Understanding program-specific audits.

Most practitioners with state and local government and not-for-profit clients know about the program-specific audit option available to certain--but not all--recipients of federal financial assistance. Many agree that guidance on this option is not fully developed and difficult to understand. The result: program-specific audits do not always provide their intended relief from audit effort and cost.

This article offers guidance by discussing both the concept and the practical application of program-specific audit requirements under Office of Management and Budget Circulars A-128, Audits of State and Local Governments, and A-133, Audits of Institutions of Higher Education and Other Not-for-profit Organizations. It also explains how applying American Institute of CPAs Statement on Standards for Attestation Engagement no. 3, Compliance Attestation, can better serve the needs of federal program managers.

WHAT IS A PROGRAM-SPECIFIC AUDIT?

The best way to understand program-specific audits is to compare them with organizationwide audits usually required by OMB. An organizationwide audit starts with the audit of the entity's financial statements--all additional grant-related audit requirements of the OMB circulars build on this audit. In an organizationwide audit auditors can issue up to eight reports on the organizationwide work required by the OMB circulars.

On the other hand, a program-specific audit starts with an audit of only the program financial statements. Generally, these statements consist of a single statement of revenues, expenditures and changes in fund balance of federal program activities administered by the recipient, including notes. The audit is conducted in accordance with Government Auditing Standards (the yellow book). All additional grant-related program-specific requirements of the OMB circulars build on the program financial statement audit. In addition to the report on the financial statements, two additional reports are issued--one on the internal control structure over the federal program and one on the entity's compliance with federal program requirements.

The auditor prepares the report on the internal control structure in accordance with the requirements of government auditing standards and based on the audit of the program's financial statements. (A sample internal control structure report for a program-specific audit prepared in accordance with government auditing standards is illustrated in exhibit 1.) The auditor prepares the report on compliance also in accordance with government auditing standards (see exhibit 2). This report does not include an opinion on compliance unless one is required by a federal program-specific audit guide (see exhibit 3).

SAVING TIME AND COST

Performing a program-specific rather than an organizationwide audit results in obvious savings due to reduced reporting requirements and the current absence of a requirement for an auditor "opinion" on compliance. The more significant savings are intmgible and difficult to measure. Experienced auditors suggest they find audit planning easier, compliance testing more focused and reporting more manageable. Also, dealing with the client and the funding agency can be more productive when the auditor does not have to be concerned about combining the program's compliance audit and reporting requirements with those of the broader organizationwide audit.

PRACTICAL APPLICATION

The biggest area of practitioner concern is determining when clients should elect the program-specific audit. It is not always the best choice. Recipients of funds under several programs may actually find that electing it calls for more reports than required by an organizationwide audit. Further, the work necessary to issue a compliance report for the program under the yellow book and program-specific audit guides issued by federal agencies is not significantly different from the work necessary to express an opinion on compliance for major programs in an organizationwide audit.

A program-specific audit usually is best only for recipients of just one program. Auditors also should recognize that proposed revisions to Circular A-133 (which will apply to both state and local government entities and notfor-profit organizations) would limit the option to recipients of just one program (see exhibit 3).

Following federal audit guides. Most program-specific audit guides suggest, rather than require, specific audit procedures and reporting. It is in the auditor's best interest to follow program-specific audit guide suggestions as if they were requirements--that is, without modification. This will help assure but not guarantee acceptance of the audit by the funding agency.

Auditors may encounter audit guides that do not conform with generally accepted auditing standards--in particular Statement on Auditing Standards no. 58, Reports on Audited Financial Statements, and no. 74 Compliance Auditing Considerations in Audits of Governmental Entities and Recipients of Governmental Financial Assistance. When this happens auditors should discuss any changes to the audit scope and reporting with the federal agency.

Audit scope. Indirect or common costs charged to the federal program should not be overlooked. Auditors should perform sufficient testing to obtain assurance that amounts charged to the federal program are allowable, based on actual costs, fairly allocated and reasonable in all material respects to total program expenditures in the program's financial statements.

