11-1 Accounting for Governmental & Nonprofit Entities JACQUELINE L. RECK SUZANNE L. LOWENSOHN 17/e Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

11-2 Auditing of Governmental and Not-for-profit Organizations C H A P T E R 11

11-3 Learning Objectives 11-1Explain the essential elements of financial audits by independent CPAs, including: The objective(s) of financial audits. The source and content of generally accepted auditing standards (GAAS). Audit report formats and opinions. The audit process.

11-4 Learning Objectives 11-2Explain what is meant by generally accepted government auditing standards (GAGAS), the source of GAGAS, and why and how GAGAS are broader than GAAS. 11-3Explain the types of audits performed under GAGAS, including financial audits, attestation engagements, and performance audits.

11-5 Learning Objectives 11-4Explain the essentials of a single audit, including: The purpose and scope of a single audit. Major program identification. Audit work required. Reports that must be submitted. 11-5Discuss special topics related to audits of governments and not-for-profit organizations.

11-6 Fundamentals of Financial Audits Financial statements that have been audited provide financial statement users with a higher level of confidence in the information contained within the statements. The auditor’s objective in performing a financial audit is to render a report expressing his or her opinion that the financial statements are presented fairly. “Present fairly” means in conformity with generally accepted accounting principles.

11-7 Government and Not-for-profit Audits Generally Accepted Auditing Standards (GAAS) Generally Accepted Government Auditing Standards (GAGAS) Single Audit Act

11-8 Generally Accepted Auditing Standards Audits of state and local governments may be performed by independent certified public accountants (CPAs) or by state or federal audit agencies. The AICPA’s Code of Professional Conduct requires CPAs to follow generally accepted auditing standards (GAAS)—standards approved by AICPA Council. State or federal auditors, whether or not they are CPAs, are also required to follow GAAS if GAAS are prescribed by law or policy for the audits they conduct.

11-9 Generally Accepted Auditing Standards Failure to follow GAAS can result in severe sanctions, including the loss of the auditor’s license to practice as a CPA. It is the auditor’s duty to adhere to auditing standards, and it is his or her technical qualifications and independence from the entity being audited that add credibility to reported financial information and increase financial statement users’ confidence in the information. GAAS provide general guidelines for audits and address the minimum responsibilities of the auditor, as well as objectives and requirements.

11-10 Basic Format of the Audit Report A title that includes the word “independent” and the addressee Introductory paragraph Management’s responsibility for the financial statements Auditor’s responsibility Opinion(s) Report on other legal and regulatory requirements Auditor’s signature and date of the audit

11-11 Types of Opinions Unmodified opinion Qualified opinion Adverse opinion Disclaimer

11-12 Why Not an Unmodified Opinion? Material departure from GAAP Material change between accounting periods in accounting principles or their method of application Scope of the examination was affected by conditions that prevented the auditor from conducting necessary audit procedures

11-13 Government Audit Process Determine appropriate GAAP Establish scope Establish audit procedures Determine materiality Conduct examination Issue opinion

11-14 Materiality Materiality must be determined for every opinion unit Governmental activities Business-type activities Aggregate discretely presented component units Each major governmental and enterprise fund The aggregate remaining fund information

11-15 Government Auditing Standards Audit standards that are to be followed by auditors of federal organizations, programs, activities, and functions are broader in scope than GAAS. Generally accepted government auditing standards (GAGAS) are set forth and explained in the publication Government Auditing Standards.

11-16 Generally Accepted Government Auditing Standards Legislators, oversight bodies, those charged with governance, and the public need to know whether (1) management and officials manage government resources and use their authority properly and in compliance with laws and regulations; (2) government programs are achieving their objectives and desired outcomes; and (3) government services are provided effectively, efficiently, economically, ethically, and equitably. Government auditing is essential in providing government accountability to legislators, oversight bodies, those charged with governance, and the public. --From the introduction to the yellow book

11-17 Types of Audits and Engagements Financial Audits Financial statement audits Compliance audits Special reports Attestation Engagements Internal control M D & A Final contract costs Performance Audits Effectiveness and results Economy and efficiency Internal control and compliance

11-18 GAGAS General Standards 1. Independence standard: In all matters relating to audit work, the audit organization and the individual auditor must be independent in mind and in appearance. 2. Professional judgment: Auditors must use professional judgment in planning and performing audits and in reporting the results. 3. Competence: The staff assigned to perform the audit must collectively possess adequate professional competence needed to address the audit objectives and perform the work in accordance with GAGAS. 4. Quality control and assurance: The audit organization must establish and maintain a system of quality control and have an external peer review at least once every 3 years.

