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CPE for Government Auditors

Blending the Green Book with the Yellow Book

Objectives:

  • Identify the purpose of the GAO’s Green Book.
  • Distinguish between components of internal control.
  • Distinguish between management objectives
  • Choose a finite subject matter on which to apply controls
  • Identify the auditor’s responsibilities regarding application of the Green Book

Most of the changes between the 2011 Yellow Book and the 2018 Yellow Book that we have discussed so far probably have not shocked you. But the change triggered by the Green Book may. The Green Book is the GAO’s version of the COSO model, and its formal title is “Standards for Internal Control in the Federal Government.”

As I am traveling and teaching the 2018 Yellow Book, I have noticed that quite a few auditors are not familiar with the Green Book which was published by the GAO in 2014. This is not good because the Green Book is by far the biggest change to the Yellow Book.

The Green Book Describes an Ideal Control Structure

The GAO’s Green Book lays out an ideal control structure – a nirvana for internal controls, if you will. And I have never encountered any entity that has achieved this ideal. Yes, I’ve seen some entities achieve control nirvana in some part or aspect of their business. But I have never seen an entire entity under complete control, and I doubt I ever will. I think the lack of perfect internal controls in an organization is a reasonable state of affairs because controls cost money to implement.

However, what I am discussing in this chapter is not the auditee’s responsibility regarding internal controls (which is the focus of the Green Book), but the auditor’s responsibility regarding internal controls. You and I know that the entity you audit has not achieved control nirvana. But instead of just knowing that in your head, the Yellow Book is asking you to document your assessment of the auditee’s internal control status in grand and glorious detail.

Here are some quotes from one of the performance audit chapters in the 2018 Yellow Book that give performance auditors pause. I’ll address financial auditors conducting the Single Audit at the end of the chapter. I added bolding to draw your eye to some new terms that I’d like you to notice.

8.41     Consideration of internal control in a performance audit begins with determining the significance of internal control to the audit objectives and documenting that determination. Some factors that may be considered when determining the significance of internal control to the audit objectives include

  1. the subject matter under audit, such as the program or program component under audit, including the audited entity’s objectives for the program and associated inherent risks;
  2. the nature of findings and conclusions expected to be reported, based on the needs and interests of audit report users;
  3. the three categories of entity objectives (operations, reporting, and compliance); and
  4. the five components of internal control (control environment, risk assessment, control activities, information and communication, and monitoring) and the integration of the components.

8.42     If internal control is significant to the audit objectives, auditors determine which of the five components of internal control and underlying principles are significant to the audit objectives, as all components of internal control are generally relevant, but not all components may be significant to the audit objectives. This determination can also identify whether specific controls are significant to the audit objectives. Determining which internal control components and principles and/or specific controls are significant to the audit objectives is a matter of professional judgment. 

8.47     Approaches for obtaining an understanding of internal control may vary and may include consideration of entity-level controls, transaction- level controls, or both. However, even when assessing only transaction- level controls, it may be beneficial to gain an understanding of entity-level controls that may affect transaction-level controls by obtaining a broad understanding of the five components of internal control at the entity level. This involves considering the relationships between the components, which work together in an integrated manner in an effective internal control system, and the principles of internal control that support each component. In addition to obtaining a broad understanding of internal control at the entity level, auditors may also obtain an understanding of internal control at the transaction level for the specific programs and processes under audit. 

Here is an infographic from the Green Book that starts to explain the highlighted terms:

The terms “three categories of entity objectives” appear at the top of the cube and the terms “five components of internal control” appear on the face of the cube. The seventeen “principles of internal control that support each component” are presented in a stack on the bottom left side of the infographic.

Nice Infographic, Now What?

Yes, the cube is cute, and the stack is pretty – but so what? What does all this new language mean to performance auditors, practically? What the cube and the stack are illustrating is the most up-to-date structure for approaching internal controls. This means that performance auditors are going to have to change the way they document internal controls! The GAO is working on a tool right now to help you with this task, but it won’t be published until the spring of 2019.

So, if you want to implement these changes in your internal control documentation right now, you will need to create a tool on your own. HUD has developed a tool that might get your creative juices flowing. Google “HUD IC Questionnaire 17 principles” to find it.

How are COSO and the Green Book Related?

But before we get too far along, let’s look at how the Green Book is related to the COSO (Committee of Sponsoring Organizations of the Treadway Commission) model and what our profession is trying to accomplish with both. As we will see, the Government Accountability Office (GAO) bases the Green Book on the COSO model.

The GAO Pushed for Better Controls in 1983.

In addition to auditing federal agencies and reporting the results back to Congress, the GAO also advises executive agencies on how to make government more efficient and effective. The Federal Managers Financial Integrity Act of 1982 requires the GAO to establish standards for internal controls. The GAO made its first efforts toward creating a standard for internal controls in 1983.

In the opening letter to this first version of the Green Book, the Comptroller General of the GAO said:

In the past decade, numerous situations came to light that dramatically demonstrated the need for controls as the Government experienced a rash of illegal, unauthorized, and questionable acts which were characterized as fraud, waste, and abuse. It is generally recognized that good internal controls would have made the commission of such wrongful acts more difficult. Consequently, increased attention is being directed toward strengthening internal controls to help restore confidence in Government and to improve its operations.

I wonder what the Comptroller General would think of the hijinks in the government realm in since that initial Green Book was issued 30 years ago!

Congress Pushed for Better Controls in 1977, and the Treadway Commission Was Formed

Six years before the Financial Managers Financial Integrity Act, corporate fraud was getting the attention of Congress. In 1977, Congress enacted the Foreign Corrupt Practices Act (FCPA) as a result of 400 US corporations admitting that they had made questionable or illegal payments to foreign officials as part of conducting business in other countries. In response, the Treadway Commission, a private-sector initiative, was formed in 1985 to inspect, analyze, and make recommendations on fraudulent corporate financial reporting.

The COSO Report Was Issued in 1992

As a result of the Treadway Commission’s initial report, the Committee of Sponsoring Organizations (COSO) was formed. COSO retained Coopers & Lybrand, a major CPA firm, to study the issues and create a report on controls. This report was titled Internal Control – Integrated Framework and was issued in 1992.

And for the first time, we were introduced to the COSO cube that many of us use in our work today.

Over time, the COSO model, as it came to be called, was integrated into various auditing standards including the American Institute of CPAs auditing standards, the GAO’s Generally Accepted Government Auditing Standards (the aforementioned Yellow Book), and the Institute of Internal Auditor’s professional literature.

SOX Renewed Interest in the COSO Model in 2002.

After a spate of corporate financial scandals (Enron, WorldCom, etc.) at the turn of the century, Congress passed the Sarbanes-Oxley Act (SOX) in 2002. The Sarbanes-Oxley Act requires that publicly traded companies in the United States certify that their internal controls over financial reporting are effective. Most corporations used the COSO model as the framework to guide this assessment.

The COSO Model and Report Were Revised in 2013

The COSO model was revised in 2013, more than 20 years after its initial creation. The 2013 revision didn’t alter the cube very much; the side of the cube now uses the term “division” instead of “unit,” and a few titles were changed on the face of the cube: “financial reporting” on the top of the original cube was changed to the more broad “reporting,” and “monitoring” was changed to “monitoring activities.”

These changes are minor compared to what COSO did to the text of the report. The original 1992 COSO report was presented in narrative form using lengthy, complex paragraphs. The 2013 version breaks each of the five elements on the face of the cube into 17 principles, and then these principles are further broken into 81 points of focus. Breaking down the narrative into smaller, more digestible concepts makes the document much easier to scan and, thus, to use.The 2013 version of the COSO model is available online for $99-270, depending on whether you want a piece of the document or the entire set of literature.

The GAO Published the Green Book in 2014

In September 2014, the GAO revised the Green Book. The 2014 version replicates the 2013 version of the COSO model but changes some terminology to customize the model for the government environment. The Green Book is free online. Get it by Googling “GAO Green Book.”

The COSO Model Has Three Main Dimensions.

The COSO model and the Green Book both represent controls using the three dimensions of a cube. The top of the cube describes WHY you need controls. The side of the cube describes WHAT you will control, and the face of the cube tells you HOW to implement controls.
Let’s talk first about the dimension of the cube that is the most difficult to grasp – the face of the cube which lists the five components of internal control. We will discuss the side and the top next.

The Five Components of Internal Control

The five components of internal control listed on the face of the cube are:

  1. control environment
  2. risk assessment
  3. control activities
  4. information and communication
  5. monitoring

I need to admit, right up front, that I have never ‘clicked’ with face of the cube. You know how some business models just make you say to yourself, “Yes, of course, that is how it is!” For instance, the “Plan, do, check, act!” model. Those four steps – plan, do, check, act – are intuitive and sensible. The five components of internal control? Not so much.

Here is how I make sense of the five components (Warning: this appears nowhere in COSO literature!):

First, the organization needs to ask what risks it is facing. Once they have done this risk assessment, they can apply control activities to keep those risks from occurring. Then valid reports need to be generated that provide information and communicate with the stakeholders of the organization who need to know how well the controls are working. The organization should not just assume, but monitor to ensure, that the control activities and reports they put in place to tamp down risk are working. And all of this effort needs to take place within an encouraging, nurturing environment that appreciates and supports controls.

Does it still sound like Greek? Let’s dig a tiny bit deeper. Let’s begin with an overview of the five components starting where the cube starts, with the control environment.

Do You Care about the Environment?

The control environment component directly addresses the attitudes of the leaders of an organization toward controls. You will also hear this component described as ‘tone at the top.’ If the leaders of an organization are uninterested in excellence in operations, strict compliance with laws and regulations, and accurate and transparent reporting, efforts toward those objectives by the employees will fail.

I have seen a wide variety of control environments, as I am sure you have. Some control environments are strong and reassuring. Others vary from strong to weak depending on who is in the leadership position, and others are crazy disasters that eventually implode. And no matter the size of your entity, the leadership’s attitude permeates the whole organization. One of my jumbo clients sells groceries in 28 countries. Since I am also a customer of this grocery retailer, I was very pleased to hear an executive in charge of food safety initiatives talk openly and emotionally about his responsibilities to keep customers safe.

He began his presentation by sharing the pictures of children in his briefcase that he looks at every day. These were not picture of his children, but children who had died of food borne illness from all food sellers – groceries and restaurants – in the United States. Then he began to share statistics about how vulnerable children are to food borne illnesses. It was clear from talking to his grocery managers, that his serious attitude toward a serious risk had also affected their attitudes and, therefore, controls.

If his powerful message permeated such a large organization, imagine how much more the viewpoint of a leader in a small organization affects controls. Smaller organizations are particularly vulnerable to the attitudes of the leadership.

Regrettably, I agreed to be the treasurer for a small organization, the local chapter of the National Speaker’s Association and served for three years. We had about thirty members and six of them were on the board. The tone at the top dramatically altered the control environment every time we elected a new president.

Most of the members of the local chapter were motivational speakers, and some of them thought that if you just believed something with all your heart and mind, you could wish anything into existence. So, when I informed them at our first board meeting that I had carefully looked over the books and that we were close to bankruptcy, the response from the president was, “Well, if we just think positive thoughts, everything will work out.” A few meetings later, my less-than-positive prognosis came true. We were broke and couldn’t pay the hotel after our monthly Saturday meeting.

The chapter’s president conveniently disappeared after I informed her of this fact. Luckily, one of our successful and moneyed members named Jim stepped in and paid the bill.

Our new savior, Jim, was immediately appointed president. Jim was a six-and-a-half-foot tall ex-Marine who knew how to lead. At our first board meeting, he told the group that we were going to set a strict budget, and that we were going to talk about it at every meeting. All expenditures had to be approved by me before they were incurred. I silently clapped and cheered in my little accounting heart!

Everyone on the board was paying attention to my financial presentation at meetings (or at least they looked like they were paying attention), and I felt great about my role as treasurer. By the end of Jim’s term, we had built our bank account balance up to a healthy $14,000.

But, when Jim’s term was up, the group elected sweet John to be our leader. John preferred to spend the board meeting hugging and vision casting rather than worrying about tacky old money. At our first meeting under John’s leadership, we all discussed relaxation techniques – which just happened to be the focus of John’s signature speech. The group again began to ignore the budget, and by the end of John’s term, we were again near bankruptcy.

I realized that I would only be successful as a treasurer with the chapter if I had the strong support of the president. It didn’t matter how wonderful and clear and compelling my budget presentations were (and I tried everything I could to wake them up to the reality of the situation – emoticons, colors, graphics, dancing, singing). I was ignored. Only when Jim created an environment of compliance and fiscal restraint did the controls over our finances work.

My situation as a powerless treasurer plays out on larger, more important scales all the time. Do you remember the financial executive at Enron, Sherron Watkins, who wrote a memo to the chief executive about Enron’s fraudulent financial statements? The leadership didn’t want to hear it and published the erroneous financial results for public consumption. No matter how well she did her job, without the support of the organization’s leadership, her efforts were thwarted.

Controls Mitigate Risks

The second component – risk assessment – is all about making sure we put our resources toward things that matter. We don’t need controls over things we aren’t worried about. Controls are created to mitigate or reduce risk.

Here is a personal example: My family has two cars. One represents more risk to us than the other because it is worth more money. Let me begin by saying that my husband and I only buy used cars and pay cash for them. I was raised in new or nearly new cars. My father bought a new car every few years and still does. But now that I am paying the bills, I appreciate my husband’s view that new cars waste money.

My husband has been driving the same Toyota Sienna minivan (that we, of course, bought used) for the past 10 years or so. It has over 200,000 miles on it and doesn’t show any sign of stopping. It looks like a hideous, rolling pile of retro junk. It is worth about $1000 per the Kelly Blue Book.

Recently, I bought a beautiful, jumbo Lexus sedan with 100,000 miles on it. The sedan cost us around $18,000. We park my Lexus in the garage and repair every little ding. The mini-van is always exposed to the weather, and if it gets a ding, my husband reasons that it only adds to its character. Because more of our money is at risk in the Lexus, (and more of my ego is on the line with the Lexus!), we treat it better and we endeavor to control what happens to it. When a hailstorm hits – as they do at least once a year here in Austin – my husband’s first question is, “Is the Lexus in the garage?”

What do you care about in your organization? Is it that your assets are safeguarded? Is it that your customers and employees are safe? Maybe you care the most about making a difference to the disadvantaged? While it would be nice to have the time and the resources to worry and control everything, no individual or organization in the history of the world has been able to pull that off.

What a risk assessment does is lay out all of the possible things you might care about on the table (or in an Excel table!). It gives you a way of ranking them and deciding where you will to focus your efforts. Controls cost time and money, and you want to be intentional about applying them.

I have seen a wide variety of risk assessment models and risk assessment documentation. You can really go nuts refining the risk assessment and contemplating every eventuality, but at a very basic level, all you have to do is decide if you care. Simply ask yourself what could go wrong. And if you don’t care about the resulting answer, you don’t need any controls over it. So, if I ask myself if I will care if my Lexus suffers hail damage, I would say that I care – the mini-van, not so much.

What Most People Think of When They Think of Controls

The third component – control activities – is what most auditors think of when they think of applying controls. Control activities include such things as segregation of critical duties, transaction approvals, timely reviews of transactions, and documentation.

Figure 6 of the Green Book contains a fabulous list of control activities:

Figure 6: Examples of Common Categories of Control Activities

  1. Top level reviews of actual performance
  2. Reviews by management at the functional or activity level
  3. Management of human capital
  4. Controls over information processing
  5. Physical control over vulnerable assets
  6. Establishment and review of performance measures and indicators
  7. Segregation of duties
  8. Proper execution of transactions
  9. Accurate and timely recording of transactions
  10. Access restrictions to and accountability for resources and records
  11. Appropriate documentation of transactions and internal controls

You Aren’t in This Alone!

Information and communication, the fourth component, acknowledges that you aren’t in this all by yourself. Various stakeholders need to keep informed about what is going on.

Any endeavor will generate critical information and this information will allow stakeholders to evaluate the success of the organization’s efforts. The information and communication component asks the manager who they need to communicate with, what they need to share, and whether the data the manager is sharing is valid.

Hopefully, You Are Being Carefully Watched, But Not in a Creepy Way

Just performing a risk assessment, applying control activities, and communicating with stakeholders is not enough. Unfortunately, we aren’t done. We need the final component – monitoring.

We can’t just set things up and hope that they run on their own forever and ever. Over time, controls slip away and atrophy. Somehow, we need to monitor to make sure that controls are working as intended and make corrections when they aren’t working as intended. And, let’s be honest here, things never work exactly as we intend.

What this means is, that if you are following the COSO model, someone will be watching! It is best if this someone can be honest about what they see without suffering any consequences, and they might watch continually or just occasionally.

We auditors apply the monitoring component and the information and communication component to our audit quality control system by creating an annual monitoring report each year.

Summarizing Five Components of Control

Let’s recap. First you have to decide what you care about and what risks you are unwilling to tolerate. You then apply controls activities to the risks you aren’t interested in experiencing. You need to share the data your activities generate (information and communication) with stakeholders and set up a monitoring function to make sure that everything you have put in place to mitigate the risks is operating as intended. All of this needs to take place within an environment that values and supports controls.

The Top and Side of the Cube: A Little Whine with That Cheese?

In order to make the top and the side of the cube come alive here, I am going to talk about my tiny little operation. And I am probably going to come off as a little whiney in places.

You see, I suffered an embarrassing failure in my business that I am still smarting over. Have you ever seen that poster on Despair, Inc.’s website of a shipwreck? Underneath it is says, “It could be that the purpose of your life is only to serve as a warning to others.” Sometimes I feel like that. See? Whiney.

My Little Idea That Became a Big Set of Processes

Since I like to write, I decided that I should start writing self-study books and selling them through other continuing professional education providers and on my own website. If anyone had told me how involved this idea was going to be before I started, I would have probably stopped right there. But luckily, I was innocent, unaware, and hopeful.

