Statement on Auditing Standards – SAE 3420

Statement on Auditing Standards – SAE 3420

Scope and objectives

SAE 3420, the Standard on Assurance Engagements (SAE) which provides guidance to practitioners who are conducting reasonable assurance engagements to report on pro forma financial information that is included in a prospectus. Pro forma financial information is a representation of how an entity’s financial position would be affected if a significant event or transaction had occurred at an earlier date.

This SAE 3420 applies when the reporting of pro forma financial information is required by securities law or regulation in the jurisdiction in which the prospectus is to be issued, or if it is generally accepted practice in that jurisdiction. However, it does not apply when pro forma financial information is provided as part of an entity’s financial statements.

In a reasonable assurance engagement, the practitioner is responsible for reporting on whether the pro forma financial information has been compiled by the responsible party on the basis of the applicable criteria. The practitioner does not have the responsibility to compile the pro forma financial information themselves. The responsible party is responsible for compiling the pro forma financial information and making pro forma adjustments to the unadjusted financial information.

The purpose of pro forma financial information is solely to illustrate the impact of a significant event or transaction on the unadjusted financial information of the entity. The compilation of pro forma financial information involves the responsible party gathering, classifying, summarizing, and presenting financial information.

The reasonable assurance engagement involves the practitioner performing procedures to assess whether the applicable criteria used by the responsible party provide a reasonable basis for presenting the significant effects directly attributable to the event or transaction. The engagement also involves evaluating the overall presentation of the pro forma financial information. However, the practitioner does not update or reissue any reports or opinions on any historical financial information used in compiling the pro forma financial information, or perform an audit or review of the financial information used in compiling the pro forma financial information.

Finally, the SAE 3420 clarifies that the performance of assurance engagements other than audits or reviews of historical financial information requires the practitioner to comply with the Framework for Assurance Engagements. The SAE 3420 expands on how the Framework is to be applied in a reasonable assurance engagement to report on pro forma financial information.

Framework for Assurance Engagements

The assurance engagements, specifically in the context of reporting on pro forma financial information included in a prospectus. The practitioner (an accountant or auditor) must comply with both the framework and the requirements of the specific engagement. Before accepting the engagement, the practitioner must ensure they have the necessary capabilities and competence to perform it. This includes knowledge and experience of the industry in which the entity operates, familiarity with relevant securities laws and regulations, and an understanding of financial reporting frameworks used in the preparation of the sources from which the financial information has been extracted.

The practitioner must also determine that the applicable criteria for the engagement are suitable and unlikely to be misleading for their intended purpose, and evaluate the wording of the opinion prescribed by relevant laws or regulations. If the sources of financial information have been audited or reviewed and a modified opinion or report has been expressed, the practitioner must consider whether the use of such opinions or reports is permitted.

If the entity’s historical financial information has never been audited or reviewed, the practitioner must consider whether they can obtain a sufficient understanding of the entity and its accounting and financial reporting practices to perform the engagement. If the engagement includes an acquisition and the acquires historical financial information has never been audited or reviewed, the practitioner must consider whether they can obtain a sufficient understanding of the acquiree and its accounting and financial reporting practices.

Finally, the practitioner must obtain the agreement of the responsible party (usually the company’s management or board of directors) that they acknowledge and understand their responsibilities for disclosing and describing the applicable criteria, compiling the pro forma financial information, and providing the practitioner with access to all relevant information, documentation, and other materials.

Planning and Performing the Engagement

The practitioner must ensure that the criteria used to compile the information are suitable and include specific minimum requirements, such as the unadjusted financial information being extracted from an appropriate source and the pro forma adjustments being directly attributable to the event or transaction and factually supportable.

Additionally, the practitioner must ensure that the adjustments made to the financial information are consistent with the entity’s applicable financial reporting framework and accounting policies, and that appropriate presentation and disclosures are made to enable users to understand the information conveyed.

The practitioner must also consider materiality when evaluating whether the pro forma financial information has been compiled on the basis of the applicable criteria in all material respects. Materiality is determined based on the size and nature of any omission or inappropriate application of an element of the compilation and depends on the context of the event or transaction, the purpose for which the information is being compiled, and the related engagement circumstances.

SAE 3420 also identifies some specific risks that may lead to the pro forma financial information not being considered compiled on the basis of the applicable criteria, such as incorrect extraction of unadjusted financial information, misapplication of accounting policies or failure of adjustments to be consistent with the entity’s policies, and inadequate or incorrect disclosures.

