Public Accounting Pyramid

The accounting industry in some ways resembles a giant pyramid scheme. At the ‘pointy end’ (aka ‘the zenith’) are the partners of the Big 4 international accounting firms. These are very prestigious and highly paid positions. Predictably there a great many people vying to be made partner – and the competition is fierce. At the base of the pyramid are the bookkeepers who ‘don’t get no respect’ and are paid very little. Consequently skilled bookkeepers are in short supply.

Consumers of public accounting services – which means virtually every business in the western world – need to understand what services public accountants provide, and how best to use these services.

Fundamentally public accountants only provide 2 kinds of service:

  1. assurance
  2. tax advice

…and the lion’s share of public accounting revenue is derived from assurance services.

About Assurance Services

Generally this refers to the involvement of a professional accountant in the preparation of financial statements. Independent readers of financial statements take comfort – or assurance – from the involvement of a professional accountant in the preparation of the financial statements.

Depending on the extent of their involvement (and the size of the fee), public accountants in Canada provide more or less assurance which they describe in a notice appended to the front of the financial statements. There are 3 types of assurance engagement, each corresponding to a different level of assurance. These are:

  1. Compilation – the accountant ‘compiles’ the financial statements based on information provided by the business and does not perform any kind of  review except to determine that the financial statements are plausible. A ‘Notice To Reader’ is attached by the public accountant to explain the limited nature of the accountant’s involvement.
  2. Review – the accountant reviews financial statements in accordance with professional standards for review engagements and attaches a ‘Review Engagement Report’.
  3. Audit – the accountant audits the financial statements in accordance with generally accepted auditing standards and attaches an ‘Independent Auditor’s Report’.

Compilations (or ‘Notice To Readers’) are the most common type of assurance services purchased by very small businesses. Technically they aren’t ‘assurance’ services at all, since the professional accountant specifically avoids providing any assurance in his or her ‘notice’. Theoretically professional accountants should not issue compilation-type financial statements if they are aware that a 3rd party is intending to rely on them for an investment decision.

In spite of this most users take a certain amount of comfort from the public accountant’s notice. Financial statements that have been ‘compiled’ by an independent public accountant are required to be ‘plausible’ – but not much else. This is generally a quantum leap up from financial statements prepared in-house by management – or those prepared by small, bookkeeping firms.

However, if it is important for a 3rd party to have confidence in a set of financial statements, the reader should insist on financial statements that have been reviewed by an accredited public accountant[1]. If the public accountant is aware that you are relying on his review to loan or otherwise invest in the company, the public accountant is required to take that reliance into account in determining the level of ‘materiality[2]’.  You might therefore consider letting the accountant know in writing that you intend to rely on the financial statements in making your investment decision.

A review engagement is a huge step up in terms of quality from a compilation engagement. An audit provides more assurance – but at a much greater cost to the company. For that reason audits are unusual for small[3], privately-held companies.

While accounting, bookkeeping and assurance services represent the lion’s share of services provided to businesses by public accounting firms, small business owners generally value tax advice more than assurance services. This is probably because they view assurance services as a necessary cost driven by the needs of 3rd parties for reliable financial information. Good tax advice on the other hand actually saves money for the entrepreneur.

 

About Tax Advice

Unfortunately income tax is exceedingly complex.  In Canada, the Income Tax Act is probably the single most complex piece of legislation there is.

For example subsection 9(1) of that act reads as follows:

“9. (1) Income — Subject to this Part, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.”

It sounds straightforward doesn’t it?

However profit isn’t actually defined in the Act. Which means you must look to the concept of profit as defined by the accounting profession…..and interpreted by the courts. What’s more, these days there are alternatives emerging in the form of the new IFRS[4] to challenge our tried and true Canadian GAAP[5].

So which standard do we apply when both are allowable? And exactly what are those standards anyway?

For the most part designated professional accountants who are licensed to practice as public accountants can provide competent advice for most domestic companies – except those that work internationally[6], perform eligible scientific research and experimental development (“SR&ED”), are engaged in mining or mining exploration, are looking for foreign investment, or need complex tax structures.

Where your company needs help in these areas you will need a specialist to assist your general practitioner. Practitioners with smaller firms are often reluctant to seek specialist advice on your behalf, for fear of losing your business. If you sense this consider seeking the advice of a specialist yourself.

Of course finding a tax specialist can be challenging.

As an employee of a large CA firm I call myself an ‘SR&ED Financial Specialist’ which is in fact what I am. If I were ‘registered in public practice’ as a CGA in British Columbia, I would not be allowed to refer to myself as a specialist – since the CGA Association does not recognize SR&ED as a specialty. Instead I could only indicate that SR&ED tax incentives are my ‘preferred area of practice’ – which any other CGA can do.

I don’t believe the Institute of Chartered Accountants of BC has similar restrictions, but in any case there are very few SR&ED specialists and they are seldom found working in small firms.

Theoretically if an accountant is providing some level of assurance on a set of financial statements (i.e. a review or an audit), the financial statements should have been prepared by someone else. The notion is that the accountant is reviewing or auditing someone else’s work. When an accountant compiles (i.e. ‘prepares’) financial statements himself, it is difficult for him to perform an unbiased review or audit – and he is prohibited from doing so.

So if you are looking to have your statements reviewed, you will need to prepare your own financial statements competently. At a minimum this means either working with a professionally-trained accounting staff, or hiring a firm that has more than one professional accountant on staff. Either way, better quality (more assurance) financial statements cost more.

People who start their own businesses are typically independent and self-reliant. They have to be to believe they can beat the odds and succeed in their own small business. While this may come as a surprise to you, many of them really delusional and more than a little bit arrogant — not to mention woefully ignorant of basic accounting principles.

If you are an entrepreneur yourself, clearly you aren’t either delusional or arrogant[7], the lenders and/or investors who need to rely on your financial statements have no way of knowing this however. They need to rely on an accredited public accountant to have a level of assurance that your numbers are worthy of belief. The more that an entrepreneur is asking from lenders or investors, the more those assurance services will cost.


[1] Note that about 75% of professional accountants are not registered to practice as public accountants. If you’re hoping to save money by hiring a designated professional part-time to prepare your financial statements, understand that they are not permitted to audit or review your financial statements.

Professional accounting bodies require that, if their members are engaged in public accounting, they must carry liability insurance, continually upgrade their professional knowledge and submit their files periodically to quality assurance reviews.

[2] Tolerance for risk

[3] Note that the notion of ‘small’ is relative here.

[4] International Financial Reporting Standards

[5] Generally Accepted Accounting Principles

[6] Including selling to customers in the US or abroad.

[7] After all you have enough sense to read this guide

Published by Rob Farrow

accountant, entrepreneur, former chef, occasional artist, angel investor, business advisor, corporate tax specialist