11-19 Additional GAGAS Requirements for Performing Financial Audits Importance of communication Follow-up on prior findings and recommendations Detection of material misstatements Development of the elements of a deficiency finding Documentation

11-20 Additional GAGAS Requirements for Reporting on Financial Audits Reporting on compliance Internal controls Report requirements Distribution

11-21 Fundamental Ethical Principles Public interest Integrity Objectivity Proper use of government information, resources and position Professional behavior

11-22 Independence The GAGAS independence standard requires that the highest degree of integrity and objectivity be maintained by any auditor performing audits of federal, state, and local governments and not-for-profit entities that receive federal financial assistance so that the public is best served. The GAGAS conceptual framework for independence assists auditors in evaluating whether a situation poses a threat to independence. If the threats are considered so significant that they cannot be eliminated or reduced to an acceptable level through the application of safeguards, auditors should decline to perform the audit, since independence has been impaired.

11-23 Nonaudit Services Before an auditor agrees to provide a nonaudit service to an audited entity, the auditor should determine whether providing such a service would create a threat to independence with respect to any GAGAS audit or attestation engagement it performs. If a threat is created that cannot be eliminated or reduced to an acceptable level by the application of safeguards, auditors should either decline to perform the nonaudit service or decline to perform or terminate the audit engagement for which independence may be impaired. The auditor is required to document conclusions regarding compliance with independence requirements and support for those conclusions.

11-24 History of the Single Audit Each federal agency conducted its own audit based on its requirements 1960 – efforts made to standardize grant accounting and auditing OMB requires federal audits be done on organization –wide basis 1984 – Single Audit Act of 1984 Amendments to Single Audit Act Requirements

11-25 Purposes of the Single Audit Act 1. Improve the financial management of state and local governments with respect to federal financial assistance programs, 2. Establish uniform requirements for audits of federal financial assistance provided to state and local governments, 3. Promote the efficient and effective use of audit resources, 4. Ensure that federal departments and agencies rely upon and use audit work done pursuant to the Single Audit Act.

11-26 Amendments and Revisions The 1984 Single Audit Act was amended and revised in 1996, 1997, 2003, and most recently in The current guidance for single audits is contained within an extensive OMB document, Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards, also known as the “super circular” or “omni circular.”

11-27 Who Must Have a Single Audit? State or local government or not-for-profit organization? Expended at least $750,000 in federal awards during year? Expended from only one program or program cluster? Perform single audit Perform either single audit or program-specific audi t Comply with any nonfederal audit requirements yes no yes no

11-28 Single Audit Requirements 1. An annual audit must be performed encompassing the nonfederal entity’s financial statements and schedule of expenditures of federal awards. 2. In accordance with generally accepted government auditing standards (GAGAS) and cover the operations of the entire nonfederal entity. Independent auditor means an external federal, state, or local auditor who meets the GAGAS independence standards or an independent public accountant.

11-29 Single Audit Requirements 3. The auditor must determine whether the financial statements are presented fairly in all material respects with GAAP and whether the schedule of expenditures of federal awards is presented fairly in relation to the financial statements taken as a whole. 4. For each major program, the auditor must obtain an understanding of the internal controls pertaining to the compliance requirements for the program, assess control risk, and perform tests of controls, unless the controls are deemed to be ineffective.

11-30 Compliance Audits The Uniform Guidance requires the auditor to express an opinion that the auditee complied with laws, regulations, and grant or contract provisions that could have a direct and material effect on each major program. To gather sufficient evidence, the auditor tests whether each major program was administered in conformity with administrative requirements contained in the Uniform Guidance and compliance requirements contained in the Compliance Supplement.

11-31 Auditee Requirements Identify all federal awards received and expended, and the federal programs under which they were received Maintain appropriate internal controls and systems to ensure compliance with all laws, regulations, and contract or grant provisions Prepare appropriate financial statements and the schedule of expenditures of federal awards, ensure that audits are properly performed and submitted when due, and follow up and take appropriate corrective action on audit findings.

