CPE for Government Auditors

Abuse, Waste & Other Shenanigans: Reportable Conditions

Objectives:

  • Classify an audit finding as: an internal control weakness; a violation of contract or grant agreement; fraud; or abuse and waste.
  • Differentiate among the elements of a finding.

If the auditee exhibits any of the following three conditions, and these conditions are significant or material, the auditor should describe them in their audit report in the form of a “finding” and recommend corrective action:

  1. Internal control weaknesses
  2. Noncompliance
  3. Fraud

But those aren’t the only less than stellar conditions an auditor may come across; the auditor may also see that the auditee is abusing their power or wasting government resources. In years past, the GAO considered abuse as a reportable condition and did not mention the concept of waste.

In the 2018 version of the Yellow Book, abuse is no longer a reportable condition. Instead abuse is joined to waste and together they are described as indicators that the other reportable conditions exist.

In this chapter, we will cover the definitions of the three reportable conditions as well as the definitions of abuse and waste. We will cover our professional responsibilities regarding the reportable conditions and talk about how to describe the reportable conditions in findings using the five elements of a finding.

Our Responsibility Is Limited

The Yellow Book repeatedly points out that we are responsible for the reportable conditions only within the context of our audit objectives. So, we are not responsible for fraud, noncompliance, and internal control weaknesses throughout the client’s operations (thank goodness!). We are only responsible for those three conditions as they relate to our audit objectives.

Definitions of the Reportable Conditions

Let’s define each of the reportable conditions in more detail. First, internal control weaknesses, next noncompliance, and then fraud.

Here is how the GAO defines an internal control weakness:

8.53: … A deficiency in internal control exists when the design, implementation, or operation of a control does not allow management or personnel to achieve control objectives and address related risks. A deficiency in design exists when a necessary control is missing or 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 control is properly designed but not implemented correctly in the internal control system. A deficiency in operating effectiveness exists when a properly designed control does not operate as designed or the person performing the control does not have the necessary competence or authority to perform the control effectively. 

Here is how the GAO defines non-compliance:

8.68 …   instances of noncompliance with provisions of laws, regulations, contracts, and grant agreements …

Here is how the GAO defines fraud:

8.73     Fraud involves obtaining something of value through willful misrepresentation. 

Each of the Reportable Conditions Has Criteria:

One thing that makes auditors very happy is audit criteria. Without audit criteria, we don’t have anything objective to measure our audit subject against.

Internal controls can be (and per the last chapter, now will be!) evaluated against the COSO model or the Green Book.

Compliance can obviously be evaluated against our some of our favorite audit criteria: law, regulations, contracts, or grant agreements.

Fraud must be evaluated against statute. A fraudster cannot be brought to court unless the prosecution can prove that a crime – per statute – was committed.

So, for each reportable condition, an auditor can comfortably bring issues up in a finding because they will have some firm criteria to base their finding on. As we will see later in this chapter, criteria is one of the five elements of a finding.

Abuse and Waste Are Subjective

In the case of the concepts of abuse and waste, the auditor must apply their judgment instead of criteria. This is not a happy spot for auditors to be.

Because abuse does not involve any firm criteria, it has been downgraded from a reportable condition to a ‘concept.’

Here is the definition of abuse:

6.23     Abuse is behavior that is deficient or improper when compared with behavior that a prudent person would consider reasonable and necessary business practice given the facts and circumstances, but excludes fraud and noncompliance with provisions of laws, regulations, contracts, and grant agreements. Abuse also includes misuse of authority or position for personal financial interests or those of an immediate or close family member or business associate.

Who is this prudent person? You’ve got me! I’ve never met one, so we won’t be able to give them a call or refer to their judgment when we are trying to decide if someone is acting abusively.

We have a similar problem with waste, which is defined for the first time in the 2018 version of the Yellow Book.

6.21     Waste is the act of using or expending resources carelessly, extravagantly, or to no purpose. Importantly, waste can include activities that do not include abuse and does not necessarily involve a violation of law. Rather, waste relates primarily to mismanagement, inappropriate actions, and inadequate oversight. 

This time, this non-existent prudent person is not mentioned, although we still aren’t left with any firm criteria to hang our hats on.

