting policies is required for unaudited interim financial statements.
d. A summary of significant accounting policies is not required for nonpublic entities.
14. In accordance with GAAP, FDF Co. is disclosing its accounting policy for the valuation of inventory. According
to APB Opinion No. 22, what is the preferred manner of disclosure of a company's significant accounting
policies, such as inventory valuation?
a. On the face of the financial statements.
b. As the initial note accompanying the financial statements.
c. As part of individual notes to the financial statements.
d. In a separate paragraph within the accountant's report on the financial statements.
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15. According to ARB No. 43, what is the disclosure requirement for notes accompanying comparative financial
statements?
a. Disclosures related to the income statement and statement of cash flows must be presented for all periods.
b. Disclosures related to the balance sheet must be presented for all periods.
c. Disclosures for prior periods must be repeated if they continue to be of significance.
d. Disclosures for prior periods must be repeated regardless of their significance to the financial statements.
16. DDE CPA wants to limit potential liability in the preparation of compiled or reviewed financial statements. Which
of the following guidelines might prove most useful to DDE in achieving this objective?
a. By not using the words the Company", the Corporation", or Management" when drafting the notes to
b. By not using the words we," us", or our" when drafting the notes to the financial statements.
c. By not disclosing unusual or innovative applications of GAAP used by the client when drafting the notes
to the financial statements.
d. By disclosing principles and methods peculiar to the industry of the client.
17. What is the reporting requirement for an accountant with respect to supplementary information that is not a part
of the basic compiled or reviewed financial statements?
a. The accountant must describe the degree of responsibility he or she takes with regard to such information
in an additional note to the financial statements.
b. The accountant must describe the degree of responsibility he or she takes with regard to such information
in the report on the financial statements.
c. The accountant must describe the degree of responsibility he or she takes with regard to such information
in a separate report.
d. The accountant must describe the degree of responsibility he or she takes with regard to such information
in the report on the financial statements or in a separate report.
18. The management of RWR Co. is trying to ascertain the reason behind recent cash flow problems, and they ask
their CPA, CAL LLP, for some ideas on this year's review to help them. Besides the basic financial statements
and accompanying notes, what might CAL present to them to assist in managing cash flow?
a. Supplementary information such as an aging of accounts receivable and days sales in accounts
receivable.
b. Supplementary information such as a cost of goods sold schedule and details of sales by product line and
salesperson.
c. Supplementary information such as budgets for an expired period and department earnings statements.
d. Supplementary information such as condensed historical financial statements and rates of inventory
turnover.
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19. What is the reporting requirement for an accountant who performs analytical procedures in the compilation of
the basic financial statements?
a. The accountant should not mention the additional procedures performed.
b. The accountant should mention the additional procedures in a separate paragraph of the compilation
report.
c. The accountant should not mention the additional procedures performed unless the client requests the
accountant to inform thirdparty lenders of the additional assurance expressed by the accountant.
d. The accountant should mention the additional procedures in supplementary information to the financial
statements.
20. The president of GSP Inc. calls a partner at WPA LLP to ask her approval for GSP to issue some clientprepared,
interim financial statements to a prospective lender. GSP also plans to inform the bank that WPA has reviewed
GSP's financial statements for the last three years. Based on the above facts, what action should the partner
at WPA take?
a. Insist that GSP include a copy of the management representation letter signed by GSP along with the
clientprepared, interim statements before issuance to the bank.
b. Insist that the review reports of the last three years be included with the clientprepared, interim statements
before issuance to the bank.
c. Insist that any reference to WPA LLP be removed from the clientprepared, interim statements before
issuance to the bank.
d. Insist that a letter drafted by WPA be included in the submission of the financial statements to the bank,
which explains the limited assurance expressed by WPA on the financial statements of GSP.
21. What is the accountant's reporting responsibility when providing more than one level of service on the same
financial statements, e.g. a compilation and review on the same financial statements?
a. The accountant should issue a report for both levels of service provided.
b. The accountant should issue a report that is appropriate for the highest level of service provided.
c. The accountant should issue a report for the lowest level of service provided.
d. The accountant should issue a report only if an engagement letter has been signed by management
describing the limitations of services provided by the accountant in the lower level of service.
22. GWB CPA has reviewed the financial statements of RMN Co. RMN requests a compilation on the same financial
statements that omits substantially all disclosures because one of RMN's potential suppliers has requested
financial information on the company. Which of the following accurately describes GWB's options regarding
the client's request?
a. GWB cannot accept the engagement because it is required to issue a report on the highest level of service
provided, in this case, a review.
b. GWB could accept the engagement, as long as it believes RMN is not trying to mislead financial statement
users.
c. GWB could accept the engagement, but is required to include a separate paragraph in the accountant's
report disclosing the existence of a complete set of reviewed financial statements.
d. GWB cannot accept the engagement because withholding information from the supplier would be
participating in a deceit and result in a fraud claim against GWB.
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23. When the accountant is updating a previously issued report on a set of compiled, comparative financial
statements, when should the report be dated?
a. The report should be dual dated to reflect the completion date in both the prior and current year.
b. The report should be dated at the completion of the accountant's inquiry and analytical review procedures.
c. The report should be dated to correspond with the date of the signed management representation letter.
d. The report should be dated when the current period financial statements are read.
24. In 2006, DDE CPA purchased a 30% minority interest in WPA Inc., a local printing business. WPA wants to hire
DDE to perform a review report on its financial statements for 2006. What are DDE's options?
a. DDE cannot perform a review because it is not independent, but it may perform a compilation as long as
the lack of independence is disclosed in the accountant's report.
b. DDE may perform a review even though it is not independent, as long as the lack of independence is
disclosed in the accountant's report.
c. DDE cannot perform a review because it is not independent, but it may perform a compilation as long as
the reason for the lack of independence is disclosed in the accountant's report.
d. DDE may perform a review even though it is not independent, as long as WPA is not a publiclytraded
company.
25. Why might an accountant decline a review engagement where the client requests that substantially all
disclosures be omitted?
a. Because the accountant is required to include each omitted disclosure in the review report.
b. Because SSARS No. 1 prohibits the issuance of a review report when substantially all disclosures have
been omitted.
c. Because the accountant must include a general statement regarding the disclosure omissions in the
review report.
d. Because the client's request to omit substantially all disclosures proves the client's intention to mislead
financial statement users.
26. GHWB CPA is planning a review and is determining materiality level for the engagement. What is the
requirement in setting materiality for a review engagement?
a. A misstatement is material if it exceeds 5% of income before tax.
b. A misstatement is material if it exceeds 10% of income before tax.
c. Materiality cannot be defined quantitatively, but GHWB should use a thirdparty" standard to set
materiality for a review engagement.
d. Materiality cannot be defined quantitatively, but GHWB should use a reasonable person" standard to set
materiality for a review engagement.
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27. When computerprepared, interim or annual financial statements contain disclosure or measurement
departures from GAAP, what is the accountant's responsibility with respect to SSARS No.1?
a. The accountant can avoid the reporting requirements of SSARS by placing a legend on the financial
statements indicating the statements were not compiled, reviewed, or audited.
b. The accountant can avoid the reporting requirements of SSARS for the interim statements by placing a
legend on the interim financial statements indicating the statements were not compiled, reviewed, or
audited. The accountant must adhere to the reporting requirements of SSARS with respect to the annual
c. The accountant cannot avoid the reporting requirements of SSARS for interim or annual financial
statements, whether prepared manually or by computer.
d. The accountant cannot avoid the reporting requirements of SSARS by placing a legend on reviewed
financial statements indicating the statements were not compiled, reviewed, or audited, but can avoid the
reporting requirements of SSARS by placing the same legend on compiled financial statements.
28. FDF CPA is performing a review on the financial statements of TVA Co. TVA refuses to allow FDR to question
its purchasing manager regarding an inventory obsolescence issue. What course of action should FDR follow?
a. Withdraw from the engagement.
b. Issue an except for" opinion in the review report.
c. Issue a disclaimer of opinion in the review report.
d. Issue a compilation report in lieu of a review report.
29. What is the reporting requirement when an accountant decides to issue a compilation report instead of a review
report due to a scope limitation?
a. The accountant should issue a compilation report that includes a separate paragraph explaining the scope
restriction and reason for stepdown in service.
b. The accountant should issue a compilation report without any reference to the scope restriction.
c. The accountant should include a reference to the scope restriction in the notes accompanying the financial
statements.
d. The accountant should include a reference to the scope restriction in the supplementary information
attached to the financial statements.
30. HST Consultants is performing management consulting services (MCS) related to sales strategies for CAL Co.
RWR CPA reviews the financial statements of CAL Co. on an annual basis. As part of the MCS engagement,
HST includes information related to sales and sales commissions paid by territory in its report. The report is
intended to be used by CAL Co.'s sales management and field reps. Based on the above, what is RWR's
reporting requirement with respect to the MCS report?
a. At a minimum, RWR must include a compilation report on the financial information included in the MCS
report.
b. At a minimum, RWR must perform inquiry and analytical procedures on the financial information included
in the MCS report.
c. Since SSARS exempts historical financial information included in MCS reports, RWR is not required to
report on the financial information included in the MCS report.
d. RWR is not required to report on partial presentations of economic activity in the MCS report.
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31. In which of the following situations would SSARS reporting requirements apply?
a. Business valuation prepared by the accountant using information from a tax return prepared by the
accountant.
b. Business valuation prepared by the accountant using information from a tax return prepared by another
accountant.
c. MCS report containing financial statements submitted to a client by the accountant.
d. MCS containing clientprepared financial statements.
32. WJC CPA reviews the basic financial statements of HRC Co. On the face of the income statement is a note that
states, See Exhibit B Schedule of Net Sales by Quarter." Based on AICPA technical guidance, what is WJC's
general reporting requirement with respect to Exhibit B?
a. Since the income statement refers to the exhibit, it is considered to be part of the basic financial statements
and is not required to be reported on separately as supplementary information.
b. Since a schedule of net sales is an example of selected financial data, it is considered to be part of the basic
financial statements and is required to be reported on separately as supplementary information.
c. Since a schedule of net sales is an example of selected financial data, it is considered to be part of the basic
financial statements and is not required to be reported on separately as supplementary information.
d. Since the income statement refers to the exhibit, it is considered to be part of the basic financial statements
and is required to be reported on separately as supplementary information.
33. SSARS No. 1 requires the accountant to compile supplementary information that accompanies financial
statements that he or she has compiled. What is one exception to this rule?
a. When the accountant has reviewed the historical financial statements.
b. When the client prepares the supplemental information.
c. When financial statements are compiled for thirdparty users.
d. When financial statements are compiled for managementuseonly.
34. FDF Co. wishes to prepare a report for its lender which includes sales by territory, an aging of accounts
receivable, and inventory turnover. What is the reporting requirement for LBP CPA, which reviews FDF's
financial statements annually?
a. If the basic financial statements are not included with the report, LBP must issue a separate compilation
report on the supplementary information before FDF issues the report to the lender.
b. If the basic financial statements are included with the report, LBP has no reporting responsibility for such
information.
c. If the basic financial statements are not included with the report, LBP has no reporting responsibility for
such information.
d. If the basic financial statements are included with the report, LBP must issue a review report on the
supplementary information before FDF issues the report to the lender.
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35. What is the primary consideration when determining whether or not to report on information contained in a
standalone chart or graph?
a. Whether a reasonable person will be misled by the graphic representation.
b. Whether the accountant is performing a compilation or review.
c. Whether the graphic representation depicts all of the elements of a financial statement.
d. Whether the graphic representation will be distributed internally or to thirdparty users.
36. HST CPA reviewed the financial statements of NAG Co. in 2005. In 2006, NAG Co. engages HST to compile
the financial statements. How will this change in level of service affect HST's report?
a. HST can reissue his review report on the 2005 financial statements bearing the same date as the original
report.
b. HST can update his review report on the 2005 financial statements bearing the same date as the original
report.
c. HST can update his review report on the 2005 financial statements bearing the current date.
d. HST can refer to his original review report in his compilation report on the current period, provided the date
on the original review report is changed to the current date.
37. An accountant wants to issue comparative financial statements for the current and prior period. The current
period statements omit substantially all disclosures, while the prior period statements were reviewed by the
accountant. Which of the following options would enable the accountant to issue comparative financial
statements?
a. The accountant will not be able to issue comparative financial statements because the current period and
prior period are not comparable.
b. The accountant can upgrade the current year's service to a review and indicate any departures from GAAP
in the review report.
c. The accountant can upgrade the current year's service to a review and include all disclosures for both
periods.
d. The accountant will not be able to issue comparative financial statements unless an engagement letter is
generated by the accountant, signed by management, acknowledging the limitations of a compilation in
which substantially all disclosures are omitted.
38. In 2006, DDE CPA gains a new compilation client, WPA Co. In 2005, the compilation report was issued by GSP
CPA. What is the most practical option available to DDE with respect to the current year's compilation report
on the comparative financial statements?
a. Have GSP reissue its report.
b. Make reference to GSP's report in its own report.
c. Perform a compilation of the 2005 financial statements and issue its own report.
d. Have GSP update its report.
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39. Which of the following situations might cause a reissued compilation or review report to be revised and, in
general, to require dual dating?
a. Restating net sales in the prior period's financial statements due to an error in the recognition of revenue.
b. Changing the method of inventory valuation from FIFO to LIFO.
c. The loss of a major operating facility due to hurricane subsequent to the balance sheet date.
d. A change in the accountant issuing the report in the current year.
40. OTB Co., a restaurant, changes its estimate for booking a monthly reserve for food spoilage in 2006. In the
comparative financial statements reviewed by DDE CPA for 2005 and 2006, what is DDE's reporting obligation
with respect to this change in estimate?
a. DDE must restate 2005 earnings to properly reflect the effect of the change in estimate and modify the 2005
report.
b. DDE must report the effect of the change in estimate in 2006 and subsequent periods and disclose the
change if the effect of the change is material.
c. DDE must restate 2005 earnings to properly reflect the effect of the change in estimate and reissue the 2005
report.
d. DDE must report the effect of the change in estimate in 2006 and subsequent periods and modify the
current year report if the disclosure is included in the financial statements.
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GLOSSARY
is reporting.
Analytical procedures: Substantive tests made by study and comparison of plausible relationships among both
financial and nonfinancial data. These tests focus on the reasonableness of expected relationships and the
identification of significant unexpected differences.
Alternative dispute resolution (ADR): A method of resolving client disputes without exposing the accountant to the
cost and uncertainty of litigation, such as arbitration or mediation.
Arbitration: A type of ADR whereby the parties to a dispute present their respective cases to an arbitrator who
renders a verdict at the conclusion of the case.
Engagement letter: A written communication with the client that documents the accountant's understanding with
the client about the performance of the professional engagement. Matters addressed in an engagement letter
include the objectives of the engagement, the accountant's responsibility, the client's responsibility, and limitations
of the engagement.
of generally accepted accounting principles (GAAP), primarily for nongovernment entities.
Inquiry: Inquiry is the seeking of appropriate information from knowledgeable persons inside (both management
and staff) or outside the entity (e.g., bankers, attorneys, vendors, customers, predecessor accountant) with the
approval of management. Inquiry is required under the performance standards of a review engagement.
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CART07
Mediation: A type of ADR in which voluntary settlement negotiations are facilitated by a neutral third party.
Quality control system: A series of policies, procedures, and related checklists designed to provide a firm with
reasonable assurance of conforming to professional standards.
Ratio analysis: A type of analytical procedure that involves the study of the relationship between two financial
statement amounts.
Reasonableness test: A type of analytical procedure that involves estimating a financial statement or the change
in an amount from the prior year by using operating or other nonfinancial data.
Representation letter: Letter signed by client management detailing representations made by management related
to all financial statements and periods covered by an accountant's review report.
Scope limitation: In a review engagement, a scope limitation occurs when the accountant is prevented from
performing adequate inquiry and analytical review procedures necessary to provide limited assurance on the
nonpublic entity.
Substantive tests: Tests of details of transactions or balances, or analytical procedures performed to detect material
misstatements.
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Third party: As defined by SSARS No. 1, all parties except for members of management who are knowledgeable
about the nature of the procedures applied and the basis of accounting or assumptions used in the preparation of
Trend analysis: A type of analytical procedure that involves the study of the change in accounts over time.
media.
250
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INDEX
A
ACCOUNTANT
Association with financial statements . . . . . . . . . . . . . . . . . . . .
Change of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consent to use name . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reporting obligation under SSARS No. 1 . . . . . . . . . . . . . . . .
Reporting obligation under SSARS No. 2 . . . . . . . . . . . . . . . .
ACCOUNTING CHANGES
Change in accounting estimate . . . . . . . . . . . . . . . . . . . . . . . .
Change in accounting method or principle . . . . . . . . . . . . . . .
Change in prior period statements . . . . . . . . . . . . . . . . . . . . . .
Change in reporting entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
174
220
174
174
217
229
229
224
229
ACCOUNTING PRINCIPLES BOARD (APB)

Opinion 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133, 229
Opinion 22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Accountant's responsibility . . . . . . . . . . . . . . . . . . . . . . . . 168, 174
Accounting changes
Accounting estimate . . . . . . . . . . . . . . . . . . . . . . . . . . . 229, 229
Accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
Reporting entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
Addressing reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Charts and graphs
Accompanying financial statements . . . . . . . . . . . . . . . . . 216
Standalone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Comparative financial statements
Change, departures from GAAP . . . . . . . . . . . . . . . . . . . . . 224
Change in prior period statements . . . . . . . . . . . . . . . . . . . 224
Change of accountants . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
Change of status (public/nonpublic) . . . . . . . . . . . . . . . . . 224
Current audited/prior compiled or reviewed . . . . . . . . . . . 219
Current compiled or reviewed/prior audited . . . . . . . . . . . 219
Current compiled/prior reviewed . . . . . . . . . . . . . . . . . . . . 218
Current reviewed/prior compiled . . . . . . . . . . . . . . . . . . . . 217
Desirability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Dual dating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179, 225
General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
Merger or purchase of a firm . . . . . . . . . . . . . . . . . . . . . . . . 222
Predecessor has ceased operations . . . . . . . . . . . . . . . . . 222
Standard reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
Compilations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Computerprepared statements . . . . . . . . . . . . . . . 127, 194, 206
Date of
Compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Dual dated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179, 225
Format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Reissued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Updated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Departures from GAAP . . . . . . . . . . . . . . . 187, 189, 190, 193, 224
Disclosures omitted . . . . . . . . . . . . . . . . . . . . . . . . . 166, 187, 219
Emphasis of a matter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Financial statements included in MCS reports . . . . . . . . . . . . 201
Heading of reports, use of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Lack of independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177, 181
Letterhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Modification of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187, 192
Omission of statement of cash flows . . . . . . . . . . . . . . . . . . . . 189
Other accountants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
Periods covered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Presentation of the accountant's report . . . . . . . . . . . . . . . . . . 127
Reference on financial
statements . . . . . . . . . . . . . . . . . . . . . . . . . 133, 134, 135, 169, 180
Reissued report . . . . . . . . . . . . . . . . . . . . . . . . . 218, 219, 220, 224
Requirements
Compiled financial statements . . . . . . . . . . . . . . . . . . . . . . 175
Reviewed financial statements . . . . . . . . . . . . . . . . . . . . . . 176
Review reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Salutations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
Scope limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200, 203
Selected disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Signature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Single financial statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Supplementary information . . . . . . . . . . . . . . . 168, 168, 204, 213
Updated . . . . . . . . . . . . . . . . . . . . . . . . . . . 179, 217, 217, 218, 218
Use of "I" versus "we" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Use of term accountant's vs. accountants' . . . . . . . . . . . . . . . 127
ACCOUNTING RESEARCH BULLETIN (ARB)

ARB 43 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133, 166
ACCOUNTING SERVICES
Effect of SSARS No. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
ADDITIONAL PROCEDURES . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Predecessor accountant's procedures . . . . . . . . . . . . . . . . . . 220
Restriction in scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200, 203
SAS No.56 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Supplementary information . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
AUDIT ENGAGEMENTS
Prior period compiled or reviewed . . . . . . . . . . . . . . . . . . . . . . 219
Subsequent period compiled or reviewed . . . . . . . . . . . . . . . 219
B
BALANCE SHEET
Format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
Only statement presented . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Titles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
C
CHARTS AND GRAPHS
Accompanying financial statements . . . . . . . . . . . . . . . . . . . . . 216
Presentation of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Standalone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
CHECKLISTS AND FORMS
Compilations (under SSARS)
Longform disclosure checklist . . . . . . . . . . . . . . . . . . . . . .
Summarized disclosure checklist . . . . . . . . . . . . . . . . . . . .
Reviews
Longform disclosure checklist . . . . . . . . . . . . . . . . . . . . . .
Summarized disclosure checklist . . . . . . . . . . . . . . . . . . . .
166
166
166
166
CODE OF PROFESSIONAL CONDUCT (AICPA)

Rule 203 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190, 192
COMMUNICATION WITH PREDECESSORS
AND SUCCESSORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221, 223
COMPILATION ENGAGEMENTS
Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177, 181
Reporting requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Subsequent period audited . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Subsequent period reviewed . . . . . . . . . . . . . . . . . . . . . . . . . . 217
Supplementary
information . . . . . . . . . . . . . . . . . . . . . . . . . 204, 205, 206, 207, 213
Classifying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Effective date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Financial statement, presentation . . . . . . . . . . . . . . . . . . . . . . .
Reclassification adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reporting in balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . .
160
160
160
160
161
162
COMPUTERGENERATED FINANCIAL
STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127, 194, 207
251

CONTINUING ACCOUNTANT
Changed prior statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Flowchart in comparative engagements . . . . . . . . . . . . . . . . . 227
CART07

Headings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Included in MCS reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
Managementuseonly legend . . . . . . . . . . . . . . . . . . . . . . . . . . 134
Presentation of period covered . . . . . . . . . . . . . . . . . . . . . . . . . 125
Referencing notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135, 166
Revision of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Single . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Submitting, defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Table of contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
Title page
Content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
Description of services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Presentation of date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Presentation of entity name . . . . . . . . . . . . . . . . . . . . . . . . . 124
Title of financial statements . . . . . . . . . . . . . . . . . . . . . . . . . 124
Titles . . . . . . . . . . . . . . . . . . . . . . . . . 133, 136, 137, 138, 139, 147
D
DISCLOSURE CHECKLISTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
DISCLOSURES
Accounting policies
As initial footnote . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Content of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Disclosure not required . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Interim financial statements . . . . . . . . . . . . . . . . . . . . . . . . . 164
Manner of disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . 164, 165
On face of statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
When required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Checklists
Longform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Summarized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Common interest realty associations (CIRAs) . . . . . . . . . . . . . 213
Comparative financial statements . . . . . . . . . . . . . . . . . . . 133, 166
Footnotes general discussion . . . . . . . . . . . . . . . . . . . . . . . . 166
Format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
On face of statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
References on statements . . . . . . . . . . . . . . . . . . . . . . 135, 166
References to entity in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
References to management in . . . . . . . . . . . . . . . . . . . . . . 166
References to report . . . . . . . . . . . . . . . . . . . . . . . . . . . 134, 180
Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Title . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Title when substantially all disclosures omitted . . . . . . . . 166
Footnotes illustrated
Oil and gas reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Omitted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166, 187, 219
On face of statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164, 166
Reference to footnotes
On face of statements . . . . . . . . . . . . . . . . . . . . . . . . . 135, 166
Selected disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
To selected information . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
Selected disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Single omission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
FORECASTS, PROJECTIONS, AND SIMILAR ITEMS

Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Historical statements, presented with . . . . . . . . . . . . . . . . . . . 207
G
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
Departures from,
discussed . . . . . . . . . . . . . . . . . . . . . . . . . . 187, 189, 190, 193, 224
Materiality of departures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
I
INCOME STATEMENT
Format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Illustrated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Only statement presented . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Titles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
137
138
203
137
INDEPENDENCE
Accountant not independent . . . . . . . . . . . . . . . . . . . . . . . 177, 181
INQUIRIES
Restriction of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200, 203
INTERIM FINANCIAL STATEMENTS
Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
ERROR CORRECTION
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Prior period statements
Comparative statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
LEVEL OF SERVICE
Change after engagement begins
Stepdowns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Comparative statements
Disclosures omitted in one period . . . . . . . . . . . . . . . . . . . 219
Flowchart discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
Higher level of service in current period . . . . . . . . . . 217, 219
Lower level of service in current period . . . . . . . . . . . 218, 219
Same level of service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
Different level of service on same set
of financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Highest level of service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Lack of independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Minimum level of service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
F
FINANCIAL ACCOUNTING STANDARDS BOARD (FASB)
Statement 130 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Statement 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Statement 25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Statement 69 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Statement 95 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146, 189
Basic financial statements . . . . . . . . . . . . . . . . . . . . . . . . . 133, 134
Client prepared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174, 226
Comparative
Advisability of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Audited together with unaudited . . . . . . . . . . . . . . . . 125, 135
Illustrated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Classifying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Effective date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Financial statement, presentation . . . . . . . . . . . . . . . . . . . . 160
Reporting in balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . 162
M
MATERIALITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
MERGER OR PURCHASE OF ACCOUNTING FIRM . . . . . . . 222
N
NONPUBLIC ENTITIES
Status
Change of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Determination of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
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STATEMENT OF POSITION
SOP 821 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
PREDECESSOR ACCOUNTANT
Changed prior period statements . . . . . . . . . . . . . . . . . . . . . . . 225
Communication with successor . . . . . . . . . . . . . . . . . . . . 221, 223
Procedures for reissuing report . . . . . . . . . . . . . . . . . . . . . . . . . 220
Representation from successor . . . . . . . . . . . . . . . . . . . . . . . . 221
STATEMENTS ON AUDITING STANDARDS

