Accountants’ Handbook Special Industries and Special Topics 10th Edition_15

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38 24 PROSPECTIVE FINANCIAL STATEMENTS • • Management has identiﬁed all key factors expected to affect the entity during the prospective period. • Management has developed assumptions for each key factor. • The assumptions are suitably supported. To determine whether management has identiﬁed all key factors and developed assumptions for each one, the accountant needs to possess, or obtain during the engagement, an appropriate knowl- edge of the industry in which the entity will operate and the accounting principles and practices of that industry. The accountant can conclude that the assumptions are suitably supported if the preponderance of information supports each signiﬁcant assumption. Preponderance here does not imply a statistical majority of information. A preponderance exists if the weight of available information tends to sup- port the assumption. The AICPA Guide states, however, “Because of the judgments involved in de- veloping assumptions, different people may arrive at somewhat different but equally reasonable assumptions based on the same information.” The accountant need not obtain support for the hypothetical assumptions in a projection, since they are not necessarily expected to occur. For a projection, the accountant considers whether the hypothetical assumptions are consistent with the purpose of the projection and whether the other assumptions are suitably supported given the hypothetical assumption. In evaluating the support for the assumptions, the accountant considers six factors: 1. Whether sufﬁcient pertinent sources of information, both internal and external to the entity, have been considered 2. Whether the assumptions are consistent with the sources from which they are derived 3. Whether the assumptions are consistent with each other 4. Whether the historical ﬁnancial information and other data used in developing the assump- tions are sufﬁciently reliable for that purpose 5. Whether the historical information and other data used in developing the assumptions are comparable over the periods speciﬁed or whether the effects of any lack of comparability were considered in developing the assumptions 6. Whether the logical arguments or theory, considered with the data supporting the assump- tions, are reasonable Support for assumptions may include market surveys, engineering studies, general economic in- dicators, industry statistics, trends and patterns developed from an entity’s operating history, and in- ternal data and analysis, accompanied by their supporting logical argument or theory. The accountant determines whether the assumptions provide a reasonable basis for the statements but cannot conclude that any outcome is expected because (1) realization of prospective results may depend on management’s intentions, which cannot be examined; (2) there is substantial uncertainty in the assumptions; (3) some of the information accumulated about an assumption may appear contra- dictory; and (4) different but similarly reasonable assumptions concerning a particular matter might be derived from common information. (iii) Evaluating Presentation. The accountant compares the presentation of the prospective ﬁnan- cial statements to the AICPA presentation guidelines [see Subsections 38.4(b) and (c)]. (b) STANDARD EXAMINATION REPORT. The accountant’s standard report on an examination of prospective ﬁnancial statements includes six statements: 1. A title that includes the word “independent” 2. An identiﬁcation of the prospective ﬁnancial statements presented
38.7 EXAMINATION SERVICES 38 25 • 3. An identiﬁcation of the responsible party and a statement that the prospective ﬁnancial state- ments are the responsibility of the responsible party 4. A statement that the accountant’s responsibility is to express an opinion on the prospective ﬁ- nancial statements based on the examination 5. A statement that the examination of the prospective ﬁnancial statements was conducted in ac- cordance with attestation standards established by the AICPA and, accordingly, included such procedures as the accountant considered necessary in the circumstances 6. A statement that the accountant believes that the examination provides a reasonable basis for the opinion 7. The accountant’s opinion that the prospective ﬁnancial statements are presented in confor- mity with AICPA presentation guidelines and that the underlying assumptions provide a rea- sonable basis for the forecast or a reasonable basis for the projection given the hypothetical assumptions 8. A caveat that the prospective results may not be achieved 9. A statement that the accountant assumes no responsibility to update the report for events and circumstances occurring after the date of the report 10. The manual or printed signature of the accountant’s ﬁrm 11. The date of the examination report The standard report on the examination of a ﬁnancial forecast is as follows: Independent Accountant’s Report We have examined the accompanying forecasted balance sheet, statements of income, retained earnings, and cash ﬂows of XYZ Company as of December 31, 20XX,* and for the year then end- ing. XYZ Company’s management is responsible for the forecast. Our responsibility is to express an opinion on the forecast based on our examination. Our examination was conducted in accordance with attestation standards established by the Ameri- can Institute of Certiﬁed Public Accountants and, accordingly, included such procedures as we con- sidered necessary to evaluate both the assumptions used by management and the preparation and presentation of the forecast. We believe that our examination provides a reasonable basis for our opinion. In our opinion, the accompanying forecast is presented in conformity with guidelines for presenta- tion of a forecast established by the American Institute of Certiﬁed Public Accountants, and the un- derlying assumptions provide a reasonable basis for management’s forecast. However, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material. We have no responsi- bility to update this report for events and circumstances occurring after the date of this report. [Signature] [Date] * If the presentation is summarized, the opening sentence of the report would begin, “We have ex- amined the accompanying summarized forecast of XYZ Company as of December 31, 20X1. . . .” The standard report on the examination of a ﬁnancial projection is as follows: Independent Accountant’s Report We have examined the accompanying projected balance sheet, statements of income, retained earn- ings, and cash ﬂows of XYZ Company as of December 31, 20XX, and for the year then ending.* XYZ Company’s management is responsible for the projection, which was prepared for [state spe- cial purpose, for example, “the purpose of negotiating a loan to expand XYZ Company’s plant”]. Our responsibility is to express an opinion on the projection based on our examination. Our examination was conducted in accordance with attestation standards established by the Amer- ican Institute of Certiﬁed Public Accountants and, accordingly, included such procedures as we