I am sure that you have had unresolvable conflicts with your loved ones over what constitutes waste. What my husband thinks is wasteful, I think is normal or necessary, and vice versa. For instance, I insist on using Orville Redenbacher raw popcorn kernels when I make popcorn. Orville Redenbacher is expensive compared to the cheap bags of generic popcorn. Several times he has snuck cheap popcorn into my Orville Redenbacher jar to make a point… but I busted him! He thinks I am being wasteful. I think Orville Redenbacher is necessary. Who is right? Me, of course!

He insists on Coke Zero and refuses to drink generic diet cola brands. He sees no hypocrisy in this.

This is exactly the kind of silly debate that auditors should not get into! Without firm criteria, limiting the amount that should be spent on popcorn or sodas, no one wins.

The GAO recognizes that abuse and waste are difficult for auditors to work with because of the lack of firm criteria, so they downgraded abuse from a reportable condition. They married abuse to the newly defined concept of waste and point out that abuse and waste can be indicators that fraud, non-compliance, or internal control weaknesses have occurred.

6.20     Given the concept of accountability for use of public resources and government authority, evaluating internal control in a government environment may also include considering internal control deficiencies that result in waste or abuse. Because the determination of waste and abuse is subjective, auditors are not required to perform specific procedures to detect waste or abuse in financial audits. However, auditors may consider whether and how to communicate such matters if they become aware of them. Auditors may also discover that waste or abuse are indicative of fraud or noncompliance with provisions of laws, regulations, contracts, and grant agreements. 

Thinking through Some Examples May Help Us

Let’s walk through two scenarios involving of less-than-stellar behavior and see whether these one of the three reportable conditions (fraud, noncompliance, internal control weaknesses), abuse and waste, or something else.

Scenario 1: First let’s consider the case of a government employee who works for a retirement system in Massachusetts. Let’s say she wants to visit her daughter in California soon. She sees an opportunity to have the retirement system pay her way when a seminar relevant to her job is offered only a half-hour’s drive from her daughter’s home. This same seminar will be available near her offices in Massachusetts in a few months and the state will not have to pay travel costs for her to attend.

Here is the scale of less-than-stellar behavior in government – from bad… so bad you want to see the person behind bars (fraud) – to just plain silly.

  • Fraud
  • Noncompliance
  • Internal Control Deficiency
  • Abuse
  • Waste
  • Unethical
  • Silly/stupid

Abuse, and waste are not reportable conditions; neither are unethical, silly, or stupid behaviors.
Let’s go from the bottom of our list up. Yes, this is pretty stupid and obvious upon examination. Unethical? Yes. Is she wasting government resources: Yes. Abuse…maybe not. An internal control deficiency? Maybe. Someone should be reviewing her choices and making sure that the travel expenditure is worth it. Non-compliance? No, I don’t think so. Fraud? Should she go to jail? No, I think jail time is a little too harsh.

Yes, she is wasting the government’s resources, but we are going to have a hard time writing a finding from that perspective because we don’t have any criteria. The Yellow Book tells us that waste and abuse can indicate that another reportable condition is present.

6.20     Given the concept of accountability for use of public resources and government authority, evaluating internal control in a government environment may also include considering internal control deficiencies that result in waste or abuse… Auditors may also discover that waste or abuse are indicative of fraud or noncompliance with provisions of laws, regulations, contracts, and grant agreements.

If this issue is relevant to my audit objective and if I want to bring it up in my audit report, I would frame this issue as an internal control weakness. Someone should have prevented her from traveling unnecessarily through by reviewing her travel plans.

Scenario 2: Let’s go through another scenario. Let’s say that we are auditing prisoner accounts at a county jail. And we find that the jail clerk has not been returning funds to inmates after they are released.

Let’s go through this one from the top! Is this fraud? Well, aren’t you eager to throw someone behind bars? I didn’t say the jail clerk took the funds home with her! I only said she just didn’t return the fund to inmates. If she took it home, yes, it would be fraud. If she just left it sitting in the county’s bank account, we are not dealing with fraud but instead noncompliance or an internal control weakness. Is it waste or abuse? No. Unethical? Yes, if it was intentional. Silly or stupid? Maybe she just has too much to do and let this task slip. I don’t think I’d call that stupid.

