A primer on FHA's audited financial requirements.

Participants in all of the FHA's insurance programs must meet certain audited financial requirements. Here's a basic review of what participants in FHA programs must do to comply with those requirements.

Lenders participating in FHA mortgage insurance programs must meet certain audited financial statement requirements. This article provides guidance to help lenders comply with those requirements.

The FHA provides insurance for private lenders against loss on mortgages financing homes, multifamily projects, property improvements and other properties. Lenders must be approved to participate in the FHA insurance programs. Participation includes originating, purchasing, holding or selling FHA-insured mortgages.

Approval may be restricted to the single-family (one-to-four dwellings) home mortgage insurance programs or the multifamily mortgage insurance programs. In addition, separate approval is required to participate in the single-family direct endorsement or coinsurance programs.

To participate in the FHA Title I or Title II insured mortgage loan programs, a lender generally must be a supervised lender, a nonsupervised lender, a loan correspondent or a government institution. A Title I or Title II supervised lender is a financial institution that is a member of the Federal Reserve System or whose accounts are insured by the Federal Deposit Insurance Corporation or the National Credit Union Administration.

A Title I nonsupervised lender is a financial institution that has as its principal activity the lending or investing of funds in mortgages, consumer installment notes, or similar advances of credit, or the purchasing of consumer installment contracts and is not a supervised lender or a government institution. A Title II nonsupervised lender is a financial institution that has as its principal activity the lending or investment of funds in real estate mortgages and does not meet the requirements of a supervised lender. A nonsupervised lender whose parent is a supervised institution is not considered to be supervised under HUD's regulations.

A Title I loan correspondent is a financial institution approved to originate Title I direct loans for sale or transfer to a sponsoring financial institution that holds a valid Title I contract of insurance and is not under suspension. A loan correspondent may be either a supervised or nonsupervised institution. A Title II loan correspondent is a lender that has as its principal activity the origination of HUD-insured mortgages for the sale or transfer to its sponsor(s). A lender that qualifies for approval as a supervised lender may also be approved as a supervised loan correspondent. A loan correspondent may have one or more sponsors and a sponsor may have one or more loan correspondents.

A government institution is a federal, state or municipal agency, a Federal Reserve Bank, the Government National Mortgage Association (GNMA), a Federal Home Loan Bank, Fannie Mae or Freddie Mac.

Audited financial statements

Nonsupervised lenders and loan correspondents are required to submit audited financial statements within 90 days of the end of each fiscal year. Supervised lenders, supervised loan correspondents and government institutions are not required to submit audited financial statements. A transmittal letter stating the Title I lender identification number or the Title II lender identification number as well as the lender's name and address should accompany the financial statements.

A lender that is approved to participate in both the Title I and Title II programs may recertify under both programs jointly. A lender may submit only one set of financial statements provided that the statements meet the requirements for both Title I and Title II. The cover letter should state that the lender is recertifying under both programs and must list both the Title I lender identification number and the Title II lender identification number.

The financial statements must include a balance sheet, a statement of operations and retained earnings, a statement of cash flows, notes to the financial statements and a computation of net worth for FHA requirements. The financial statements must conform to generally accepted accounting principles (GAAP).

The financial statements must be audited by a certified public accountant (CPA) or an independent public accountant (IPA), as defined by the Comptroller General of the United States, licensed before December 31, 1970. The CPA firm name, address, phone number and employer identification number (EIN) as well as the name of the individual audit partner or sole proprietor responsible for the audit engagement must be stated in the report or in a transmittal letter accompanying the report.

The audit must be performed in compliance with the Consolidated Audit Guide for Audits of HUD Programs issued by HUD, Office of the Inspector General (OIG) in July 1993 (HUD Handbook 2000.04 REV-1). The audit must cover the financial statements for the fiscal year and must be conform with generally accepted auditing standards (GAAS). In addition, except for Title II nonsupervised loan correspondents, the audit must be conducted in accordance with Government Auditing Standards, 1994 Revision, issued by the Comptroller General of the United States.

The auditor's report on the financial statements, often referred to as the opinion, must be unqualified. The auditor's opinion report must explicitly state that the audit was conducted in accordance with GAAS and, except for Title II nonsupervised loan correspondents, Government Auditing Standards (GAS). The auditor's opinion report also should state that accompanying supplementary information, such as the computation of net worth for FHA requirements, is not a part of the basic financial statements. The auditor's report should state whether the supplementary information is fairly stated in relation to the basic financial statements taken as a whole.

