A quarterly newletter by the Boston Chapter of the Association of Legal Administrators
Yes, even among the most experienced law firm financial administrators and stakeholders there exist some misconceptions or misunderstandings regarding the scope of assurance services provided by their independent certified public accountant (CPA). Furthermore, understanding the why’s and wherefore’s regarding the scope of assurance services under ever-changing standards should prove to enhance your communications with your CPA and increase the efficiency and effectiveness of your financial statement assurance engagement.
Identifying the Expectation Gap – Some Background
Most commonly, CPA firms are engaged to audit or review a law firm’s financials due to a requirement imposed by a lender or embedded in a partnership or operating agreement. In some cases, firm owners opt for audit or review regardless of any obligation to do so.
Generally, the requirement for a financial statement by a lender is impacted by loan size or total committed credit and the existence of any collateral or guarantees. These considerations also impact the lender’s decision as to whether the financial statement should be audited or reviewed.
Law firm financial statements are most commonly prepared on an other comprehensive basis of accounting (OCBOA), i.e., income tax, modified cash, and modified accrual. Alternatively, a limited number of firms present financial statements prepared in accordance with generally accepted accounting principles (GAAP), i.e., the accrual basis.
Relative to both the level of assurance and the basis of accounting, there may exist expectation gaps or misunderstandings impacting the reliance placed upon the financial statements and underlying financial records of the firm.
Gap One: Levels of Assurance – Review vs. Audit
Financial Statement Review
The objective of a financial statement review is to provide the basis for communicating whether the CPA is aware of any material modifications that should be made to the financial statements for them to conform to GAAP or OCBOA.
The standards under which a financial statement review is performed are codified in AICPA Statement on Standards for Accounting and Review Services (SSARS) No. 10 Performance of Review Engagements, effective for calendar year 2005 and thereafter. SSARS No. 10 includes expanded guidance regarding the nature and extent of analytical procedures as well as additional guidance on judgmental matters and workpaper documentation. The updated standards also require inquiries and representations related to fraud.
The procedures performed in connection with a financial statement review are as follows:
It’s important to understand that a review does not provide assurance that the CPA will become aware of all significant matters that would be disclosed in an audit. Nor does a review contemplate tests of accounting records, examination of corroborating evidence related to inquiry responses, obtaining an understanding or internal control, or assessment control risk. Such procedures fall within the scope of a financial statement audit.
Financial Statement Audit
The objective of a financial statement audit is to provide the basis for obtaining reasonable assurance about whether the financial statements, taken as a whole, are free of material misstatement.
There are two sets of standards under which an audit may be performed. Auditing standards established by the Public Company Accounting Oversight Board govern the performance of audits of public companies. General Accepted Auditing Standards (GAAS) issued by the Auditing Standards Board (ASB) of the AICPA represent the standards under which private companies are audited, unless a private company specifically engages a CPA firm to audit in accordance with PCAOB audit standards.
Procedures performed in connection with an audit include:
The title of Statement of Auditing Standard (SAS) No. 94 clearly states the nature of the audit requirement - The Effect of Information Technology on the Auditor's Consideration of Internal Control in a Financial Statement Audit. While technology in the law firm environment is generally extensive, within the scope of a financial statement audit, the primary concern is to understand the controls surrounding technologies which support the financial reporting process. Some of the technologies/software considered significant to the financial reporting process include network applications and platforms as well as certain business applications such as:
While, as previously mentioned, the guidance for reviews includes some inquiry and representations regarding fraud, financial statement No. 99, Consideration of Fraud in a Financial Statement Audit, requires more detailed procedures and documentation regarding fraud risk. In the context of your financial statement audit, your auditors will consider the risk of material misstatement, which would result from either the misappropriation of assets or fraudulent financial reporting. The auditors will consider, among other things, incentives and pressures inherent in your compensation programs or systems of accountability and reward. Additionally, SAS 99 requires that revenue recognition and management’s override of controls be presumed and audit procedures designed to address these presumed areas of fraud risk. It is important to note that the scope of SAS 99 is not to test for fraud, but rather to consider the risk of fraud and its impact on the financial statements.
The nature of the fraud risk regarding SAS 99 procedures that you should anticipate in an audit include inquiries of finance and accounting personnel, chief executives, and others as deemed appropriate by your auditors (such as HR director, practice group leaders, CIO, etc.). It is not appropriate for you to restrict the scope of these inquiries. SAS 99 also requires unpredictability in a recurring audit engagement and the testing of non-standard journal entries.
