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Chapter 38 Auditing Governmental Units


38 Auditing Governmental Units 38.1 OVERVIEW OF THE STATE AND LOCAL GOVERNMENTAL ENVIRONMENT 38.2 GOVERNMENTAL ACCOUNTING AND REPORTING PRINCIPLES (a) Fund Accounting, (i) Governmental Funds, (ii) Proprietary Funds, (iii) Fiduciary Funds, (iv) Account Groups, (b) Modified Accrual Basis of Accounting, (c) Encumbrances, (d) Standard Setting for Governmental Accounting, (e) Financial Reporting, (f) Financial Reporting After Implementation of GASB Statements No. 33 and No. 34 38.3 RISK FACTORS AND AUDIT REACTION (a) Types of Governmental Audits, (i) Financial Audits, (ii) Performance Audits, (b) Single Audit Considerations, (c) Risk Factors and Materiality Considerations, (d) Overall Audit Strategy and Planning Considerations, (e) Management Representation Letter, 38.4 TYPICAL TRANSACTIONS (a) Budget Cycle, (b) Revenue Cycle, (i) Assessed Taxes, (ii) Self-Assessed Taxes, (iii) Intergovernmental Revenue, (iv) Other Governmental Revenues, (c) Purchasing Cycle, 38.5 SUBSTANTIVE TESTS (a) Balance Sheet Accounts, (i) Receivables from Taxes, (ii) Due to and Due from Other Funds, and Other Interfund Accounts,

(iii) Restricted Assets, (iv) General Fixed Assets Account Group, (v) Liabilities, (vi) Fund Equity, (vii) Contingent Liabilities from Grant Noncompliance, (b) Comparisons of Budget and Actual and Other Operating Statements, 38.1 OVERVIEW OF THE STATE AND LOCAL GOVERNMENTAL ENVIRONMENT State and local governmental accounting and auditing are in a period of significant and rapid change, as evidenced by changing governmental accounting principles and major revisions in 1994 to Government Auditing Standards and to the AICPA's audit and accounting guide, Audits of State and Local Governmental Units. Increasing numbers of governmental units are preparing financial statements in conformity with generally accepted accounting principles (GAAP) and having them audited in accordance with generally accepted auditing standards (GAAS). The expanding use of financing vehicles by port, housing, development, and transportation authorities and similar entities also has broadened the field of governmental accounting and auditing. Increasing attention has been focused on the appropriate spending of federal funds and on the auditor's role in preventing or detecting misappropriations of taxpayers' dollars. Because of this, standards covering governmental financial reporting, disclosure, and testing have become more uniform. Users of governmental financial statements are different from and represent a more diverse range of interests than users of a business entity's financial statements. In addition to investors, labor organizations, oversight agencies, policy makers, and operating management-all of which have counterparts in the commercial environment-governmental entities also provide information to senior levels of government (for such purposes as grant compliance or data analysis) and, most important, their constituencies, which are most directly affected by decisions about obtaining and using resources. The needs of this wide variety of users differ. Holders of bonds are interested in fiscal performance and soundness of financial condition. Resource providers, whether taxpayers, other governmental entities, or legislatures, wish to ensure that governmental units are expending those resources efficiently and in the manner prescribed by law. The objectives of bondholders and constituents may conflict; for example, a large fund balance is desirable to bondholders but not to constituents. Managements of governmental entities must strike a balance between the objectives of the two groups. A characteristic of the governmental environment of particular significance to the auditor is the large number of regulations that govern expenditures at all levels. Probably the most pervasive regulations are those embodied in a governmental entity's budgetary system; budgets that set revenue and expenditure levels have a greater effect on the operations of governments than budgets do in most other organizations. In addition, a network of regulations is embodied in

laws that must be complied with by department, program, or grant administrators at a particular level of government or at lower levels. Thus, a department cannot overspend its budget, and its expenditures must meet the requirements of contracts, awards, laws, and regulations that govern the allowability of costs charged to specific contracts or programs. Auditing guidelines and regulations established by federal, state, and local governments do not supersede GAAS, but may prescribe additional requirements. Generally accepted government auditing standards (GAGAS) for federally assisted programs are set forth in Government Auditing Standards, popularly referred to as the "Yellow Book," first published by the U.S. General Accounting Office (GAO) in 1972 and most recently revised in 1999. The AICPA has provided guidance to the auditor in its audit and accounting guide, Audits of State and Local Governmental Units, which includes examples of auditors' reports. In addition, when auditing a state or local governmental unit that receives federal financial assistance, the auditor must comply with the requirements of the Single Audit Act (the Act) as described in Circular A-133, "Audits of States, Local Governments, and Non-Profit Organizations," issued by the U.S. Office of Management and Budget (OMB). Statement on Auditing Standards (SAS) No. 74, Compliance Auditing Considerations in Audits of Governmental Entities and Recipients of Governmental Financial Assistance (AU Section 801), which superseded SAS No. 68, explains the relationship among GAAS, the Yellow Book, and the Act. SAS No. 74 also requires auditors to design audits to provide reasonable assurance that the financial statements are free of material misstatements resulting from violations of laws and regulations that have a direct and material effect in determining financial statement amounts. SAS No. 74 thus clarifies that violations of such laws and regulations are covered by the provisions of SAS No. 54, Illegal Acts by Clients. 38.2 GOVERNMENTAL ACCOUNTING AND REPORTING PRINCIPLES Governmental accounting and reporting principles are unique in several respects and reflect the fundamental differences between commercial entities and governmental units. (a) Fund Accounting The most notable distinction between governmental and commercial accounting is the concept of fund accounting and the presentation of financial statements by fund types and account groups. In the governmental environment, the entity being audited is not viewed as an integrated accounting unit; instead, each of the individual fund types encompassed by the entity is considered and shown (although not necessarily reported on) separately. Transactions involving more than one fund should be recorded using interfund receivable and payable accounts. Fund accounting is used by governments as a means of controlling and accounting for various types of restricted resources and related expenditures. The three broad types of funds typically found in governmental accounting systems are governmental, in which the primary concern is accounting for service delivery and