Auditors should test compliance with general requirements that apply to the program being audited (see exhibit 2), which include federal laws and regulations that apply to all or many federal programs, such as cash management, procurement procedures and political activity prohibitions.

Program financial statements and schedules. When a federal audit guide does not prescribe a financial statement format, recipients should prepare a single statement showing program revenues, expenditures. and fund balance in accordance with generally accepted accounting principles. A schedule, such as a schedule of grant budget versus actual expenses or a schedule of federal awards granted and expended, may be prepared instead of a program financial statement. In practice, schedules often are thought of as financial statements. Other information required by the funding organization should be presented as supplemental schedules and be reconcilable to the program financial statement.

When reporting on program financial statements prepared on a basis of accounting prescribed by a funding agency that is not in accordance with GAAP, auditors should issue a report under SAS no. 62, Special Reports, for an other comprehensive basis of accounting.

It is not necessary for the auditor's report to state that the financial statements of the program are less than those of the entire entity. The notes to the financial statements should say they present revenues, expenditures and fund balances of only that portion of the entity's funds and account groups attributable to the program.

Reporting on a program's financial statements when the auditor questions costs. In a program-specific compliance report the auditor may question a material amount of program costs for lack of compliance. Practitioners often ask what kind of report--qualified, unqualified, adverse or disclaimer of opinion--an auditor should issue on the program's financial statements that include questioned costs. Should the auditor also ask the client to adjust the financial statements for the material questioned costs?

Because auditors do not disallow costs, questioned costs are contingent liabilities. Auditors question costs only for possible disallowance by federal departments granting funds. The accounting for and disclosure of questioned costs therefore should be based on the criteria in Financial Accounting Standards Board Statement no. 5, Accounting for Contingencies, which considers the probability that an actual liability has occurred or an asset has been impaired.

If the audited entity adjusts the financial statements based on the material questioned costs, the auditor should issue an unqualified opinion and should consider discussing the adjustment in an explanatory paragraph following the opinion. If the material questioned costs are disclosed, the audited entity should include in the program financial statements the total of all program costs incurred, including the material questioned costs. The entity should identify material costs questioned by the auditor in a separate column on the face of the program financial statements or in the notes. In accordance with the provisions of SAS no. 58, the auditor would then issue an unqualified opinion with respect to total costs in the program's financial statements even if the questioned costs are material. However, in accordance with the provisions of paragraphs 23 through 26 of SAS no. 58, an explanatory paragraph following the opinion likely would be required. In July 1995, the auditing standards board proposed eliminating the requirement for this explanatory paragraph.

There are two circumstances in which a qualified, adverse or disclaimer of opinion on the program-specific financial statements is appropriate:

* If the audited entity does not adjust the financial statements for or disclose the material questioned costs, the program-specific financial statements are not a fair presentation.

* When forming an opinion on the program-specific financial statements, the auditor should consider the extent of additional potentially unallowable costs in transactions not tested. If the auditor cannot reasonably reach a conclusion on these matters, a scope limitation exists.

AN EFFECTIVE NEW METHOD

The federal community and practitioners should consider using SSAE no. 3 for program-specific audits. SSAE no. 3 engagements would add focus to the individual recipient's compliance, make the program-specific audit process less confusing and serve the needs of federal program managers. In any event, overall recipient compliance would likely improve. While SSA-E no. 3 is voluntary today, the increasing interest in and development of its applications may make its use mandatory in the future.

This attestation standard covers applying agreed-upon procedures to or an examination of management's assertions about compliance with laws and regulations or about internal controls over such compliance. In an SSAE no. 3 audit, the independent accountant reports on management's assertions on compliance with established criteria.

