A Flood of Risk Assessment Rising in Review Engagements During COVID-19
There are vast financial reporting implications arising from COVID-19, creating new matters of concern, assessment and evaluation.
The original article appeared in the Pennsylvania CPA Journal, the official publication of PICPA.
This activity has necessitated a reassessment of our understanding of our clients’ business, industry, markets, supply chains and every sphere of impact on a financial report. In audit engagements, risk assessment in nearly every financial reporting area will require enhanced and revised consideration. We may have to completely change the risks assessed and our entire approach.
Reviewed Financial Statements
Review engagement responsibilities begin to creep toward those in an audit with SSARS No. 25, Materiality in a Review of Financial Statements and Adverse Conclusions. When it becomes effective (periods ending after Dec. 15, 2021), explicit requirements will be added for CPAs to determine materiality for the financial statements as a whole, and to apply this materiality in designing the review procedures and evaluating the results.
Currently, determining and assessing materiality is implied, although the presumption has always been that without such determination the CPA is unable to meet the fundamental objectives of a review engagement (to obtain limited assurance as a basis for review reporting). Materiality has a significant implication on risk.
Consideration of materiality is made in the context of the financial reporting framework used to prepare the financial statements. Financial statements prepared using U.S. generally accepted accounting principles (GAAP) have Financial Accounting Standards Board Concepts Statement 8, which indicates that an omission or misstatement of an item in the financial statements is material if, in light of surrounding circumstances, its magnitude is such that it is probable that the judgment of a reasonable person relying upon the report would have been influenced by the inclusion or correction of the item. Thus, misstatements/omissions are considered to be material if they could reasonably be expected to influence the economic decisions of users.
Like risk assessment, a judgment about materiality should be made in light of surrounding circumstances, the size or nature of a misstatement, or a combination of both, along with matters deemed material to users of the financial statements. So, an item’s magnitude by itself, without regard to the nature and circumstances generally, is not a sufficient basis for a materiality judgment. Accordingly, both quantitative and qualitative considerations must be kept in mind.
Enter the coronavirus. CPAs must now carefully assess what users need to know to achieve the following:
- A reasonable knowledge of business and economic activities
- An understanding of the materiality bases used to prepare and present the financial statements
- Recognition of the inherent uncertainties resulting from estimates, judgments and the likely implications of future events
- The ability to make reasonable economic decisions based on the financial statements
In this context, the prolonged impact of the coronavirus will most certainly necessitate that CPAs reassess many of the perceptions of the needs of the users, the goals and biases of management, the reliability of accounting information, and even the uncertainties of analytical data that are the core of gathering review evidence. Further, the engagement findings must be assessed within the context of an amended assessment of the business.
Some examples may include matters such as the following:
- Reductions in revenues
- Disproportionate changes in costs of sales
- Payroll losses or payroll costs
- Spikes in costs related to customer/employee protections and safety
- Inventory spoilage
- Implications of defaults (on leases, loans, ratios, etc.)
Materiality is the basis for engagement benchmarks for the planning, execution, reassessment, and modification of review procedures. Thus, all review evidence gathered must be assessed through the lens of the business risks and their impact on management, owners, and users.
Within the framework of U.S. GAAP, paramount concerns include impairment of assets (both tangible and intangible), collectability of receivables, the extent of contingencies, the realizability of inventories, and the ability to meet the cash requirements due to debtors. The financial statements must, within the financial reporting framework, reflect financial position and operating results, define cash flow, and present disclosures that enhance understandability.
Within a special purpose framework, even though impairments and accrual of contingencies may not be measured factors, financial statements must still clearly depict financial position, operating results, cash flows, and disclosures that enhance understandability. No matter the reporting framework, a consideration of the entity’s ability to continue as a going concern necessitates consideration of risk.
In GAAP financials, management’s representations and plans must be carefully considered, assessed, and documented. Even SSARS has stepped up the magnification of responsibilities, particularly in a review (AR-C Section 90). However, both a compilation (AR-C Section 80) and a preparation (AR-C Section 70) necessitate that the CPA has sufficient knowledge as to whether omission of any going concerns disclosure would be misleading. If so, the financial statements must either be revised or the CPA resigns from the engagement.
The intricacies of Paragraph 22 of AR-C Section 90 will have an extremely different and enhanced significance in a coronavirus-influenced environment. Consider these required inquiries and their effects on financial statements:
- Unusual or complex situations (e.g., ASC 606, impairments, debt/cash flow concerns, and pandemics)
- Significant transactions (cut personnel, closings, or changes in the basic business model)
- Events subsequent to the date of the financial statements
- Fraud or suspected fraud (consider the fraud triangle and the desperation of the entity and its management)
- Instances of noncompliance or suspected noncompliance with laws and regulations (massive Paycheck Protection Program loans/grants and Small Business Administration borrowings)
- Related parties and significant new related parties (whether disclosed or not disclosed)
- Litigations, claims, and assessments
- Significant assumptions and estimates
All in all, it seems to come down to deeply assessing (“reviewing”) risk.
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James J. Newhard, CPA, is a sole practitioner in Paoli, a CPE presenter for Kaplan Financial Education, and a past-president of PICPA’s Greater Philadelphia Chapter. He serves on numerous state and chapter A&A and tax committees, and is a member of the Pennsylvania CPA Journal Editorial Board.