demonstrating compliance with resource restrictions; proprietary, in which the concern is cost recovery (through user charges or fees) or cost determination for specific activities; and fiduciary, which account for assets held by a government as trustee or agent. These types of funds have been further subdivided and defined by the Governmental Accounting Standards Board (GASB). (i) Governmental Funds. Governmental funds and their purposes are as follows: General Fund: Accounts for all financial resources except those required to be accounted for in another fund. Special Revenue Funds: Account for the proceeds of specific revenue sources (other than from expendable trusts or for major capital projects) that are legally restricted to expenditures for specified purposes. Capital Project Funds: Account for financial resources to be used for the acquisition or construction of major capital facilities (other than those financed by proprietary funds and fiduciary funds). Debt Service Funds: Account for the accumulation of resources for and payment of general long-term debt principal and interest. (ii) Proprietary Funds. The two kinds of proprietary funds are: Enterprise Funds: Account for operations that are financed and managed similar to the operations of private business entities. The governing body may have decided that the costs (including depreciation) of providing goods or services to the general public on a continuing basis should be financed or recovered primarily through user charges, or that periodic determination of revenues earned, expenses incurred, and net income is appropriate for capital maintenance, public policy, management information, accountability, or other purposes. Internal Service Funds: Account for financing of goods or services provided by one department or agency to other departments or agencies of a governmental unit or to other governmental units on a cost-reimbursement basis. (iii) Fiduciary Funds. Also called trust and agency funds, fiduciary funds account for assets held by a governmental unit in a trustee capacity or as agent for individuals, private organizations, other governmental units, or other funds. Fiduciary funds include expendable trust funds, nonexpendable trust funds, pension trust funds, and agency funds. (iv) Account Groups. In addition to the three fund types, two account groups are used to establish accountability over fixed assets and long-term obligations. The general fixed assets account group reflects a governmental unit's fixed assets, except those used in enterprise, internal service, or nonexpendable trust fund activities and therefore recorded in those funds.

Historically, governments have not recorded "infrastructure" assets such as streets, sidewalks, bridges, and storm drains on the theory that they were immovable and not subject to theft. There is a growing trend, however, to record these items both for better accountability and for more accurate service cost information. Similarly, depreciation on these assets normally is not recorded, but increasing concern over the deterioration of the nation's infrastructure has prompted renewed interest in doing so. Such records would be helpful, for example, in ensuring accountability and in developing indirect cost systems. A government's policy for recording fixed assets and related accounts should be disclosed. Originally, the general long-term debt account group was established to account for all governmental debt not carried as a liability of another fund. Its use has expanded to include other noncurrent liabilities, such as lease commitments, claims and judgments, and compensated absences. (b) Modified Accrual Basis of Accounting Another distinguishing characteristic of governmental accounting is the use of a modified accrual basis of accounting for reporting purposes. For governmental funds and expendable trust funds, the accrual basis of accounting is modified to focus on a measurement of financial flows, that is, to show the increase or decrease in financial resources. Revenues and other financial resources (such as bond proceeds) are recognized in the accounting period in which they become available and measurable. Expenditures are recognized on the accrual basis, with certain exceptions, among them: Unmatured principal and interest on general long-term debt, which usually are recorded as expenditures in the year of payment Inventory, which usually is recorded as an expenditure when purchased Prepaid items, such as insurance, which usually are recorded as expenditures when paid GASB Statement No. 34, as explained later in this chapter, requires the use of the flow of financial resources measurement focus and the accrual basis of accounting. (c) Encumbrances Encumbrances are another unique aspect of governmental accounting. The GASB defines encumbrances as "commitments related to unperformed (executory) contracts for goods or services." Many governments' budgetary laws require that encumbrances be recorded in governmental funds for which an annual budget has been adopted; their purpose is to aid in budgetary control and accountability, and they are also useful for cash planning. Encumbrances outstanding at year-end are neither expenditures nor liabilities. In some governmental units, budget appropriations lapse at year-end, while in other units they are carried forward. If appropriations are carried forward, outstanding encumbrances should be recorded by reserving part of the fund balance as a reserve for encumbrances. If appropriations lapse but the governmental unit intends to honor the commitments, outstanding