An unqualified opinion resulting from an audit reports that the financial statements are presented fairly in accordance with the applicable comprehensive basis of accounting in all material respects. Note that an audit opinion does not attest to the absolute accuracy of the financial statements.
Other opinions may be issued in connection with an audit. A qualified or “except for” opinion may result when the financial statements include a departure from the applicable comprehensive basis of accounting. Such a departure may include inadequate disclosure or may arise from a scope limitation. An adverse opinion is issued when the financials include material and pervasive departures. A disclaimer of an opinion usually relates to scope limitations that are so significant that auditors conclude that a qualified opinion is not appropriate.
Analytics in a Review and an Audit
In either a review or an audit of a law firm, analytical review represents a significant element of the work. A review requires inquiry regarding the reasonableness of the analytical relationships. Corroboration of explanations of management is left to the judgment of the CPA.
Analytics in the scope of an audit serve three purposes. Preliminary analytical considerations are required during the planning stages of an audit as a basis for establishing the nature, timing and extent of testing. Final analytical procedures are part of supervisory reviews are also required. Preliminary and final analytics generally do not include detailed analytics at the individual account level.
Within the scope of substantive audit work—depending on a variety of factors such as materiality, account inherent risk, and control risk—substantive analytics performed at the account level provide an efficient approach to auditing and inevitably provide a basis for identifying anomalies that may require further investigation through inquiry and corroboration or detailed testing.
Gap Two: Basis of Accounting – What Accounts Are You Looking At?
The second area of expectation gap relates to the scope of accounts subject to review or audit procedures as determined by the basis of accounting being presented. (Given the limited application of GAAP for law firm financial reporting, I have assumed, for purposes of discussion here, that accounts receivable (AR) and work in progress or unbilled fees (WIP) are not on the balance sheet.)
While AR and WIP are significant assets of a law firm and, generally, subject to frequent management reporting, review, and analysis; because these accounts do not appear on a law firm’s balance sheet that is reported on by the CPA, these accounts are not subject to review or audit procedures.
However, because the activity and comparative fluctuations in these significant accounts relate very directly to other accounts in the financial statements, analytical review within the scope of a review or an audit will incorporate data related to these accounts. For example, if a law firm has experienced a comparative increase in income tax basis revenue year-over-year, it is important for the CPA to understand to what extent the increase represents growth in the business or was impacted by improved collections. Review of days sales outstanding year-over-year will provide insight regarding the change in revenue. Determining whether the business grew or collections improved, or a combination of both, impacts the understanding of fluctuations in other accounts and data such as payroll and head count and various operating expense accounts.
Of course, in connection with a CPA’s review of an accrual basis balance sheet, the AR and WIP would be subject to analytical procedures and such other procedures as deemed necessary. In connection with an audit of an accrual basis balance sheet, analytics would be performed in addition to validation of individual AR and WIP balances.
Lenders or owners should be informed regarding the extent, if any, of assurance provided relative to AR and WIP. In the absence of assurance by the CPA relative to these significant accounts, some firms engage their CPAs to perform certain agreed-upon procedures relative to AR and WIP. Such agreed-upon procedures can provide a basis for recommendations and feedback regarding the operating results of the firm in the context of the effectiveness of procedures and controls surrounding the administration of these accounts.
Client escrow or cash held in trust represent assets that do not belong to the firm. These segregated assets, if material, often are disclosed in the footnotes to the financial statements but are not subject to review or audit procedures. Those firms with significant trust operations often will contract, under a separate engagement, a review of controls over trust operations in consideration of their fiduciary duty related to those assets in their custody. Compliance with IOLTA regulations may also be an area of separate engagement outside of the scope of your financial statement review or audit.
Summary
A law firm’s financial management and internal and external stakeholders should be apprised of the scope of procedures performed and the extent of assurance provided in a review or audit opinion. Additionally, the significance of AR and WIP and client funds should not support a presumption that these assets are subject to the scope of procedures in the review or audit of the financial statements.
Biography
Margery L. Piercey, CPA is a Principal at Wolf & Company, P.C., a regional certified public accounting and business consulting firm with offices in Boston and Springfield, Massachusetts and Albany, New York. Margery has over twenty years of experience including a number of law firms and other professional service firms. She has developed training and customized review and audit programs specific to the law firm industry.