38 26 PROSPECTIVE FINANCIAL STATEMENTS • considered necessary to evaluate both the assumptions used by management and the preparation and presentation of the projection. We believe our examination provides a reasonable basis for our opinion. In our opinion, the accompanying projection is presented in conformity with guidelines for presen- tation of a projection established by the American Institute of Certiﬁed Public Accountants, and the underlying assumptions provide a reasonable basis for management’s projection [describe the hy- pothetical assumption, for example, “assuming the granting of the requested loan for the purpose of expanding XYZ Company’s plant as described in the summary of signiﬁcant assumptions”]. How- ever, even if [describe hypothetical assumption, for example, “the loan is granted and the plant is expanded”], there will usually be differences between the projected and actual results, because events and circumstances frequently do not occur as expected, and those differences may be mater- ial. We have no responsibility to update this report for events and circumstances occurring after the date of this report. The accompanying projection and this report are intended solely for the information and use of [identify speciﬁed parties, for example, “XYZ Company and DEF National Bank”] and are not in- tended to be and should not be used by anyone other than these speciﬁed parties. [Signature] [Date] * If the presentation is summarized, the opening sentence of the report would begin, “We have ex- amined the accompanying summarized projection of XYZ Company as of December 31, 20X1. . . .” When the prospective ﬁnancial statements are presented as a range, the report also includes a sep- arate paragraph describing the range [see Subsection 38.6(d) for an example]. (c) MODIFIED EXAMINATION REPORTS. There are four types of modiﬁed examination reports: 1. A qualiﬁed report, used when the statements depart from the AICPA presentation guidelines but the deﬁciency does not affect the assumptions (although if the matter is highly material, the accountant may issue an adverse report) 2. An adverse report, used when the statements fail to disclose signiﬁcant assumptions or when the assumptions do not provide a reasonable basis for the presentation 3. A disclaimer used when the accountant is precluded from applying procedures considered necessary in the circumstances 4. A reference to another accountant, used when another accountant examines the prospective ﬁ- nancial statements of a signiﬁcant portion of the entity, such as a major subsidiary (i) Qualiﬁed Opinion. The accountant issues a qualiﬁed opinion if there is a material presenta- tion deﬁciency that does not affect the assumptions. The following is an examination report qualiﬁed because of a presentation deﬁciency: Independent Accountant’s Report We have examined the accompanying forecasted balance sheet, statements of income, retained earnings, and cash ﬂows of XYZ Company as of December 31, 20XX, and for the year then ending. XYZ Company’s management is responsible for the forecast. Our responsibility is to express an opinion on the forecast based on our examination. Our examination was conducted in accordance with attestation standards established by the American Institute of Certiﬁed Public Accountants and, accordingly, included such procedures as we considered necessary to evaluate both the assumptions used by management and the prepara- tion and presentation of the forecast. We believe our examination provides a reasonable basis for our opinion.
38.7 EXAMINATION SERVICES 38 27 • The forecast does not disclose signiﬁcant accounting policies. Disclosure of such policies is re- quired by guidelines for presentation of a forecast established by the American Institute of Certiﬁed Public Accountants. In our opinion, except for the omission of the disclosure of the signiﬁcant accounting policies as discussed in the preceding paragraph, the accompanying forecast is presented in conformity with guidelines for presentation of a forecast established by the American Institute of Certiﬁed Public Accountants, and the underlying assumptions provide a reasonable basis for management’s fore- cast. However, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those differences may be mater- ial. We have no responsibility to update this report for events and circumstances occurring after the date of this report. [Signature] [Date] (ii) Adverse Report. The accountant who believes a signiﬁcant assumption is unsupported or not disclosed issues an adverse opinion. An adverse opinion is also issued when the accountant believes that a departure from the presentation guidelines not involving the assumptions is serious enough to warrant it. The following is an example of an adverse report issued by the accountant because an as- sumption was unreasonable: Independent Accountant’s Report We have examined the accompanying forecasted balance sheet, statements of income, retained earnings, and cash ﬂows of XYZ Company as of December 31, 20XX, and for the year then ending. XYZ Company’s management is responsible for the forecast. Our responsibility is to express an opinion on the forecast based on our examination. Our examination was conducted in accordance with attestation standards established by the Ameri- can Institute of Certiﬁed Public Accountants and, accordingly, included such procedures as we con- sidered necessary to evaluate both the assumptions used by management and the preparation and presentation of the forecast. We believe our examination provides a reasonable basis for our opinion. As discussed under the caption “Sales” in the summary of signiﬁcant forecast assumptions, the forecasted sales include, among other things, revenue from the Company’s federal defense con- tracts continuing at the current level. The Company’s present federal defense contracts will expire in March 20XX. No new contracts have been signed and no negotiations are under way for new federal defense contracts. Furthermore, the federal government has entered into contracts with an- other company to supply the items being manufactured under the Company’s present contracts. In our opinion, the accompanying forecast is not presented in conformity with guidelines for pre- sentation of a ﬁnancial forecast established by the American Institute of Certiﬁed Public Accoun- tants because management’s assumptions, as discussed in the preceding paragraph, do not provide a reasonable basis for management’s forecast. We have no responsibility to update this report for events and circumstances occurring after the date of this report. [Signature] [Date] There is no caveat about actual results differing from those forecasted since the accountant be- lieves the forecast assumptions to be unreasonable. (iii) Disclaimer. The accountant who cannot apply all the procedures deemed necessary to support an opinion on the statements issues a disclaimer. An example of a disclaimer follows: Independent Accountant’s Report We were engaged to examine the accompanying forecasted balance sheet, statements of income, re- tained earnings, and cash ﬂows of XYZ Company as of December 31, 20XX, and for the year then ending. XYZ Company’s management is responsible for the forecast.
