^< /lO HAS?. MassachusettsDepartmentofRevenue DivisionofLocalSen/ices FrederickA.Laskey, Commissioner JosephJ.Cliessey,Jr.,DeputyCommissioner UMASS/AMHERST Audit Primer Prepared by the Bureau ofAccounts January 2001 I LJ visitourwebsiteat a::! http./AwAv.statema.us/dls t MassachusettsDepartmentofRevenue DivisionofLocalServices PurposeofthisPrimer Today, citizens demand more detailed explanations on howefficientlygovernment uses theirtax dollars. In this era oftight budgets, staffreductions and increased public scrutiny, local officials need all the helpful resourcestheycan get. One such helpful resource is an audit. Itstrue benefit, however, depends largely upon one's abilityto understand its concerns and to act upon them responsibly. The purpose ofthis Primeris to help local officials better understand the audit and how to manage more effectivelywith it. RealPeople. RealProblems Thefollowing are actual examples ofconditions thatcan be revealed in an audit. • Unreconciled cash led to mishandled funds. The audit reports oftwo communities detected a financial problem butthe local officialsfailed to act resulting in one caseto imprisonmentand in the otherto possible indictment. • Uncollected taxes and lack oftaxtakings resulted in a free cash deficit. Outstanding taxes affect notonlyfree cash buttaxpayers' confidence in their community'stax administration system and in theirlocal officials. Poor collections can result in revenue borrowing, a reduction to bond rating and to increased interest costs. • Cash receipts notturned overon a timely basis resulted in unwarranted borrowing. Taxeswere notturned overtotheTreasurerfora long period of time resulting in a cash shortfall and a need to borrow cash. • Failuretofile 1099's resulted in penalties. When a town failed to distribute IRS form 1099 to its contractors, thetown had to payconsiderable interest and penaltiestothe IRS. • Conversion from manualto computersystems notclosely monitored, resulted in overtime paid to resolve problems and numerous yearend adjustments. A system conversion, although advantageous, must be monitored to ensure accuracy, otherwise, records may haveto undergo a costly and time-consuming reconstruction. • Unpaid insurance premiums resulted in canceled policies. The and the insurancewas employees, the community insurance premium was nottimely paid canceled. When cash was mishandled bywas unableto recover. MassachusettsDepartmentofRevenue DivisionofLocalServices Whatisanaudit? An audit is an examination ofsystems, procedures, programs and financial data. In fact, the audit is a valuable managementtool in evaluating the performance ofcities and towns. The productofan audit, the audit report/opinion, is prepared by an independent party, an auditor, and explainswhatprocedureswere performed, how, and whatwasfound. The accompanying financial statements arethe responsibilityofthe community. The auditoris concerned with the accuracy ofthesefinancial statements measured in mathematical terms and in terms ofconformancewith GenerallyAccepted Accounting Principles (GAAP). To determinethis accuracy and conformity, the auditorconducts an examination in conformance to anothersetofnational standards known as GenerallyAccepted Auditing Standards (GAAS). Whomayperformanauditformycommunity? Financial audits can be performed by any certified public accounting firm. A listoffirms that have performed municipal audits can be obtained fromthe Massachusetts Society ofCertified PublicAccountants (MSCPA) orthrough the Commonwealth of Massachusetts Bureau ofAccounts. Aswell as being reliable, thesefirms mustalso be independent. An independentaudit is one performed by an auditorganization that isfreefrom personal orexternal impairmentsto independence and maintains an independentattitude and appearance. The auditorganization hasthe responsibilityformaintaining independence sothat opinions, conclusions,judgments and recommendationswill be impartial and will be viewed as impartial by knowledgeablethird parties. Whomustbeaudited? Entities expending $300,000 ormore in federal assistance eitherdirectlyfrom the federal governmentor indirectlythrough a state agency must havewhat is known as a SingleAudit in conformancewith thefederal SingleAuditActof 1984. Asingle audit will coverthe internal and administrative controls covering allfederalfinancial assistance as well asthe central control systems ofthe community. These audits must MassachusettsDepartmentofRevenue DivisionofLocalServices be conducted in accordance with GAAS, GovernmentAuditing Standards and other federal guidance. Entities may have a program-specificaudit ifthey receivefunds from only onefund. These audits mustalso be conducted in accordancewith the previously mentioned guidance and regulations. Entities receiving under$25,000 in federal assistance have no audit requirement bythe Federal Government but must maintain adequate accounting records. IsTHEAUDITREPORTIMPORTANTTOLOCALOFFICIALS? Periodic audits assurethe publicthattheircommunity'sfinancial health and practices are being reviewed by an independent authority. Even when an audit reportdetects trouble, quick and decisive action by local officials can keep the publicconfidentthat theirgovernment is in responsible hands. Whatcananauditdoforyou? Identify areas in need ofimproved and/orofoutstanding financial management. Auditors should