LEVELS OF ASSURANCE: You may want a CPA to analyze in order to assure the accuracy of the analysis due to the method used. Alternatively, you may come across a financial statement in disclosures or discovery and need to figure out what it is and how reliable it is. A CPA can provide three levels of assurance, all three based on GAAP:
- AUDIT: Publicly traded companies need this on an annual basis. It is the highest level of assurance. There is testing of transactions and balances. Here are some things to look at in analyzing an audit. First, look for the statement “we have audited” in the cover letter. This means an actual audit took place. You want an unqualified analysis. A statement like “In our opinion, the consolidated financial statements referred to present fairly in all material respects…” is about as good as it gets. “We are concerned about internal control…” may be a red flag. Although, some small companies inevitably have weaknesses that cannot be cured. For example, a one-person shop where the owner makes a bank deposit has a “control problem” but that may be unavoidable for budgetary reasons. An adverse opinion or disclaimer indicates a problem. Maybe there is a lack of records, for example. At the end of the day, viable and healthy companies will want an unqualified opinion in an audit. Public companies need an annual audit. Other companies do not.
- REVIEW REPORT: This will usually say “We have reviewed…” A review has less scope than an audit. One big difference is that they do not go into internal control for producing financial statements and there is nothing about assessing fraud risk. With a review, there is no obligation on the part of the CPA to look into whether the business owner is providing fraudulent information.
- COMPILATION REPORT: This is the least comprehensive form of assurance. The CPA simply takes the information given and makes a financial statement. It may be for tax purposes, for example. If you see “for management use only” that often indicates that it is simply a compilation report.
OTHER ‘ASSURANCE’ REPORTS: In addition to the foregoing 3 levels of assurance, you can have an independent report by CPAs without having a whole financial statement. These differ in that there is no assurance of solvency. They may, however, show cash flow or other factors that are of use. A lot of small business owners have no expertise in hiring financial professionals and may hire people without this level of expertise or may try to generate reports based on their own software. Too much reliance on software, no matter how good it is, will have the GIGO — “garbage in, garbage out” — factor that it is based only on what is given. This differs from GAAP which includes analysis and judgment of the individual CPA.
DEPRECIATION: “Useful lives” are set up to determine a range of depreciation in the value of an item. There is judgment involved, but it should be realistic. If you are looking at a financial statement and it does not make sense, perhaps the “useful life” of the asset is being shortened or lengthened to manipulate income, giving a distorted impression. The more realistic question should be: how long will this asset be important to you?
Watch out with tax basis accounting because depreciation can be used to mislead the other party or court about the income and profitability of a business. Just because the IRS accepts this for tax purposes does not mean a family law judge will agree that your real estate business has no profit due to major depreciation write offs for your real property. On the other hand, in some real estate operations such as a REIT, or real estate investment trust, it might make sense to ignore depreciation (or add it back at the end of the financial statement) because there will be no replacement. Think about it: for a trust, one may want to show value, whereas in divorce or with the IRS there is an incentive to minimize value and income (if you are the one giving away a share or paying based on income). The interests differ resulting in possible distortion. If called out on this distortion, the effort to mislead may backfire. This also shows why obtaining financial statements in support of loans, fiduciary checks and public offerings (which indicate high value and income) are critical to a person wanting to document distortions falsely indicating a business is floundering.
Some companies have dollar amounts or percentage amounts that determine whether something is depreciated or expensed. This information may be useful to review and assess. For example, one business owner realized that nothing under $5,000 was assessed, so if he wanted to misuse funds, he made sure it was less than $5,000. He was caught.