38 28 PROSPECTIVE FINANCIAL STATEMENTS • As discussed under the caption “Income from Investee” in the summary of signiﬁcant forecast assumptions, the forecast includes income from an equity investee constituting 23% of fore- casted net income, which is management’s estimate of the Company’s share of the investee’s income to be accrued for 20XX. The investee has not prepared a forecast for the year ending December 31, 20XX, and we were therefore unable to obtain suitable support for this assumption. Because, as described in the preceding paragraph, we are unable to evaluate management’s as- sumption regarding income from an equity investee and other assumptions that depend thereon, the scope of our work was not sufﬁcient to express, and we do not express, an opinion with re- spect to the presentation of, or the assumptions underlying, the accompanying forecast. We have no responsibility to update this report for events and circumstances occurring after the date of this report. [Signature] [Date] In a disclaimer there is no caveat about differences between actual and forecasted assumptions since the accountant is not satisﬁed about the reasonableness of the assumptions. Notwithstanding his scope limitation, if the accountant is aware of material deﬁciencies in the forecast, those deﬁciencies should be discussed in the disclaimer. (iv) Divided Responsibility. When another accountant is involved in the examination, the princi- pal accountant may refer to the work of the other accountant as a basis, in part, for the principal ac- countant’s own report. The reference is done in essentially the same way divided-responsibility reports are done for audits of historical ﬁnancial statements. (d) INDEPENDENCE. The accountant who examines prospective ﬁnancial statements is required to be independent. If not, the accountant generally issues a compilation report rather than disclaim an opinion after the examination. 38.8 AGREED-UPON PROCEDURES (a) SCOPE OF SERVICE. An engagement to apply agreed-upon procedures to prospective ﬁnancial statements involves applying the procedures speciﬁed by the users of the statements and reporting the results of their application. The level of service is ﬂexible; the accountant’s report may only be distributed to the users who speciﬁed the procedures. Thus, it is a limited- distribution service. (b) PROCEDURES. The procedures applied in an engagement may be limited or extensive, de- pending on the users’ needs. For example, the service may consist of procedures below the level done in a compilation (such as mere assembly) or may be similar to those done in an examination. Alternatively, the service may consist of different levels of procedures applied to different amounts in the statements, such as a high level of work done on forecasted sales and very limited procedures on forecasted expenses. An accountant may perform an agreed-upon procedures attest engagement on prospective ﬁ- nancial statements provided that the following conditions are met: 1. The accountant is independent. 2. The accountant and the speciﬁed parties agree upon the procedures performed or to be per- formed by the accountant. Generally, the accountant’s procedures may be as limited or as extensive as the speciﬁed parties desire, as long as the speciﬁed parties take responsibility for their sufﬁciency. However, mere reading of a ﬁnancial forecast does not constitute a
38.8 AGREED-UPON PROCEDURES 38 29 • procedure sufﬁcient to permit an accountant to report on the results of applying agreed- upon procedures. 3. The speciﬁed parties take responsibility for the sufﬁciency of the agreed-upon procedures for their purposes. 4. The prospective ﬁnancial statements include a summary of signiﬁcant assumptions. 5. The prospective ﬁnancial statements to which the procedures are to be applied are subject to reasonably consistent evaluation against criteria that are suitable and available to the speci- ﬁed parties. 6. Criteria to be used in the determination of ﬁndings are agreed upon between the accountant and the speciﬁed parties. 7. The procedures to be applied to the prospective ﬁnancial statements are expected to result in reasonably consistent ﬁndings using the criteria. 8. Evidential matter related to the prospective ﬁnancial statements to which the procedures are applied is expected to exist to provide a reasonable basis for expressing the ﬁndings in the ac- countant’s report. 9. Where applicable, the accountant and the speciﬁed users agree on any agreed-upon material- ity limits for reporting purposes. 10. Use of the report is to be restricted to the speciﬁed parties. (c) REPORTS. The accountant’s report on the results of applying agreed-upon procedures should contain the following elements: 1. A title that includes the word “independent” 2. Identiﬁcation of the speciﬁed parties 3. Reference to the prospective ﬁnancial statements covered by the accountant’s report and the character of the engagement 4. A statement that the procedures performed were those agreed to by the speciﬁed parties iden- tiﬁed in the report 5. Identiﬁcation of the responsible party and a statement that the prospective ﬁnancial state- ments are the responsibility of the responsible party 6. A statement that the agreed-upon procedures engagement was conducted in accordance with attestation standards established by the AICPA 7. A statement that the sufﬁciency of the procedures is solely the responsibility of the speciﬁed parties and a disclaimer of responsibility for the sufﬁciency of those procedures 8. A list of the procedures performed (or reference to them) and related ﬁndings 9. Where applicable, a description of any agreed-upon materiality limits 10. A statement that the accountant was not engaged to and did not conduct an examination of prospective ﬁnancial statements; a disclaimer of opinion on whether the presentation of the prospective ﬁnancial statements is in conformity with AICPA presentation guidelines and on whether the underlying assumptions provide a reasonable basis for the forecast, or a reason- able basis for the projection given the hypothetical assumptions; and a statement that if the accountant had performed additional procedures, other matters might have come to the ac- countant’s attention that would have been reported 11. A statement of restrictions on the use of the report because it is intended to be used solely by the speciﬁed parties 12. Where applicable, reservations or restrictions concerning procedures or ﬁndings 13. A caveat that the prospective results may not be achieved 14. A statement that the accountant assumes no responsibility to update the report for events and circumstances occurring after the date of the report
38 30 PROSPECTIVE FINANCIAL STATEMENTS • 15. Where applicable, a description of the nature of the assistance provided by a specialist 16. The manual or printed signature of the accountant’s ﬁrm 17. The date of the report The following is an example of a report on the application of agreed-upon procedures: Independent Accountant’s Report on Applying Agreed-Upon Procedures Board of Directors—XYZ Corporation Board of Directors—ABC Company At your request, we have performed certain agreed-upon procedures, as enumerated below, with re- spect to the forecasted balance sheet, statements of income, retained earnings, and cash ﬂows of DEF Company, a subsidiary of ABC Company, as of December 31, 20XX, and for the year then ending. These procedures, which were agreed to by the Boards of Directors of XYZ Corporation and ABC Company, were performed solely to assist you in evaluating the forecast in connection with the proposed sale of DEF Company to XYZ Corporation. DEF Company’s management is re- sponsible for the forecast. This agreed-upon procedures engagement was conducted in accordance with attestation standards established by the American Institute of Certiﬁed Public Accountants. The sufﬁciency of these pro- cedures is solely the responsibility of the speciﬁed parties. Consequently, we make no representa- tion regarding the sufﬁciency of the procedures described below either for the purpose for which this report has been requested or for any