Other audit requirements

In addition to the auditor's report on audited financial statements and supplementary information, nonsupervised lenders and nonsupervised loan correspondents are required to provide an auditor's report on internal controls and an auditor's report on compliance with applicable laws and regulations. These reports are required for every Title II nonsupervised lender regardless of the number of loans originated or serviced during the audit period.

For fiscal years ended on or after November 30, 1995, Title II nonsupervised loan correspondents are no longer required to submit reports on compliance and internal controls. For this reason, the auditor's report for Title II nonsupervised loan correspondents need not state that the audit was conducted in accordance with GAS because GAS requires reports on internal controls and compliance with laws and regulations. However, an audited financial statement, with a computation of adjusted net worth, must still be submitted in accordance with the OIG Audit Guide, (HUD Handbook 2000.04, REV-1).

The rationale for waiving this requirement is that the sponsor is responsible to the department for the actions of its loan correspondents in originating insured mortgages and is required to supervise and perform quality control reviews of its loan correspondents. This includes periodic visits and meetings to make sure the loan correspondent is complying with the department's loan origination requirements and prudent lending practices. Eliminating these reports will reduce the costs of preparing financial statements for loan correspondents, most of whom have limited financial capacity. This waiver will encourage more lenders to participate in the FHA programs and increase the availability of mortgage credit for homebuyers.

The auditor's report on internal controls should be a combined report on the internal control-structure policies and procedures as they relate to both financial reporting and administering the HUD-assisted programs. The report must identify the entity's significant internal control-structure policies and procedures. It also must identify the internal control-structure policies and procedures considered by the CPA and any reportable conditions and material weaknesses noted.

The report on internal controls should state that the audit was conducted in accordance with GAAS, GAS and the Consolidated Audit Guide for Audits of HUD Programs issued by HUD's Office of the Inspector General in July 1993. The report must explicitly cite the OIG Audit Guide issued in July 1993. For financial audits of periods ending on or after January 1, 1995, the 1994 revision of GAS must be used.

The OIG Audit Guide, (HUD Handbook 2000.04, REV-1) provides an example of such a report on page 2-8. The Non-Authoritative Practice Aids of the American Institute of Certified Public Accountants (AICPA) illustrates the sample reports included in Chapter 2 of the HUD Handbook 2000.04 REV-1 as amended by the 1994 revision to GAS, which was effective for financial audits of periods ending on or after January 1, 1995.

The auditor's report on compliance with applicable laws and regulations should follow the applicable example in the OIG Audit Guide, HUD Handbook 2000.04 REV-1, page 2-12, an opinion on compliance with specific requirements applicable to major HUD-assisted programs, or page 2-14, a report on compliance with specific requirements applicable to nonmajor HUD-assisted programs, which receive $300,000 or less for the period under audit. The report on compliance with laws and regulations should state that the audit was conducted in accordance with GAAS, Government Auditing Standards, and the Consolidated Audit Guide for Audits of HUD Programs issued by HUD's OIG in July 1993. The report must explicitly cite the OIG Audit Guide issued in July 1993. For financial audits of periods ending on or after January 1, 1995, the 1994 revision of GAS must be used.

It is expected that the specific compliance requirements identified in the OIG Audit Guide will cover those laws and regulations that, if not complied with, could have a direct and material effect on the financial statements. In such cases, the compliance reports listed earlier and illustrated in the OIG Audit Guide are the only reports necessary for reporting on the audited lender's compliance with laws and regulations. However, if the auditor considers that additional laws and regulations could have a direct and material effect on the financial statements, then the auditor also should cover compliance with those laws and regulations in accordance with the GAS.

The report on compliance should identify and include all material instances of noncompliance. For Title II nonsupervised lenders, all instances of noncompliance, regardless of materiality, must be reported even if corrective action has been taken after the audit period. In addition, the auditor should determine if significant findings from previous audits have been corrected and disclose those that remain uncorrected at the time of the audit. Officials with the audited lending institution must provide a corrective action plan that describes the corrective action taken or the steps planned in response to findings of noncompliance.

Any report on illegal acts should be covered in a separate report in accordance with GAS and sent to the HUD inspector general. Illegal acts are to be reported regardless of whether the condition has been corrected.

Adjusted net worth

Title I and Title II nonsupervised lenders and loan correspondents must meet FHA net worth requirements. The lender's net worth must be based only on assets that are acceptable to FHA. Any unacceptable assets must be deducted from the lender's net worth to determine the FHA adjusted net worth. The OIG Audit Guide, (HUD Handbook 2000.04 REV-1), sets forth a list of unacceptable assets.