Practitioners should use SSAE no. 3 for program-specific audits whenever they can obtain approval to do so from the federal grantor agency. Using it to report on management's assertions on compliance and the internal control structure could make reports clearer and more useful. Compliance requirements and internal control structure criteria set forth in published rules, regulations, audit guides and compliance supplements are general in nature and not tailored to a specific recipient's circumstances. In an attestation engagement, testing and reporting on management's written assertions on its own compliance with these requirements would make the reported scope of the program-specific audit more relevant to the recipient. The attestation standards are more easily applied to a program-specific audit because management's assertions on multiple programs in an organizationwide audit could be cumbersome.

An SSAE no. 3 engagement is one type of financial-related audit under government auditing standards. Thus, federal program-specific audits and audit guides do not have to incorporate allocated and reasonable in all allocated and reasonable in all this standard's provisions. With the approval of the federal grantor agency, attestation engagements are a good way to report on the internal control structure and compliance. Of course, the program financial statements can be audited only under generally accepted auditing standards that have been incorporated into government auditing standards.

Some federal agency program-specific audit guides and regulations require the use of SSAE no. 3 attestation procedures and reporting on compliance and the internal control structure. Several U.S. Department of Education audit-attestation guides for student loan programs incorporate SSAE no. 3 requirements for reporting on management's assertions on compliance, and the Federal Aviation Administration is preparing an attestation guide for audits of passenger facilities charges collected by air carriers. The OMB is considering the attestation standards for final revisions to Circular A-133.

THE RIGHT CHOICE FOR THE RIGHT ENTITY

CPAs should be aware that an organizationwide audit under Circulars A-128 and A-133 is not always necessary for eligible federal grant recipients. Use of SSA-E no. 3 could clarify the program-specific audit process and better serve the needs of federal program managers.

RELATED ARTICLE: Organizationwide Audit Reports May Change

The American Institute of CPAs has established a task force to reevaluate the need for and simplify the multitude of organizationwide reports. The task force is made up of representatives from several AICPA committees, the General Accounting Office, the Office of Management and Budget and the inspector general and state auditor communities.

Several simplification options are being considered. Any new reporting development will require due process and approval of the AICPA auditing standards board and federal officials. While the number of reports will likely decrease in an organizationwide audit, all of the report elements required by generally accepted auditing standards and government auditing standards probably-will remain. For more information on the AICPA task force, contact Mary M. Foelster, AICPA technical manager in Washington, D.C., at [phone].

RELATED ARTICLE: EXECUTIVE SUMMARY

* PROGRAM-SPECIFIC AUDITS allow certain recipients of certain federal financial assistance to have program-specific rather than organizationwide audits. Because current guidance for program-specific audits under OMB Circulars A-128 and A-133 is not fully developed, anticipated savings in audit effort and cost are not always achieved.

* PRACTITIONERS NEED MOPE GUIDANCE on the authoritative literature supporting program-specific audit procedures and on the preparation of reports and financial statements under program-specific audits.

* PENDING REVISIONS to OMB Circular A-133 applicable to not-for-profit organizations would change the eligibility criteria for conducting program-specific audits and the required scope of work and reports. CPAs considering the program-specific option should understand the pending revisions which will also be applicable to state and local government entities.

* THE FEDERAL COMMUNITY AND practitioners should consider use of SSAE no. 3, Compliance Attestation, for program-specific audits. Since SSAE no. 3 engagements improve the focus on an individual recipient's compliance, they could clarify the program-specific audit process and better serve the needs of federal program managers.

EDWARD P. CHAIT, CPA, is director of government auditing standards support services in the national office of Price Waterhouse, LLP. A member of the AICPA governmental technical standards subcommittee, he is a former member of the Institute's government accounting and auditing committee, on which he was chair of the task force on program-specific audits.

RELATED ARTICLE: Exhibit 1: Sample Internal Control Structure Report

We have audited the financial statement(s) of (name of program) of (name of entity) as of and for the year ended June 30, 19X1, and have issued our report thereon dated (date of report).

