CPE for Government Auditors

General Principles & Basic Premises


  • Differentiate between principles applicable to state and local governments and nonprofits
  • Define key government regulators and their related acronyms
  • Sequence the four layers of rules governing grants

Introduction to Federal Cost Principles

Now you’ve done it. You’ve taken on a federal grant – either to administer one or to audit one!

Federal grants can be very tricky, with many strings attached.  But luckily the federal government tends to be specific about their expectations regarding how the resources are to be used.

In general, governments strive to enhance accountability and transparency in their recordkeeping and reporting.  The citizens have a right to know what happened to their tax money.  And they have the right to know that the money was spent properly.

What this means for us, the professionals working with these grants, is that we have to dot every “i” and cross every “t.”  Most grants undergo several layers of scrutiny, and grantees are constantly under threat of the ”de-obligation” of federal grant funds (which means the feds ask for their money back) if they don’t follow the rules.

This course examines some of the significant aspects of the federal government’s expectations regarding the use of taxpayers’ dollars – the cost principles.

We will examine the federal cost principles applicable to state and local governments and Indian tribal governments and to nonprofit organizations that receive federal grants. The cost principles apply to almost all federal grant programs, although some do have exceptions contained in their program regulations or individual grant terms and conditions. This text does not specifically address universities, hospitals, or for-profit entities, although the cost principles for those entities are very similar.

When an entity receives federal grants, or expects to in the near future, it should ensure that one or more of its employees have a strong working knowledge of the federal cost principles.

Is That Allowable?

When you behave and spend resources within the federal guidelines, your expenditures are deemed ”allowable.”

As an administrator, you may need to answer confidently questions similar to these:

  • Is it allowable to buy a truck to deliver meals to the elderly?
  • Is it allowable to purchase food for the annual holiday party with federal funds?
  • Is the salary for the agency’s receptionist chargeable to the grant?
  • Is the cost for defending our patent chargeable to the grant?

If you are unsure about the allowability of costs, the auditor and grantor will question your competency.  And when auditors or grantors start to doubt your credibility, they have a responsibility to dig a little deeper, and it is never pleasant to be on the receiving end of a dig.

On the other hand, if you are an auditor, you need to be able to detect when costs are not allowable and help the client come into compliance with grant regulations.

Acronyms, Definitions, and Relationships

Before we delve into the federal regulations, we’d better master a few key acronyms and terms.  The federal government is rife with them.

Here are some you will see frequently in this text:

OMB – Office of Management and Budget– An agency in the executive branch of the federal government.  The OMB works with the president to help him direct all of the federal agencies at his command such as the Department of Defense, the Department of Health and Human Services, Department of Housing and Urban Development, etc.

CFR – Code of Federal Regulations– The Code of Federal Regulations is authored by the federal agencies that administer the grants.  So the Department of Defense and the Department of Health and Human Services write these regulations.  The CFR is divided into 50 titlesthat represent broad areas subject to federal regulation. Each of 50 broad titles usually indicates the issuing agency.  Each title is further subdivided into parts, similar to chapters that cover specific regulatory areas. The OMB issues Title 2 of the CFR.

Non-Federal entity— Astate, local government, Indian tribe, institution of higher education (IHE), or nonprofit organization that carries out a Federal award as a recipient or subrecipient.  Note that the term non-Federal entity does not include for-profit organizations.

Pass-through entity—A non-Federal entity that provides a subaward to a subrecipient to carry out part of a federal program.

Equipment— Tangible personal property (including information technology systems) having a useful life of more than one year and a per-unit acquisition cost of $5,000 or more.

A further word about the OMB:  The OMB helps the president design the federal budget.  It also issues directives in the form of “circulars” and “bulletins” to executive branch agencies. These issuances convert law and executive directions into implementable actions and are to be used by the federal agencies in carrying out their missions.  The circulars define terms and fill in the blanks with references that Congress may or may not fill in.  They are usually fairly easy to read as the OMB does its best to speak in plain English, but they are often long and detailed.

