Chapter 11

Auditing of Governmental

and Not-for-Profit Organizations

McGraw-Hill © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives

After studying Chapter 11, you should be able to:

Explain the essential characteristics of financial audits by independent CPAs, including:

o the objective(s) of financial audits

o the source and content of generally accepted auditing standards (GAAS)

o the types of audit reports that can be rendered

o the contents of an unqualified and a qualified audit report

o materiality

o required supplementary information

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Learning Objectives (Cont’d)

Explain what is meant by o generally accepted government auditing standards

(GAGAS)

o the source of GAGAS

o why GAGAS are much broader than GAAS

Explain the types of audits performed under GAGAS, includingo Financial audits

o Attestation engagements

o Performance audits

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Learning Objectives (Cont’d)

Explain the characteristics of a single audit, including:

o the purpose

o which entities must have a single audit

o what auditing work is required

o how major programs are selected for audit

o what reports must be rendered, when, and to whom

Describe the role of audit committees.

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Key Terms

Attestation engagements Nonaudit workAudit committee Opinion unitsAudit findings Oversight agencyCognizant agency Performance auditsCompliance audit Program-specific auditEngagement letter Questioned costFinancial audits Reportable conditionGAAP hierarchy Risk-based approachGAAS Single auditGAGASMajor programsMaterialityMaterial weakness

Financial — An opinion as to whether financial statements are fairly stated 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.

Types of Governmental Audits

Unqualified (clean) Explanatory language can be added but still unqualified. See Ill. 11-2

Qualified opinion Except for matter noted, financial statements still present fairly in conformity with GAAP. See Ill. 11-3

Adverse opinion - Financial statements do not present fairly in conformity with GAAP

Disclaimer of opinion - Often due to inability records or non-existence of records

Types of Auditor’s Opinions

Paragraphs in a standard audit report: Opening Identifies the financial statements being audited

Scope Describes the nature of the audit

Opinion Expresses the auditor’s opinion about the fairness of the financial statements

Explanatory Used in most governmental audits but seldom used in corporate audits

Auditor’s Standard Report

GAAP HierarchySAS No. 69, as amended by SAS No. 91

Category Nongovernmen-tal Entities

State and Local Governments

Federal Governmental

Entities

a FASB statements… GASB statements…

FASAB statements…

b AICPA Audit and Accounting Guide…

AICPA Audit and Accounting Guides…

FASAB Technical Bulletins…

c FASB Emerging Issues Task Force…

AICPA Practice 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 Audits of State and Local Governmental Units (2002) requires auditors to make separate materiality determinations for each opinion unit. Under GASBS 34, these are governmental activities business-type activities aggregate discretely presented component units each major governmental and enterprise fund the aggregate remaining fund information

Auditing RSI

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.

Standards issued by the AICPA.

10 standards (expanded on by about 100 SASs.) 3 general standards 3 field work standards 4 reporting standards

Applicable to financial audits only.

Generally Accepted Auditing Standards (GAAS)

Standards issued by the U.S. General Accounting Office in its “yellow book.”

Required of auditors in a Single Audit of organizations that expend more than $300,000 in federal sources in any year.

Generally Accepted Government Auditing Standards (GAGAS)

Generally Accepted Government Auditing Standards (GAGAS) are Broader than GAAS

GAAS GAGAS GAAS GAGAS GAAS GAGAS

General Standards

3 4 5 5 0 4

Field Work Standards

3 7 2 7 0 4

Reporting Standards

4 11 4 9 0 4

Totals 10 22 11 21 0 12

Standard on adequacy of professional proficiency requires auditors to have: A thorough knowledge of governmental auditing and

the specific or unique environment in which the audited entity operate

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 and at least 24 hours of which must be related directly to the audit environment

Unique Aspects of GAGAS

GAGAS standards place much more emphasis on compliance with laws and regulations than do GAAS

Unique Aspects of GAGAS (Cont’d)

Independence Standards

Independence is the cornerstone of the auditing profession and the second general standards in both the AICPA’s GAAS and GAO’s GAGAS.

GAO issued Amendment No. 3 to Government Auditing Standards in 1999 to address independence when nonaudit work is performed for audit clients, effective for audits performed after January 1, 2003.