We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statement(s) are free of material misstatement.

The management of (name of entity) is responsible for establishing and maintaining an internal control structure for (name of program). In fulfilling this responsibility, estimates and judgments by management are required to assess the expected benefits and related costs of internal control structure policies and procedures. The objectives of an internal control structure are to provide management with reasonable, but not absolute, assurance that assets are safeguarded against loss from unauthorized use or disposition, that transactions are executed in accordance with management's authorization and recorded properly to permit the preparation of financial statement(s) in accordance with generally accepted accounting principles. Because of inherent limitations in any internal control structure, errors or irregularities may nevertheless occur and not be detected. Also, projection of any evaluation of the structure to future periods is subject to the risk that procedures may become inadequate because of changes in conditions or that the effectiveness of the design and operation of policies and procedures may deteriorate.

In planning and performing our audit of the financial statement(s) of (name of program) of (name of entity) for the year ended June 30, 19X1, we obtained an understanding of the internal control structure. With respect to the internal control structure, we obtained an understanding of the design of relevant policies and procedures and whether they have been placed in operation, and we assessed control risk in order to determine our auditing procedures for the purpose of expressing our opinion on the financial statement(s) of the program and not to provide an opinion on the internal control structure. Accordingly, we do not express such an opinion.

We noted certain matters involving the internal control structure and its operation that we consider to be reportable conditions under standards established by the American Institute of Certified Public Accountants. Reportable conditions involve matters coming to our attention relating to significant deficiencies in the design or operation of the internal control structure that, in our judgment, could adversely affect the entity's ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statement(s) of the program.

[Include paragraphs to describe the reportable conditions noted.

A material weakness is a reportable condition in which the design or operation of one or more of the specific internal control structure elements does not reduce to a relatively low level the risk that errors or irregularities in amounts that would be material in relation to the financial statement(s) being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.

Our consideration of the internal control structure would not necessarily disclose all matters in the internal control structure that might be reportable conditions and, accordingly, would not necessarily disclose all reportable conditions that are also considered to be material weaknesses as defined above. However, we believe none of the reportable conditions described above is a material weakness.

This report is intended for the information of the audit committee, management, and (name of funding agency). However, this report is a matter of public record, and its distribution is not limited. (Signature) (Date)

(This example has been prepared in accordance with the requirements of Government Auditing Standards. Revisions to OMB Circular A-128 dated April 12, 1985, and OMB Circular A-133 dated March 8, 1990, may necessitate additional reporting or modifications of this example.)

RELATED ARTICLE : Exhibit 2: Sample Program-Specific Compliance Report When No Federal Audit Guide Is Available

We have audited the financial statement(s) of (name of program) of (name of entity) as of and for the year ended June 30, 19X1, and have issued our report thereon dated (date of report).

We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statement(s) are free of material misstatement.

Compliance with laws, regulations, contracts and grants applicable to (name of program) of (name of entity) is the responsibility of (name of entity)'s management. As part of obtaining reasonable assurance about whether the financial statement(s) are free of material misstatement, we performed tests of (name of entity)'s compliance with general and specific provisions of laws, regulations, contracts and grants for the (name of program). However, the objective of our audit of the financial statement(s) of the program was not to provide an opinion on overall compliance with such provisions. Accordingly, we do not express such an opinion.

The results of our tests disclosed no instances of noncompliance that are required to be reported herein under Government Auditing Standards.(1)

This report is intended for the information of the audit committee, management and (funding agency). However, this report is a matter of public record and its distribution is not limited. (Signature) (Date)

(1) See Government Auditing Standards, Chapter 5, paragraphs 5. 18-5.19, for reporting criteria.

(This example was prepared in accordance with the requirements of Government Auditing Standards. Revisions to OMB Circular A-128 dated April 12, 1985, and OMB Circular A-133 dated March 8, 1990, may necessitate additional reporting or modifications of this example.)