The OMB, in an effort to make it easier for grantees to find the information they need to manage grants, has relocated those that are circulars applicable to federal grants to Title 2 of the Code of Federal Regulations.  Previously, the cost principles were in several circulars, but now they reside in 2 CFR 200, Subpart E.  This makes sense, as the circulars are directions for federal agencies, and grantees are used to looking for federal rules in the CFRs.

This relocation is part of a broader initiative to make Title 2 of the CFR the single location where the public can find guidance for grants and agreements. Future reform efforts may eventually seek to incorporate the Cost Principles for Hospitals, which are now included in the Department of Health and Human Services regulations, into the CFR.

The uniform cost principles covered in this course are contained in 2 CFR 200:  Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards. The broader initiative provides a good foundation for streamlining and simplifying the policy framework for grants and agreements.

Four Layers of Regulations Applicable to Each Grant

There are four layers of regulations usually applicable to each federal grant:

  1. Cross-cutting administrative rules (2 CFR 200, Subpart B-D);
  2. Cost principles (2 CFR 200, Subpart E);
  3. Program rules (individual programs rules); and
  4. Individual grant terms and conditions (specific grant terms).

Layer 1: Cross-Cutting Administrative Rules

Cross-cutting administrative rules cover issues such as:

  • Budget revisions,
  • Procurement, and
  • Property standards.

For governmental units and nonprofits, these rules, which differ by type of entity, are set out in 2 CFR 200, Subparts B, C and D.

Layer 2: Cross-Cutting Cost Principles

Cross-cutting cost principles address the general rules for what makes a cost allowable and the rules for specific types of costs. These rules are set out in 2 CFR 200, Subpart E.

Part 200, Subpart E of 2 CFR, does not apply to hospitals, regardless of whether the entity is organized as a governmental organization or as a private nonprofit.  The cost principles for hospitals, which are not the focus of this text, are covered under 45 CFR 75, Appendix IX.

If you work with a for-profit entity (such as a defense contractor), the Federal Acquisition Regulations (known as FAR) apply.

The cost principles in 2 CFR 200, Subpart E “…must be used in determining the allowable costs of work performed by the non-Federal entity under Federal awards.  These principles also must be used by the non-Federal entity as a guide in the pricing of fixed-price contracts and subcontracts where costs are used in determining the appropriate price.[1]

There is one exception. The federal government requires a small number of very large nonprofit organizations to follow the FAR rather than 2 CFR 200, Subpart E[2].  There is a list of these large nonprofits in Appendix VIII to Part 200—Nonprofit Organizations Exempted From Subpart E—Cost Principles of Part 200.

Did you catch all that? CFRs, circulars, and FAR.  I hope the OMB keeps working on making things simpler, don’t you?

Layer 3: Program Rules

Program rules, which differ by federal program, are customarily cited in the grant award. They may conflict with, and override, cross-cutting administrative rules and the cost principles.  That is totally within the rights of the granting agency and makes it loads of fun to keep up with grants from more than one granting agency.

Layer 4: Individual Grant Terms and Conditions

The federal grantor can go one step further than allowing or restricting behavior in the program rules. It can write specific terms and conditions for a grant going to a particular entity.

For instance, if a grantee has a history of violating grant rules, the federal grantor may consider the grantee ”high risk.”  As a result, the grantor can spell out terms for the grantee that other recipients are not required to meet.  Of course, if the grantee objects, it does not have to sign the agreement or take the money.   But once the agreement is signed, the grantee is locked into the terms negotiated with the grantor.

Overview of General Principles & Basic Premises

Below is the basic structure of 2 CFR 200, Subpart E. The full text of Subpart E appears as an attachment to this course.

