Quick Answer
Financial statements can be audited (full CPA opinion), reviewed (limited assurance), or compiled (no assurance). GAAP, set by the FASB, requires public companies to use accrual accounting, which records revenue when earned and expenses when incurred, not when cash moves.
Two questions decide how much you can trust a set of numbers: who checked them, and when did the company book the transaction. This lesson covers both.
How Much Assurance Does the Statement Provide?
| Feature | Audited | Unaudited |
|---|---|---|
| Examination level | Full independent audit by a certified public accountant (CPA) | Review or compilation; no full audit performed |
| Opinion issued | Yes - auditor issues a formal opinion | No formal opinion; may include a review report |
| GAAP compliance verified | Yes - auditor confirms conformity with GAAP | Not confirmed by an independent auditor |
| Required for | SEC annual filings (10-K), public company financial statements | Internal use, interim reports (10-Q is reviewed but not audited), small private companies |
| Reliability | Highest level of assurance | Lower level of assurance |
Exam Tip: Gotchas
A "review" provides limited assurance (less than an audit). A "compilation" provides no assurance at all; the accountant merely assembles the financial data into statement format. Only a full audit provides reasonable assurance with a formal opinion.
Who Sets and Enforces the Accounting Rules?
- Generally Accepted Accounting Principles (GAAP) - the standard framework for financial accounting in the United States
- Established by the Financial Accounting Standards Board (FASB)
- Ensures consistency, comparability, and transparency across companies
- Public companies must follow GAAP for SEC filings
What Does the PCAOB Do?
- The Public Company Accounting Oversight Board (PCAOB) oversees auditors of public companies
- Created by the Sarbanes-Oxley Act of 2002 (SOX)
- Sets auditing standards for public company audits
When Does a Company Record Revenue: Cash or Accrual?
| Feature | Cash Basis | Accrual Basis |
|---|---|---|
| Revenue recognition | When cash is received | When revenue is earned (regardless of cash receipt) |
| Expense recognition | When cash is paid | When expense is incurred (regardless of cash payment) |
| Matching principle | Not applied | Applied - expenses matched to the revenue they help generate |
| Used by | Small businesses, sole proprietors | All public companies (required by GAAP), large private companies |
| SEC filings | Not acceptable | Required |
- Accrual accounting is required by GAAP for public companies
- Under accrual accounting, a company records revenue when a sale is made (for example, goods shipped), even if the customer has not yet paid
- Under cash accounting, that same revenue would not be recorded until payment is received
- The matching principle (accrual basis) requires that expenses be recognized in the same period as the revenue they help generate
Example: XYZ Landscaping completes a $4,500 patio project in March. The customer pays in June.
- Under cash accounting: Revenue is recorded in June (when cash received)
- Under accrual accounting: Revenue is recorded in March (when the work was completed)
Exam Tip: Gotchas
Under accrual accounting, a company can show high revenue and net income on the income statement while having very little cash. This is why the statement of cash flows is essential: it shows the actual cash position regardless of how revenue and expenses are recorded.
What Should You Check on Exam Day?
- Match the assurance level to the service: audit = formal opinion and reasonable assurance, review = limited assurance, compilation = no assurance.
- Remember that GAAP is set by the FASB, while the PCAOB oversees the auditors of public companies (created by Sarbanes-Oxley).
- Confirm the accounting basis before answering a revenue-timing question: accrual records revenue when earned, cash records it when received.
- Watch for a scenario testing high accrual net income against a low cash balance; that gap is exactly what the statement of cash flows explains.