Applicability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219, 224
No. 1, AU 530 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
No. 26, AU 504 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219, 223
No. 29, AU 551 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
No. 35, AU 622 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
No. 42, AU 552 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
No. 56, AU 329 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
PRIOR PERIOD ADJUSTMENTS . . . . . . . . . . . . . . . . . . . . . . . . 224

PUBLIC ENTITIES
Status
Change of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Determination of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
STATEMENTS ON STANDARDS FOR ACCOUNTING AND

REVIEW SERVICES (SSARS)
Applicability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Interpretations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177, 187
No. 1 . . . . . . . . . . . . . . . . . . . . . 133, 134, 134, 135, 167, 174, 222
No. 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218, 218, 219, 221,
221, 222, 225, 227
No. 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174, 177
No. 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
R
Successor accountant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
REVIEW ENGAGEMENTS
Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177, 181
Omission of statement of cash flows . . . . . . . . . . . . . . . . . . . . 189
Prior or subsequent period disclosures omitted . . . . . . . . . . . 219
Prior period audited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Prior period compiled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
Reporting requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Scope restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200, 203
Subsequent period audited . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Subsequent period compiled . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Supplementary information . . . . . . . . . . . . . . . . . . . 204, 204, 213
SUBSEQUENT EVENTS
Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Reissued reports, effect on . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
SUCCESSOR ACCOUNTANT
Communication with predecessor . . . . . . . . . . . . . . . . . . 221, 223
Merger or purchase of a firm . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
Prior period statement
Reporting options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
Restated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Relation to predecessor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
S
SCOPE OF EXAMINATION
Restriction on scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200, 203
SUPPLEMENTARY INFORMATION
Charts and graphs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Client prepared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Common interest realty associations . . . . . . . . . . . . . . . . . . . . 213
Compiled financial statement . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Consolidation or combination . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
Expired budgets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
Nature of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
Percentages presented . . . . . . . . . . . . . . . . . . . . . . . . . . . 168, 207
Presentation in statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Reference to report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . 168, 168, 204, 213, 214
Required by AICPA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Required by FASB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Reviewed financial statements . . . . . . . . . . . . . . . . . . . . . 167, 205
Schedule headings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

Captions within statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Definition of cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Direct method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Elements of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
Format . . . . . . . . . . . . . . . . . . . . . . . . 147, 148, 150, 152, 152, 153
Indirect method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
Noncash investing and financing activities . . . . . . . . . . . . . . . 153
Not required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146, 189
Omission of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
Operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Requirements to present . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Title . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
Types of transactions excluded . . . . . . . . . . . . . . . . . . . . . . . . . 148
Types of transactions included . . . . . . . . . . . . . . . . . . . . . 147, 148
STATEMENT OF CHANGES IN RETAINED EARNINGS

Combined with statement of income . . . . . . . . . . . . . . . . . . . . 138
Format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
Restatement, illustration of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
Separate statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138, 139
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Changes other than to retained earnings . . . . . . . . . . . . . . . .
Comparative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Illustrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Negative equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Single year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
UNAUDITED FINANCIAL STATEMENTS

Nonpublic entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Public entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Use of word "unaudited'' . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
140
140
140
141
141
WORKPAPERS
Review
Reviewed by predecessor . . . . . . . . . . . . . . . . . . . . . . . . . . 221
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CART07
COURSE 3
PROPRIETORSHIPS, PARTNERSHIPS,
AND S CORPORATIONS: SPECIAL REPORTING ISSUES
OVERVIEW
COURSE DESCRIPTION:
This interactive selfstudy course addresses the special issues relating to

proprietorships, partnerships, and S corporations and the related reporting
requirements when issuing compiled or reviewed financial statements of these
entities.
DATE:
August 2007
RECOMMENDED FOR:
PREPARATION:
Basic knowledge of proprietorships, partnerships, and S corporations.
CPE CREDIT:

FIELD OF STUDY:
Accounting
EXPIRATION DATE:
KNOWLEDGE LEVEL:
Basic
Lesson 1 Proprietorships
Determine when to issue proprietorship or personal financial statements.
Identify other special reporting requirements of compiled or reviewed financial statements of proprietorships.
Lesson 2 Partnerships
Identify the special reporting requirements of compiled or reviewed financial statements of partnerships.
Recognize issues related to changes in partners and the related effects on partners' capital accounts.
Calculate changes in partnership assets and capital accounts under the bonus and goodwill methods.
Compare the advantages and disadvantages of operating as a limited liability corporation (LLC) or a limited
liability partnership (LLP).
Lesson 3 S Corporations
Identify the special reporting requirements of compiled and reviewed financial statements of S corporations.
Summarize the unique aspects of the retained earnings accounts maintained by S corporations.
Evaluate the effects of income and loss, distributions and termination of S corporation status on the retained
earnings accounts of an S corporation.
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P.O. Box 966
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Lesson 1:Proprietorships
This lesson discusses the unique characteristics of proprietorships. Attention is focused on the difficulties
accountants face when the assets of a proprietorship and owner are not properly separated. Also, the lesson
includes a discussion on the presentation of the basic financial statements of a proprietorship, with particular focus
on the disclosure of income taxes and accounting treatment of selfemployed retirement plans.
Determine when to issue proprietorship or personal financial statements.
Identify other special reporting requirements of compiled or reviewed financial statements of proprietorships.
GENERAL
A proprietorship is an unincorporated business enterprise wholly owned by one individual. Because it represents
a specific business activity using identifiable resources, the basic purpose of proprietorship financial statements is
the same as other business enterprises to present financial position, results of operations, and cash flows. Thus,
the basic principles of financial statement presentation apply. Certain peculiarities of proprietorships are discussed
in the following paragraphs.
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SEGREGATING PROPRIETORSHIP AND PERSONAL ACCOUNTS

Because a proprietorship is unincorporated, it is often difficult to properly segregate the assets of the business from
the personal assets and liabilities of the owner of the business. The proprietor often does not maintain separate
bank accounts and books for the proprietorship and may record business cash receipts and disbursements
through his personal account. If the accountant is not able to properly segregate the personal and business assets
and liabilities, it is not appropriate to issue financial statements described as those of a proprietorship. In this
situation, the accountant may recommend to his client that personal financial statements be issued instead. The
identifiable net proprietorship assets should be presented on one line in the personal financial statements.
Even when separate books are maintained, the accountant may face some significant judgments as to what
constitutes a proprietorship asset, liability, revenue, or expense. For instance, investment activities may be carried
on through the business accounts. In some situations, it may be appropriate to include the investment activities in
the proprietorship financial statements, e.g., the proprietor considers the funds temporarily invested until needed in
the proprietorship. In other cases, investment activities unrelated to the proprietorship are transacted through the
proprietorship bank accounts and should not be part of the proprietorship financial statements.
To avoid confusion about the contents of proprietorship statements, it is generally recommended that a note to the
financial statements clearly state what accounts or operations are included in the statements. The following are
examples of notes clarifying the content of the statements:
NOTE A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Operations
The financial statements include only those assets and liabilities of the proprietor, A.B. Jones, that
relate to his oil and gas operations.
Operations
The financial statements have been prepared solely from the accounts of the XYZ Company and
do not include the personal accounts of the owner or those of any other operation in which he is
engaged.
Accountants sometimes question whether they should include an emphasis paragraph in the accountant's report
that clarifies what accounts or operations are included in the proprietor's financial statements, particularly when the
financial statements omit substantially all disclosures. Accountants should avoid using emphasis paragraphs
whenever possible. Such paragraphs require the accountants to choose the information in the financial statements
that should be emphasized. Unless the omission of disclosures is intended to mislead financial statement users, a
standard paragraph that adequately informs users of the limitations of the financial statements is recommended.
Furthermore, the use of emphasis paragraphs is discouraged in compiled financial statements that omit substan
tially all disclosures because generally emphasis paragraphs should not introduce new information to the reader of
If the accountant decides to add such a paragraph to the compilation or review report, the accountant needs to
consider whether such a disclosure could be construed as being the representation of the accountant rather than
the client, and should word the emphasis paragraph accordingly. An alternative to adding an emphasis paragraph
to the compilation report clarifying the content of the proprietor's financial statements may be to include selected
disclosures about only a few matters in the form of notes to the compiled financial statements. Note also that when
financial statements omit substantially all disclosures, emphasis paragraphs in the accountant's report should not
be viewed as a substitute for making selected disclosures. The accountant should consider whether the propri
etor's election to include only selected disclosures causes the financial statements to be misleading (for example,
by omitting only the disclosures that contain negative information). If so, the accountant should request that the
financial statements be revised to include the omitted disclosures.
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SELFSTUDY QUIZ
following section.
1. If an accountant is unable to separate the personal and business assets of the owner of a proprietorship, what
type of service, if any, might be performed instead?
a. Compilation of proprietorship financial statements.
b. Compilation of personal financial statements.
c. Review of proprietorship financial statements.
d. The accountant is precluded from performing any attest service for the owner or the proprietorship due
to the lack of segregation of financial information.
2. Why do proprietorships present special reporting challenges to accountants, even when separate accounts
are maintained for the owner and proprietor?
a. Due to the nature of proprietorships, activities unrelated to the proprietorship are sometimes carried out
within proprietorship accounts.
b. Due to the nature of proprietorships, the basic principles of financial presentation do not apply, and special
reporting considerations must be addressed by the accountant.
c. Due to the nature of proprietorships, the provision for income taxes presented in the financial statements
of the proprietorship requires a special calculation.
d. Due to the nature of proprietorships, the accrual basis of accounting is not applied, and the accountant
must reflect the proper basis of accounting in the compiled or reviewed financial statements.
3. How might an accountant mitigate the ambiguity inherent in proprietorship financial statements for the end
users of the statements?
a. Include a note to the financial statements that explicitly describes items of a personal financial nature that
are included in the financial statements of the proprietorship.
b. Obtain a representation letter from the owner indicating that all items included in the financial statements
of the proprietorship are activities directly related to the business operations of the proprietorship.
c. Obtain a signed engagement letter from the owner that describes the limitations of the procedures
performed due to the nature of a proprietorship.
d. Include a note to the financial statements that explicitly describes what operations or accounts are included
in the statements.
4. Why are emphasis paragraphs generally discouraged in the accountant's report when issuing financial
statements for proprietorships that omit substantially all disclosures?
a. Such paragraphs restrict the judgment on the part of the accountant in determining what information
should be included in the notes to the financial statements.
b. Such paragraphs could be construed as being the representation of the client and potentially mislead
financial statement users.
c. Such paragraphs require the accountant to select which information in the financial statements requires
emphasis.
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SELFSTUDY ANSWERS
1. If an accountant is unable to separate the personal and business assets of the owner of a proprietorship, what
type of service, if any, might be performed instead? (Page 258)
a. Compilation of proprietorship financial statements. (This answer is incorrect. When segregation of the
owner's personal and business accounts is not possible, the issuance of compiled financial statements
of the proprietorship is not appropriate.)
b. Compilation of personal financial statements. (This answer is correct. When segregation of the
owner's personal and business accounts is not possible, the issuance of financial statements of the
proprietorship is not appropriate; however, personal financial statements of the owner could be
compiled instead.)
c. Review of proprietorship financial statements. (This answer is incorrect. The issuance of reviewed financial
statements of the proprietorship is not appropriate when the accountant is unable to segregate the owner's
personal and business accounts.)
d. The accountant is precluded from performing any attest service for the owner or the proprietorship due
to the lack of segregation of financial information. (This answer is incorrect. While the issuance of compiled
or reviewed financial statements of the proprietorship is not appropriate, the accountant may still provide
other attest services to the owner.)
2. Why do proprietorships present special reporting challenges to accountants, even when separate accounts
are maintained for the owner and proprietor? (Page 258)
a. Due to the nature of proprietorships, activities unrelated to the proprietorship are sometimes carried
out within proprietorship accounts. (This answer is correct. Since a proprietorship is wholly owned
by one individual, activities unrelated to the proprietorship and related to the personal activities of
the owner are often transacted through the proprietorship bank accounts.)
b. Due to the nature of proprietorships, the basic principles of financial presentation do not apply, and special
reporting considerations must be addressed by the accountant. (This answer is incorrect. The basic
principles of financial statements apply in the financial statement presentation of proprietorships.)
c. Due to the nature of proprietorships, the provision for income taxes presented in the financial statements
of the proprietorship requires a special calculation. (This answer is incorrect. Proprietorships are not
taxpaying entities; therefore, no provision for income tax is made in the financial statements of a
proprietorship.)
d. Due to the nature of proprietorships, the accrual basis of accounting is not applied, and the accountant
must reflect the proper basis of accounting in the compiled or reviewed financial statements. (This answer
is incorrect. While the accountant must always address the basis of accounting used in the financial
statements, proprietorships may employ the accrual basis of accounting.)
3. How might an accountant mitigate the ambiguity inherent in proprietorship financial statements for the end
users of the statements? (Page 258)
a. Include a note to the financial statements that explicitly describes items of a personal financial nature that
are included in the financial statements of the proprietorship. (This answer is incorrect. If the accountant
cannot segregate items of a personal and business nature of the owner and the proprietorship,
proprietorship financial statements should not be issued.)
b. Obtain a representation letter from the owner indicating that all items included in the financial statements
of the proprietorship are activities directly related to the business operations of the proprietorship. (This
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answer is incorrect. While an accountant may obtain representations to that effect, the representation letter
would be part of the accountant's workpapers and does not reduce the confusion for the end user of the
c. Obtain a signed engagement letter from the owner that describes the limitations of the procedures
performed due to the nature of a proprietorship. (This answer is incorrect. While an engagement letter is
recommended for all engagements, the letter would be part of the accountant's workpapers and does not
reduce the confusion for the end user of the financial statements.)
d. Include a note to the financial statements that explicitly describes what operations or accounts are
included in the statements. (This answer is correct. By clearly stating what activities are included
in the statements, i.e. only activities relating to the business of the proprietor, the accountant
reduces the confusion related to the contents of the statements.)
4. Why are emphasis paragraphs generally discouraged in the accountant's report when issuing financial
statements for proprietorships that omit substantially all disclosures? (Page 258)
a. Such paragraphs restrict the judgment on the part of the accountant in determining what information
should be included in the notes to the financial statements. (This answer is incorrect. In fact, such
paragraphs require increased judgment on the part of the accountant as to what should be emphasized.
Instead, usage of a standard paragraph in the accountant's report is recommended to reduce the exposure
of the accountant.)
b. Such paragraphs could be construed as being the representation of the client and potentially mislead
financial statement users. (This answer is incorrect. Emphasis paragraphs can be construed as being
representations of the accountant and should be used sparingly to avoid exposure on the part of the
accountant.)
c. Such paragraphs require the accountant to select which information in the financial statements
requires emphasis. (This answer is correct. Because emphasis paragraphs usually introduce new
information to readers of financial statements, their use is discouraged. Instead a standard
paragraph referring to the omission of disclosures is recommended.)
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FEDERAL INCOME TAXES

Proprietorships are not taxpaying entities. The income of the proprietorship is only one of the items considered
when the individual proprietor pays his income taxes. Therefore, no provision for income tax expense or the related
liability is included in the financial statements of a proprietorship. Although not required by GAAP, this fact should
generally be disclosed in the financial statements. Likewise, withdrawals subsequent to the balance sheet date to
pay the proprietor's personal income taxes should also be disclosed. The following is an example of how the
income tax note might read:
Income Taxes
Income from the proprietorship is combined with the income and expenses of the proprietor from
other sources and reported in the proprietor's individual federal and state income tax returns. The
proprietorship is not a taxpaying entity for purposes of federal and state income taxes, and thus
no income taxes have been recorded in the statements. The proprietor customarily makes
estimated tax payments toward his personal income tax liability from the proprietorship bank
account. These payments are treated as withdrawals of capital. Subsequent to the balance sheet
date, the proprietor withdrew $25,000 from the proprietorship for the purpose of making his fourth
and final estimated tax payment for 20X5.
If the financial statements omit substantially all disclosures, some accountants consider including an emphasis
paragraph in the accountant's report for proprietorship financial statements regarding income taxes (that is, stating
that there is no provision for income tax expense included in the financial statements or that withdrawals were made
subsequent to the balance sheet date to pay the proprietor's personal income taxes). As discussed previously,
such paragraphs should generally be avoided.
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CASH BASIS AND TAX BASIS STATEMENTS

Compiled or reviewed financial statements of a proprietorship are frequently issued on either the tax or cash basis
of accounting, and thus, terms such as Balance Sheet" and Statement of Income and Proprietor's Capital" should
not be used. The statements should generally be titled Statement of Assets, Liabilities, and Capital Cash Basis
(or Income Tax Basis)" and Statement of Revenues and Expenses Cash Basis (or Income Tax Basis)."
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EQUITY SECTION OF BALANCE SHEET

The equity section of the balance sheet of a proprietorship should be labeled Proprietor's Capital." Unlike
corporations, no distinction is made on the balance sheet between capital contributed, beginning capital, or
retained earnings. However, as discussed in the following paragraph, a statement of changes in proprietor's capital
may be necessary.
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STATEMENT OF CHANGES IN PROPRIETOR'S CAPITAL

General Requirements
According to APB Opinion No.12, Paragraphs9 and 10, disclosure of changes in the separate accounts compris
ing stockholders' equity is required when both financial position and results of operations are presented. This
disclosure should also be made in OCBOA financial statements. Likewise, these principles are equally applicable
to entities other than corporations. Thus, the proprietor's capital should disclose changes such as the following:
a. Contributions to capital.
b. Earnings.
c. Drawings.
Compiled financial statements that omit substantially all disclosures may not include a statement of changes in
proprietor's capital and may not disclose the changes on the face of the financial statements. Some accountants
have questioned whether this lack of information should be considered a departure from GAAP. According to
Paragraph 10 of APB Opinion No.12, the changes in equity accounts is considered a required disclosure but not
a required statement. Therefore, such information is not required to be disclosed in compiled financial statements
that omit substantially all disclosures. However, when disclosures are omitted from compiled financial statements,
it is preferable to show the changes in equity accounts either on the income statement or face of the balance sheet.
Disclosure with Statement of Income
In many cases, these changes can be appropriately disclosed by presenting a combined statement of income and
changes in proprietor's capital. The following is an excerpt from such a statement:
NET INCOME
BEGINNING PROPRIETOR'S CAPITAL
Drawings for the year
Additional capital contributed
ENDING PROPRIETOR'S CAPITAL
50,000
125,000
(45,000 )
10,000
$ 140,000
JOE'S GROCERY STORES

STATEMENT OF CHANGES IN PROPRIETOR'S CAPITAL
20X6
Capital contributed
Capital withdrawn
265
20X5
110,000
90,000

(55,000 )
75,000
60,000
15,000
(40,000 )
145,000
110,000
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Disclosure in Notes to Financial Statements

Disclosure of changes in proprietor's capital in the notes to the financial statements is also acceptable and may be
preferable if additional explanation of a capital transaction is necessary. An example follows:
NOTE E CHANGES IN PROPRIETOR'S CAPITAL
Changes to Mr. Jones's capital account for 20X5 are presented below:
Capital contributed
Capital withdrawn
110,000
90,000
150,000
(60,000 )
290,000
During the year, Mr. Jones inherited the office building that the proprietorship formerly leased. The
building was contributed to the proprietorship at its estimated fair market value of $150,000.
Capital withdrawn includes personal expenses paid by the proprietorship on behalf of Mr. Jones,
as well as direct cash withdrawals.
Disclosure in a Separate Statement
In other circumstances, such as when more detail or description of the changes is desired or when comparative
statements are presented, it may be appropriate to present a separate Statement of Changes in Proprietor's
Capital.
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CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS

The same general rules concerning consolidated financial statements, the equity method of accounting, and
combined financial statements that apply to other business entities are also applicable to proprietorships. There
fore, it may be appropriate, when a proprietorship owns a controlling interest in a corporation, to issue statements
that consolidate the accounts of the proprietorship and the controlled corporation. The accountant should refer to
ARB No.43, chapter 1A, Paragraph 3; ARB No.51, as amended; and TIS 1400.02 for appropriate guidance. In
connection with its project to provide comprehensive guidance on accounting for affiliations between entities, the
FASB has issued an exposure draft of a proposed SFAS, Consolidated Financial Statements, Including Accounting
and Reporting of Noncontrolling Interests in Subsidiaries. This proposed SFAS would replace ARB No.51, Consoli
dated Financial Statements; supersede SFAS No. 94, Consolidation of All MajorityOwned Subsidiaries; and amend
a number of other pronouncements. It retains aspects of ARB No.51 and also provides guidance for the account
ing and reporting of noncontrolling interests in consolidated financial statements as well as the loss of control of
subsidiaries. The FASB is currently redeliberating the exposure draft and expects to issue a final Statement at a later
date.
It may also be appropriate to present combined financial statements for a group of commonly owned proprietor
ships or for a proprietorship and a corporation or partnership that is controlled by the proprietor. Note that
combined and consolidated statements follow the same general accounting principles, and thus the distinction as
to whether the proprietor or proprietorship owns the interest in the corporation has no effect other than on the title
of the statements, i.e., combined or consolidated.
The accountant should also note that the equity method of accounting (APB Opinion No.18, Accounting Interpreta
tion No.2 of APB Opinion No.18, and SFAS No.94) is also applicable to proprietorships and may apply to
unconsolidated investments in corporations or partnerships.
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SELFEMPLOYED RETIREMENT PLANS