GAO Independence Standards–Nonaudit Work

DEFINITION: That solely performed for the benefit of the entity requesting the work and does not provide for a basis for conclusions, recommendations, or opinions as would a financial audit, attestation engagement, or performance audit.

Two overarching principles:(1) Auditors should not perform management functions or make management decision.

(2) 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)

Acceptable, no safeguards need to be in place Providing routine advice or methodologies, serving on advisory

committees, answering technical questions, providing training

Prohibited Maintaining the accounting records, posting transactions to the

records, recommending a single person for a position. supervising the information technology system

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 correction entries that management accepts

Safeguards

(1) Preclude nonaudit personnel from planning… the audit

(2) Do not reduce the scope of the audit

(3) Document consideration of nonaudit work

(4) Document an understanding with the client of the objectives and scope of the audit work

(5) Include policies to ensure compliance with independence standards

(6) Avoid certain nonaudit work such as operating the client’s accounting system

(7) Make all documentation available for peer review

Intended (among other purposes) to improve the efficiency and effectiveness of governmental audit effort

Replaces a multitude of grant-by-grant audits with a single, comprehensive, entity-wide audit

All federal awarding agencies are required to accept the single audit reports as satisfying their program’s audit requirements

Single Audit

1996 Single Audit Act Amendments: Raises the threshold for a single audit from $100,000

received to $300,000 expended

Extends statutory requirement for single audit coverage to not-for-profit organizations as well as state and local governments

Establishes a risk-based approach for audit testing, thus placing greater audit coverage on high risk programs

Single Audit (Cont’d)

1996 Single Audit Act Amendments: Improves the contents and timeliness of single

audit reporting Permits the Office of Management and Budgeting

(OMB) to administratively revise Single Audit requirements without requiring additional legislation

OMB Circular A-133 and the related Compliance Supplement provide implementing guidance for conducting the single audit

Single Audit (Cont’d)

Q: Who has to have an audit under GAGAS? see Illustration 11-7

A: Any state or local government or not-for-profit organization that expends at least $300,000 in federal awards during a year must have an audit in conformity with GAGAS. If expended only for one program or one program

cluster, the entity can have a program audit, otherwise the audit must be a single audit.

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

Recommend working Case 11-1 to understand nuances of calculation

Single Audit (Cont’d)

Annual audit encompassing the entity’s financial statements and schedule of expenditures of federal awards

Audit must be conducted by an independent auditor 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.

Single Audit Requirements

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

Single Audit Requirements (Cont’d)

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 Circular and other specified requirements

Compliance Audits (as part of single audit)

Using sliding scale shown in CH 11, 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

At a minimum, audit all high risk Type A programs and either

(1) half of the high-risk Type B programs or

(2) one high-risk Type B program for each low-risk Type A program

Audit at least enough major programs to ensure that at least 50% of total federal award expenditures are audited

Selection of Programs for Single Audit (Cont’d)

Both auditee and auditor have responsibilities for the “reporting package” that must be sent to the single audit clearinghouse in Indiana

Reporting package consists of:Financial statements and schedule of

expenditures of federal awardsSummary schedule of prior audit findingsAuditor’s reports (see Ill. 11-10; now condensed

to three reports by AICPA SOP 98-3)Corrective action plan

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: reportable conditions (significant internal control deficiencies that could adversely affect compliance), or material weaknesses (severe reportable conditions that render internal controls ineffective in reducing risk of noncompliance to an acceptably low level)

Required Reporting Under Single Audit

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

Schedule of Findings and Questioned Costs (Cont’d)

To promote quality control, nonfederal entities expending more than $25 million in federal awards are assigned a cognizant agency—usually the agency providing the predominant amount of support.

Cognizant agency provides technical advice and liaison, conducts quality control reviews, refers substandard audits for disciplinary action, and facilitates communication

Cognizant Agencies and Oversight Agencies

Nonfederal entities expending less than $25 million are assigned an oversight agency rather than a cognizant agency

Oversight agencies have similar but less extensive responsibilities than oversight agencies

Cognizant Agencies and Oversight Agencies (Cont’d)

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 $300,000 of federal awards

GAGAS are broader than GAAS in that they include standards for financial and performance audits.

The single audit improves both the efficiency and effectiveness of audits of nonfederal entities with significant expenditures of federal award.

End

Concluding Comments