Chapter 12 Auditing of Governmental and Not-for-Profit Organizations McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives After studying Chapter 12, you should be able to: Explain the essential elements of financial audits by independent CPAs, including: The objective(s) of financial audits The source and content of GAAS Audit report formats and opinions The audit process 12-2
12-3 Learning Objectives (Cont d) Explain what is meant by GAGAS, the source of GAGAS, and why and how GAGAS are broader than GAAS Explain the types of audits performed under GAGAS, including financial audits, attestation engagements and performance audits
12-4 Learning Objectives (Cont d) Explain the essentials of a single audit, including: The purpose and scope Major program identification Audit work required Reports that must be submitted, and when and to whom Describe the implications of the Sarbanes-Oxley Act of 2002 on governments and not-for-profit organizations
12-5 Objective of a Financial Audit The independent auditor s objective is to render a report expressing an opinion that the financial statements present fairly the financial position, changes in financial position, and, where applicable, cash flows of the organization Present fairly means in conformity with appropriate generally accepted accounting principles (GAAP) Opinions are based on reasonable assurance that the statements are free from material misstatements
Generally Accepted Auditing Standards (GAAS) 12-6 Auditors performing financial audits follow GAAS, reflected in Statements of Auditing Standards (SASs) issued by the AICPA 10 standards (expanded on by more than 100 SASs) 3 general standards 3 field work standards 4 reporting standards See Ill. 12-1
12-7 Auditor s Standard Report Paragraphs in a standard audit report (see Ill. 12-2): Opening Scope Opinion Identifies the financial statements being audited Describes the nature of the audit Expresses the auditor s opinion about the fairness of the financial statements Explanatory Used in most governmental audits, usually related to the auditor s role in reviewing supplementary information
12-8 Types of Auditor s Opinions Unqualified (clean) Statements present fairly the financial position and changes in position (and cash flows, if applicable) according to GAAP. See Ill. 12-2 Qualified opinion Statements contain a material departure from GAAP or there is a material change between periods in GAAP. See Ill. 12-3 Adverse opinion Financial statements do not present fairly in conformity with GAAP Disclaimer of opinion Often due to inability to examine records
12-9 GAAP Hierarchy SAS No. 69 and No. 91 Ill. 12-4 Category Nongovernmental Entities State and Local Governments a FASB statements... GASB statements... b c AICPA Audit and Accounting Guide... FASB Emerging Issues Task Force... AICPA Audit and Accounting Guides... AICPA Practice Bulletins... Federal Governmental Entities FASAB statements... FASAB Technical Bulletins... AICPA AcSec Bulletins... d AICPA Q&As... GASB Q&As... FASAB Implementation Guides...
Materiality Definition: In the auditor s judgment, the level at which the quantitative or qualitative effects of misstatements will have a significant impact on users evaluations AICPA Audit and Accounting Guide State and Local Governments requires auditors to make separate materiality determinations for each opinion unit. These are: Governmental activities Business-type activities Aggregate discretely presented component units Each major governmental and enterprise fund The aggregate remaining fund information 12-10
Auditing Required Supplementary Information (RSI) 12-11 RSI, such as MD&A and budgetary comparison schedules, are outside the scope of the financial statement audit Auditors apply certain limited procedures in connection to RSI to provide assurance that they are fairly presented in relation to the basic financial statements
Types of Governmental Audits Ill. 12-5 12-12 Financial An opinion as to whether financial statements are presented fairly in conformity with GAAP and all material facts are disclosed Attestation engagement Examinations or procedures that lead to a report and assertion about subject matter that is the responsibility of another party; e.g., internal controls, compliance, MD&A, contract amounts, performance measures Performance A determination of whether managers are using resources efficiently and effectively in accomplishing organizational goals
Generally Accepted Government Auditing Standards (GAGAS) 12-13 Standards issued by the U.S. Government Accountability Office in its yellow book Required of auditors in a Single Audit of organizations that expend more than $500,000 in federal resources in any year States may also require yellow book audits of their local governments
12-14 GAGAS Financial Audit Standards There are 4 general standards GAGAS incorporates the GAAS fieldwork standards and adds 5 additional standards GAGAS incorporates the GAAS reporting standards and adds 8 additional standards
Unique Aspects of GAGAS 12-15 The standard on competency requires, among other things, that auditors have: A thorough knowledge of governmental auditing standards and the specific or unique environment in which the audited entity operates At least 80 hours of CE (CPE) every two years of which at least 20 hours must be completed in each of the two years at least 24 hours must be related directly to governmental auditing or the unique environment in which the audited entity operates
12-16 Unique Aspects of GAGAS (Cont d) GAGAS standards place much more emphasis on compliance with laws and regulations than do GAAS
12-17 Independence Standards Independence is the cornerstone of the auditing profession and is the first general standard in the GAO s GAGAS and the second general standard in the AICPA s GAAS GAGAS independence standard was changed in 2002 to address primarily nonaudit work performed for audit clients
GAO Independence Standards Nonaudit Work 12-18 DEFINITION: Work solely performed for the benefit of the entity requesting the work and which does not provide for a basis for conclusions, recommendations, or opinions as would a financial audit, attestation engagement, or performance audit
GAO Independence Standards Nonaudit Work (Cont d) 12-19 Two overarching principles: Auditors should not perform management functions or make management decisions Auditors should not audit their own work or provide nonaudit services in situations when the nonaudit services are significant to the audit subject matter
GAO Independence Standards Nonaudit Work (Cont d) 12-20 What work is acceptable (no safeguards need to be in place)? Providing routine advice or methodologies, serving on advisory committees, answering technical questions, providing training What work is prohibited? Maintaining the accounting records, posting transactions to the records, recommending a single person for a position, supervising the information technology system