encumbrances should be disclosed either by a reservation of the fund balance or in a note to the financial statements. The unit's policy as to appropriations and encumbrances should be disclosed in the accounting policies footnote. (d) Standard Setting for Governmental Accounting The GASB was established in 1984 under the auspices of the Financial Accounting Foundation for the purpose of establishing accounting principles for state and local governmental units. [The National Council on Governmental Accounting (NCGA) previously performed that function.] One of the GASB's first actions was to address the then-current status of governmental accounting principles and to adopt certain of the NCGA statements and interpretations as part of generally accepted accounting principles for governmental entities. Those statements and interpretations, as well as GASB statements, interpretations, and technical bulletins issued as of June 30, 2000, are included in the GASB's Codification of Governmental Accounting and Financial Reporting Standards as of June 30, 2000. GASB pronouncements issued after that date have not yet been included in the Codification. The AICPA has designated the GASB as the body to establish financial accounting principles for state and local governmental entities under Rules 202 and 203 of the AICPA Code of Professional Conduct. In the agreement that established the GASB, a hierarchy of generally accepted accounting principles applicable to state and local governments was specified in which GASB pronouncements take precedence over Financial Accounting Standards Board (FASB) pronouncements. The agreement also provided that, if the GASB had not issued a pronouncement on a particular matter, governmental entities were to be guided by FASB pronouncements. In 1989, this agreement was changed, placing FASB pronouncements issued since the formation of the GASB at a lower level; effectively, such FASB pronouncements do not need to be followed. Under the hierarchy established by SAS No. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles in the Independent Auditor's Report (AU Section 411), FASB pronouncements are not a source of established accounting principles for state and local governments unless the GASB issues a standard incorporating them into GAAP for state and local governments. GASB Statement No. 20, Accounting and Financial Reporting for Proprietary Funds and Other Governmental Entities That Use Proprietary Fund Accounting, issued in September 1993, allows governments to make a one-time election to adopt all or no FASB pronouncements issued subsequent to 1989 for proprietary funds. (e) Financial Reporting NCGA Statement No. 1 specifies that for fair presentation of financial position, results of operations, and cash flows for proprietary and similar trust funds in conformity with GAAP, a governmental unit should prepare and issue general-purpose financial statements, consisting of:



Combined balance sheet-all fund types and account groups Combined statement of revenues, expenditures, and changes in fund balances-all governmental fund types and expendable trust funds



Combined

statement

of

revenues,

expenditures,

and

changes

in

fund

balances-budget and actual-general and special revenue fund types (and similar governmental funds for which annual budgets have been legally adopted) Combined statement of revenues, expenses, and changes in retained earnings/fund balances-all proprietary fund types and similar trust funds Combined statement of cash flows-all proprietary fund types and similar trust funds

The GASB also recommends that a governmental unit issue a comprehensive annual financial report (CAFR) containing an introductory section, a financial section, and a statistical section. The introductory section contains financial highlights and organizational information. The financial section consists of the financial statements listed above plus combining statements by fund type, individual fund and account group statements, detailed budgetary data, and schedules. The statistical section may indicate compliance with legal or contractual provisions, present historical trend data, or simply report information in greater detail. In identifying other agencies (such as housing authorities, utility systems, or school boards) that should be included as part of the governmental entity, the auditor should be aware that defining the entity to be included in the general-purpose financial statements and CAFR is not always straightforward. GASB Statement No. 14, The Financial Reporting Entity, establishes standards for defining and reporting on the financial reporting entity. The financial reporting entity consists of (a) the primary government, (b) organizations for which the primary government is financially accountable, and (c) other organizations, the nature and significance of whose relationship with the primary government are such that exclusion would cause the reporting entity's financial statements to be misleading or incomplete. In addition, Statement No. 14 provides for discrete presentation of components as well as blending of component units, depending on the relationship with the primary government. This criterion causes the reporting entity to be defined broadly and results in the inclusion in the reporting entity's financial statements of governmental units that may be audited by auditors other than those of the primary government. This could result in financial statements in which all or the majority of the components of a fund type are not audited by the auditor who is expected to issue the opinion. The AICPA audit and accounting guide, Audits of State and Local Governmental Units, provides guidance in this situation. (f) Financial Reporting After Implementation of GASB Statements No. 33 and No. 34 (NEW) In December 1998, the GASB issued Statement No. 33, Accounting and Financial Reporting for Nonexchange Transactions, and in July 1999 it issued Statement No. 34, Basic Financial Statements-and Management's Discussion and Analysis-for State and Local Governments.

These statements, which are quite complex, substantially change (a) the way a government's major transactions are accounted for in general-purpose external financial statements and (b) the governmental financial reporting model. (i) GASB Statement No. 33. Statement No. 33 establishes new accounting and reporting standards for recognition of nonexchange transactions. Nonexchange transactions are those in which a governmental entity gives or receives value without directly giving or receiving equal value in return, as opposed to exchange transactions, in which the governmental entity gives or receives essentially equal value. The principal issue in Statement No. 33 is the determination of when and how nonexchange revenues and expenses should be recognized in the accounting records and financial statements. (1) Classes of Nonexchange Transactions. Statement No. 33 divides governmental nonexchange transactions into four classes, which are defined as follows: Derived tax revenues, which result from assessments imposed on exchange transactions (e.g., income taxes, sales taxes, and other assessments on earnings or consumption) Imposed nonexchange revenues, which result from assessments imposed on nongovernmental entities, including individuals, other than assessments on exchange transactions (e.g., property taxes and fines) Government-mandated nonexchange transactions, which occur when a government at one level provides resources to a government at another level and requires the recipient to use the resources for a specific purpose (e.g., federal programs that state or local governments are mandated to perform) Voluntary nonexchange transactions, which result from legislative or contractual agreements, other than exchanges, entered into willingly by the parties (e.g., certain grants such as HUD grants and private donations) The principal characteristics of voluntary nonexchange transactions are that both entities, either or both of which can be governmental entities, enter willingly into a legislative or contractual agreement; that is, the agreement is not imposed on either the provider or the recipient. The provider may even specify that the funds be returned if the transactions are contravened after they have been recognized. Meeting eligibility requirements is essential to this type of transaction. (2) Eligibility Requirements. The eligibility requirements for a specific nonexchange transaction determine the appropriate accounting for it. Usually, eligibility requirements include time requirements. Time requirements relate to when the recipient is entitled to the nonexchange resources; this differs from purpose requirements, which relate to how the nonexchange resources must be used. Time requirements affect the timing of recognition of revenues and expenses, while purpose requirements do not. Governmental entities that receive purpose resources should report resulting assets, equity, and fund balances as restricted. For governmental funds, purpose resources would be reported as a reservation of a fund balance. The eligibility requirements for government-mandated and voluntary nonexchange transactions are further defined in Statement No. 33 as one or more of the following:



Required characteristics of recipients. The recipient (and secondary recipient, if applicable) has the characteristics specified by the provider. For example, under certain federal programs, recipients are required to be states, and secondary recipients are required to be school districts.