other purpose. a. With respect to forecasted rental income, we compared the occupancy statistics about ex- pected demand for rental of housing units used in the forecast to occupancy statistics for the following comparable properties. Comparable properties for this purpose are deﬁned as [de- scribe characteristics of comparability, e.g., those located in Sample City with between xxx and yyy rental units, rental prices within z% of those used in the forecast.] [List comparable properties] As a result of performing this procedure, we found occupancy statistics used in the forecast were [describe ﬁndings]. b. We traced each amount in the forecast to underlying schedules prepared by management and tested the arithmetical accuracy of management’s calculations of rental income, operating in- come, and income tax expense contained thereon. We found no differences as a result of these procedures. We were not engaged to, and did not, conduct an examination, the objective of which would be the expression of an opinion on the accompanying prospective ﬁnancial statements. Accord- ingly, we do not express an opinion on whether the prospective ﬁnancial statements are pre- sented in conformity with AICPA presentation guidelines or on whether the underlying assumptions provide a reasonable basis for the presentation. Had we performed additional pro- cedures, other matters might have come to our attention that would have been reported to you. Furthermore, there will usually be differences between the forecasted and actual results, be- cause events and circumstances frequently do not occur as expected, and those differences may be material. We have no responsibility to update this report for events and circumstances occur- ring after the date of this report. This report is intended solely for the information and use of the Boards of Directors of ABC Com- pany and XYZ Corporation and is not intended to be and should not be used by anyone other than these speciﬁed parties. [Signature] [Date]
38.9 INTERNAL USE SERVICES 38 31 • 38.9 INTERNAL USE SERVICES (a) SCOPE OF SERVICES. The accountant who assembles and submits or reports on prospective ﬁnancial statements for third-party use, must compile, examine, or apply agreed-upon procedures to them. However, for internal use the accountant’s services and reports can be more ﬂexible. Internal use services generally are provided in the form of consulting, tax planning, or so-called controllership services. In these types of service, the objective of the service is not to lend credibility to the statements and there is no third-party reliance on them, so AICPA guidelines allow the accoun- tant to structure the engagement and report to ﬁt the circumstances. The accountant may provide compilation, examination, or agreed-upon procedures for internal use prospective ﬁnancial statements but is not required to do so. (b) DETERMINING WHETHER USE IS INTERNAL. The accountant may provide internal use services if the accountant believes that third-party use is not reasonably expected. In arriving at this belief, the accountant may rely on the oral or written representation of management, unless some- thing comes to the accountant’s attention to contradict management’s representation. The AICPA Guide (Section 10.02) provides the following guidelines for determining whether out- siders are considered third parties: In deciding whether a party that is or reasonably might be expected to use an accountant’s report is considered to be a third party, the accountant should consider the degree of consistency of in- terest between [management] and the user regarding the forecast. If their interests are substan- tially consistent (for example both the [preparer] and the user are employees of the entity about which the forecast is made), the user would not be deemed to be a third party. On the other hand, where the interests of the [preparer] and user are potentially inconsistent (for example, the [pre- parer] is a nonowner manager and the user is an absentee owner), the user would be deemed a third party. In some cases, this determination will require the exercise of considerable profes- sional judgment. (c) PROCEDURES. The procedures applied in an internal use engagement are usually based on the nature of the engagement. They may focus on developing prospective data, or they may focus on improving operations or ﬁnancial planning with prospective data being only a by-product of the en- gagement. (d) REPORTS. The accountant’s report for internal use services is ﬂexible. Such reports some- times speak solely to the prospective ﬁnancial statements, but often they focus on alternative or rec- ommended courses of action. The standard compilation, examination, or agreed-upon procedures reports may be issued for in- ternal use, but often they are not used. Reports on prospective ﬁnancial statements for internal use generally take three broad forms: plain paper, legend, and formal. Where there is a report on the statements, it may stand alone or may be incorporated into another report, such as a consultant’s report. (i) Plain Paper. “Plain paper” means that the accountant provides neither a report on the state- ments nor any other written communication that accompanies them. In a plain-paper situation, there would be nothing apparent to the reader to associate the accountant with the statements. (ii) Legend. When an accountant’s written communication (such as a transmittal letter) accompa- nies the prospective ﬁnancial statements, the AICPA Guide (Section 22.09) requires that the accoun- tant include (1) a caveat that prospective results may not be achieved and (2) a statement that the prospective ﬁnancial statements are for internal use only. Many accountants choose to present this as a legend on the statement itself.
38 32 PROSPECTIVE FINANCIAL STATEMENTS • (iii) Formal Report. The accountant may decide to issue a report on a service. However, the ac- countant is not permitted to report on a forecast or projection, even for internal use, if it does not dis- close the signiﬁcant assumptions. According to the AICPA Guide (Section 22.06), a report for internal use preferably: • Is addressed to management • Identiﬁes the statements being reported on • Describes the character of work performed and the degree of responsibility taken with respect to the statements • Includes a caveat that the prospective results may not be achieved • Indicates the restrictions as to the distribution of the statements and report • Is dated as of the date of the completion of the accountant’s procedures • For a projection, describes the limitations on the usefulness of the presentation The following is an example of a report on an internal use service consisting of assembly of a forecast: To Mr. John Doe, President XYZ Company We have assembled, from information provided by management, the accompanying forecasted balance sheet, statements of income, retained earnings, and cash ﬂows of XYZ Company as of December 31, 20XX,* and for the year then ending. We have not compiled or examined the ﬁnancial forecast and ex- press no assurance of any kind on it. Further, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those dif- ferences may be material. In accordance with the terms of our engagement, this report and the accom- panying forecast are restricted to internal use and may not be shown to any third party for any purpose. * If the presentation is summarized as discussed in Subsection 38.4(b), the ﬁrst sentence would read, in part, “We have assembled . . . the accompanying summarized forecast of XYZ Company . . . .” An example of a report on the assembly of a projection is as follows: To Mr. John Doe, President XYZ Company We have assembled, from information provided by management, the accompanying projected balance sheet, statements of income, retained earnings, and cash ﬂows, and summaries of signiﬁcant assump- tions and accounting policies of XYZ Company as of December 31, 20XX,* and for the year then end- ing. The accompanying projection and this report were prepared for [description of the special purpose, e.g., “presentation to the Board of Directors of XYZ Company for its consideration as to whether to add a third operating shift”]. We have not compiled or examined the ﬁnancial projection and express no as- surance of any kind on it. Further, even if [description of the hypothetical assumption, e.g., “the third operating shift is added”], there will usually be differences between the projected and actual results, be- cause events and circumstances frequently do not occur as expected, and those differences may be ma- terial. In accordance with the terms of our engagement, this report and the accompanying projection are restricted to internal use and may not be shown to any third party for any purpose. * If the presentation is summarized as discussed in Subsection 38.4(b), the ﬁrst sentence would read, in part, “We have assembled . . . the accompanying summarized forecast of XYZ Company . . . .” In addition to the above, the accountant’s report on prospective ﬁnancial statements for in- ternal use would:
