What are prospective financial statements? Prospective financial statements encompass financial forecasts and financial projections. Pro forma financial statements and partial presentations are specifically excluded from this category. Financial forecasts are prospective financial statements that present, to the best of the responsible party’s knowledge and belief, an entity’s expected financial position, results of operations, and cash flows. They are based on assumptions about conditions actually expected to exist and the course of action expected to be taken.
Financial projections are prospective financial statements that present, to the best of the responsible party’s knowledge and belief, an entity’s expected financial position, results of operations, and cash flows. They are based on assumptions about conditions expected to exist and the course of action expected to be taken, given one or more hypothetical (i.e., “what-if”) assumptions. Responsible parties are those who are responsible for the underlying assumptions. While the responsible party is usually management, it may be a third party. Example: If a client is negotiating with a bank for a large loan, the bank may stipulate the assumptions to be used. Accordingly, in this case, the bank would represent the responsible party.
This post summarizes the prospective financial statements from the accountant’s perspective; the use of the prospective financial statements, accountant’s reponsibilities, minimum items presented on the report, compilation and examination procedures, and agreed-upon procedures on the prospective financial statements.
Responsibilities Of Accountant On Prospective Financial Statements
Statement on Standards for Attestation Engagements #10 specifically precludes an accountant from compiling, examining, or applying agreed-upon procedures to prospective financial statements that fail to include a summary of significant assumptions. The practice standards in the Statement are not applicable:
- To engagements involving prospective financial statements that are restricted to internal use
- To those used solely in litigation support services (e.g., in circumstances where the practitioner is serving as an expert witness)
The Use Of Prospective Financial Statements
The intended use of an entity’s prospective financial statements governs the type of prospective financial statements to be presented:
- When an entity’s prospective financial statements are for general use, only a financial forecast is to be presented. “General use” means that the statements will be used by persons not negotiating directly with the responsible party. Example: In a public offering of a tax shelter interest.
- When an entity’s prospective financial statements are for limited use, either a financial forecast or a financial projection may be presented. “Limited use” refers to situations where the statements are to be used by the responsible party alone or by the responsible party and those parties negotiating directly with the responsible party. Example: If a client is negotiating directly with a bank, either a forecast or a projection is appropriate.
Minimum Items Included In Prospective Financial Statements
Financial forecasts and financial projections may be in the form of either complete basic financial statements or financial statements containing the following minimum 12 items:
- Sales or gross revenues
- Gross profit or cost of sales
- Unusual or infrequently occurring items
- Provision for income taxes
- Discontinued operations or extraordinary items
- Income from continuing operations
- Net income
- Basic and fully diluted earnings per share
- Significant changes in financial position
- Management’s (or another responsible party’s) intent as to what the prospective statements present, a statement indicating that management’s (or another responsible party’s) assumptions are predicated on facts and circumstances in existence when the statements were prepared, and a warning that the prospective results may not materialize
- Summary of significant assumptions
- Summary of significant accounting policies
Compilation Of Prospective Financial Statements
The Procedure – Compilation procedures applicable to prospective financial statements are not designed to provide any form of assurance on the presentation of the statements or the underlying assumptions. They are essentially the same as those applicable to historical financial statements. Additional procedures:
- Inquire of the responsible party as to the underlying assumptions developed.
- Compile or obtain a list of the underlying assumptions and consider the possibility of obvious omissions or inconsistencies.
- Verify the mathematical accuracy of the assumptions.
- Read the prospective financial statements in order to identify departures from AICPA presentation guidelines.
- Obtain a client representation letter in order to confirm that the responsible party acknowledges its responsibility for the prospective statements (including the underlying assumptions).
An accountant is precluded from compiling forecasts and projections that do not present the summary of significant assumptions. Furthermore, the practitioner should not compile a projection that fails to identify the underlying hypothetical assumptions or describe the limitations on the utility of the projection.
- An identification of the prospective financial statements presented
- A statement as to the level of service provided and the fact that the prospective financial statements were compiled in accordance with attestation standards established by the AICPA
- A statement describing the limited scope of a compilation and the fact that no opinion or any other form of assurance is being expressed
- A warning that the prospective results may not materialize
- A statement that the accountant is under no responsibility to update his or her report for conditions occurring after the compilation report is issued
- The date of the report, which should coincide with the completion of the compilation procedures
- The accountant’s signature
- In the case of a projection, a separate middle paragraph describing the limitations on the utility of the statements
- A separate paragraph when the statements present the expected results in the form of a range of values
- If the accountant is not independent, a statement as to this fact (No disclosure should be made as to the reasons why the accountant feels that he or she is not independent.)
- A separate explanatory paragraph when the prospective statements contain a departure from AICPA presentation guidelines or omit disclosures unrelated to the significant assumptions
Examination Of Prospective Statements
An examination of prospective financial statements evaluates:
- The preparation of the statements
- The support of the related underlying assumptions
- The conformity of the statements with AICPA presentation guidelines
The practitioner’s report should contain an opinion as to whether:
- The statements are presented in conformity with the AICPA guidelines
- The underlying assumptions provide a reasonable basis for the forecast
- The underlying assumptions provide a reasonable basis for the projection in light of the hypothetical assumptions
The Procedure – In performing an examination of prospective financial statements, the practitioner should:
Step-1. Assess inherent and control risk as well as limit his or her detection risk.
Step-2. Consider the sufficiency of external sources (such as government and industry publications) and internal sources (such as management-prepared budgets) of information supporting the underlying assumptions.
