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McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved Essentials of Accounting for Governmental and Not-for- Profit Organizations Chapter 13: Auditing; Tax-Exempt Organizations; And Performance Evaluation 0 10 20 30 40 50 60 70 80 90 1st Q tr 2nd Q tr 3rd Q tr 4 th Q tr East W est N o r th

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Page 1: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved

McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved

Essentials of Accounting for Governmental and Not-for-

Profit Organizations

Chapter 13:

Auditing; Tax-Exempt Organizations;

And Performance Evaluation

0

10

20

30

40

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60

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Qtr

2nd

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E as t

Wes t

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Page 2: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-213-2

Overview of Chapter 13

• Auditing GNP organizations– Audit Reports

– The Single Audit Act

• Tax issues for nonprofit organizations• Reporting Service Efforts and

Accomplishments (SEA Measures)

Page 3: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-313-3

Source of Auditing Standards

• AICPA – Statements of Auditing Standards (GAAS)

• GAO – Government Auditing Standards (GAGAS)

• AICPA Audit and Accounting Guides– Audits of State and Local Governments– Not-for-profit Organizations

Page 4: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-413-4

The Yellow Book

Government Auditing Standards, issued by the GAO, incorporate AICPA auditing standards and provide extensions that are necessary due to the unique nature of public entities

United States Government Accountability Office

Government

Auditing

Standards

Page 5: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-513-5

Differences in Public Sector Audits

• Auditor knowledge of government accounting and auditing

• Public availability of audit reports

• Written evaluations of internal controls

• Distribution of audit reports and availability of working papers to federal authorities

Page 6: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-613-6

Types of Engagements

• Financial Audits– Provide reasonable assurance that financial statements

are presented fairly in all material respects and comply with GAAP.

• Attestation Engagements Include Reporting on:– Internal controls

– Compliance with laws and regulations

– Prospective financial information

– Costs under contracts

Page 7: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-713-7

Types of Engagements (cont’d)

• Performance Audits– Economy and efficiency audits --

• involve aspects of appropriate acquisition, use, and safeguarding of resources

– Program audits -- • assess the degree to which mission objectives have been

achieved while adhering to applicable laws and regulations

• Nonaudit Services– Providing or explaining information – Providing advice or assistance to management

Page 8: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-813-8

Financial Statement Audits

• Auditors must first determine a level of materiality

• Financial statement audits involve – examination of transactions on a test basis,

– forming judgments about internal controls and compliance with laws and regulations, and

– rendering an opinion about whether the financial statements are prepared fairly in accordance with GAAP.

Page 9: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-913-9

Opinion Units

• Because of the various levels of reporting (government-wide, fund-type, and individual fund) the auditor must determine a level of materiality for each.

• A separate materiality evaluation is made for:– Governmental activities

– Business-type activities

– Each major fund

– Aggregate component units

– The aggregate of all remaining fund information

Page 10: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-1013-10

Opinion units (cont’d)

• One effect of reporting on opinion units is that some opinion units may receive unqualified opinions while others receive modified opinions.

• For example: failure to report infrastructure assets could result in an adverse opinion regarding the governmental activities (government-wide statements) and an unqualified opinion for all other component units.

Page 11: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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The auditor is required to prepare up to five reports:

1. A report containing an opinion on the financial statements.

2. A report discussing the evaluation and testing of internal control and compliance with laws and regulations.

3. A report discussing significant deficiencies in internal controls.

4. A report describing instances of fraud, illegal acts, or other material noncompliance.

5. A report containing the views of responsible officials of the audited organization regarding any reported significant deficiencies.

Page 12: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-1213-12

Types of Audit Opinions on Overall Statements

• Unqualified -- – Statements appear to be in conformity with GAAP -- no “ifs,

ands, or but” exception type of qualifying language.

• Qualified - – Largely in conformity with GAAP except for some specified

item(s).

• Adverse - – Not in accordance with GAAP.

• Disclaimer - – Not able to express an opinion, usually because auditor was

precluded from doing some necessary procedure.