Obtaining an Understanding of How the Responsible Party Has Compiled the Pro Forma Financial Information and Other Engagement Circumstance

The practitioner should inquire of the responsible party and other entity personnel involved in compiling the pro forma financial information, as well as other appropriate parties, such as those charged with governance and the entity’s advisors. The practitioner should also read relevant supporting documentation such as contracts or agreements, and minutes of meetings of those charged with governance.

The practitioner may obtain an understanding of how the responsible party has compiled the pro forma financial information by considering the source from which the unadjusted financial information has been extracted, the steps taken by the responsible party to extract the unadjusted financial information from the source, the responsible party’s competence in compiling pro forma financial information, the nature and extent of oversight by the responsible party of other entity personnel involved in compiling the pro forma financial information, and the responsible party’s approach to identifying appropriate disclosures to support the pro forma financial information.

In a business combination or divestment, the practitioner should understand the responsible party’s approach and criteria for allocations of income, overheads, and assets and liabilities among or between the relevant businesses. The explanatory notes accompanying the pro forma financial information should disclose these matters.

The practitioner should also have an understanding of the nature of the entity and any acquire or dives tee, including their operations, assets and liabilities, and the way they are structured and financed. Relevant industry, legal and regulatory, and other external factors pertaining to the entity and any acquire or dives tee should also be considered, such as industry conditions, legal and regulatory environment, taxation, government policies, and general economic conditions. Finally, the practitioner should have an understanding of the applicable financial reporting framework and the accounting and financial reporting practices of the entity and of any acquire or dives tee, including their selection and application of accounting policies.

Obtaining Evidence about the Appropriateness of the Source from Which the Unadjusted Financial Information Has Been Extracted

The obtain evidence about the appropriateness of the source from which unadjusted financial information has been extracted. The practitioner must determine whether the responsible party (the entity that has prepared the financial information) has extracted the information from an appropriate source.

Factors that affect the appropriateness of the source include whether there is an audit or review report on the source, whether the source is permitted or prescribed by relevant laws or regulations, and whether it is consistent with the entity’s accounting policies and covers an appropriate period.

If there is no audit or review report on the source, the practitioner must perform procedures to satisfy that the source is appropriate. Factors that may affect the nature and extent of these procedures include the practitioner’s knowledge of the entity, how recently the entity’s financial information was audited or reviewed, and whether the entity’s financial information is subject to periodic review by the practitioner.

The practitioner may perform procedures such as inquiring of the responsible party about the process by which the source has been prepared, corroborating the information provided by the responsible party, and comparing the source with prior period financial information.

SAE 3420 also notes that, other than in the case of an entity formed for purposes of the transaction and which has never had any trading activity, it is unlikely that relevant law or regulation will permit an entity to issue a prospectus if its historical financial information has never been audited or reviewed.

Obtaining Evidence about the Appropriateness of the Pro Forma Adjustments

The practitioner (e.g. an auditor or accountant) should follow when evaluating whether the pro forma adjustments made by a company are appropriate. Pro forma adjustments are made to financial statements to illustrate the impact of an event or transaction (such as a merger or acquisition) on the company’s financial position.

To determine whether the pro forma adjustments are appropriate, the practitioner should evaluate the responsible party’s approach to identifying the necessary adjustments, which may involve reviewing contracts, agreements, and other documents. The practitioner should also perform analytical procedures and evaluate relevant analyses and worksheets prepared by the responsible party and other entity personnel involved in compiling the pro forma financial information.

In addition, the practitioner should determine whether the pro forma adjustments are directly attributable to the event or transaction and factually supportable. If the pro forma adjustments include financial information from an acquire or dives tee and there is no audit or review report on the source of that information, the practitioner should perform procedures to ensure that the information is factually supportable.

If the source from which the acquire financial information has been extracted has been audited or reviewed by the practitioner, the acquire financial information will typically be factually supportable. If the source has been audited or reviewed by another practitioner or has not been audited or reviewed at all, the practitioner may need to perform additional procedures to ensure that the information is factually supportable.

Overall, the steps those practitioners should take to ensure that pro forma adjustments are appropriate and supported by reliable information.

The Calculations within the Pro Forma Financial Information

The practitioner must ensure that the calculations within the pro forma financial information are accurate.

The practitioner must evaluate the overall presentation and structure of the pro forma financial information. This includes ensuring that it is clearly labelled to distinguish it from historical or other financial information, and that it illustrates the impact of the event or transaction in a manner that is not misleading. Appropriate disclosures must also be provided to enable users to understand the information conveyed.

