Integral to Sound Financial Management
(from Maine Townsman, December 1984)
by Robert Reny, Director Financial Management Services
As municipal resources have become increasingly scarce and the financial stability of many communities has been threatened, fiscal responsibility and accountability are now areas of growing concern for both elected and appointed local government officials. These problems can only be addressed through a sound financial management program. A key element in a successful program is the independent audit.
Unfortunately, the role of the independent auditor has not been well understood and their work has not been fully utilized as a management tool by many local governments. Auditors are specialists in investigating, verifying and discovering information about an organization’s finances. Learning how to acquire and use this financial specialty can do much to improve a local government’s efficiency and effectiveness.
The Audit Process
A financial audit is an examination of the financial records of a governmental unit that is conducted in accordance with generally accepted auditing standards. The result of the audit is a report rendered by an independent auditor of how appropriately a government’s financial statements depict its financial condition and results of its operations. An independent audit is one performed by persons not in any way affiliated with the government being audited in order to ensure complete objectivity and professionalism.
The independent auditor’s opinion will usually fall into one of four categories:
1. Unqualified Opinion—The statements present fairly the financial position and results of operations of the government unit on a basis consistent with prior years. This is the so called “clean opinion.”
2. Qualified Opinion—The opinion is similar to the above but with certain exceptions to generally accepted accounting principles which are clearly explained in the opinion.
3. Adverse Opinion—This “bad opinion” states that the financial statements do not fairly present the financial position and the results of operation of the governmental unit. The opinion would include the reasons for the adverse opinion.
4. Disclaimer of Opinion—The auditor cannot render an opinion usually because the financial records are incomplete or the scope of the audit is too restrictive.
In addition to financial audits, auditors often perform compliance audits in which the auditor reviews operations in terms of compliance with various laws and regulations regarding financial operations. Compliance audits have always been a vital part of governmental audits.
Although audits are required by Maine law, there are several more fundamental reasons why a local government should have an independent audit:
· The audit provides a professional opinion of the financial condition of your government unit.
· Audited financial statements provide reliable financial information to evaluate the financial health and stability of your governmental unit.
· The auditor should provide recommendations to strengthen and improve the management and efficiency of your governmental unit.
· The audit will ensure that the local government is in compliance with all applicable legal provisions.
With these very reasons in mind, many communities are now re-evaluating their auditing services and how to best obtain these services.
Involve Elected Officials
Elected officials should involve themselves in the audit process because they hold the ultimate responsibility for the financial operations of their municipalities. Governing a municipality requires management of its financial affairs. Since the independent audit is a key element in overall financial management, municipal officers must participate in the audit process to help them understand and control the financial affairs of their communities.
The nationally recognized accounting firm of Coopers and Lybrand, in its publication entitled The “Municipal Audit—Choice and Opportunity”, feels this involvement important because:
“The municipality’s financial operations and internal controls may be substantially improved as a result of an audit, since auditors are required to report in writing any significant control weaknesses they find, and would normally make recommendations for needed improvements—particularly if municipal officials direct their attention to areas of concern at the outset.
Precisely because the public’s demand for understandable financial information is growing, it is highly desirable—for both the public and municipal officials—that this information be lent credibility by the professional opinion of an independent auditor, intelligently chosen.
By participating in the audit process and gaining insight into the financial operations of the municipality, the municipal officials render an important public service and enhance their ability—and visibility—as public servants.”
It’s also important that the participants in the audit process include elected officials because audit results often have political implications. For example, if a municipality’s records were in such a condition that an audit could not be conducted, people might get concerned to what happened to their municipal funds over the years which could lead to a loss of state or federal assistance. In addition, public officials who do not involve themselves in this process will miss a valuable opportunity to gain insight into their municipality’s financial operations.
The use of audit committees in both private corporations and governmental units throughout the country continues to grow. The Municipal Finance Officers Association (MFOA) conducted a survey in late 1983 that indicated that 25% of the respondents in their national survey had established some form of audit committee. The survey found heavy participation by the audit committees in the selection of independent auditors.
It is recommended that the auditors be selected by an audit committee partially composed of 2 or 3 elected officials preferably with experience in financial matters. In addition, it may be advisable to include the chief administrative officer or financial officer as well as finance or budget committee members and informed citizens such as accountants, bankers, executives and other persons with similar backgrounds. The audit committee should seek the advice of anyone it believes can help, especially people knowledgeable about auditing. The committee can operate as a subcommittee of the governing board.
MFOA lists the following tasks as appropriate for a local government’s audit committee:
· Screen and select an independent auditor on the basis of specific criteria, including qualifications, experience, approach, and local needs;
· Determine the scope of the audit and specify which grants should be reviewed;
· Review the audit plan and identify areas of audit concern and potential problems;
· Review the audit’s progress;
· Review the final results, including the financial statements and the accountants’ report;
· Present to the entire council the financial statements and the report on internal control.