I’d probably frame the finding as noncompliance in this scenario. Maybe an internal control weakness. Later in this chapter, we will talk about how to write noncompliance and internal control weakness findings.

Now that we understand how to identify reportable conditions, let’s talk about our professional responsibility regarding them.

Our Responsibility to Detect the Reportable Conditions

Do you remember the audit trifecta I introduced during our discussion of independence? When applied to independence, the trifecta is called the ‘conceptual framework.’ The trifecta is a three-step process: 1. understand your subject, 2. assess risk, and 3. respond.

This time, the standards rename the trifecta and refer to it as ‘designing your audit to detect…’
Whenever a standard-setting body pulls the trifecta out of its hat, you know that the standard-setting body wants you to think and wants the thinking documented. The most intense thing the standards can ask you to do is think through the steps of the trifecta, and thus what follows are some of the GAO’s most intense standards.

With a slight variation in language, the GAO is asking auditors to go through all three steps of the trifecta when it comes to each of the reportable conditions. The language is a little more convoluted when it comes to internal controls than the language surrounding the other two reportable conditions. Let me start with the most straightforward presentation of the trifecta among all three reportable conditions – the trifecta applied to noncompliance.

The Trifecta Applied to Noncompliance

Look at this quote from the Yellow Book regarding the auditor’s responsibilities regarding noncompliance and find the steps of the trifecta.

8.68     Auditors should identify any provisions of laws, regulations, contracts, and grant agreements that are significant within the context of the audit objectives and assess the risk that noncompliance with provisions of laws, regulations, contracts, and grant agreements could occur. Based on that risk assessment, the auditors should design and perform procedures to obtain reasonable assurance of detecting instances of noncompliance with provisions of laws, regulations, contracts, and grant agreements that are significant within the context of the audit objectives. 

Step one of the trifecta, “understand the subject” has been changed to “identify any provisions… that are significant,’ the risk assessment step is addressed head-on, and the last step of the trifecta, the response, is now “design procedures to detect.” The whole trifecta as it applies to non-compliance has all been addressed in one short paragraph.

The Trifecta Applied to Fraud

The trifecta gets a little trickier when it comes to our responsibility for fraud, but it is still in there! It is just enhanced. And there is a difference between the requirements to apply the trifecta in financial audit standards and in the performance audit standards. Financial auditors must follow the AICPA standards regarding fraud – and these standards are more detailed and specific than the GAO’s standard for performance auditors.

Here is a table outlining both standards:

FINANCIAL AUDITS PERFORMANCE AUDITS
1. understand the subject

  • Ask questions of auditee
  • Consider fraud risk factors
1. understand the subject

  • Gather and assess information
  • Consider fraud risk factors
2. assess risk

  • Brainstorm with team
  • Assess magnitude and likelihood of potential frauds
2. assess risk

  • Brainstorm with team
  • Assess magnitude and likelihood of potential frauds

3. respond with procedures

 

3. respond with procedures

 

What is the difference? The performance auditor does not have to ask questions of the auditee. Financial auditors following the AICPA standards for fraud occasionally end up insulting the auditee with these questions because they are very direct. The questions stop just shy of accusing the interviewee of committing fraud themselves!

Here is what the Yellow Book directs performance auditors to do regarding fraud. Try again to find the trifecta!

8.71     Auditors should assess the risk of fraud occurring that is significant within the context of the audit objectives. Audit team members should discuss among the team fraud risks, including factors such as individuals’ incentives or pressures to commit fraud, the opportunity for fraud to occur, and rationalizations or attitudes that could increase the risk of fraud. Auditors should gather and assess information to identify the risk of fraud that is significant within the scope of the audit objectives or that could affect the findings and conclusions. 

8.72     Assessing the risk of fraud is an ongoing process throughout the audit. When information comes to the auditors’ attention indicating that fraud, significant within the context of the audit objectives, may have occurred, auditors should extend the audit steps and procedures, as necessary, to (1) determine whether fraud has likely occurred and (2) if so, determine its effect on the audit findings. 

The trifecta is presented out of order in those last two paragraphs, but it is still there; understanding the audit subject is called “gather and assess information,” the risk assessment is addressed head-on, and the response is called “extend the audit steps and procedures.”