Time requirements. Time requirements specified by enabling legislation or the provider have been met. That is, the period when the resources are required to be used (or sold, disbursed, or consumed) or when use is first permitted has begun, or the resources are being maintained intact, as specified by the provider.



Reimbursements. applicable program.

The

provider

offers

resources

on

a

reimbursement

("expenditure-driven") basis, and the recipient has incurred allowable costs under the

Contingencies (applies only to voluntary nonexchange transactions). The provider's offer of resources is contingent on a specified action of the recipient and on the action having occurred. For example, the recipient is required to raise a specific amount of resources from third parties or to dedicate its own resources for a specified purpose, and it has complied with those requirements.

(3)

Revenue

Recognition. The

timing

of

recognition

of

assets,

liabilities,

and

expenses/expenditures resulting from nonexchange transactions should be the same, regardless of whether an entity uses the accrual or the modified accrual basis of accounting. Asset recognition should occur when all applicable eligibility requirements have been met or when resources have been received, whichever comes first. Revenue is recognized by accrual-basis entities when criteria for revenue recognition described in Statement No. 33 have been met. For modified-accrual-basis entities, revenue also has to be "available," defined as revenue that has been collected in the current period or will be collected soon enough after the end of the current period to pay liabilities of the current period. In March 2000, the GASB issued Interpretation No. 6, Recognition and Measurement of Certain Liabilities and Expenditures in Governmental Fund Financial Statements-an interpretation of NCGA Statements 1, 4, and 5; NCGA Interpretation 8; and GASB Statements No. 10, 16, and 18, which further defines "available." GASB Statement No. 33 also provides guidance on recognizing promises made by private donors, contraventions of provider stipulations, and nonexchange revenues administered or collected by another government. Statement No. 33 is effective for periods beginning after June 15, 2000. (ii) GASB Statement No. 34. Statement No. 34 establishes new reporting requirements for financial statements of state and local governments. Traditionally, governments have used a financial reporting model that is substantially different from that used in the private sector. Statement No. 34 continues many of the characteristics of the traditional governmental financial reporting model but changes some and adds others. The changes to the reporting requirements are the most comprehensive in the history of state and local government reporting. These changes were necessitated by the substantially different and more comprehensive information required by financial statement users. Instead of the previous focus on individual funds and fund types, which were reported in the aggregate, the emphasis is now on both "government-wide" and "fund" financial statements.

The old concept of funds has been retained, but in a different format. Both types of financial statements will be required. Also required are both a management's discussion and analysis (MD&A) and other expanded required supplementary information (RSI). Thus, the new format will include MD&A, government-wide statements, fund-based statements, notes to financial statements, and RSI. While the focus of financial reporting on funds and groupings of funds will continue, the new financial reporting model adds reporting on the overall governmental entity. The government-wide financial statements will be reconciled to the fund financial statements on the face of the fund statements or in a separate schedule. Fund financial statements under the new model will be based on major funds rather than on types of funds. Paragraphs 74 and 75 of GASB Statement No. 34 provide specific rules for determining what constitutes a major fund. All nonmajor funds will be aggregated and presented in a single column. The modified accrual basis of accounting will continue to be used for the fund financial statements. When those financial statements are included within the government-wide financial statements, however, the full accrual basis of accounting will be used. The new financial reporting model requires comparisons of actual results with both the original and the final amended budget. Budgetary comparisons will be required for the general fund and individual major special revenue funds. Statement No. 34 calls for the comparisons to be presented as RSI following the notes to the financial statements; however, a government may elect to continue the practice of presenting budgetary comparisons as a basic financial statement. GASB Statement No. 34 requires that the financial statements be accompanied by MD&A, which is an analytical overview of the financial statements. MD&A is considered to be required supplementary information covered by AU Section 558. GASB Statement No. 34 mandates the reporting of infrastructure assets, such as roads, bridges, tunnels, and dams. They should be recorded at historical cost, if known, or estimated cost. Further, for larger governments, this requirement will apply retroactively to infrastructure assets that were acquired in fiscal years beginning after June 15, 1980, or that received major renovations or improvements since that date. These assets will be subject to depreciation unless the government meets the qualifications of paragraph 23 of Statement No. 34 for using a modified approach of reporting costs of preservation of infrastructure assets in lieu of depreciation. Many, but not all, of the financial and reporting standards of the GASB and its predecessor, NCGA, will be superseded when Statement No. 34 becomes effective. Other major changes made by Statement No. 34 include the following: Requiring use of the direct, rather than the indirect, method of reporting cash flows Limiting the use of fiduciary funds to accounting for resources that are not available to support government operations and programs Eliminating the distinction between expendable and nonexpendable trust funds (both will be called "private purpose" trust funds) Using a new "permanent fund" to account for endowment-type arrangements available to support governmental operations or programs