A proprietor may set up a retirement plan similar to profit sharing, pension, or other types of employee benefit plans
used by corporations. There is no authoritative guidance on how to account for such plans in a proprietorship.
Thus, there is diversity in practice as to whether payments to partners and related retirement benefits are treated as
an expense to the proprietorship or as distribution of proprietor's capital.
Retirement plans (commonly referred to as Keogh or HR10 Plans) are required by federal income tax laws to
include present and future employees other than the proprietor. Thus, payments to such plans should be recorded
as an expense of the proprietorship rather than as a withdrawal of capital. When the proprietor makes payments to
the Individual Retirement Accounts of employees as well as to his own IRA, i.e., an SEPIRA plan, the payments
should be recorded as an expense of the proprietorship.
Regardless of the method used to account for retirement plan payments, the significant provisions of the propri
etor's plan (Keogh or SEPIRA) and the accounting policy followed for the proprietor's share should be properly
disclosed in the notes to the financial statements.
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SELFSTUDY QUIZ
following section.
5. Which of the following disclosures related to accounting polices in the notes to the financial statements of a
proprietorship most likely differs from a C corporation?
a. Nature of operations.
b. Accounts receivable.
c. Income taxes.
d. Use of estimates.
6. In the case of compiled or reviewed financial statements of a proprietorship, when is it most likely that the title
Balance Sheet" will be unacceptable?
a. When the financial statements include the personal investments of the owner.
b. When the financial statements are issued using a basis of accounting other than GAAP.
c. When the financial statements are issued using the accrual basis of accounting.
d. When the financial statements of a proprietorship are compiled or reviewed, SSARS No. 1 requires the use
of the title, Statement of Assets, Liabilities and Proprietor's Capital.
7. What is the primary difference between the equity section of the balance sheet of a proprietorship and that of
a corporation?
a. In the equity section of a proprietorship's balance sheet, there are not separate line items for capital
contributed, beginning capital or retained earnings.
b. In the equity section of a proprietorship's balance sheet, APB Opinion No. 12 requires disclosure of
changes in the separate accounts comprising proprietor's equity.
c. In the equity section of a proprietorship's balance sheet, additional capital contributed is titled, Additional
Proprietor's Equity."
d. In the equity section of a proprietor's balance sheet, there are separate line items disclosing the earnings
and drawings of the proprietor for the periods presented.
8. In general, what are the elements required to properly reflect the changes in proprietor's capital in the financial
statements of a proprietorship?
a. Net income or loss, contributions of capital, withdrawals of capital and ending proprietor's capital.
b. Beginning proprietor's capital, net income or loss, withdrawals of capital and ending proprietor's capital.
c. Beginning proprietor's capital, net income or loss, contributions of capital, withdrawals of capital and
ending proprietor's capital.
d. Beginning proprietor's capital, net income or loss, contributions of capital, withdrawals of capital,
dividends paid and ending proprietor's capital.
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9. How should the payments to an owner's SEPIRA be accounted for in the proprietorship financial statements
of a proprietorship with no employees?
a. The payments to the owner's SEPIRA must be charged as an expense to the proprietorship. Separate
disclosure in the notes to the financial statements is not necessary.
b. The payments to the owner's SEPIRA must be reported as a distribution of proprietor's capital. Separate
disclosure in the notes to the financial statements is not necessary.
c. The payments to the owner's SEPIRA may be charged as an expense to the proprietorship or reflected
as a distribution of proprietor's capital. Separate disclosure in the notes to the financial statements is not
necessary.
d. The payments to the owner's SEPIRA may be charged as an expense to the proprietorship or reflected
as a distribution of proprietor's capital. The accounting policy for the plan payments and related benefits
should be disclosed in the notes to the financial statements.
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SELFSTUDY ANSWERS
5. Which of the following disclosures related to accounting polices in the notes to the financial statements of a
proprietorship most likely differs from a C corporation? (Page 262)
a. Nature of operations. (This answer is incorrect. When comparing the notes to the financial statements of
a C corporation and a proprietorship, no difference in the required disclosure regarding the nature of
operations would exist.)
b. Accounts receivable. (This answer is incorrect. The disclosure related to accounts receivable of a
proprietorship would not necessarily differ from that of a C corporation.)
c. Income taxes. (This answer is correct. Since proprietorships are not taxpaying entities, the
disclosure related to income taxes would differ from a C corporation, which is a taxpaying entity.
The disclosure of the proprietorship would indicate that no income taxes have been recorded in the
statements and indicate the amount of subsequent owner withdrawals, if any, necessary to pay
estimated income taxes of the owner.)
d. Use of estimates. (This answer is incorrect. Both a proprietorship and a C corporation might use estimates
in the determination of financial statement items. Therefore, the note disclosing the use of estimates in the
accounting policies section might be similar.)
6. In the case of compiled or reviewed financial statements of a proprietorship, when is it most likely that the title
Balance Sheet" will be unacceptable? (Page 263)
a. When the financial statements include the personal investments of the owner. (This answer is incorrect.
If the personal investments of the owner are not segregated from that of the proprietorship, the accountant
should not issue compiled or reviewed financial statements of the proprietorship.)
b. When the financial statements are issued using a basis of accounting other than GAAP. [This answer
is correct. Since such financial statements are frequently issued using the tax or cash basis of
accounting, modification of the title is necessary, such as Statement of Assets, Liabilities, and
Capital Cash Basis (or Income Tax Basis).]
c. When the financial statements are issued using the accrual basis of accounting. (This answer is incorrect.
If the accrual basis of accounting is used by the proprietorship, the title Balance Sheet" would generally
be acceptable.)
d. When the financial statements of a proprietorship are compiled or reviewed, SSARS No. 1 requires the use
of the title, Statement of Assets, Liabilities and Proprietor's Capital. (This answer is incorrect. SSARS No.
1 does not require the use of this title in compilations or reviews of the financial statements of
proprietorships.)
7. What is the primary difference between the equity section of the balance sheet of a proprietorship and that of
a corporation? (Page 264)
a. In the equity section of a proprietorship's balance sheet, there are not separate line items for capital
contributed, beginning capital or retained earnings. (This answer is correct. In a proprietorship's
balance sheet, there is only a single line item, Proprietor's Capital.")
b. In the equity section of a proprietorship's balance sheet, APB Opinion No. 12 requires disclosure of
changes in the separate accounts comprising proprietor's equity. (This answer is incorrect. APB Opinion
No. 12 applies to the disclosure of changes in the separate accounts of stockholders' equity. While
generally believed to apply to entities other than corporations, disclosure is not required on the face of the
balance sheet.)
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c. In the equity section of a proprietorship's balance sheet, additional capital contributed is titled, Additional
Proprietor's Equity." (This answer is incorrect. A separate line item is not included for additional paidin
capital in the equity section of the balance sheet of a proprietorship.)
d. In the equity section of a proprietor's balance sheet, there are separate line items disclosing the earnings
and drawings of the proprietor for the periods presented. (This answer is incorrect. Separate line items
detailing the earnings and drawings of the owner are not included in the equity section of the balance sheet
of a proprietorship.)
8. In general, what are the elements required to properly reflect the changes in proprietor's capital in the financial
statements of a proprietorship? (Page 265)
a. Net income or loss, contributions of capital, withdrawals of capital and ending proprietor's capital. (This
answer is incorrect. Beginning proprietor's equity should also be included to adequately disclose the
changes in proprietor's equity of the periods presented.)
b. Beginning proprietor's capital, net income or loss, withdrawals of capital and ending proprietor's capital.
(This answer is incorrect. The changes in proprietor's equity should also include any contributions of
capital made by the proprietor during the periods presented.)
c. Beginning proprietor's capital, net income or loss, contributions of capital, withdrawals of capital
and ending proprietor's capital. (This answer is correct. Each of these elements should be present
when disclosing the changes in proprietor's capital. Generally, this disclosure is made in a
combined statement of income and changes in proprietor's capital or in the notes to the financial
statements.)
d. Beginning proprietor's capital, net income or loss, contributions of capital, withdrawals of capital,
dividends paid and ending proprietor's capital. (This answer is incorrect. Dividends paid, an element in
a statement of changes in retained earnings of a corporation, would not be an element present in the
statement of changes in proprietor's capital.)
9. How should the payments to an owner's SEPIRA be accounted for in the proprietorship financial statements
of a proprietorship with no employees? (Page 268)
a. The payments to the owner's SEPIRA must be charged as an expense to the proprietorship. Separate
disclosure in the notes to the financial statements is not necessary. (This answer is incorrect. The payments
to the SEPIRA are not required to be charged as an expense to the proprietorship. Also, disclosure of the
policy should be made in the notes to the financial statements.)
b. The payments to the owner's SEPIRA must be reported as a distribution of proprietor's capital. Separate
disclosure in the notes to the financial statements is not necessary. (This answer is incorrect. The payments
to the SEPIRA are not required to be reported as a distribution of proprietor's capital. Also, disclosure of
the policy should be made in the notes to the financial statements.)
c. The payments to the owner's SEPIRA may be charged as an expense to the proprietorship or reflected
as a distribution of proprietor's capital. Separate disclosure in the notes to the financial statements is not
necessary. (This answer is incorrect. Disclosure of the policy should be made in the notes to the financial
statements.)
d. The payments to the owner's SEPIRA may be charged as an expense to the proprietorship or
reflected as a distribution of proprietor's capital. The accounting policy for the plan payments and
related benefits should be disclosed in the notes to the financial statements. (This answer is correct.
There is no authoritative guidance on how to account for such plans in a proprietorship; therefore,
the items may be expensed or treated as a distribution of capital. Disclosure in the notes is required
regardless of treatment.)
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Lesson 2:Partnerships
This lesson discusses the unique characteristics of partnerships. The course addresses issues related to the basis
of accounting used in a partnership and the related reporting requirements. Partnership issues pertaining to
income taxes, guaranteed payments, and loans between the partnership and partner are covered. Changes in
ownership of the partnership are discussed in detail, including informative examples using the bonus and goodwill
method of recording the entry or withdrawal of partners. A discussion of limited liability companies and limited
liability partnerships compares these types of entities with partnerships and S corporations.
Identify the special reporting requirements of compiled or reviewed financial statements of partnerships.
Recognize issues related to changes in partners and the related effects on partners' capital accounts.
Calculate changes in partnership assets and capital accounts under the bonus and goodwill methods.
Compare the advantages and disadvantages of operating as a limited liability corporation (LLC) or a limited
liability partnership (LLP).
SELECTING AN ACCOUNTING BASIS

Generally, the partnership agreement dictates the accounting basis to be used in preparing a partnership's
financial statements. Frequently, the agreement will specify the cash or income tax basis of accounting. Because of
the complicated Internal Revenue Service provisions applicable to partnerships, many accountants encourage
their partnership clients to use the income tax basis of accounting. Likewise, many limited partnerships are
designed to provide maximum tax benefits to the partners, and great emphasis is placed on the income tax basis
of the assets. Thus, most frequently, partnerships present their financial statements on the income tax basis of
accounting.
Cash and tax basis statements do not purport to present financial position and results of operations in accordance
with GAAP. Thus, partnership financial statements presented on the cash or tax basis should not be described in
terms that are generally applicable to accrual basis statements [see SSARS No. 15 (AR 100.04)]. For example,
instead of Balance Sheet," the term Statement of Assets, Liabilities, and Capital Income Tax Basis" should be
used. Similarly, instead of Income Statement," the term Statement of Revenues and Expenses Income Tax
Basis" may be used. Also, a statement of cash flows is not required for tax or cash basis partnership financial
statements because the statements do not purport to present financial position and results of operations in
accordance with GAAP.
If the partnership agreement does not specify a basis of accounting other than GAAP, the partnership financial
statements should include all statements required by GAAP, which would include:
a. Balance Sheet.
b. Statement of Income.
c. Statement of Changes in Partners' Capital.
d. Statement of Cash Flows.
SFAS No. 130, Reporting Comprehensive Income, requires comprehensive income and its components to be
reported when a company presents a full set of financial statements that report financial position, results of
operations, and cash flows. Comprehensive income may be reported in the income statement, in a separate
statement of comprehensive income, or in a statement of changes in owners' equity.
The basic financial statement presentation principles should be applied to partnership financial statements pre
sented on the accrual basis. The following paragraphs discuss some of the unique problems of partnership
financial statement presentation.
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SPECIAL ACCOUNTING TREATMENT SPECIFIED IN AGREEMENT OR

HYBRID ACCOUNTING METHODS
It is common for a partnership agreement to specify an accounting treatment for one or more items that is not in
accordance with GAAP or OCBOA. For example, the partnership agreement may specify that no depreciation is to
be recorded on real property. In such situations, the accountant has two reporting options:
a. If the distribution of the report is to be limited solely to the partners or to those with whom the partnership
is negotiating directly, issue a specialpurpose report, discussed below.
b. If the distribution of the report is not limited, determine the general basis of accounting being used for other
items, i.e., GAAP, cash, or tax, and handle the accounting treatment of the special item or items as
departures from GAAP or OCBOA, discussed below.
Specialpurpose Report Based on the Basis of Accounting Specified in the Partnership Agreement
Interpretation No. 28 of SSARS No. 1 (AR 100.109.119) provides guidance for an accountant engaged to compile
or review financial statements prepared on a basis of accounting specified in a contractual agreement. It also
requires that the distribution of the report be restricted. In the case of a partnership agreement, distribution would
be restricted to the partners or to those with whom the partnership is negotiating directly. In this case, the term
negotiating directly refers to those individuals who have an opportunity to ask questions about the partnership's
Financial Statements Prepared on a Basis of Accounting Specified in the Partnership Agreement Intended
for General Use
If the accountant's report on financial statements prepared on a basis of accounting specified in a partnership
agreement is to be distributed to parties other than the partners or those with whom the partnership is negotiating
directly, the accountant should handle any items requiring special accounting treatment as departures from GAAP
or OCBOA. Following is an example of a note to the financial statements describing a departure specified by a
partnership agreement:
Basis of Accounting
The partnership agreement specifies use of the tax basis of accounting for all items of income and
expense except for depreciation on real property. The agreement specifies that no depreciation
will be recognized on real property. For the year ended December 31, 20X5, the partnership tax
return included a deduction of $75,000 for depreciation of buildings. Cumulative depreciation on
buildings totaled $180,000 at December 31, 20X5. These financial statements do not reflect
current or accumulated depreciation on real property and thus are not in accordance with the tax
basis of accounting.
When departures from GAAP or OCBOA are significant or pervasive, the accountant should consider the need to
include an explanatory paragraph in the report emphasizing the limitations of the financial statements. [See
Interpretation No. 7 of SSARS No. 1 (AR 9100.23.26).]
Client Interpretations of the Partnership Agreement
When the accountant submits compiled or reviewed specialpurpose financial statements prepared on a basis of
accounting prescribed in an agreement that results in a presentation that is not in conformity with GAAP or OCBOA,
Interpretation No. 28 of SSARS No. 1 (AR 9100.109.119) requires that the accountant's report include a descrip
tion of any significant interpretations made by the client regarding provisions of the agreement.
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FEDERAL INCOME TAXES

Income from a partnership is taxed to the partners rather than to the partnership. Therefore, the financial statements
of the partnership should not include federal income tax expense or the related liability. If the statement of income
shows net income after federal income taxes, it is not prepared in accordance with GAAP (TIS 7200.02). However,
when the partnership's financial statements are presented on an accrual basis, it may be appropriate to record a
liability for any substantial partner withdrawals that are anticipated in order to pay income taxes and that are
formally approved before the balance sheet date. Although not required by GAAP, the financial statements should
disclose (a) that the partnership does not pay income taxes and (b) any anticipated withdrawals by partners to pay
income taxes, whether or not recorded as a liability in the financial statements. With respect to item (b), the
accountant should consider disclosing any withdrawals made since the balance sheet date. An illustrative note
follows:
Federal Income Taxes
The partnership is not a taxpaying entity for federal income tax purposes, and thus no income tax
expense has been recorded in the statements. Income from the partnership is taxed to the
partners in their individual returns. The partners customarily make substantial capital withdrawals
in April of each year to pay their personal income tax liabilities. At December 31, 20X5, $75,000
has been deposited in a partnership savings account in anticipation of partner withdrawals.
SFAS No. 109 requires publicly held entities that are not subject to income taxes because income is taxed directly
to their owners to disclose that fact and the net difference between the financial and tax bases of the entities' assets
and liabilities. The requirement generally applies to mutual funds, real estate investment trusts, regulated invest
ment companies, and certain partnerships. Although SFAS No. 109 does not require nonpublic companies to
disclose similar information, disclosing that income is taxed directly to the owners and that as a result, the
partnership did not recognize a provision for income taxes is generally recommended, as illustrated in the preced
ing paragraph. Also, in some circumstances, nonpublic companies may consider it useful to disclose their tempo
rary differences. The disclosure of the nature of temporary differences ordinarily will satisfy the primary users of the
financial statements and, thus, it is not necessary to disclose the amount of the basis differences.
Occasionally, a partnership agreement requires that a provision for income taxes be computed at a specified rate
and be included as an expense of the partnership. The inclusion of such a tax provision is a departure from GAAP
and should be reported as such.
The Impact of FIN 48 on Partnerships
The measurement and disclosure principles of FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in
Income Taxes, do not affect the financial statements of an entity that is not potentially subject to income taxes. To
illustrate, assume that the IRS examines the Form 1065 of a partnership and disallows certain deductions. Any
additional income taxes will be imposed on the partners rather than the partnership, and accordingly FIN 48 would
have no effect on the partnership's financial statements.
Partnerships only need to consider the measurement and disclosure principles of FIN 48 if the entity has the
potential to be subject to income taxes. A more detailed discussion of FIN 48 is beyond the scope of this course.
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STATE INCOME AND FRANCHISE TAXES

If a state or other taxing authority levies a tax on the partnership and the tax is based on net income, the financial
statements should show the tax as an expense of the partnership. Because the payment of income taxes by a
partnership is rare, the financial statements should disclose the nature of the tax (if material).
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GUARANTEED PAYMENTS TO PARTNERS

Guaranteed payments to partners are often made as salary payments for services or interest on capital accounts.
The conventional method of accounting for such payments is to treat them as part of the allocation of partnership
net income, rather than as an expense in determining net income. However, in some situations, e.g., when the
payments are designed to reflect reasonable compensation for services, it may be more meaningful to show the
payments as expenses of the partnership. Whenever guaranteed payments are material, the method of accounting
for them should be stated in the accounting policies disclosures.
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LOANS BETWEEN PARTNERS AND THE PARTNERSHIP

Loans from partners to the partnership, which are greater than the capital required to be contributed, are conven
tionally accounted for as loans rather than capital. In most states, such loans have preferential treatment over
capital upon dissolution. Thus, they should be classified in the balance sheet as liabilities rather than capital, and
interest on the loans should be recorded as an expense of the partnership. The appropriate disclosures required for
related party transactions and notes payable are illustrated in the following example:
NOTE C NOTES PAYABLE TO PARTNERS
The notes payable to partners represent unsecured demand loans payable to certain partners.
Interest on the notes is payable quarterly at the prime interest rate charged by local banks.
Loans to partners, which are not intended to be withdrawals of capital or profits, are considered assets of the
partnership by law in most states. These loans should be recorded in the balance sheet as an asset rather than a
reduction of capital. Again, a related party disclosure, such as the following, is appropriate:
NOTE D LOANS TO PARTNERS
Loans to partners are 180day unsecured loans due May 31, 20X5. The loans bear interest at the
rate of 10% per annum, payable at maturity.
SFAS No. 57, Related Party Disclosures, defines related parties and sets the requirements for related party
disclosures.
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EQUITY SECTION OF THE BALANCE SHEET

The equity section of the balance sheet of a partnership should be labeled Partners' Capital." In some situations,
it may be desirable to disclose the capital accounts of the individual partners or classes of partners. Examples of
such presentations on the face of the balance sheet follow:
PARTNERS' CAPITAL
John Jones
Jim Smith
Bill Adams
PARTNERS' CAPITAL
General Partner
Limited partners
50,000
130,000
85,000
265,000
110,000
(1,275,000 )
$ (1,165,000 )
The same type of presentation might also be made in a note, rather than on the face of the statements.
Generally, no distinction is made on the balance sheet between capital contributed, beginning capital, or retained
earnings, as is done for corporations. However, as discussed in the following paragraph, a statement of changes in
partners' capital may be necessary.
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STATEMENT OF CHANGES IN PARTNERS' CAPITAL

APB Opinion No. 12 requires changes in the stockholders' equity accounts to be disclosed whenever the financial
statements purport to present both financial position and results of operations. While not specifically discussed in
accounting literature, financial statements on the cash or tax basis of accounting or financial statements of entities
other than corporations should generally disclose changes in the components of the capital or equity section of the
balance sheet. Accordingly, changes in partners' capital should be disclosed. In many cases, these changes can
be best disclosed by presenting a combined statement of income and changes in partners' capital as follows:
NET INCOME
BEGINNING PARTNERS' CAPITAL
Drawings for the year
Additional capital contributed
ENDING PARTNERS' CAPITAL
150,000
225,000
(145,000 )
30,000
260,000
It may be preferable to present a separate statement of changes in partners' capital in circumstances such as the
following:
a. When more detail or description of the transactions is desired.
b. When comparative statements are presented.
c. When changes in individual partners' capital accounts are presented.
Exhibit 21 and Exhibit 22 show examples of separate Statements of Changes in Partners' Capital."
Exhibit 21
Example Statements of Changes in Partners' Capital
ABC DISTRIBUTING PARTNERSHIP
STATEMENTS OF CHANGES IN PARTNERS' CAPITAL
20X6
BEGINNING PARTNERS' CAPITAL
Capital contributed
Capital withdrawn
ENDING PARTNERS' CAPITAL
280
20X5
110,000
90,000

(55,000 )
75,000
60,000
15,000
(40,000 )
145,000
110,000
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Exhibit 22
Example Statements of Changes in Partners' Capital
XYZ PARTNERSHIP
STATEMENT OF CHANGES IN PARTNERS' CAPITAL
Partner X
Partner Y
Partner Z
BEGINNING CAPITAL
Share of net income
Capital contributed
Drawings
50,000
85,000

(80,000 )
75,000
60,000

(70,000 )
40,000
45,000
10,000
(40,000 )
165,000
190,000
10,000
(190,000 )
ENDING CAPITAL
55,000
65,000
55,000
175,000
281
Total
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SELFSTUDY QUIZ
following section.
10. What is the most likely reason the majority of partnerships use the income tax basis of accounting in preparing
financial statements?
a. Because the provisions of the Internal Revenue Service applicable to partnerships are simpler than those
required to prepare GAAPbased financial statements.
b. Because partnerships are subject to state law, and most states require the income tax basis of accounting
to be used in the preparation of partnership financial statements.
c. Because most partnerships are designed as tax shelters.
d. Because partnerships are frequently designed to maximize tax benefits to the partners.
11. What type of report should an accountant issue when the partnership agreement specifies treatment of an
accounting item that is not in accordance with GAAP?
a. If the report will only be used by the partners, the accountant should issue a report on compiled or reviewed
financial statements and disclose the item as a departure of GAAP in a note to the financial statements.
b. If the report will only be distributed to those with whom the partnership is negotiating directly, the
accountant should issue a report on compiled or reviewed financial statements and disclose the item as
a departure of GAAP in a note to the financial statements.
c. If the report will only be used by the partners, the accountant should issue a special purpose report.
d. If the distribution of the report is intended for unlimited users, the accountant should issue a special
purpose report.
12. With respect to income taxes, which of the following is most likely to be disclosed in the compiled or reviewed
financial statements of a partnership?
a. Anticipated distributions to partners to pay income taxes.
b. The provision for income taxes and related liability to the partnership.
c. Net income after federal income taxes.
d. The amount of the book versus tax temporary differences in the financial statements of the partnership.
13. In general, how should loans from partners to the partnership and related items be accounted for in the financial
statements of a partnership?
a. The loans should be classified as capital contributions and included in partner equity. Related interest
expense should be recorded as an expense of the partnership. Disclosure of the related party transaction
should be made in the note to the financial statements.
b. The loans should be classified as liabilities in the balance sheet. Related interest expense should be
recorded as an expense of the partnership. Disclosure of the note related party transaction should be made
in the note to the financial statements.
c. The loans should be classified as liabilities in the balance sheet. Related interest expense should be
recorded as an increase in the capital account of the partner. Disclosure of the related party transaction
should be made in the note to the financial statements.
d. The loans should be classified as liabilities in the balance sheet. Related interest expense should be
recorded as an expense of the partnership. Disclosure of the related party transaction is not required in
a note to the financial statements.
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14. Based on guidance related to corporations in APB Opinion No. 12, when should the financial statements of a
partnership disclose changes in partners' capital?
a. When a change occurs within a partner's capital account during the period presented by the financial
statements.
b. When the financial statements present the results of operations of a partnership.
c. When the financial statements present both financial position and results of operations.
d. When a new partner is admitted to the partnership.
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SELFSTUDY ANSWERS
10. What is the most likely reason the majority of partnerships use the income tax basis of accounting in preparing
financial statements? (Page 273)
a. Because the provisions of the Internal Revenue Service applicable to partnerships are simpler than those
required to prepare GAAPbased financial statements. (This answer is incorrect. The IRS provisions
applicable to partnerships are very complex.)
b. Because partnerships are subject to state law, and most states require the income tax basis of accounting
to be used in the preparation of partnership financial statements. (This answer is incorrect. The partnership
agreement dictates the accounting basis to be used in preparing the financial statements, not state law.)
c. Because most partnerships are designed as tax shelters. (This answer is incorrect. While some
partnerships are designed as tax shelters, this is not the most likely reason to use the income tax basis of
accounting.)
d. Because partnerships are frequently designed to maximize tax benefits to the partners. (This
answer is correct. Due to the emphasis on the tax basis of assets, the income tax basis of accounting
is the most logical method of presenting the financial statements of a partnership.)
11. What type of report should an accountant issue when the partnership agreement specifies treatment of an
accounting item that is not in accordance with GAAP? (Page 274)
a. If the report will only be used by the partners, the accountant should issue a report on compiled or reviewed
financial statements and disclose the item as a departure of GAAP in a note to the financial statements.
(This answer is incorrect. The accountant should not issue a report on compiled or reviewed financial
statements if the report will only be distributed to the partners.)
b. If the report will only be distributed to those with whom the partnership is negotiating directly, the
accountant should issue a report on compiled or reviewed financial statements and disclose the item as
a departure of GAAP in a note to the financial statements. (This answer is incorrect. The accountant should
not issue a report on compiled or reviewed financial statements if the report will only be distributed to those
with whom the partnership is negotiating directly.)
c. If the report will only be used by the partners, the accountant should issue a special purpose report.
(This answer is correct. Based on guidance in SSARS No. 1, special issue reports should be issued
when the financial statements contain departures from GAAP as specified by the partnership
agreement and will only be distributed to the partners or to those with whom the partnership is
negotiating directly.)
d. If the distribution of the report is intended for unlimited users, the accountant should issue a special
purpose report. (This answer is incorrect. If the report is intended for those other than partners and those
with whom the partnership is negotiating directly, a special purpose report is not appropriate.)
12. With respect to income taxes, which of the following is most likely to be disclosed in the compiled or reviewed
financial statements of a partnership? (Page 275)
a. Anticipated distributions to partners to pay income taxes. (This answer is correct. While not required
by GAAP, such disclosure is generally recommended in order to inform financial statement users
of substantial partner withdrawals that are anticipated or have been made subsequent to the
balance sheet date.)
b. The provision for income taxes and related liability to the partnership. (This answer is incorrect. Since
income is taxed to the partners and not to the partnership, the financial statements of the partnership
should not reflect income tax expense or the related liability.)
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c. Net income after federal income taxes. (This answer is incorrect. Since income is taxed to the partners and
not to the partnership, disclosure of net income after taxes would be a departure from GAAP. This
presentation would not likely be found in the financial statements of a partnership.)
d. The amount of the book versus tax temporary differences in the financial statements of the partnership.
(This answer is incorrect. In some circumstances, the nature of temporary differences is disclosed in the
notes to the financial statements, but the amounts of the differences will not likely be disclosed.)
13. In general, how should loans from partners to the partnership and related items be accounted for in the financial
statements of a partnership? (Page 278)
a. The loans should be classified as capital contributions and included in partner equity. Related interest
expense should be recorded as an expense of the partnership. Disclosure of the related party transaction
should be made in the note to the financial statements. (This answer is incorrect. The loan made by the
partner, when it exceeds the required capital contribution, will not generally be classified as a capital
contribution. In addition, interest is not calculated on equity.)
b. The loans should be classified as liabilities in the balance sheet. Related interest expense should
be recorded as an expense of the partnership. Disclosure of the note related party transaction
should be made in the note to the financial statements. (This answer is correct. All three elements
would generally satisfy the reporting and disclosure requirements of loans made to a partnership
by a partner.)
c. The loans should be classified as liabilities in the balance sheet. Related interest expense should be
recorded as an increase in the capital account of the partner. Disclosure of the related party transaction
should be made in the note to the financial statements. (This answer is incorrect. Interest paid by the
partnership related to a loan made by a partner should not be recorded as an increase to the partner's
capital account.)
d. The loans should be classified as liabilities in the balance sheet. Related interest expense should be
recorded as an expense of the partnership. Disclosure of the related party transaction is not required in
a note to the financial statements. (This answer is incorrect. Disclosure of related party transactions is
required by SFAS No. 57.)
14. Based on guidance related to corporations in APB Opinion No. 12, when should the financial statements of a
partnership disclose changes in partners' capital? (Page 280)
a. When a change occurs within a partner's capital account during the period presented by the financial
statements. (This answer is incorrect. Changes in individual equity accounts are not addressed in the
guidance provided by APB Opinion No. 12.)
b. When the financial statements present the results of operations of a partnership. (This answer is incorrect.
APB Opinion No. 12 would not require the disclosure of changes stockholders' equity in this case.)
c. When the financial statements present both financial position and results of operations. (This
answer is correct. While APB Opinion No. 12 applies to corporations and stockholders' equity,
practitioners generally apply its provisions when compiling or reviewing financial statements of
entities other than corporations.)
d. When a new partner is admitted to the partnership. (This answer is incorrect. The presence of new
shareholders is not addressed in the guidance provided by APB Opinion No. 12.)
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CHANGES IN PARTNERSHIP INTEREST