I knew before I started that writing a book is pretty involved. Writing the text is just the beginning; the text has to be edited, revised, and formatted. Lots of processes for that.

My idea to sell to other vendors involved maintaining relationships with those vendors, creating and managing contracts, and lots and lots of communication. Process, process, process.

And since I wanted to sell the books on my website, I needed a website that would allow folks to buy things – so I needed an online store. Process. Since I wanted students to be able to buy and take an online quiz and get credit for the courses online, I had to work with programmers for years and years and years to create the quiz and automatic grading software. Process.

Do I need to go on? Because I can . . . I so can. But I’ll stop there and point out that everything I have described so far would be categorized as ‘operating’ on the top of the cube.

Let’s talk about the top of the cube for a minute…

The Top of the Cube

The top of the cube represents management’s objectives. In less fancy terms, it answers the question, “Why bother having controls?” Yes, as we said in an earlier chapter, controls are there to mitigate risk. But we wouldn’t even have a risk unless we decided to do something, to act in the world. I wouldn’t need controls and processes over my self-studies if I hadn’t decided to write and sell self-study books.

The management objectives at the top of the cube help us categorize why we do things. The top of the cube has three management objectives: operations, reporting, and compliance.

If management is concerned with operations, they are concerned that they deliver their goods and services while efficiently using their entity’s resources. If management is concerned about reportingthey are focused on making sure that reports generated for stakeholders are reliable. For instance, the entity needs to ensure that the financial statements it publishes and sends into regulators are accurate. And if the entity is concerned about compliance, they are making sure that they stay in line with laws and regulations.

I was mistaken that my business was mostly about writing (process or operations). It ended up being mostly about compliance.

Compliance Ate My Lunch

I recognized that no one would read my books for grins. I mean, who wants to read a 300-page book entitled, “The Yellow Book Interpreted” for fun and information only? I knew that I had to offer my books for continuing professional education credit or they wouldn’t sell at all. To qualify for continuing professional education credits for CPAs, I had to register with NASBA (the National Association of State Boards of Public Accountancy).

Years ago, the thought of working with NASBA was slightly intimidating but not prohibitively intimidating. But it seems that I chose a very bad moment to enter the market. As I was authoring my first books, NASBA was busy tightening up its requirements. This meant that I had to add all sorts of components to my books, including quiz questions that are hard to answer. By hard to answer, I mean I have to write the questions in such a way that the answer isn’t obvious – sort of like the obscure questions on the CPA exam. Oh joy! I never imagined myself as a question writer, but I embraced my new task and sent my first book into NASBA for testing. I passed and started selling my books.

All was well until my testing software started failing here and there, and I decided to create a new software program. The next time NASBA ran their test using my new software, they were able to find a flaw in the software that allowed students to jimmy the system and earn credit without taking the quiz. NASBA yanked my license. Huge, embarrassing ouch!

All the clients I had cultivated dropped me like a hot potato. I had to start the lengthy process of fixing the bugs in the software and applying for the license again. NASBA put the review of my courses on the back burner, and it took an entire year for them to review my courses and reinstate my license.

Compliance had eaten my lunch, and my dinner, and my midnight snack.

I won’t go into details about the remaining management objective, reporting, but as you can imagine, I must report to several regulatory bodies every year so that they can ensure I am staying in compliance. One regulatory body requires that I write out every course I offer on a teeny-tiny spreadsheet by hand! Electronic submissions are not allowed. Every course and every student must be tracked and maintained in reports that fit each regulator’s demands. Another process and another set of controls.

All organizations take on the same three areas – operations, compliance, and reporting when they decide to act.

Now for the Right-Hand Side of the Cube

If I told you that you needed to develop controls over the entire planet and keep everyone in line, you wouldn’t be too happy.

How about if I asked you to control the United States? Still too big a task? How about Texas? Yes, too big. How about Austin, Texas? No. How about the state capital complex in Austin, Texas? Getting closer.

What if I asked you to control the north door of the state capital to ensure that all people entering the state capitol building are screened by the Capitol Police? Now, I can work on controls for that! But anything larger, and I get overwhelmed.

And being overwhelmed probably means that I am going to approach the subject in a disorganized way. And being disorganized usually leads to leaving something important undone.

The whole point of the COSO cube is to help us organize our thoughts. The top organizes our purpose in creating controls, the front organizes the types of controls, and the right hand side simply helps us pick a subject — an area to work on. The side of the cube organizes the subject of our controls. This model lists the subject matter of controls as:

  • Entity
  • Division
  • Operating Unit
  • Function
Here is an example from a fictional university:
  • Entity: University of Universal Understanding (UUU)
  • Division: Philosophy Department
  • Operating Unit: Dean Supreme’s Office
  • Function: Curriculum development and divination
To me, the cube doesn’t go far enough in breaking the subject down into manageable, controllable pieces. I imagine that the function “curriculum development and divination” involves a process and each step of the process should be controlled. I advise you to break the subject matter into small enough pieces so that it is obvious what the controls should be.For instance, the process of revising and re-publishing my books is a discreet subject matter. In order to tackle it, I had to break the process into a dozen major steps. And then for a good number of those steps, I had to layer on controls. The result is a two-page checklist with over 20 items that involves five people to complete!

If I had imagined creating controls at a higher level – say for my whole self-study business – I would have gotten hopelessly lost. And my self-study business is just one of five ways I make a living. If I had just started the layering on of controls at that high level, the result would have definitely ended up as a hodge-podge of controls and processes that didn’t get the job done.

So, to summarize: the top of the cube tells us whywe develop controls and the right-hand side helps us decide exactly what we are going to control.

Another Layer of Detail

Because the face of the cube is a little too summarized for COSO and the GAO, both have broken the components on the face into 17 principles as follows:
CONTROL ENVIRONMENT
  1. The oversight body and management should demonstrate a commitment to integrity and ethical values.
  2. The oversight body should oversee the entity’s internal control system.
  3. Management should establish an organizational structure, assign responsibility, and delegate authority to achieve the entity’s objectives.
  4. Management should demonstrate a commitment to recruit, develop, and retain competent individuals.
  5. Management should evaluate performance and hold individuals accountable for their internal control responsibilities.

RISK ASSESSMENT

  1. Management should define objectives clearly to enable the identification of risks and define risks tolerances.
  2. Management should identify, analyze and respond to risks related to achieving the defined objectives.
  3. Management should consider the potential for fraud when identify, analyzing, and responding to risks.
  4. Management should identify, analyze, and respond to significant changes that could impact the internal control system.

CONTROL ACTIVITIES

  1. Management should design control activities to achieve objectives and respond to risks.
  2. Management should design the entity’s information system and related control activities to achieve objectives and respond to risks.
  3. Management should implement control activities through policies.

INFORMATION AND COMMUNICAITON

  1. Management should use quality information to achieve the entity’s objectives.
  2. Management should internally communicate the necessary quality information to achieve the entity’s objectives.
  3. Management should externally communicate the necessary quality information to achieve the entity’s objectives.

MONITORING

  1. Management should establish and operate monitoring activities to monitor the internal control system and evaluate the results.
  2. Management should remediate identified internal control deficiencies on a timely basis.

What Does All This Mean for the Auditor?

The purpose of the Green Book is to encourage governments to implement strong, well thought out controls. The purpose of the Yellow Book is to encourage auditors to perform convincing and thorough audits. By integrating the Green Book into the Yellow Book, the GAO is requiring performance auditors to evaluate controls using all of the dimensions of the cube plus the 17 principles. This means that auditor’s internal control documentation must change to include the 17 principles.

Theoretically, as auditors use the new model to evaluate governments, the governments will be encouraged adopt the model in their own organization and thus strengthen their controls.
In the intro to the chapter, we looked at these requirements from the performance audit chapter of the Yellow Book:

8.41     Consideration of internal control in a performance audit begins with determining the significance of internal control to the audit objectives and documenting that determination. Some factors that may be considered when determining the significance of internal control to the audit objectives include

  1. the subject matter under audit, such as the program or program component under audit, including the audited entity’s objectives for the program and associated inherent risks;
  2. the nature of findings and conclusions expected to be reported, based on the needs and interests of audit report users;
  3. the three categories of entity objectives (operations, reporting, and compliance); and
  4. the five components of internal control (control environment, risk assessment, control activities, information and communication, and monitoring) and the integration of the components.

8.42     If internal control is significant to the audit objectives, auditors determine which of the five components of internal control and underlying principles are significant to the audit objectives, as all components of internal control are generally relevant, but not all components may be significant to the audit objectives. This determination can also identify whether specific controls are significant to the audit objectives. Determining which internal control components and principles and/or specific controls are significant to the audit objectives is a matter of professional judgment.

8.47     Approaches for obtaining an understanding of internal control may vary and may include consideration of entity-level controls, transaction- level controls, or both. However, even when assessing only transaction- level controls, it may be beneficial to gain an understanding of entity-level controls that may affect transaction-level controls by obtaining a broad understanding of the five components of internal control at the entity level. This involves considering the relationships between the components, which work together in an integrated manner in an effective internal control system, and the principles of internal control that support each component. In addition to obtaining a broad understanding of internal control at the entity level, auditors may also obtain an understanding of internal control at the transaction level for the specific programs and processes under audit. 

Hopefully now, after we have covered those terms, those paragraphs hold more meaning. But it also may scare you a little bit because it is new and it is detailed!

To Save Time

As you can tell, documenting internal controls is going to be a lot of work! But before you start looking for another job, there is something you can do to minimize the documentation. You can refine your objective early in the audit process!

The Yellow Book says auditors are only responsible for documenting internal controls that are relevant to the audit objective. Thank you, GAO! So, the more specific you are about your audit objectives, the less controls you will end up having to document!

Here is the paragraph that allows you to focus on only documenting controls that a relevant to your audit objective:

8.49     If internal control is determined to be significant to the audit objectives, auditors should assess and document their assessment of the design, implementation, and/or operating effectiveness of such internal control to the extent necessary to address the audit objectives. 

If you dig into controls AFTER you have performed your inherent risk assessment and refined your audit objectives, you will conserve precious audit resources and, maybe, be able to tolerate your job for another year or two.

How the Green Book Affects Financial Auditors

Currently, the financial audit chapter of the Yellow Book does not emphasize the Green Book. This is because the AICPA has not adopted the 2013 version of the COSO model with the 17 principles. The AICPA is still working with the original version of the COSO model without the principles. So, if you are performing a straight up financial audit, you don’t have to worry about documenting the 17 principles.

If you are performing the Single Audit, you do need to apply the new model including the 17 principles because the Uniform Administrative Rules, Cost Principles and Audit Requirements for Federal Awards (the Uniform Guidance) mentions the Green Book. And as we just read, the Green Book structure includes the 17 principles. Check out this quote from the Uniform Guidance directed at the auditee:

200.303 Internal Controls
The non-Federal entity must:
(a) establish and maintain effective internal control over the Federal award that provides reasonable assurance that the non-Federal entity is managing the Federal Award in compliance with federal statutes, regulations, and the terms and conditions of the federal award. These internal controls should be in compliance with guidance in “Standards for Internal Control in the Federal Government” issued by the Comptroller General of the United States and the “Internal Control Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

And check out this requirement directed at the auditor regarding internal controls over compliance. I added bolding to emphasize the reference to the Green Book.

200.514 (c) Internal control. (1) The compliance supplement provides guidance on internal controls over Federal programs based upon the guidance in Standards for Internal Control in the Federal Government issued by the Comptroller General of the United States and the Internal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). (2) In addition to the requirements of GAGAS, the auditor must perform procedures to obtain an understanding of internal control over Federal programs sufficient to plan the audit to support a low assessed level of control risk of noncompliance for major programs.

This lands auditors working on the compliance portion of the Single Audit in the same position as performance auditors; they will have to evaluate and document the auditee’s application of all 17 principles. Fun-ness!

Does your team meet the 2018 Yellow Book Independence Standards?

Chapter 3: Independence

As I revise my self-study book, “The Yellow Book Interpreted,” I will be sharing chapters with you.

Objectives: 

  • Classify your ethical responsibilities in the government environment 
  • Apply the conceptual framework in evaluating threats to your independence as an auditor 
  • Identify the attributes of professional judgment per GAO standards

All Three Together

In prior versions of the Yellow Book, the ethics, independence, and professional judgment standards were presented in different chapters. Now they are joined in one long chapter.

These are some of the least specific standards in the Yellow Book as all require the application of professionalism, maturity, and judgment. And how do you regulate professionalism, maturity, and judgment? You can’t. You can only talk about them in generalities.

We will cover the three standards in the order presented in Chapter 3 of the Yellow Book. First ethics, then independence, and lastly professional judgment.

Ethics

In order to understand the GAO’s perspective on ethics and independence, we need to talk about three themes of the Yellow Book that kick off the standards in the first few pages of the Yellow Book. These three themes – accountability, transparency, and service –  put us in the right frame of mind when auditing in the government environment.

Accountability

What is accountability? I had heard the term tossed around the government so frequently that I never even thought about its meaning. Now I know that accountability does notmean that you got it right. It just means that you take ownership of it.

I met a cowboy auditor in West Texas who said, “You might be right, or you might be wrong, but you’d better the hell document it.” That sums up accountability quite nicely. When things go bad, you are there to say, “Yes, that was me. I’m sorry.” When things go well, you can keep your job.

Recently on TV news, I saw a high school coach who was responsible for the death of one of his teenage football players. And instead of being contrite, he said something like, “Everyone is forgetting that I suffered a loss, too, and that I will hold on to this for the rest of my life.” That is not exactly what the parents of that boy wanted to hear. He deflected accountability and tried to engender empathy for himself. I doubt that will serve him well in his community.

The GAO repeatedly reminds us that we are accountable to the taxpaying public for our actions and that we, as auditors, have a role in holding government leaders accountable.

1.02     The concept of accountability for use of public resources and government authority is key to our nation’s governing processes.

1.05     Government auditing is essential in providing accountability to legislators, oversight bodies, those charged with governance, and the public. Auditsprovide an independent, objective, nonpartisan assessment of the stewardship, performance, or cost of government policies, programs, or operations, depending upon the type and scope of the engagement.

One of the tough things about the GAO standards is they are not written for government officials (although government officials are mentioned a few times); they are written as standards for auditors. So, while we hold public officials and employees accountable for their actions, we are accountable for our actions, too.

Transparency

Actions and information that are transparent and open for everyone’s inspection and review.

1.07     Audits performed in accordance with GAGAS provide information used for oversight, accountability, transparency, and improvements of government programs and operations. GAGAS contains requirements and guidance to assist auditors in objectively acquiring and evaluating sufficient, appropriate evidence and reporting the results. When auditors perform their work in this manner and comply with GAGAS in reporting the results, their work can lead to improved government management, better decision making and oversight, effective and efficient operations, and accountability and transparency for resources and results.

The State of Texas government has put every single transaction online in real time. I can, with a few clicks of the mouse, see that the Texas Department of Transportation bought a van, how much the van was, who they bought it from, why they need it, and what color of funds (general revenue, special revenue, enterprise revenues) paid for it. They occasionally consider putting all state employee payroll data online – yes, names, pay grade, title, the whole bit. Why? Because citizens own the government, and we citizens have a right to know how our money is being used!

Theoretically, if you do as President Obama frequently advised in his speeches and shine light in the dark places, those in hiding will be exposed and held accountable.

Service

If you audit Hurst Construction, your ultimate audience for the audit report is Mr. Hurst, his board of directors, and the bank. But, if you audit a public housing project, your ultimate clients are not the managers of the project, the boards of directors, or the banks. Your ultimate beneficiaries of the report are not even the grantors. The ultimate beneficiaries of your work are the low-income children who live in the housing project.

We have to remember, as governmental auditors, that we are checking to see whether tax dollars are being used for their intended purpose and whether the public is being served by our auditee’s efforts.

3.08     A distinguishing mark of an auditor is acceptance of responsibility to serve the public interest. This responsibility is critical when auditing in the government environment. GAGAS embodies the concept of accountability for public resources, which is fundamental to serving the public interest.

We hold our clients to a higher standard of behavior than we do in the commercial sector. While it was OK for AIG to go on a lavish $500,000 spa junket before the US taxpayers bailed them out in 2008, it certainly was not OK after the bailout.

Later, we will see that the GAO asks you to report even more bad behaviors than the AICPA does. If Mr. Hurst wants to put his jet-setting, never-worked-a-day-in–their-life kids on the payroll, more power to him. Auditors in the commercial sector do not have a responsibility to say anything about that. But in the government realm, we call that abuse, and we do have a professional, and I have to add, moral, responsibility to do something with that knowledge. We’ll discuss more about abuse later.

Five Main Sections of the Ethics Section

The ethics discussion is divided into five main principles:

a.   The public interest 
            b.   Integrity 
            c.   Objectivity 
            d.   Proper use of government information, resources, and position 
            e.   Professional behavior 

Let’s discuss each one in turn.

The Public Interest

When Johnson and Johnson found out that someone had tampered with one of their products, Tylenol, and that people were dying as a result, they immediately recalled the product. This cost Johnson and Johnson an estimated $100 million. They could have made a lot of other, less responsible and possibly less expensive choices. But because they had a mission statement that put the customer first and the shareholders second, it was obvious what they should do.

In government, our first responsibility is to the public. Not to the person who hired us and is writing our checks. Not to the federal grantor. We are responsible for bringing anything to light that harms the kid in the housing development.  Sometimes this will cost us.

A city auditor told me that he sees a higher purpose in his work. It is his job to make sure that the monies collected by the city are turned back to support those who need services and who may not have a voice in the government. He works on the citizens’ behalf, and because of this higher purpose, doesn’t care whether he makes his auditees upset when he publishes his reports.

3.07     The public interest is defined as the collective well-being of the community of people and entities the auditors serve. Observing integrity, objectivity, and independence in discharging their professional responsibilities assists auditors in meeting the principle of serving the public interest and honoring the public trust. The principle of the public interest is fundamental to the responsibilities of auditors and critical in the government environment.