review, certain departmental policies and procedures and commenton their legality and/oreffectiveness. Analyzethe overall financial position ofthe communityand recommend improvements. The financial statements thataccompanythe auditor's reportcan be confusing to laymen. Auditors should explain theirfindings sothatyou may actappropriately. Review internal control procedures. Are procedures being performed properly? You, as an elected official, could be at risk. Auditors routinely reviewtimely reconciliation of bank statementsto cash, reconciliation ofreceivables, turnoverofreceipts, timely submission ofcertain stateforms and properwithholding requirements. Have you reviewed these areas lately? Whatdoesanauditinclude? An audit includes a reportofthe auditor's opinion, addressed tothe chiefexecutive officer, signed bythe auditfirm and dated the lastday ofthe auditor's field work. MassachusettsDepartmentofRevenue DivisionofLocalServices According totheAmerican Institute ofCPAs Inc. Statement#58 onAuditing Standards, the basicelements ofthis reportare: a. Atitlethat includestheword independent b. Astatementthatthefinancial statements identified in the reportwere audited c. Astatementthatthefinancial statements arethe responsibilityofthe Company's Community's management and thatthe auditor's ( ) responsibility isto express an opinion on thefinancial statements based on his audit d. Astatementthatthe auditwas conducted in accordancewith generally accepted auditing standards e. A statementthatgenerally accepted auditing standards requiresthatthe auditorplan and perform the auditto obtain reasonable assurance about whetherthe financial statements arefree ofmaterial misstatement f. Astatementthatan audit includes Examining, on atest basis, evidence supporting the amounts and disclosures in thefinancial statements Assessing the accounting principles used and significantestimates made by management Evaluating the overall financial statement presentation g. Astatementthatthe auditorbelievesthat his audit provides a reasonable basisforhis opinion h. An opinion astowhetherthefinancial statements presentfairly, in all material respects, thefinancial position ofthegovernmententityas ofthe balance sheetdate and the results ofits operations and its cash flowsfor the period then ended are in conformitywith generally accepted accounting principles." Whatisthemanagementletter? The management letteristhe portion ofthe audit reportwhere recommendations are included forcorrective action to improve problem areas. Problem areas such as internal control and othermaterialweaknesses, complianceviolations and non- reportable conditionsthatcould signal largerfuture problems could be included. Comments may be included from local officials regarding their responsetothe audit MassachusettsDepartmentofRevenue DivisionofLocalServices reportaswell asfrom the auditorregarding the status ofrecommendations made in priormanagement letters. The management letterand any reportable ormaterial conditions should be used asthe basis ofa corrective action plan. Whatkindofopinionsdoauditorsgive? Thereare basicallyfourtypes ofopinions. • Unqualified or"Clean" Opinion: The auditorstatesthatthe financial statements representfairly (accurately) thefinancial condition ofthe entity on the date ofthe statements and forthefiscal period ending on thatdate. In otherwords, there are no problems with the audit. • Qualified opinion The auditorexplains a departurefrom accounting : standards bythe entity ora limitation in the scope ofauditwork. The auditor then statesthatexceptforthe departure noted in the opinion, the statements are accurate. In this case, there are no majorproblemswith the audit and the qualifications are usually dueto no record offixed assets or unfunded pension liability. Most auditsfall into this category. • Adverse opinion The auditorstatesthatthefinancial statements are notfairly : presented in conformitywith GenerallyAccepted Accounting Principles (GAAP) orthe community has refused to conform with GenerallyAccepted Accounting Principles (overstating fund balance, forexample). • Disclaimerofopinion: The auditorstatesthe he/she is unableto offeran opinion on the fairpresentation ofall ora portion ofthefinancial statements. The auditorwas unable to determine ifthe community'sfinancial statements (balance sheet, forexample ), were correct or incorrectdue to inadequate accounting records. Whatisareportablecondition? According tothe Statement#60 on Auditing Standards bytheAmerican Institute of CPAs Inc., reportable conditions are "significantdeficiencies in the design oroperation ofthe internal control structurewhich could adversely affectthe organization's abilityto record, process, summarize and reportfinancial data consistentwith the assertions of management in thefinancial statements". MassachusettsDepartmentofRevenue DivisionofLocalServices The auditor is required by national standardsto communicate any reportable conditions in writing to management. Someexamples once again according to Statement#60 could be: • Inadequate overall internal control structure design • Absence ofappropriate segregation ofduties consistentwith appropriate control objectives • Inadequate provisionsforthe safeguarding ofassets • Evidence ofwillful wrongdoing byemployees ormanagement". Examplesofreportableconditions Reportable conditions should be