Page 13: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-1313-13

Purpose of Single Audit Act

• Before 1984, State and local governments and Not-for-profits receiving financial aid from several different federal agencies, had multiple audits.

• The initial Single Audit Act sought to impose one set of stringent audit guidelines so that only one audit would have to be conducted to satisfy multiple grantor agencies.

Page 14: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Single Audit: Development

• The initial Single Audit Acts in OMB circulars A-128 and A-133 required a single audit if federal financial assistance was over $100,000.

• In 1996 A-133 was revised and replaced A-128 . The current threshold for a single audit is federal financial assistance EXPENDITURES of over $500,000.

• If federal assistance > $500,000 but is all from one agency, a program audit may be used instead of a single audit.

Page 15: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Supervision of Single Audits

• Oversight agency – Agency with largest grants receive audit reports

• Cognizant agency– Entities with $50 Million or more of federal

awards are monitored by a cognizant agency -- agency with largest grants normally selected

• Compliance supplement -- includes any special guidelines for particular grants

Page 16: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-1613-16

Risk-based Audit Process

• Must consider effect of pass-through entities and subrecipients

• Must identify MAJOR programs• Group programs using risk-based approach

– Type A - larger programs– Type B - smaller programs and low risk large

programs– Type A programs receive closer auditing than

Type B’s

Page 17: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Selecting Programs for Audit

• Generally, the auditor is required to express an opinion on compliance on major programs which must add up to 50% of the federal funds expended by the audited organization

• However, if the audited organization is determined to be “low risk”, the percentage is lowered to 25%

Page 18: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-1813-18

The Sarbanes-Oxley Act

• Signed into law in 2002 in response to scandals in the business sector

• Intended to improve corporate governance and limit the services accounting firms may provide to their audit clients.

Page 19: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-1913-19

The Sarbanes-Oxley Act cont’d

• While act only applies to corporations filing with the SEC, it has changed the way public accounting forms relate to all their clients, including governmental and NFP.

• The Act has influenced governing boards and many NFP Boards have begun to model themselves on corporate governance “best practices” initiated by SOx

Page 20: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-2013-20

Governmental Auditing Standards

• GAO standards for independence already prohibit auditors from performing many non-audit services.

• Like governmental accounting, governmental auditing follows a unique set of guidelines established by the GAO that require auditors to evaluate and report on the system of internal controls and compliance with laws and regulations.

Page 21: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Sarbanes-Oxley Act has changed the world

• As a result of heightened public awareness for the importance of accountability and independence, other provisions of the SOx Act are being voluntarily adopted by NFP organizations.

• Pressure to adopt these practices has come from funding foundations that have announced that SOx compliance will be a factor in the awarding of grants.

Page 22: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-2213-22

Tax-Exempt Organizations• Most nonprofits file IRS form 1023 Application

for Recognition of Exemption to obtain favorable tax treatment for donors

• Local law governs exemptions from sales tax and property tax.

• Most NFPs must still file an IRS Form 990 information return if gross receipts are over $25,000.

• NFPs with over $1000 of unrelated business income file Form 990-T.

• Other reports may be filed with the state.

Page 23: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-2313-23

Tax Code: Types of nonprofits

• The tax code specifies several different classes of nonprofit organizations by purpose.

• The most common are §501(c)(3) organizations

Page 24: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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§501(c)3 Organizations

– Include religious, charitable, scientific, literary, educational, amateur sports organizations, orgs for prevent of cruelty to children or animals.

– Requires that no dividends be paid and no substantial political activity.

– 501(c)(3)’s status allows donors to take a charitable deduction on their U.S. tax return for donations.

Page 25: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Form 990 Information Return• Requires financial statement information similar to

that required by GAAP.– Also reveals information about compensation of highest

paid employees and contractors.• Taxpayer Bill of Rights 2 (1996) requires that 990s

must be made available to those who request it -- commonly posted to a web site.

• Also asks questions to make sure the organization is still operating in accordance with its exempt mission.