In my business, I transfer in and out of two worlds – the government world and the commercial world – and indeed they are different. In the commercial world fortunes are made by doing what is not expressly prohibited. In the government world, action won’t be taken unless it is expressly permitted.

Commercial entities are not interested in transparency. A friend of mine, an engineer, says that Apple is one of the most secretive organizations for which he has ever worked. At the corporate headquarters store, they sell a T-Shirt that says, “I visited the Apple Corporate Offices in Cupertino…and that is all I can say about it.” Apple doesn’t want their auditor shining light in their dark places.

But government auditors must shine light in dark places to serve the children, the elderly, and the disabled.

And taxpayers get very, very upset if even a tiny bit of their hard-earned tax dollars are squandered. Not long ago, I helped develop a training event for a government employee retirement system. Afterwards, to celebrate our success, the retirement system managers insisted that we dine at a first-rate steakhouse in Dallas – you know the type, where you pay $45 for an à la carte steak. We had wine and appetizers, and one guy ordered a $35 brandy. I was very uncomfortable. I thought that if any of their members walked in and recognized them as the folks in charge of their retirement funds, they would have a lot of explaining to do. The retirees don’t want their money going for high living! If you work for a corporation, go ahead and enjoy. Live it up! But in a conscientious government environment, I can’t even get a cup of coffee for free.

Integrity

Both the integrity and objectivity sections of the Yellow Book mention independence and freedom from political or ideological bias.

When I started in public accounting, the managing partner made it very clear to me that I should not put any bumper stickers on my car indicating affiliation with any political party, university, or even a radio station! When talking to the client, I was not to express opinions on the events of the day or engage the clients in religious, social, or political discussions. I was to be personality-less! In this way, the client could never question whether I had a bias as I made my audit conclusions.

He was, not so subtly, pointing out that what the firm sold was auditor integrity and objectivity. And if the client doubted either or those, our product – our conclusions and opinions – was useless.

Integrity
3.09     Public confidence in government is maintained and strengthened by auditors performing their professional responsibilities with integrity. Integrity includes auditors conducting their work with an attitude that is objective, fact-based, nonpartisan, and nonideological with regard to audited entities and users of the auditors’ reports. Within the constraints of applicable confidentiality laws, rules, or policies, communications with the audited entity, those charged with governance, and the individuals contracting for or requesting the audit are expected to be honest, candid, and constructive.

3.10     Making decisions consistent with the public interest of the program or activity under audit is an important part of the principle of integrity. In discharging their professional responsibilities, auditors may encounter conflicting pressures from management of the audited entity, various levels of government, and other likely users. Auditors may also encounter pressures to inappropriately achieve personal or organizational gain. In resolving those conflicts and pressures, acting with integrity means that auditors place priority on their responsibilities to the public interest.

Objectivity

Objectivity

3.11      The credibility of auditing in the government sector is based on auditors’ objectivity in discharging their professional responsibilities. Objectivity includes independence of mind and appearance when providing audits, maintaining an attitude of impartiality, having intellectual honesty, and being free of conflicts of interest. Maintaining objectivity includes a continuing assessment of relationships with audited entities and other stakeholders in the context of the auditors’ responsibility to the public. The concepts of objectivity and independence are closely related. Independence impairments impact objectivity.

Proper Use of Government Information, Resources, and Position

A professor at University of Texas at Arlington teaches ethics and leadership to government leaders in communist bloc countries. He developed several case studies for the leaders-in-training to discuss. One case study described how a mayor used city employees to landscape his backyard– clearly an improper usage of government resources. But unlike previous case studies, the professor didn’t hear anything back from them the next week. Instead the leaders stalled for a month before they admitted that they just didn’t understand the ethical dilemma in the scenario. Using the labor of government employees for personal benefit is one of the perks of being a government leader in a communist bloc country! Not so under Yellow Book standards:

3.12     Government information, resources, and positions are to be used for official purposes and not inappropriately for the auditor’s personal gain or in a manner contrary to law or detrimental to the legitimate interests of the audited entity or the audit organization. This concept includes the proper handling of sensitive or classified information or resources.

3.13     In the government environment, the public’s right to the transparency of government information has to be balanced with the proper use of that information. In addition, many government programs are subject to laws and regulations dealing with the disclosure of information. To accomplish this balance, exercising discretion in the use of information acquired in the course of auditors’ duties is an important part in achieving this goal. Improperly disclosing any such information to third parties is not an acceptable practice.

3.14     Accountability to the public for the proper use and prudent management of government resources is an essential part of auditors’ responsibilities. Protecting and conserving government resources and using them appropriately for authorized activities is an important element in the public’s expectations for auditors.

3.15     Misusing the position of an auditor for financial gain or other benefits violates an auditor’s fundamental responsibilities. An auditor’s credibility can be damaged by actions that could be perceived by an objective third party with knowledge of the relevant information as improperly benefiting an auditor’s personal financial interests or those of an immediate or close family member; a general partner; an organization for which the auditor serves as an officer, director, trustee, or employee; or an organization with which the auditor is negotiating concerning future employment.

Professional Behavior

Any behavior that could cause someone to question your professionalism can detract from your credibility. And, credibility helps sell audit recommendations.

3.16     High expectations for the auditing profession include compliance with all relevant legal, regulatory, and professional obligations and avoidance of any conduct that might bring discredit to auditors’ work, including actions that would cause an objective third party with knowledge of the relevant information to conclude that the auditors’ work was professionally deficient. Professional behavior includes auditors putting forth an honest effort in performanceof their duties and professional services in accordance with the relevant technical and professional standards.

Consider the following true scenario (with a few small changes to protect identities): You are the internal audit director of a large city. You recently hired a new auditor fresh out of college and have been grooming him for a career conducting governmental audits. Recently, you assigned him to conduct a performance audit of your city’s police department.

Everything has been going well until last week when you saw a picture of him in the local newspaper at the city’s Mardi Gras celebration. He was pictured on the very top of a street light without his shirt wearing dozens of bead necklaces. The police stood below and appeared to be yelling at him to come down. You show him the picture and ask him what he thought he was doing. He becomes immediately defensive and tells you that what he does on his own time is none of your business. He had some college buddies in town and they were celebrating an upcoming wedding.

The professional behavior standard says nothing about distinguishing your behavior between your work life and your personal life. But does this new auditor’s personal behavior compromise his credibility with the police force? Yes, indeed! If he doesn’t respect the law on his personal time, he can’t expect the police department to respect his audit during his professional time.

To maintain your shop’s professional image, you will probably have to remove this auditor from the engagement and replace him with another auditor.

As auditors, we sell our credible, objective, high integrity opinions  andconclusions about an audit subject.

Borrowing from the later discussion on independence in chapter 3:

3.22     Auditors and audit organizations maintain independence so that their opinions, findings, conclusions, judgments, and recommendations will be impartial and viewed as impartial by reasonable and informed third parties. 

3.19     Auditors and audit organizations should avoid situations that could lead reasonable and informed third parties to conclude that the auditors and audit organizations are not independent and thus are not capable of exercising objective and impartial judgment on all issues associated with conducting the engagement and reporting on the work. 

Independence

Did you notice how many times the words independence and objectivity showed up in the ethics requirements? Independenceis one of the most complicated and granular standards in the Yellow Book clocking, in at almost 30 pages of text!

I am going to summarize the major requirements of the Yellow Book regarding independence. But as you know, summaries leave out details that might be important to you. So please at least scan Chapter 3 to make sure you have applied the independence standards to your specific situation.

The GAO Isn’t Empathetic When It Comes to Independence

The GAO, a legislative auditor, is in a rare situation; they are truly independent. They can say whatever needs to be said and not suffer any consequences because they are funded by and report directly to Congress, not the federal agencies that they audit.

The GAO did not set out to have anythingto do with internal or external auditors. They wrote the Yellow Book for themselves. But over the decades, through a series of laws and regulations, they became responsible for groups of folks for whom they seem to have little empathy because both internal auditors and external auditors have inherent independence challenges. Internal auditors are employees of the entity they audit and attend the same holiday parties as their auditees. External auditors are contractors who are paid by the auditee, and if they don’t make the auditee happy, they don’t get to keep the gig during the next audit cycle.

For the last few decades, the GAO has been working with mixed success to clarify and strengthen the auditor independence standards so that all government auditors are working with the highest level of objectivity and integrity. Along the way, they decided that going their own way with the standards confused CPAs in public practice. So, they adopted the AICPA rules for independence and added a few significant modifications. The AICPA invented something called the “conceptual framework” for evaluating auditor independence, which I will explain shortly.

The Bottom Line of Auditor Independence

The essential steps the GAO wants you to go through if you encounter an independence threat are:

  1. apply the conceptual framework when you encounter a threat
  2. document your application of the conceptual framework
  3. if the threat involves you performing a non-auditservice, make sure the client has SKE
  4. document the client’s SKE
  5. have the client agree they are responsible for the results of the non-audit service
  6. document this understanding with the client in writing

Let’s go through each step.

Apply the Conceptual Framework

The AICPA uses a decision process for evaluating independence that they call the “conceptual framework.” Typical of the AICPA, they make something very straightforward sound complex and involved. You know, something only a well-paid, CPA-typeprofessional can implement!

I am not intimidated or wowed by their conceptual framework, and you shouldn’t be either. It is simply putting fancy terminology around the way all humans make decisions. First, we understand our options, then we decide what is important to us, and then we choose. But since you have to use the conceptual framework, it would be good for you to use the exact language the AICPA and GAO use:

3.27     Auditors should apply the conceptual framework at the audit organization, engagement team, and individual auditor levels to 

1.identify threats to independence; 

2.evaluate the significance of the threats identified, both individually and in the aggregate; and 

3.apply safeguards as necessary to eliminate the threats or reduce them to an acceptable level. 

Let’s think through the conceptual framework in more personal terms before we take on an audit example. Let’s talk about the decision process you go through when dating!

Step 1 of the Conceptual Framework: Identify Threats

In dating terms, identifying threats means spending time with your intended to find out more about them and identify potential relationship killers or aspects of their personality, habits, or baggage that could cause you future misery. Maybe he is way too close to his mother, or his ex-wife is extremely hard to handle, or his football/golf/hunting/fishing hobby is likely to leave you on your own most weekends.

Step 2 of the Conceptual Framework: Evaluate the Significance of the Threats Identified, Both Individually and in the Aggregate

In dating terms, this means you now need to figure out whether you can actually tolerate being left alone most weekends. Maybe you like to be alone, so you can shop, spend time with friends, or volunteer. But if his mother’s constant visits and calls are unwanted, his ex-wife’s picture is still on his mantle, and he spent the last three weekends getting sunburned and drunk at the golf course, this is what the AICPA calls “threats in the aggregate.”

Step 3 of the Conceptual Framework: Apply Safeguards as Necessary to Eliminate the Threats or Reduce Them to an Acceptable Level

In dating terms, this might mean breaking up, finding a new supportive social structure, agreeing to limits on his hobby, or moving to another country without phone or internet service to escape his mother.

Not exactly rocket science, huh? Conceptual framework… PLEASE!

The GAO just adds to the aura of complexity by coming up with a diagram in the appendix. I can tell when people have gotten a bit too granular when I see two things: a key that explains acronyms and terminology and/or a flowchart. When auditors feel the need to add a key that explains acronyms and technical terms to the back cover of their report, they mistakenly assume their readers care enough to actually use it to read their complex report! The same is true when they have to draw a flowchart similar to the following:

GAGAS chart

Trifecta Step #1 – Identify Threats

Let’s start by looking at the list of threats: conceptual framework step #1.

3.30     Auditors should evaluate the following broad categories of threats to independence when applying the GAGAS conceptual framework: 

1.Self-interest threat: The threat that a financial or other interest will inappropriately influence an auditor’s judgment or behavior. 
2.Self-review threat: The threat that an auditor or audit organization that has provided nonauditservices will not appropriately evaluate the results of previous judgments made or services provided as part of the nonauditservices when forming a judgment significant to a GAGAS engagement. 
3.Bias threat: The threat that an auditor will, as a result of political, ideological, social, or other convictions, take a position that is not objective. 
4.Familiarity threat: The threat that aspects of a relationship with management or personnel of an audited entity, such as a close or long relationship, or that of an immediate or close family member, will lead an auditor to take a position that is not objective. 
5.Undue influence threat: The threat that influences or pressures from sources external to the audit organization will affect an auditor’s ability to make objective judgments. 
6.Management participation threat: The threat that results from an auditor’s taking on the role of management or otherwise performing management functions on behalf of the audited entity, which will lead an auditor to take a position that is not objective. 
7.Structural threat: The threat that an audit organization’s placement within a government entity, in combination with the structure of the government entity being audited, will affect the audit organization’s ability to perform work and report results with integrity.

3.38     Examples of circumstances that create self-interest threats for an auditor follow: 

a.   An audit organization having undue dependence on income from a particular audited entity. 
b.   A member of the audit team entering into employment negotiations with an audited entity.
c.   An audit organization discovering a significant error when evaluating the results of a previous professional service provided by the audit organization. 
d.   A member of the audit team having a direct financial interest in the audited entity. However, this would not preclude auditors from auditing pension plans that they participate in if (1) the auditors have no control over the investment strategy, benefits, or other management issues associated with the pension plan and (2) the auditors belong to such pension plan as part of their employment with the audit organization or prior employment with the audited entity, provided that the plan is normally offered to all employees in equivalent employment positions. 

3.39     Examples of circumstances that create self-review threats for an auditor follow: 

1.An audit organization issuing a report on the effectiveness of the operation of financial or performance management systems after designing or implementing the systems. 
2.An audit organization having prepared the original data used to generate records that are the subject matter of the engagement. 
3.An audit organization providing a service for an audited entity that directly affects the subject matter information of the engagement. 
4.A member of the engagement team being, or havingrecently been, employed by the audited entity in a position to exert significant influence over the subject matter of the engagement. 

3.40     Examples of circumstances that create bias threats for an auditor follow: 

1.A member of the engagement team having preconceptions about the objectives of a program under audit that arestrong enough to affect the auditor’s objectivity. 
2.A member of the engagement team having biases associated with political, ideological, or social convictions that result from membership or employment in, or loyalty to, a particular type of policy, group, entity, or level of government that could affect the auditor’s objectivity. 

3.41     Examples of circumstances that create familiarity threats for an auditor follow: 

a.   A member of the engagement team having a close or immediate family member who is a principal or senior manager of the audited entity. 
b.   A member of the engagement team having a close or immediate family member who is an employee of the audited entity and is in a position to exert significant influence over the subject matter of the engagement. 
c.   A principal or employee of the audited entity having recently served on the engagement team in a position to exert significant influence over the subject matter of the engagement. 
d. An auditor accepting gifts or preferential treatment from an audited entity, unless the value is trivial or inconsequential. 
e. Senior engagement personnel having a long association with the audited entity. 

3.42     Examples of circumstances that create undue influence threats for an auditor or audit organization include existence of the following: 

a.   External interference or influence that could improperly limit or modify the scope of an engagement or threaten to do so, including exerting pressure to inappropriately reduce the extent of work performed in order to reduce costs or fees. 
b.   External interference with the selection or application of engagement procedures or in the selection of transactions to be examined. 
c.   Unreasonable restrictions on the time allowed to complete an engagement or issue the report.
d.   External interference over assignment, appointment, compensation, and promotion. 
e.    Restrictions on funds or other resources provided to the audit organization that adversely affect the audit organization’s ability to carry out its responsibilities. 
f.    Authority to overrule or to inappropriately influence the auditors’ judgment as to the appropriate content of the report. 
g.   Threat of replacing the auditor or the audit organization based on a disagreement with the contents of an audit report, the auditors’ conclusions, or the application of an accounting principle or other criteria. 
h.   Influences that jeopardize the auditors’ continued employment for reasons other than incompetence, misconduct, or the audited entity’s need for GAGAS engagements. 

3.43     Examples of circumstances that create management participation threats for an auditor follow: 

1.A member of the engagement team being, or having recently been, a principal or senior manager of the audited entity. 
2.An auditor serving as a voting member of an entity’s management committee or board of directors, making policy decisions that affect future direction and operation of an entity’s programs, supervising entity employees, developing or approving programmaticpolicy, authorizing an entity’s transactions, or maintaining custody of an entity’s assets. 
3.An auditor or audit organization recommending a single individual for a specific position that is key to the audited entity or program under audit, or otherwise ranking or influencing management’s selection of the candidate. 
4.An auditor preparing management’s corrective action plan to deal with deficiencies detected in the engagement. 

3.44     Examples of circumstances that create structural threats for an auditor follow: 

1.For both external and internal audit organizations, structural placement of the audit function within the reporting line of the areas under audit. 
2.For internal audit organizations, administrativedirection from the audited entity’s management. 

By the way, performing a non-audit service in addition to your audit is automatically a threat.

Conceptual Framework Step #2 – Evaluate the Significance of the Threat

Did you see yourself inStep 1? If so, proceed to the conceptual framework/trifecta step #2 evaluating the significance of the threat. Whether a threat is a big deal or not is entirely up to your judgment, even though the standard does ask you to imagine a hypothetical judge – the classic “objective third party with knowledge of relevant facts.”

3.46     When evaluating threats to independence, an acceptable level is a level at which a reasonable and informed third party would likely conclude that the audit organization or auditor is independent. The concept of a reasonable and informed third party is a test that involves an evaluation by a hypothetical person. Such a person possesses skills, knowledge, and experience to objectively evaluate the appropriateness of the auditor’s judgments and conclusions. This evaluation entails weighing all the relevant facts and circumstances, including any safeguards applied, that the auditor knows, or could reasonably be expected to know, at the time that the evaluation is made. 

Conceptual Framework Step #3 – Apply Safeguards

If you decide that you or the imaginary third party believes these threats to be significant, you move on to conceptual framework/trifecta step #3: apply safeguards:

3.49     Safeguards are actions or other measures, individually or in combination, that auditors and audit organizations take that effectively eliminate threats to independence or reduce them to an acceptable level. Safeguards vary depending on the facts and circumstances. 