11-32 Risk-Based Approach for Selecting Major Programs for Audit Step 1: Identify larger federal programs and analyze based on the following criteria: Total Federal Awards Expended Threshold for Type A Program $750,000 to $100 million Larger of $750,000 or 3% (.03) of total federal awards expended More than $100 million to $10 billion Larger of $3 million or.3% (.003) of total federal awards expended More than $10 billion Larger of $30 million or.15% (.0015) of total federal awards expended

11-33 Risk-Based Approach for Selecting Major Programs for Audit Step 2 : Identify low-risk Type A programs: programs previously audited in at least one of the two most recent audit periods as a major program, with no internal control deficiencies identified as major weaknesses, opinion modifications, or significant questioned costs in the most recent audit period; programs with no significant changes in personnel or systems that would have significantly increased risk; and programs that, in the auditor’s professional judgment, are low risk.

11-34 Risk-Based Approach for Selecting Major Programs for Audit Step 3: Identify Type B programs that, based on the auditor’s professional judgment and criteria discussed above, are high risk. The auditor is not expected to perform risk assessments on relatively small federal programs. Risk assessments are performed only for those Type B programs that exceed twenty-five percent (0.25) of the Type A threshold determined in Step 1.

11-35 Risk-Based Approach for Selecting Major Programs for Audit Step 4: At a minimum, audit as major programs all Type A programs not identified as low risk and high-risk Type B programs totaling at least one-fourth the number of low-risk Type A programs identified as low-risk in Step 2.

11-36 Risk-Based Approach for Selecting Major Programs for Audit The percentage of coverage rule requires the auditing of as many major programs as necessary to ensure that at least 50 percent of total federal awards expended are audited. In addition to the possibility of reduced audit coverage resulting from individual Type A programs being classified as low risk, the Uniform Guidance also provides that the auditee itself can be classified as low risk and thereby receive even greater reduction in audit coverage.

11-37 Required Reports for Single Audit Financial statements and schedule of expenditures of federal awards Summary schedule of prior audit findings Auditor’s reports Corrective action plan Must be submitted electronically to the federal clearinghouse designated by the OMB within the earlier of 30 days after receipt of the auditor’s report(s) or nine months after the end of the audit period

11-38 Required Auditor’s Reports 1. An opinion (or disclaimer of opinion) as to whether the financial statements are presented fairly in all material respects with GAAP and whether the schedule of expenditures of federal awards is fairly stated in all material respects in relation to the financial statements taken as a whole. 2. A report on internal control over financial reporting and compliance with federal statutes, regulations, and the terms and conditions of the federal award, noncompliance with which could have a material effect on the financial statements. 3. A report on compliance for each major program and on internal control over compliance. 4. A schedule of findings and questioned costs.

11-39 Audit Findings A material weakness is a deficiency in internal control so that there is a possibility a material misstatement will not be prevented, detected or corrected on a timely basis. A significant deficiency is less severe than a material weakness but something that needs to be brought to management’s attention Deficiency A cost either not supported by adequate documentation or appears unreasonable. Questioned cost

11-40 Audit Findings The schedule of findings and questioned costs should include (a) A summary of the auditor’s results, including such information as type of opinion rendered on the financial statements, significant deficiencies or material weaknesses relating to internal control, material noncompliance affecting the financial statements, major programs audited, type of opinion on compliance for major programs and significant deficiencies or material weaknesses in internal control affecting major programs, and a statement as to whether the auditee qualified as low risk. (b) Findings related to the audit of the financial statements required to be reported by the yellow book (GAGAS). (c) Audit findings and questioned costs.

11-41 Special Topics Single Audit quality has been an area of concern for decades. The AICPA has created a Governmental Audit Quality Center to promote the importance of quality governmental audits and the value of such audits to purchasers of governmental audit services. The GAO and OMB provide frequent updates to GAGAS and federal fund audit requirements and guidelines.

11-42 Special Topics When seeking an external auditor, governments and not-for-profits should prepare a formal request for proposal (RFP). Requests for proposals should include information about the governmental entity and cover the scope of services (financial audit, Single Audit, and any additional compliance auditing), the auditing standards to be followed (GAAS, GAGAS, or state-mandated standards), reports to be issued, assistance to be provided to the auditor, and other considerations.

11-43 Special Topics Impact of SOX Applies to publicly held companies and their auditing firms Indirect impact on governments and not-for-profits Government/not-for-profit entities could benefit from adopting certain requirements of SOX

11-44 Looking Forward In this chapter, we examined audits of governmental and not-for-profit organizations, including the essential elements of financial audits, GAAS and its relationship to GAGAS, and the impact and requirements of the single audit. Chapter 12 explores in depth budgeting and performance measurement.