Page 26: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Unrelated Business Income Tax

• Tax-exempt organizations are required to pay tax (at the corporate rate) on income generated from a trade or business unrelated to the entity’s tax-exempt purposes

• The purpose of the tax is to prevent nonprofits from having an “unfair” tax advantage over business enterprises with competing goods and services

Page 27: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Unrelated Business Income Tax

• Even unrelated business income will be exempt from income tax if– Not carried on regularly– Run by volunteers– Involves sales of donated items– Operated for convenience of employees

and patrons.

Page 28: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-2813-28

Income Exempt from UBIT

– Some income is given specific exemption:• Royalties, dividends, interest and annuities• Research revenues• Income from public entertainment at a fair• Revenues from labor, agriculture, or business

trade shows• Income from rental or exchange of

membership lists

Page 29: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-2913-29

Performance Evaluation - Ratios

• To compare entities of varying size, it is useful to compute financial ratios– Not-for-profit Ratios– Governmental Ratios

Page 30: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-3013-30

Not-for-Profit Ratios

A. Program Expense Ratio: Program Service Expenses Total Expenses

What proportion of each dollar is used on programs?

B. Fundraising Efficiency: Fundraising Expenses

Contribution Revenue

How much does it cost to raise a dollar of contributions?

Page 31: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Not-for-profit Ratios (Cont’d)

C. Working Capital Ratio (Current Assets – Current Liabilities) Total Expenses

If multiply by 12 months: How many months of operating expenses

are available in working capital?

Page 32: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Governments:Users of Financial Statements

• Citizen groups

• Legislative and oversight officials

• Investors

• Creditors

Page 33: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Bond Markets and Financial Analysis

• The CAFR is a major data source for professional bond rating agencies such as– Moody’s, Standard and Poor’s, Fitch’s Investors

Services– Bonds are rated from Aaa to C – Insured bonds are automatically rated Aaa

• The financial condition of state and local governments affects the cost of debt and/or bond insurance.

Page 34: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Common ratios: Debt balances

• Net debt per capita– Shows average outstanding debt per citizen

• Net debt to fair value of property– Shows % of debt outstanding on taxable property

• Net debt to assets– A measure of solvency – can be computed

separately for governmental and business-type activities

Page 35: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Common ratios: Net Asset balances

• Net assets/Expenses – A measure of overall financial position

• Unrestricted net assets/ Expenses– A more conservative measure of availability of

resources to meet expenses

Page 36: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Common ratios: Governmental fund statements

• Unreserved fund balance as % of revenues (General Fund)– Shows level of rainy day fund

• Governmental revenues per capita:– Shows the citizen tax burden

• Debt service to total expenditures: Principal and interest payments/total expenditures of general, and debt service funds– Shows % of budget used up for debt repayment

Page 37: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Common ratios: Enterprise Fund Statements

• Interest coverage – revenue bonds– (Total Revenues – operating expenses) /

interest expense.– Shows degree of credit risk

• Operating ratio – enterprise funds– (operating expenses, excluding

depreciation) / operating revenues. Useful even if the enterprise fund has no debt.

Page 38: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Common ratios cont’d

• Other issues to consider– Population trends, – trends in assessed values, – economic trends, – debt limits and margins, – pension position,

– current issues in the news, etc.

Page 39: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

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Service Efforts and Accomplishments Reporting

• Because the bottom line is not a good indicator of government performance, governments often provide non-financial performance measures.

• Examples include crime statistics, lane-mile of highways maintained, cost per student, etc.

• The GASB has reserved the authority to one day begin to issue standards governing SEA reporting

Page 40: McGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin©2007, The McGraw-Hill Companies, All Rights Reserved Essentials

13-4013-40

SEA Levels of Reporting

• Input – resources dedicated to a problem

• Output – the quantity of service provided

• Outcome – the extent to which results are achieved or needs are satisfied

• Efficiency – relate costs (inputs) to output measures

• Cost Outcome – relate inputs to outcomes