Eliminating the enterprise fund equity account "contributed capital"; all contributed capital will be accounted for as a separate category of revenue Reporting government-wide financial statement equity as "invested in capital assets net of related debt," "restricted," or "unrestricted" Eliminating account groups previously used to report general fixed assets and long-term debt, and reporting such assets directly in the government-wide financial statements



Encouraging the reporting of assets and liabilities in the government-wide financial statements in the order of their relative liquidity, although reporting of such assets and liabilities as current and noncurrent is permitted



Reporting current and noncurrent assets and liabilities by proprietary funds Using a new "net expense" format for reporting government-wide activities Classifying transfers in a single category rather than multiple categories Requiring other supplementary information Establishing special reporting for special-purpose governments, for example, assessment districts and water utilities, as opposed to general-purpose government reporting

The effective date for GASB Statement No. 34 is staggered, based on the government's total annual revenues for the first fiscal year ending after June 15, 1999, and ranges from fiscal years ending after June 15, 2002, to those ending after June 15, 2004. In all cases, earlier implementation is encouraged, and the GASB recommends that both Statement No. 33 and No. 34 be implemented together. (iii) GASB Statement No. 35. In November 1999, the GASB issued Statement No. 35, Basic Financial Statements-and Management's Discussion and Analysis-for Public Colleges and Universities-an amendment of GASB Statement No. 34, which generally requires public colleges and universities, in their separately issued financial statements, to follow the guidance in Statement No. 34 for special-purpose governments engaged only in business-type activities, only in governmental activities, or in both governmental and business-type activities. The effective dates parallel the effective dates for Statement No. 34. 38.3 RISK FACTORS AND AUDIT REACTION This section discusses risk factors that are prevalent in the governmental environment and their audit implications. (a) Types of Governmental Audits Both the auditor and management of the governmental unit should understand the type and scope of the audit to be performed. The Yellow Book describes two types of governmental audits. (i) Financial Audits. Financial audits include financial statement audits and financial related audits.



Financial statement audits are concerned with whether the financial statements present fairly the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. Financial statement audits also include audits of financial statements prepared in conformity with any of several other bases of accounting discussed in SAS No. 62, Special Reports (AU Section 623).



Financial related audits are concerned with whether (1) financial information is presented in accordance with established or stated criteria, (2) the entity has adhered to specific financial compliance requirements, or (3) the entity's internal control over financial reporting and safeguarding assets is suitably designed and implemented to achieve the control objectives.

(ii) Performance Audits. Performance audits include economy and efficiency audits and program audits. Economy and efficiency audits are concerned with (1) whether the entity is acquiring, protecting, and using its resources (such as personnel, property, and space) economically and efficiently, (2) the causes of inefficiencies or uneconomical practices, and (3) whether the entity has complied with laws and regulations concerning matters of economy and efficiency. Program audits are concerned with (1) the extent to which the desired results or benefits established by the legislature or other authorizing body are being achieved, (2) the effectiveness of organizations, programs, activities, or functions, and (3) whether the entity has complied with laws and regulations applicable to the program. Performance audits traditionally have been performed by federal or state government auditors. If during the course of a financial audit, however, an independent auditor identifies an opportunity for improved economy or efficiency, he or she should consider communicating this to management. (b) Single Audit Considerations The auditor frequently is engaged to perform an audit of a governmental unit in accordance with OMB Circular A-133 and the Single Audit Act. Referred to as a "single audit," it requires that the auditor perform procedures beyond those required by GAAS and GAGAS, in terms of both their nature and extent. The requirements of the Act are covered in Chapter 32. For audit efficiency, the auditor should consider the requirements of Circular A-133 and the Act when planning the engagement. For instance, federal regulations specify criteria for selecting grant costs to be tested in a single audit. The Act also specifies that the auditor obtain an understanding of controls used in administering federal financial assistance. Early identification of the requirements of the Act can prevent unnecessary duplication of efforts. (c) Risk Factors and Materiality Considerations

The auditor should be sensitive to certain elements of risk that are unique to formulating a strategy for a governmental audit. For example, the absence of a unified, consistent level of overall financial management in many governmental units suggests that the strength of management and the performance of specific departments or programs may vary widely. The auditor also should be sensitive to the materiality implications of autonomous, decentralized, individual entities and programs. A single department, program, or grant that is discovered not to be in compliance with laws, regulations, or contract terms may generate publicity and attendant effects far out of proportion to the normal materiality considerations in a commercial or industrial environment. In this regard, the Yellow Book states, "In an audit of the financial statements of a government entity that receives government assistance, auditors may set lower materiality levels than in similar-type audits in the private sector because of the public accountability of the entity, the various legal and regulatory requirements, and the visibility and sensitivity of government programs, activities, and functions." Also, as noted earlier, SAS No. 74 requires auditors to design audits to provide reasonable assurance that the financial statements are free of material misstatements resulting from violations of laws and regulations that have a material effect in determining financial statement amounts. Therefore, the auditor should consider external pressures exerted by the political process and the nature of the governmental unit's constituency. Much can be learned about the expectations of those constituencies by reading newspapers and minutes of council and legislative proceedings, hearings, and investigations. The auditor should consider the level of financial statements on which his or her opinion is to be expressed. If the auditor has been engaged to express an opinion on the combined, or general-purpose, financial statements, materiality should be determined separately for each fund type and account group, and the individual discrete component units should be presented in side-by-side columns. In this case, the fund type and account group and component unit columns are considered to be elements of the financial statements. If the auditor has been engaged to express an opinion on the individual fund statements, materiality should be established at that level. In addition, there are no working capital or income measurements in governmental accounting, so the auditor must look to other measures of materiality, such as total assets, liabilities, fund balances, revenues, and expenditures. (d) Overall Audit Strategy and Planning Considerations As mentioned earlier, governmental accounting uses the modified accrual basis, which focuses on the measurement of financial flows as opposed to profit or loss. As a result, the balance sheet often does not include productive assets, such as inventory and fixed assets, that enter into the determination of income. In addition, receivables and payables on the balance sheet usually are not derived from the revenue and purchasing cycles, but are recorded as assets independently of those cycles. For these reasons, it is often more efficient to test the flow of transactions and the resulting operating accounts separately from the balance sheet accounts. For example, based on the inherent risks identified and the understanding of internal control, the auditor may decide to perform tests of controls directed at the authorization and accuracy of input of transactions and at the completeness and