The Trifecta Applied to Internal Controls

The application is becoming more complicated as we move through the reportable conditions. Did you notice? The trifecta is clearly laid out in the non-compliance requirements, obscured ever so slightly in the fraud standards and then, as you will see, strangely overcomplicated when it comes to talking about internal controls.

Step 1 of the Trifecta – gathering information

8.40     If it is determined that internal control is significant to the audit objectives, auditors should obtain an understanding of such internal control. 

Step 2 of the Trifecta – assess risk

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. 
In this case, the GAO does not use the term ‘risk assessment’ but instead uses the terminology “if significant.” So, risk is obscured, but an auditor can’t determine what is ‘significant’ without doing a risk assessment!

Step 3 of the Trifecta – respond

8.51     Assessments of internal control involve designing and performing procedures to obtain sufficient, appropriate evidence, as required in paragraphs 8.90 through 8.94, to support and document the auditors’ findings and conclusions on design, implementation, and/or operating effectiveness of controls that are significant to the audit objectives. The controls being assessed are generally the key controls identified during the planning phase of the engagement, which may include controls at both the entity and transaction levels. Changes may be made to the initial determination of key controls based on additional information gathered during the course of fieldwork. 

I told you, overcomplicated! But the three steps of the trifecta are there for internal controls, too.

Findings

Now that you know that there are three triggers for a finding, you also need to know how to write a finding. The GAO is very specific about what goes into a finding; findings per Yellow Book standards include five elements:

  • Condition
  • Effect
  • Cause
  • Criteria
  • Recommendation

Where Did These Elements Come From?

The elements of a finding are the standard elements of a persuasive argument outlined centuries ago by Greek philosophers. Legend has it that an audit manager at the GAO earned a master’s in philosophy and was wise enough to include the elements of a persuasive argument in the Yellow Book. At the time, his colleagues thought he was crazy (as is often assumed about philosophy majors), but now we applaud his contribution.

The elements of a finding are where the GAO puts legs on its concepts of accountability and transparency and are central to the way that government auditors think about their work at the micro level (reportable conditions) and the macro level (as questions we must answer with our audit objectives). But I am getting a little off track! Let’s go back to the micro level and talk about how to use the elements to support a finding.

Questions Answered by the Elements

Each element answers a question for the reader that they need answered in order to be persuaded to change. The recommendation describes the change that needs to occur.

CONDITION: What is the problem?
EFFECT: Why does this problem matter? What is the impact?
CAUSE: How did the condition happen?
CRITERIA: Says who?
RECOMMENDATION 1: How do we resolve the condition?
RECOMMENDATION 2: How do we resolve the cause?

Here are the GAO definitions of each of the elements:

6.26     Condition: Condition is a situation that exists. The condition is determined and documented during the audit. 

6.28     Effect or potential effect: The effect or potential effect is the outcome or consequence resulting from the difference between the condition and the criteria. When the audit objectives include identifying the actual or potential consequences of a condition that varies (either positively or negatively) from the criteria identified in the audit, effect is a measure of those consequences. Effect or potential effect may be used to demonstrate the need for corrective action in response to identified problems or relevant risks. 

6.27     Cause: The cause is the factor or factors responsible for the difference between the condition and the criteria, and may also serve as a basis for recommendations for corrective actions. Common factors include poorly designed policies, procedures, or criteria; inconsistent, incomplete, or incorrect implementation; or factors beyond the control of program management. Auditors may assess whether the evidence provides a reasonable and convincing argument for why the stated cause is the key factor contributing to the difference between the condition and the criteria. 

6.25     Criteria: For inclusion in findings, criteria may include the laws, regulations, contracts, grant agreements, standards, measures, expected performance, defined business practices, and benchmarks against which performance is compared or evaluated. Criteria identify the required or desired state or expectation with respect to the program or operation. Criteria provide a context for evaluating evidence and understanding the findings, conclusions, and recommendations in the report. In a financial audit, the applicable financial reporting framework, such as generally accepted accounting principles, represents one set of criteria. 

6.52     (RecommendationsAlong with assisting management or oversight officials of the audited entity in understanding the need for corrective action, clearly developed findings assist auditors in making recommendations for corrective action. If auditors sufficiently develop the elements of a finding, they may provide recommendations for corrective action. 