Conventional methods for changes in partnership interest frequently require that partnership assets be written up
to appraised values. Practical solutions to some common practice problems associated with changes in a partner
ship interest are discussed in the following paragraphs.
Changes in partnership interest normally take one of the following forms:
a. A new partner is admitted.
b. A partner withdraws (because of retirement or otherwise).
c. A partner dies.
These events are not mutually exclusive; for example, a retiring partner may sell his interest to a new partner.
However, each of these events is discussed separately.
Accounting Issues
Authoritative pronouncements do not provide guidance on accounting for partnership admissions and withdraw
als. However, accounting textbooks, which are included in level (e) of the hierarchy of GAAP, generally discuss two
methods of accounting for those transactions: the bonus method and the goodwill method. Under the bonus
method, assets contributed for an admission are valued at their fair market value at the date of contribution, but
assets distributed for a withdrawal are not revalued. (Under APB Opinion No. 29, the assets to be distributed are
adjusted to fair value, and the adjustment is included in income. The distribution is then recorded at fair value.)
Under the goodwill method, the value of the partnership as a whole is imputed based on the price of the partnership
interest being sold or acquired, and assets are adjusted (through a debit to assets and a credit to capital) to reflect
the imputed value. Both methods generally are applied the same whether the transaction is between the partner
ship and individual partners or solely between individual partners.
Accounting textbooks generally discuss the bonus and goodwill methods as equally acceptable alternatives, but
there are other publications that either indicate a preference for, or opposition to, one method over the other in
certain instances. Some observe that a corporation would usually recognize no change in basis for similar
transactions and, therefore, question whether different results should be obtained for similar transactions based on
the form of organization. The FASB's Emerging Issues Task Force (EITF) studied certain aspects of accounting for
partnership transactions. Its discussions indicated the use of a third method to account for withdrawals in practice.
That method, referred to as the push down method, permits a partial revaluation to the extent that the price of the
acquired interest differs from the book value of the interest. (The push down method yields the same results as the
push down method for corporations. The excess of the partner's personal basis calculated using the equity method
of accounting over that partner's proportionate share of the equity of the partnership is pushed down to the
partnership. Note that the push down method would yield a different result than the bonus method, which would
not permit revaluation.) The EITF discussions also indicated concern about the appropriateness of complete
revaluation as comprehended by the goodwill method.
The accounting issue is whether a change in basis of accounting should be recorded for a change in ownership.
Under the bonus method, there is no change in basis, but under the push down method, there is a partial change
and under the goodwill method, there is a complete change in basis. Since the EITF did not reach a consensus on
Issue No. 8546, Partnership's Purchase of Withdrawing Partner's Equity," it shouldn't override the guidance in
textbooks and other publications. Nevertheless, it indicates that, although there is support for a change in basis,
there is also a belief that the available methods should not be viewed as equally acceptable alternatives and that the
complete revaluation comprehended by the goodwill method is rarely appropriate. Accordingly, accounting for
partnership capital transactions based on the facts and circumstances surrounding each individual transaction is
generally recommended. In general, a change in basis is only appropriate if a new controlling interest (that is,
ownership of more than 50% of the partnership) is established.
EITF Issue No. 8816, Basis in Leveraged Buyout Transactions," provides guidance on accounting for leveraged
buyouts (LBOs). Although that guidance was clearly not intended to govern accounting for partnership transac
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tions, the substance of an LBO is analogous to a change in partners' capital, and the accounting issue is the same:
whether to record a change in the basis of accounting when there is a change in ownership. Therefore, an
approach for deciding whether to recognize a change in the basis of accounting based on the EITF's guidance on
LBOs is summarized as follows:
a. There should be no change in basis unless there is a new controlling interest in the partnership. This means
that (1) a new partner owns more than 50% of the partnership or (2) no subset of the continuing partners
owned more than 50% of the partnership before the transaction. (The partners function together to control
the partnership; therefore, if the continuing partners as a group did not own a controlling interest in the
partnership before the transaction, the requirement for a new controlling interest would be met.) If any of
the continuing partners own a relatively small interest in the partnership after the transaction (e.g., 5% or
less), it may be appropriate to ignore them in determining whether the continuing partners controlled the
partnership before the transaction.
b. If the above requirement is met, the total capital of the partnership after the transaction should be calculated
as the sum of
(1) The percentage of ownership of new partners multiplied by the fair value of the partnership before the
transaction.
(2) The lower of the percentage of ownership of continuing partners before and after the transaction
multiplied by the book value (that is, partners' capital as reported in the GAAP financial statements)
of the partnership before the transaction.
(3) The excess of percentage of ownership of continuing partners after the transaction over the
percentage used in the preceding step, if any, multiplied by the fair value of the partnership before the
transaction.
(4) The fair value of the assets contributed by the new partners (if partners are withdrawing, subtract the
fair value of assets distributed to them).
c. The adjustment of partners' capital required by this calculation should be charged or credited to partners'
capital not to earnings.
d. Since the basis of assets will no longer be comparable with the basis used in priorperiod financial
statements, financial statements presented after the transaction should not be presented in comparison
with such statements.
e. The method used to account for the transaction should be disclosed in a separate note describing the
transaction.
PPC's Guide to Preparing Financial Statements contains a more detailed discussion of this issue. However, the
following paragraphs illustrate how to apply the preceding recommendations.
Admission of a New Partner
No taxable gain or loss should be recognized when cash or other assets are contributed to a partnership, and the
tax bases of the assets in the hands of the partnership are the same as the tax bases in the hands of the contributing
partners.
Both the bonus method and the goodwill method require the contributed assets to be recorded at fair market value.
Thus, both differ from partnership tax accounting when appreciated assets are contributed. The following para
graphs describe and illustrate the bonus and goodwill methods.
The Bonus Method. Briefly described, the bonus method records the cash or contributed assets at FMV and
reallocates capital among partners but does not record appraisal increases in existing assets or record implicit
goodwill. The bonus method of accounting parallels GAAP for recording the issuance of stock in a corporation to
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a new stockholder (except when one corporation acquires another under the purchase method of accounting).
This parallel holds regardless of whether the new partner buys his interest from the partnership or the individual
partners. Thus, the bonus method generally causes no problems of comparability between financial statements of
periods prior to the admission of the new partner and subsequent periods. (Old assets are presented on the same
basis as previously presented, and new assets contributed are presented at FMV, which is consistent with GAAP.)
An example of the bonus method is illustrated in Exhibit 23.
Exhibit 23
Admission of a New Partner Using the Bonus Method
1. Partnership's summarized balance sheet before admission (A and B are equal partners):
ASSETS
160,000
LIABILITIES
PARTNERS' CAPITAL
Partner A
Partner B
60,000
50,000
50,000
100,000
160,000
2. Partner C contributes assets with FMV of $70,000 (or $70,000 cash) for a onethird interest:
Assets
Capital A
Capital B
Capital C
[(100,000 + 70,000) 3 = 56,666]
70,000
6,667
6,667
56,666
3. Summarized balance sheet after admission:

ASSETS
230,000
LIABILITIES
PARTNERS' CAPITAL
Partner A
Partner B
Partner C
60,000
56,667
56,667
56,666
170,000
230,000
The Goodwill Method. The goodwill method entails revaluing the partnership's existing assets and considering
goodwill based on the price to be paid by the new partner. This method results in entries to the partnership books
to record appraisal increases and/or goodwill. It parallels the purchase method of accounting for mergers and
acquisitions. The revaluation, generally, destroys the comparability of the financial statements for periods prior to
admission with subsequent periods. Assuming the same facts as in the previous illustration, application of the
goodwill method is illustrated in Exhibit 24.
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Exhibit 24
Admission of a New Partner Using the Goodwill Method
1. Partnership's summarized balance sheet before admission:
ASSETS
160,000
LIABILITIES
PARTNERS' CAPITAL
Partner A
Partner B
60,000
50,000
50,000
100,000
160,000
2. Partner C contributes assets with FMV of $70,000 (or $70,000 cash) for a onethird interest:
DR
Assets
Capital C
CR
70,000
70,000
3. The existing assets of the partnership are revalued:

Implicit value of 100% of partnership based on Partner C's FMV
($70,000 3)
Less book value before admission
Less market value of assets contributed by a new partner
210,000
(100,000 )
(70,000 )
Increase in partners' capital
40,000
DR
Assets (or goodwill)a
Capital A
Capital B
CR
40,000
20,000
20,000
4. Summarized balance sheet after admission:

ASSETS (including goodwill, if any)
270,000
LIABILITIES
PARTNERS' CAPITAL
Partner A
Partner B
Partner C
60,000
70,000
70,000
70,000
210,000
270,000
Note:
a
Goodwill is recorded only if the excess of market value of tangible assets over their book value is less
than the $40,000 increase computed in item 3.
*
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In the example illustrated in Exhibit 23 and Exhibit 24, the new partner did not acquire control and a subset of the
partners (A and B) controlled the partnership before the admission of partner C. Therefore, the requirement for a
change in ownership described has not been met. Thus, there should be no change in basis. The accounting for
the transaction would be the same as that illustrated in Exhibit 23 for the bonus method.
An example of appropriate disclosure in this situation follows:
NOTE X ADMISSION OF A PARTNER
In 20X6, a new partner acquired a onethird interest in the Partnership for cash of $70,000, and
new capital of $70,000 was recorded. As shown in the accompanying statement of partners'
capital accounts, the admission caused some realignment of the capital accounts of existing
partners to reflect each partner's revised interest in the Partnership's book value after the con
tribution.
When such transactions take place other than at the end of the fiscal year of the partnership, the accountant is
faced with additional problems. Should the statements reflect the entire year or only the period subsequent to the
transaction? In most instances, users will want full year statements. The full year statements should include
pretransaction earnings as previously calculated (unadjusted for the writeup of assets under the goodwill method).
However, disclosing the pro forma effect on net income of the transaction as if it had taken place at the beginning
of the year is generally recommended.
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SELFSTUDY QUIZ
following section.
15. To comply with GAAP, what is the primary source of guidance related to accounting for partnership admissions
and withdrawals?
a. FASB Statements and Interpretations.
b. AICPA Statements of Position.
c. Accounting textbooks.
d. AICPA Technical Practice Aids.
16. When accounting for a change in partnership interest, what is a primary difference between the bonus method
and the goodwill method?
a. Under the bonus method, assets distributed for a withdrawal are revalued. Under the goodwill method,
assets distributed for a withdrawal are not revalued.
b. Under the bonus method, there is no change in basis. Under the goodwill method, there is a partial change
in basis.
c. Under the bonus method, there is a partial change in basis. Under the goodwill method, there is a complete
change in basis.
d. Under the bonus method, there is no change in basis. Under the goodwill method, there is a complete
change in basis.
17. According to guidance issued in EITF Issue No. 8816 relating to leveraged buyouts, under which of the
following circumstances would a change in basis occur given a change of ownership in a partnership?
a. When any partner is admitted to the partnership.
b. When a new partner purchases a 33% interest in the partnership from an existing partner.
c. When a new partner purchases a 50% interest in the partnership from the partnership subsequent to the
death of a partner.
d. When a new partner purchases a 65% interest in the partnership from a retiring partner.
Assume the following facts when answering questions 1821:
On June 30, 2006, Happy Partnership's balance sheet is summarized as follows:
Assets
250,000
Liabilities
Partners' Capital
Partner X (60% partner)
Partner Y (40% partner)
150,000
60,000
40,000
100,000
$
On June 30, 2006, Partner Z buys a 30% interest in the partnership for $80,000 cash.
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18. Using the bonus method, what is the balance of Partner X's capital account after the contribution by new Partner
Z?
a. $60,000.
b. $73,000.
c. $75,600.
d. $77,400.
19. Using the bonus method, what are total assets in Happy Partnership subsequent to the sale?
a. $250,000.
b. $330,000.
c. $350,000.
d. $425,000.
20. Using the goodwill method, what is the balance of Partner Y's capital account after the contribution by new
Partner Z?
a. $54,667.
b. $74,667.
c. $83,333.
d. $126,667.
21. Using the goodwill method, what are total assets in Happy Partnership subsequent to the sale?
a. $330,000.
b. $416,667.
c. $465,333.
d. $495,667.
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SELFSTUDY ANSWERS
15. To comply with GAAP, what is the primary source of guidance related to accounting for partnership admissions
and withdrawals? (Page 287)
a. FASB Statements and Interpretations. (This answer is incorrect. FASB Statements and Interpretations,
included in Level A in the hierarchy of GAAP as described in SAS No. 69, is not a source on this issue.)
b. AICPA Statements of Position. (This answer is incorrect. AICPA Statements of Position, included in Level
B in the hierarchy of GAAP as described in SAS No. 69, is not a source on this issue.)
c. Accounting textbooks. (This answer is correct. Accounting textbooks, included in Level E in the
hierarchy of GAAP as described in SAS No. 69, are the primary source in dealing with partnership
admissions and withdrawals.)
d. AICPA Technical Practice Aids. (This answer is incorrect. AICPA Technical Practice Aids, included in Level
E in the hierarchy of GAAP as described in SAS No. 69, is not a source on this issue.)
16. When accounting for a change in partnership interest, what is a primary difference between the bonus method
and the goodwill method? (Page 287)
a. Under the bonus method, assets distributed for a withdrawal are revalued. Under the goodwill method,
assets distributed for a withdrawal are not revalued. (This answer is incorrect. Under the bonus method,
assets distributed for a withdrawal are not revalued. Under the goodwill method, all assets are adjusted
to reflect the imputed value of the asset based on the price of the partnership being sold or acquired.)
b. Under the bonus method, there is no change in basis. Under the goodwill method, there is a partial change
in basis. (This answer is incorrect. The answer does not properly reflect the accounting for a change in
partnership interest under the goodwill method.)
c. Under the bonus method, there is a partial change in basis. Under the goodwill method, there is a complete
change in basis. (This answer is incorrect. The answer does not properly reflect the accounting for a
change in partnership interest under the bonus method.)
d. Under the bonus method, there is no change in basis. Under the goodwill method, there is a
complete change in basis. (This answer is correct. The bonus method generally parallels GAAP
when recording the issuance of stock in a corporation to a new stockholder, i.e. old assets are
presented on the same basis as previously presented. The goodwill method, on the other hand,
revalues the partnership's existing assets and records goodwill based on the price to be paid by the
new partner.)
17. According to guidance issued in EITF Issue No. 8816 relating to leveraged buyouts, under which of the
following circumstances would a change in basis occur given a change of ownership in a partnership?
(Page 287)
a. When any partner is admitted to the partnership. (This answer is incorrect. According to guidance issued
in EITF Issue No. 8816 relating to leveraged buyouts, every change in ownership would not give rise to
a change in basis.)
b. When a new partner purchases a 33% interest in the partnership from an existing partner. (This answer is
incorrect. According to guidance issued in EITF Issue No. 8816 relating to leveraged buyouts, a new
owner who purchased 33% of the partnership would not cause a change in basis.)
c. When a new partner purchases a 50% interest in the partnership from the partnership subsequent to the
death of a partner. (According to guidance issued in EITF Issue No. 8816 relating to leveraged buyouts,
a new owner who purchased 50% of the partnership would not cause a change in basis.)
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d. When a new partner purchases a 65% interest in the partnership from a retiring partner. (This answer
is correct. While EITF Issue No. 8816 relates to LBOs, the same principle can be applied to changes
in partnership interests. According to the EITF, a change in basis should only occur when a new
partner owns more than 50% of the partnership or no subset of continuing partners owned more than
50% of the partnership before the transaction.)
On June 30, 2006, Happy Partnership's balance sheet is summarized as follows:
Assets
250,000
Liabilities
Partner's Capital
150,000
60,000
40,000
100,000
250,000
On June 30, 2006, Partner Z buys a 30% interest in the partnership for $80,000 cash.
Z? (Page 288, Page 289)
a. $60,000. (This answer is incorrect. The balance of X's capital account would increase as a result of the sale
of to Z.)
b. $73,000. (This answer is incorrect. A $13,000 increase to the capital account of X does not properly reflect
the balance subsequent to the sale.)
c. $75,600. (This answer is correct. Total partners' capital after the sale of 30% of the partnership is
$180,000 ($100,000 + $80,000). $180,000 30% = $54,000, or Partner Z's capital account. $26,000
($80,000 $54,000) of Z's contribution should be allocated to X and Y. Since X owned 60% prior
to the sale, X's capital account will be increased by $15,600, or $26,000 60%, resulting in a capital
account balance for X of $75,600, $60,000 + $15,600.)
d. $77,400. (This answer is incorrect. A $17,400 increase to the capital account of X does not properly reflect
the balance subsequent to the sale.)
19. Using the bonus method, what are total assets in Happy Partnership subsequent to the sale? (Page 288,
Page 289)
a. $250,000. (This answer is incorrect. Total assets of the partnership would increase subsequent to the
purchase of a 30% interest by Partner Z.)
b. $330,000. (This answer is correct. Prior to the sale, total assets were $250,000. After debiting cash
for $80,000, total assets of the partnership would be $330,000.)
c. $350,000. (This answer is incorrect. Total assets of the partnership would not increase by $100,000 based
on the facts above.)
d. $425,000. (This answer is incorrect. Total assets of the partnership would not increase by $175,000 based
on the facts above.)
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Partner Z? (Page 289, Page 290)
a. $54,667. (This answer is incorrect. Partner Y's capital account would increase by more than $14,667 as
a result of this transaction under the goodwill method.)
b. $74,667. (This answer is correct. Using the goodwill method, the total value of partners' capital is
imputed by taking purchase price of $80,000 and dividing it by the percentage ownership of Z, 30%.
This results in an imputed value of $266,667. Next, the book value of partners' capital and the value
of the assets used to purchase the partnership interest are subtracted from $266,667, resulting in
an increase to partners' capital of $86,667 ($266,667 100,000 80,000 = $86,667). Since Partner
Y owned 40% prior to the sale, the capital account of Partner Y would increase by $34,667, or $86,667
40%. Partner Y's total capital account would be $74,667, or $40,000 + $34,667.)
c. $83,333. (This answer is incorrect. Partner Y's capital account would not increase by $43,333 as a result
of this transaction under the goodwill method.)
d. $126,667. (This answer is incorrect. Partner Y's capital account would not increase by $86,667 as a result
of this transaction under the goodwill method.)
21. Using the goodwill method, what are total assets in Happy Partnership subsequent to the sale? (Page 289,
Page 290)
a. $330,000. (This answer is incorrect. Using the goodwill method, total assets would increase by more than
the purchase price of $80,000 based on the facts above.)
b. $416,667. (This answer is correct. The $250,000 in Total Assets on June 30, 2006, would be increased
by the purchase price of $80,000 and the increase of $86,667 in imputed value of the partners' capital
accounts, or $250,000 + 80,000 + 86,667 = $416,667.)
c. $465,333. (This answer is incorrect. Using the goodwill method, total assets would not increase by
$215,333 based on the facts above.)
d. $495,667. (This answer is incorrect. Using the goodwill method, total assets would not increase by
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Withdrawal or Death of a Partner

The withdrawal or death of a partner introduces the same accounting alternatives discussed in the previous section
regarding admission of new partners. Withdrawal because of death, retirement, or otherwise is generally accom
plished by one of the following methods:
a. Distribution in kind.
b. Sale to a third party.
c. Sale to the remaining partners.
d. Sale to the partnership.
All four situations can be accounted for by either the bonus or goodwill method. In most states, the retirement or
death of a partner causes the partnership to legally terminate; thus, it is preferable to begin a new accounting
period for the new entity at the effective date of death or retirement, regardless of which accounting method is used.
If financial statements that include the portion of the fiscal year before death or retirement are presented, they
should include appropriate disclosures concerning the change in ownership, including the method of accounting
used and the effect of that method.
When the partnership acquires the withdrawing partner's interest under a retirement, death, or disability provision,
which obligates the partnership to pay a fixed and determinable sum to the partner or his beneficiary, the goodwill
method may be the more appropriate accounting method. The bonus method could produce large deficits in
capital when the obligation to the withdrawing partner is recorded without recording the increase in values of the
partnership assets.
Retirement or death provisions that provide for a specified payment for life should be actuarially valued and
recorded as part of the purchase cost of the interest of the withdrawing partner. If the partnership agreement
specifies a fixed and determinable amount plus a contingent amount based on future profits, the fixed amount
should be the basis of entries to record the withdrawal, and future payments made as a result of the contingent
payment provisions should be recorded as an expense of the partnership in the period incurred (and determin
able). The existence of such a contingent payment provision should be disclosed in each period covered by the
provision, even if no expense is incurred in the period.
The Bonus Method. Distributions in kind accounted for under the bonus method are illustrated in Exhibit 25:
Exhibit 25
Withdrawal of a Partner Using the Bonus Method
1. Partnership's summarized balance sheet before distribution:
ASSETS
150,000
LIABILITIES
PARTNERS' CAPITAL
Partner A
Partner B
Partner C
60,000
40,000
20,000
30,000
90,000
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150,000
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2. Partner C withdraws. The FMV of C's interest is $60,000. Assets with a book value of $25,000 and a market
value of $60,000 are distributed to completely terminate C's interest:
DR
Capital C
Capital A
Capital B
Assets (distributed)
CR
30,000
3,333
1,667
25,000
3. Summarized balance sheet after withdrawal:

ASSETS
125,000
LIABILITIES
PARTNERS' CAPITAL
Partner A
Partner B
60,000
43,333
21,667
65,000
125,000
The Goodwill Method. Distributions in kind accounted for by the goodwill method are illustrated in Exhibit 26.
Exhibit 26
Withdrawal of a Partner Using the Goodwill Method
1. Partnership's summarized balance sheet before distribution:
ASSETS
150,000
LIABILITIES
PARTNERS' CAPITAL
Partner A
Partner B
Partner C
60,000
40,000
20,000
30,000
90,000
150,000
2. The existing assets of the partnership are revalued based on Partner C's FMV of $60,000:
Implicit value of 100% of partnership based on Partner C's FMV
($60,000 3)
Less existing book value
180,000
(90,000 )
Increase in partners' capital
90,000
DR
Assets (or goodwill, if applicable)
Capital A
Capital B
Capital C
299
90,000
CR
$
40,000
20,000
30,000
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3. Partner C withdraws:
DR
Capital C
Assets
CR
60,000
60,000
4. Summarized balance sheet after withdrawal:

ASSETS
180,000
LIABILITIES
PARTNERS' CAPITAL
Partner A
Partner B
60,000
80,000
40,000
120,000
180,000
Deciding whether to recognize a change in basis is discussed earlier in this lesson. Partners A and B are consid
ered to operate the partnership as a group, and they had control of the partnership before C's withdrawal.
Therefore, the requirements for a new controlling interest have not been met and there should be no change in
basis. The transaction would be accounted for using the bonus method. However, a gain would be recognized for
any appreciation in the assets distributed, and the distribution recorded at fair value. This difference from the bonus
method only affects the income statement for the period of the transaction and does not affect the balance sheet
after the transaction. The assets and liabilities would be valued the same for financial statement purposes and for
income tax reporting.
Sale to the partnership is accounted for as illustrated in the previous two paragraphs, except that the assets
distributed consist of cash and/or debt obligations of the partnership.
Accounting for withdrawal by sale to a third party or to existing partners individually parallels the accounting
treatment for admission of a new partner, as discussed previously in this lesson.
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SELFSTUDY QUIZ
following section.
On September 30, 2006, Harmonious Partnership's balance sheet is summarized as follows:
Assets
500,000
Liabilities
Partner's Capital
Partner Z (20% partner)
200,000
180,000
60,000
60,000
300,000
500,000
On September 30, 2006, Partner Y retires from the partnership. The fair market value of Partner Y's interest is
$100,000. Assets with a book value of $50,000 and a fair market value of $100,000 are distributed to completely
terminate Y's interest.
22. Using the bonus method, what is the balance of Partner X's capital account after the termination of Partner Y's
interest?
a. $130,000.
b. $182,500.
c. $185,000.
d. $187,500.
23. Using the bonus method, what are total assets in Harmonious Partnership subsequent to the sale?
a. $400,000.
b. $440,000.
c. $450,000.
d. $500,000.
24. Using the goodwill method, what is the balance of Partner Z's capital account after the termination of Partner
Y's interest?
a. $60,000.
b. $100,000.
c. $110,000.
d. $160,000.
301
25. Using the goodwill method, what are total assets in Harmonious Partnership subsequent to the sale?
a. $400,000.
b. $450,000.
c. $500,000.
d. $600,000.
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SELFSTUDY ANSWERS
On September 30, 2006, Harmonious Partnership's balance sheet is summarized as follows:
Assets
500,000
Liabilities
Partner's Capital
200,000
180,000
60,000
60,000
300,000
500,000
On September 30, 2006, Partner Y retires from the partnership. The fair market value of Partner Y's interest is
$100,000. Assets with a book value of $50,000 and a fair market value of $100,000 are distributed to completely
terminate Y's interest.
22. Using the bonus method, what is the balance of Partner X's capital account after the termination of Partner Y's
interest? (Page 298)
a. $130,000. (This answer is incorrect. The balance of X's capital account would increase as a result of the
termination of Y's interest.)
b. $182,500. (This answer is incorrect. A $2,500 increase to the capital account of X does not properly reflect
the balance subsequent to the termination of Y's interest.)
c. $185,000. (This answer is incorrect. A $5,000 increase to the capital account of X does not properly reflect
the balance subsequent to the termination of Y's interest.)
d. $187,500. (This answer is correct. The difference between the book value of the assets distributed,
$50,000, and the balance in Y's capital account, $60,000, is $10,000. Partner X's capital account
would be credited for 75% of this difference, based on his 60% share and Partner Z's 20% share
(60/80 = 75%). After crediting Partner X's account by $7,500, Partner X's capital account will be
$187,500, or $180,000 + $7,500.)
23. Using the bonus method, what are total assets in Harmonious Partnership subsequent to the sale? (Page 288,
Page 289)
a. $400,000. (This answer is incorrect. Total assets of the partnership would not be reduced by the fair market
value of the assets distributed under the bonus method.)
b. $440,000. (This answer is incorrect. Total assets of the partnership would not decrease in an amount equal
to Y's capital account prior to the termination of the interest in the partnership.)
c. $450,000. (This answer is correct. Prior to the sale, total assets were $500,000. After distributing
assets with a book value of $50,000, total assets of the partnership would equal $450,000.)
d. $500,000. (This answer is incorrect. Total assets of the partnership would decrease subsequent to the
distribution of Y's interest.)
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24. Using the goodwill method, what is the balance of Partner Z's capital account after the termination of Partner
Y's interest? (Page 298, Page 299)
a. $60,000. (This answer is incorrect. Partner Z's capital account would increase as a result of the termination
of Y's interest.)
b. $100,000. (This answer is correct. Using the goodwill method, the total value of partners' capital is
imputed by taking the FMV of Y's interest, $100,000, and dividing it by the percentage ownership of
Y, 20%. This results in an imputed value of $500,000. Next, the book value of partners' capital is
subtracted from $500,000, resulting in an increase to partners' capital of $200,000 ($500,000
$300,000). Since Partner Z owned 20% prior to the sale, the capital account of Partner Z would
increase by $40,000, or $200,000 20%. Partner Z's total capital account would equal $100,000, or
$60,000 + $40,000.)
c. $110,000. (This answer is incorrect. Partner Z's capital account would not increase by $50,000 as a result
of the termination of Y's interest under the goodwill method.)
d. $160,000. (This answer is incorrect. Partner Z's capital account would not increase by $100,000 as a result
of the termination of Y's interest under the goodwill method.)
25. Using the goodwill method, what are total assets in Harmonious Partnership subsequent to the sale?
(Page 298, Page 299)
a. $400,000. (This answer is incorrect. Using the goodwill method, total assets would not decrease by
b. $450,000. (This answer is incorrect. Using the goodwill method, total assets would not decrease by
c. $500,000. (This answer is incorrect. Using the goodwill method, total assets would increase due to the
termination of Y's interest based on the facts above.)
d. $600,000. (This answer is correct. The $500,000 in Total Assets on September 30, 2006, would be
increased when the value of the partners' equity is imputed by taking the FMV of Y's interest,
$100,000, and dividing it by the percentage ownership of Y, 20%. This results in an imputed value
of $500,000. Next, the book value of partners' capital is subtracted from $500,000, resulting in an
increase to total assets of $200,000 ($500,000 $300,000). Next, total assets are reduced by the
FMV of the distributed assets, $100,000, in termination of Y's interest. Thus, total assets after the
termination equal $600,000, $500,000 + 200,000 100,000 = $600,000.)
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ACCOUNTING FOR INVESTMENTS IN PARTNERSHIPS AND JOINT