The first function of an audit committee should be to determine what are the municipality’s audit needs and how they can be met. This audit scope, what the auditor is expected to do, should be defined together with the auditor. For instance, the municipality’s needs may include a financial and compliance audit for revenue sharing requirements or other grant programs. The committee may also have to consider the need for accounting and financial advice, the adequacy of controls and security for the municipality’s computer system or service bureau, as well as other areas the auditor may emphasize or review.
The use of an audit committee is an ongoing responsibility, the committee’s work is not completed once the audit scope has been defined and the auditor selected. The committee must stay involved to oversee the preparation of the report, review drafts prior to issuance, maintain liaisons and follow up on any recommendations made by the auditors.
The audit relationship begins with the selection of the auditor and is a continuing relationship throughout the year. The auditor should be engaged by and report to the governing board of the municipality. The auditor is an independent representative of the taxpayer and is expected to report to the public on the financial conduct of management through the governing board. This relationship can be maintained through an audit committee organized as a subcommittee of the governing board. All reports and recommendations must be presented to the governing board for their ultimate consideration.
When selecting an auditor, one important fact should be kept in mind—all audits are not necessarily the same. The quality of the audit can vary considerably from one firm to another depending on the methodology and philosophy of each firm. This is true of all professional services. The trick is to find the one best suited to your municipality and its needs.
The first step in the selection process is to develop appropriate selection criteria. The criteria should assist the committee in determining those auditors that have a basic understanding of municipal operations in general and of your municipality in particular. This understanding of the governmental environment is crucial for the proper conduct of a municipal audit.
The following factors should be included as criteria in selecting an auditor:
Understanding of the Problem. The auditor should be able to demonstrate understanding of the municipality’s requirements and plan for meeting them.
Experience. The prior experience and reputation of the auditor in auditing municipalities. The auditor should provide references that should be checked of its municipal experience.
Staff Qualifications. The skill and experience of the specific persons who will be performing the audit services.
Price. Cost is also an important criteria but must be evaluated in relation to the services provided and the quality of that service.
Methodology. The auditor’s approach to the audit should be logical and consistent with the required tasks and the desired results. This criteria should also include the anticipated timeliness of the audit and the reports.
Cost is generally a function of the effort devoted by the auditor. Such factors as the number of funds or entities to be audited, the extent of computerization, the adequacy of the internal controls and accounting system and the timing of the audit will all affect the cost of the engagement. In evaluating cost, you must attempt to evaluate the quality of service being provided.
Price should never be the only criterion in the auditor selection process. The selection process must also assure audit quality even though audit quality can often be difficult to measure. Price should be considered only in relation to the other criteria, with significant weight assigned to the experience and technical approach of the auditor. Remember that in audit services, you tend to get what you pay for.
With the criteria and their relative importance established, the committee should consider drafting a request for proposals to be sent to prospective auditors. The use of a request for proposals is a formal but comprehensive approach to the auditor selection process.
Request for Proposals
There are a number of ways for municipalities to select an auditor using established criteria but the use of a Request for Proposals (RFP) is probably the most efficient. A RFP ensures that all interested auditors understand exactly what is expected of them, and are presenting their qualifications in a comparable format to ensure proper evaluation of the proposals.
The first general area of concern to be addressed in a RFP is that of providing general information on the municipality and its financial systems. The RFP should identify the municipality’s funds and account groups, summarize its accounting and reporting practices and should describe any special problem areas such as prior audit exceptions. By providing copies of budgets, previous annual reports, etc. the municipality can avoid unnecessarily extensive descriptions of its financial operations in the RFP. If a computer system is used in your municipality, this section should include a description of both the hardware and the software.
The next major area to be covered in a RFP is that of the audit scope. Potential responders need to know what will be expected from them if they are awarded the audit. The scope of the audit to be performed must be clearly defined. At minimum, the RFP should provide answers to the following questions:
· What financial records will be audited?
· What year or years will be audited?
· What type of audit will be performed?
· What is the schedule for completing the audit?
· When are the reports due and how many copies will be required?
· Will there be any areas of special attention such as data processing or cash management?
· What extent will the auditor be required to prepare or assist in the drafting or reproducing of the financial statements?
The third major area of concern in the RFP is that of the general qualifications to be sought in an auditor. Proposers should be asked to set forth their qualifications to conduct the audit so they may be used as a selection criteria in the evaluation process. Information that will be of general value to the municipality include:
· Size of the firm.
· Biographies of key personnel.
· Relevant experience in conducting municipal audits.
