Who Provides Explanatory Notes and Disclosures?
The explanatory notes and disclosures, like the financial statements themselves, are the responsibility of the company’s management and its accounting staff. Management and the internal accounting staff prepare the explanatory notes and disclosures by using the applicable American Institute of Certified Public Accountants (AICPA) disclosure checklist. All GAAP guides contain a comprehensive appendix listing the full AICPA disclosure checklist.
After management prepares the financial statements and explanatory notes and disclosure information, the company often hires an independent certified public accountant (CPA) to evaluate management’s work. The CPA is independent, which means she has no special relationship to or financial interest in the company. The CPA may or may not be required to be independent, depending on the work the CPA performs for the client.
CPAs perform three major types of financial statement work:
Audits: Auditing is the process of investigating information that’s prepared by someone else, usually company management and the accountants the company employs, in order to determine whether the financial statements are fairly stated. CPAs performing audits must investigate the assertions that a company makes on its financial statements, including any notes and disclosures.
Financial statement assertions often relate to how the company conducts business, such as how it makes and spends money and how it records financial information about its property, plant, and equipment; its long-term liabilities and equity; and its cash and investments.
An audit provides a reasonable level of positive assurance, which means the financial statements are free of material errors and are stated in accordance with GAAP. An audit does not, however, provide an absolute guarantee that the financial statements contain no errors. Also, an audit isn’t designed or performed to detect all fraud.
Although accountants employed by the business prepare the financial statements (including the notes and disclosures), only an independent CPA can audit them.
Reviews: When a CPA conducts a review, she looks at the company’s documents and provides negative assurance, which means the CPA finds no reason to believe the information prepared by company management is incorrect.
For example, the CPA looks over the company’s financial statements, noting whether they’re of proper appearance. For example, do the statements contain appropriate explanatory notes and disclosures per the AICPA disclosure checklist? Do they conform to GAAP? Reviews are usually performed for privately owned companies when the users of the financial statements require some sort of assurance about the financial statements’ assertions but don’t require a full-blown audit.
Compilations: If a CPA is hired to do a compilation, she can compile financial statements (using information provided by company management) that omit footnote disclosures required by GAAP or that use another comprehensive basis of accounting, such as cash-basis accounting. Preparing the statements this way is okay as long as omitting the explanatory notes and disclosures is clearly indicated in the report without intent to mislead users.
When footnote disclosures have been omitted, CPAs add a paragraph to the compilation report stating that management has elected to omit disclosures. This paragraph lets the user know that if the financial statements did contain the explanatory notes or disclosures, that information may affect their conclusions.
Here’s an example of the language used when a company is omitting compilation disclosures:
Management has elected to omit substantially all the disclosures required by generally accepted accounting principles. If the omitted disclosures were included in the financial statements, they might influence the users’ conclusions about the company’s financial position, results of operations, and its cash flows. Accordingly, these financial statements are not designed for those who are not informed about such matters.