3.50     Examples of safeguards include 

a.   consulting an independent third party, such as a professional organization, a professional regulatory body, or another auditor to discuss engagement issues or assess issues that are highly technical or that require significant judgment; 
b.   involving another audit organization to perform or re-perform part of the engagement; 
c.   having an auditor who was not a member of the engagement team review the work performed; and 
d.   removing an auditor from an engagement team when that auditor’s financial or other interests or relationships pose a threat to independence. 

3.69     The following are examples of actions that in certain circumstances could be safeguards in addressing threats to independence related to nonauditservices: 

a.   not including individuals who provided the nonauditservice as engagement team members; 
b.   having another auditor, not associated with the engagement, review the engagement and nonauditwork as appropriate; 
c.   engaging another audit organization to evaluate the results of the nonauditservice; or 
d.   having another audit organization re-perform the nonauditservice to the extent necessary to enable that other audit organization to take responsibility for the service. 

And, typical of a Yellow Book audit standard, you don’t get to just go through the process in your head. You get to document your reasoning process, too. Yes, you will need another memo!

After applying the conceptual framework, you might be just fine. If you have a threat, you put a safeguard in place and go on your merry way. But if the nature of your threat is caused because you are taking on a non-audit service, a handful of additional requirements apply.

What Is a Nonaudit Service?

A non-audit service is almost anything that you do for the auditee that isn’t an audit. Examples include helping them document internal controls, monitoring transactions on their behalf, or creating financial statements.

Non-audit services are called “consulting services” by other standards. For instance, the IIA divides their standards up into two main pieces, assurance standards andconsulting standards. And the IIA encourages internal auditors to perform consulting engagements in order to add value to their organization.

The GAO wishes you would just stick with auditing and let someone else provide consulting services because they believe that consulting services have an impact on your auditor independence. To make auditors think twice about taking on consulting services (non-audit services), the GAO requires that the client has skills, knowledge, and experience (SKE) and that the client takes responsibility for the product of the non-audit service in writing.

SKE

The GAO wants to make sure that the client is sophisticated enough to tell if the auditor made a mistake with the product of their consulting service. Pay close attention to a new sentence at the bottom of 3.79 (bolding added).

3.73     Before auditors agree to provide nonauditservices to an audited entity that the audited entity’s management requested and that could create a threat to independence, either by themselves or in aggregate with other nonauditservices provided, with respect to any GAGAS engagement they conduct, auditors should determine that the audited entity has designated an individual who possesses suitable skill, knowledge, or experience and that the individual understands the services to be provided sufficiently to oversee them. 

3.74     Auditors should document consideration of management’s ability to effectively oversee nonauditservices to be provided. 

3.75     In cases where the audited entity is unable or unwilling to assume these responsibilities (for example, the audited entity does not have an individual with suitable skill, knowledge, or experience to oversee the nonauditservices provided, or is unwilling to perform such functions because of lack of time or desire), auditors should conclude that the provision of these services is an impairment to independence. 

3.79     A critical component of determining whether a threat to independence exists is consideration of management’s ability to effectively oversee the nonauditservice to be provided. Although the responsible individual in management is required to have sufficient expertise to oversee the nonauditservices, management is not required to possess the expertise to perform or re-perform the services. However, indicators of management’s ability to effectively oversee the nonauditservice include management’s ability to determine the reasonableness of the results of the nonauditservices provided and to recognize a material error, omission, or misstatement in the results of the nonauditservices provided. 

ClientMust Take Responsibility in Writing

Once you have documented your application of the conceptual framework, applied safeguards, and decided and documented that the client has SKE, you now create a letter of agreement with the client stating that the client is responsible for the results of the non-audit service.

3.76     Auditors providing nonauditservices to audited entities should obtain agreement from audited entity management that audited entity management performs the following functions in connection with the nonauditservices: 

1.assumes all management responsibilities; 
2.oversees the services, by designating an individual, preferably within senior management, who possesses suitable skill, knowledge, or experience; 
3.evaluates the adequacy and results of the services provided; and
4.accepts responsibility for the results of the services. 

The Bottom Line of Auditor Independence: A Review

Again, I recommend that you read the independence section of the Yellow Book yourselfbecause as I summarize and simplify the standard, I naturally have to leave some detail out that might be pertinent to you!  Here again is the bottom line:

  1. apply the conceptual framework when you encounter a threat
  2. document your application of the conceptual framework
  3. if the threat involves a non-audit service, make sure the client has SKE
  4. document the client’s SKE
  5. have the client agree they are responsible for the results of the non-audit service
  6. document this understanding with the client in writing

Notice three levels of documentation: the application of the conceptual framework, the proof of SKE, and the letter assigning responsibility for the subject matter to the client.

Specifically Addressed Non-Audit Services

The GAO knows that auditors are still performing non-audit services, regardless of the GAO’s disdain for them and their repeated warnings. And they also know of a handful of non-audit services that are performed pretty regularly. I want to mention two of thembecause I see these non-audit services being performed quite often myself. One is continuous monitoring and the other is financial statement preparation.

Continuous Monitoring as a Non-Audit Service

Continuous monitoring is always a hot topic at IIA conferences. Continuous monitoring technology allows managers to watch transactions and controls in real time to identify outliers and correct errors or even fraud promptly. But, in a list of non-auditservices that impair auditor independence, the GAO specifically prohibits the auditor from performing internal control monitoring on behalf of the client.

3.97     Auditors should conclude that providing or supervising ongoing monitoring procedures over an entity’s system of internal control impairs independence because the management participation threat created is so significant that no safeguards could reduce the threat to an acceptable level. 

Creating the Financial Statements

The GAO also specifically addresses this non-audit service, and although it does not firmly prohibit auditors from both creating the subject matter of the audit (the financial statements) and opiningon the same subject matter, they do make the auditor think and rethink his or her decision to proceed.

Relevant clauses regarding preparing the financial statements include the following:

3.87     Auditors should conclude that the following services involving preparation of accounting records impair independence with respect to an audited entity: 

1.determining or changing journal entries, account codes or classifications for transactions, or other accounting records for the entity without obtaining management’s approval; 
2.authorizing or approving the entity’s transactions; and 
3.preparing or making changes to source documents without management approval. 

3.88     Auditors should conclude that preparing financial statements in their entirety from a client-provided trial balance or underlying accounting records creates significant threats to auditors’ independence, and should document the threats and safeguards applied to eliminate and reduce threats to an acceptable level in accordance with paragraph 3.33 or decline to provide the services. 

3.89     Auditors should identify as threats to independence any services related to preparing accounting records and financial statements, other than those defined as impairments to independence in paragraph 3.87 and significant threats in paragraph 3.88. These services include 

1.recording transactions for which management has determined or approved the appropriate account classification, or posting coded transactions to an audited entity’s general ledger; 
2.preparing certain line items or sections of the financial statements based on information in the trial balance; 
3. posting entries that an audited entity’s management has approved to the entity’s trial balance; and
4. preparing account reconciliations that identify reconciling items for the audited entity management’s evaluation. 

3.90     Auditors should evaluate the significance of threats to independence created by providing any services discussed in paragraph 3.89 and should document the evaluation of the significance of such threats

So, although the GAO does not expressly prevent auditors from both preparing and auditing the financial statements, the GAO puts up as many barriers as they can:

Barrier # 1: The auditor must identify the preparation of the financials as a threat and apply appropriate safeguards.

Barrier # 2. The auditor must document their rationale that the threat has been mitigated through safeguards or decline the engagement.

Barrier # 3. The auditor must determine that the client has the skills, knowledge, andexperience to be able to tell if the auditor made a mistake in the financials and document that rationale

Barrier #4. The client must take responsibilities for the financials in writing.

That’s enough to keep me away from preparing and auditing the financial statements. How about you?

Professional Judgment

Professional judgment is one of the least specific Yellow Book standards. It is similar to the warning that your mother would give you when you were going out to play, “Be careful!”

Now if mom had given me specific instructions, like “Don’t play in the street,” I would know what she expected of me. But, “Be careful!”? How does a five-year-old know what “careful” looks like? That is similar to what we read in the professional judgment standard. The GAO cautions us to apply professional judgment but then never defines the term. Instead,they offer this explanation:

3.110    Professional judgment includes exercising reasonable care and professional skepticism. 

Yep, sounds like your mama, “Be reasonable, girl! Take care, girl! And don’t let anyone pull the wool over your eyes! It is a wicked world out there.”

Maybe I will show my kids this explanation of professional skepticism some day:

3.110    Attributes of professional skepticism include a questioning mind, awareness of conditions that may indicate possible misstatement owing to error or fraud, and a critical assessment of evidence. Professional skepticism includes being alert to, for example, evidence that contradicts other evidence obtained or information that brings into question the reliability of documents or responses to inquiries to be used as evidence. Further, it includes a mindset in which auditors assume that management is neither dishonest nor of unquestioned honesty. Auditors may accept records and documents as genuine unless they have reason to believe the contrary. Auditors may consider documenting procedures undertaken to support their application of professional skepticism in highly judgmental or subjective areas under audit. 

Maybe that explanation will keep both my kids and us auditors out of trouble.

In the next chapter, we introduce the competency standard. And thoughtfully, the GAO has provided a nice segue for to the topic of competence at the end of Chapter 3:

3.111    Using the auditor’s professional knowledge, skills, and abilities, in good faith and with integrity, to diligently gather information andobjectivelyevaluate the sufficiency and appropriateness of evidence is a critical component of GAGAS engagements. Professional judgment and competence are interrelated because judgments made depend upon the auditor’s competence, as discussed in chapter 4. 

Introduction to the Yellow Book Interpreted

Objectives: 

  • Differentiate between the Yellow Book and other auditing standards
  • Assess whether an engagement requires the use of the Yellow Book
  • Identify the way the Yellow Book is organized

Why do they call it the “Yellow Book”?

The Yellow Book goes by many names:

  • Government Auditing Standards,
  • Generally Accepted Government Audit Standards (GAGAS – I love that one… pronounced “gag us”), and, of course,
  • The Yellow Book.

Legend has it that the original title of the Yellow Book was the “Golden Rule of Government Auditing,” and the cover was supposed to be gold. But when it came back from the printer, the cover was yellow. Whoops! Bye-bye catchy title, hello kitschy title – the Yellow Book. If you ever run across a hard copy, the cover is indeed a sunny yellow. Whether the inside is full of sun will be yours to judge as you read this text!

Why Does the Yellow Book Exist?

The Government Accountability Office (GAO) is the legislative auditor for the federal government. They first published the Yellow Book back in the 1970s as a guide for their own auditors. This is why the Yellow Book exists because the GAO wanted to set an audit standard for itself.

But in 1984, Congress passed a law called the Single Audit Act that made the Yellow Book relevant to a different set of auditors, CPAs in public practice. The Single Audit Act addresses audits of federal grants and requires that the audit be conducted in accordance with Government Auditing Standards. I don’t think the GAO intended to be involved in setting standards for CPAs in public practice. But through the passage of the Act, they were burdened with that responsibility. Subsequent to the Act, several state legislatures passed laws requiring the use of the Yellow Book for audits of governmental entities.

Who might use the Yellow Book on an Audit?

For the first time in 2018, the GAO lists users of the Yellow Book. This list is not comprehensive as it leaves out some of my clients including internal auditors working inside of state agencies and universities, but it is still interesting to see who the GAO thinks it is writing for:

1.12      GAGAS provides standards that are used by a wide range of auditors and audit organizations that audit government entities, entities that receive government awards, and other entities. These auditors and audit organizations may also be subject to additional requirements unique to their environments. Examples of the various types of users who may be required or may elect to use GAGAS include the following: 

Contract auditors: audit organizations that specialize in conducting engagements pertaining to government acquisitions and contract administration 

Certified public accounting firms: public accounting organizations in the private sector that provide audit, attestation, or review services under contract to government entities or recipients of government funds 

Federal inspectors general: government audit organizations within federal agencies that conduct engagements and investigations relating to the programs and operations of their agencies and issue reports both to agency management and to third parties external to the audited entity 

Federal agency internal auditors: internal government audit organizations associated with federal agencies that conduct engagements and investigations relating to the programs and operations of their agencies 

Municipal auditors: elected or appointed officials in government audit organizations in the United States at the city, county, and other local government levels 

State auditors: elected or appointed officials in audit organizations in the governments of the 50 states, the District of Columbia, and the U.S. territories 

Supreme audit institutions: national government audit organizations, in the United States or elsewhere, typically headed by a comptroller general or auditor general 

The Yellow Book has to be called into play by someone else.

Just because the Yellow Book exists does not mean you have to follow it in conducting a governmental audit. The Yellow Book has to be called forth by something or someone external to it:

1.08     Laws, regulations, contracts, grant agreements, and policies frequently require that engagements be conducted in accordance with GAGAS. In addition, many auditors and audit organizations voluntarily choose to conduct their work in accordance with GAGAS. The requirements and guidance in GAGAS in totality apply to engagements pertaining to government entities, programs, activities, and functions, and to government assistance administered by contractors, nonprofit entities, and other nongovernmental entities when the use of GAGAS is required or voluntarily adopted. 

The Yellow Book may be called forth by law or policy. The Single Audit Act is just one of many laws that call the Yellow Book into play. For instance, the State of Texas passed a law that all audits conducted by internal audit shops in the state will be conducted using government auditing standards.

If you conduct an audit of a city, the city may have a policy requiring that all audits be conducted in accordance with government auditing standards. Or, the request for proposal for the audit may request that the audit be conducted in accordance with government auditing standards. But it wouldn’t be surprising if the city does not have a policy or a law that mentions the Yellow Book. In this case, the internal auditor for the city would likely follow Institute of Internal Auditors (IIA) Standards and the external auditor would follow American Institute of Certified Public Accountants (AICPA) auditing standards.

The bottom line is that just because you audit a government does not mean you have to use the Yellow Book. If you cannot find any law or policy requiring it, you do not have to follow it. The Yellow Book is not like the AICPA’s audit standards, which, just because they exist, must be followed when expressing an opinion on the financial statements.

For instance, let’s say you are engaged to express an opinion on the financial statements of a small town in Georgia that does not receive any federal funds. Are you required to follow the Yellow Book on this engagement? To figure this out, you need to do more research. You need to determine whether the state of Georgia has a law or regulation requiring the use of GAGAS on audits of towns and cities in the state. You must also find out whether the town has a rule or regulation in its city charter that requires the use of GAGAS. The request for proposal may include a request that the audit be conducted in accordance with Yellow Book. You need to look at all these rules, regulations, and policies to find the answer.

You don’t necessarily have to use the Yellow Book when working as an internal auditor of a government or as a monitor of governmental funds.Obviously, if you work for the federal government and conduct an audit of federal funds, you probably use the Yellow Book in your work because the Inspector General Act or the CFO Act requires it. But if you are a county auditor, you probably are not required to use it to guide your work.

Here is an example. Many state agencies have set up monitoring teams to ensure that federal and state pass-through funds are being spent properly, and they usually look at a finite set of compliance requirements. Nowhere do state regulations or laws require that the state agencies follow the Yellow Book. And, the agencies do not conduct or contribute to the Single Audit of the sub-recipients. Therefore, these monitoring teams do not conduct their work to comply with the Yellow Book, even though they audit governmental funds of governmental entities.

The GAO lists several laws or regulations that may require the use of the Yellow Book:

1.09     The following are some of the laws, regulations, and or other authoritative sources that require the use of GAGAS:

  1. The Inspector General Act of 1978, as amended, 5 U.S.C. App. requires that the statutorily appointed federal inspectors general comply with GAGAS for audits of federal establishments, organizations, programs, activities, and functions. The act further states that the inspectors general shall take appropriate steps to assure that any work performed by nonfederal auditors complies with GAGAS.
  2. The Chief Financial Officers Act of 1990 (Public Law 101-576), as expanded by the Government Management Reform Act of 1994 (Public Law 103-356), requires that GAGAS be followed in audits of executive branch departments’ and agencies’ financial statements. The Accountability of Tax Dollars Act of 2002 (Public Law 107-289) generally extends this requirement to most executive agencies not subject to the Chief Financial Officers Act unless they are exempted for a given year by the Office of Management and Budget (OMB).
  3. The Single Audit Act Amendments of 1996 (Public Law 104-156) require that GAGAS be followed in audits of state and local governments and nonprofit entities that receive federal awards. OMB Circular No. A-133, Audits of States, Local Governments, and Non- Profit Organizations, which provides the government wide guidelines and policies on performing audits to comply with the Single Audit Act, also requires the use of GAGAS.

1.10      Other laws, regulations, or authoritative sources may require the use of GAGAS. For example, auditors at the state and local levels of government may be required by state and local laws and regulations to follow GAGAS. Also, auditors may be required by the terms of an agreement or contract to follow GAGAS. Auditors may also be required to follow GAGAS by federal audit guidelines pertaining to program requirements, such as those issued for Housing and Urban Development programs and Student Financial Aid programs. Being alert to such other laws, regulations, or authoritative sources may assist auditors in performing their work in accordance with the required standards.

1.11      Even if not required to do so, auditors may find it useful to follow GAGAS in performing audits of federal, state, and local government programs as well as audits of government awards administered by contractors, nonprofit entities, and other nongovernment entities. Many audit organizations not formally required to do so, both in the United States of America and in other countries, voluntarily follow GAGAS.

When the AICPA gets involved

The Yellow Book covers several different categories of engagements: financial audits, attestation engagements, reviews of financial statements, and performance audits. If you conduct a financial audit, you must also follow the AICPA audit standards. If you conduct an attestation engagement, you must also follow the AICPA attestation standards. If you conduct a review of the financial statements, you must follow the AICPA’s review standards. However, if you conduct a performance audit, you don’t have to follow the AICPA standards or any other standards for that matter!

The Yellow Book states, in the sections dealing with financial audits and attestation engagements, that the AICPA standards are to be applied. Then the Yellow Book adds a few additional requirements of its own. For example, the AICPA does not require that the findings contain the five distinct elements of a persuasive argument, but the Yellow Book does.