Subpart E – Cost Principlesis organized as follows:

General Provisions
§200.400 Policy guide.
§200.401 Application.Basic Considerations
§200.402 Composition of costs.
§200.403 Factors affecting allowability of costs.
§200.404 Reasonable costs.
§200.405 Allocable costs.
§200.406 Applicable credits. 
§200.407 Prior written approval (prior approval).
§200.408 Limitation on allowance of costs. 
§200.409 Special considerations. 
§200.410 Collection of unallowable costs. 
§200.411 Adjustment of previously negotiated indirect (F&A) cost rates containing unallowable costs.
Direct and Indirect (F&A) Costs 
§200.412 Classification of costs. 
§200.413 Direct costs. 
§200.414 Indirect (F&A) costs. 
§200.415 Required certifications. Special Considerations for States, Local Governments and Indian Tribes 
§200.416 Cost allocation plans and indirect cost proposals. 
§200.417 Interagency service. Special Considerations for Institutions of Higher Education 
§200.418 Costs incurred by states and local governments.
§200.419 Cost accounting standards and disclosure statement. General Provisions for Selected Items of Cost 
§200.420 Considerations for selected items of cost. 
§200.421 Advertising and public relations. 
§200.422 Advisory councils.
§200.423 Alcoholic beverages. 
§200.424 Alumni/ae activities. 
§200.425 Audit services. 
§200.426 Bad debts.
§200.427 Bonding costs. 
§200.428 Collections of improper payments. 
§200.429 Commencement and convocation costs. 
§200.430 Compensation—personal services. 
§200.431 Compensation—fringe benefits. 
§200.432 Conferences. 
§200.433 Contingency provisions. 
§200.434 Contributions and donations. 
§200.435 Defense and prosecution of criminal and civil proceedings, claims, appeals and patent infringements.
§200.436 Depreciation.
§200.437 Employee health and welfare costs.
§200.438 Entertainment costs. 
§200.439 Equipment and other capital expenditures. 
§200.440 Exchange rates. 
§200.441 Fines, penalties, damages and other settlements. 
§200.442 Fund raising and investment management costs. 
§200.443 Gains and losses on disposition of depreciable assets. 
§200.444 General costs of government. 
§200.445 Goods or services for personal use. 
§200.446 Idle facilities and idle capacity.
§200.447 Insurance and indemnification. 
§200.448 Intellectual property. 
§200.449 Interest. 
§200.450 Lobbying. 
§200.451 Losses on other awards or contracts. 
§200.452 Maintenance and repair costs. 
§200.453 Materials and supplies costs, including costs of computing devices.
§200.454 Memberships, subscriptions, and professional activity costs.
§200.455 Organization costs. 
§200.456 Participant support costs.
§200.457 Plant and security costs
§200.458 Pre-award costs. 
§200.459 Professional service costs.
§200.460 Proposal costs.
§200.461 Publication and printing costs. 
§200.462 Rearrangement and reconversion costs. 
§200.463 Recruiting costs. 
§200.464 Relocation costs of employees. 
§200.465 Rental costs of real property and equipment.
§200.466 Scholarships and student aid costs.
§200.467 Selling and marketing costs.
§200.468 Specialized service facilities.
§200.469 Student activity costs.
§200.470 Taxes (including Value Added Tax).
§200.471 Termination costs. 
§200.472 Training and education costs.
§200.473 Transportation costs. 
§200.474 Travel costs. 
§200.475 Trustees.


While not specifically stated in 2 CFR 200, it is reasonable to conclude that the uniform guidance intends to promote effective program delivery, efficiency, and better relationships between governmental entities and the Federal government in administering (1) grants, (2) cost reimbursement contracts, and (3) other agreements with the federal government.

The cost principles are designed to assure that federal awards bear their fair share of costs except where prohibited or restricted by law or regulation.  For instance, as a condition to receiving a federal award, some grants require that the grantee contribute a share, in either funds (real money) or “in–kind” contributions (goods and services provided by others) to total award expenditures.  Generally, this type of requirement is intended to provide assistance while assuring the grantee’s support for the project.