· Professional background of the staff that will be assigned to the audit.
· Descriptions of the audit approach and the audit procedures to be used.
· Names, addresses and telephone numbers of persons who may be contacted for reference.
An addition to the three major topics covered, the RFP should also address the evaluation criteria and the rules for submission of the proposals. The audit firms have a right to know what criteria will be used to evaluate their proposals. The municipality should also reserve the right to conduct oral interviews to help in the selection process as well as the right to accept or reject any or all proposals if it feels it is in the best interest of the municipality to do so.
The municipality may also want to explain the extent of the assistance that it will provide the auditor. This assistance can have a significant effect on both the timing and the cost of the audit.
Model drafts of guidelines for the preparation of requests for audit proposals are available from MMA. One was prepared to meet the needs of the small towns in Maine and the others to suit the needs of the larger municipalities in the state.
These drafts can be used to prepare your RFP. The guidelines are stated in general terms so that each municipality will have to tailor the model draft to reflect the specific needs of their municipality. In certain areas, the guidelines are presented as suggestions which may be modified or omitted to reflect your particular needs. By filling in these areas the model drafts could easily be used as is to obtain audit proposals. The model drafts should help both municipalities and auditors improve the entire RFP process.
A good professional relationship should be the goal of any municipality in its dealings with its independent auditors. Effective communications between the municipal officials and the auditors is the key to a successful audit relationship. Such a relationship requires that each party understand each other and the purpose of the relationship.
The municipality should expect the audit firm to provide their services in a professional manner. The staff should be experienced and knowledgeable in auditing techniques and municipal financial operations. The auditor must be completely independent of the municipality in both fact and appearance. This independence is essential in order for the auditor to issue an opinion on the financial statements and to provide guidance on difficult financial problems. The auditor also has the right to expect cooperation in the conduct of the audit and to receive assistance whenever feasible.
As part of the on-going communication process, municipal officials (or audit committee) should meet with the auditors on a regular basis to monitor the entire audit process. Areas of discussion include:
· Audit scope to ensure all areas of concern are addressed.
· Review of the progress of the audit and the audit deadlines.
· Any accounting or auditing problems and their solutions as they arise.
· Review of draft financial statements.
· Review of the auditor’s recommendations and the municipality’s responses.
The municipality should request a formal exit conference before the final release of the audit report is made. Municipal officials and audit supervisors can then discuss the entire audit process and the reports that the auditor will be releasing as well as any problems encountered by either party. Exit conferences help maintain effective communication, provide a check against misunderstandings and avoid surprises that may be contained in the reports.
The auditor’s report of comments and recommendations is a letter containing their observations about any weaknesses found in the municipality’s internal controls—that is, in its methods of safeguarding assets, ensuring accounting accuracy and promoting adherence to municipal policies and legal requirements. This is the type of information that the auditors will obtain during the course of their audit. The letter should also contain the auditor’s recommendations for correcting any problems or weaknesses that were located during the audit process. The report can do much to help a municipality reduce expenditures and improve revenues. Municipalities should specify in their RFPs the scope and content of these “management letters” to help achieve the maximum results from their audit.
The management letter should address the municipality’s systems, operations and procedures. The following questions will illustrate typical issues and areas of concern:
· Is information reported on a timely basis and used for control purposes?
· Are statutes, ordinances, policies and bond requirements being complied with?
· Is there proper segregation of duties consistent with staff limitations?
· Are utilities and other enterprise funds self-sufficient and profitable?
· Can the municipality do anything to improve its credit rating?
· Does the letter identify areas of improvements in operations as well as in internal controls?
· Were prior years’ recommendations addressed? If not, why?
The quality of the management letter will directly reflect the auditor’s skill, the experience and knowledge of municipal financial management. Coopers and Lybrand, in its publication, The Municipal Audit—Choice and Opportunity, insists that the auditor selection process is the key to a good report. “Elected officials, by devoting their skills, energy and time to the task of judicious auditor selection, help ensure that their municipality will get the full benefit of a comprehensive report whose recommendations are practicable.”
Your community should insist that a management letter be prepared by the auditor. The report is the primary means by which the auditor can help a local government improve its financial management and increase its operating efficiency.
Independent audits provide many benefits. There’s much to be gained from a municipal association with professional independent auditors. To receive these benefits, it is the responsibility of the municipal officers to ensure that this valuable management tool is used to the maximum advantage of the municipality.
The key to a successful audit is the auditor selection process. Careful planning and the use of a sound RFP will allow your municipality to select the independent audits that can best meet your needs and provide quality services at a reasonable cost.
An audit can and should do more than simply satisfy a legal requirement. An audit is an excellent management tool. It should be used to serve the financial information needs of your community. If it does not meet these needs, management should ask why.