Periodically, the GAO revises the Yellow Book. When the GAO revises, they seek to match the language in the Yellow Book to the language in the AICPA standards. This is true even in the performance standards because the GAO wants the Yellow Book to use consistent terms and concepts throughout. Why do I mention this? If you are a performance auditor, you can’t entirely ignore the AICPA because when the AICPA moves and updates, the GAO matches their move and updates the financial AND performance audit chapters accordingly.

The Single Audit Layers

If you are one of the lucky souls who conduct Single Audits, you must pay attention to several layers of standards.

In addition to requiring that its instruction be followed, Single Audit requirements demand that the audit be conducted in accordance with government auditing standards. Upon opening the Yellow Book, you discover that a Single Audit qualifies as a financial audit. The financial audit chapters inside the Yellow Book then say that you must also follow the AICPA audit standards.

So, the layering looks like this:

Single Audit requirements
Yellow Book
AICPA audit standards (AU-C)

More often than not, if you audit a federal program, you must look at other requirements generated by the federal grantors that exceed the Single Audit requirements in the Uniform Guidance. For instance, in auditing HUD programs, you must follow the HUD audit guide as well as the Single Audit requirements (and hence the Yellow Book and the AICPA standards). Instead of three layers, you must be apply four layers of audit requirements. Does anybody want out of governmental auditing yet?

The Focus of This Manual

The focus of this manual is to cover onlythe government auditing standards, the Yellow Book. The manual will not delve into the AICPA standards, the IIA standards, or the Single Audit requirements in detail, although I may refer to them from time to time. The Yellow Book provides plenty of fodder for discussion on its own.

How the Yellow Book Is Organized

One key to understanding the Yellow Book standards is to get comfortable with the way they are organized. The standards are conveniently organized by introductory material and general standards as well as financial, attestation, and performance standards.

CHAPTER 1: Foundation and Principles for the Use and Application of Government Auditing Standards: This chapter introduces the types of audits and meaning of must, should, and may
CHAPTER 2: General Requirements for Complying with Government Auditing Standards
CHAPTER 3: Ethics, Independence, and Professional Judgment
CHAPTER 4: Competence and Continuing Professional Education
CHAPTER 5: Quality Control and Peer Review
CHAPTER 6: Standards for Financial Audits: This chapter is applicable to financial audits only and discusses fieldwork standards, including documentation and client communications during planning. This chapter also discusses reporting standards, including the need to garner client responses to findings. This chapter builds on top of AICPA audit standards.
CHAPTER 7: Standards for Attestation Engagements and Reviews of Financial Statements. This chapter is applicable to attestation engagements and reviews of financial statements only and is very redundant of financial auditing standards. This chapter builds on the AICPA’s Statements on Standards for Attestation Engagements (SSAEs) and the Statement on Standards for Accounting and Review Services (SSARS).
CHAPTER 8: Fieldwork Standards for Performance Audits. This chapter is applicable to performance audits only and does not layer on top of any other standards.
CHAPTER 9: Reporting Standards for Performance Audits. This chapter is applicable to performance audits only and does not layer on top of any other standards.

163 Times!

The 2018 version of the Yellow Book mentions audit objectives 163 times in one chapter; Chapter 8 the Performance Audit Fieldwork chapter. That tells me that objectives run the show!

A few years ago, I created a white paper on objectives.  The concepts covered in the white paper are even more important today.  Please find a copy of it here.

And if you want to experience creating and refining objectives along with me, please join me in Austin on September 6 &7.

Audit on!

Leita

What is an auditor?

Please enjoy this first chapter of self-study book Essential Skills for Government Auditor  available on YellowBook-CPE.com.

So here you are, an auditor. No other job title is more likely to be a conversation stopper at a dinner party.  No one likes to be audited.

But auditors do have an important role to play because, unfortunately, government leaders can’t trust program managers when they say, “Everything here is fine.  Don’t worry about us!” Government leaders and citizens do worry and want assurance from someone they can trust that everything is going well.  The auditor is that professional whom the leaders and the citizens can trust.

One definition of auditor is:  An independent professional who evaluates a subject matter against agreed-upon criteria.

This definition has several important components: independence, subject matter, and criteria.  Let’s look at each of those components in turn.

Independence

Auditors must be independent of their clients and the subject matter they are auditing.  But who are these clients?

The Government Accountability Office (GAO), the federal audit organization that writes the governmental auditing standards (a.k.a. the Yellow Book) has a very broad definition of client.  The GAO says, “A distinguishing mark of an auditor is acceptance of responsibility to serve the public interest.” And they define public interest as “the collective well-being of the community and entities the auditors serve.”  Did you know you had such a noble job?

CPAs are held to the same standard. They are certified “public” accountants after all. They have a primary responsibility to the public and a secondary responsibility to their audit client.

Clients in the government realm include management of the auditee, governing bodies, oversight bodies, special interest groups, other citizens, and the people who actually benefit from the government’s services.

If you think about it, auditors are often the only professionals involved in an organization or in a program who can comfortably speak the truth because they are, hopefully, shielded from backlash because they are independent.

GAGAS (Yellow Book) 20113.04     Auditors and audit organizations maintain independenceso that their opinions, findings, conclusions, judgments, and recommendations will be impartial and viewed as impartial by reasonable and informed third parties. Auditors should avoid situations that could lead reasonable and informed third parties to conclude that the auditors are not independent and thus are not capable of exercising objectiveand impartial judgment on all issues associated with conducting the audit and reporting on the work.

The recipients of governmental funds aren’t likely to uncover their own risks or highlight their own weaknesses because they could lose their funding. And the oversight bodies might be so far removed from the program that they don’t have a sense of what is really happening.

You can make quite a difference in an organization. The GAO’s Yellow Book says that you are “essential to the nation’s governing process!” Wow, that is quite a responsibility!

Consulting vs. Auditing

Some professionals who call themselves auditors are actually consultants. They help the client implement systems or spend months working to help the client with a technical issue. Consultants are allowed to get involved in the day-to-day operations of a department.

The Institute of Internal Auditors (one of the standard setting bodies that I will explain further in the next chapter) encourages consulting and has created consulting standards for their members.

The Government Accountability Office (GAO) calls consulting by another name, “non-audit services,” and puts up numerous barriers to prevent auditors from also serving as consultants. The GAO believes that you cannot both consult regarding an audit subject matter and later serve as objective, independent evaluator of the same subject matter.

In this text, our focus will be on auditing and auditing standards.

Subject matter and criteria

Auditors opine or conclude on whether a subject matter meets a certain criteria.

All auditors struggle to keep their audits limited in size and scope. It is extremely easy to create monstrous projects that are hard to reign in and report on.

In response to this struggle, most audit standards require that you develop a finite objective and scope for each engagement.   Imbedded in the audit objective are the audit subject and the criteria the auditor will use to evaluate the audit subject.

The GAO has this to say about the audit objective and scope in the Yellow Book:

GAGAS6.08The objectives are what the audit is intended to accomplish. They identify the audit subject matter and performance aspects to be included, and may also include the potential findings and reporting elements that the auditors expect to develop. Audit objectives can be thought of as questions about the program that the auditors seek to answer based on evidence obtained and assessed against criteria. The term “program” is used in GAGAS to include government entities, organizations, programs, activities, and functions.GAGAS 6.09

Scope is the boundary of the audit and is directly tied to the audit objectives. The scope defines the subject matter that the auditors will assess and report on, such as a particular program or aspect of a program, the necessary documents or records, the period of time reviewed, and the locations that will be included.

The objective and scope define what the project is, as well as what it is not. Objectives are assessed against agreed upon criteria, which are benchmarks established by law, governing organizations, or company policies and procedures. (For more on criteria, read Chapter 6.)

To satisfy the audit objective, you will gather and document audit evidence.  The techniques that you use to gather evidence are called audit methodologies.

6.10     The methodology describes the nature and extent of audit procedures for gathering and analyzing evidence to address the audit objectives. Audit procedures are the specific steps and tests auditors perform to address the audit objectives. Auditors should design the methodology to obtain reasonable assurance that the evidence is sufficient and appropriate to support the auditors’ findings and conclusions in relation to the audit objectives and to reduce audit risk to an acceptable level.

All three of these elements – the objective, scope, and methodology – are essential to describe what you seek to accomplish on the audit. (For more on methodology, see Chapter 15.)   The GAO requires that auditors both document these three defining elements in the working papers and disclose them in the audit report.

Audit deliverables

As Stephen Covey says, you should begin with the end in mind.  So before we dig in to the steps of conducting an audit, let’s look at what you will have when you are all done.  Auditors create three deliverables from an audit project:

  • The answer to the audit objective – called either an audit conclusion or an audit opinion
  • Findings – issues that the auditor would like to see addressed or corrected by the client
  • Working papers –documentation of the evidence the auditor gathered to support the conclusions and the findings.

If you are following GAO’s audit standards (The Yellow Book) for performance audits, you must put this promise – word for word – in your audit report:

7.30     We conducted this performance audit in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

As you seek to satisfy your audit objectives, you will gather evidence using audit methodologies.  Some auditors call audit methodologies audit tests or audit program steps.  The results of applying these methodologies must be documented.

6.79     Auditors must prepare audit documentation related to planning, conducting, and reporting for each audit. Auditors should prepare audit documentation in sufficient detail to enable an experienced auditor, having no previous connection to the audit, to understand from the audit documentation the nature, timing, extent, and results of audit procedures performed, the audit evidence obtained and its source and the conclusions reached, including evidence that supports the auditors’ significant judgments and conclusions. An experienced auditor means an individual (whether internal or external to the audit organization) who possesses the competencies and skills that would have enabled him or her to conduct the performance audit. These competencies and skills include an understanding of (1) the performance audit processes, (2) GAGAS and applicable legal and regulatory requirements, (3) the subject matter associated with achieving the audit objectives, and (4) issues related to the audited entity’s environment.6.80     Auditors should prepare audit documentation that contains evidence that supports the findings, conclusions, and recommendations before they issue their report.

Questions auditors answer

In order to give the client assurance regarding an audit subject, you must answer questions that naturally arise as you seek the answer to your audit objective.

Notice that these questions assume that something is wrong.  Auditors tend to think that way!  Because of time constraints, auditors focus on risks, negative events, and the issues that need fixing instead of proving the good that occurs in an organization.  In that way, auditors are like journalists.

  1. What is the current state of affairs? (condition)
  2. What should be the current state of affairs? (criteria)
  3. What has caused the current state of affairs? (cause)
  4. Why is the current state of affairs undesirable? (effect)
  5. What should be done to correct the current state of affairs? (recommendation)

You will see these questions used in later chapters and referred to as the “elements of a finding.” Auditors following IIA & GAO standards use them to write audit findings when they find something that needs to be corrected, such as an internal control weakness, non-compliance, fraud, and/or abuse.

What I hope to do in this text is show you the steps auditors follow to create their three main deliverables (the conclusion/opinion, the findings, and the audit documentation) as well as give you the tools to answer these questions for your clients.

Let’s tweak that definition of an auditor

Now that we have discussed independence, audit subject matter, audit criteria, and audit deliverables, we should tweak our definition of an auditor. We began the chapter with this definition: An independent professional who evaluates a subject matter against agreed-upon criteria.

Please allow me to enhance it a bit based on what we just read: An auditor is an independent professional who concludes whether a subject matter meets an agreed upon criteria by gathering evidence through performing custom-designed audit methodologies.  Aren’t you glad I didn’t start with that?

Yellow Book Ethics

Enjoy this excerpt from the self-study text: The Yellow Book Interpreted which qualifies for 15 hours of CPE.

 

The GAO has a few things to say about a government auditor’s ethical responsibilities and, thus, added a large section on ethics to the 2007 revision of the Yellow Book.  The same ethical principles appear in the 2017 exposure draft.

Themes of GAGAS
GAGAS is a very high-minded document.  And, in order to understand the GAO’s perspective on ethics, we need to talk about three themes of the Yellow Book that kick off the first chapter of the standards.

These three themes — accountability, transparency, and service -­- put us in the right frame of mind when auditing in the government environment.

Accountability
What is accountability? I had heard the term tossed around the government so frequently that I never even thought about its meaning.  Now I know that accountability does not mean that you got it right. It just means that you take ownership of it.

I met a cowboy auditor in West Texas who said, “You might be right or you might be wrong, but you’d better the hell document it.”  That sums up accountability quite nicely.  When things go bad, you are there to say, “Yes, that was me.  I’m sorry.”  When things go well, you can keep your job.

Recently on CNN, I saw a high school coach who was responsible for the death of one of his teenage football players.  And instead of being contrite, he said something like, “Everyone is forgetting that I suffered a loss, too, and that I will hold on to this for the rest of my life.”  That is not exactly what the parents of that boy wanted to hear. He deflected accountability and tried to engender empathy for himself.  I doubt that will serve him well in his community.

The GAO repeatedly reminds us that we are accountable to the taxpaying public for our actions and that we, as auditors, have a role in holding government leaders accountable.

1.01      The concept of accountability for use of public resources and government authority is key to our nation’s governing processes.

1.03     Government auditing is essential in providing accountability to legislators, oversight bodies, those charged with governance, and the public. Audits provide an independent, objective, nonpartisan assessment of the stewardship, performance, or cost of government policies, programs, or operations, depending upon the type and scope of the audit.

One of the tough things about the GAO standards is they are not written for government officials (although government officials are mentioned a few times); they are written as standards for auditors.  So, while we hold public officials and employees accountable for their actions, we are accountable for our actions, too.

Transparency
Actions and information that is transparent is open for everyone’s inspection and review.

1.05     Audits performed in accordance with GAGAS provide information used for oversight, accountability, transparency, and improvements of government programs and operations. GAGAS contains requirements and guidance to assist auditors in objectively acquiring and evaluating sufficient, appropriate evidence and reporting the results. When auditors perform their work in this manner and comply with GAGAS in reporting the results, their work can lead to improved government management, better decision making and oversight, effective and efficient operations, and accountability and transparency for resources and results.

The state of Texas has put every single transaction online – LIVE— and rates the transparency of local government as well.  I can, with a few clicks of the mouse, see that the Texas Department of Transportation bought a van, how much the van was, who they bought it from, why they need it, and what color of funds (general revenue, special revenue, enterprise revenues) paid for it.

Why?  Because citizens own the government, and we have a right to know.  Google “windows on Texas state government” to start your own exploration.

Service
If you audit Hurst Construction, your ultimate audience for the audit report is Mr. Hurst, his board of directors, and the bank.  But, if you audit a public housing project, your ultimate clients are not the managers of the project, the boards of directors, or the banks.  Your ultimate beneficiaries of the report are not even the grantors.  The ultimate beneficiaries of your work are the low-income children who live in the housing project.

We have to remember, as governmental auditors, that we are checking to see whether tax dollars are being used for their intended purpose and whether the public is being served by our auditee’s efforts.

1.16      A distinguishing mark of an auditor is acceptance of responsibility to serve the public interest. This responsibility is critical when auditing in the government environment. GAGAS embodies the concept of accountability for public resources, which is fundamental to serving the public interest.

We hold our clients to a higher standard of behavior than we do in the commercial sector. While it was OK for AIG to go on a lavish $500,000 spa junket before the US taxpayers bailed them out, it certainly was not OK after the bailout.

Later, we will see that the GAO asks you to report even more bad behaviors than the AICPA does.  If Mr. Hurst wants to put his jet-setting, never-worked-a-day-in–their-life kids on the payroll, more power to him. Auditors in the commercial realm do not have a responsibility to say anything about that. But in the government realm, we call that abuse, and we do have a responsibility to report it.  We’ll discuss more about abuse later.

Five main sections of the ethics section
The ethics discussion is divided into five main principles:

a.   The public interest
b.   Integrity
c.   Objectivity
d.   Proper use of government information, resources, and position
e.    Professional behavior

Let’s discuss each one in turn.

The public interest 
A city auditor once told me that he sees a higher purpose in his work.  It is his job to make sure that the monies collected by the city are turned back to support those who need services and who may not have a voice in the government.  He works on the citizens’ behalf, and because of this higher purpose, he doesn’t care whether he makes his auditees upset with his reports.  Now that is integrity!

1.15      The public interest is defined as the collective well-being of the community of people and entities the auditors serve. Observing integrity, objectivity, and independence in discharging their professional responsibilities assists auditors in meeting the principle of serving the public interest and honoring the public trust. The principle of the public interest is fundamental to the responsibilities of auditors and critical in the government environment.

In my business I transfer in and out of two worlds – the government world and the commercial world – and indeed they are different.

An auditor from the GAO made the distinction between the two by saying that in the commercial world fortunes are made by doing what is not expressly prohibited; in the government world action won’t be taken unless it is expressly permitted.

Commercial entities do not seek transparency.  At the Apple corporate headquarters store, they sell a T-Shirt that says, “I visited the Apple Corporate Offices in Cupertino… and that is all I can say about it.”

But government auditors must shine light in dark places in order to serve their customer, the public.  And taxpayers get very, very upset if even a tiny bit of their hard-earned tax dollars are squandered.

Not long ago, I was helping a government employee retirement system develop a training event. Afterwards, to celebrate our success, we all went out to a first-rate steakhouse in Dallas – you know the type, where you pay $45 for an à la carte steak. We had wine and appetizers, and one guy ordered a $35 brandy. I was very uncomfortable. I thought that if any of their members walked in and recognized them as the folks in charge of their retirement funds, the retirement system would have a lot of explaining to do. The retirees don’t want their money squandered on high living for government employees!

If you work for a corporation, go ahead and enjoy the perks and the luxuries. But when you work for government, don’t be surprised if you can’t even get a cup of coffee!

Integrity & Objectivity
Many seasoned professionals have told me that they believe that auditor independence is an unattainable ideal; an external auditor’s independence is compromised when the auditee writes a check to pay the auditor’s fee and an internal auditor takes a salary from the entity they audit. They argue, that at best, an auditor can provide an objective viewpoint and maintain integrity by making sure that external pressures do not force them to cover up the truth.