accuracy of accumulated data for the purchasing cycle. If those tests support an assessment of control risk at low, the auditor might restrict substantive testing of the operating accounts affected by the purchasing cycle to analytical procedures, but might perform detailed substantive tests to satisfy the audit objectives for accounts payable. Computer software can be used to enhance the efficiency of governmental audits. For example, governmental entities frequently combine the cash balances of their agencies in order to be able to invest in assets with higher yields than otherwise would be available or to facilitate the treasury function in other ways. Software can be used to test both the distribution of interest to the various agencies and the accuracy of the equity positions of the individual agencies in the pooled cash fund. Similarly, software may be used to test assessed tax rolls, including calculation of the tax on individual properties and its distribution to the appropriate governmental agencies or units. (e) Management Representation Letter In addition to the items applicable to audits of business entities generally, a governmental management representation letter should cover several areas that are specific to governmental units and activities, namely, the inclusion of all component units, the proper classification of fund types and account groups, and compliance with budgets, laws, and regulations and with grant requirements, and management's responsibility for identifying and disclosing to the auditor all laws and regulations that have a direct and material effect in determining financial statement amounts. Changes in government administrations may cause difficulty in obtaining representations from former officials, and their replacements may not be willing or able to provide representations about periods and events that occurred before they took office. This could lead to a scope limitation that would require a qualified opinion. 38.4 TYPICAL TRANSACTIONS Many governmental units use the cash basis of accounting throughout the year, with budgetary controls for expenditures, and adjust their accounting to the modified accrual basis at year-end for financial statement presentation purposes. By contrast, most commercial enterprises use the full accrual basis of accounting, which provides a degree of control over both revenues and expenditures by permitting analysis of interim financial statements as well as the timely comparison of control accounts with their supporting detail. Because of these differences in bookkeeping methods, the auditor of a governmental entity often devotes more attention to the flow of transactions than to the resulting balance sheet accounts. He or she should therefore have a thorough understanding of the transaction cycles and of the laws and regulations that govern the entity's transactions. As discussed earlier, a governmental entity's adoption of GASB Statements No. 33 and No. 34 will change the accounting for many of its transactions and significantly change the government's financial reporting. The discussion of typical transactions and related controls in the main volume is based on accounting and reporting under standards predating Statements No. 33 and No. 34.

(a) Budget Cycle A government's budget is a financial plan that contains the legal authority to spend money and incur liabilities. The budgetary process and the role that budgets play in governments differ from comparable considerations in business enterprises. Because a government's budget has the force of law once it has been adopted, it has great significance to both the governmental unit and the auditor. NCGA Statement No. 1 recommends that annual budgets be adopted by every governmental unit (whether or not required by law or regulation). Budgetary control should be provided through the accounting system, and budgetary comparisons should be included in the appropriate financial statements. The annual budget should be established in accordance with applicable legal requirements, which might include, for example, holding public budget hearings, publishing the proposed or final budget, and approval of the budget by a higher level of government or the citizenry. The budget must conform to any applicable revenue and expenditure limitation laws or regulations; supplemental appropriations and budgetary transfers also must be in accordance with governmental regulations and limitations. The adopted budget and subsequent supplemental appropriations should be recorded in the accounting system as a means of controlling expenditures and permitting management to monitor compliance with the budget on an ongoing basis. Budgetary controls frequently provide for a review of the remaining appropriation before final approval is given for an expenditure. Encumbrance accounting, described earlier, also enhances budgetary control by reducing the remaining appropriation when purchase orders are issued. Because the budget cycle is central to the operations of a governmental unit, the auditor usually places particular emphasis on the cycle when assessing control risk. That is, the auditor will seek evidence that controls, as they affect the budget cycle, have been properly designed and placed in operation, and are operating effectively. (b) Revenue Cycle Governmental revenues can be classified conveniently into seven types: Assessed taxes Self-assessed taxes Intergovernmental revenue Revenue received for governmental services Licenses, fees, permits, and fines