The Hardest Element to Develop Is the Cause

Filling in the blanks on these elements might look easy on paper, but when presented with a real-life scenario, most auditors struggle with coming up with a solid cause. The GAO has formally recognized this struggle by recommending for the first time in its standards that auditors use an internal control weakness as the cause:

6.18     Auditors should consider internal control deficiencies in their evaluation of identified findings when developing the cause element of the identified findings. 

6.29     Regardless of the type of finding identified, the cause of a finding may relate to one or more underlying internal control deficiencies. Depending on the magnitude of impact, likelihood of occurrence, and nature of the deficiency, the deficiency could be a significant deficiency or material weakness in a financial audit. 

6.30     Considering internal control in the context of a comprehensive internal control framework, such as Standards for Internal Control in the Federal Government or Internal Control—Integrated Framework can help auditors to determine whether underlying internal control deficiencies exist as the root cause of findings. Identifying these deficiencies can help provide the basis for developing meaningful recommendations for corrective actions. 

If internal control weaknesses are the cause, they can’t also serve as the condition statement. OK, an auditor CAN start a finding with an internal control weakness as the cause, but that choice often ends up with the auditor saying something rude and personal about the auditee. Let me show you what I mean by using a few examples.

Did I Show Up to Work on Time?

Let’s pretend that you have been tasked with concluding whether I show up on time for my seminars.

I show up at least an hour ahead of start time because I often find the venue and the AV in disarray. I also need a little time to get settled in and accustomed to the environment so that I can adjust any plans I have for eliciting interaction from the audience.

Whether or not I show up on time for my seminars is a question of fact; do I or don’t I show up on time?

Because getting to work an hour ahead of the start is so important for me, I layer on a variety of controls to make sure that I am on time. One thing I do is set at least three alarm clocks: my iPhone alarm, my bedside plug-in alarm, and a battery powered alarm. If I am in a hotel, I ask for a wake-up call. If I am home, I alert my family to the need to get me up in the morning.

Why so many layers of redundant controls? Because all of them have failed me at one time or another. Sometimes two of them fail me.

Whether my alarm clocks go off is a different question than whether I got to work on time. Whether my alarm clocks go off is an internal control question.

Now is the question of fact or the question of controls a more important question to answer?

  • The question of fact: Did Leita show up to work on time?
  • The control question: Did Leita’s alarm clocks go off?

Yes, whether I showed up to work on time is the most important question to ask.

And it is possible that I showed up at work on time and it had nothing to do with my alarm clocks? Yes. Sometimes I naturally wake up ahead of my alarm clocks.

And is it possible that my alarm clocks worked but I still didn’t make it work on time? Yes! Maybe I got hung up in traffic or got lost on the way.

Now, let’s imagine that I did not make it to work on time because I only set one alarm and it didn’t go off. Here is the resulting finding:

CONDITION: Leita was late to work

EFFECT: She delayed the start of the seminar by 40 minutes while she adjusted her mike and toyed with the LCD projector.

CAUSE: Her alarm clock did not go off

CRITERIA: Contract clause 20b says that the seminar starts at 8:00 a.m.

RECOMMENDATION 1: Leita is on time for work

RECOMMENDATION 2: Leita, set another alarm clock

Findings are always easier to write if you start with a fact-based statement as the condition and then use a control weakness as a cause.

Now imagine that instead of starting with the fact-based statement as the condition statement, I started with the control weakness as the condition:

CONDITION: Leita’s alarm clock did not go off

EFFECT: Leita was late to work

CAUSE: Operator error – Leita set the clock for 5:00 p.m. instead of 5:00 a.m.

CRITERIA: International time standards clearly state that a.m. represents the term ante meridiem, meaning before midday and post meridiem (p.m.) meaning after midday.

RECOMMENDATION 1: Leita should ensure her alarm clock goes off by setting a new one.

RECOMMENDATION 2: Leita should get a clue what a.m. and p.m. mean.

Yes, that was silly. The criteria was were silly. The cause got personal. See how badly things can turn out when you start with the control as the condition statement? Still not convinced? Let’s try a more realistic scenario.