38.10 SOURCES AND SUGGESTED REFERENCES 38 33 • 1. Indicate if the accountant is not independent with respect to the client (the report would not express any assurance on the statements if there is a lack of independence) and 2. Note any disclosures required under the presentation guidelines (see Subsection 34.4(a)) whose omission comes to the accountant’s attention (other than omitted assumptions). The report might either describe the omitted disclosures or merely note the omission of dis- closures in a manner such as: This ﬁnancial forecast was prepared to help you develop your personal ﬁnancial plan. Accordingly, it does not include all disclosures required by the guidelines established by the American Institute of Certiﬁed Public Accountants for presentation of a ﬁnancial forecast. 38.10 SOURCES AND SUGGESTED REFERENCES American Institute of Certiﬁed Public Accountants, Accounting and Review Services Committee, “Compilation and Review of Financial Statements,” Statement on Standards for Accounting and Review Services No. 1. AICPA, New York, 1978. , Auditing Standards Board, “Attestation Standards: Revision and Recodiﬁcation,” Statement on Stan- dards for Attestation Engagements No. 10, AICPA, New York, 2001. , Guide for Prospective Financial Information. AICPA, New York, 1999. Commerce Clearing House, SEC Accounting Rules. CCH, Chicago, 1990. Financial Accounting Standards Board, “Statement of Cash Flows,” Statement of Financial Accounting Stan- dards No. 95. FASB, Stamford, CT, 1987. Pallais, Don, and Holton, Stephen D., Guide to Forecasts and Projections, 3rd ed. Practitioners Publishing, Fort Worth, TX, 1998.
39 CHAPTER PERSONAL FINANCIAL STATEMENTS Dennis S. Neier, CPA Goldstein Golub Kessler LLP Joel O. Steinberg, CPA Goldstein Golub Kessler LLP 39.1 GUIDANCE 39.5 PROVISION FOR INCOME 2 TAXES (a) Applicable Professional Standards 2 12 (b) Acceptance of Clients 2 (a) Deﬁnition 12 (c) Establishing an Understanding (b) Computing the Provision for with the Client 3 Income Taxes 13 (d) Client Representation Letters 3 (c) Tax Basis 13 (d) Disclaimer 13 39.2 GENERAL DESCRIPTION AND REQUIREMENTS 3 39.6 STATEMENT OF CHANGES (a) Deﬁnition 3 IN NET WORTH 13 (b) Ownership 4 (c) Uses 4 (a) Deﬁnition 13 (d) Accounting Basis 4 (b) Uses 13 (e) Order of Presentation 4 (c) Format 14 39.3 ASSETS 9 39.7 DISCLOSURES 14 (a) Estimated Current Value 9 (b) Receivables 9 39.8 COMPILATION 15 (c) Marketable Securities 9 (d) Limited Partnership Interests 9 (e) Precious Metals 10 39.9 REVIEW 16 (f) Options on Assets Other than Marketable Securities 10 39.10 AUDITS 17 (g) Life Insurance 10 (h) Closely Held Businesses 10 (i) Real Estate 11 39.11 REPORTS 17 (j) Personal Property 11 (k) Intangible Assets 11 39.12 COMPILED FINANCIAL (l) Future Interests 11 STATEMENTS NOT EXPECTED TO BE USED BY A THIRD 39.4 LIABILITIES 11 PARTY 23 (a) Estimated Current Amount 11 (b) Noncancelable Commitments 12 39.13 SOURCES AND SUGGESTED (c) Contingent Liabilities 12 REFERENCES 24 (d) Income Taxes Payable 12 39 1 •
39 2 PERSONAL FINANCIAL STATEMENTS • 39.1 GUIDANCE (a) APPLICABLE PROFESSIONAL STANDARDS. The authoritative guide on the prepara- tion of personal ﬁnance statements is Statement of Position (SOP) 82-1, “Accounting and Fi- nancial Reporting for Personal Financial Statements,” issued by the American Institute of Certiﬁed Public Accountants (AICPA). Accountants are often engaged to compile, review, or audit personal ﬁnancial statements. Standards for compilation of ﬁnancial statements prescribed by Statement on Standards for Ac- counting and Review Services (SSARS) No. 1, “Compilation and Review of Financial State- ments,” as amended by SSARS 8, “Amendment to Statement on Standards for Accounting and Review Services No. 1,” are applicable to the compilation of personal ﬁnancial statements in the same manner as to the compilation of other ﬁnancial statements. However, a subsequent AICPA release, SSARS No. 6, “Reporting on Personal Financial Statements Included in Written Personal Financial Plans,” allows accountants to prepare per- sonal ﬁnancial statements that omit disclosures required by generally accepted accounting prin- ciples (GAAP) so long as the statement will be used solely in the development of the client’s personal ﬁnancial plan and not to obtain credit or to meet other disclosure requirements. If an accountant prepares a personal ﬁnancial statement under this exemption, he should issue a writ- ten report stating the restricted purpose of the statement and noting that it has not been audited, reviewed, or compiled. Nonetheless, SSARS No. 6 does not preclude an accountant from com- plying with SSARS No. 1, as amended, in such engagements. (Also see Section 39.8, “Compi- lation and Review”). Standards for review of ﬁnancial statements prescribed by SSARS No. 1, as amended, apply to the review of personal ﬁnancial statements in the same manner as to the review of other ﬁ- nancial statements (also see Section 39.8) and generally accepted auditing standards (GAAS) apply to the audit of personal ﬁnancial statements in the same manner as to the audit of other ﬁ- nancial statements. Accountants may also be asked to report on speciﬁed elements, accounts, or items of a per- sonal ﬁnancial statement. In those circumstances, the guidance provided by Statement on Audit- ing Standards (SAS) No. 62, “Special Reports,” or Accounting and Review Services Interpretation No. 8 of SSARS No. 1, “Reports on Speciﬁed Elements, Accounts, or Items of a Financial Statement,” should be followed as applicable. (b) ACCEPTANCE OF CLIENTS. Before accepting an engagement involving personal ﬁnan- cial statements, the accountant ordinarily would evaluate certain aspects of the potential client relationship. The accountant may wish to consider facts that might bear on the integrity of the prospective client. Consideration of the character and reputation of the individual helps to minimize the pos- sibility of association with a client who lacks integrity. The extent of the accountant’s inquiries before acceptance might depend on his or her previous knowledge of the client and the nature of the client’s ﬁnancial activities. The accountant may want to consult predecessor accountants or auditors, attorneys, bankers, and others having business relationships with the individual re- garding facts that might bear on the integrity of the prospective client. This does not suggest that, in accepting an engagement, the accountant vouches for the integrity or reliability of a client. However, prudence suggests that an accountant be selective in determining his or her professional relationships. The accountant may also wish to consider circumstances that present unusual business risk, such as considering whether an individual is in serious ﬁnancial difﬁculty. In addition, the accountant may want to consider the effect of the lack of independence on the type of report he may issue in compliance with professional standards. SSARS No. 1 permits the accountant to issue a compilation report on personal ﬁnancial statements of an individual with respect to whom he is not independent. However, the accountant should be independent to issue a review report or an audit opinion.