VENTURES
Accounting for an investment in a partnership is a source of confusion to practitioners. Confusion exists regardless
of whether the owner is an individual, corporation, or another partnership.
APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, is the authoritative
pronouncement that comes closest to being on point. APB Opinion No. 18 requires the use of the equity method of
accounting by investors holding investments in unconsolidated subsidiaries and corporate joint ventures. APB
Opinion No. 18 does not address investments in partnerships and unincorporated joint ventures. However, AICPA
Interpretation No. 2 of APB Opinion No. 18, while specifically stating that APB Opinion No. 18 does not address
such investments, does state that many of the provisions of APB Opinion No. 18 are appropriate in accounting for
a partnership interest. The same factors (a controlling financial interest and the ability to exercise significant
influence over operating and financial policies) that are necessary for use of the equity method by investors in
corporate common stock apply to investments in partnerships.
The term investor as defined in APB Opinion No. 18 refers to a business entity. The Opinion also specifically
excludes estates, trusts, and individuals from coverage of its provisions. Thus, it appears that the equity method is
appropriate for use by corporate investors, by partnerships, and by proprietorships that have investments in
partnerships or joint ventures.
Based on APB Opinion No. 18 and Interpretation No. 2, corporate investors, partnerships, and proprietorships
should use the equity method of accounting for investments of 20%50% in a partnership or unincorporated joint
venture. The Interpretation notes that, for unincorporated joint ventures in certain industries, e.g., oil and gas
ventures, it may be appropriate for the investor to record in its financial statements its pro rata share of the assets,
liabilities, revenues, and expenses of the venture. (Such a presentation may be appropriate if the investor owns an
undivided interest in each of the venture's assets and is proportionately liable for its share of each of the venture's
liabilities. However, the EITF concluded in Issue No. 001, Investor Balance Sheet and Income Statement Display
under the Equity Method for Investments in Certain Partnerships and Other Ventures," that such a presentation is
not appropriate for investments in unincorporated legal entities accounted for by the equity method unless the
investee is in either the construction industry or an extractive industry that traditionally has used that presentation.)
For investments of less than 20%, the cost method generally should be used.
If the equity method is used to account for an investment in a partnership, e.g., when the investor has more than a
20% interest and has the ability to exercise significant influence over partnership policies, the investor would record
its prorata share of partnership profits or losses by adjusting the carrying value of its investment in the partnership.
The equity method is ordinarily discontinued if losses reduce the investment (and net advances) to zero. However,
if the investor has guaranteed obligations of the partnership or is otherwise committed to provide further financial
support, losses should continue to be recorded by the investor to the extent of the additional funds committed. (See
TIS 2220.12.) Such situations occur frequently for partnerships that use recourse financing. An investment in a
partnership accounted for by the equity method that has been reduced below zero should be presented as a
liability in the balance sheet.
In summary, an investment in a partnership or joint venture should be recorded in the statements of the investor (if
the investor is a corporation, proprietorship, or another partnership) in accordance with the equity method of
accounting as described in APB Opinion No. 18. An exception is that in certain industries it may be appropriate for
the investor to account for the pro rata share of the assets, liabilities, revenues, and expenses of the venture. It
should also be noted that APB Opinion No. 18 states that the equity method is not a valid substitute for consolida
tion. Thus, the accountant should also consider ARB No. 51, as amended, concerning consolidated financial
statements, when the investing entity owns over 50% of the partnership or FASB Interpretation No. 46R, Consolida
tion of Variable Interest Entities, if control is achieved other than through voting interests.
Accountants should consider whether ARB No. 51 requires consolidation because the reporting entity controls the
partnership through a means other than ownership of a majority voting interest. FIN 46R interprets ARB No. 51 to
provide guidance on criteria for determining when looking at nominal voting rights is not effective for determining
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if the reporting entity has a controlling financial interest in the partnership and also provides guidance on looking for
a controlling financial interest in those situations.
In addition, EITF Issue No. 045, Determining Whether a General Partner, or the General Partners as a Group,
Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights," establishes a
presumption that the general partners in a limited partnership control that partnership, regardless of the extent of
the general partners' ownership interests. The assessment of whether the rights of the limited partners should
overcome that presumption is a matter of judgment that depends on the facts and circumstances. The general
partners do not control the limited partnership if the limited partners have either
a. the substantive ability to dissolve (liquidate) the limited partnership or otherwise remove the general
partners without cause or
b. substantive participating rights.
Also note that in certain situations it may be appropriate to present combined statements for a group of commonly
owned partnerships or for a corporation and partnership commonly owned. (See ARB No. 51, paragraph 22.)
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ACCOUNTING FOR PARTNERSHIP RETIREMENT PLANS

A partnership may set up a retirement plan patterned after profit sharing, pension, or other types of employee
benefit plans used by corporations. There is no authoritative guidance on how to account for such plans in a
partnership. Thus, there is diversity in practice as to whether payments to partners and related retirement benefits
are an expense to the partnership or a distribution of partner equity.
Retirement plans are required by federal income tax laws to include present and future employees other than the
partners. Therefore, payments to such plans should be recorded as expenses of the partnership rather than as
withdrawals of capital. When the partnership makes payments to employees' IRAs as well as to those of the
partners (SEPIRAs), the payments should be recorded as an expense of the partnership.
Regardless of the method used to account for partner payments, the significant provisions of the partnership's plan
and the accounting policy for the partners' portion should be properly disclosed in the notes to the financial
statements.
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CHANGE IN LEGAL FORM OF ENTITY

A change in the legal form of business (for example, from or to a partnership) is not considered a change in
accounting principle (or change in reporting entity) and is, therefore, not subject to the accounting and disclosure
requirements of SFAS No. 154. Absent any authoritative accounting and disclosure guidance that addresses such
a change, disclosure of the change in legal form and/or tax status should be made in the notes to the financial
statements.
When one or more prior years' statements are presented after a change to or from a partnership, the question often
arises as to whether prior year statements should be modified. SFAS No. 154 implies that a change to or from
partnership status is not viewed as a change in accounting principle. Therefore, retrospective application is
inappropriate. However, in order to enhance the comparability, it may be necessary to modify the format of the prior
year statements. If that is done, a note such as the one illustrated later in the lesson may be included to disclose the
change.
As a practical matter, especially when a corporation is converted to a partnership, accountants may choose to
recommend that their partnership clients present singleperiod statements for the first reporting period following
the change.
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LIMITED LIABILITY COMPANIES

Limited liability companies (LLCs) are business entities created under state law that can be used in all states.
Limited liability companies are owned by members and combine many of the tax advantages of a partnership with
the liability protection of a corporation. In many cases, LLCs are more flexible than S corporations. Each state
establishes its own LLC rules and characteristics.
Advantages and Disadvantages of LLCs
Advantages. Advantages of LLCs include the following:
They have limited liability (that is, members are not personally liable for the LLC's debts or liabilities, except
to the extent of their investment and any remaining capital commitment to the LLC).
The number of members is not limited.
Members may be corporations, trusts, partnerships, other LLCs, or others.
Double taxation affecting most C corporations is avoided. Income is passed through to the members for
taxation purposes.
Members can participate in managing the LLC.
Distributions to members do not have to be directly proportional to the members' ownership percentages
as they do for S corporations.
They can have different classes of ownership.
Disadvantages. Disadvantages of LLCs include the following:
They sometimes have a limited life, such as by termination on the death or bankruptcy of a member.
Transfer of interests is more difficult. (Under most LLC statutes, a member can assign his or her interest to
a nonmember, but the assignee cannot become a substitute member and acquire all of the attributes of
the assigning member's interest unless the remaining members consent to the transfer. Without such
approval, the assignee is entitled only to receive the share of profits or other compensation by way of
income and return of contributions to which the assigning member otherwise would be entitled.
Accordingly, interests in LLCs formed under those statutes are not freely transferable.)
The enacted laws vary from state to state. Therefore, the LLC must determine how it will be treated for both
tax and liability purposes in other states.
LLC statutes are recent creations, and the interpretation of those statutes remains somewhat uncertain.
Assisting Clients. Accountants with clients considering establishing a new business as an LLC or converting an
existing entity into an LLC should carefully consider the advantages and disadvantages of LLCs, as previously
discussed. Accountants should then research the LLC statutes of the states in which the client plans to do (or does)
business. Knowledge of those factors, along with an understanding of the basic characteristics of an LLC, should
allow accountants to assist their clients in making the best decision. (Note that when researching LLC statutes,
accountants often consult with the client's attorney.)
Organization
Although there is a Uniform Limited Liability Company Act, most states have not adopted it as the model for state
LLC statutes. Instead, the state statutes typically represent a mix of provisions derived from state business corpora
tion acts and limited partnership acts. Accordingly, considerable differences exist among the various state statutes.
By necessity, this discussion of LLCs is general in nature and should not be considered a substitute for obtaining
a thorough understanding of applicable state LLC statutes.
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Articles of Organization. An LLC is established by filing articles of organization with the appropriate state agency.
Generally, an LLC can conduct any lawful business except for those expressly prohibited by the applicable LLC
statute or which are prohibited under other state statutes regulating particular business activities. Most state LLC
laws require that the company's name include a designation of its legal status. Examples of such required
designations include Limited Liability Company," LLC," Limited Company," and LC."
Operating Agreement. The owners of an LLC are referred to as members, and their rights and powers are usually
provided in the company's operating agreement." The operating agreement is the LLC equivalent of a partnership
agreement or corporate bylaws.
General Tax Treatment
The attractiveness of LLCs depends on their treatment as partnerships for federal income tax purposes. Under the
check the box regulations, LLCs with more than one member are by default treated as partnerships for federal
income tax purposes, even though they have corporate characteristics. (LLCs also can elect to be treated as
corporations; however, that option is attractive only in limited circumstances, such as when S corporation status is
desired to minimize the owners' liability for payroll taxes on their earnings.)
Singlemember LLCs. A single member LLC is a disregarded entity by default. That means its existence will be
ignored for federal income tax purposes, and the income and expenses of the LLC will be taxed to the LLC's owner.
Alternatively, a singlemember LLC can elect to be taxed as a corporation. For example, an LLC business owned by
a single individual is treated as a sole proprietorship. An LLC wholly owned by another legal entity, such as a
corporation, is treated as an unincorporated branch of the parent entity. A corporation owning a singlemember
LLC is not required to file a consolidated return, but merely reports the LLC's income and expenses as if they were
the corporation's. Alternatively, a singlemember LLC can elect to be treated as a corporation in the event that
choice is more attractive.
Default Classification Rules. Domestic LLCs in existence before January 1, 1997, generally retain their existing tax
status by default. However, existing singlemember LLCs that claimed partnership status under the former tax rules
are classified by default as sole proprietorships or unincorporated branches of a parent entity, rather than as
partnerships. New domestic LLCs are automatically treated as partnerships if they have more than one member, or
as sole proprietorships or unincorporated branches if there is only a single member. Alternatively, LLCs can choose
to be treated as corporations by making an affirmative check the box election. An LLC wishing to elect a classifica
tion different from its initial default classification must file an affirmative check the box election. The same is true
when an LLC later wishes to change its existing classification. An entity that elects to change its classification
cannot change its classification again during the 60 months after the effective date of the election [Reg.
301.77013(c)(1)(iv)]. This rule does not apply to a newly formed entity's election out of its default classification at
inception or if the organization's business is actually transferred to another entity.
Conversion of an Existing Entity to an LLC. Internal Revenue Service private letter rulings generally have held
that the conversion of a partnership to an LLC (whether by merger or otherwise) is treated as a continuation of the
partnership with no tax consequences, unless the conversion causes a shift in the allocation of liabilities among the
partners/members. If a shift in liabilities causes a deemed distribution of cash in excess of a member's basis in the
LLC, a gain will be recognized. A shift in liabilities may also result in the recognition of gain if a member's amount
at risk is reduced below zero because of the liability shift. The conversion of a corporation to an LLC (assuming the
LLC is treated as a partnership) will result in the recognized liquidation of the corporation and the formation of a new
partnership for federal income tax purposes, with all of the accompanying tax consequences. Gain or loss will be
recognized by the shareholders, as well as by the corporation on the disposition of its property upon liquidation.
Accounting and Reporting Issues
While LLCs are unique legal entities, they do not give rise to a significant number of accounting or reporting issues
that differ from those of partnerships. To provide guidance on applying existing accounting literature to LLCs, the
AICPA's Accounting Standards Executive Committee issued Practice Bulletin 14, Accounting and Reporting by
Limited Liability Companies and Limited Liability Partnerships (PB 14). [PB 14 also applies to limited liability
partnerships (LLPs). LLPs are addressed later in this course.]
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The remainder of this lesson discusses some of the unique issues accountants typically address when compiling
or reviewing the financial statements of LLCs, using the guidance from PB 14.
Financial Statement Headings. The headings of an LLC's financial statements should clearly identify the entity as
an LLC. PB 14 requires this even in jurisdictions where LLCs are not required by law to include the LLC designation
in their names.
Federal Income Taxes. If the LLC is considered a partnership for federal income tax purposes, income is taxed to
the members rather than to the LLC. As noted previously regarding partnerships, the financial statements of the
LLC should not include federal income tax expense or the related liability. If the statement of income shows net
income after federal income taxes, it is not prepared in accordance with GAAP. However, it may be appropriate to
record a liability for any substantial member withdrawals that are anticipated in order to pay income taxes and that
are formally approved before the balance sheet date. Although not required by GAAP, the financial statements
should generally disclose (a) that the LLC does not pay federal income taxes and (b) any anticipated withdrawals
by members to pay income taxes, whether or not recorded as a liability in the financial statements. With respect to
item (b), the accountant should consider disclosing any withdrawals made since the balance sheet date. An
illustrative note follows:
Federal Income Taxes
The Company is not a taxpaying entity for federal income tax purposes, and thus no income tax
expense has been recorded in the statements. Income of the Company is taxed to the members
in their respective returns. The members customarily make substantial capital withdrawals in April
of each year to pay their federal income tax liabilities. At December 31, 20X5, $75,000 has been
deposited in a Company savings account in anticipation of member withdrawals.
SFAS No. 109 requires publicly held entities that are not subject to income taxes because income is taxed directly
to their owners to disclose that fact and the net difference between the financial and tax bases of the entities' assets
and liabilities. The requirement generally applies to mutual funds, real estate investment trusts, regulated invest
ment companies, and certain partnerships. Although SFAS No. 109 does not require nonpublic companies to
disclose similar information, disclosing that income is taxed directly to the owners and that as a result, the company
did not recognize a provision for income taxes is generally recommended, as illustrated in the preceding para
graph. Also, in some circumstances, nonpublic companies may consider it useful to disclose their temporary
differences. In general, the disclosure of the nature of temporary differences ordinarily will satisfy the primary users
of the financial statements and, thus, it is not necessary to disclose the amount of the basis differences.
An LLC's operating agreement may also require that a provision for income taxes be computed at a specified rate
and be included as an expense of the LLC. The inclusion of such a tax provision is a departure from GAAP and
should be reported as such.
State Income and Franchise Taxes. Depending on the state of organization, an LLC may be subject to significant
state income or franchise taxes. If a state or other taxing authority levies a tax on the LLC and the tax is based on net
income, as discussed previously regarding partnerships, the financial statements should show the tax as an
expense of the LLC. The expensed taxes include those based on net income, taxable capital, or similar amounts.
Franchise tax is frequently based on taxable capital rather than net income. Furthermore, as specifically addressed
in PB 14, if taxable income differs significantly from book income, deferred taxes should be recorded in accordance
with SFAS No. 109. LLCs are generally treated as partnerships for federal income tax purposes. However, if the LLC
is subject to federal income taxes, the LLC should account for the federal income taxes in accordance with SFAS
No. 109. The financial statements also should disclose the nature of the tax (if material). If the LLC's tax status in a
jurisdiction changes from taxable to nontaxable, any deferred tax assets and liabilities related to that jurisdiction
should be eliminated.
Equity Section of the Balance Sheet. Since owners of a limited liability company are referred to as members, PB
14 states that the equity section of the balance sheet should be labeled Members' Equity."
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Ownership interests may be represented by membership certificates or shares. For example, an LLC may issue
Class I shares that have unlimited voting rights and Class II shares that have only limited rights and privileges.
Different classes of shares may also have different rights as to the distribution of assets upon dissolution of the
company. If ownership interests are represented by membership certificates or shares, the equity section of the
balance sheet will resemble that of a corporation.
MEMBERS' EQUITY
Managing members
Nonmanaging members
75,000
25,000
100,000
If ownership interests are not represented by membership certificates or shares, the equity section of the balance
sheet will resemble that of a partnership. Generally, only a single amount will be shown. However, if it is desirable
to disclose separately the equity accounts of those members who have been designated as managers, a presenta
tion such as the following can be made:
MEMBERS' EQUITY
Managing members
Nonmanaging members
75,000
25,000
100,000
PB 14 states that the components of members' equity may be presented on the face of the balance sheet or in the
notes.
The operating agreement of some LLCs may provide that unless the transfer (for example, by assignment or
inheritance) of a member's interest is approved by the remaining members, the transferee will not be permitted to
participate in the management of the LLC or become a member. Instead, the transferee is entitled only to receive
the share of profits or other compensation by way of income and return of contributions to which the assigning
member otherwise would be entitled.
PB 14 states that if a member's equity account is less than zero, a deficit should be reported even though the
member's liability may be limited. In addition, if the LLC records amounts due from members for capital contribu
tions, those amounts should be presented as deductions from members' equity rather than as assets.
Conversion of an Existing Entity to an LLC. LLCs frequently are formed when an existing entity is converted to
LLC status. The converting entity often is a partnership. However, C corporations and S corporations may also
merge with an LLC or convert to LLC status. An LLC formed by the conversion of a partnership generally is
considered a continuation of the partnership, and no new taxable entity comes into being. However, the conversion
of a corporation to LLC status results in the creation of a new entity for tax purposes. (As discussed previously,
according to SFAS No. 154, a change in the legal form of business is not considered a change in reporting entity.)
Comparative Financial Statements. When one or more prior years' financial statements are presented after a
change to an LLC, the question arises whether the prior year statements should be modified. As discussed in the
preceding paragraph, changes in the legal form of business, for example, from an S corporation or partnership to
an LLC, are not changes in the reporting entity. Consequently, retrospective application is not appropriate. How
ever, in order to enhance the comparability, it may be necessary to modify the format of the prior year statements.
If that is done, a note such as the following can be included to disclose the change:
NOTE X RECLASSIFICATIONS
Certain accounts in the prioryear financial statements have been reclassified for comparative
purposes to conform with the presentation in the currentyear financial statements.
As a practical matter, especially when a corporation is converted to an LLC, accountants may choose to recom
mend that their LLC clients present singleperiod statements for the first reporting period following the change.
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While changing the legal form of an entity to an LLC does not constitute a change in reporting entity, formation of
an LLC may in some cases result in a change in reporting entity. For example, if commonlyowned companies for
which combined financial statements had not previously been presented were combined into a single LLC, a
change in reporting entity would occur. In that case, the disclosures required by SFAS No. 154 should be made and
the change should be retrospectively applied to the financial statements for all prior periods presented.
LLC Disclosures Specified in PB 14. According to PB 14, an LLC should disclose the following:
A description of any limitation of members' liability. (The identification of the entity as a limited liability
company or partnership alerts financial statement readers to the general limitation of members' liability.
Therefore, the additional requirement of PB14 to describe limitations only relates to special limitations, such
as those imposed by some states on the managing member's liability or the special liability considerations
for members of professional limited liability entities.)
The amount of each class of members' interests if more than one class exists, each having varying rights,
preferences, and privileges of each class. (As further discussed previously, if the LLC does not report the
equity amount of each class separately in the equity section of the balance sheet, the equity amounts must
be disclosed in the notes.)
The date the LLC will cease to exist if it has a finite life.
The separate components of members' equity, such as undistributed earnings, earnings available for
withdrawal, or unallocated capital, if the LLC maintains such components. (This disclosure is permitted but
not required.)
The fact that the company's assets and liabilities previously were held by a predecessor entity or entities
(for LLCs formed by combining entities under common control or by converting from another type of entity).
These LLCs are also encouraged to make the relevant disclosures in paragraph 51 of SFAS No. 141,
Business Combinations.
Any relevant income tax disclosures required by SFAS No. 109.
Formation of an LLC. PB 14 states that if an LLC is formed by combining entities under common control or by
converting from another form of entity, an LLC should initially record its assets and liabilities based on amounts
recorded by the predecessor entity (or entities) in a manner similar to a pooling of interests. In addition, in the year
of formation, the LLC should disclose that the assets and liabilities were previously held by a predecessor entity or
entities.
Disclosure of Change in Legal Form and/or Tax Status. In general, disclosure of the change in legal form and/or
tax status should also be made. Conversion of an existing entity to an LLC is discussed earlier in this lesson.
Singlemember LLCs. For accounting and reporting purposes, a singlemember LLC should follow the rules for
LLCs (as discussed earlier), not proprietorships. There may, however, be a few presentation differences that should
be considered. For example, for a singlemember LLC, the report should be addressed to the member of XYZ LLC
versus to the members of XYZ LLC. In addition, the equity statement for a singlemember LLC should be called the
Statement of Member's Equity" versus the Statement of Members' Equity." Practitioners may also want to
consider adding a footnote to singlemember LLC statements noting that the statements do not include personal
accounts (as in the case of a proprietorship).
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LIMITED LIABILITY PARTNERSHIPS