An Audit Example

Here is a more realistic example. Let’s say that you are auditing a school lunch program. And let’s say that you find that kids who are not eligible for a government-subsidized lunches are getting free lunches. Here is a simple outline of what a finding might look like:

CONDITION: Ineligible children served free lunch
EFFECT: School spent $XX,XXX in federal funds on the ineligible lunches in 20XX.
CAUSE: No screening for eligibility
CRITERIA: Federal grant terms and conditions, clause XXX says…
RECOMMENDATION 1: Ensure only eligible students enjoy free lunch
RECOMMENDATION 2: Screen for eligibility

See how nicely that works if you start out the finding with a statement of fact as your condition and use a control weakness as a cause. Just like the GAO suggested.

If you choose “not screening children for eligibility” – a control weakness – as your cause, where are you going to go next? What is the cause going to be? Did they not screen for eligibility because they forgot? Didn’t care? Didn’t know they were supposed to? None of these comments are flattering, edifying, or insightful. Try not to go there! Start off with the statement of fact (Leita is not at work, kids are not eligible) and use a control weakness as the cause.

Solid Findings Look Like This

Here is a simple formula for a solid finding:

  • CONDITION: Noncompliance described
  • EFFECT: Quantification of noncompliance
  • CAUSE: Failed or non-existent control
  • CRITERIA: Compliance requirement
  • RECOMMENDATION 1: Ensure compliance
  • RECOMMENDATION 2: Repair or establish control

Or alternatively, a finding might look like this:

  • CONDITION: Did not achieve program goals
  • EFFECT: Quantification of impact
  • CAUSE: Failed control OR noncompliance
  • CRITERIA: Compliance requirement
  • RECOMMENDATION 1: Ensure meet goals
  • RECOMMENDATION 2: Repair control or ensure compliance

Weak Findings Look Like This

Again, if you do not take the GAO’s advice to make internal control weaknesses the cause, you might end up with a disparaging remark about the client’s ability to do their job. The following format is not ideal:

  • CONDITION: Internal control failure described
  • EFFECT: Quantification of impact
  • CAUSE: Another failed control or disparaging remark about the client’s ability
  • CRITERIA: Green Book
  • RECOMMENDATION 1: Repair or establish internal control
  • RECOMMENDATION 2: Repair or establish secondary internal control or do your job!

Special Reporting Requirement for Financial Auditors

Speaking of transparency, the GAO also wants financial auditors to be transparent regarding the auditor’s responsibility for the three reportable conditions. So, the GAO requires that financial auditors add language regarding the reportable conditions to their audit reports that is not required by the AICPA.

A financial auditor following AICPA financial auditing standards always includes an opinion on the financial statements in their audit report. Auditors following GAO standards must add language specifically addressing the auditor’s work regarding internal controls and compliance. If the auditor finds the remaining reportable condition, fraud, they are expected to address the fraud in this additional language also.

Most auditors put this additional language in a separate letter in the audit report.

Here is what the GAO says about this additional language:

6.39     Auditors should report on internal control and compliance with provisions of laws, regulations, contracts, or grant agreements regardless of whether they identify internal control deficiencies or instances of noncompliance. 

6.40     When providing an opinion or a disclaimer on financial statements, auditors should report as findings any significant deficiencies or material weaknesses in internal control over financial reporting that the auditors identified based on the engagement work performed. 

6.41     Auditors should include in their report on internal control or compliance the relevant information about noncompliance and fraud when auditors, based on sufficient, appropriate evidence, identify or suspect

  1. noncompliance with provisions of laws, regulations, contracts, or grant agreements that has a material effect on the financial statements or other financial data significant to the audit objectives or
  2. fraud that is material, either quantitatively or qualitatively, to the financial statements or other financial data significant to the audit objectives.

6.42     Auditors should include either in the same or in separate report(s) a description of the scope of the auditors’ testing of internal control over financial reporting and of compliance with provisions of laws, regulations, contracts, and grant agreements. Auditors should also state in the report(s) whether the tests they performed provided sufficient, appropriate evidence to support opinions on the effectiveness of internal control and on compliance with provisions of laws, regulations, contracts, and grant agreements. 