2 CFR 200, Subpart B General Provisions 
§200.100 Purpose
            (a) (1) This part establishes uniform administrative requirements, cost principles, and audit requirements for Federal awards to non-Federal entities, as described in §200.101 …
            (c)  Cost Principles. Subpart E—Cost Principles of this part establishes principles for determining the allowable costs incurred by non-Federal entities under Federal awards. The principles are for the purpose of cost determination and are not intended to identify the circumstances or dictate the extent of Federal government participation in the financing of a particular program or project. The principles are designed to provide that Federal awards bear their fair share of cost recognized under these principles except where restricted or prohibited by statute. (emphasis added)


In the first few chapters of this portion of the text, we discuss the General Provision, Basic Considerations (§200.402 Composition of costs through §200.417 Cost accounting standards and disclosure statement).  In later chapters, we cover General Provisions for Selected Items of Costand the allowability of these items (§200.420 Considerations for selected items of cost through §200.475 Trustees).

Subpart Eof 2 CFR 200 establishes the general principles and standards for a uniform approach in determining allowable costs incurred by governmental units and nonprofit organizations, respectively, under federal awards.  Although the wording may vary slightly from previous cost standards, the general principles are essentially the same.

To be allowable, a cost must both meet the cost principles and be permissible.  The general cost principles require that costs must be necessary and reasonable, allocable, treated consistently, adequately documented, etc. These criteria are crucial to the overall allowability of award costs.

While specific items of cost (e.g., salary, travel costs, indirect costs) may be permissible under federal rules, they may fail to meet one of the essential general cost principles. When this occurs, the costs are unallowable.  On the whole, far more costs are determined to be unallowable because they fail the general standards than because they fail the specific requirements. Therefore, the general cost principles are of the greatest importance to those administering federal awards.

Metaphorically, the cost principles could be likened to a well-defined property line in that it is necessary to know the boundary (rules) before erecting a building (incurring award costs).

Application of the General Principles

The rules regarding the allowability of costs apply to the total composition of cost, which includes both direct costs and indirect costs.  We discuss direct costs and indirect costs in more depth later in this course.  However, at this point, let us give you a brief definition of each, which you will see again later.

Total Cost:

§200.402 Composition of costs.
Total cost. The total cost of a Federal award is the sum of the allowable direct and allocable indirect costs less any applicable credits.


Direct Costs:
Direct costs are those costs that can be identified with a “final cost objective.”  A final cost objective is a specific activity or function for which the entity wants to know the total costs.  Virtually all federal grants are final cost objectives, as grantees need to know their costs in order to prepare the proper claim forms.  But there may be additional items for which the grantee wants to know the total costs incurred.

 §200.413 Direct costs. 
            (a) General. Direct costs are those costs that can be identified specifically with a particular final cost objective, such as a Federal award, or other internally or externally funded activity, or that can be directly assigned to such activities relatively easily with a high degree of accuracy.  Costs incurred for the same purpose in like circumstances must be treated consistently as either direct or indirect (F&A) costs.


Indirect Costs:
In general, indirect costs are those costs incurred by the grantee organization for a common or joint purpose benefiting more than one project.

§200.56 Indirect (facilities & administrative (F&A)) costs. 
Indirect (F&A) costsmeans those costs incurred for a common or joint purpose benefitting more than one cost objective, and not readily assignable to the cost objectives specifically benefitted, without effort disproportionate to the results achieved. To facilitate equitable distribution of indirect expenses to the cost objectives served, it may be necessary to establish a number of pools of indirect (F&A) costs. Indirect (F&A) cost pools should be distributed to benefitted cost objectives on bases that will produce an equitable result in consideration of relative benefits derived.


For example, if you provide school lunches to low-income children, you incur a variety of costs; some costs are easily traceable to the program and some are not.  Being “direct” indicates that a cost was incurred specifically for this program. Indirect costs are a little more fuzzy, or difficult to trace to a program.