Limited liability partnerships (LLPs) are a special type of partnership that exist under state laws. LLPs were enacted
in response to the concern that a partner of a professional firm can be held liable for the malpractice of another
partner in the same firm.
The partners in an LLP remain personally liable for the commercial and other obligations of the entity, their own acts
and omissions, and the acts and omissions of persons under their supervision. However, LLP partners are not liable
for acts and omissions by the other LLP partners or nonsupervised employees. In many states, the LLP statutes
provide that LLP partners are not personally liable for the LLP's contract liabilities unless they are personally
guaranteed. In such states, LLPs are similar to LLCs with regard to the issue of owner exposure to the entity's
liabilities.
Advantages and Disadvantages of LLPs
Advantages. The major advantages of LLPs are favorable passthrough taxation rules; the flexibility to structure
ownership interests with varying rights to cash flow, liquidation proceeds, and tax allocations; and the low cost of
converting to LLP status. Most states only require the filing of a registration statement and payment of a fee (which
can be significant) to form an LLP. No new partnership agreement is required.
Disadvantages. The primary disadvantage of LLPs is the liability in some states of the partners for the debts and
other obligations of the LLP (exclusive of liability for professional acts and omissions of others). Thus, an LLP
sometimes provides its partners with less liability protection than is available to members of an LLC but more than
is available under a general partnership. In addition, the annual registration fee in some states is significant (as
much as $5,000) and some states require significant levels of malpractice insurance.
LLPs Compared to LLCs. From a liability limitation standpoint, the use of an LLC is sometimes preferable to the
use of an LLP. However, LLPs are available for professional practices in some states where LLCs are not.
The administrative aspects of adopting LLP status for a professional practice (for example, meeting the state board
of accountancy rules) should be minimal in comparison to obtaining permission to operate as an LLC, especially
in the case of a multistate practice.
Accounting and Reporting Issues
Similar to LLCs, LLPs do not give rise to a significant number of accounting or reporting issues that differ from those
of partnerships. PB 14, Accounting and Reporting by Limited Liability Companies and Limited Liability Partnerships,
provides guidance on applying existing accounting literature to LLPs (as well as LLCs). In fact, PB 14 states in its
guidance that the collective term limited liability companies" includes both LLCs and LLPs. Therefore, the unique
accounting and reporting issues for LLCs discussed in this lesson also apply to LLPs.
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SELFSTUDY QUIZ
following section.
26. Which of the following is a primary disadvantage of a limited liability corporation (LLC)?
a. The members of an LLC have unlimited liability.
b. LLC statutes are recent creations, and the interpretation of those statutes remains somewhat uncertain.
c. Only individuals and trusts are permitted to be members.
d. Only one class of ownership is permitted.
27. Assuming no election is made, how is a singlemember LLC treated for tax purposes?
a. As a partnership.
b. As a sole proprietorship.
c. As an S corporation.
28. Which of the following is an advantage of a limited liability partnership (LLP)?
a. Provides greater liability protection than an LLC.
b. The cost of registration in each state is minimal.
c. Due to the increased liability protection, states do not require partners in an LLP to purchase malpractice
insurance.
d. Provides greater liability protection than a general partnership.
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SELFSTUDY ANSWERS
26. Which of the following is a primary disadvantage of a limited liability corporation (LLC)? (Page 309)
a. The members of an LLC have unlimited liability. (This answer is incorrect. Limited liability of the members
is one of the advantages of an LLC.)
b. LLC statutes are recent creations, and the interpretation of those statutes remains somewhat
uncertain. (This answer is correct. While LLCs are advantageous due to their flexibility, their recent
emergence makes the application of the laws and other nontax matters less predictable than
partnerships or corporations.)
c. Only individuals and trusts are permitted to be members. (This answer is incorrect. Members may also be
corporations, partnerships, or other entities, adding to the flexibility of the LLC.)
d. Only one class of ownership is permitted. (This answer is incorrect. The ownership structure of an LLC is
not limited to one class of member.)
27. Assuming no election is made, how is a singlemember LLC treated for tax purposes? (Page 310)
a. As a partnership. (This answer is incorrect. LLCs with more than one member are treated as partnerships
by default.)
b. As a sole proprietorship. (This answer is correct. A singlemember LLC is a disregarded entity by
default. The LLC will be treated as a sole proprietorship unless an election is made to be treated as
a corporation.)
c. As an S corporation. (This answer is incorrect. However, a singlemember corporation may elect to be
treated as a corporation.)
28. Which of the following is an advantage of a limited liability partnership (LLP)? (Page 314)
a. Provides greater liability protection than an LLC. (This answer is incorrect. LLCs provide greater liability
protection than an LLP because in some states the partners of an LLP may be liable for the debts and other
obligations of the LLP.)
b. The cost of registration in each state is minimal. (This answer is incorrect. The annual registration fee in
some states is significant.)
c. Due to the increased liability protection, states do not require partners in an LLP to purchase malpractice
insurance. (This answer is incorrect. Some states require partners to purchase malpractice insurance
despite the added liability protections of an LLP.)
d. Provides greater liability protection than a general partnership. (This answer is correct. Liability
protection is greater under an LLP because partners are not liable for the acts of other LLP partners
or nonsupervised employees.)
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Lesson 3:S Corporations

This lesson discusses the unique characteristics of S corporations. The course describes the specific issues related
to financial statement presentation of an S corporation. The retained earnings accounts necessary to ensure
compliance with federal tax law and assist the users of the S corporation financial statements are addressed in
detail. Finally, conversion to and from an S corporation and the impact on the financial statements are covered.
Identify the special reporting requirements of compiled and reviewed financial statements of S corporations.
Summarize the unique aspects of the retained earnings accounts maintained by S corporations.
Evaluate the effects of income and loss, distributions and termination of S corporation status on the retained
earnings accounts of an S corporation.
GENERAL
Because they are viewed legally as corporations, authoritative literature has not addressed accounting, presenta
tion, and reporting issues of S corporations separate from those of conventional corporations (hereafter referred to
as C corporations"). For most general ledger account groupings, the accounting treatment is, indeed, the same as
that for a C corporation. However, for the federal income tax (normally absent in S corporations) and retained
earnings account groupings, subtle and sometimes major differences are caused by the unique federal income tax
treatment of S corporations.
With the changes initiated by the Tax Reform Act of 1986, electing S corporation status became more common.
Therefore, practitioners should be aware of the unique accounting issues of S corporations. This chapter explores
these issues and develops guidance based on (a) the Subchapter S Revision Act of 1982 (which dropped the
Subchapter S designation") and subsequent amendments, acts, and technical corrections affecting that guid
ance, (b) logical extensions and inferences of GAAP, and (c) state corporation law. Much of GAAP for shareholders'
equity is traditional and taken from leading textbooks. Discussions relating to state corporation law are based on
the Model Business Corporation Act that has been adopted, at least in part, in most states. Because corporation
law may vary among states, procedures presented in this lesson may require adaptation to conform to a particular
state's law.
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FINANCIAL STATEMENT PRESENTATION

Balance Sheet
The balance sheet of an S corporation is the same as for a C corporation. Accordingly, the balance sheet should
generally report a single retained earnings amount. The components of retained earnings can be disclosed in the
notes to financial statements or in a separate statement of retained earnings if the information would be meaningful
to the users.
Statement of Income
The details of the statement are the same as for a C corporation except that, as a general rule, no federal income
tax expense is reported. A supplementary schedule showing the allocation of taxable income to shareholders and
reconciling the total taxable income to net income can be used to provide additional informative disclosures to
shareholders. See Exhibit 34 for an illustration.
Statement of Retained Earnings
Although not required by GAAP as explained previously, some practitioners use a statement of retained earnings to
disclose the changes in components of retained earnings of S corporations. Each component of retained earnings
can be identified separately with disclosure of its beginning balance, transactions or events that caused changes,
and ending balance. As an alternative to this statement, disclosure is sometimes made in the notes.
Statement of Comprehensive Income
The statement of comprehensive income of an S corporation is the same as for a C corporation. Comprehensive
income may be reported in a single statement of income and comprehensive income, in a separate statement of
comprehensive income, or in a statement of changes in equity that includes comprehensive income. Regardless of
the method used, the statement displaying comprehensive income must include net income, the components of
other comprehensive income, and a total comprehensive income amount.
Statement of Cash Flows
This statement is the same as for a C corporation.
Comparative Financial Statements
When one or more prior years' statements are presented after a change to or from S corporation status, the
question arises whether prior year statements should be modified. A change in the legal form of business (for
example, from or to an S Corporation) is not a change in reporting entity according to SFAS No. 154. Also, SFAS
No. 154 implies that a change to or from S corporation status is not viewed as a change in accounting principle.
Therefore, retrospective application is inappropriate. However, in order to enhance comparability, it may be
necessary to modify the format of the C corporation's income statements to focus on income before taxes as well
as on net income. Disclosure of the change in legal form and/or tax status should also be made.
Summary of Unique Disclosures
The following is a general list of disclosures that are unique to S corporations (this list may not be allinclusive):
a. The S corporation status of the corporation should be disclosed either in the notes or the accountant's
report.
b. A description of the tax consequences of the S corporation election should be presented in the notes.
Sample wording follows.
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Income taxes
The Company has elected to be taxed under the provisions of Subchapter S of the
Internal Revenue Code. Under those provisions, the Company does not pay federal
corporate income taxes on its taxable income (... is not allowed a net operating loss
carryover or carryback as a deduction). Instead, the stockholders are liable for individ
ual federal income taxes on their respective shares (... include their respective shares
of the Company's net operating loss in their individual income tax returns).
c. Dividends paid after the S corporation election terminates, e.g., special posttermination distributions of
the Accumulated Adjustments Account should be disclosed as a subsequent event.
d. If there is a danger that the S election could be retroactively terminated by the IRS, the contingency (federal
income taxes) should be evaluated in the context of SFAS No. 5. Consideration should also be given to
FASB Interpretation No. 48, Accounting for Uncertainties in Income Taxes.
e. Material tax/book differences and their treatment in the financial statements should be disclosed.
f. The amount of accumulated earnings not distributed but previously taxed to the stockholders (AAA and
PTI) should be disclosed in financial statements designed primarily for stockholder use. There is no GAAP
requirement to disclose separate retained earnings accounts, and some practitioners no longer do so.
g. Although not required, the details of the various retained earnings accounts are sometimes disclosed in
the statement of retained earnings or in a note.
The Impact of FIN 48 on S Corporations
The measurement and disclosure principles of FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in
Income Taxes, cannot affect the financial statements of an entity that is not potentially subject to income taxes.
Since many S corporations do not have the potential to be subject to income taxes, their financial statements are
not impacted by FIN 48.
However, some S corporations have the potential to be subject to income taxes on taxable income generated after
conversion from a regular corporation. These S corporations need to consider the measurement and disclosure
principles of FIN 48.
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SELFSTUDY QUIZ
following section.
29. What modification might an accountant need to make when issuing comparative financial statements after a
change from C corporation to S corporation status?
a. Because the change to an S corporation represents a change in accounting principle, the financial
statements should be revised retrospectively to reflect the change in S corporation status for all periods
presented to increase comparability.
b. Because the change to an S corporation represents a change in reporting entity, the financial statements
should be revised retrospectively to reflect the change in S corporation status for all periods presented to
increase comparability.
c. Since S corporations generally do not include a provision for income taxes or related liability, comparative
financial statements cannot be issued.
d. The format of the C corporation's income statements should focus more on income before taxes to
increase comparability.
30. Where should the tax consequences of electing S corporation status be disclosed?
a. The accountant's report.
b. Supplementary information to the financial statements.
c. Notes to the financial statements.
d. On the face of the income statement.
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SELFSTUDY ANSWERS
29. What modification might an accountant need to make when issuing comparative financial statements after a
change from C corporation to S corporation status? (Page 318)
a. Because the change to an S corporation represents a change in accounting principle, the financial
statements should be revised retrospectively to reflect the change in S corporation status for all periods
presented to increase comparability. (This answer is incorrect. Based on interpretations of SFAS No. 154,
a change to S corporation status is not viewed as a change in accounting principle and retrospective
application is not necessary.)
b. Because the change to an S corporation represents a change in reporting entity, the financial statements
should be revised retrospectively to reflect the change in S corporation status for all periods presented to
increase comparability. (This answer is incorrect. Based on SFAS No. 154, a change to S corporation status
is not viewed as a change in reporting entity and retrospective application is not necessary.)
c. Since S corporations generally do not include a provision for income taxes or related liability, comparative
financial statements cannot be issued. (This answer is incorrect. While this is the primary difference
between a C and S corporation, it does not preclude the issuance of comparative financial statements.)
d. The format of the C corporation's income statements should focus more on income before taxes to
increase comparability. (This answer is correct. Since an S corporation is generally not subject to
federal income tax, this modification will assist users in comparing the results of operations for the
periods presented.)
30. Where should the tax consequences of electing S corporation status be disclosed? (Page 318)
a. The accountant's report. (This answer is incorrect. The tax consequences of electing S corporation status
should not be disclosed in the accountant's report.)
b. Supplementary information to the financial statements. (This answer is incorrect. The tax consequences
of electing S corporation status should not be disclosed in the supplementary information to the financial
statements.)
c. Notes to the financial statements. (This answer is correct. The tax consequences of electing S
corporation status should be disclosed in the notes to the financial statements.)
d. On the face of the income statement. (This answer is incorrect. The tax consequences of electing S
corporation status should not be disclosed on the face of the income statement.)
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RETAINED EARNINGS ACCOUNTING PROCEDURES GENERAL

DISCUSSION
General Requirements
Although practitioners may show a single balance sheet caption and amount for retained earnings of an S
corporation, maintenance of separate retained earnings accounts in the books is good accounting practice for the
following reasons:
a. Maintenance of separate retained earnings accounts is generally necessary for proper tax accounting of
an S corporation.
b. More often than not, the primary users of financial statements of S corporations are shareholders who are
interested in the impact of the corporate earnings on their personal tax returns.
Terminology and Definitions
Because many of the terms and concepts of S corporation accounting have novel and specific meanings, it is
helpful to clarify them before describing accounting procedures. The following definitions of terms and associated
abbreviations are used throughout the remainder of this chapter.
a. Accumulated Adjustments Account (AAA). An amount defined by federal tax regulations that reflects the
aggregate amount of undistributed income and gains that have been taxed to the shareholders after 1982.
The AAA is increased by taxable income and by separately stated items of income such as net capital gains;
it is not increased by taxexempt income. The AAA is reduced by tax losses and separately stated items
of deduction such as charitable contributions and net capital losses, and it is also reduced by such
nondeductible items as fines and penalties. However, expenses related to taxexempt income do not
reduce the AAA. Distributions paid to shareholders reduce the AAA to the extent that such distributions do
not exceed the adjusted AAA balance at yearend (before considering distributions for the year). The
amounts included in the AAA also affect the shareholders' tax bases in the shares.
b. Previously Taxed Income (PTI). An amount defined under the old Subchapter S federal tax regulations and
applicable only to corporations that were electing Subchapter S status for tax years beginning before 1983.
PTI represents the accumulated taxable income that was not paid as cash dividends prior to March 15,
1983, but was earned in Subchapter S tax years beginning prior to January 1, 1983. If a corporation filed
tax returns on a fiscalyear basis, these dates should be adjusted accordingly. Previous Subchapter S tax
regulations viewed PTI as belonging" to individual shareholders, and this provision has not changed.
Therefore, PTI is reduced when distributions in excess of the AAA are paid to shareholders and when
shareholders sell their shares or otherwise withdraw from the corporation. PTI will never increase for S
corporations. Distributions of PTI reduce the shareholders' tax bases in their shares, and PTI is permanently
extinguished if the S corporation election is terminated.
PTI will be negative if past tax losses exceed taxable income. Negative PTI does not affect the tax status
of future distributions to shareholders. However, its existence may limit the total amount of dividends that
may be declared because of state laws. Negative PTI remains on the books indefinitely or until S
corporation status is terminated. As a practical matter, negative PTI can be merged with other retained
earnings, if any (see item e.).
c. Accumulated Earnings and Profits (AEP). An amount defined by federal tax regulations that applies to S
corporations with previous Subchapter C status; it generally does not apply to corporations that
immediately elect S corporation status. AEP generally represents retained earnings existing when S
corporation status is attained, with certain adjustments required by the federal tax regulations (for example,
in calculating AEP, straightline depreciation must be used in place of accelerated depreciation methods).
AEP may be reduced only by dividends to shareholders after the AAA and PTI have been distributed, unless
the corporation elects otherwise as provided by the income tax rules. As with PTI, no new AEP may be
generated by S corporations (unless another corporation with AEP is merged). Distributions of AEP do not
reduce the shareholders' tax bases in the shares.
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AEP will be negative if past C corporation losses exceed income; negative AEP does not affect the tax status
of future distributions to shareholders. However, its existence may limit the total amount of dividends that
may be declared because of state laws. Negative AEP remains on the books indefinitely.
The Small Business Jobs Protection Act of 1996 previously eliminated AE&P accumulated during any
pre1983 S corporation tax year, provided the corporation was an S corporation during its first tax year
beginning after 1996. The Small Business and Work Opportunity Tax Act of 2007 completes the process
and eliminates such AE&P accumulated during any pre1983 S corporation tax year, effective for the S
corporation's first tax year beginning after May 25, 2007, even though the S corporation was not an S
corporation for its first tax year beginning after 1996. As a result of these changes, an S corporation can
have only AE&P accumulated during a prior C corporation year or acquired from a C corporation through
a taxfree corporate reorganization.
d. Tax Temporary Adjustments (TTA). A term developed for this lesson to represent retained earnings changes
that result when tax/book differences originate and then reverse. Such differences are not recognized for
tax purposes in the AAA and AEP calculations. Unlike other retained earnings (see item e.), TTA are not
viewed as part of shareholders' tax bases in their shares. The use of the TTA account is necessary to
maintain a doubleentry financial accounting system while maintaining the AAA, AEP, and shareholders'
bases at amounts recognized for tax purposes. This account will usually return to zero when timing
differences completely reverse. In some cases, though, TTA will remain on the books indefinitely,
particularly if the status of the S corporation changes.
e. Other Retained Earnings (ORE). Any amount that would be viewed as retained earnings under GAAP and
state corporation law that is included in shareholders' bases for tax purposes, but is not included in the
specific definitions above. The amount of ORE is increased by taxexempt income and is reduced by
expenses incurred to generate this taxexempt income and by dividends paid to shareholders in excess
of aggregate distributions from the AAA, PTI, and AEP. This account is also used by S corporations with
PTI because a source of ORE would be PTI that remains with the corporation when a shareholder sells
shares or otherwise withdraws. Although this account is treated as paidin capital for tax purposes, i.e., the
items affect the shareholders' bases, GAAP and state corporation law imply that it should be viewed as
retained earnings for accounting purposes.
The ORE generally tracks changes in the other adjustments account (OAA), which is maintained for tax
purposes. [For a comprehensive discussion of the OAA, see the IRS instructions to Form 1120S relating
to Schedule M2, columns (a) and (b).] However, as discussed in the previous paragraph, the ORE is a
broader account maintained for financial accounting purposes.
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SELFSTUDY QUIZ
following section.
S Corporation retained earnings are segregated into five different accounts. For items 3135, select the appropriate
retained earnings account based on the description provided.
31. Retained earnings of a corporation, earned during the period from 19921999, existing at the time that an S
corporation election is made in 2000.
a. Accumulated Adjustments Account (AAA).
b. Previously Taxed Income (PTI).
c. Accumulated Earning and Profits (AEP).
d. Tax Temporary Adjustments (TTA).
e. Other Retained Earnings (ORE).
32. This retained earnings account is neither increased by taxexempt income nor decreased by expenses related
to taxexempt income.
33. This retained earnings account is treated as paidin capital for tax purposes.
34. A corporation founded and beginning operations in 2006 would never have to maintain this retained earnings
account, regardless of when S corporation status is elected.
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35. This retained earnings account is needed to maintain a doubleentry financial accounting system and
shareholders' bases at amounts recognized for tax purposes.
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SELFSTUDY ANSWERS
S Corporation retained earnings are segregated into five different accounts. For items 3135, select the appropri
ate retained earnings account based on the description provided. (Page 323)
31. Retained earnings of a corporation, earned during the period from 19921999, existing at the time that an S
corporation election is made in 2000. (Page 323)
a. Accumulated Adjustments Account (AAA). (This answer is incorrect. The scenario would not affect AAA.)
b. Previously Taxed Income (PTI). (This answer is incorrect. The scenario would not affect PTI.)
c. Accumulated Earning and Profits (AEP). (This answer is correct. AEP generally represents retained
earnings of S corporations that previously had Subchapter C status. Generally, corporations that
elect S corporation status immediately do not have AEP.)
d. Tax Temporary Adjustments (TTA). (This answer is incorrect. The scenario would not affect TTA.)
e. Other Retained Earnings (ORE). (This answer is incorrect. The scenario would not affect ORE.)
32. This retained earnings account is neither increased by taxexempt income nor decreased by expenses related
to taxexempt income. (Page 323)
a. Accumulated Adjustments Account (AAA). (This answer is correct. AAA reflects the aggregate
amount of income and gains taxed to shareholders after 1982. AAA is not affected by taxexempt
income and related expenses.)
b. Previously Taxed Income (PTI). (This answer is incorrect. The scenario would not affect PTI.)
c. Accumulated Earning and Profits (AEP). (This answer is incorrect. The scenario would not affect AEP.)
d. Tax Temporary Adjustments (TTA). (This answer is incorrect. The scenario would not affect TTA.)
e. Other Retained Earnings (ORE). (This answer is incorrect. The scenario would not affect ORE.)
33. This retained earnings account is treated as paidin capital for tax purposes. (Page 323)
a. Accumulated Adjustments Account (AAA). (This answer is incorrect. The description does not reflect AAA.)
b. Previously Taxed Income (PTI). (This answer is incorrect. The description does not reflect PTI.)
c. Accumulated Earning and Profits (AEP). (This answer is incorrect. The description does not reflect AEP.)
d. Tax Temporary Adjustments (TTA). (This answer is incorrect. The description does not reflect TTA.)
e. Other Retained Earnings (ORE). (This answer is correct. ORE includes any amount that would be
viewed as retained earnings under GAAP and state corporation law that is included in shareholders'
bases for tax purposes.)
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34. A corporation founded and beginning operations in 2006 would never have to maintain this retained earnings
account, regardless of when S corporation status is elected. (Page 323)
a. Accumulated Adjustments Account (AAA). (This answer is incorrect. If the corporation described elects S
corporation status, it will need to maintain an AAA retained earnings account.)
b. Previously Taxed Income (PTI). (This answer is correct. PTI represents the accumulated taxable
income that was not paid as cash dividends prior to March 15, 1983, but was earned in Subchapter
S tax regulations beginning prior to January 1, 1983.)
c. Accumulated Earning and Profits (AEP). (This answer is incorrect. If the corporation described elects S
corporation status, it might need to maintain an AEP retained earnings account depending on when the
election is made.)
d. Tax Temporary Adjustments (TTA). (This answer is incorrect. If the corporation described elects S
corporation status, it might need to maintain a TTA retained earnings account.)
e. Other Retained Earnings (ORE). (This answer is incorrect. If the corporation described elects S corporation
status, it might need to maintain an ORE retained earnings account.)
35. This retained earnings account is needed to maintain a doubleentry financial accounting system and
shareholders' bases at amounts recognized for tax purposes. (Page 323)
a. Accumulated Adjustments Account (AAA). (This answer is incorrect. The description does not reflect AAA.)
b. Previously Taxed Income (PTI). (This answer is incorrect. The description does not reflect PTI.)
c. Accumulated Earning and Profits (AEP). (This answer is incorrect. The description does not reflect AEP.)
d. Tax Temporary Adjustments (TTA). (This answer is correct. TTA maintains AAA, AEP, and
shareholders' bases at amounts recognized by shareholders. This account balance normally is zero
when the timing differences reverse.)
e. Other Retained Earnings (ORE). (This answer is incorrect. The description does not reflect ORE.)
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ILLUSTRATIONS FOR TRACKING SEPARATE RETAINED EARNINGS

ACCOUNTS
The next several paragraphs of this lesson describe and illustrate accounting procedures designed to maintain
these separate components of retained earnings for tax purposes and yet in total equal GAAP retained earnings.
Although separate retained earnings accounts may be maintained for the reasons discussed earlier, the balance
sheet of an S corporation generally reflects a single retained earnings account. As noted previously, there is no
requirement to disclose separate retained earnings accounts, and many practitioners no longer do so. Conse
quently, the examples in the following sections illustrate the accounting entries tracking the separate retained
earnings accounts, but do not illustrate separate statements of retained earnings.
Accounting procedures for tracking retained earnings of S corporations are illustrated by considering three hypo
thetical companies reflecting three different situations (the year, 20X6, is assumed to be a tax year after December
31, 1982):
a. Brand NU Company, a newly formed corporation that elected S corporation status on January 1, 20X6.
b. Ceecorp Company, a previously existing conventional corporation that elected S corporation status on
January 1, 20X6.
c. Wassub Company, a previously existing Subchapter S corporation that became an S corporation on
January 1, 1983.
Each firm has four 25% shareholders: Mr. Able, Ms. Baker, Dr. Cole, and Mr. Dale. Each corporation uses the
calendar year for tax and financial reporting purposes.
Procedures for Newly Formed S Corporations
Selected accounts from the Brand NU Company adjusted trial balance as of December 31, 20X6, are presented in
Exhibit 31. During the accounting period following incorporation and election, the company has recorded transac
tions and made adjusting entries in accordance with GAAP. Distributions of $60,000 paid during the period are
recorded in an account titled Dividends." State corporation laws generally refer to distributions from a corporation
to its shareholders as dividends." However, for federal tax purposes, only distributions of the corporation's
accumulated earnings and profits (AEP) are considered dividends" subject to tax at the shareholder level. For
financial accounting purposes, a distribution from an S corporation can be a distribution from the AAA, PTI, or AEP
as discussed previously. Furthermore, corporate distributions are generally recorded in an account titled Divi
dends."
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Exhibit 31
Selected Accounts from Adjusted Trial Balance
BRAND NU COMPANY
ADJUSTED TRIAL BALANCE
December 31, 20X6
(Selected Accounts Only)
Debit
Retained earnings
Sales
Cost of goods sold
Officer and employee salaries
Operating expenses
State income taxes
Officer life insurance premiums
Interest income (tax exempt)
Dividends
Credit
$
$ 1,200,000
250,000
350,000
40,000
30,000
60,000

2,000,000
50,000
Exhibit 32
Entry to Record Income
Debit
Sales
Cost of goods sold
Operating expenses
State income taxes
Income summary
$ 2,000,000
50,000
Credit
$ 1,200,000
250,000
350,000
40,000
30,000
180,000
Exhibit 33
Closing Entries
Debit
Income summary
Retained earnings AAA
ORE

Dividends
180,000
60,000
*
330
Credit
$
130,000
50,000
60,000
CART07
The various revenue and expense accounts are closed to an income summary account at the end of the accounting
period. The entry to record income would be as shown in Exhibit 32. The $180,000 balance in the income summary
account represents net income as computed under GAAP. Taxable income that flows through to shareholders,
however, is only $160,000 because of the $20,000 net permanent difference between taxexempt interest income
($50,000) and nondeductible officer life insurance premiums ($30,000). The taxable income of $160,000 less
$30,000 nondeductible life insurance premiums results in a net $130,000 credit to the AAA, and the nontaxable
income of $50,000 is credited to ORE. The dividends of $60,000 are less than taxable income and would thus be
deducted entirely from the AAA. If tax/book timing differences exist, a third retained earnings account (TTA) is
necessary as discussed later in this lesson. Closing entries to allocate income and dividends to retained earnings
are shown in Exhibit 33.
Practitioners may wish to present, as supplementary information, a schedule of income allocation similar to Exhibit
34, which reconciles net income and taxable income allocated to shareholders. Such presentations are useful to
shareholders in understanding the relationship of the financial statement income of the company to their personal
tax consequences.
Exhibit 34
Schedule of Income Allocation
BRAND NU COMPANY
SCHEDULE OF INCOME ALLOCATION
TAXABLE INCOME ALLOCATED TO SHAREHOLDERS
Able
Baker
Cole
Dale
TOTAL TAXABLE INCOME
40,000
40,000
40,000
40,000
160,000
TAXEXEMPT INCOME
50,000
NONDEDUCTIBLE EXPENSES
(30,000 )
NET INCOME
180,000
Recommended disclosures for S corporation financial statements are summarized previously.