Investment revenue Contributions and donations

The aspects of each type of revenue that are unique to governments are discussed in this section. Controls for cash receipts are similar to those in commercial and industrial enterprises. (i) Assessed Taxes. The primary sources of revenue in this category are real property and special assessment taxes, which are levied according to the various state and local tax regulations. Many municipalities assess, levy, and collect their own property taxes. Sometimes the assessing, billing, and collecting are performed by one governmental entity for a group of entities. In such cases, a portion of the funds is retained by the collecting entity and the remaining amounts are recorded as "additions to agency funds" for future distribution to the other governmental entities. In such instances, the collecting government acts as a "service organization" for the other governments. SAS No. 70, Reports on the Processing of Transactions by Service Organizations (AU Section 324), provides guidance on assessing internal control of service organizations and for entities whose transactions are processed by service organizations. The auditor should have a clear understanding of the controls over the tax assessing and collection process as well as controls over appealing and changing valuations. (ii) Self-Assessed Taxes. Revenue in this category is based on taxpayer assessments; the accurate determination and reporting of amounts due are the responsibility of individual taxpayers. Examples of self-assessed taxes are income, sales, excise, utility, and personal property taxes. As with assessed taxes, sometimes one governmental entity collects self-assessed taxes for a group of entities. The recording of taxes collected by this process is the same as for assessed taxes. Income taxes may present an audit problem because the source documents-the tax forms-may be covered by a confidentiality law that prevents the auditor from obtaining and testing them. In that event, the auditor may have to use the work of the governmental entity's internal auditors, which may involve testing their work or even designing specific procedures for them to follow. [SAS No. 65, The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements (AU Section 332), provides guidance.] For other self-assessed taxes, such as sales taxes, the auditor should consider the existence of a master file of taxpayers and the government's procedures applied to the file, including examinations. (iii) Intergovernmental Revenue. Intergovernmental revenue received by state and local governments can take one of three forms: Entitlements and shared revenue, which are based on a legally established or predetermined amount Collections, which result from collections made by another governmental entity



Expenditure reimbursement-type grants, which are received as partial or full reimbursement of expenditures that meet certain preestablished criteria

There are two audit concerns about intergovernmental revenue. The first is ascertaining whether completeness and accuracy controls have been designed and placed in operation. The second is determining that the governmental unit is in compliance with the terms of the law or regulation establishing the revenue. As discussed later in the chapter [Section 5(b), Contingent Liabilities from Grant Noncompliance], noncompliance with laws or regulations may cause accounts to be uncollectible or may require repayments. (iv) Other Governmental Revenues. Transactions involving revenues from services; licenses, fees, permits, and fines; investment revenue; and contributions and donations generally are recorded on the cash basis. Control objectives for such transactions relate principally to completeness of input. (c) Purchasing Cycle The purchasing cycle consists of two distinct parts (goods and services, and payroll). The auditor's primary concern for both is that transactions are properly authorized. In a governmental unit, the objective of proper authorization of expenditures has implications beyond those in other entities. Proper authorization implies that the expenditure is part of a legally adopted budget, that the persons contracting for the goods or services and approving their payment are properly authorized to do so, that the goods or services have been received, and that all laws and regulations affecting the expenditure (e.g., a requirement to obtain competitive bids) have been complied with. In obtaining an understanding of internal control and assessing control risk for the purchasing cycle, the auditor needs to be aware that some important controls may not be applied as part of financial transaction processing. For example, a payment made to or on behalf of an individual under a government grant may require the individual to meet certain criteria in order to be eligible to receive the payment. The determination of eligibility, which is an important part of the authorization and payment process, often is made by someone outside of the financial area, such as a program administrator. The auditor needs to be aware of this and consider it when assessing control risk. A significant and unique control in government payroll systems is known as "position control." Governments budget specific numbers of people in prescribed employment categories or positions at specified salary levels. For example, a department may be assigned one manager, two assistant managers, and four clerks. A position master file, similar to the employee master file, is created and maintained, based on the budget. In obtaining an understanding of internal control and assessing control risk, the auditor should consider controls established to ensure that changes made to both of these files are properly authorized. The auditor generally performs tests to determine that the position master file and the employee master file match, that salaries conform with the budget, and that the positions and salaries are authorized by the budget.

Government payroll systems are often structured so that employees, once they are included in the employee master file, continue to receive paychecks unless some positive action is taken to remove them from that file. That is, the payroll system typically is not based on time reporting by employees. As a result, there is the possibility of phantom employees. In assessing control risk, the auditor should consider whether controls exist to ensure that only employees who are properly includable on the payroll are paid and that they are paid in accordance with required attendance. Payroll costs (and related overhead charges) may be chargeable to grants and thus reimbursable. Controls often are established to ensure that work was actually performed on grants, and that payroll costs are appropriately classified and allocated to those grants. Under the single audit approach, discussed earlier, compliance with the terms of some grants is tested as part of the requirements of OMB Circular A-133. In addition, the auditor may wish to test whether payroll rates related to federal grants comply with applicable local ordinances. The union-scale requirements of the Davis-Bacon Act are also important for construction projects financed with federal grants. 38.5 SUBSTANTIVE TESTS This section discusses those aspects of substantive tests that are unique to audits of governmental units and activities. Most audit objectives and procedures to meet them are, of course, similar to those for business enterprises and are not discussed here. (a) Balance Sheet Accounts As discussed earlier, a governmental entity's adoption of GASB Statements No. 33 and No. 34 will change many of the accounts previously used in its financial reporting. The following balance sheet accounts, substantive tests of which are described in the main volume, will no longer exist once Statements No. 33 and No. 34 are implemented: General fixed assets group Reserve for encumbrances Designated fund balances

(i) Receivables from Taxes. Governmental fund-type revenue presently is recognized under the modified accrual basis of accounting, that is, when it becomes measurable and available. (This may change when GASB Statement No. 11 is implemented, as discussed earlier.) The concept of measurable and available has not been quantified for all sources of revenue. NCGA Interpretation No. 3, however, specifies that property taxes that are due as of the balance sheet date and are expected to be collected within 60 days of year-end should be recognized as revenues; other taxes that have been assessed are reported as deferred revenues. The auditor often tests the accuracy and collectibility of tax receivables by examining cash receipts after year-end; material receivables resulting from collections by other governmental units may be confirmed. Total property tax revenue typically is reconciled to the value of assessed property.