Later in this text, when we examine the GAO’s guidance for independence, the concepts of integrity and objectivity introduced here in the ethics chapter are raised again.

Both the integrity and objectivity sections of the ethics chapter of the Yellow Book mention auditor independence and freedom from political or ideological bias.

Integrity
1.17      Public confidence in government is maintained and strengthened by auditors performing their professional responsibilities with integrity. Integrity includes auditors conducting their work with an attitude that is objective, fact-based, nonpartisan, and nonideological with regard to audited entities and users of the auditors’ reports… 

1.18      … In discharging their professional responsibilities, auditors may encounter conflicting pressures from management of the audited entity, various levels of government, and other likely users. Auditors may also encounter pressures to inappropriately achieve personal or organizational gain. In resolving those conflicts and pressures, acting with integrity means that auditors place priority on their responsibilities to the public interest.

Objectivity
1.19      The credibility of auditing in the government sector is based on auditors’ objectivity in discharging their professional responsibilities. Objectivity includes independence of mind and appearance when providing audits, maintaining an attitude of impartiality, having intellectual honesty, and being free of conflicts of interest…The concepts of objectivity and independence are closely related…

Proper use of government information, resources, and position
A professor at UT Arlington teaches ethics and leadership to government leaders in Romania. He develops case studies for them to ponder each week.

One case study asked the students to discuss the ethical dilemma posed when a mayor used city employees to build a brick barbecue pit in his backyard – clearly an improper use of government resources. The professor didn’t hear back from his students in Romania for a month.

After several Skype conversations, the Romanians finally admitted that they just didn’t understand the ethical issue in the scenario. Using the labor of government employees for personal benefit is one of the perks of being a government leader in Romania! That professor has a lot of work to do!

1.20     Government information, resources, and positions are to be used for official purposes and not inappropriately for the auditor’s personal gain or in a manner contrary to law or detrimental to the legitimate interests of the audited entity or the audit organization. This concept includes the proper handling of sensitive or classified information or resources.

1.23     Misusing the position of an auditor for financial gain or other benefits violates an auditor’s fundamental responsibilities. An auditor’s credibility can be damaged by actions that could be perceived by an objective third party with knowledge of the relevant information as improperly benefiting an auditor’s personal financial interests or those of an immediate or close family member; a general partner; an organization for which the auditor serves as an officer, director, trustee, or employee; or an organization with which the auditor is negotiating concerning future employment.

Professional behavior
Any behavior that could cause someone to question your professionalism can detract from your credibility. And credibility helps sell audit recommendations.

1.24     High expectations for the auditing profession include compliance with all relevant legal, regulatory, and professional obligations and avoidance of any conduct that might bring discredit to auditors’ work, including actions that would cause an objective third party with knowledge of the relevant information to conclude that the auditors’ work was professionally deficient…

Consider the following true scenario (with a few small changes to protect identities): You are the internal audit director of a large city. You recently hired a new auditor fresh out of college and assigned him to conduct a performance audit of your city’s police department.

Everything has been going well until last week when you saw a photo of him in the local newspaper at the city’s Mardi Gras celebration. He was pictured near the top of a street light without his shirt wearing dozens of bead necklaces. The police stood below and appeared to be yelling at him to come down.

You show him the picture and he becomes immediately defensive and tells you that what he does on his own time is none of your business. He reasoned that he had some college buddies in town and it was natural for him to show them a good time.

This standard on professional behavior does not mention that it applies only to an auditor’s work life. But does this auditor’s behavior during his personal time compromise his credibility with the police force? Yes, indeed!  How is he going to face the officers during an exit conference?

To maintain your shop’s professional image, you will probably have to remove this young auditor from the engagement and replace him with another auditor from your shop.

Auditors are paid for our credible, objective, high integrity opinions and conclusions about an audit subject.  And this young man blew all that away with his antics.

Borrowing from the later discussion on independence in chapter 3:

3.04     Auditors and audit organizations maintain independence so that their opinions, findings, conclusions, judgments, and recommendations will be impartial and viewed as impartial by reasonable and informed third parties. Auditors should avoid situations that could lead reasonable and informed third parties to conclude that the auditors are not independent and thus are not capable of exercising objective and impartial judgment on all issues associated with conducting the audit and reporting on the work.

In our next chapter, we will address the types of audits covered by Yellow Book standards.

Pulling It All Together

What’s the matter with the crowd I’m seeing?
“Don’t you know that they’re out of touch?”
Should I try to be a straight-A student?
“If you are then you think too much.
Don’t you know about the new fashion, honey?
All you need are looks and a whole lot of money?”
It’s the next phase, new wave, dance craze, anyways
It’s still rock and roll to me.
Everybody’s talkin’ ‘bout the new sound
Funny, but it’s still rock and roll to me.
It’s Still Rock and Roll to Me, Billy Joel

Objectives:

  • Sequence the steps of developing an internal control structure

Whew!  You made it. We are in the last chapter! Congrats, you have held on through a long case study and a complicated model.

In this final chapter, we are taking another look at the steps of creating a control structure from scratch which will also serve as a review of this text. I will quote various excerpts from the Green Book as I go.  Also, we will address what happens when auditors visit to evaluate your controls.

Steps of developing controls

As I see it, the steps of developing controls are as follows:

1.Choose a subject matter

Maybe you have been asked to develop controls for a whole organization or just a segment of an organization.  In either case, you will benefit from breaking your subject matter down into smaller more defined segments because it is easier to imagine controls for something specific than to imagine controls for something broad.

For instance, if I asked you to control the University of Michigan, you would probably walk out the door never to come back!  But if I asked you to control student financial aid at the University of Michigan, you would feel better.  If I asked you to set up controls to make sure that student financial aid at the University of Michigan is distributed on time, you’d feel super because that is very doable!

The side of the COSO cube prompts us to break the subject matter down into segments.  In the COSO and Green Book literature, the side of the cube is dubbed the ’levels of organizational structure.’  I think of it instead as ‘what’ you are planning to control.

2. Focus on what is risky

Now that you have broken the organization up into segments, you can hone in on the segments that are the most likely to cause trouble.

Risk assessment is the second control component on the face of COSO model, but it is, in practice, the first component you consider when establishing controls.

For each piece, you ask four questions:

  1. What could go wrong?
  2. So what?
  3. How big of a deal is the ‘so what?’
  4. How likely are things to go wrong?

Here are the terms the Green Book uses for all of these questions:

  1. What could go wrong? The Green Book calls the answer to this question ‘identified risks.’
  2. So what?  The Green Book calls this ‘significance.’
  3. How big a deal is the so what?  The Green Book calls this ‘magnitude.’
  4. How likely are things to go wrong?  The Green book calls this ‘likelihood.’

From the Green Book:

7.05 Management analyzes the identified risks to estimate their significance, which provides a basis for responding to the risks. Significance refers to the effect on achieving a defined objective. 

7.06 Management estimates the significance of the identified risks to assess their effect on achieving the defined objectives at both the entity and transaction levels. Management estimates the significance of a risk by considering the magnitude of impact, likelihood of occurrence, and nature of the risk. Magnitude of impact refers to the likely magnitude of deficiency that could result from the risk and is affected by factors such as the size, pace, and duration of the risk’s impact. Likelihood of occurrence refers to the level of possibility that a risk will occur. The nature of the risk involves factors such as the degree of subjectivity involved with the risk and whether the risk arises from fraud or from complex or unusual transactions. The oversight body may oversee management’s estimates of significance so that risk tolerances have been properly defined. 

3. Decide if you want to tolerate the risk

When you are confronted with a risk, you have four choices of how to handle it:  you can accept it and live with the possible consequences, you can avoid it by not doing the activity, you can mitigate it by layering on controls or you can ask someone else to take on responsibility for it.

If you choose to keep on doing or to tolerate the activity that causes the risk, but you’d rather not suffer from this choice, you will proceed through the rest of the steps laid out here to help you create the controls to mitigate the risk.  Mitigate is a fancy word for ‘reduce.’

From the Green Book:

7.08 Management designs responses to the analyzed risks so that risks are within the defined risk tolerance for the defined objective. Management designs overall risk responses for the analyzed risks based on the significance of the risk and defined risk tolerance. These risk responses may include the following: 

  • Acceptance - No action is taken to respond to the risk based on the insignificance of the risk. 
  • Avoidance - Action is taken to stop the operational process or the part of the operational process causing the risk. 
  • Reduction - Action is taken to reduce the likelihood or magnitude of the risk. 
  • Sharing - Action is taken to transfer or share risks across the entity or with external parties, such as insuring against losses. 
8.06 Management analyzes and responds to identified fraud risks so that they are effectively mitigated. Fraud risks are analyzed through the same risk analysis process performed for all identified risks…


4. Come up with a control objective

In order to focus your efforts and make sure that everyone is clear about what you are working toward, the Green Book recommends you come up with a clear control objective.

The Green Book talks about objectives in two layers.  In one layer, they ask you to consider ‘why’ you want to control something.   Is it because you are concerned about operations, compliance or reporting? The GAO calls these ‘categories of objectives’ and they are listed on the top of the cube.
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OV1.01 Internal control is a process effected by an entity’s oversight body, management, and other personnel that provides reasonable assurance that the objectives of an entity will be achieved (see fig. 2). These objectives and related risks can be broadly classified into one or more of the following three categories: 

  • Operations - Effectiveness and efficiency of operations 
  • Reporting - Reliability of reporting for internal and external use 
  • Compliance - Compliance with applicable laws and regulations 

OV1.02 These are distinct but overlapping categories. A particular objective can fall under more than one category, can address different needs, and may be the direct responsibility of different individuals. 
Operations Objectives 

OV2.19 Operations objectives relate to program operations that achieve an entity’s mission. An entity’s mission may be defined in a strategic plan. Such plans set the goals and objectives for an entity along with the effective and efficient operations necessary to fulfill those objectives. Effective operations produce the intended results from operational processes, while efficient operations do so in a manner that minimizes the waste of resources. 

OV2.20 Management can set, from the objectives, related subobjectives for units within the organizational structure. By linking objectives throughout the entity to the mission, management improves the effectiveness and efficiency of program operations in achieving the mission. 

Reporting Objectives 

OV2.21 Reporting objectives relate to the preparation of reports for use by the entity, its stakeholders, or other external parties. Reporting objectives may be grouped further into the following subcategories: 

  • External financial reporting objectives - Objectives related to the release of the entity’s financial performance in accordance with professional standards, applicable laws and regulations, as well as expectations of stakeholders. 
  • External nonfinancial reporting objectives - Objectives related to the release of nonfinancial information in accordance with appropriate standards, applicable laws and regulations, as well as expectations of stakeholders. 
  • Internal financial reporting objectives and nonfinancial reporting objectives - Objectives related to gathering and communicating information needed by management to support decision making and evaluation of the entity’s performance. 

Compliance Objectives

OV2.22 In the government sector, objectives related to compliance with applicable laws and regulations are very significant. Laws and regulations often prescribe a government entity’s objectives, structure, methods to achieve objectives, and reporting of performance relative to achieving objectives. Management considers objectives in the category of compliance comprehensively for the entity and determines what controls are necessary to design, implement, and operate for the entity to achieve these objectives effectively. 

OV2.23 Management conducts activities in accordance with applicable laws and regulations. As part of specifying compliance objectives, the entity determines which laws and regulations apply to the entity. Management is expected to set objectives that incorporate these requirements. Some entities may set objectives to a higher level of performance than established by laws and regulations. In setting those objectives, management is able to exercise discretion relative to the performance of the entity. 

But later in the book, the GAO drills down into the categories and describes the need for a specific, customized control objective.

6.02 Management defines objectives in specific and measurable terms to enable the design of internal control for related risks. Specific terms are fully and clearly set forth so they can be easily understood. Measurable terms allow for the assessment of performance toward achieving objectives. Objectives are initially set as part of the objective-setting process and then refined as they are incorporated into the internal control system when management uses them to establish the control environment. 

6.03 Management defines objectives in specific terms so they are understood at all levels of the entity. This involves clearly defining what is to be achieved, who is to achieve it, how it will be achieved, and the time frames for achievement. All objectives can be broadly classified into one or more of three categories: operations, reporting, or compliance. Reporting objectives are further categorized as being either internal or external and financial or nonfinancial. Management defines objectives in alignment with the organization’s mission, strategic plan, and performance goals. 

6.04 Management defines objectives in measurable terms so that performance toward achieving those objectives can be assessed. Measurable objectives are generally free of bias and do not require subjective judgments to dominate their measurement. Measurable objectives are also stated in a quantitative or qualitative form that permits reasonably consistent measurement. 

Our objective was, “Do controls deter the coach from using his purchasing card for personal purchases as defined by Grace School District Policy #C7.459?”

5. Compare the baseline to the ideal

Now it is time to talk to managers and find out if there are any existing controls in place.  This will be your baseline of controls.

16.02 Management establishes a baseline to monitor the internal control system. The baseline is the current state of the internal control system compared against management’s design of the internal control system. The baseline represents the difference between the criteria of the design of the internal control system and condition of the internal control system at a specific point in time. In other words, the baseline consists of issues and deficiencies identified in an entity’s internal control system. 

16.03 Once established, management can use the baseline as criteria in evaluating the internal control system and make changes to reduce the difference between the criteria and condition. Management reduces this difference in one of two ways. Management either changes the design of the internal control system to better address the objectives and risks of the entity or improves the operating effectiveness of the internal control system. As part of monitoring, management determines when to revise the baseline to reflect changes in the internal control system. 

Next, you will compare the baseline to the ideal:  the list of 17 principles.  When management has not already addressed a principle with a control or two, then you will need to design a control for that principle.  Remember, in order to judge a control system as effective, all five components and the underlying 17 principles should be in place!

OV3.03 To determine if an internal control system is effective, management assesses the design, implementation, and operating effectiveness of the five components and 17 principles. If a principle or component is not effective, or the components are not operating together in an integrated manner, then an internal control system cannot be effective. 

Appendix I: The 17 principles support the effective design, implementation, and operation of the associated components and represent requirements necessary to establish an effective internal control system. The 17 principle requirements of the Green Book are as follows: 

  1. The oversight body and management should demonstrate a commitment to integrity and ethical values. 
  2. The oversight body should oversee the entity’s internal control system. 
  3. Management should establish an organizational structure, assign responsibility, and delegate authority to achieve the entity’s objectives. 
  4. Management should demonstrate a commitment to recruit, develop, and retain competent individuals. 
  5. Management should evaluate performance and hold individuals accountable for their internal control responsibilities. 
  6. Management should define objectives clearly to enable the identification of risks and define risk tolerances. 
  7. Management should identify, analyze, and respond to risks related to achieving the defined objectives. 
  8. Management should consider the potential for fraud when identifying, analyzing, and responding to risks. 
  9. Management should identify, analyze, and respond to significant changes that could impact the internal control system. 
  10. Management should design control activities to achieve objectives and respond to risks. 
  11. Management should design the entity’s information system and related control activities to achieve objectives and respond to risks. 
  12. Management should implement control activities through policies. 
  13. Management should use quality information to achieve the entity’s objectives. 
  14. Management should internally communicate the necessary quality information to achieve the entity’s objectives. 
  15. Management should externally communicate the necessary quality information to achieve the entity’s objectives. 
  16. Management should establish and operate monitoring activities to monitor the internal control system and evaluate the results. 
  17. Management should remediate identified internal control deficiencies on a timely basis. 

6. Consider cost 

Before you run out and implement all of the controls you designed in the last step, stop and think about how much each of the controls is going to cost you.  Do you need to invest in technology to make the control work?  Or do you need to beef up your staff?  Also, consider whether the new controls will slow down processes and frustrate employees, suppliers and customers.  Excessive controls are also known as ‘red tape’ and ‘burdensome bureaucracy!’

OV4.07 Management may decide how an entity evaluates the costs versus benefits of various approaches to implementing an effective internal control system. However, cost alone is not an acceptable reason to avoid implementing internal controls. Management is responsible for meeting internal control objectives. The costs versus benefits considerations support management’s ability to effectively design, implement, and operate an internal control system that balances the allocation of resources in relation to the areas of greatest risk, complexity, or other factors relevant to achieving the entity’s objectives. 

7. Does it prevent, detect or correct?

Again, before you proceed with the hard work of implementing the controls you designed, take some time to evaluate whether each control is preventative, corrective, or detective.  Detective controls are nice, but stopping the risk before it happens would be better than cleaning up the mess after it happens. This is especially true when it comes to unacceptable risks such as death and injury.  Make sure you have a good mix of all three types of controls with a preponderance of preventative controls.

8. Document

At this point, you are working with a large volume of information.  Just in case you get a little overwhelmed and forgetful, you’d better write down everything you have worked on so far.  The GAO is pretty firm about documentation:

OV4.08 Documentation is a necessary part of an effective internal control system. The level and nature of documentation vary based on the size of the entity and the complexity of the operational processes the entity performs. Management uses judgment in determining the extent of documentation that is needed. Documentation is required for the effective design, implementation, and operating effectiveness of an entity’s internal control system. The Green Book includes minimum documentation requirements as follows: 

  • If management determines that a principle is not relevant, management supports that determination with documentation that includes the rationale of how, in the absence of that principle, the associated component could be designed, implemented, and operated effectively. (paragraph OV2.06) 
  • Management develops and maintains documentation of its internal control system. (paragraph 3.09) 
  • Management documents in policies the internal control responsibilities of the organization. (paragraph 12.02) 
  • Management evaluates and documents the results of ongoing monitoring and separate evaluations to identify internal control issues. (paragraph 16.09) 
  • Management evaluates and documents internal control issues and determines appropriate corrective actions for internal control deficiencies on a timely basis. (paragraph 17.05) 
  • Management completes and documents corrective actions to remediate internal control deficiencies on a timely basis. (paragraph 17.06) 

OV4.09 These requirements represent the minimum level of documentation in an entity’s internal control system. Management exercises judgment in determining what additional documentation may be necessary for an effective internal control system. If management identifies deficiencies in achieving these documentation requirements, the effect of the identified deficiencies is considered as part of management’s summary determination as to whether the related principle is designed, implemented, and operating effectively. 