Procedures for Previous Conventional Corporations
Selected accounts from Ceecorp Company's adjusted trial balance at December 31, 20X6, are shown in Exhibit
35. The conventional corporate retained earnings account at December 31, 20X5, in the amount of $100,000,
became AEP on January 1, 20X6. (See the previous discussion for a definition of AEP. This example ignores
tax/book temporary differences arising before S Corporation status is attained. These differences are discussed
later in this lesson.)
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Exhibit 35
CEECORP COMPANY
December 31, 20X6
Debit
Retained earnings AEP
Sales
Cost of goods sold
Operating expenses
State income taxes
Dividends
Credit
$
$ 1,200,000
300,000
461,000
2,000
30,000
6,000
100,000
2,000,000
50,000
The revenue and expense accounts are closed to the income summary account as shown in Exhibit 36 with a
resulting net income computed under GAAP of $57,000.
Exhibit 36
Entry to Record Income
Debit
Sales
Cost of goods sold
Operating expenses
State income taxes
Income summary
$ 2,000,000
50,000
Credit
$ 1,200,000
300,000
461,000
2,000
30,000
57,000
Income would be allocated as shown in Exhibit 37. The $37,000 taxable income would flow through to the
shareholders. This amount less the nondeductible expenses of $30,000 is recorded as the AAA, resulting in a net
credit of $7,000 to that account. The $50,000 of taxexempt interest income becomes part of ORE because this
amount is added directly to shareholders' bases in the shares. If tax/book timing differences exist, adjustments of
the AAA and ORE accounts are necessary. This topic is discussed later in this lesson.
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Exhibit 37
Closing Entry to Allocate Income to Retained Earnings
Debit
Income summary
ORE
57,000
Credit
$
7,000
50,000
Assume that Ceecorp had a poor financial year in 20X5, so that only $6,000 in distributions were paid $1,500 to
each shareholder. This amount is less than taxable income; hence, it reduces only the AAA as shown in Exhibit 38.
Exhibit 38
Closing Entry to Allocate Dividends to Retained Earnings
Debit
Dividends
6,000
Credit
$
6,000
Procedures for Previous Subchapter S Corporations

Selected accounts from Wassub Company's adjusted trial balance at December 31, 20X6, are shown in Exhibit 39.
PTI of $9,000 for each shareholder was brought forward when the corporation changed from Subchapter S to S
corporation status on January 1, 1983. The AEP represents retained earnings on the books when the corporation
changed from Subchapter C to Subchapter S status. Assume there were no tax/book timing differences at that time
and that no changes in PTI or AEP have occurred since January 1, 1983.
Exhibit 39
WASSUB COMPANY
December 31, 20X6
Debit
Retained earnings PTI
Sales
Cost of goods sold
Operating expenses
State income taxes
Interest income (taxexempt)
Dividends
Credit
$
$ 1,200,000
300,000
420,000
2,000
30,000
40,000
*
333
36,000
180,000
2,000,000
50,000
CART07
The entry to close the revenue and expense accounts is similar to those illustrated in the previous cases and is not
illustrated here. The company would report net income of $98,000 computed under GAAP, an excess of taxexempt
income over nondeductible expenses of $20,000, and taxable income of $78,000. The entry to allocate net income
is shown in Exhibit 310. The procedures are the same as discussed above for previous C corporations. Because
the dividends of $40,000 are less than taxable income, the entire amount reduces the AAA as shown in Exhibit 311.
Exhibit 310
Debit
Income summary
ORE
98,000
Credit
$
48,000
50,000
Exhibit 311
Debit
Dividends
40,000
Credit
$
40,000
Assume instead that distributions of $80,000 ($20,000 to each shareholder) were paid. IRC Sec. 1379(c), applica
ble to tax years beginning after December 31, 1982, states that provisions of previous law continue to apply with
respect to distribution of PTI. This fact implies that distributions reduce the AAA, PTI, AEP, and ORE in that order.
The entry to allocate distributions from the various retained earnings accounts would now be as shown in Exhibit
312.
Exhibit 312
Debit
Dividends
48,000
32,000
Credit
80,000
Recommended S corporation disclosures are summarized previously in this lesson.

Tax rules viewed PTI as belonging" to individual shareholders under the previous act, and this feature has not been
changed. Therefore, each shareholder's PTI would be reduced by $8,000, and practitioners may wish to disclose
the changes in each shareholder's PTI in a supplementary schedule. See Exhibit 313.
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Exhibit 313
Supplementary Schedule to Disclose Changes in Each Shareholder's PTI
WASSUB COMPANY
SCHEDULE OF PREVIOUSLY TAXED INCOME
Jan. 1
ABLE
BAKER
COLE
DALE
Dividends
Dec. 31
9,000
9,000
9,000
9,000
(8,000 )
(8,000 )
(8,000 )
(8,000 )
1,000
1,000
1,000
1,000
TOTALS $
36,000
(32,000 )
4,000
Should any shareholders sell their shares, they cannot take with them the PTI previously viewed as theirs. Such PTI
remains with the corporation because federal tax regulations prohibit both the transfer of PTI to new shareholders
who buy the shares and the reallocation of PTI to remaining shareholders. Furthermore, tax regulations do not allow
S corporations to add withdrawingshareholder PTI to AEP.
Under most state corporation laws, PTI of withdrawing shareholders is viewed as retained earnings. Therefore, an
entry would be required to transfer the remaining PTI to ORE. To illustrate, assume that Ms. Baker sells her shares
to Mr. Eanes early in 20X7. The entry to record the transfer is presented in Exhibit 314.
Exhibit 314
Entry to Transfer PTI to ORE
Debit
ORE
335
1,000
Credit
$
1,000
CART07
EFFECT OF LOSSES ON RETAINED EARNINGS ACCOUNTS

S corporation losses passed through to shareholders are deductible to the extent of shareholders' adjusted bases
in the corporation's stock plus debt due them from the corporation. Losses that exceed shareholders' stock and
debt bases may be carried over and deducted by them in succeeding years when the corporation has income until
completely absorbed or the S corporation election is terminated.
Accounting procedures for S corporation losses parallel the procedures previously illustrated for profits. The AAA
is reduced (debited) for the amount of loss that is passed through to the shareholders. The AAA is also reduced for
nondeductible expenses not related to taxexempt income. Taxexempt income less related expenses is credited to
ORE. Existing PTI or AEP accounts are not affected by S corporation losses. The AAA may carry a debit balance as
a result of losses. Following the normal order of priority, distributions made while the AAA has a debit balance
would be considered made first from PTI and then from AEP, assuming that total retained earnings has a credit
balance. If total retained earnings amounts to a deficit, dividends cannot normally be legally declared even though
PTI and AEP may have credit balances. State corporation law generally recognizes retained earnings as a single
amount.
To illustrate loss accounting procedures, refer to the examples for Ceecorp Company for the year 20X6 (Exhibit 35
through Exhibit 38). Procedures are essentially the same for all S corporations; hence, they are not illustrated
separately. At the end of 20X6, Ceecorp has AAA with a $1,000 balance and ORE with a $50,000 balance. Assume
that shareholders had paid $40,000 ($10,000 each) for their shares. Therefore, shareholders' bases in the shares
would be $91,000 ($22,750 each). Also assume that Dr. Cole has a note payable from the corporation of $5,000.
Assume further that Ceecorp realizes a net loss of $200,000 in 20X7, and that there are no tax/book differences. In
this case, the income summary account would have a debit balance of $200,000. The entry to close the net loss is
shown in Exhibit 315. As a result, the AAA now has a debit balance of $199,000. The capital stock, paidin capital,
and notes payable accounts are not reduced because these items are not legally canceled.
Exhibit 315
Closing Entry to Allocate Net Loss to Retained Earnings
Debit
Income summary
200,000
Credit
$
200,000
The entire $200,000 loss is allocated to shareholders ($50,000 each). The maximum loss that can be deducted by
the shareholders in 20X7, however, is $96,000 ($22,750 each to Able, Baker, and Dale, and $27,750 to Cole). The
remaining $104,000 loss can be deducted in future profitable years ($26,000 to each shareholder). (Disclosure of
the future tax effect for shareholders should be considered.)
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EFFECT OF TAX/BOOK DIFFERENCES ON RETAINED EARNINGS

ACCOUNTS
S corporations do not normally pay federal income taxes and thus do not report federal tax liabilities and deferred
taxes. Nevertheless, it may be necessary to record originating and reversing tax/book temporary differences
because these differences affect the various retained earnings accounts and sometimes require that additional
retained earnings accounts be established. The accounting procedures vary depending on the origin of the S
corporation and whether the temporary differences originated before or after S corporation status was attained.
Many tax/book differences originate with income under GAAP in excess of taxable income. Therefore, the following
discussions and illustrations incorporate this presumption. All of the illustrations are based on the following data:
assume that during 20X6, a company purchased assets for $50,000. For tax purposes, the cost will be recovered
using threeyear MACRS. For accounting purposes, the company records straightline depreciation over five years
with no residual value. A summary of the relevant data is as follows:
Cost
Recovered
Year
Depreciation
20X6
20X7
20X8
20X9
2010
16,665
22,225
7,405
3,705

(33.33%) $
(44.45%)
(14.81%)
(7.41%)
TOTALS
50,000
Difference
10,000 (20%) $
10,000
10,000
10,000
10,000
50,000
Cumulative
Difference
6,665 $
12,225
(2,595 )
(6,295 )
(10,000 )
6,665
18,890
16,295
10,000

0
Differences Originating after S Corporation Status Is Attained

To illustrate accounting procedures for newly created corporations that immediately elect S corporation status,
refer to the adjusted trial balance for Brand NU Company for the year 20X6 in Exhibit 31 and assume:
a. Depreciation expense of $10,000 is included in operating expenses.
b. GAAP net income for 20X6 is $180,000.
c. GAAP net income includes $50,000 of nontaxable income and $30,000 of nondeductible expenses.
d. Taxable income for 20X6 is $153,335 ($180,000 GAAP income $6,665 excess MACRS depreciation
$50,000 nontaxable income + $30,000 nondeductible expenses).
When closing the income summary account, it is necessary to use an additional retained earnings account called
TTA to record the tax/book temporary difference. This is illustrated in Exhibit 316.
Exhibit 316
Debit
Income Summary
ORE
Retained earnings TTA
*
337
180,000
Credit
$
123,335
50,000
6,665
CART07
The amount of TTA represents taxable income that will be allocated to shareholders in future years and thus should
be disclosed separately. The supplementary schedule of income allocation for 20X6 is shown in Exhibit 317. An
explanatory note, describing the nature of material differences between book and taxable income, is generally
recommended.
Exhibit 317
Supplementary Schedule of Income Allocation
BRAND NU COMPANY
SCHEDULE OF INCOME ALLOCATION
TAXABLE TO SHAREHOLDERS IN 20X6
Able
Baker
Cole
Dale
TOTAL TAXABLE INCOME
38,334
38,334
38,334
38,333
153,335
TAXABLE TO SHAREHOLDERS IN FUTURE YEARS
6,665
TAXEXEMPT INCOME
50,000
(30,000 )
NONDEDUCTIBLE EXPENSES
NET INCOME
180,000
Assume net income computed under GAAP for years 20X7 through 2010 is as follows:
20X7
20X8
20X9
2010
200,000
250,000
150,000
190,000
Assume further that there are no tax/book differences except for the difference between cost recovery and straight
line depreciation expense. Entries to close net income for each of these years are presented in Exhibit 318.
Observe that the TTA account is reduced to zero when the temporary difference completely reverses in 2010.
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Exhibit 318
Entries to Close Net Income to Retained Earnings
Debit
20X7 Income summary
200,000
20X8 Income summary

250,000
2,595
20X9 Income summary

150,000
6,295
20X10 Income summary

190,000
10,000
Credit
$
12,225
187,775
252,595
156,295
200,000
Differences Originating before S Corporation Status Is Attained

Tax/book temporary differences originating before S corporation status is attained produce some interesting
questions:
a. How should preS corporation temporary differences be reflected in the retained earnings accounts?
b. How should the reversal of these preS corporation differences be recorded?
c. What should be done with existing deferred taxes, if any?
Because temporary differences produce a difference between GAAP income and taxable income, the GAAP
retained earnings will differ from the tax concept of AEP for C corporations.
At the time of conversion to S corporation status, AEP, as defined for tax purposes, is frozen. Generally, the GAAP
retained earnings balance should be segregated into two or more parts at the time a corporation converts to an S
corporation.
a. AEP. As defined for tax purposes.
b. TTA. The net temporary differences.
c. ORE. Permanent differences, etc., that do not enter the calculation of AEP.
These separate component accounts for retained earnings preserve the tax concept of AEP yet maintain a GAAP
retained earnings balance.
When a Subchapter S corporation converts to S corporation status (before January 1, 1983, for calendar year
Subchapter S corporations), PTI (representing undistributed taxable income) is frozen. Temporary differences in
PTI should be segregated out into TTA as illustrated above for former C corporations. Reversals of the temporary
differences in the TTA account should be accounted for as previously illustrated.
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Although the temporary differences originating before attaining S corporation status will reverse, they will not
generate a tax liability so long as S corporation status is maintained. Thus, deferred taxes previously recorded will
not become due. SFAS No. 109, Accounting for Income Taxes, requires that existing deferred tax assets and
liabilities be eliminated through a charge or credit to income tax expense for the period in which the enterprise
ceases to be a taxable enterprise.
Because the concept of a TTA account is not commonly known, many existing S corporations may include within
their various retained earnings accounts elements of tax/book differences and/or deferred taxes. Establishing a TTA
account and reallocating within the retained earnings accounts any material amounts of tax/book differences is
generally recommended. This will allow the accounting records to properly reflect GAAP and yet maintain retained
earnings accounts for the tax concepts of AEP, PTI, AAA, etc.
Tax/Book Differences Existing When S Corporation Status Terminates
Tax/book temporary differences existing when S corporation status terminates is discussed later in this lesson.
Tax Basis of Accounting
Converting from GAAP to the tax basis of accounting at the time of conversion to S corporation status will eliminate
the need to account for tax/book temporary differences. Practitioners should consider this option in light of the
intended uses of the financial statements.
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EFFECT OF TERMINATION OF THE S CORPORATION ELECTION ON

RETAINED EARNINGS ACCOUNTS
When an S corporation election is terminated, it is necessary for financial accounting purposes to merge retained
earnings items that have resulted from income that has flowed through and been taxed to shareholders (AAA and
PTI) with ORE. The merged retained earnings account should then be separated from retained earnings such as
AEP that have resulted from earnings that were taxable to the corporation. Distributions from the former are
generally viewed as taxfree returns of capital for tax purposes, whereas distributions from the latter are generally
taxable to shareholders as are any other dividends.
When a corporation terminates its S corporation election, it has a specified period during which it can distribute all
of the AAA; any AAA not distributed becomes part of ORE. This period ends on the latter of (a) one year after the last
day of the corporation's last taxable year as an S corporation or (b) the date the last S corporation tax return is due
(including extensions). S corporations are generally required to file a short year S corporation return for the part of
the year prior to termination and a short year return as a conventional corporation for the portion of the year after
termination. It is not necessary, however, to close the books. Income is allocated between the S corporation and the
C corporation year on a pro rata basis. However, several exceptions to this allocation procedure are available.
Alternatively, the corporation (to avoid the accumulated earnings tax or personal holding company tax) can elect to
have all of its distributions during this period taxed as dividends and not reduce the basis of the shares. If this
treatment is elected, the distribution is recorded as a debit to AEP. The PTI on the date of termination also becomes
part of ORE; however, special posttermination distribution provisions do not apply to PTI. In subsequent periods,
once S corporation status has ended, all income becomes part of AEP, and any dividends paid must first come from
AEP before taxfree distributions can be made from ORE. It is beneficial, therefore, for the corporation to reduce the
AAA by the maximum extent possible during the posttermination period through dividend distributions, consider
ing its cash position and borrowing ability. Otherwise, the AAA could be effectively frozen" when it becomes ORE.
General Accounting Procedures
To illustrate accounting procedures, assume that management of Term Company, an S corporation with the same
ownership structure as described previously, terminated its S corporation election on July 1, 20X5. The adjusted
trial balance for the year 20X5 is presented in Exhibit 319. Note that retained earnings amounts are beginningof
year amounts. It is assumed that the distributions of $200,000 were paid before September 15, 20X5, and that this
amount was the largest possible reduction in the AAA based on the company's financial position. The company
filed a shortyear tax return as an S corporation on September 15, 20X5, covering the period January 1 through
June 30, 20X5. It will file another shortyear return as a conventional corporation on March 15, 20X6, for the period
July 1 through December 31, 20X5. It made no additional distributions in 20X5.
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Exhibit 319
TERM COMPANY
December 31, 20X5
Debit
ORE
Sales
Cost of goods sold
Operating expenses
Federal income taxes
Dividends
Credit
$
$ 1,200,000
580,000
40,000
200,000
250,000
40,000
200,000
50,000
2,000,000
The company did not close its books when it terminated its S corporation election, but it did calculate its taxable
income through June 30, 20X5, to be $120,000. There are no tax/book differences for the year. Taxable income for
the period July 1 to December 31 is $100,000. Therefore, income before taxes for the year is $220,000. Tax expense
for the last half of the year is $40,000 (assume a 40% tax rate). Net income would thus be $180,000 ($120,000 +
$100,000 $40,000). The entry to allocate income to retained earnings is shown in Exhibit 320. Earnings after
June 30, 20X5, are recorded as increases of AEP because they are taxable to the corporation.
Exhibit 320
Debit
Income summary
Retained earnings AEP (100,000 40,000)
342
180,000
Credit
$
120,000
60,000
CART07
Distributions, although after termination of S corporation status, are within the posttermination period, and thus are
not distributions of the C corporation's earnings but instead reduce the AAA (unless the corporation elected the
alternative method described previously). Exhibit 321 illustrates the entry to record the distributions.
Exhibit 321
Entry to Record Distributions
Debit
Dividends
200,000
Credit
$
200,000
An additional entry is needed as shown in Exhibit 322 to merge PTI and the undistributed portion of the AAA into
ORE.
Exhibit 322
Entry to Merge PTI and AAA into ORE
Debit
(250,000 + 120,000 200,000)
ORE
170,000
40,000
Credit
210,000
Tax rules require that in subsequent years all distributions be allocated first to AEP. Consequently, pretermination
earnings that have been merged and reported as ORE cannot be distributed until all AEP is exhausted. In practice,
however, it may be impossible to distribute AEP without impairing the financial condition of the company. Preter
mination earnings of terminated S corporations may thus be effectively frozen.
Because federal tax rules view ORE as paidin capital, a terminated S corporation may wish to transfer it to paidin
capital. State corporation law generally permits boards of directors to transfer retained earnings to paidin capital
but does not require such a transfer. If the board of directors of Term Company complies with state law and explicitly
transfers ORE to paidin capital, the accounting entry to record the transfer would be as shown in Exhibit 323. The
resulting statement of retained earnings follows logically and is not illustrated. A footnote describing the transfer
(not illustrated in this lesson) would normally be required to disclose the change in legal status to shareholders.
Exhibit 323
Entry to Transfer ORE to Paidin Capital
Debit
ORE
Additional paidin capital from transfer of retained earnings
*
343
260,000
Credit
$
260,000
CART07
A transfer of ORE to paidin capital may give corporations less flexibility in managing its shareholders' equity
because state corporation law generally places greater restrictions on paidin capital than on retained earnings.
Therefore, a terminated S corporation may choose not to make this transfer. If a transfer is not made, financial
statements prepared in accordance with GAAP should continue to report pretermination earnings as ORE. Note
disclosure would normally be required to inform shareholders that distributions from this item can be made tax free
after other earnings have been distributed.
Tax/Book Differences and Termination
The procedures illustrated in the preceding paragraphs of this lesson illustrate how to account for AEP, AAA, PTI,
and ORE in the event of termination of the S corporation election. If unreversed tax/book temporary differences
exist, how should the TTA account be accounted for? Generally, closing the TTA account and transferring it to ORE
is recommended. SFAS No. 109, Accounting for Income Taxes, requires the reinstatement of deferred tax assets
and liabilities on existing differences.
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COMPILATION AND REVIEW REPORTS OF S CORPORATIONS

The only policy generally adopted as uniquely applicable to S corporations is that the S corporation status be
disclosed in the accountant's report parenthetically after the name of the company.
345
346
CART07
CART07
SELFSTUDY QUIZ
following section.
36. For federal tax purposes, which of the following would be considered a dividend subject to tax at the
shareholder level?
a. A distribution from a corporation's AAA.
b. A distribution from a corporation's PTI.
c. A distribution from a corporation's AEP.
d. A distribution from a corporation's ORE.
37. If an S Corporation earns $25,000 in taxexempt interest, which of the following accurately describes the effect
on its retained earnings accounts?
a. ORE increases by $25,000.
b. TTA is decreased by $25,000.
c. TTA is increased by $25,000.
d. AAA is increased by $25,000.
38. If distributions to shareholders exceed the amount of AAA of an S Corporation, what retained earnings account
would be reduced next?
a. ORE.
b. AEP.
c. PTI.
d. TTA.
39. In which of the following situations would an S corporation be unable to legally declare dividends?
a. When the AAA account reflects a debit balance, or deficit.
b. When the cumulative total of all retained earnings account balances is a deficit.
c. When the AEP account balance is zero.
d. When the cumulative balance of AAA and ORE reflect a debit balance, or deficit.
40. When a corporation terminates the S corporation election, which of the following is an effect on the retained
earnings accounts?
a. In subsequent periods, all net income or net loss becomes part of AAA.
b. Merge AAA and PTI with ORE.
c. In subsequent periods, any dividends paid are distributed first from ORE.
d. To the extent the corporation has AEP, dividends must be distributed and taxed to the shareholders. Basis
in the shares is not reduced.
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SELFSTUDY ANSWERS
36. For federal tax purposes, which of the following would be considered a dividend subject to tax at the
shareholder level? (Page 329)
a. A distribution from a corporation's AAA. (This answer is incorrect. A distribution from AAA would not be
treated as a dividend taxable at the shareholder level for federal tax purposes.)
b. A distribution from a corporation's PTI. (This answer is incorrect. A distribution from PTI would not be
c. A distribution from a corporation's AEP. (This answer is correct. While distributions from other
retained earnings accounts may be referred to as dividends," only distributions from AEP are taxed
as dividends at the shareholder level for federal tax purposes.)
d. A distribution from a corporation's ORE. (This answer is incorrect. A distribution from ORE would not be
37. If an S Corporation earns $25,000 in taxexempt interest, which of the following accurately describes the effect
on its retained earnings accounts? (Page 330, Page 331)
a. ORE increases by $25,000. (This answer is correct. ORE is increased by taxexempt income.)
b. TTA is decreased by $25,000. (This answer is incorrect. TTA is not decreased by $25,000 because
taxexempt income represents a permanent, not a temporary, tax difference.)
c. TTA is increased by $25,000. (This answer is incorrect. TTA is not increased by $25,000 because
taxexempt income represents a permanent, not a temporary, tax difference.)
d. AAA is increased by $25,000. (This answer is incorrect. AAA is increased by taxable income and net capital
gains, not taxexempt income.)
38. If distributions to shareholders exceed the amount of AAA of an S Corporation, what retained earnings account
would be reduced next? (Page 334)
a. ORE. (This answer is incorrect. When distributions exceed AAA, ORE is not the next retained earnings
account to be reduced.)
b. AEP. (This answer is incorrect. When distributions exceed AAA, AEP is not the next retained earnings
account to be reduced.)
c. PTI. (This answer is correct. Distributions reduce AAA, PTI, AEP, and ORE in that order.)
d. TTA. (This answer is incorrect. TTA is not affected by distributions to shareholders.)
39. In which of the following situations would an S corporation be unable to legally declare dividends? (Page 336)
a. When the AAA account reflects a debit balance, or deficit. (This answer is incorrect. If the AAA account
balance is negative, the S corporation may still be able to legally declare dividends.)
b. When the cumulative total of all retained earnings account balances is a deficit. (This answer is
correct. If the retained earnings accounts of the S corporation cumulatively reflect a debit balance,
or deficit, dividends can not be declared legally because state corporate law recognizes retained
earnings as a single amount.)
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c. When the AEP account balance is zero. (This answer is incorrect. If the account balance of AEP is zero,
the S corporation may still be able to legally declare dividends.)
d. When the cumulative balance of AAA and ORE reflect a debit balance, or deficit. (This answer is incorrect.
If the cumulative balance of AAA and ORE is negative, the S corporation may still be able to legally declare
dividends.)
40. When a corporation terminates the S corporation election, which of the following is an effect on the retained
earnings accounts? (Page 341)
a. In subsequent periods, all net income or net loss becomes part of AAA. (This answer is incorrect. In
subsequent periods, all income or net loss is applied to AEP.)
b. Merge AAA and PTI with ORE. (This answer is correct. For financial accounting purposes, amounts
that have flowed through and been taxed to the shareholder should be combined with ORE.
Distributions from this accumulation of retained earnings would be considered taxfree returns of
capital.)
c. In subsequent periods, any dividends paid are distributed first from ORE. (This answer is incorrect. In
subsequent periods, any dividends are distributed first from AEP.)
d. To the extent the corporation has AEP, dividends must be distributed and taxed to the shareholders. Basis
in the shares is not reduced. (This answer is incorrect. A corporation can elect to distribute dividends from
AEP to avoid the accumulated earnings tax.)
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CART07