For the school lunch program, the costs of food and the labor involved in cooking and serving the food would generally be considered direct costs.  Let’s say that the cost of food is 40 cents, the cost of labor to cook it is 20 cents, and the cost to serve is 24 cents.  This totals 84 cents of direct costs.

The school district incurs a litany of other costs to make the program work. We call these fuzzier costs “overhead” costs.  With the school lunch program, the administrative staff has to do the paperwork to ensure that the students are qualified to receive the lunches. The accounting department has to compile cost reimbursement paperwork to submit to the grantor.  The janitor has to clean the lunchroom and kitchen.  The electricity bill has to be paid.  The lunchroom monitors must be compensated.  The program has to be marketed or communicated to parents who are eligible for the program.  We could go on and on and on!

If the school district asked the federal grantor to reimburse the district for only 84 cents per lunch per student, the district would be in the hole on this program, which isn’t very fair. In addition to spending the 84 cents for direct costs per school lunch, the district might spend another 49 cents on indirect costs. If the federal government mandates the program, they often (but not always!) pay for the whole program. Instead of paying only 84 cents, the federal grantor would reimburse the district $1.33 per lunch.

Occasionally, I receive comments from people who think that only the direct costs are real costs.  These individuals believe that indirect costs are just a technique to siphon funds away from the real work of the grant.  I usually respond to such comments by asking whether they like the idea of receiving paychecks every couple of weeks, whether they like to have desks on which to work, whether they like having the building heated in the winter, etc.  These are all real costs even though they cannot be directly related to an individual project.

Complexities Involved with Indirect Costs

Management accountants spend much of their careers trying to figure out how to allocate costs to a particular product or service.  The proper way to allocate indirect costs to a product or service often is a bone of contention with these professionals. Some are fans of an intense cost allocation technique called “Activity Based Costing,”[3]and others prefer to use a simple method to spread the costs in the pool among services and programs.

In the example above, how do you treat the salary of the chief accountant of the school district?  Is he directly involved with the school lunch program? No.  But does his administrative work in some way contribute to the operations of the program.  Sure. So what is fair to charge the grantor, and what is not?

The cost principles described in later chapters go into great detail about permissible indirect costs.  But here is what the cost principles do not do.  Neither the Cost Principles for State, Local, and Indian Tribal Governments nor the Cost Principles for Nonprofit Organizations:

  • Identify who will pay for what or that the federal government is mandated to fund a particular program. The extent of federal and organizational participation in financing the award is part of the grant agreement, not the cost principles; or
  • Allow the grantee to build profit into their cost estimates or reimbursement requests.  The grantee should not endeavor to generate profits to support other programs or activities by charging the federal grantor in excess of allowable costs.

Basic Premises

Because the federal grantor is the ultimate steward of the public’s resources, funds cannot be sent to entities that cannot handle them properly.

The rules for governmental units specifically state, “…governmental units are responsible for the efficient and effective administration of Federal awards through the application of sound management practices.”

Thus, the grantee must manage the grant so that the program accomplishes its goals.  The federal government expects the grantee to:

  • Manage efficiently,
  • Administer federal funds in accordance with the following:
  • Applicable underlying agreements,
  • The specific award agreement, and
  • The program’s objectives, and
  • Establish its own organizational structure.

Super High Airfare!

A few years ago, while teaching a class on the cost principles to employees of a U.S. territory, a student raised a question about grant-related travel costs associated with their grant.

This student explained that flights to the U.S. had to be reserved four to six weeks in advance. But, because of the island’s cumbersome administrative process, the tickets might be purchased only a few days before the flight.  Since the tickets were purchased so late, their cost often was more than double the reservation price.

A federal grant representative had warned the employees of the grantee that she might no longer accept the higher flight prices.  The student was troubled by that possibility.