9. Evaluate the design vs. operation

Once you have organized your thoughts and chosen controls for all five components and the 17 principles, someone has to put them into action.  That could take a while.  As usual, it is best to be patient and thorough instead of agitated and spotty.  Ha.  Agitated and spotty is a great title for a teen romance novel!

The GAO takes pains to mention the difference between the design of a control and the implementation of a control in over a dozen places in the Green Book.  Here are a few quotes:

OV2.13 Internal control is a dynamic, iterative, and integrated process in which components impact the design, implementation, and operating effectiveness of each other. No two entities will have an identical internal control system because of differences in factors such as mission, regulatory environment, strategic plan, entity size, risk tolerance, and information technology, and the judgment needed in responding to these differing factors. 

OV3.05 When evaluating design of internal control, management determines if controls individually and in combination with other controls are capable of achieving an objective and addressing related risks. When evaluating implementation, management determines if the control exists and if the entity has placed the control into operation. A control cannot be effectively implemented if it was not effectively designed. A deficiency in design exists when (1) a control necessary to meet a control objective is missing or (2) an existing control is not properly designed so that even if the control operates as designed, the control objective would not be met. A deficiency in implementation exists when a properly designed control is not implemented correctly in the internal control system. 

10. Evaluate whether you can declare your controls effective!

Sorry to say that your work isn’t done when you finish designing, documenting and implementing controls.  True to the monitoring component of the COSO model, you can’t just set things up and forget them.  You need to come back and evaluate whether everything you have set up is working, correct any unintended consequences of your efforts, improve controls and start the cycle all over again.

OV3.03 To determine if an internal control system is effective, management assesses the design, implementation, and operating effectiveness of the five components and 17 principles. If a principle or component is not effective, or the components are not operating together in an integrated manner, then an internal control system cannot be effective. 

This is a great place to introduce auditors back into our conversation because they may be able to help you ensure that the controls you designed are functioning properly.  That is what we will do in our next newsletter.

Is that your job? More on Control Environment

13 The next day, Moses took his seat to hear the people’s disputes against each other. They waited before him from morning till evening.

14 When Moses’ father-in-law saw all that Moses was doing for the people, he asked, “What are you really accomplishing here? Why are you trying to do all this alone while everyone stands around you from morning till evening?”

15 Moses replied, “Because the people come to me to get a ruling from God. 16 When a dispute arises, they come to me, and I am the one who settles the case between the quarreling parties. I inform the people of God’s decrees and give them his instructions.”

17 “This is not good!” Moses’ father-in-law exclaimed. 18 “You’re going to wear yourself out—and the people, too. This job is too heavy a burden for you to handle all by yourself. 19 Now listen to me, and let me give you a word of advice, and may God be with you. You should continue to be the people’s representative before God, bringing their disputes to him.20 Teach them God’s decrees, and give them his instructions. Show them how to conduct their lives. 21 But select from all the people some capable, honest men who fear God and hate bribes. Appoint them as leaders over groups of one thousand, one hundred, fifty, and ten. 22 They should always be available to solve the people’s common disputes, but have them bring the major cases to you. Let the leaders decide the smaller matters themselves. They will help you carry the load, making the task easier for you. 23 If you follow this advice, and if God commands you to do so, then you will be able to endure the pressures, and all these people will go home in peace.”

24 Moses listened to his father-in-law’s advice and followed his suggestions. 25 He chose capable men from all over Israel and appointed them as leaders over the people. He put them in charge of groups of one thousand, one hundred, fifty, and ten. 26 These men were always available to solve the people’s common disputes. They brought the major cases to Moses, but they took care of the smaller matters themselves.  
EXODUS 18 NLT

In this chapter, we will cover the remaining three principles included in the control environment component of the COSO model:  Principle 3 – structure, responsibility and authority, Principle 4 -competence and Principle 5 – accountability.

Not even Moses, God’s chosen leader, could get it done all on his own.  Taking care of everything for everyone will absolutely wear a person out.

I watched a TV biography on Jim Henson, the creator of the Muppets.   He tried to be involved in every aspect of his business – Sesame Street, an HBO series, the next Muppet movie- even as his team grew to 300 people.  He didn’t take care of himself, contracted a very common illness, and refused to slow down long enough to go to the doctor.  By the time he got to the hospital, it was too late and he died at age 53!

No, most of us don’t work under that kind of pressure, but I have made myself sick trying to do it all several times.  I have learned to delegate and to give those to whom I delegate the authority to act without checking in with me.  My late-found ability to let go allows me to spend time doing what I do best and allows me some space to rest and think.

From the Green Book’s perspective, the reason we have controls is to make sure the entity achieves its objectives.  If an entity unwisely lays too much responsible on one individual, and isn’t intentional about organizing itself and dividing and delegating the work, the Green Book points out that the entity simply won’t get where it wants to be.

3.01 Management should establish an organizational structure, assign responsibility, and delegate authority to achieve the entity’s objectives. 

3.06 To achieve the entity’s objectives, management assigns responsibility and delegates authority to key roles throughout the entity….

3.07 Management considers the overall responsibilities assigned to each unit, determines what key roles are needed to fulfill the assigned responsibilities, and establishes the key roles. Those in key roles can further assign responsibility for internal control to roles below them in the organizational structure, but retain ownership for fulfilling the overall responsibilities assigned to the unit. 

That isn’t my job!

One of the deadliest things that someone in customer service can utter is, “That isn’t my job.”  What this person and organization have failed to realize is that I, as a customer, do not give a flying rat’s patootie whose job it is, I just want my product or service with as little hassle as possible.

I recently used my frequent flyer miles on American Airlines to buy tickets on British Airways.  Big mistake.  After two hours of work booking the tickets, I found out that I had no seat assignments.  The next day, I spent another two hours getting seat assignments.  When I would ask American Airlines for help, they would pass me off to British Airways.  When I asked British Airways for help – you guessed it – they passed me off to American Airlines.

After several internet searches, a few password wrestling matches, multiple phone calls and hours of being on hold, I finally found a sympathetic ear.  Everyone else I encountered wanted to pass the responsibility on to someone else or gave me incomplete or erroneous information, but this angel stayed with me until I got the information I needed.

Who are the angels?

After figuring out what needs to be done, you have to put competent people in place to get it done.   Usually, an organization has to invest in its people to enable them to be good at their job.  My angel at American Airlines obviously had years of experience in customer care and knew exactly how to help me cut through all of the red tape and get my seat assignments.  I hope American is investing more in her.

The Green Book is clear that management is responsible for investing in its people and should not expect employees to be ready to work on their first day on the job!

4.01 Management should demonstrate a commitment to recruit, develop, and retain competent individuals. 

4.05 Management recruits, develops, and retains competent personnel to achieve the entity’s objectives. Management considers the following: 

  • Recruit - Conduct procedures to determine whether a particular candidate fits the organizational needs and has the competence for the proposed role. 
  • Train - Enable individuals to develop competencies appropriate for key roles, reinforce standards of conduct, and tailor training based on the needs of the role. 
  • Mentor - Provide guidance on the individual’s performance based on standards of conduct and expectations of competence, align the individual’s skills and expertise with the entity’s objectives, and help personnel adapt to an evolving environment. 
  • Retain - Provide incentives to motivate and reinforce expected levels of performance and desired conduct, including training and credentialing as appropriate. 

I’d love to hold customer service accountable

At the beginning of each call to the airlines, I heard “This call is recorded and may be used for training purposes.”  What I’d love the message to say instead is, “This call is being monitored by someone who will hold these customer care representatives accountable if they send you to the wrong place or give you wrong or incomplete information.”  Wouldn’t it be nice if, at the end of each interaction with a customer care rep, you could evaluate whether they helped you or frustrated you?  Is it just me, or have you noticed that the customer care reps only connect you with the evaluation when they know you are happy?

So how do you hold people accountable?  

When I teach budgeting courses, I discuss how budgets are the translation of an organization’s plan into numbers.  I emphasize that unless an organization identifies when managers are off plan and holds them accountable, a budget just becomes a silly, wasteful, paper-pushing exercise.

Through real life stories told by the participants in my classes and my own work experience, I’ve compiled a list of options organizations can use to hold folks accountable.  Here is a list of some of the options from least stringent to most stringent:

  • Send out a variance report to all managers
  • Require managers to explain variances to the accountant
  • Require managers to explain variances in writing
  • Require managers to explain variances during a staff meeting
  • Require managers to explain variances during a meeting with executives
  • Evaluate budget performance in the manager’s annual performance evaluation
  • Reprimand managers who do not stay on track with the budget
  • Withhold bonuses from managers who stray from the budget
  • Fire managers who dismiss and ignore the budget

Did you think the last one was too extreme?  A mature CFO shared with the class that every time he pushed forward a new initiative on behalf of the executive team, he made sure the executives gave him the ability to fire anyone who did not play along.  He told a story about the executive team wanting to hold managers to a tighter and very unpopular budget.  When one division director rebelled and would not follow the budget, the CFO fired him.  After that, he had no problem keeping the other managers in line.

Here is what the Green Book says about holding people accountable:

5.03 Management holds entity personnel accountable for performing their assigned internal control responsibilities. The oversight body, in turn, holds management accountable as well as the organization as a whole for its internal control responsibilities. 

The flip side of stringency

But the Green Book also acknowledges the negative, flip side of holding folks accountable.  Whatever gets measured gets done – which is a good thing… sort of.  But on the flip side, employees will occasionally do silly and wasteful things to meet expectations.

For example, I audited a manufacturer of computer components in the late 80’s.   At the end of the year, the manufacturing managers received a bonus if their inventory was minimal.  So, on December 30, the managers filled two semi trucks full of inventory and sent the trucks off to an unwitting customer in California.

The shipment was rejected by the customer on January 2 because they hadn’t ordered the components.  The trucks arrived back in Texas, full of inventory, on January 4.

The managers received their bonuses and the year-end records looked good – so on one hand, the manager’s mission was accomplished. But on the other hand, the records were misleading, the customer in California was annoyed, and the manufacturer wasted thousands on the bogus shipment.

From the Green Book:

5.04 If management establishes incentives, management recognizes that such actions can yield unintended consequences and evaluates incentives so that they align with the entity’s standards of conduct. 

5.07 Management adjusts excessive pressures on personnel in the entity. Pressure can appear in an entity because of goals established by management to meet objectives or cyclical demands of various processes performed by the entity, such as year-end financial statement preparation. Excessive pressure can result in personnel “cutting corners” to meet the established goals. 

The Control Environment Component is full of wisdom

The definition of wisdom is: the quality of having experience, knowledge, and good judgment. It is apparent that the creators of the COSO model and the Green Book have been around the block a few times and know the harm poor controls can do.

The control environment component of the COSO model tells us that what leaders do, matters; that oversight bodies have an important role to play in keeping controls strong; that everyone should know their job, be equipped to perform their job, and be held accountable for doing their jobs.

Here is a summary of the control environment component from the introduction to the chapter:

Overview 
The control environment is the foundation for an internal control system. It provides the discipline and structure, which affect the overall quality of internal control. It influences how objectives are defined and how control activities are structured. The oversight body and management establish and maintain an environment throughout the entity that sets a positive attitude toward internal control. 

Principles 
1. The oversight body and management should demonstrate a commitment to integrity and ethical values. 
2. The oversight body should oversee the entity’s internal control system. 
3. Management should establish an organizational structure, assign responsibility, and delegate authority to achieve the entity’s objectives. 
4. Management should demonstrate a commitment to recruit, develop, and retain competent individuals. 
5. Management should evaluate performance and hold individuals accountable for their internal control responsibilities. 

Woven into these principles are warnings that our best intentions can go awry:

  • Under the first principle on tone at the top, we are warned that well-designed controls can break down when leaders act badly.
  • Under the second principle on oversight, we are warned that management might not want to fix obvious problems and therefore must be forced to act by an oversight body.
  • Under the fourth principle on competence, we are warned that our best people can leave us, and we’d better have a plan to keep the organization going without them.
  • Under the fifth principle on accountability, we are warned that holding people accountable can result in squirrely behavior that goes against the ultimate objectives of the entity.

What’s next?

In the next chapter, we will collect all of the controls we came up with for our case study, sort them out and then evaluate them for effectiveness and cost.

Chapter 12: Information and Communication

                        Might be a rock n’ roll addict, prancing on the stage

                        Might have money and drugs at your command, women in a cage

                        You may be a business man or some high degree thief

                        They may call you Doctor or they may call you Chief

 

                        But you’re gonna’ have to serve somebody, yes indeed

                        Your gonna’ have to serve somebody.

                        Well, it may be the devil, or it may be the Lord

                        But you’re gonna’ have to serve somebody.

Bob Dylan, Gotta’ Serve Somebody

 

My business is minuscule, but that doesn’t exempt me from having to formalize my information processes and comply with reporting requirements of oversight entities.

Every year, I send a detailed report of my CPE offerings to the National Association of State Boards of Accountancy (NASBA).  They want to know how many classes I offered, who taught them, where they were offered and for what group, the date of the classes, and the number of hours granted.

The first year I prepared the report, I suffered.  I had to dig up physical files from earlier in the year and reconstruct all of the data, so I could input it into the report.  Slog!  It took days to put it together, and when I was finished, NASBA sent it back to me because it wasn’t formatted correctly.  Really?  More time, more suffering.

The State of Texas Board of Accountancy requires similar information, but their report has to be handwritten!  Hand… friggin… written… with an ink pen.  That takes a while to complete…

I realized after that first fiasco that I needed to go paperless and track the information I needed throughout the year rather than wait to gather the data at the last minute.  My assistant Chelsea and I have a checklist of all of the documents we must collect after each class, and we maintain a running spreadsheet of the data I am required to report.  All of the information is kept in a Dropbox file that she and I share and update each time I teach.  No more messy paper files.

This year, I only spent a few hours creating both reports!  And on top of that fabulous achievement, I also feel more confident in the information I am reporting because Chelsea and I double-check each other throughout the process.

I also have to report my income to the IRS every year.  When I first started my business, I reasoned that I could keep the books myself because I am a CPA. The only problem is, I do not enjoy bookkeeping.  I waited until the end of the year to force myself to sit down and input transactions into QuickBooks.

As you can imagine, I forgot the purpose of several payments that occurred early in the year and had to SWAG a description of the transactions.  SWAG stands for Sophisticated Wild Ass Guess.   After about five SWAGS, I decided I needed to stop the madness and hired a real bookkeeper, Carol, who keeps contemporary information on my business.  Carol sends me up-to-date financials every Monday, and when it is time to report to the IRS, all the transactions are there, ready to report.  No SWAGs necessary.

I have learned the hard way that thinking of the info you need to accumulate and share in advance is better than trying to gather it – and guess at it – months or even a year later.

The Green Book is Out to Save You from Suffering

The authors of the COSO model and Green Book must have gone through similar experiences.  So, they advise us to think ahead about the information that needs to be shared and to make sure the data shared is valid.

In the chapter on Information and Communication they ask us to apply three principles:

13. Management should use quality information to achieve the entity’s objectives.

14. Management should internally communicate the necessary quality information to achieve the entity’s objectives.

15. Management should externally communicate the necessary quality information to achieve the entity’s objectives.

Principle #13 – no SWAGs

Auditors are trained to never take anyone’s word on anything.  Auditors are trained to seek convincing evidence and not base any conclusions on testimony.  Because both of my above reports could be audited, I am prepared to back up all of my data with original documents!  For instance, the information I send to NASBA about the classes I offer is backed up with sign-in sheets from attendees.  And the transactions in my accounting records are backed up with receipts and bank statements.

The first principle under the Information and Communication component advises us to put controls in place to make sure all of the information in the reports is valid and backed up with evidence.  Three attributes apply to this principle:

13.01 Management should use quality information to achieve the entity’s objectives.

Attributes

The following attributes contribute to the design, implementation, and operating effectiveness of this principle:

  • Identification of Information Requirements
  • Relevant Data from Reliable Sources
  • Data Processed into Quality Information

Attribute 1: Figure out who wants the information and what information they need

This attribute asks “Who cares about whether your work succeeds or whether your controls are functioning?”  Our case study objective, is Do controls prevent the coach from using his purchasing card for personal purchases as defined by Grace School District Policy #C7.459?   I imagine that the following folks will care if the coach is making personal purchases:

  • The director of the athletic department
  • The executive team of the school
  • The school board
  • The citizens of the school district

Once we have a sense of who we will be sharing information with, we need to find out what they want to know.  We can inquire of the stakeholders directly, or we can make some assumptions about what they need. Knowing what they want rather than guessing what they want is best because the frequency and accuracy of information costs time and money; it is a waste of resources to generate and report information they don’t need.

Section 13.03 says that the process of identifying what stakeholders need is an iterative process… in other words, you will have to redesign the content of your reports several times before you hit on content that is meaningful to the stakeholders.

Here is what the Green Book has to say about this attribute.

Identification of Information Requirements

13.02 Management designs a process that uses the entity’s objectives and related risks to identify the information requirements needed to achieve the objectives and address the risks. Information requirements consider the expectations of both internal and external users. Management defines the identified information requirements at the relevant level and requisite specificity for appropriate personnel.

13.03 Management identifies information requirements in an iterative and ongoing process that occurs throughout an effective internal control system. As change in the entity and its objectives and risks occurs, management changes information requirements as needed to meet these modified objectives and address these modified risks.

Attribute #2: Who you get the information from matters

It is always preferable to get your evidence – or the back-up for your reports – from objective third parties.  So, instead of asking the coach to describe his own transactions, source your information from the credit card statement.  The credit card company has no reason to disguise the purpose of purchases, but the coach does.  If any transaction looks iffy, you could ask for original receipts from the coach.