CARTG073 Proprietorships, Partnerships, and S Corporations: Special Reporting
Issues
Test Instructions
be misinterpreted.
courses). In order to receive the discounted fees, all courses must be submitted for grading at the same time.
7.
P.O. Box 966
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1. How does the basic purpose of the financial statements of a proprietorship differ from that of a C corporation?
a. A proprietorship's financial statements purport to show the assets of the business operation and the
personal assets of the owner.
b. A proprietorship's financial statements do not purport to reflect the cash flows the business operations.
c. A proprietorship's financial statements purport to present financial position, results of operations, and cash
flows using the cash basis of accounting only.
d. The basic purpose of the proprietorship's financial statements is the same as that of a C corporation.
2. HST, a local CPA, is providing compilation services to John Smith, a small business owner. Mr. Smith operates
EBusiness out of his house and does not maintain separate bank accounts for personal and business use.
What is the most appropriate way for HST to present the business operations of Mr. Smith in compiled financial
statements?
a. HST should disclose the lack of segregation of assets in a note in the compiled proprietorship financial
statements of EBusiness.
b. HST should disclose the net identifiable assets of the business on one line in the compiled personal
financial statements of Mr. Smith.
c. HST should disclaim an opinion on the proprietorship financial statements of EBusiness in the
accountant's report.
d. HST should disclose the net identifiable assets of Mr. Smith on one line in the compiled proprietorship
financial statements of EBusiness.
3. Which of the following investment activities would be appropriately included in compiled financial statements
of a proprietorship?
a. A condominium in the name of the business that is used exclusively by the owner and the owner's family.
b. An automobile in the name of the business primarily driven by the spouse of the owner.
c. A money market fund in owned by the business that the owner has indicated will be used to replace aging
equipment used in the business.
d. A brokerage account in the name of the business through which the owner executes daytrading activities.
4. RMN, a local CPA, is compiling the basic financial statements for WTG, a sole proprietorship. The financial
statements will omit substantially all disclosures, and RMN wants to ensure that the financial statements are
not misleading to users. What is the most appropriate course of action to achieve this objective?
a. The accountant's report should include emphasis paragraphs identifying areas of the financial statements
that might be misleading due to the omission of disclosures.
b. The accountant's report should include a standard paragraph in the accountant's report emphasizing the
limitations of the financial statements.
c. The accountant's report should include emphasis paragraphs as a substitute for making selected
disclosures in the financial statements.
d. The financial statements should include the statement, See accountant's report and selected financial
information."
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5. What is one similarity between the financial statements of a proprietorship and a partnership?
a. There is no provision for income tax expense.
b. Retained earnings is presented on one line in the balance sheet.
c. The financial statements are prepared on the tax basis of accounting.
d. The equity method of accounting does not apply to either proprietorships or partnerships.
6. JQA CPA is reviewing the financial statements of ABC Toys, a sole proprietorship. ABC Toys uses the tax basis
of accounting to avoid temporary differences between book and tax records. When issuing the financial
statements, what title should JQA use to show the results of operations for the period covered?
a. Statement of Revenues and Expenses Income Tax Basis
b. Income Statement Income Tax Basis
c. Statement of Results of Operations Income Tax Basis
d. Statement of Income and Proprietor's Capital Income Tax Basis
7. When would an accountant be required to present a statement of changes in proprietor's capital?
a. A statement of changes in proprietor's capital is not required when the financial statements are presented
on another comprehensive basis of accounting.
b. When the financial position of the proprietorship is presented.
c. When the financial position and results of operations of the proprietorship are presented.
d. When the results of operations and statement of cash flows of the proprietorship are presented.
8. In 2006, ABC Toys, a sole proprietorship, earned net income of $75,000. During 2006, John Smith, the owner,
withdrew $15,000 to pay federal income taxes due for 2005. On January 1, 2006, proprietor's capital was
$95,000. On June 30, 2006, ABC Toys bought a new piece of machinery for $100,000 using available cash.
What is the balance of ending proprietor's capital on December 31, 2006?
a. $155,000.
b. $170,000.
c. $330,000.
d. $405,000.
9. What is the most likely reason why a sole proprietor might not want to set up a Keogh plan to fund retirement?
a. The payments to the plan are considered a distribution of proprietor's capital and would not reduce income
tax liability.
b. The disclosure requirements relating to the plan are very complex, increasing the cost of the accountant's
report.
c. The proprietor cannot include other employees in a Keogh plan, reducing its flexibility.
d. The proprietor must include present and future employees in the plan.
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10. In general, what dictates the accounting basis to be used in preparing a partnership's financial statements?
a. State law.
b. Partnership agreement.
c. General partner.
d. Articles of organization.
11. KBP Ltd. specifies accounting treatment that is not in accordance with GAAP for several items in its financial
statements. KBP engages GWB CPA to issue compiled financial statements for the partnership covering 2006.
GWB decides that a specialpurpose report would be most appropriate based on the intended use of the
financial statements. To which of the following parties should the compiled financial statements be issued?
a. To those who have the background knowledge to understand the financial statements.
b. To those with whom the partnership is negotiating directly.
c. To those with whom the partnership is engaged in business.
d. To those who are not defined as third parties in SSARS No. 1.
12. If the financial statements of a partnership include a provision for income taxes computed at a specified rate,
what is the accountant's responsibility when issuing compiled or reviewed financial statements?
a. The accountant should disclose the effects in the supplementary information to the financial statements.
b. The accountant should disclose this departure in GAAP in a separate paragraph in the accountant's report.
c. The accountant should disclose this departure in GAAP in a note to the financial statements.
d. The accountant should disclose this departure in GAAP only if it has a significant effect on the financial
statements.
13. Effective January 1, 2007, the state in which FTR Ltd. organized as a partnership will begin collecting a business
tax on all limited partnerships based on net income of the partnerships over a fiscal or calendar year. How
should FTR's accountant record the tax imposed by the state?
a. As an expense of the partnership and, if material, the nature of the tax in a note to the financial statements.
b. As a distribution to each partner on a pro rata basis, adjusting each partner's basis accordingly.
c. As an expense of the partnership and a decrease to the partner's basis accordingly.
d. As a distribution to each partner on a pro rata basis, and the partnership should record the anticipated tax
as a liability on the balance sheet.
14. Which of the following items is most likely to be reflected in the income statement in the financial statements
of a partnership?
a. A loan to a partner that exceeds the partner's capital account.
b. The salary of a partner for reasonable compensation for services.
c. Federal income tax expense based on net income before taxes.
d. Distributions to a partner on a pro rata basis based on the net income of the partnership.
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15. Tweedle, a limited partner in TDD Ltd., makes a loan to TDD in 2006 of $50,000. Tweedle's pro rata share of
net income from TDD for 2006 is $85,000. On January 1, 2006, Tweedle's capital account was $65,000. During
2006, Tweedle took draws from TDD totaling $95,000. What is the balance of Tweedle's capital account on
December 31, 2006?
a. $20,000.
b. $30,000.
c. $55,000.
d. $105,000.
16. Why is the goodwill method of accounting for a change in partnership interest not appropriate in most cases?
a. Because the goodwill method only results in a partial change in value of asset and capital.
b. Because the goodwill method is consistent with a change in ownership in a corporation, where no change
in basis occurs.
c. Because the goodwill method does not comply with GAAP, and its use would require additional disclosure
in the notes to the financial statements.
d. Because the goodwill method contemplates the complete revaluation of historical cost balance sheets.
On September 30, 2006, Budding Partnership's balance sheet is summarized as follows:
Assets
500,000
Liabilities
Partners' Capital
200,000
180,000
90,000
30,000
300,000
500,000
On September 30, 2006, Partner A buys a 10% interest in the partnership for $60,000 cash.
A?
a. $184,600.
b. $186,800.
c. $188,600.
d. $194,400.
18. Using the bonus method, what is the balance of Partner Y's capital account after the contribution by new Partner
A?
a. $92,400.
b. $95,600.
c. $97,200.
d. $99,800.
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19. Using the bonus method, what is the balance of Partner Z's capital account after the contribution by new Partner
A?
a. $30,800.
b. $31,600.
c. $32,400.
d. $33,200.
20. Based on the facts described in this scenario, why might the bonus method be more appropriate than the
goodwill method in this case?
a. Because subsequent to the purchase, there is not a new controlling interest in the partnership.
b. Because subsequent to the purchase, assets are now properly recorded at fair market value.
c. Because subsequent to the purchase, each of the existing partners' shares in the partnership decreased
on a percentage basis.
d. Because subsequent to the purchase, there has been a partial revaluation of each original partners' capital
account to reflect fair market value.
On April 30, 2006, Thriving Partnership's balance sheet is summarized as follows:
Assets
800,000
Liabilities
Partners' Capital
300,000
250,000
150,000
100,000
500,000
800,000
On April 30, 2006, Partner A buys a 10% interest in the partnership for $80,000 cash.
21. Using the goodwill method, what is the balance of Partner X's capital account after the contribution by new
Partner A?
a. $280,000.
b. $340,000.
c. $360,000.
d. $380,000.
Partner A?
a. $216,000.
b. $224,000.
c. $236,000.
d. $242,000.
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23. Using the goodwill method, what is the balance of Partner Z's capital account after the contribution by new
Partner A?
a. $132,000.
b. $138,000.
c. $144,000.
d. $148,000.
24. Using the goodwill method, what is the net increase to the total assets of Thriving Partnership after revaluation?
a. $250,000.
b. $300,000.
c. $350,000.
d. $400,000.
25. Why might the goodwill method be more appropriate than the bonus method when a partnership acquires a
withdrawing partner's interest under a retirement, death or disability provision?
a. Because the goodwill method maintains the historical cost basis valuation of the balance sheet in
accordance with GAAP.
b. Because the bonus method could produce large, deficit balances in capital accounts when distributions
to the withdrawing partner are made and the partnership assets are not revalued.
c. Because under the bonus method, the partnership must recognize gain to the extent that the fair market
value of the assets distributed to the withdrawing partner exceed the partnership basis in the assets.
d. Because the goodwill method is more appropriate when there is a change in controlling interest in the
partnership.
26. Which of the following is a primary advantage of a limited liability corporation (LLC)?
a. Income is passed through to the members for taxation purposes.
b. The Uniform Limited Liability Company Act has been adopted by most states, simplifying the ability to
operate in multiple jurisdictions.
c. Transfer of interests between members is simpler due to the right of assignation.
d. The organizational structure of an LLC is simpler because only one class of ownership is permitted.
27. WJC, an LLC with 3 members, asks its accountant, HRB CPA, about the tax treatment of the company and its
members related to its organization as an LLC. Which of the following might represent appropriate guidance
from HRB to WJC?
a. WJC should elect to be treated as a partnership to minimize the members' liability for payroll taxes on their
earnings.
b. Since WJC has less than 5 members, the LLC can elect to be treated as an unincorporated entity,
simplifying the tax compliance process.
c. WJC should elect to be treated as a partnership for tax purposes to avoid the double taxation of income
to its members.
d. WJC should elect to be treated as a partnership because of the increased liability protection afforded to
partnerships.
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28. What is one important aspect an accountant should consider when a client wants to convert an existing entity
to an LLC?
a. If the existing entity is a corporation, the conversion will result in a change reporting entity and the new
company must adhere to the disclosure requirements of SFAS No. 154.
b. If the existing entity is a partnership, the partners will recognize gain or loss based on the fair market value
and the basis of the partnership assets.
c. If the existing entity is a corporation, gain or loss will be recognized by the shareholders.
d. If the existing entity is a partnership, the conversion to an LLC will result in the liquidation of the partnership
and the formation of a new entity.
29. When issuing compiled or reviewed financial statements for an S corporation, what are two of the major
differences compared to a C corporation which an accountant should consider?
a. Income taxes and the statement of cash flows.
b. Income taxes and retained earnings.
c. Retained earnings and the statement of comprehensive income.
d. Retained earnings and the basis of accounting.
30. Why might an accountant maintain separate retained earnings accounts when preparing compiled or reviewed
financial statements?
a. Because GAAP requires the disclosure of separate retained earnings accounts of an S corporation.
b. Because maintenance of separate retained earnings accounts assists third party users in understanding
the nature of the capital structure of the S corporation.
c. Because the articles of organization of an S corporation generally require the maintenance of separate
retained earnings accounts.
d. Because separate retained earnings accounts are generally necessary for proper tax accounting of an S
corporation.
For items 3135, select the appropriate retained earnings account based on the description provided.
31. Retained earnings that are not viewed as part of shareholders' tax bases in their shares.
c. Tax Temporary Adjustments (TTA).
d. Other Retained Earnings (ORE).
32. This retained earnings account represents amounts defined under the old Subchapter S federal tax regulations
and is applicable only to corporations electing Subchapter S status for tax years beginning before 1983.
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33. This retained earnings account is increased by taxexempt income.

b. Accumulated Earning and Profits (AEP).
34. This retained earnings account is increased by taxable income and by separately stated items of income such
as net capital gains.
35. This retained earnings account does not generally apply to corporations that immediately elect S corporation
status.
a. Previously Taxed Income (PTI).
b. Accumulated Earning and Profits (AEP).
Brand New Co. (BNC) began operations on January 1, 2005, at which time the company elected S corporation
status. BNC is owned equally by 5 shareholders. In 2005, BNC did not make any distributions to the shareholders.
As of December 31, 2005, BNC's retained earnings accounts are summarized as follows:
Retained Earnings
Retained Earnings AAA
Other Retained Earnings (ORE)
150,000
10,000
160,000
In 2006, BNC earned net income of $120,000, including $15,000 of taxexempt interest income. $5,000 in meals
and entertainment expenses were nondeductible. BNC made a total dividend distribution of $50,000 to its
shareholders.
36. Based on the above information, what is the balance of AAA as of December 31, 2006?
a. $185,000.
b. $205,000.
c. $220,000.
d. $270,000.
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37. Based on the above information, what is the balance of ORE as of December 31, 2006?
a. $25,000 credit balance.
b. $60,000 credit balance.
c. $25,000 debit balance.
d. $40,000 debit balance.
38. Based on the above information, how much taxable income is allocated to each shareholder for the year ended
December 31, 2006?
a. $16,000.
b. $18,000.
c. $22,000.
d. $24,000.
Grown Up Co. (GUC) began operations on January 1, 1995. Retained earnings as of December 31, 2005, totaled
$250,000. The company elected S corporation status on January 1, 2006. GUC is owned equally by 3
shareholders. As of January 1, 2006, BNC's retained earnings accounts are summarized as follows:
Retained Earnings
Retained Earnings AAA
Other Retained Earnings AEP
Other Retained Earnings (ORE)
0
250,000
0
250,000
In 2006, GUC earned net income of $70,000, including $4,000 of taxexempt interest income. GUC made a total
dividend distribution of $90,000 to its shareholders.
39. Based on the above information, what is the balance of AEP as of December 31, 2006?
a. $164,000.
b. $160,000.
c. $226,000.
d. $250,000.
40. Based on the above information, what amount of dividends distributed by GUC will be subject to federal income
tax at the shareholder level?
a. $20,000.
b. $24,000.
c. $86,000.
d. $90,000.
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GLOSSARY
is reporting.
Accumulated Adjustments Account (AAA): A retained earnings account maintained by an S corporation that
reflects the aggregate amount of undistributed income and gains that have been taxed to the shareholders after
1982.
Accumulated Earnings and Profits (AEP): A retained earnings account maintained by an S corporation that
applied to S corporations with previous Subchapter C status, generally representing retained earnings existing when
S corporation status is attained.
Bonus method: A method of accounting for changes in partnership interests of a partnership. The bonus method
generally does not result in a change of basis to partnership assets.
of generally accepted accounting principles (GAAP), primarily for nongovernmental entities.
Goodwill method: A method of accounting for changes in partnership interests of a partnership. The goodwill
method generally results in a complete change of basis to partnership assets.
Guaranteed payments: Payments typically made to partners in a partnership in the performance of services or as
interest on capital accounts.
Limited liability company: Business entities created under state law that combine many of the tax advantages of
a partnership with the liability protection of a corporation.
Limited liability partnership: Special partnerships formed under state law that were created to shield a partner of
a professional firm from liability arising from the malpractice of another partner in the same firm.
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Other Retained Earnings (ORE): A retained earnings account maintained by an S corporation that represents any
amount that would be viewed as retained earnings under GAAP and state corporation law that is included in
shareholders' bases for tax purposes, but is not included in AAA, PTI, or AEP.
Partnership: An unincorporated business enterprise formed under state law by two or more individuals or other
entities. A partnership agreement filed under applicable state law serves as primary document governing partnership
organization, including the accounting basis used in preparing a partnership's financial statements.
Previously Taxed Income (PTI): A retained earnings account maintained by an S corporation applicable only to
corporations that were electing Subchapter S status for tax years beginning before 1983, representing the
accumulated taxable income that was not paid as cash dividends prior to dates certain.
Proprietorship: An unincorporated business enterprise wholly owned by one individual.
S corporation: An incorporated business enterprise that generally is not subject to federal income tax. Income or
loss is passed through to the shareholder and taxed at the shareholder level instead of the corporate level, similar
to a partnership.
nonpublic entity.
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Tax Temporary Adjustments (TTA): A retained earnings account maintained by an S corporation, representing
amounts that result when tax/book differences originate and then reverse. Such amounts are not viewed as part of
shareholders' tax bases in their shares, but they are necessary to maintain a doubleentry financial accounting
system.
media.
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CART07
INDEX
A
Federal income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311

Financial statement headings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
Formation of an LLC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
LLC disclosures specified in PB 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
State income and franchise taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
Advantages and disadvantages of LLCs . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Organization
Articles of organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Operating agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Single member . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310, 313
Emphasis of a matter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
Omission of statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
ACCOUNTING PRINCIPLES BOARD (APB)
Opinion 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
Opinion 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265, 280
Opinion 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267, 305
ACCOUNTING RESEARCH BULLETIN (ARB)
ARB 43 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267, 305
ARB 51 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267, 305
LIMITED LIABILITY PARTNERSHIPS

Accounting and reporting issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
Advantages and disadvantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
Compared to LLCs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
COMBINED FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
OTHER COMPREHENSIVE BASIS OF ACCOUNTING

Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Statement titles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Tax basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
CONSOLIDATED FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . 267

CORPORATE JOINT VENTURES
Accounting for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
PARTNERSHIPS
Accounting for investments in partnerships . . . . . . . . . . . . . . . . . . . . . . . 305
Admission of new partner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Allocation of income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
Bonus method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287, 298, 298, 300
Book vs. tax differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
Capital accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279, 280
Carryover basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
Change in legal form of entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
Changes in interest of partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Contingent payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
Contributed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279, 280
Dissolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287, 298
Financial statements
Accrual basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Basis specified in partnership agreement . . . . . . . . . . . . . . . . 274, 275
Cash basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273, 280
Disclosure items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274, 275, 278, 291
Equity section . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279, 280
Illustrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Statement of changes in partners' capital . . . . . . . . . . . . . . . . . . . . . 280
Tax basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273, 280
Franchise taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
Goodwill method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287, 289, 298, 299
Guaranteed payments to partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275, 276
Joint ventures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Loans with partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
Retirement plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
Special accounting treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
Withdrawals of partners' capital . . . . . . . . . . . . . . . . . . . . . . . . . 275, 287, 298
DISCLOSURES
Accounting policies
Proprietorship financial statements . . . . . . . . . . . . . . . . . . 258, 262, 266
Footnotes illustrated
Accounting policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258, 274, 275
Income tax liability and provision . . . . . . . . . . . . . . . . . . . . 262, 275, 318
Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274, 275, 278, 291
Property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
Proprietorships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258, 262, 266
Related party . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
S corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
E
EQUITY METHOD OF ACCOUNTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
F
FINANCIAL ACCOUNTING STANDARDS BOARD (FASB)
Statement 94 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267, 305
Statement 96 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
Combined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparative
S corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consolidated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Illustrated financial statements and drafting forms
Statement of changes in partners' capital . . . . . . . . . . . . . . . . . . . . .
267
318
267
280
PROPRIETORSHIPS
Anticipated withdrawals of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
Cash basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
Combined financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
Consolidated financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258, 262, 266
Equity section . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264, 265
Illustrated financial statements
Statement of changes in proprietor's capital . . . . . . . . . . . . . . . . . . . 265
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
Proprietor's capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
Relationship to personal financial statements . . . . . . . . . . . . . . . . . . . . . . 258
Reports on compiled financial statements without footnotes . . . . . . . . . 262
Retirement plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Segregation of assets from personal assets . . . . . . . . . . . . . . . . . . . . . . . 258
Statement of changes in proprietor's capital . . . . . . . . . . . . . . . . . . . . . . . 265
Subsequent withdrawal of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
Tax basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
FRANCHISE TAXES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
I
INCOME TAXES
Footnotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262, 275, 276, 318
Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275, 276
Proprietorships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
S corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318, 337
State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
J
JOINT VENTURES, INVESTMENTS IN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
L
LIMITED LIABILITY COMPANIES
Accounting and reporting issues
Comparative financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conversion of an existing entity to an LLC . . . . . . . . . . . . . . . . . . . . .
Disclosure of change in legal form and/or tax status . . . . . . . . . . . .
Equity section of the balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . .
312
312
313
311
S CORPORATIONS
Accumulated adjustments account (AAA) . . . . . . . . . . . . . . . . . . . . . . . . . 323
365

Accumulated earnings and profits (AEP) . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Change in legal form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
Financial statement presentation
Balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
Cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
Comparative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318, 335
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
Income statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
Reports on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318, 318, 323
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318, 323, 337
Other retained earnings (ORE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Previously taxed income (PTI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Retained earnings accounting illustrations
Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Former C corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
CART07
Former Subchapter S corporations . . . . . . . . . . . . . . . . . . . . . . . . . . .

Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Newly formed S corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reasons for maintaining separate accounts . . . . . . . . . . . . . . . . . . .
Tax/book temporary differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Termination of S corporation election . . . . . . . . . . . . . . . . . . . . . . . . .
Tax temporary adjustments (TTA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
333
336
329
323
337
341
323

Not required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Omission of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
SUBSEQUENT EVENTS
Withdrawal of capital
Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275, 287, 298
Proprietorships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
366
CART07
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Guide To Compilation & Review

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CART07

SELFSTUDY CONTINUING PROFESSIONAL EDUCATION

Companion to PPC's Guide to

Fort Worth, Texas

Copyright 2007 Thomson Tax & Accounting

Interactive Selfstudy CPE

Engagement Letters and Workpaper Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Compilation Procedures and Checklists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Review Procedures and Checklists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COURSE 2: PREPARING FINANCIAL STATEMENTS FOR COMPILATIONS AND REVIEWS

Form and Presentation of Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Reporting on Compiled or Reviewed Financial Statements . . . . . . . . . . . . . . . . . . . . . . .

COURSE 3: PROPRIETORSHIPS, PARTNERSHIPS, AND S CORPORATIONS:

ANSWER SHEETS AND EVALUATIONS

Guide to Compilation and Review Engagements

COMPANION TO PPC'S GUIDE TO COMPILATION AND REVIEW ENGAGEMENTS

This interactive selfstudy course addresses several aspects of compilation and

Users of PPC's Guide to Compilation and Review Engagements

Basic knowledge of Attest Engagements and Related Reporting Requirements

8 QAS Hours, 8 Registry Hours

Postmark by September 30, 2008

Guide to Compilation and Review Engagements

TO COMPLETE THIS LEARNING PROCESS:

Guide to Compilation and Review Engagements

Lesson 1:Engagement Letters and Workpaper

Guide to Compilation and Review Engagements

Will We Offend Our Longstanding Clients?

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

e. Restriction on Distribution. If accountants discover that managementuseonly financial statements have

Guide to Compilation and Review Engagements

Using Engagement Letters to Minimize Liability

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Required and Suggested Workpapers for a Compilation of Thirdpartyuse Financial Statements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

INDEPENDENCE ISSUES RELATING TO COMPILATION AND REVIEW

Guide to Compilation and Review Engagements

Nonprofit Organization Clients

No Independence Interpretations or Rulings. In situations where there are no independence interpretations or

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Guide to Compilation and Review Engagements

Reporting to the board of directors on behalf of management.

Independence Would Not Be Impaired

Independence Would Be Impaired

Accept responsibility to authorize pay

Guide to Compilation and Review Engagements

Independence Would Not Be Impaired

Independence Would Be Impaired

SELFSTUDY CONTINUING PROFESSIONAL EDUCATION

Interactive Selfstudy CPE

This interactive selfstudy course addresses several aspects of compilation and

Will We Offend Our Longstanding Clients?

e. Restriction on Distribution. If accountants discover that managementuseonly financial statements have

Required and Suggested Workpapers for a Compilation of Thirdpartyuse Financial Statements

Accept responsibility to authorize pay

Commit the client to employee compen

Make or approve business risk deci

COMPILATIONS OF MANAGEMENTUSEONLY FINANCIAL STATEMENTS

Accountants' Responsibilities When Managementuseonly Financial Statements Are Distributed to Third