39.2 GENERAL DESCRIPTION AND REQUIREMENTS 39 3 • Before accepting an engagement involving personal ﬁnancial statements, the accountant may want to ask the potential client about the availability of records and consider whether available records provide a basis sufﬁcient for providing the services requested. Incomplete or inadequate accounting records are likely to give rise to problems in compiling, reviewing, or auditing per- sonal ﬁnancial statements. Because of the informal nature of most personal ﬁnancial records, the accountant should evaluate the need to perform other accounting services in conjunction with personal ﬁnancial records. Professional standards require the accountant to attain a certain level of knowledge of his client’s ﬁnancial activities. Before accepting an engagement, the accountant should consider whether he can obtain an appropriate understanding of the nature of the prospective client’s ﬁ- nancial activities and the specialized accounting principles and practices related to any of the client’s ﬁnancial activities. (c) ESTABLISHING AN UNDERSTANDING WITH THE CLIENT. Once the accountant has decided to accept an engagement involving personal ﬁnancial statements, he should establish an understanding with the client, preferably in writing, regarding the services to be performed and the terms and objectives of the engagement. (d) CLIENT REPRESENTATION LETTERS. During an engagement, the client makes many representations to the accountant. Generally accepted auditing standards require that an inde- pendent auditor performing an audit in accordance with GAAS obtain written representations from management for all ﬁnancial statements and periods covered by the auditor’s reports. The representation should be addressed to the auditor and should be made as of a date no earlier than the date of the auditor’s report. SAARS No. 1 requires that the accountant obtain a representation letter from the client as part of every review engagement as well. Compilation engagements do not contemplate tests of accounting records and of responses to inquiries by obtaining corroborating evidential matter. However, because of the informal nature of most personal ﬁnancial records, it is advisable to obtain written representation from the client to conﬁrm the oral representation made in all per- sonal ﬁnancial statement engagements. 39.2 GENERAL DESCRIPTION AND REQUIREMENTS (a) DEFINITION. A personal ﬁnancial statement presents the personal assets and liabilities of an individual, a husband and wife, or a family. It is not a ﬁnancial statement on a business owned by the person; in fact, it differs from a business ﬁnancial statement in several important ways (see Exhibit 39.1). The essential purpose of a personal ﬁnancial statement is to measure wealth at a speciﬁed date— to take a snapshot of the person’s ﬁnancial condition. It does this by presenting: • Estimated current values of assets • Estimated current amounts of liabilities • A provision for income taxes based on the taxes that would be owed if all the assets were liqui- dated and all the liabilities paid on the date of the statement • Net worth The basic personal ﬁnancial statement containing this information is called a statement of ﬁnan- cial condition, not a balance sheet. Values and amounts for one or more prior periods may be in- cluded for comparison with the current values and amounts, but this is optional. The statement of changes in net worth is also optional (also, see Section 39.8). It presents the major sources of in- crease or decrease in net worth (see Exhibit 39.2).
39 4 PERSONAL FINANCIAL STATEMENTS • Personal Business Objective Measurement of wealth Reporting of earnings, evaluation of performance Uses Procural of credit, information for Facilitation of ﬁnancial planning; shareholders, regulatory procural of credit; provision of requirements disclosures to the public or the court Valuation Current value Historical cost Method of Accrual Accrual accounting Classiﬁcation None: assets presented in order of Assets and liabilities classiﬁed current liquidity, liabilities in order of or long term maturity Excess of assets Net worth Equity earnings over liabilities Exhibit 39.1 Personal and business ﬁnancial statements compared. (b) OWNERSHIP. A personal ﬁnancial statement covering a whole family usually presents the assets and liabilities of the family members in combination, as a single economic unit. However, the members may have different ownership interests in these assets or liabilities. For example, the wife may have a remainder interest in a testamentary trust, whereas the husband may own life in- surance with a net cash surrender value. It may be useful, especially when the statement is to be used in a divorce case, to disclose each individual’s interests separately. This may be done in sep- arate columns within the statement, in the notes to the statement, or in additional statements for each individual. Often an individual covered by the statement is one of a group of joint owners of assets, as with community property or property held in joint tenancy. In this case, the statement should include only the individual’s interest as a beneﬁcial owner under the laws of the state. If the parties’ shares in the assets are not clear, the advice of an attorney may be needed to determine whether the per- son should regard any interest in the assets as his or her own, and if so, how much. The statement should make full disclosure of the joint ownership of the assets and the grounds for the allocation of shares. (c) USES. Many individuals or families use personal ﬁnancial statements for investment, tax, re- tirement, gift and estate planning, and obtaining credit. A personal ﬁnancial statement may also be required for disclosure to the court in a divorce case or to the public when the individual is a candi- date or an incumbent of public ofﬁce. (d) ACCOUNTING BASIS. SOP 82-1 establishes the use of estimated current values and amounts and the accrual basis of accounting as GAAP for personal ﬁnancial statements. The AICPA Personal Financial Statements Guide (the “Guide”) allows accountants to prepare, compile, review, or audit personal ﬁnancial statements on other comprehensive bases of accounting, such as histori- cal cost, tax, or cash. (e) ORDER OF PRESENTATION. Assets are presented in order of liquidity and liabilities in order of maturity. No distinction is made between current and long-term assets and liabilities because there is no operating cycle in a person’s ﬁnancial affairs.
