Prospective Financial Information (Forecasts and Projections)

17.2 Prospective Financial Information (Forecasts and Projections)

Prospective financial information provides crucial insights into an entity’s future financial performance and position. While historical financial statements look back at what has occurred, prospective financial statements look forward, helping stakeholders make informed decisions regarding strategy, investment, and resource allocation. This section discusses the nature and purpose of forecasts and projections, engagement options available to auditors and practitioners, and the limitations on the use of such information.

1. Introduction to Prospective Financial Statements

Prospective financial statements can take various forms, but the two primary types recognized by U.S. professional standards are:

1. Financial Forecasts – These statements outline management’s best estimate of the entity’s expected financial position, results of operations, and cash flows based on the most likely assumptions.
2. Financial Projections – These statements consider a hypothetical scenario, often presented as a “what-if” analysis. Organizations can model future financial outcomes under potential changes, such as geographic expansions or strategic pivots.

Both forecasts and projections are governed by AICPA attestation standards, primarily AT-C Section 305, which addresses the performance and reporting requirements for examinations and agreed-upon procedures on prospective financial information.

2. Financial Forecasts: Most Likely Events

A financial forecast estimates what management believes will happen under expected conditions. For example, an entity might forecast next year’s revenue growth rate of 5%, assuming stable market demand and continued business relationships.

1. Basis of Assumptions
   Management’s assumptions in a forecast typically reflect the most likely economic, market, and operational conditions.

   • Possible assumptions can include:
     • Projected volume of sales.
     • Known cost increases or decreases in raw materials.
     • Anticipated changes in labor or overhead.

2. Use Cases

   • Securing additional financing or renewing an existing line of credit.
   • Supporting internal budgeting and capital expenditure planning.
   • Communicating expected performance to shareholders.

3. Practitioner’s Responsibility
   In an examination engagement (see Section 17.1 for an overview of examinations, reviews, and agreed-upon procedures), the CPA expresses an opinion on whether the forecast follows AICPA guidelines for presentation and the reasonableness of assumptions.

3. Financial Projections: Hypothetical Scenarios

A financial projection, by contrast, allows management to explore potential changes that may differ from the most likely scenario. For instance, opening 10 new branches, investing in a major technology upgrade, or acquiring another company could be considered in a projection.

1. Basis of Hypothetical Assumptions

   • Projections hinge on “what-if” conditions that may or may not occur.
   • These assumptions often reflect more speculative or strategic possibilities.

2. Use Cases

   • Evaluating the financial implications of significant acquisitions or mergers.
   • Assessing the potential returns on major capital investments.
   • Presenting scenarios to potential investors who are evaluating new opportunities.

3. Practitioner’s Responsibility
   For an examination of a projection, the CPA focuses on whether the presentation conforms to professional standards and whether the hypothetical assumptions are consistent with the stated scenario. The auditor does not, however, attest to the likelihood that the hypothetical events themselves will occur.

4. Engagement Options for Prospective Financial Information

When providing attestation services related to prospective financial information, the CPA may perform:

1. Examination Engagement

   • Objective: To express an opinion on whether the prospective financial statements are in conformity with AICPA guidelines and whether the underlying assumptions provide a reasonable basis for the presentation.
   • Scope: Typically more in-depth and requires the auditor to gather sufficient, appropriate evidence supporting management’s assumptions.

2. Agreed-Upon Procedures Engagement

   • Objective: The CPA performs only the procedures agreed upon with the specific users of the statements (e.g., verifying the arithmetic accuracy or comparing inputs to underlying data).
   • Report Characteristics:
     • The report is usually restricted in distribution to the parties who agreed upon the procedures.
     • The CPA presents the findings but does not provide an overall conclusion or opinion on the entire forecast or projection.

Diagram: Overview of Engagement Options

    flowchart LR
	    A((Prospective Financial Statements)) --> B(Examination Engagement)
	    A --> C(Agreed-Upon Procedures)
	    B --> D(Opinion on Presentation & Reasonableness of Assumptions)
	    C --> E(Specific Agreed Procedures & Findings)

Figure Explanation:
• In an Examination Engagement, the CPA expresses an opinion regarding the overall presentation and the reasonableness of the underlying assumptions.
• In an Agreed-Upon Procedures Engagement, the CPA only performs and reports on procedures agreed by specific parties, without expressing a conclusion on the entire prospective financial statement.