noted in the management letter. In such a situation, the management letterwould read asfollows: • We noted certain matters involving the internal control structure and its operation thatwe considerto be reportable conditions understandards established bytheAmerican Institute ofCertified PublicAccountants. Reportable conditions involve matters coming to ourattention relating to significantdeficiencies in the design oroperation ofthe internal control structurethat, in ourjudgment, could adverselyaffectthe organization's abilityto record, process, summarize and reportfinancial data consistentwith the assertions ofmanagement in thefinancial statements. • We noted in ourreviewoftheTreasurer's officethattheTreasureris, also, the Parking Clerk. Although, wefound no evidence ofanywrongdoing, the Treasurercould be in a position as Parking Clerkto void valid parking and not depositthefunds paid bythe violator. • During the audit, we noted thatdepartment headswere not receiving monthly expenditure reports detailing budgetto actual information, thus increasing the potentialforoverexpending appropriated amounts overthefiscal years. • During ourcomparison ofthetaxes receivable detail tothe general ledger, we noted numerous instances ofunrecorded activity. Since periodic reconciliationswere not being performed between the general ledgercontrol balances and the supporting detail, discrepancieswent undetected. MassachusettsDepartmentofRevenue DivisionofLocalServices Whatismateriality? An audit is notdesigned to detectall errors. Thiswould betoo costly. The auditor designsthe auditto detect material errors. According to Gauthier: "A potential erroris considered to be material, (i.e., important, significant) tothe financial statements ifitcould havethe effectofchanging a reader's impression ofthe government'sfinancial position, results ofoperations orcash flows. In makingjudgments concerning a potential error's materiality', auditors consider both its quantitative and qualitative impact." The size alone ofa potential errorcan make itquantitatively material. Forexample, an auditor is likelyto considera potential operating statementerrorexceeding a certain percentage oftotal revenues as material. A potential errorthat changed whatwould have been a surplus into a deficit might be considered material, regardless ofsize. Whatisamaterialweakness? According to Stephen Gauthier's book, "An Elected official's GuideToAuditing," some reportable conditions are more seriousthan others and are ofsuch magnitudethatthey could potentially result in a material misstatementofthefinancial statements. These are known as material weaknesses, one examplewould be a government's failure to reconcile monthly bank statements tothe cash balances reported in the books of accounts. Bydefinition, all material weaknesses are reportable conditions. Notall reportable conditions, however, are material weaknesses. Auditors generally distinguish reportable conditionsthatare material weaknessesfromthosethatare not." WhatisaCorrectiveActionPlan? Acorrective action plan is a formal documentwhich identifiesthe problem, whatwill be doneto correct it, who is responsibleforcorrecting the problem and the reporting mechanism to notewhen the correction is made. Managementshould develop a corrective action plan. Once approved, periodically reporttothe committeethe status ofall corrective actions. The audit committee should MassachusettsDepartmentofRevenue DivisionofLocalServices approvethe plan orreturn itto managementwith theircomments. The Bureau of Accounts can assist in the developmentofsuch a plan ifrequested. Whatmeasurescanacommunitytaketoensureproperinternalcontrol? There are several procedures including periodicaudits, segregation ofduties and periodic reportsfrom local officials. To ensurethatmanagementtakes corrective action on anyconditions reported in the audit report, both publicand private sector organizations have been turning increasinglyto auditcommittees. Whatisanauditcommittee? The auditcommittee is a group ofindividuals responsibleforaudit procurementand monitoring. Cities and towns should considerestablishing a separate auditcommittee to establish the need for, then to receive and reviewthe audit report. As a rule, the completed auditshould not be delivered solelytothe city audit, ortown accountant, for review. The audit committee should include representativesfrom: The Mayor/City Council or Board ofSelectmen Finance committee School committee WaterorSewerCommission (ifseparatelyelected) Town Manager Finance Director/Accountant/Auditor/Treasurer/Collector Informed citizens Audit committees playan important role in providing direction and guidanceto managementand in serving as a linktothe independentauditor. GAAS requiresthat auditors ensurethatthe audit committee is informed ofimportant mattersthatarise in connection with an auditofthefinancial statements. Generally, the auditcommittee should discussthe audit report including the management letterand corrective action plan with the community's managementand require a replytothe auditor's comments. HowSHOULDtheAUDITCOMMITTEESELECTTHEAUDITOR? By MGL, ChapterSOB, Section 15, contractswith certified publicaccountants are not subjecttothe provisions ofthe Uniform ProcurementAct. Nonetheless, a city ortown should requestaudit proposalsfrom CPAs orfirmswith experience auditing local