Now, if I were the grant representative, I would have questioned the excessive cost a lot earlier. While it wasn’t the student’s (or his classmates’) fault, and the problem related to the administrative unit within the territory, the grant was not made to the student(s) but to the island itself.  In my opinion, the grant representative acted appropriately since the territory had not complied with the basic requirement for “efficient and effective administration.” Such unreasonable travel costs would be deemed unallowable.

Entity Type Determines Rules

The type of entity of the grantee organization determines which rules the entity must follow. All entities must follow the program-specific rules cited in the award documents and any specific award terms and conditions.  In addition, recipients, except for hospitals, for-profit entities, and certain very large nonprofit entities, must follow the requirements set forth in 2 CFR 200.  In this text, we cover the cost principles for only nonprofit organizations and state and local governments.

Subpart E – Cost Principles
General Provisions
§200.400 Policy guide.
The application of these cost principles is based on the fundamental premises that:
            (a) The non-Federal entity is responsible for the efficient and effective administration of the Federal award through the application of sound management practices.
            (b) The non-Federal entity assumes responsibility for administering Federal funds in a manner consistent with underlying agreements, program objectives, and the terms and conditions of the Federal award.
            (c) The non-Federal entity, in recognition of its own unique combination of staff, facilities, and experience, has the primary responsibility for employing whatever form of sound organization and management techniques may be necessary in order to assure proper and efficient administration of the Federal award.
            (d) The application of these cost principles should require no significant changes in the internal accounting policies and practices of the non-Federal entity.  However, the accounting practices of the non-Federal entity must be consistent with these cost principles and support the accumulation of costs as required by the principles, and must provide for adequate documentation to support costs charged to the Federal award.
            (e) In reviewing, negotiating and approving cost allocation plans or indirect cost proposals, the cognizant agency for indirect costs should generally assure that the non-Federal entity is applying these cost accounting principles on a consistent basis during their review and negotiation of indirect cost proposals. Where wide variations exist in the treatment of a given cost item by the non-Federal entity, the reasonableness and equity of such treatments should    be fully considered.  See §200.56 Indirect (facilities & administrative (F&A)) costs.
            (f)  For non-Federal entities that educate and engage students in research, the dual role of students as both trainees and employees contributing to the completion of Federal awards for research must be recognized in the application of these principles.
            (g) The non-Federal entity may not earn or keep any profit resulting from Federal financial assistance, unless expressly authorized by the terms and conditions of the Federal award. See also §200.307 Program income.

[1]§200.401, Application. (a) General.
[2]§200.401. (c) Exemptions.                   Some nonprofit organizations, because of their size and nature of operations, can be considered to be similar to for-profit entities for the purpose of applicability of cost principles.  
[3]Activity Based Costing (ABC) incorporates many methods of allocating overall costs, such as accounting, depreciation, procurement, etc.

Tone at the Top & Oversight

You say you got a real solution
Well, you know
We’d all love to see the plan

You ask me for a contribution
Well, you know
We’re doing what we can

But if you want money for people with minds that hate
All I can tell is brother you have to wait
Don’t you know it’s gonna be
All right, all right, all right

You say you’ll change the constitution
Well, you know
We all want to change your head

You tell me it’s the institution
Well, you know
You better free you mind instead

But if you go carrying pictures of chairman Mao
You ain’t going to make it with anyone anyhow
Don’t you know it’s gonna be
All right, all right, all right

Revolution: The Beatles

Two of the five principles imbedded in the control environment component of the Green Book remind us that you can layer on all the controls you want, but if your leadership doesn’t care about controls, the controls will not be respected by employees, and the controls will break down.  The risks that you are trying to avoid by implementing controls will eventually occur because the environment of the entity encourages and allows – rather than prevents and corrects – bad behaviors.