Title I and Title II loan correspondents are required to maintain an FHA adjusted net worth of $50,000 plus $25,000 per branch, up to a maximum of $250,000. Title I nonsupervised lenders are required to maintain an FHA adjusted net worth of $250,000. Title II nonsupervised lenders approved for participation only in the multifamily mortgage insurance programs are required to keep an FHA adjusted net worth of $250,000. Title II nonsupervised lenders approved for participation only in the multifamily mortgage insurance programs are not subject to net worth requirements based on mortgage volume.

As of January 9, 1995, Title II nonsupervised lenders are required to have an FHA adjusted net worth of $250,000 plus 1 percent of the volume of FHA single-family insured mortgages the lender originated, purchased and serviced that exceeds $25 million during its fiscal year up to a maximum requirement of $1 million. All non-supervised lenders that have a fiscal year-end of January 1995 or later must have their independent auditors complete the adjusted net worth calculation noted in Attachment 1 to Mortgagee Letter 95-6. Lenders and independent auditors should refer to 24 CFR 202.12(n)(1) and HUD Handbook 4060.1 REV-1 paragraph 2-4 and Appendix 9.

An FHA computation of adjusted net worth is required even if no loans were originated during the period. As previously noted, the auditor's opinion report should state that accompanying supplementary information, including the computation of net worth for FHA requirements, is fairly stated in relation to the basic financial statements taken as a whole.

Title I and Title II loan correspondents, Title I nonsupervised lenders and Title II nonsupervised lenders approved for participation only in the multifamily mortgage insurance programs must present an FHA computation of adjusted net worth in accordance with HUD Handbook 2000.04 REV-1, paragraph 7-6. Basically, this computation of FHA adjusted net worth consists of net worth (stockholders' equity) per balance sheet less unacceptable assets.

Liquid assets

Title II nonsupervised lenders and loan correspondents must maintain liquid assets in the amount of 20 percent of their net worth, up to a maximum of $100,000, as required by 24 CFR 202.12(q). FHA uses 20 percent of the required net worth, rather than the lender's actual net worth, to determine the required liquid assets for loan correspondents only. Liquid assets must be unrestricted and consist of cash or cash equivalents. Real property, such as land, is not a liquid asset.

FHA review of financial statements

FHA reviews all annual audit reports submitted by Title I and Title II nonsupervised lenders and nonsupervised loan correspondents to determine whether the lender meets FHA net worth and other financial and reporting requirements. FHA reviews the notes to the financial statements for any indication of fraud or practices not in compliance with FHA requirements and to determine that the FHA principal activity requirement is met. In those instances in which the financial statements show that the FHA net worth requirements or liquid asset requirements are not met, FHA also reviews the notes to the financial statements for evidence that the FHA requirements have been met subsequent to the balance sheet date.

When a Title I or Title II nonsupervised lender or nonsupervised loan correspondent fails to submit its audit report within 90 days of the close of its fiscal year, or submits an incomplete or unacceptable audit report, the lender will be sent a Notice of Violation by HUD's Mortgagee Review Board. The lender can submit an acceptable audit report or other documents within 30 days after receipt of the notice. If an acceptable audit report is not filed within the 30-day period, the lender's FHA approval will be withdrawn.

If the financial statements show that the lender does not meet FHA net worth requirements, the lender must submit acceptable evidence certified by its CPA that demonstrates that the lender currently has sufficient net worth to meet the FHA requirements. Similarly, if the financial statements show that the lender does not meet the liquid assets requirement, the lender must submit acceptable evidence certified by a CPA that demonstrates that the lender is currently maintaining the minimum required liquid assets.

In addition to failure to meet the net worth requirements and failure to meet the liquid asset requirements, deficiencies in audited financial statements commonly found include failure to provide the EIN of the CPA firm; failure to provide the name of the audit partner in charge of the audit engagement; failure of Title II nonsupervised lenders to use the required adjusted net worth format; omission of the net worth calculation; omission of CPA firm's complete address and phone number; omission of the auditor's report on internal controls and the auditor's report on compliance with laws and regulations; failure to state in the auditor's opinion report that the financial statements conform to GAAP; failure to specifically cite the July 1993 HUD OIG Audit Guide; and failure to specifically cite GAAS and/or Government Auditing Standards (when applicable).

Alexis M. Stowe, CPA, CISA, CFE, CGFM, is a principal and vice president of Gardiner, Kamya & Associates, P.C., Washington, D.C., providing management consulting, auditing and accounting services to government, nonprofit and commercial entities, including the FHA.