39.2 GENERAL DESCRIPTION AND REQUIREMENTS 39 5• Assets and liabilities of a closely held business that is conducted as a separate entity are not combined with similar personal items in a personal ﬁnancial statement. Instead, the estimated current net value of the person’s investment in the entity is shown as one amount. But if the person owns a business activity that is not conducted as a separate entity, such as a real estate investment with a related mortgage, the assets and liabilities of the activity are shown as sepa- rate amounts. JAMES AND JANE PERSON Statements of Financial Condition December 31, 20X3 and 20X2 December 31 20X3 20X2 Assets Cash $0,003,700 $0,015,600 Bonus receivable 20,000 10,000 Investments Marketable securities (Note 2) 160,500 140,700 Stock options (Note 3) 28,000 24,000 Kenbruce Associates (Note 4) 48,000 42,000 Davekar Company, Inc. (Note 5) 550,000 475,000 Vested interest in deferred proﬁt-sharing plan 111,400 98,900 Remainder interest in testamentary trust (Note 6) 171,900 128,800 Cash value of life insurance ($43,600 and $42,900), less loans payable to insurance companies ($38,100 and $37,700) (Note 7) 5,500 5,200 Residence (Note 8) 190,000 180,000 Personal effects (excluding jewelry) (Note 9) 55,000 50,000 Jewelry (Note 9) $0,040,000 $0,036,500 $1,384,000 $1,206,700 Liabilities Income taxes—current year balance $00,08,800 $0,000,400 Demand 10.5% note payable to bank 25,000 26,000 Mortgage payable (Note 10) 98,200 99,000 Contingent liabilities (Note 11) $0,000,000 $0,000,000 132,000 125,400 Estimated income taxes on the differences between the estimated current values of assets and the estimated current amounts of liabilities and their tax bases (Note 12) 239,000 160,000 Net worth $1,013,000 $0,921,300 $1,384,000 $1,206,700 The notes are an integral part of these statements. (Continued) Exhibit 39.2 Illustrative ﬁnancial statements. (Source: Reproduced with permission from AICPA, Per- sonal Financial Statements Guide, Appendix E: Statement of Position No. 82-1, “Account- ing and Financial Reporting for Personal Financial Statements,” 1992, pp. 53–58.)
39 6 PERSONAL FINANCIAL STATEMENTS • JAMES AND JANE PERSON Statements of Changes in Net Worth For the Years Ended December 31, 20X3 and 20X2 Year ended December 31 20X3 20X2 Realized increases in net worth Salary and bonus $0,095,000 $085,000 Dividends and interest income 2,300 1,800 Distribution from limited partnership 5,000 4,000 Gains on sales of marketable securities $0,001,000 $000,500 $0,103,300 $091,300 Realized decreases in net worth Income taxes 26,000 22,000 Interest expense 13,000 14,000 Real estate taxes 4,000 3,000 Personal expenditures $0,036,700 $032,500 $0,079,700 $071,500 Net realized increase in net worth $0,023,600 $019,800 Unrealized increases in net worth Marketable securities (net of realized gains on securities sold) 3,000 500 Stock options 4,000 500 Davekar Company, Inc. 75,000 25,000 Kenbruce Associates 6,000 Deferred proﬁt-sharing plan 12,500 9,500 Remainder interest in testamentary trust 43,100 25,000 Jewelry $0,003,500 $000,000 $0,147,100 $060,500 Unrealized decrease in net worth Estimated income taxes on the differences between the estimated current values of assets and the estimated current amounts of liabilities and their tax bases $0,079,000 $022,000 Net unrealized increase in net worth $0,068,100 $038,500 Net increase in net worth 91,700 58,300 Net worth at the beginning of year $0,921,300 $863,000 Net worth at the end of year $1,013,000 $921,300 The notes are an integral part of these statements. Exhibit 39.2 Continued.
39.2 GENERAL DESCRIPTION AND REQUIREMENTS 39 7• JAMES AND JANE PERSON Notes to Financial Statements Note 1. The accompanying ﬁnancial statements include the assets and liabilities of James and Jane Person. Assets are stated at their estimated current values and liabilities at their estimated current amounts. Note 2. The estimated current values of marketable securities are either (a) their quoted closing prices or (b) for securities not traded on the ﬁnancial statement date, amounts that fall within the range of quoted bid and asked prices. Marketable securities consist of the following: December 31, 20X3 December 31, 20X2 Number of Estimated Number of Estimated Shares or Current Shares or Current Bonds Values Bonds Values Stocks Jaiven Jewels, Inc. 1,500 $098,813 McRae Motors, Ltd. 800 11,000 600 $004,750 Parker Sisters, Inc. 400 13,875 200 5,200 Rosenﬁeld Rug Co. 1,200 96,000 Rubin Paint Company 300 9,750 100 2,875 Weiss Potato Chips, Inc. 200 $020,337 300 $025,075 $153,775 $133,900 Bonds Jackson Van Lines, Ltd. (12% due 7/1/X9) 5 5,225 5 5,100 United Garvey, Inc. (7% due 11/15/X6) 2 $001,500 2 $001,700 $006,725 $006,800 $160,500 $140,700 Note 3. Jane Person owns options to acquire 4,000 shares of stock of Winner Corp. at an option price of $5 per share. The option expires on June 30, 20X5. The estimated current value is its published selling price. Note 4. The investment in Kenbruce Associates is an 8% interest in a real estate limited partnership. The estimated current value is determined by the projected annual cash receipts and payments capital- ized at a 12% rate. Note 5. James Person owns 50% of the common stock of Davekar Company, Inc., a retail mail order business. The estimated current value of the investment is determined by the provisions of a shareholders’ agreement, which restricts the sale of the stock and, under certain conditions, requires the company to re- purchase the stock based on a price equal to the book value of the net assets plus an agreed amount for goodwill. At December 31, 20X3, the agreed amount for goodwill was $112,500, and at December 31, 20X2, it was $100,000. A condensed balance sheet of Davekar Company, Inc., prepared in conformity with generally ac- cepted accounting principles, is summarized below: (Continued) Exhibit 39.2 Continued.