Spoiled by Oil

I worked as a federal grants controller for a state agency in Texas for a few years.  Every time we got a new governor, the executive team of this agency was replaced with political appointees.  That worked fine under Governor Ann Richards.  She appointed good executives who had a background in government.  But when George Bush became governor, he appointed a friend of his who had worked with him in Houston in the oil business.  His friend never quite adjusted to the way the state worked and the state’s limits on spending.

In her first month on the job, she replaced all of her office furniture with furniture from the most expensive furniture store in Austin.  She had a driver on call at all times and often had a car sitting outside her office at the ready.  She seldom bothered herself with meetings and the business of the agency because she was bored by the mundane nature of the agency’s goals.  But one of the goals of the agency did intrigue her; the goal to bring business to Texas.

Her predecessor focused on convincing businesses in neighboring states, like Oklahoma and Louisiana, to relocate to Texas and many did.  But our new executive set her sights on the champagne business in France!  This allowed her to travel first class to France, tour wineries, sample bubbly, and hobnob with the vintners.  While in France, she entertained wine industry leaders lavishly, all on the taxpayer’s dime. Yes, this is reasonable and normal behavior when you work for a corporation, but not when you work for government!

Elizabeth, my neighbor in the cubicle farm in the accounting department, refused to process the expense report that resulted from the executive’s first jaunt to France.  I overheard Elizabeth inform the ex-oil exec that she had broken every state travel rule possible.  The executive informed Elizabeth that if she didn’t process that voucher, Elizabeth could pack up her things and leave.  Elizabeth was a single mother with a daughter with a severe learning disability.  She had to keep her job.   So, with tears, Elizabeth submitted the ridiculous, noncompliant expense report for payment.

Next, Roxanne, the budget analyst, told the executive that she was way over budget and informed her that future trips would have to be cancelled.  The executive also threatened Roxanne with termination.  Roxanne stopped complaining and cut someone else’s budget to accommodate the trips to France because she, too, needed her job.

Once word got around that the accounting department no longer had any teeth, other leaders started misbehaving and Elizabeth and Roxanne, two of our strongest controls, were powerless to stop them.

I am not sure exactly how the downfall unfolded, as I ended up leaving the agency myself (voluntarily!),  but the bad behavior of the executive and her team was eventually caught by the Comptroller of Public Accounts, who in turn informed the Legislature of the shenanigans.  When the press got a hold of some juicy tidbits of bad behavior by the agency leadership, the executive team was fired and the Legislature defunded the agency and split it into pieces.   Each piece was given to another state agency that had a track record of compliance with state rules.

Tone at the Top and Oversight

The ex-oil executive’s impact on the agency and the eventual demise of the agency were predicted in the GAO’s Green Book.

First, under Principle #1, Tone at the Top, the Green Book warns that controls will break down when leadership does not set an “1.03 … example that demonstrates the organization’s values, philosophy, and operating style”, and when leadership does not have a “1.04 …commitment to doing what is right, not just maintaining a minimum level of performance necessary to comply with applicable laws and regulations.

And 1.05 says, “Without a strong tone at the top to support an internal control system, the entity’s risk identification may be incomplete, risk responses may be inappropriate, control activities may not be appropriately designed or implemented, information and communication may falter, and the results of monitoring may not be understood or acted upon to remediate deficiencies.”

Under principle #2, Exercise Oversight, the Green Book predicted that the Legislature would eventually break up the agency and fire the executive team:

2.08 … Members of an oversight body scrutinize and question management’s activities, present alternative views, and act when faced with obvious or suspected wrongdoing.

It is almost as if the authors of the COSO model and Green Book have seen these kind of shenanigans before…

Standards of Conduct

Our ex-oil executive did not understand (or care?) that government employees are stewards of the taxpayer’s money and that the taxpayer is never happy when they hear that government employees are enjoying themselves!  One of my clients, a city auditor, forbid her staff from having birthday and holiday celebrations after the local newspaper printed photos of her staff eating at their desks.  The photo’s caption pointed out how wasteful and lazy the auditors were!