5. Limitations on Use

Prospective financial information is, by its very nature, uncertain and subject to change. As a result, the distribution or use of such reports may sometimes be restricted:

1. Restricted Use of Projections

   • Typically, financial projections may only be appropriate for certain limited users who understand the hypothetical scenario (e.g., a potential investor specifically interested in an expansion scenario).
   • The CPA’s report includes language highlighting restrictions on the distribution of the report to intended users.

2. Cautionary Statements

   • Practitioners often include disclaimers emphasizing that actual results could vary significantly from the forecast or projection, given the inherent unpredictability of future events.
   • The report may mention significant risks or uncertainties, such as market volatility, economic downturns, or unforeseen regulatory changes.

3. Role of Reasonable Assumptions

   • Even a well-prepared forecast or projection can be rendered obsolete by changing conditions.
   • Management bears responsibility for regularly reassessing the assumptions and updating the prospective financial information as necessary.

6. Best Practices, Common Pitfalls, and Strategies

1. Best Practices

   • Clearly Document Assumptions: A thorough, written explanation of key assumptions fosters transparency and credibility.
   • Integrate with Strategic Planning: Use prospective statements as a living document that informs day-to-day decisions.
   • Engage Stakeholders: Involve department heads or other key personnel to validate assumptions and ensure buy-in.

2. Common Pitfalls

   • Overly Optimistic Forecasts: Underestimating costs or overestimating revenue can result in unreliable financial projections.
   • Inconsistent Underlying Data: Failing to reconcile prospective information with historical patterns or actual data can undermine credibility.
   • Poor Communication: Complex assumptions must be clearly communicated to users who may not have financial expertise.

3. Strategies to Overcome Challenges

   • Sensitivity Analyses: Perform multiple scenarios (best case, worst case, and base case) to highlight how results can shift under varying conditions.
   • Regular Updates: Update forecasts or projections periodically to reflect changes in business conditions.
   • Professional Judgment: Engage experts when certain assumptions relate to specialized fields (e.g., legal, environmental, or technological changes).

7. Practical Illustrations and Case Studies

Below are a few examples to illustrate the practical application of prospective financial information:

1. Case Study: Restaurant Chain Expansion

   • A mid-sized restaurant group is considering expanding into two new cities. They prepare a financial forecast based on expected market demand. The CPA firm conducts an examination engagement and concludes the assumptions are reasonable. However, the report includes cautions about potential local economic variability and potential supply chain disruptions.

2. Case Study: Technology Startup Projections

   • A technology startup constructs financial projections assuming it raises $5 million in venture capital funding. The CPA conducts agreed-upon procedures requested by the prospective investors (e.g., verifying cost assumptions for product development). The final report carefully states that the hypothetical scenario depends on achieving full funding from investors.

8. Glossary

• Financial Forecast: Management’s best guess for future results, grounded in expected conditions and the most likely set of assumptions.
• Financial Projection: A scenario-based statement allowing testing of “what if” conditions that may differ from the most likely scenario.
• Reasonableness of Assumptions: The CPA does not guarantee actual outcomes but evaluates if logic, consistency, and data support the assumptions.

9. References and Resources

• Official References

• AT-C Section 305 (Examination of Prospective Financial Information)
  • Additional Resources
• AICPA “Guide for Prospective Financial Information”
• Practice aids for creating disclaimers and restricted-use paragraphs
• See also “SSAE Attestation Standards” for broader context on examinations, reviews, and agreed-upon procedures

By mastering the complexities of forecasting and projecting financial data, CPA candidates and professionals can provide meaningful insights to stakeholders while recognizing the inherent uncertainties of looking ahead. As prospective financial information inevitably influences decision-making, a thorough and diligent approach helps maintain trust and credibility.

Test Your Knowledge of Prospective Financial Statements: Forecasts and Projections

For Additional Practice and Deeper Preparation

Auditing & Attestation CPA Mock Exams (AUD): Comprehensive Prep
• Tackle full-length mock exams designed to mirror real AUD questions—from risk assessment and ethics to internal control and substantive procedures.
• Refine your exam-day strategies with detailed, step-by-step solutions for every scenario.
• Explore in-depth rationales that reinforce understanding of higher-level concepts, giving you a decisive edge on test day.
• Boost confidence and reduce exam anxiety by building mastery of the wide-ranging AUD blueprint.

Disclaimer: This course is not endorsed by or affiliated with the AICPA, NASBA, or any official CPA Examination authority. All content is created solely for educational and preparatory purposes.