6.43     If auditors report separately (including separate reports bound in the same document) on internal control over financial reporting and on compliance with provisions of laws, regulations, contracts, and grant agreements, they should include a reference in the audit report on the financial statements to those additional reports. They should also state in the audit report that the reports on internal control over financial reporting and on compliance with provisions of laws, regulations, contracts, and grant agreements are an integral part of a GAGAS audit in considering the audited entity’s internal control over financial reporting and compliance. If separate reports are used, the auditors should make the report on internal control and compliance available to users in the same manner as the financial audit report to which it relates. 

The Language Differs Depending on the Financial Audit Objectives

Some financial auditors opine on whether the financial statements are presented in accordance with accounting standards, period. Let’s call those Plain Jane financial audits. Some financial auditors conduct the Single Audit. The Single Audit includes an opinion on the financial statements as well as an opinion on compliance for major programs.

On a Plain Jane financial audit, the auditor does not opine on compliance or internal controls in the additional language.

For the Single Audit, auditors opine on compliance for major programs. Single Auditors also have a heightened responsibility for internal controls over compliance. These additional responsibilities on the Single Audit are reflected in specifically designed additional language regarding compliance and internal control.

The AICPA provides example language for both audits – the Plain Jane financial audit and the Single Audit – on its “Government Audit Quality Center” website. I recommend that you use the wording suggested by the AICPA verbatim! Don’t get creative with this language; just make sure you included it when you report on a Yellow Book financial audit!

Example Language for a Plain Jane Financial Audit

Here is an example of the additional language regarding compliance and internal control for a Plain Jane financial audit. This language does not apply to the Single Audit. Please do not rely on this example for your work as the letters are frequently updated by the AICPA!

Report on Internal Control Over Financial Reporting and on Compliance and Other Matters Based on an Audit of Financial Statements Performed in Accordance with Government Auditing Standards (for a Governmental Entity) 

(No Material Weaknesses Identified; No Significant Deficiencies Identified; No Reportable Instances of Noncompliance or Other Matters Identified) 

Independent Auditor’s Report 

[Appropriate Addressee] 

We have audited, in accordance with the auditing standards generally accepted in the United States of America and the standards applicable to financial audits contained in Government Auditing Standards issued by the Comptroller General of the United States, the financial statements of the governmental activities, the business-type activities, the aggregate discretely presented component units, each major fund, and the aggregate remaining fund information of Example Entity, as of and for the year ended June 30, 20X1, and the related notes to the financial statements, which collectively comprise Example Entity’s basic financial statements, and have issued our report thereon dated August 15, 20X1. 

Internal Control over Financial Reporting 
In planning and performing our audit of the financial statements, we considered Example Entity’s internal control over financial reporting (internal control) to determine the audit procedures that are appropriate in the circumstances for the purpose of expressing our opinions on the financial statements, but not for the purpose of expressing an opinion on the effectiveness of Example Entity’s internal control. Accordingly, we do not express an opinion on the effectiveness of Example Entity’s internal control. 

A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis. A material weakness is a deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance. 

Our consideration of internal control was for the limited purpose described in the first paragraph of this section and was not designed to identify all deficiencies in internal control that might be material weaknesses or significant deficiencies. Given these limitations, during our audit we did not identify any deficiencies in internal control that we consider to be material weaknesses. However, material weaknesses may exist that have not been identified. 

Compliance and Other Matters 
As part of obtaining reasonable assurance about whether Example Entity’s – financial statements are free from material misstatement, we performed tests of its compliance with certain provisions of laws, regulations, contracts, and grant agreements, noncompliance with which could have a direct and material effect on the determination of financial statement amounts. However, providing an opinion on compliance with those provisions was not an objective of our audit, and accordingly, we do not express such an opinion. The results of our tests disclosed no instances of noncompliance or other matters that are required to be reported under Government Auditing Standards. 

Purpose of this Report

The purpose of this report is solely to describe the scope of our testing of internal control and compliance and the results of that testing, and not to provide an opinion on the effectiveness of the entity’s internal control or on compliance. This report is an integral part of an audit performed in accordance with Government Auditing Standards in considering the entity’s internal control and compliance. Accordingly, this communication is not suitable for any other purpose. 

[Auditor’s signature] 

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.
Description: Macintosh HD:Users:Leita:Dropbox:+TOPICS:controls:coso model picture:Slide1.jpg

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.

Visit the Yellowbook-CPE.com Student Center
Click to learn more about Yellowbook requirements.

Login

Lost your password?