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Financial Statement Preparation, Audit Findings and Auditor Independence

As featured in The Government Finance Officers Association's Newsletter on Governmental Accounting, Auditing, and Financial Reporting.

A small government that is not able to prepare its financial statements in conformity with generally accepted accounting principles (GAAP) may nonetheless possess the skills, knowledge, and experience (SKE) necessary to oversee the financial statement auditor's preparation of GAAP financial statements on their behalf. Auditors who find themselves in this position have been known to ask whether doing so compromises their independence or would result in an audit finding.

Management, of course, is responsible for the fair presentation of the financial statements, while the independent auditor is responsible for opining on whether the financial statements are fairly presented. Frequently, especially in the case of smaller governments, management is quite capable of keeping its books and records in a manner sufficient for internal managerial needs, but not sufficient for external financial reporting in conformity with GAAP. This disconnect may be limited to the year-end-only requirements of government-wide financial reporting and note disclosure, or it may extend to other adjustments necessary to convert non-GAAP internal financial statements to a GAAP-basis presentation. Regardless, management is responsible for establishing internal controls over the preparation of GAAP-basis financial statements.

That does not mean that management has to actually prepare the financial statements, only that it has to have adequate internal controls over their preparation. It is entirely acceptable for management to "outsource" the preparation of the external financial statements to their independent auditor as a matter of efficiency/convenience (after all, management would only prepare financial statements once each year, whereas auditors likely would do so multiple times for their various clients). Even so, management still would have to have internal controls in place to review the financial statements and provide reasonable assurance that any misstatements would be detected and corrected (auditors have been known to make mistakes too!)

An auditor may determine that management, while taking responsibility for the financial statements, actually lacks the internal controls necessary for their proper preparation. The auditor might base such a determination on actual errors identified and adjustments required during the preparation of the financial statements, or based on an assessment of management's understanding of the more complex aspects of government-wide financial reporting and/or note disclosure requirements. If so, it is appropriate for the auditor to report a finding (either a material weakness or significant deficiency in internal control over financial reporting).

Turning to the issue of auditor independence, Government Auditing Standards (commonly known as the "Yellow Book") specifically identifies financial statement preparation as a "nonaudit service" that poses a potential threat to an auditor's independence. That threat is not insurmountable, but does haves to be evaluated using the conceptual framework laid out in the Yellow Book. The specific risk is that the auditor could be auditing his/her own work, and the typical safeguard put in place to mitigate that risk to an acceptable level is the assignment of a senior member of management to oversee and take responsibility for the work of the auditor. However, in order for this safeguard to be effective, the management representative would need to have the skill, knowledge, and experience necessary to effectively serve in this capacity. Note, however, that the Yellow Book expressly states that this individual "is not required to possess the expertise to perform or reperform the services" (paragraph 3.34).

A home improvement analogy might be helpful to illustrate these points. Assume a homeowner is reasonably handy around the house, but not well suited to even minor plumbing tasks. If that homeowner needed to have a new garbage disposal installed under the kitchen sink, the homeowner probably would need to hire a professional to do so. Now, the homeowner may well understand at least some of the mechanics of the process (the disposal is mounted to the underside of the sink drain, rubber gaskets are used to make a firm seal, plumber's putty is applied to further strengthen the bond, the water drain hose from the dishwasher connects to the port on the side of the disposal using a PVC clamp, and the trap drain connects at the bottom in the same way). Likewise, once the plumber has finished, the homeowner can run water down the disposal, check for leaks, and generally satisfy himself/herself that everything appears to be in good working order. All the same, the homeowner would have no idea if the work was up to the standards of the local plumbing code, but would just have to take the plumber's word for it.

In the preceding example, the homeowner, of course, plays the role of management and the plumber plays the role of the financial statement auditor. The homeowner is fully responsible for the operation of the garbage disposal, just as management is fully responsible for the fair presentation of the financial statements. Also, the homeowner is unable to replace the garbage disposal or to determine that it is installed in full compliance with the local plumbing code, just as management is unable to prepare the financial statements and determine that they comply with GAAP. In that case, management would appropriately receive a finding because it failed to have internal controls over financial reporting. However, the auditor's independence would not be compromised so long as management had sufficient SKE to oversee the auditor's financial statement preparation and take responsibility for it.

Put another way, there is a continuum of potential auditor involvement in the process. There is a point at which management's knowledge of GAAP is insufficient to avoid a finding, but still sufficient to preserve auditor independence. However, once the client's knowledge has fallen below the threshold necessary to demonstrate SKE (a very subjective determination, to be sure), auditor independence would be impaired as well. In this last case, there are several potential options.

  • Management could get training sufficient to raise its SKE to an acceptable level. For this to work, the training needs to be substantive (e.g., a certificate of completion for a four-hour class is no substitute for actual SKE).
  • A member of the community or board with a financial background, could work together with management so that the government could collectively demonstrate an appropriate level of SKE.
  • The government could outsource either its year-end audit preparation or the review of the auditor-prepared draft financial statements to another CPA firm or individual. This approach could be expensive, and governments are well advised to turn first to another local government. For example, neighboring school districts could sharing share a single finance director for these higher level needs, while maintaining separate accounting staffs.

One final note: while no longer included in the authoritative auditing literature, the example presented in Statement of Auditing Standards No. 112 of an entity that has appropriate internal controls over the preparation of GAAP-basis external financial statements is still very helpful. In that example, the American Institute of Certified Public Accountants illustrated that one way that an auditor could document that a finding was not warranted was by: 1) providing draft financial statements and grouping codes (that map the client's T/Btrial balance to the F/Sfinancial statements) to management; 2) having management prepare or review a disclosure checklist (the checklist used by the Government Finance Officers Association's Certificate of Achievement for Excellent in Financial Reporting Program is well suited for this); and 3) by management taking responsibility for the fair presentation of the financial statements and related disclosures (something that is required in any case). My own audit firm uses this approach as the gold standard for documenting why a finding is not warranted when we draft the financial statements as a convenience for our clients with SKE. Again, the key is that management really does have the SKE to provide a meaningful review of the drafts and disclosure checklist. That is a very subjective call, and is based on education, experience, and the general feeling the auditor gets while interacting with management (i.e., do they "get it"?).

Mr. Blann is the Director of Governmental Audit Quality for Rehmann, a regional CPA firm.

 

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