39 8 PERSONAL FINANCIAL STATEMENTS • December 31 20X3 20X2 Current assets $3,147,000 $2,975,000 Plant, property, and equipment—net 165,000 145,000 Other assets $0,120,000 $0,110,000 Total assets $3,432,000 $3,230,000 Current liabilities 2,157,000 2,030,000 Long-term liabilities $0,400,000 $0,450,000 Total liabilities $2,557,000 $2,480,000 Equity $0,875,000 $0,750,000 The sales and net income for 20X3 were $10,500,000 and $125,000 and for 20X2 were $9,700,000 and $80,000. Note 6. Jane Person is the beneﬁciary of a remainder interest in a testamentary trust under the will of the late Joseph Jones. The amount included in the accompanying statements is her remainder interest in the estimated current value of the trust assets, discounted at 10%. Note 7. At December 31, 20X3 and 20X2, James Person owned a $300,000 whole life insurance pol- icy. Note 8. The estimated current value of the residence is its purchase price plus the cost of improve- ments. The residence was purchased in December 20X1, and improvements were made in 20X2 and 20X3. Note 9. The estimated current values of personal effects and jewelry are the appraised values of those assets, determined by an independent appraiser for insurance purposes. Note 10. The mortgage (collateralized by the residence) is payable in monthly installments of $815 a month, including interest at 10% a year through 20Y8. Note 11. James Person has guaranteed the payment of loans of Davekar Company, Inc., under a $500,000 line of credit. The loan balance was $300,000 at December 31, 20X3, and $400,000 at De- cember 31, 20X2. Note 12. The estimated current amounts of liabilities at December 31, 20X3, and December 31, 20X2, equaled their tax bases. Estimated income taxes have been provided on the excess of the estimated current values of assets over their tax bases as if the estimated current values of the assets had been real- ized on the statement date, using applicable tax laws and regulations. The provision will probably differ from the amounts of income taxes that eventually might be paid because those amounts are determined by the timing and the method of disposal or realization and the tax laws and regulations in effect at the time of disposal or realization. The estimated current values of assets exceeded their tax bases by $850,000 at December 31, 20X3, and by $770,300 at December 31, 20X2. The excess of estimated current values of major assets over their tax bases are— December 31 20X3 20X2 Investment in Davekar Company, Inc. $430,500 $355,500 Vested interest in deferred proﬁt-sharing plan 111,400 98,900 Investment in marketable securities 104,100 100,000 Remainder interest in testamentary trust 97,000 53,900 Exhibit 39.2 Continued.
39.3 ASSETS 39 9• 39.3 ASSETS (a) ESTIMATED CURRENT VALUE. Assets are presented at their estimated current value. This is deﬁned by SOP 82-1 as “the amount at which the item could be exchanged between a buyer and a seller, each of whom is well informed and willing, and neither of whom is compelled to buy or sell.” Sales commissions and other costs of disposal should be considered if they are expected to be material. SOP 82-1 recognizes that determining the estimated current value of some assets may be difﬁcult, and if the costs of doing so would appear to exceed the beneﬁts, it recommends that the person use his judgment. In general, the best way to determine estimated current value is by reference to recent market prices of similar assets in similar circumstances. If recent market prices are not available, other meth- ods may be used, including the use of appraisals, the adjustment of historical cost by reference to a speciﬁc price index, the capitalization of past or prospective earnings, the use of liquidation values, or the use of discounted amounts of projected cash receipts. Whatever method is used, it should be consistently applied from period to period for the same asset. (b) RECEIVABLES. Receivables are presented at the discounted amounts of cash expected to be collected, using the prevailing interest rate at the date of the statement. (c) MARKETABLE SECURITIES. Marketable securities are stocks, bonds, unfulﬁlled futures contracts, options on traded securities, certiﬁcates of deposit, and money market accounts for which market quotations are publicly available. The estimated current value of a marketable secu- rity is its closing price on the date of the statement, less the expected sales commission. Individual Retirement Accounts and Keogh accounts should be presented net of the penalty charge for early withdrawal. If the security was not traded on that date, but published bid and asked prices are available, SOP 82-1 states that the estimated current value should be within the range of those prices. Some accoun- tants, however, believe that only the bid price should be used, because “people can ask all they want for an asset, but what matters is what others will pay for it.” 1 If bid and asked prices are not available for the date of the statement, the estimated current value is the closing price on the last day that the security was traded, unless the trade occurred so far back in the past as to be meaningless by the date of the statement. On over-the-counter securities, unfortunately, the market does not speak with a single voice. Dif- ferent quotations may be given by the ﬁnancial press, quotation publications, ﬁnancial reporting ser- vices, and various brokers. In such a case, the mean of the bid prices, of the bid and asked prices, or of the prices quoted by a representative sample of brokers may be used as the estimated current value. Large blocks of stock may also pose a problem. If a large block of stock were dumped on the mar- ket, the price might not hold up. On the other hand, a controlling interest might be worth more, share for share, than a minority interest. Market prices may need to be adjusted for these factors to deter- mine estimated current value. Preparers should consult a qualiﬁed stockbroker for an opinion on this problem. Restrictions on the transfer of a stock are yet another factor that might call for an adjustment of market prices to determine estimated current value. (d) LIMITED PARTNERSHIP INTERESTS. If interests in a limited partnership are actively traded, the estimated current value of such an interest should be based on the prices of recent 1 M. D. Kinsman and B. Samuelson, “Personal Financial Statements: Valuation Challenges and Solutions,” Jour- nal of Accountancy, September 1987, p. 139.