The practitioner must consider whether any significant events subsequent to the date of the source from which the unadjusted financial information has been extracted have come to their attention that may require reference to, or disclosure in, the explanatory notes to the pro forma financial information to avoid the latter being misleading.

Lastly, the practitioner must read the other information included in the prospectus containing the pro forma financial information to identify material inconsistencies, if any, with the pro forma financial information. If a material inconsistency or misstatement of fact is identified, the practitioner must discuss the matter with the responsible party. If correction of the matter is necessary and the responsible party refuses to do so, the practitioner may take further appropriate action, which could include modifying the practitioner’s opinion or withdrawing from the engagement.

Written Representations

The practitioner is required to request written representations from the responsible party that they have identified all appropriate pro forma adjustments necessary to illustrate the impact of the event or transaction at the date or for the period of the illustration, and that the pro forma financial information has been compiled, in all material respects, on the basis of the applicable criteria.

The purpose of these written representations is to obtain assurance from the responsible party that they have complied with their obligations and that the pro forma financial information is accurate and reliable. The written representations provide the practitioner with evidence to support their opinion and help to reduce the risk of material misstatements in the pro forma financial information.

Forming the Opinion

The practitioner must take to form an opinion on whether the pro forma financial information has been compiled in accordance with the applicable criteria. The practitioner must obtain sufficient appropriate evidence about whether the compilation of the pro forma financial information is free from material omissions or inappropriate use or application of a pro forma adjustment. The practitioner must also evaluate whether the responsible party has adequately disclosed and described the applicable criteria, and determine if any specific criteria developed by the responsible party need to be disclosed.

The practitioner must form an opinion on whether the pro forma financial information has been compiled, in all material respects, on the basis of the applicable criteria. If the practitioner concludes that the pro forma financial information has been compiled correctly, an unmodified opinion should be expressed. If a modified opinion is necessary, the practitioner must apply the requirements of the Framework for Assurance Engagements regarding modified opinions.

In some cases, the practitioner may need to draw users’ attention to a matter presented or disclosed in the pro forma financial information or the accompanying explanatory notes. This may be done through an Emphasis of Matter paragraph, which should only be included if the practitioner has obtained sufficient appropriate evidence that the matter does not affect whether the pro forma financial information has been compiled in all material respects on the basis of the applicable criteria.

Preparing the Assurance Report

 The report should include several basic elements, such as a title that clearly indicates that the report is an independent assurance report, an addressee(s) as agreed in the terms of engagement, and introductory paragraphs that identify the pro forma financial information, the source of the unadjusted financial information, the period covered by the pro forma financial information, and a reference to the applicable criteria on the basis of which the responsible party has performed the compilation of the pro forma financial information.

The practitioner’s report should also include a statement that the responsible party is responsible for compiling the pro forma financial information on the basis of the applicable criteria, as well as a description of the practitioner’s responsibilities, including the practitioner’s responsibility to express an opinion about whether the pro forma financial information has been compiled, in all material respects, by the responsible party on the basis of the applicable criteria.

The report should also contain a statement that the engagement was performed in accordance with SAE 3420, ‘Assurance Engagements to Report on the Compilation of Pro Forma Financial Information Included in a Prospectus’, and statements that a reasonable assurance engagement to report on whether the pro forma financial information has been compiled, in all material respects, on the basis of the applicable criteria involves performing procedures to assess whether the applicable criteria used by the responsible party provide a reasonable basis for presenting the significant effects directly attributable to the event or transaction.

The practitioner’s opinion in the report should use one of the following phrases: “The pro forma financial information has been compiled, in all material respects, on the basis of the [applicable criteria]” or “The pro forma financial information has been properly compiled on the basis stated.” The exact wording of the opinion may vary depending on the jurisdiction and relevant law or regulation. Finally, the report should be dated and signed by the practitioner.

Assurance Engagements to Report on the Compilation of Pro Forma Financial Information Included in a Prospectus

The International Standard on Assurance Engagements (ISAE) 3420 deals with assurance engagements related to the compilation of pro forma financial information included in a prospectus. SAE 3420 mentions a specific circumstance where the relevant law or regulation prohibits the publication of a prospectus that includes a modified opinion regarding whether the pro forma financial information has been compiled in all material respects on the basis of the applicable criteria. In this situation, the practitioner should discuss the matter with the responsible party. If the responsible party does not agree to make the necessary changes, the practitioner may withhold the report, withdraw from the engagement, or seek legal advice.