GAO Independence Standards Nonaudit Work (Cont d) 12-21 What work is permitted (if safeguards are in place)? Preparing draft financial statements based on management s trial balance, maintaining depreciation schedules for which management has determined the key elements in the calculations, proposing adjusting and correcting entries that management accepts
12-22 Safeguards Document consideration of nonaudit work Document an understanding with the client of the objectives and scope of the audit work Exclude personnel who provided nonaudit services from any involvement with the audit Do not reduce the scope and extent of audit work below the level that would be appropriate if the nonaudit work were performed by an unrelated party
12-23 What is the Purpose of a Single Audit? Improve the efficiency and effectiveness of governmental audit effort Replace a multitude of grant-by-grant audits with a single, comprehensive, entity-wide audit Provide all federal awarding agencies a single report of a recipient of federal awards to satisfy a program s audit requirements
Determining Who Must Have a Single Audit 12-24 State and local governments, not-for-profit organizations, including colleges and hospitals, that expend more than $500,000 in federal financial assistance in a year If expended only for one program or one program cluster, the entity may have a program audit, otherwise the audit must be a single audit
12-25 Single Audit (Cont d) 1996 Single Audit Act Amendments: Establishes a risk-based approach for audit testing, thus placing greater audit coverage on high risk programs Improves the contents and timeliness of single audit reporting Permits the Office of Management and Budget (OMB) to administratively revise Single Audit requirements without requiring additional legislation See OMB Circular A-133 and the related Compliance Supplement for implementation guidance
12-26 Single Audit (Cont d) Calculation of amount of federal awards expended Calculation can be complex Basic rule is that a federal award has been expended when the federal agency has become at risk and the nonfederal recipient has a duty of accountability See Ill. 12-8
12-27 Single Audit Requirements Annual audit encompassing the entity s financial statements and schedule of expenditures of federal awards Audit must be conducted by an independent auditor Auditors must follow GAGAS (yellow book standards) Auditor must determine whether financial statements present fairly in conformity with GAAP and the schedule of federal financial awards is presented fairly in relation to the financial statements
12-28 Single Audit Requirements (Cont d) Auditor must obtain an understanding of internal controls pertaining to the compliance requirements for each major program, and assess control risk and perform tests of control Federal and nonfederal pass-through agencies are assigned certain responsibilities for compliance
Compliance Audits (as Part of Single Audit) 12-29 For each major program the auditor must test whether the program: Was administered in conformity with the appropriate OMB Circular (A-102 or A-110) Complied with detailed requirements in the A- 133 Compliance Supplement and other specified requirements
Selection of Programs for Single Audit 12-30 Use the sliding scale shown in Chapter 12 and follow the steps in Ill. 12-9 Identify Type A programs Identify low-risk programs (based on no audit findings in most recent audit and absence of certain risk factors) Assess risk of Type B programs (major programs that are not Type A programs)
Selection of Programs for Single Audit (Cont d) 12-31 At a minimum, audit all high risk Type A programs and either half of the high-risk Type B programs or one high-risk Type B program for each low-risk Type A program Audit enough major programs to ensure that at least 50% of total federal award expenditures are audited
Required Reporting Under Single Audit 12-32 Both auditee and auditor have responsibilities for the reporting package that must be filed electronically and sent to the single audit clearinghouse Reporting package consists of: Financial statements and schedule of expenditures of federal awards Summary schedule of prior audit findings Auditor s reports (see Ill. 12-10) Corrective action plan
12-33 Required Reporting Under Single Audit Schedule of findings and questioned cost Describes such matters as internal control weaknesses, instances of noncompliance, questioned costs, fraud, and material misrepresentations by the auditee Internal control weaknesses are reported as either: significant deficiencies (significant internal control deficiencies that could adversely affect compliance), or material weaknesses (significant deficiency that does not allow internal control components to reduce the risk of detection or prevention to an acceptably low level)
Schedule of Findings and Questioned Costs (Cont d) 12-34 A questioned cost usually involves an instance of noncompliance with a law or regulation where the costs are either not allowable, are unreasonable, or are not supported by adequate documentation Known questioned costs greater than $10,000 or likely costs greater than $10,000 must be reported in the schedule of findings and questioned costs
12-35 Cognizant Agencies To promote quality control, nonfederal entities expending more than $50 million in federal awards are assigned a cognizant agency usually the agency providing the predominant amount of support The cognizant agency provides technical advice and serves as a liaison, conducts quality control reviews, refers substandard audits for disciplinary action, and facilitates communication
12-36 Oversight Agencies Nonfederal entities expending less than $50 million are assigned an oversight agency rather than a cognizant agency Oversight agencies have similar but less extensive responsibilities than oversight agencies
Single Audit Quality The President s Council on Integrity and Efficiency s 2007 report on the national single audit sampling project found 48.6% of single audits were of acceptable quality 16.0% were of limited reliability 35.5% were of unacceptable quality Recommendations on improving single audit quality Improve the single audit standards and guidance Establish minimum training requirements Establish consequences for submitting unacceptable audits 12-37
Impact of Sarbanes-Oxley Act of 2002 12-38 SOX applies to publicly-held companies, but many governments are adapting some best practices in the areas of: Audit Committees subsets of the governing council that appoint, oversee, and work with the external auditor throughout the year Internal Controls OMB Circular A-123 Management s Responsibility for Internal Control is one example of a review and tightening of internal controls in the government sector
Concluding Comments Auditors add value to information by being independent and conforming to professional auditing standards (GAAS or GAGAS) GAGAS applies to audits of nonfederal entities that expend at least $500,000 of federal awards GAGAS are broader than GAAS in that they include standards for financial and performance audits and attestation engagements The single audit improves both the efficiency and effectiveness of audits of nonfederal entities with significant expenditures of federal awards END 12-39