Step-3. Determine the consistency of the assumptions and the sources from which they are predicated.
Step-4. Determine the consistency of the assumptions themselves.
Step-5. Determine the reliability and consistency of the historical financial information used.
Step-6. Evaluate the preparation and presentation of the prospective financial statements:
- Does the presentation reflect the underlying assumptions?
- Are the assumptions mathematically accurate?
- Do the assumptions reflect an internally consistent pattern?
- Do the accounting principles in use reflect those expected to be in effect in the prospective period?
- Are the AICPA presentation guidelines followed?
- Is there adequate disclosure of the assumptions?
Step-7. Obtain a client representation letter to confirm that the responsible party acknowledges its responsibility for the presentation of the prospective financial statements and the underlying assumptions.
Accountant’s Report On the Examination Reports – The accountant’s report on examined prospective financial statements should include:
- A title that includes the word independent
- Identification of the prospective financial statements presented
- Identification of the responsible party and a statement that the prospective financial statements are the responsibility of the responsible party
- A statement that the practitioner’s responsibility is to express an opinion on the prospective financial statements based on his or her examination
- A statement that the examination was performed in accordance with attestation standards established by the AICPA and, accordingly, included such procedures as the practitioner considered necessary in the circumstances.
- A statement that the practitioner believes that the examination provides a reasonable basis for his or her opinion.
- An opinion on the presentation of the prospective financial statements in terms of their conformity with AICPA presentation guidelines
- An opinion as to whether the underlying assumptions provide a reasonable basis for the prospective financial statements.
- A warning that the prospective results may not materialize
- A statement that the accountant is under no responsibility to update his or her report for conditions occurring after the examination report is issued
- The accountant’s signature, which may be manual or printed
- The date of the report, which should coincide with the completion of the examination procedures
Modification on Examination Report – Examination on prospective financial statement need to be modified for one of the following reason:
- Range Of Values – When prospective financial statements contain a range of values, the report should contain an additional paragraph clearly indicating this. The explanatory paragraph should be similar to the one added to compilation reports on prospective financial statements containing a range of values.
- Departure From AICPA Presentation Guidelines – When the prospective financial statements contain a departure from the AICPA presentation guidelines, issue either an “except for” qualified opinion or an adverse opinion. An “except for” qualified opinion should contain an explanatory middle paragraph which describes the departure. The opinion paragraph should specifically refer to the explanatory middle paragraph.
- Significant Assumption Does Not Provide Reasonable Basis – When the accountant believes that one or more significant assumptions (including hypothetical assumptions) do not provide a reasonable basis for the prospective financial statements, the issuance of an adverse opinion is justified.
- Scope Limitation – When the accountant is unable to perform one or more examination procedures considered necessary for the particular engagement, a disclaimer of an opinion should be expressed. The disclaimer should clearly describe the scope limitation in a separate explanatory paragraph.
- Emphasis Of A Matter – The accountant may emphasize a matter in a separate paragraph while simultaneously expressing an unqualified opinion. This is accomplished in a manner similar to emphasizing a matter already disclosed in historical financial statements.
- Division Of Responsibility – When another auditor is involved and the principal auditor wishes to divide the responsibility for the overall examination report, the principal auditor should modify the report in a manner similar to the modifications pertinent to historical financial statements.
When Agreed-Upon Procedures Permitted – It is permissible to undertake an engagement involving the application of agreed-upon procedures to prospective financial statements provided that:
- The accountant is independent
- The procedures performed or to be performed are agreed upon by the accountant and the specified users
- The specified users take responsibility for the sufficiency of the agreed-upon procedures
- A summary of significant assumptions is included in the prospective financial statements
- The prospective financial statements are subject to reasonably consistent estimation or measurement
- The accountant and the specified users agree upon the criteria to be used in the determination of findings
- The procedures to be applied are expected to result in reasonably consistent findings
- Evidential matter is expected to exist to provide a reasonable basis for expressing the accountant’s findings
- A description of any agreed-upon materiality limits for reporting purposes is included in the accountant’s report
- The accountant’s report is restricted to use by the specified users
Accountant’s Report Of Result Of Agreed-upon Procedures – The accountant’s report on prospective financial statements subjected to agreed-upon procedures should include:
- A title including the word “independent”
- An identification of the specified parties
- A reference to the prospective financial statements and the character of the engagement
- A statement that the procedures performed were those agreed to by the specified parties
- An identification of the responsible party and a statement that the prospective financial statements are the responsibility of the responsible party
- A statement that the agreed-upon procedures engagement was conducted in accordance with attestation standards established by the American Institute of Certified Public Accountants
- A statement that the specified users are responsible for the sufficiency of the procedures and a disclaimer of responsibility for the sufficiency of those procedures
- A listing of the procedures performed (or a reference thereto) and the related findings
- A description of any agreed-upon materiality limits
- A statement that the accountant was not engaged to, and did not, examine the prospective financial statements; a disclaimer of opinion; a statement that if the accountant had performed additional procedures, other matters might have been reported
- A restriction on the use of the report because it is generally intended to be used solely by the specified parties.
- A description of any reservations or restrictions concerning procedures or findings
- A warning that the prospective results might not materialize
- A statement that the accountant is under no responsibility to update his or her report for conditions occurring after the report is issued
- A description of the nature of the assistance provided by any specialists
- The accountant’s signature, which may be manual or printed
- The date of the report