Obviously, Texas citizens went nuts when they heard about the champagne fueled trips to France! Maybe the ex-oil executive read the standards of conduct when she signed the mountain of paperwork necessary to become a state employee.  Or maybe the standards weren’t specific enough.  But either way, the GAO points out that standards of conduct are one of the ways to help ensure a healthy tone at the top and throughout the organization:

1.06 Management establishes standards of conduct to communicate expectations concerning integrity and ethical values. The entity uses ethical values to balance the needs and concerns of different stakeholders, such as regulators, employees, and the general public. The standards of conduct guide the directives, attitudes, and behaviors of the organization in achieving the entity’s objectives. 

1.07 Management, with oversight from the oversight body, defines the organization’s expectations of ethical values in the standards of conduct. Management may consider using policies, operating principles, or guidelines to communicate the standards of conduct to the organization. 

Nip bad behavior in the bud!

The GAO goes on to say that there isn’t much point in having a standard of conduct, if you don’t enforce it.  Here is what the Green Book has to say about making sure that bad behavior is identified and remediated:

1.09…To gain assurance that the entity’s standards of conduct are implemented effectively, management evaluates the directives, attitudes, and behaviors of individuals and teams. Evaluations may consist of ongoing monitoring or separate evaluations. Individual personnel can also report issues through reporting lines, such as regular staff meetings, upward feedback processes, a whistle-blowing program, or an ethics hotline. 

1.10 Management determines the tolerance level for deviations. Management may determine that the entity will have zero tolerance for deviations from certain expected standards of conduct, while deviations from others may be addressed with warnings to personnel. Management establishes a process for evaluations of individual and team adherence to standards of conduct that escalates and remediates deviations. 

Sometimes management is not motivated to take action on bad behaviors, possibly because they are complicit in the behaviors.  That is where the oversight body comes in handy:

2.12…The oversight body oversees and provides direction to management on the remediation of these deficiencies. The oversight body also provides direction when a deficiency crosses organizational boundaries or units, or when the interests of management may conflict with remediation efforts. 

Qualifications for the Oversight Body

Governments usually operate under layers of oversight.  Most government entities have boards, and these boards report to a local legislative body which ultimately reports to a federal grantor who reports to Congress.  In some countries, the United Nations acts as an oversight body for the legislative body.  The United States refused to submit itself to this oversight.

The GAO’s Green Book tells us both what an oversight body is supposed to do and who they should be:

2.03 … An oversight body oversees the entity’s operations; provides constructive criticism to management; and where appropriate, makes oversight decisions so that the entity achieves its objectives in alignment with the entity’s integrity and ethical values. 

2.05 Members of an oversight body understand the entity’s objectives, its related risks, and expectations of its stakeholders. 

2.06 … Capabilities expected of all members of an oversight body include integrity and ethical values, leadership, critical thinking, and problem-solving abilities. 

2.07 Further, in determining the number of members of an oversight body, the entity or applicable body considers the need for members of the oversight body to have specialized skills to enable discussion, offer constructive criticism to management, and make appropriate oversight decisions. Some specialized skills may include the following: 

  • Internal control mindset (e.g., professional skepticism and perspectives on approaches for identifying and responding to risks and assessing the effectiveness of the system of internal control) 
  • Programmatic expertise, including knowledge of the entity’s mission, programs, and operational processes (e.g., procurement, human capital, and functional management expertise) 
  • Financial expertise, including financial reporting (e.g., accounting standards and financial reporting requirements and budgetary expertise) 
  • Relevant systems and technology (e.g., understanding critical systems and technology risks and opportunities) 
  • Legal and regulatory expertise (e.g., understanding of applicable laws and regulations) 

What’s next?

The control environment component of the COSO model/Green Book covers five principles.  In this chapter, we covered two: tone at the top and the qualities and roles of an oversight body.  In the next two chapters we will discuss the remaining principles.

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