However, it notes that the practice of withholding the report is not common in India. Therefore, the option of withholding the report by the practitioner has been deleted from the Indian version of the standard.

Quiz on “Preface to the Standards on Quality Control, Auditing, Review, Other Assurance and Related Services”

1. True or False: Pro forma financial information is used to represent the impact of a significant event or transaction on an entity’s financial position.

Answer: True

2. When does SAE 3420 apply?

a) When pro forma financial information is provided as part of an entity’s financial statements.

b) When securities law or regulation requires reporting of pro forma financial information in a prospectus.

c) When it is generally accepted practice in any jurisdiction.

d) Both b) and c)

Answer: d)

3. Who is responsible for compiling the pro forma financial information in a reasonable assurance engagement?

a) The practitioner

b) The responsible party

c) The auditor

d) Both a) and b)

Answer: b)

4. The practitioner’s responsibility in a reasonable assurance engagement involving pro forma financial information includes:

a) Compiling the pro forma financial information

b) Assessing the applicable criteria used by the responsible party

c) Updating historical financial information

d) Performing an audit of the financial information

Answer: b)

5. True or False: Assurance engagements other than audits or reviews of historical financial information require compliance with the Framework for Assurance Engagements.

Answer: True

6. Factors that affect the appropriateness of the source from which unadjusted financial information has been extracted include:

a) Whether the source has been audited or reviewed

b) Consistency with the entity’s accounting policies

c) Coverage of an appropriate period

d) All of the above

Answer: d)

7. In evaluating the pro forma adjustments made by a company, the practitioner should:

a) Review contracts and agreements

b) Perform analytical procedures

c) Evaluate relevant analyses and worksheets

d) All of the above

Answer: d)

8. True or False: Materiality is not a consideration when evaluating whether the pro forma financial information has been compiled on the basis of the applicable criteria.

Answer: False

9. Written representations from the responsible party are obtained to:

a) Support the practitioner’s opinion

b) Ensure compliance with securities laws

c) Compensate for lack of evidence

d) None of the above

Answer: a)

10. The assurance report should include:

a) The practitioner’s opinion

b) A description of the practitioner’s responsibilities

c) The addressee(s) of the report

d) All of the above

Answer: d)

Additional questions:

11. What is the purpose of the Framework for Assurance Engagements?

a) To provide guidance on auditing standards

b) To establish quality control measures

c) To outline the procedures for reviewing financial statements

d) To provide guidance on assurance engagements other than audits or reviews of historical financial information

Answer: d)

12. True or False: The practitioner must have the necessary industry knowledge and experience to perform the engagement involving pro forma financial information.

Answer: True

13. In a reasonable assurance engagement, the practitioner’s responsibility includes:

a) Compiling the pro forma financial information

b) Assessing the overall presentation of the pro forma financial information

c) Determining the applicable criteria for the engagement

d) Updating the entity’s financial reporting framework

Answer: b)

14. SAE 3420 identifies specific risks that may result in pro forma financial information not being considered compiled on the basis of the applicable criteria. These risks include:

a) Incorrect extraction of unadjusted financial information

b) Misapplication of accounting policies

c) Failure of adjustments to be consistent with the entity’s policies

d) All of the above

Answer: d)

15. True or False: The practitioner must obtain the agreement of the responsible party to disclose and describe the applicable criteria and provide access to all relevant information and documentation.

Answer: True

16. The practitioner may obtain an understanding of how the responsible party has compiled the pro forma financial information by:

a) Inquiring of the responsible party and entity personnel involved in compilation

b) Reading relevant supporting documentation

c) Evaluating the responsible party’s approach to identifying appropriate disclosures

d) All of the above

Answer: d)

17. When obtaining evidence about the appropriateness of the source from which unadjusted financial information has been extracted, the practitioner may perform procedures such as:

a) Inquiring of the responsible party about the preparation process

b) Corroborating the information provided by the responsible party

c) Comparing the source with prior period financial information

d) All of the above

Answer: d)

18. The practitioner must ensure that the calculations within the pro forma financial information are:

a) Consistent with the entity’s applicable financial reporting framework

b) Accurate and supported by reliable information

c) Disclosed in the accompanying explanatory notes

d) All of the above

Answer: d)

19. True or False: The practitioner’s opinion in the assurance report should use the exact wording prescribed by relevant laws or regulations.

Answer: False

20. The practitioner’s assurance report should include:

a) The title indicating it is an independent assurance report

b) An addressee(s) as agreed in the terms of engagement

c) A statement of the practitioner’s responsibilities

d) All of the above

Answer: d)