The Interplay Between Case Law and Professional Standards for Compiled Financial Statements

• Author: Joanne D. Williams,Craig P. Ehrlich
• Date: 01 September 2011
• Published date: 01 September 2011
• DOI: http://doi.org/10.1111/j.1744-1714.2011.01118.x

The Interplay Between Case Law and

Professional Standards for Compiled

Financial Statements

Craig P. Ehrlich

n

and Joanne D. Williams

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INTRODUCTION

Small businesses and other private companies make up 99.7 percent of U.S.

employers and generate half the nonfarm output of the U.S. economy.

1

Yet ,

in sharp contrast to the vast literature concerning audits of large, publicly

traded companies by large, public accounting firms and auditor liability,

there is little legal literature dealing with the important small-business sector.

In this article we address the interplay between judicial decisions, on the one

hand, and the professional standards, on the other, as they relate to accoun-

tants’ unaudited financial statements compiled for small businesses.

Recognizing that their financial reporting issues are distinctive, the

Financial Accounting Standards Board and the American Institute of Cer-

tified Public Accountants (AICPA) recently have formed the Private Com-

pany Financial Reporting Committee to address the financial reporting

needs of private companies and their constituents.

2

r2011 The Authors

American Business Law Journal r2011 Academy of Legal Studies in Business

409

American Business Law Journal

Volume 48, Issue 3, 409–448, Fall 2011

n

Associate Professor of Business Law, Babson College; B.S., J.D., University of Illinois,

Urbana.

nn

Associate Professor of Accounting, Babson College; A.B., University of California, Berkeley;

M.B.A., Texas A&M University; Ph.D., Te xas A&M University; CPA, Texas.

1

Derek Leebaert, How Small Businesses Contribute to U.S. Economic Expansion (2006),

America.Gov, http://www.america.gov/st/econ-english/2008/July/20080814223926XJyrreP0.

615597.html. But see David Hirschberg, The Job-Generation Issue and Its Impact on Health Insur-

ance Policy,44C

HALLENGE 82 (2001) (questioning these and other statistics about small business).

2

Private Company Financial Reporting,PRIVATE COMPANY FINANCIAL REPORTINGCOMMITTEE, http://

www.pcfr.org/ (last visited Apr. 28, 2011).

Small, privately held businesses call upon an accountant, typically a

sole practitioner, to prepare unaudited financial statements. One type

of this work is called compilation, which involves accumulating financial

data from the client’s accounting system and assisting the client in pre-

paring conventional financial statements. The accountant does not test

the quality of the client’s internal controls and does not test the veracity

of the statements. Often small businesses require this write-up assistance

on a monthly, quarterly, or yearly basis, and many accountants routinely

prepare such compilations.

3

A compilation performed for a ‘‘nonissuer’’ merely presents ‘‘in the

form of financial statements, information that is the representation of

management.’’

4

By definition, a compilation carries with it no ‘‘assurance

on the financial statements,’’

5

and the accountant’s report disclaims

an opinion or any other form of assurance.

6

This distinctively sets a com-

pilation apart from a review and an audit. By contrast, these latter two

services are considered assurance services, as well as attest services. In a

review engagement, the accountant expresses ‘‘limited assurance,’’ but not

an opinion, about financial statements, based on analytical procedures and

inquiries of client management. An audit is the highest level of assurance.

In connection with an audit, the certified public accountant (CPA) also

performs verification and substantiation procedures. When the audit is

completed, the CPA’s standard audit report states that the audit was per-

formed in accordance with generally accepted auditing standards (GAAS)

and expresses an opinion that the financial statements present fairly the

entity’s financial position and results of operations.

3

Thomas A. Ratcliffe et al., A Fresh Approach for Compilation and Review,J.ACCT., July 2009, at

24, 25. This article notes that, of the 44,000 registered CPA firms in the United States, 31,000

are sole practitioners. Id.

4

AICPA, AICPA PROFESSIONAL STANDARDS,STATEMENTS ON STANDARDS FOR ACCOUNTING AND

REVIEW SERVICES AND RELATED ACCOUNTING AND REVIEW SERVICES INTERPRETATIONS § 100.04

(2009) [hereinafter AR].

5

Id. This point is made twice, in AR Sections 100.06 and .12. Courts have also described how

the absence of assurance distinguishes a compilation from a review (which tests the financial

statements by analytical means) and an audit (which tests not only by analytical means but also

by actual physical testing), although they do not always refer to the AR. In re CitX Corp., 448

F.3d 672, 675 (3d Cir. 2006); Harik v California Teachers Association, 326 F.3d 1042, 1048

(9th Cir. 2003).

6

AR, supra note 4, § 100.13(c).

410 Vol. 48 / American Business Law Journal

Under the Uniform Accountancy Act, a compilation engagement is

not considered to be an attest service, and as such, the accountant need not

be independent of the client.

7

However, Section 14(a) of the Uniform Ac-

countancy Act declares this service to be the exclusive province of licens-

ees.

8

Although a compilation does not involve ‘‘any explicit assurance,’’ the

Introductory Comments to the Uniform Accountancy Act note that there is

a ‘‘danger of innocent reliance on the implicit representations of skill and

assurances of reliability of such reports if they are issued by persons not

having the professional qualifications that such reports imply.’’

9

Indeed,

bankers have advised the Accounting and Review Services Committee

(ARSC) that they believe that a CPA’s involvement in compiling or review-

ing a client’s financial statements will improve the reliability of the infor-

mation.

10

The Uniform Accountancy Act effectively imposes a qualification

standard on compilations.

The ARSC of the AICPA promulgates the professional standards

governing compilation services. They are known as the Statements on Stan-

dards for Accounting and Review Services (SSARS) and the related Accounting

and Review Services Interpretations. The cumulative codification of the SSARS

is referred to by accountants as ‘‘the AR.’’

11

The first set of compilation

rules, known as SSARS No. 1, became effective in July 1979. SSARS No. 1

7

UNIFORM ACCOUNTANCY ACT § 3(b) (5th ed. 2007), available at http://www.aicpa.org/Advocacy/

State/StateContactInfo/uaa/DownloadableDocuments/UAA_Fifth_Edition_January_2008.pdf.

See also AR § 100.23. The Uniform Accountancy Act is a model codification developed by the

AICPA‘‘to serve as model legislation to state legislators as a means of decreasing the litigation

of accounting malpractice claims and to limit the liability of accountants to those persons with

whom the accountant does not have a direct contractual relationship.’’ Dominick F.Impastato,

III, Comment, Louisiana Revised Statute Section 37: 91-Removing Accountability from the Account-

ing Profession,49L

OY.L.REV.553, 573–74 (2003). Even though the accountant need not be in-

dependent of the client in this circumstance, a lack of independence should be disclosed in the

accountant’s report. However, as discussed more fully infra, the 2009 Revision characterizes a

compilation as an ‘‘attest engagement,’’ which is defined as an engagement that requires inde-

pendence. This is confusing because, under existing andrevised rules, a compiling accountant need

not be independent as long as the lack of independence is disclosed. See infra text accompanying

notes 194–96.

8

UNIFORM ACCOUNTANCY ACT,supra note 7.

9

Id. at UAA-I-3.

10

Ratcliffe et al., supra note 3, at 25 (‘‘[B]ankers have advised ARSC that they welcome the

involvement of a CPA throughout the year because they believe the CPA’s involvement will

improve the reliability of the financial information.’’).

11

AR, supra note 4.

2011 / The Interplay Between Case Law and Professional Standards 411