From the Green Book:

Relevant Data from Reliable Sources

13.04 Management obtains relevant data from reliable internal and external sources in a timely manner based on the identified information requirements. Relevant data have a logical connection with, or bearing upon, the identified information requirements. Reliable internal and external sources provide data that are reasonably free from error and bias and faithfully represent what they purport to represent. Management evaluates both internal and external sources of data for reliability. Sources of data can be operational, financial, or compliance related. Management obtains data on a timely basis so that they can be used for effective monitoring.

Attribute #3: Don’t let anyone doctor the report before it is published

The last attribute addresses how the evidence is processed.  The true financial results for Enron, which were created from reliable and relevant evidence by the Enron accounting department, didn’t look that attractive, so the Enron executives made a few fraudulent changes to the reports before they were published.  Obviously, we don’t want to allow bogus changes to our reports in order to make the results look more acceptable.

This is what the Green Book has to say about processing data.

Data Processed into Quality Information

13.05 Management processes the obtained data into quality information that supports the internal control system. This involves processing data into information and then evaluating the processed information so that it is quality information. Quality information meets the identified information requirements when relevant data from reliable sources are used. Quality information is appropriate, current, complete, accurate, accessible, and provided on a timely basis. Management considers these characteristics as well as the information processing objectives in evaluating processed information and makes revisions when necessary so that the information is quality information.  Management uses the quality information to make informed decisions and evaluate the entity’s performance in achieving key objectives and addressing risks.

13.06 Management processes relevant data from reliable sources into quality information within the entity’s information system. An information system is the people, processes, data, and technology that management organizes to obtain, communicate, or dispose of information.

Answering Who, What, When, Where & How

So, now that the Green Book has prompted you to answer the who and what questions –who you need to communicate with and what information they need –  principles 14 & 15 prompt us to answer the when, where, and how questions.

The content of principle  14 & 15 are very similar.  Principle 14 focuses on internal reporting and principle 15 focuses on external reporting.  Both ask that we consider:

  • Audience - The intended recipients of the communication
  • Nature of information - The purpose and type of information being communicated
  • Availability - Information readily available to the audience when needed
  • Cost - The resources used to communicate the information
  • Legal or regulatory requirements - Requirements in laws and regulations that may impact communication

A report for our case study

Let’s make up a report for our case study example.  Remember our control objective is:

Do controls prevent the coach from using his purchasing card for personal purchases as defined by Grace School District Policy #C7.459? 

Thinking through each of the prompts given in section 14.07 and 15.07:

Audience

The intended recipients of the communication

The school board and the public.

Nature of information

The purpose and type of information being communicated

This report will contain a bar graphic for each user of the purchasing card and will look something like this:

chart1

It will also include a detailed list of transactions for each cardholder that will include the date of the transaction, the vendor, the amount of the purchase, and the items purchased.

Availability

Information readily available to the audience when needed

The board will receive the report every month via email and the report will be available to the public on the school’s website after the board has reviewed it.

Cost

The resources used to communicate the information

Accounting has the transaction information readily available in the general ledger, but it is not separated by user.  So, the initial cost to set up individual accounts for each user will require some customization of the accounting software.  But, once it is set up, the report should only take an accountant an hour to create and email to the board.  The webmaster will have to post the report to the site, and that should take about 30 minutes.

Legal or regulatory requirements

Requirements in laws and regulations that may impact communication

This report will not help satisfy any regulatory requirements imposed by the state or federal government. However, the Comptroller of the State will award us a ‘Transparency’ award and will feature our report on their website if we meet their award criteria.

Information and Communication is the most straightforward component

The information and communication component of the COSO model/Green Book advises us to make sure that the information we share is valid and communicated in a manner that is helpful to stakeholders.  In my opinion, it is the most straightforward and clear component of the COSO model/Green Book.

So far, we have covered three components of the COSO model/Green Book – the risk assessment component, the control activities component and the information and communication component.  In the next chapter, we will cover the monitoring component.

My comments to the GAO on the 2017 exposure draft of GAGAS

Here is the short response that I sent to the GAO on the 2017 exposure draft of GAGAS.  The deadline for comments is July 6.  Please send your comments to YellowBookComments@gao.gov.

6/20/17

GAO GAGAS Team –

Thank you for giving the audit community a chance to comment.  I am in the relatively unique position of having the privilege to work with teams using every chapter of the Yellow Book.  I work with CPA firms who apply the financial audit standards in the conduct of the Single Audit, internal audit shops and monitors in government who follow the performance audit standards, and legislative auditors who apply both financial and performance standards.  I also work with shops that don’t want to hear anything about the Yellow Book at all (!) and instead follow only IIA or AICPA standards.

Here are a half-a-dozen items I ask you to consider for the finalized 2017 revision:

1. Disclose all auditor responsibilities and the corresponding results and conclusions in the audit report

Please require auditors to include a more direct statement regarding the auditor’s responsibilities for all five reportable conditions in the audit report as well as the auditor’s results or conclusions regarding those responsibilities. 

In the proposed revision, an auditor is responsible for five reportable conditions – fraud, internal control weaknesses, non-compliance, waste, and abuse – but per the reporting standards the auditor need only describe their responsibilities regarding two of these conditions – internal control and compliance – to the reader of the audit report.  The reporting requirements have not evolved along with the audit standards to include statements regarding fraud, waste and abuse.

The AICPA’s canned audit reports regarding internal controls and compliance are opaque and user-unfriendly.  I know that you do not have the power to revise these letters, but I also know that you can influence the content of the AICPA’s letters and encourage clarity and transparency in all auditors’ reports if you decide to alter the required disclosures.

2. Revive the report quality elements
Please revive the ‘report quality elements’ listed in the 2011 version of the Yellow Book at A7.02.  I use the report quality elements quite a bit in my teaching – especially the guidance reminding auditors about timeliness and conciseness.

3. Revive the clear reference to the Single Audit
The 2007 version of the Yellow Book contained a clear reference to the Single Audit that was removed in the 2011 version.  Will you please add it back so there is no doubt that the Single Audit is classified as a financial audit?  It was in section 1.22(b) of the 2007 version and said “(5) auditing compliance with regulations relating to federal award expenditures and other governmental financial assistance in conjunction with or as a by- product of a financial statement audit. “

4. Define the term ‘performance aspect’ and remind auditors of the danger of vague performance aspects
Would you please define the term ‘performance aspects’? Section 8.08 mentions ‘performance aspects’ but does not define the term. The International Standards for Supreme Audit Organizations defines the term ‘performance aspect”, but most auditors I work with are unaware of those standards.

It would be very helpful if you would go on to remind auditors that the terms effectiveefficient and economical are very general and vague and that the auditor would benefit from using a more specific performance aspect in their objective – such as timeliness or accuracy.  I have witnessed countless audit teams suffering from scope creep and messy audit reports when they include the words efficient and effective in their audit objectives.

5. Simplify the peer review requirements
Please simplify and shorten the peer review requirements by including only the minimum requirements at the “Requirements for Audit Organizations Not Affiliated with Recognized Organizations” in paragraphs 5.80 through 5.113.   By mentioning specific organization’s peer review programs in section 5.64, you are creating more work for yourself and the audit community because now you will need to approve these organization’s approaches each time you revise the Yellow Book.  You will also have to screen other organization’s systems before inclusion in the Yellow Book. This can easily become political and bureaucratic and can be completely avoided by mentioning the minimum requirements only.

6. Revise an awkward sentence
This sentence is a bit convoluted:
6.20 Auditors should consider potential internal control deficiencies in their evaluation of identified findings when developing the cause element of the identified findings when significant to the audit objectives.
Maybe just say - Auditors should consider whether an internal control deficiency is the cause for identified findings.

Thank you again for the chance to comment, and thank you for working to make the Yellow Book the most comprehensive and clear audit standard in existence today.

Leita

Fraud Risk per the GAO’s Green Book

Just because you’re unaware of the risk, doesn’t mean it isn’t there

Just because you aren’t conscious of something dangerous, doesn’t mean it isn’t lurking.   One of the most important themes of the GAO’s Green Book (and the 2013 COSO model it is sourced from) is consciousness.  Instead of just playing along with the crowd without regard to the risk, the Green Book encourages you to become conscious of risk, imagine the worst, and then plan to prevent it.

Do you think that people in the 1940’s had a sneaking suspicion that smoking was unhealthy?  Or do you think their desire to be glamorous like all those smoldering (forgive the pun) Hollywood movie stars overrode their common sense?

And in the 70’s my mom and dad slathered themselves with olive oil and lay in the sun to get a reddish brown ‘tan’.  Coppertone products promised to magnify the power of the sun.  Now my dad gets skin cancer removed from his face, arms, and hands every six months or so.

Everybody went nuts buying non-stick cookware in the 80’s only to find out that the Teflon emits dangerous gasses into your food when heated.  In the 90’s we all started drinking bottled water with no concern for the environmental impact, and in the 2000’s we went ‘wireless’ and may be exposing our brains to harmful radio waves.  Lately, we all have to concede that if we transact with the world at all, our personal data is out there and available to criminals in Russia.

I am thinking of that classic parental line here, “If your crazy friend Carl jumped off a bridge, would you do it to?”  Going along with the crowd can be dangerous.

Sometimes you can pre-empt negative consequences

It is all very nice to look back in hindsight and realize that you shouldn’t have followed the crowd and jumped off that bridge.  But sometimes, you can work ahead of a problem to prevent bad results.

For instance, I opened a new business account at a bank recently.  And I know that it is dangerous to give my bank account number to folks who are making deposits into my account and/or who have the power to withdraw money from my account.  But I put the risk out of my mind because I didn’t think I could do anything about it.

Hand me the Coppertone, I’ll play along!  My thinking was, “That’s how business is done and I want to play.”

But my new bank has thought about this risk and offered me not one, but two checking accounts.  I can share one checking account number with vendors and customers who are coming in and out of my account and the other account – where the bulk of my money is – is accessible and known only to me and my bookkeeper.  Nice.

Fraud is real but it isn’t entirely unavoidable

The Certified Fraud Examiners estimate that 5% of an organization’s annual revenue is lost to fraud.   http://www.acfe.com/rttn2016/docs/Staggering-Cost-of-Fraud-infographic.pdf

And although the Certified Fraud Examiners don’t say it outright, they are implying that most organizations suffer fraud.   If an organization grows to over 100 employees, someone is probably doing something squirrely.

I spent a year writing a self-study book on Fraud for Government Auditors.  Unfortunately, I wrote it in 2008 as our economy was crashing.   As I wrote, I became hyper-aware of bad behavior and fraud everywhere I went.  It was exhausting and disheartening to see fraud every time I left the house or read the news, so 8 years later, I have turned the consciousness dial down quite a bit and become mostly numb to it once more. There is only so much moral outrage you can muster day after day after day.

The Green Book asks the leaders of the organization to think about fraud before it happens.  It is asking them, for at least a few days while they prepare a risk assessment, to muster some moral outrage before the organization actually suffers fraud so that they can plan around it, just like my new bank.

Fraud risk specifically

So in our last chapter, we discussed inherent risk in general and how the Green Book encourages us to think about the risk of death, injury, shame, loss of money or non-achievement of goals.

Now, we are going to focus on fraud risk specifically.  Fraud can cause injury, shame, loss of money, or non-achievement of goals.  But occupational fraud, the fraud discussed in the Green Book, is not likely to cause death.

The GAO dedicates a good portion of the chapter in the Green Book on risk assessment to assessing fraud risk.

Principle 8 states: 8.01: Management should consider the potential for fraud when identifying, analyzing, and responding to risks. 

Luckily, the GAO’s green book doesn’t stop there, but instead, shares several models that will help us be more conscious of fraud as we are assessing fraud risk: the fraud tree and the fraud triangle. We are going to discuss each in turn.

Like a good spiritual guide, the fraud tree and fraud triangle enhance consciousness

Both the fraud tree and the fraud triangle have helped me see fraud where I didn’t see it before.  And once your consciousness has been raised, you see new things everywhere.

You may have experienced this with your car.  I am the happy owner of a plain white Lexus sedan.  Before I owned a Lexus, I was oblivious to how many were on the road. Now I see them everywhere.  You remember that weird movie called The Sixth Sense… where the lead declares “I see dead people!”?  I see Lexi.

A broad overview of the fraud tree

As a supplement to this article, I am also going to publish a series of chapters from my book on fraud so you can get to know the fraud tree in more detail.  Be looking for those over the next few weeks. But in this short article, we are just going to do a broad overview of the fraud tree.

So don’t read any of those newsletters or read the rest of this newsletter unless you want to see fraud everywhere.

THE FRAUD TREE

A fraud investigator once told me, fraud is lyin’, cheat’n, and steal’n.  But the Certified Fraud examiners are more formal about classifying fraud and use much better grammar.  The Certified Fraud Examiners came up with a whole taxonomy of occupational fraud which they dubbed the ‘fraud tree.’  If you are having a hard time reading the graphic below, visit the Certified Fraud Examiners page at http://www.acfe.com/fraud-tree.aspx for a clearer graphic.

Fraud Tree

The fraud tree divides fraud into three categories:

Corruption

Misappropriation of assets

Fraudulent reporting

Corruption includes bribery and extortion – which are flip sides of the same coin.  When a person without power pays a person in power for a favor, it is a bribe. When a person in power demands payment from someone who needs a favor, it is extortion.

A contractor with a Texas county told me that he and all of the other contractors knew that in order to win contracts, they would have to give expensive gifts to the county purchaser. Whenever requests for proposals were discussed with contractors, the purchaser would mention things he needed for his house – like a new grill or a lawnmower.  The contractors knew that whoever was first to buy the grill or lawnmower would win the contract. Eventually, the purchaser’s requests became more extravagant and frequent. The contractors had to take turns bidding on contracts, so they could distribute the extra expense more evenly among them.

Corruption also includes illegal gratuities.  An illegal gratuity is when you reward or pay someone in advance in hope of future favor. This is the way the US Congress works. Corporations and lobbyists support campaigns and slather favors on Congressmen in hopes that the Congressman’s decisions on future legislation will be favorable to them.

The last category in corruption is conflict of interest.  This is a wide category of bad behaviors where favors are granted to friends and family.  My friend has recently been elected treasurer of her homeowner’s association.  She has already found out that the chairman of the board is awarding work to companies that his daughters own.  My friend suspects, but cannot prove yet, that the chairman owns the companies and that the daughters are owners on paper only.

The second branch of the tree is misappropriation of assets. Misappropriation of assets is when cash or other assets of the organization are stolen or misused.  Notice that the fraud tree has two main branches under misappropriation of assets – 1. cash and 2. inventory and other assets.

fraud2

Cash can be stolen in three ways; cash can be taken after it has been captured in the accounting records (larceny), or before it hits the accounting records (skimming), or it can be disbursed in what looks like legitimate transactions for illegitimate purposes, like payments to fake (ghost) emplo

yees or fake (shell) companies.  As you can tell from the tree, cash misappropriation includes a wide variety of creative categories for fraudsters to choose from.

Other assets, like inventory and fixed assets can be stolen or misused.  The mail clerk in a state agency I worked for was using the state’s van on weekends to deliver pizzas!

And the last category is fraudulent statements.  We are all aware of the infamous financial statement fraud scandals at Enron and WorldCom that wreaked havoc on our national economy.  But we might not be as well acquainted with non-financial statement fraud.  A false claim or statement for personal gain falls into this category.  Fifty-eight percent of hiring managers said they’ve caught a lie on a resume per a Career Builder Survey concluded in 2014. http://www.careerbuilder.com/share/aboutus/pressreleasesdetail.aspx?sd=8%2F7%2F2014&id=pr837&ed=12%2F31%2F2014  And many governments use performance measures to convince grantors and the citizenry that they are doing a good job handling public resources. But as you can imagine, sometimes these performance measures are altered, manipulated, or even completely made up.

One of my favorite stories about fraudulent performance measures is about the Public Works Department in the City of San Deigo. Their Public Works Department said they filled potholes within a week, when the truth is most potholes took months to repair.  When asked about the discrepancy, the Public Works Department said that their definition of repaired does not meet most people’s definition of repaired.  Tricky?  Yes.  Fraudulent?  I’d say so because the managers in the Public Works Department benefited from exaggerating the Department’s effectiveness.  See the amusing article about this fraud here: http://www.voiceofsandiego.org/topics/government/the-citys-false-pothole-pledge/

When I audited performance measures at a state department of criminal justice (the state prison system), I found that most measures were pulled directly out of the sky.  They were estimates that made the department look good, not measures of real results.

If you were reading closely, you might have noticed a small difference in wording

I don’t really know why the GAO and the COSO model chose to leave out non-financial statement fraud from their literature, but they did.  Here is the quote referring to the fraud tree in the Green Book:

Green Book 8.02 Management considers the types of fraud that can occur within the entity to provide a basis for identifying fraud risks.  Types of fraud are as follows:

  • Fraudulent financial reporting - Intentional misstatements or omissions of amounts or disclosures in financial statements to deceive financial statement users. This could include intentional alteration of accounting records, misrepresentation of transactions, or intentional misapplication of accounting principles.
  • Misappropriation of assets - Theft of an entity’s assets. This could include theft of property, embezzlement of receipts, or fraudulent payments.
  • Corruption - Bribery and other illegal acts.

See how the Green Book doesn’t talk about fraudulent statements in general but fraudulent financial statements only.

If you are an aficionado of SAS 99 (now AU 316), the AICPA’s guidance on an auditor’s responsibility for detecting fraud, you may recognize that the AICPA focuses their discussion of fraud on fraudulent financial statement reporting only.  This makes sense because the AICPA is clear about its audit objective – to opine on whether the financial statements are created in accordance with an accounting standard (usually GAAP).  But the Green Book – because it covers an entire organization, should include all components of the fraud tree.

If you know the reason for this, please share.  Otherwise, I am going to say it is a flaw of the Green Book until someone can convince me otherwise.

Next time, we will discuss the fraud triangle and do an example fraud risk assessment.

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