(ii) Due to and Due from Other Funds, and Other Interfund Accounts. Most interfund account balances are liquidated before year-end; those that are not should be examined to support their treatment as loans rather than as equity contributions. A typical auditing procedure is to reconcile all funds to each other (total due to's should equal total due from's) and to determine that there is a reasonable purpose for the interfund balance (i.e., that it was created by a normal operating interfund activity). The auditor also should determine that the receivable balances can be considered current available resources in the governmental funds. Amounts that are not currently available should be reserved against. (iii) Restricted Assets. Revenue bond indentures frequently require that a specified amount of cash be restricted for debt service or system rehabilitation. Such restricted assets should equal the sum of payables from restricted assets and the equity reserved for the restricted purpose. The auditor should determine that the amount of the restriction has been determined properly in accordance with the regulating instrument. (iv) General Fixed Assets Account Group. The general fixed assets account group is used to provide accountability for capital assets, even though their cost is charged to expenditures of a governmental fund when incurred. This practice was not always followed in the past, with the result that cost records may not be currently available. When the governmental unit establishes fixed asset carrying amounts, the auditor should determine that the procedures for estimating cost are reasonable and consistent. The same is true for assets donated to governmental activities. (v) Liabilities. Governmental accounting systems sometimes do not distinguish between actual liabilities in the form of accounts payable and encumbrances. There is no need to make that distinction for budgetary reporting purposes since both are deductions from budgeted appropriations. The distinction is necessary for reporting under GAAP, however, because expenditures and encumbrances are reported differently, and the auditor should ensure that it is made. The auditor also should perform tests to determine whether the reserve for encumbrances is supported by authorized commitments. Judgments payable, litigation claims, and unfunded pensions and other employee-related accruals should be evaluated to determine that they will be payable from expendable available financial resources. If so, they should be treated as liabilities of the appropriate governmental fund; if not, presently they are treated as liabilities in the general long-term debt account group. (vi) Fund Equity. Changes in aggregate fund balances normally should result only from differences between revenues and other financing sources, and expenditures and other financing uses reported on the operating statement, residual equity transfers as defined in NCGA Statement No. 1, and prior-period adjustments [Statement of Financial Accounting Standards No. 16, Prior Period Adjustments (Accounting Standards Section A35)]. It is not uncommon, however, for governmental entities erroneously to record operating items directly in equity accounts. Accordingly, the auditor should review activity in all fund equity accounts to ensure that all charges and credits that should go through the operating statement have in fact done so. Reserves are established to identify the existence of assets that are not available to be spent currently or assets that have claims against them that are not liabilities at the date of

the balance sheet, such as encumbrances. Designations of fund balances are the result of voluntary management decisions to earmark resources for specific future uses. Designated fund balances should be supported by specific plans approved by senior management and, if appropriate, a legislative body. (vii) Contingent Liabilities from Grant Noncompliance. As noted earlier, grants frequently specify conditions with which the recipient must comply. Although some of those conditions are nonfinancial, such as those that relate to environmental and employment practices, others are of a financial nature, for example, those that specify costs properly chargeable to a grant. If costs are disallowed or a grant is rescinded by the granting agency, a contingent liability could result. The auditor should consider whether instances of noncompliance should result in financial statement accruals or disclosures. Conceptually, there can be no quantitative materiality guidelines for evaluating the extent of a contingent liability that could result from a grant violation. In many cases, an entire grant could legally or contractually be canceled as a result of a minor violation. As a practical matter, however, the act of noncompliance generally has to be very serious to cause the recipient to lose grant funds that are material in relation to the financial statements. That presumption may be tested by reviewing historical records of the grantor's acceptance of performance under similar grants and the effects of disallowed costs, or by discussion with the grantor agency. (b) Comparisons of Budget and Actual and Other Operating Statements As discussed earlier, the reporting of budgetary information will change when a governmental entity adopts GASB Statements No. 33 and No. 34. As noted earlier, a combined statement of revenues, expenditures, and changes in fund balances-budget and actual-is required by NCGA Statement No. 1 for general and special revenue fund types and similar governmental funds for which annual budgets have been legally adopted. The auditor's responsibility for and approach to that statement are the same as for the other financial statements. In addition to the auditing procedures appropriate under GAAS and GAGAS, usually the auditor is subject to a regulatory requirement to test the governmental unit's compliance with statutory and other regulations by comparing budgeted with actual expenditures at the level of detail at which the budget is legally controlled. Actual expenditures reported on this and the other operating statements should be subjected to analytical procedures-budget to actual and current year to prior years-and explanations for variances sought. The budget versus actual comparison should be made using the basis of accounting used to develop the budget. If the budget has been prepared on the modified accrual basis, it may contain GAAP exceptions. Sometimes budgets may be prepared on the cash basis or may include encumbrances. The basis used to prepare the budget should be disclosed and differences between it and GAAP should be reconciled on the face of the statement or in the notes. The auditor may wish to test the current-period encumbrances and the controls for reappropriating these amounts, if applicable to the particular governmental unit. As discussed earlier, encumbrances are a means of measuring total commitments made against a particular

budgetary amount. The auditor may wish to expand the normal cutoff procedures to include encumbrances. When a fund, program, or object of annual budgetary spending authority is exhausted, management should seek a budgetary amendment for further expenditures. Occasionally in such circumstances, management may attempt to override budgetary controls by miscoding expenditures. The auditor should assess the appropriateness of segregation of duties between the expenditure coding and approval functions, and should consider the need to test the coding of expenditures.

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